In yet another in a series of F reorganization rulings, the IRS issued Letter Ruling 200701017, holding that the formation of a new corporation, followed by the contribution of S stock and an immediate qualified subchapter S subsidiary (QSub) election, will be treated as an F reorganization (i.e., a mere change in identity, form or place of organization under Sec. 368(a)(1)(F)). The new corporation was created so that the existing one could distribute assets up to the new holding company to protect them from the existing corporation’s potential liabilities. A mere distribution of the assets would have exceeded the accumulated adjustments account and created a taxable distribution of C corporation earnings and profits and, potentially, Sec. 311(b) gain.
Under Prop. Regs. Sec. 1.368-2(m)(1)(i), a mere change occurs if, as a result of a transaction or series of transactions:
1. All the stock of the resulting corporation, including stock issued before the transfer, is issued in respect of the transferring corporation’s stock.
2. There is no change in the corporation’s ownership in the transaction, except a change that has no effect other than that of a redemption of less than all of the corporation’s shares.
3. The transferring corporation completely liquidates in the transaction.
4. The resulting corporation does not hold any property or have any tax attributes (including those specified in Sec. 381(c)) immediately before the transfer.
Prop. Regs. Sec. 1.368-2(m)(1)(ii)(A) allows an exception to the third item above, in that the transferring corporation is not required to legally dissolve. However, the regulation remains in proposed form; Treasury continues to examine the appropriate definition of a “mere change.”
Application of Step-Transaction Doctrine
Prop. Regs. Sec. 1.368-2(m)(3)(i) also adopts historical application of the step-transaction doctrine to F reorganizations, treating a series of related transactions that together result in a mere change as an F reorganization. Further, the fact that an F reorganization occurs within a larger transaction that results in more than a mere change will not cause failure of the otherwise qualifying F reorganization; see Prop. Regs. Sec. 1.368-2(m)(3)(ii). Precedent for this application is found in Rev. Ruls. 2003-48, 96-29, 79-250, 69-516 and 61-156.
These rulings generally discuss application of the step-transaction doctrine to the continuity-of-interest (COI) requirement. In Rev. Rul. 69-516, the Service respected an F reorganization that represented a step in a series of transactions that ultimately resulted in a C reorganization. This ruling is significant, as application of the step-transaction doctrine could have collapsed the entire transaction into a C reorganization; however, the IRS did not rule that the step-transaction doctrine should ignore the F reorganization. In Rev. Rul. 79-250, the Service held that application of the step-transaction doctrine should not cause an F reorganization to fail when it is part of a series of transactions in a larger transaction. Rev. Rul. 96-29 ruled on identical facts as found in Rev. Rul. 79-250; however, in addition to ruling similarly on the facts, it emphasized the unique application of the step-transaction doctrine to F reorganizations. The courts have ruled similarly on the applicability of the step-transaction doctrine to F reorganizations, ruling that such a reorganization is functionally unrelated to other simultaneous or almost-simultaneous transactions; see Reef Corp., 368 F2d 125 (5th Cir. 1966), cert. den.; Aetna Casualty and Surety Co., 568 F2d 811 (2d Cir. 1976); and Casco Products Corp., 49 TC 32 (1967).
Promulgation of the QSub regulations added yet another wrinkle. The preamble states that “the final regulations provide that general principles of tax law, including step transaction, apply to determine the tax consequences of the transactions that include a QSub election”; see TD 8869, 1/21/00. While Treasury did not include an example of a QSub election in conjunction with an F reorganization in the final regulations, it clearly intended the contribution of S stock to a new S corporation to qualify as an F reorganization. Preamble Section 2, “F” Reorganizations During the Transition Period, provides that:
…formation of a new shell S corporation (Newco) by the shareholders of an existing S corporation, followed by the contribution of the stock of the existing S corporation to Newco, coupled with an immediate QSub election for the existing corporation, should be characterized as a reorganization under section 368(a)(1)(F) if all of the other requisites of that section are met.
Regs. Sec. 1.1361-4(a)(5) established a transition period, applicable for QSub elections before 2001, during which the step-transaction doctrine would not apply. However, Treasury concluded in Section 2 that the transition rules were intended to offer relief for taxpayers during this transition period; thus, the step-transaction doctrine continued to apply to F reorganizations, as the result was generally considered taxpayer-favorable.
Why does it matter? If the transaction was not an F reorganization, would it not qualify as a D reorganization (see Regs. Sec. 1.1361-4(a)(2)(ii), Example (3))? If the transaction meets the requirements of both an F and a D reorganization, the F reorganization prevails; see Rev. Rul. 57-276. In that ruling, the holding company was deemed a continuation of the QSub, and the tax year of the S corporation continued; see also Rev. Rul. 64-250. In addition, any existing QSub elections do not terminate; see Rev. Rul. 2004-85. There is also some question as to whether built-in gains tax recognition under Sec. 1374 is restarted following a D reorganization.
Pre- and Post-Reorganization Transactions
While not addressed in Letter Ruling 200701017, qualification as an F reorganization could also be important for pre- and post-reorganization transactions. Neither the COI nor the continuity-of-business-enterprise requirements apply to an F reorganization; see Regs. Sec. 1.368-1(b). Prop. Regs. Sec. 1.368-2(m)(5) shows one such application of this provision in Example (6), in which, immediately following the F reorganization, all of the corporation’s stock is sold; however, the sale does not prevent qualification of the F reorganization. Applying this theory to an S holding company, an F reorganization could provide a number of planning opportunities.
Example: An S corporation target, X Corp., holds not only business assets, but also highly appreciated nonbusiness assets (or unwanted business assets of another division) that it does not intend to sell. Acquirer Y Corp. not only wants a basis step-up in the acquired assets, but also must acquire the X stock to retain certain valuable X contracts and licenses. The common answer to Y’s dilemma is the use of Sec. 338(h)(10). However, in this situation, the Sec. 338(h)(10) transaction will generate significant gain under Sec. 331 on the distribution of the highly appreciated unwanted assets. Could an F reorganization be the answer?
Prior to consummating the acquisition, X implements a holding-company structure and QSub election, becoming a disregarded QSub. At this point, this is a valid F reorganization. If X then distributes the highly appreciated unwanted assets to the holding company, Z, the distribution should be a nonevent for Federal tax purposes.
Following the distribution, Y purchases the QSub stock from Z. This acquisition should be treated as Z’s sale of the QSub’s assets to Y, followed by Y’s contribution of the assets to the target (a newly formed corporation for Federal tax purposes); see Regs. Sec. 1.1361-5(b)(3), Example (9).
The result to Y is no different from an acquisition with a Sec. 338(h)(10) election; however, X avoided gain recognition on the highly appreciated unwanted assets. Does this series of transactions represent an F reorganization, followed by a separately respected sale of assets? If a good corporate business purpose is established, it would appear that it does.
In summary, the interplay of the F reorganization and the disregarded-entity provisions provides numerous planning opportunities to well-informed taxpayers and tax advisers. However, Treasury continues to study the definition of a “mere change”; a letter ruling request remains advisable for taxpayers looking for certainty.