IRS Applies Reverse Acquisition Regulations: A Substance-over-Form Approach

By Bart Stratton, CPA, and Janine De Gregorio, CPA, Washington, DC

Editor: Annette B. Smith, CPA

Consolidated Returns

Determining whether a transaction is characterized as a reverse acquisition under the consolidated return regulations can be challenging. The IRS has recently interpreted the reverse acquisition rules broadly and has issued private letter rulings applying a substance-over-form approach to transactions that may not fit within the literal definition of a reverse acquisition in Regs. Sec. 1.1502-75(d)(3). This item focuses on tax implications of reverse acquisitions and reviews recent private letter rulings in which the IRS applied substance-over-form principles.

Reverse Acquisition Rules

Generally, a reverse acquisition occurs when a larger corporate group or corporation (by reference to fair market value) is acquired by a member of a smaller group or corporation. The IRS developed the reverse acquisition rules in 1966 to prevent taxpayers from manipulating the effects of the consolidated return regulations. Prior to these rules, a taxpayer could choose which consolidated group terminated by having that group be the target in the acquisition.

The reverse acquisition rules generally look to the substance of the transaction and recharacterize the transaction so that the larger group is treated as continuing to exist. The reverse acquisition rules provide guidance on identifying the group that continues to exist for purposes of filing a consolidated return (Regs. Sec. 1.1502-75(d)(3)(i)), carrying over a loss (Regs. Sec. 1.1502-75(d)(3)(v)(b)), determining the group’s accounting period (Regs. Sec. 1.1502-75(d)(3)(v)), and indicating the losses and other tax attributes that may be subject to the separate return limitation year rules (Regs. Sec. 1.1502-1(f)(3)).

Under Regs. Sec. 1.1502-75(d)(3)(i), a reverse acquisition occurs if:

  • One corporation acquires the stock or substantially all the assets of another corporation (the target);
  • As a result of the acquisition, the target becomes a member of the consolidated group of which the acquirer is the common parent; and
  • Immediately after the acquisition, the target’s shareholders have a controlling interest (i.e., more than 50% of the fair market value) of the outstanding stock (including preferred stock) of the acquirer as a result of owning the target’s stock.

If a transaction qualifies as a reverse acquisition, the acquirer’s group terminates its existence as of the close of the date of the acquisition, and the target’s group continues to exist and files a consolidated return with the acquirer as the new common parent of the combined group.

A reverse acquisition may result from a variety of tax-free transactions (e.g., a Sec. 351 exchange or Sec. 368(a) reorganization) as well as taxable transactions (e.g., a sale or exchange). However, the target’s shareholders must receive a sufficient amount of stock in the acquirer to be in control of that acquirer after the acquisition.

Example: A Corp., a foreign entity, owns P and T consolidated groups. The stock of P, the common parent of the P group, is worth $80, and the stock of T, the common parent of the T group, is worth $100. In year 1, A contributes all the T stock to P in exchange for P shares in a Sec. 351 transfer. Both because the value of the T group is greater than the value of the P group and because A receives a greater than 50% interest in P as a result of its contribution of its T shares, a reverse acquisition has occurred. As a result, the P group is treated as ceasing to exist at the end of the day on the acquisition date, and the T group is treated as remaining in existence, with P becoming the common parent of the combined P and T groups.

IRS Guidance

Aside from the issue of which group or corporation survives, a reverse acquisition also affects other consolidated return issues, such as the application of the separate return limitation year rules, stock basis adjustments under Regs. Sec. 1.1502-31, earnings and profits adjustments under Regs. Sec. 1.1502-33(f), and tax return filings and elections.

Consistent with the substance-over-form concept of the reverse acquisition rules, the IRS has advocated analyzing the underlying substance of Regs. Secs. 1.1502-75(d)(2) and (3) rather than the literal language. For instance, in Rev. Rul. 82-152, P, the common parent of an affiliated group that included S, a wholly owned subsidiary of P, and T, a wholly owned subsidiary of S, entered into a transaction in which T merged with and into P, with P surviving the merger, and the former P shareholders exchanged all their P stock for S stock. The S stock owned by P was canceled. As a result of this transaction, P became a first-tier subsidiary of S.

While acknowledging that the transaction did not fit the description of either an acquisition of assets by a subsidiary under Regs. Sec. 1.1502-75(d)(2)(ii) (which applies only to situations in which the common parent ceases to exist) or a reverse acquisition under Regs. Sec. 1.1502-75(d)(3) (which applies only to situations in which the acquiring and acquired corporations were not affiliated prior to the transaction), the IRS ruled that the merger of the second-tier subsidiary with and into the common parent of the affiliated group did not cause the termination of the affiliated group. Instead, the IRS held that because the transaction was indistinguishable in substance from the transaction described in Regs. Sec. 1.1502-75(d)(2)(ii), the transaction should not result in a termination of the P group.

The IRS has continued to take this approach in private letter rulings. In Letter Ruling 200744006, P, which was wholly owned by a partnership (LLC1), was the common parent of an affiliated group that filed a consolidated return. The P stock constituted more than 50% of the fair market value of the LLC1 assets. LLC1 formed T, a corporation, and T formed LLC2, a limited liability company that was wholly owned by T. LLC2 merged with and into LLC1, which survived. Because the P stock constituted more than 50% of the fair market value of LLC1’s assets, the IRS ruled that more than 50% of T stock was acquired by reason of the transitory, deemed ownership of P by the shareholders of LLC1. Thus, the IRS ruled that the transaction was a reverse acquisition and that the former parent group remained in existence with T as the new common parent.

In Letter Ruling 200905001, Distributing, a publicly traded foreign corporation, formed Newco, which in turn formed Merger Sub. Merger Sub merged into Distributing in a reverse subsidiary merger in which Distributing became a wholly owned subsidiary of Newco (the merger). Subsequently, Distributing spun off the stock of Controlled, a parent of a consolidated group, to Newco in a Sec. 355 transaction. After the merger, the old foreign parent company (Distributing) was interposed between two U.S. corporations (Newco and Controlled).

After the spin-off, Distributing and all its foreign subsidiaries were held by the Controlled consolidated group with Newco as the new common parent, thereby increasing the overall value of the Controlled consolidated group. Notwithstanding the insertion of a foreign entity into the consolidated group, the economic change in the group, and the failure to meet the exact requirements of either Regs. Sec. 1.1502-75(d)(2)(ii) or (3), the IRS ruled that the formation of Merger Sub followed by the reverse subsidiary merger qualified as a Sec. 368(a)(1)(B) tax-free reorganization, and the Controlled consolidated group continued with Newco as the new common parent.


The guidance described above indicates that taxpayers should not assume that the reverse acquisition regulations apply only to those transactions that satisfy the literal language of the regulations. Instead, taxpayers should consider whether the reverse acquisition rules might apply to any transaction that results in a change in an acquiring corporation’s shareholdings of more than or equal to 50%, when such stock is used as consideration for acquiring a target’s stock or assets, and whether a private letter ruling might be available.


Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, DC.

For additional information about these items, contact Ms. Smith at (202) 414-1048 or

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.

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