Tax issues

Proposed Rules Affect Reorganizations Involving Disregarded Entities

Proposed Internal Revenue Service regulations could affect tax planning for mergers involving commercial real estate structures such as real estate investment trusts that use disregarded entities. The proposed regulations will limit the number of reorganizational structures available to corporate taxpayers for strategic tax planning in such mergers and acquisitions.

Disregarded entities, which are entities that are not considered separate from their owners for federal income tax purposes, are an increasingly popular part of business and real estate ownership structures because of their general utility, flexibility, and administrative ease. This especially has been true since 1997 regulations made single-member limited liability company status popular.

The proliferation of disregarded entities, particularly SMLLCs, has raised issues about their federal income tax treatment in the context of transactions traditionally governed by statutes created for plain-vanilla C and S corporations.

Issues regarding disregarded entities include qualified REIT subsidiaries, qualified subchapter S subsidiaries, and SMLLCs in the context of tax-free reorganizations pursuant to Internal Revenue Code Section 368(a).

In response to questions about whether mergers of disregarded entities into acquiring corporations and vice versa can qualify as tax-free reorganizations under Section 368(a)(1)(A), the IRS recently issued proposed regulations (Reg.-106186-98).

Alphabet Reorganizations IRC Section 368(a), which governs tax-free reorganizations, is complex; however, a basic understanding of tax-free reorganizations can shed light on the proposed regulations' implications.

Generally, the IRC allows tax-free reorganization treatment for corporate taxpayers that use certain reorganizational structures that the section defines.

Specifically, IRC Section 368(a)(1) describes seven transactions that qualify as tax-free reorganizations in subparagraphs A through G. The popular name assigned to each form of reorganization corresponds to its respective subparagraph letter.

In addition to certain fundamental prerequisites that apply to all reorganizations, each of the seven structures has its own separate requirements. For example, to qualify as a B reorganization, an acquiring corporation cannot use property other than its own stock - or "boot" - as consideration for the stock of the target. This requirement is unique to the B reorganization.

Conversely, all mergers and acquisitions must meet the "continuity of interest requirement" - which essentially requires that a portion of the shareholders of the transferor corporation continue to hold what they receive from the transferee corporation - to qualify as tax-free.

Accordingly, each merger plan should be approached differently depending on the involved parties' circumstances and overall business objectives.

The A reorganization generally is considered the easiest to qualify for while still achieving some flexibility. Such reorganizations offer several advantages over other types, including allowing substantially all of a target's assets to be transferred to the acquiring corporation, as well as the flexibility to use more boot as consideration for the stock of the target corporation.

An A reorganization is defined as a "statutory merger or consolidation," which means that a statutory merger must be accomplished under the applicable federal or state laws governing such transactions. Taxpayers using A reorganizations also must meet other general merger requirements including that all parties involved in the transaction qualify as parties to a reorganization.

What Qualifies? The proposed regulations address the status for A reorganizations for two merger situations involving disregarded entities.

Merger of a Disregarded Entity Into an Acquiring Corporation. The IRS agrees with most commentators that a merger of a disregarded entity into an acquiring corporation is not a statutory merger qualifying as an A reorganization, stating that the "owner's assets (other than those held in the disregarded entity) are not transferred to the acquiring corporation and the owner does not cease to exist as a result of the state or federal law merger transaction" as required by a strict interpretation of the IRC and the other corresponding authority. However, the proposed regulations go on to say that the transaction can qualify for tax-free treatment for federal income tax purposes as a C, D, or F reorganization if it meets all applicable requirements.

However, the requirements of those reorganizations arguably are more difficult to meet.

Merger of a Target Corporation Into a Disregarded Entity. Regarding whether or not the merger of a target corporation into a disregarded entity should qualify as an A reorganization, two general schools of thought exist.

The first argues that, because the disregarded entity is ignored for federal income tax purposes, the transaction should be treated as a merger of the target into the owner of the disregarded entity. The logic driving this argument is that if the owner of the disregarded entity is a corporation, all other general requirements are met, and the target could have merged into the owner of the disregarded entity in a transaction that qualifies as a reorganization, then the merger should qualify as an A reorganization.

The second position, which includes the IRS stance, argues that the merger of the target corporation into the owner of the disregarded entity does not qualify as a federal or state statutory merger, "because the owner, the only potential party to a reorganization ... is not a party to the state or federal law merger transaction."

Accordingly, the proposed regulations provide that the merger of a target corporation into a disregarded entity cannot qualify for tax-free treatment as an A reorganization.

However, like the merger of a disregarded entity into an acquiring corporation, the proposed regulations indicate that the merger of a target corporation into a disregarded entity can qualify for tax-free treatment for federal income tax purposes as C, D, or F reorganizations if it meets relevant requirements.

Real Estate Planning Implications These positions reverse those that the IRS previously has taken in private-letter rulings which stated that the merger of a REIT into a qualified REIT subsidiary qualifies as an A reorganization.

However, taxpayers should remember that the proposed regulations do indicate that mergers involving disregarded entities can qualify for other types of reorganization treatment. As always, consult with your tax adviser before undertaking any significant transaction.

Steven M. Friedman and Samuel H. Hoppe

Steven M. Friedman is a tax partner and Samuel H. Hoppe is a tax professional in the McLean, Va., office of Ernst & Young. Contact them at (703) 747-1000 or and


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