Not every company that goes public enters into an initial public offering (IPO). When it is not a priority to accomplish the fundraising of an IPO, a common way that companies go public is through a "reverse merger" into a public shell corporation.
In a reverse merger, a private corporation (the transferor corporation) is merged into an existing public shell corporation (the resulting corporation) with the public shell corporation surviving. This is often described as the minnow swallowing the whale. The public shell corporation may be the gutted shell of a former public corporation that took its business private or may be an entity that never had an operating business and was formed solely to be a shell that reports to the SEC. Nonetheless, a reverse merger is generally a cheaper and faster process for going public than the more traditional IPO.
A company that uses a reverse merger to go public generally would like to structure the merger as a tax-free reorganization under Sec. 368 to reduce its income taxes. There are a few advantages to a tax-free reorganization under Sec. 368(a)(1)(F), commonly referred to as an "F reorganization," compared to the other tax-free reorganizations listed under Sec. 368, notably that an F reorganization does not close the tax year of the transferor corporation and that losses incurred following the F reorganization can be carried back to pre-reorganization years (Sec. 381(b) and Regs. Sec. 1.381(b)-1(a)(2)). In addition, the resulting corporation inherits the employer identification number of the transferor corporation in an F reorganization (Rev. Rul. 73-526). On Sept. 21, the IRS issued final regulations (T.D. 9739) describing six requirements for a transaction to qualify as an F reorganization (the final regulations).
F Reorganization Definition
An F reorganization is defined as "a mere change in identity, form, or place of organization of one corporation, however effected" (Sec. 368(a)(1)(F)). The final regulations clarify that this includes only transactions whereby: (1) The resulting corporation stock is distributed in exchange for transferor corporation stock; (2) the same person or persons own all the transferor corporation stock immediately before the transaction and all the resulting corporation stock immediately after the transaction; (3) the resulting corporation has no prior assets or attributes; (4) the transferor corporation liquidates; (5) the resulting corporation is the only acquiring corporation; and (6) the transferor corporation is the only acquired corporation.
"One Corporation" Requirement
Although the statutory definition of an F reorganization requires only "one corporation," it does not preclude the use of more than one entity to consummate the reorganization. As such, a corporation may generally merge into a newly formed corporation in a transaction qualifying as an F reorganization. However, as discussed in the explanation to the final regulations, the "one corporation" requirement has generally sought to preclude a transaction from qualifying as an F reorganization when the resulting corporation has "preexisting activities or tax attributes." When viewed together, the six requirements in the final regulations ensure that an F reorganization involves only one corporation at the beginning and end of the process.
Under the first requirement of the final regulations, all of the stock of the resulting corporation must be distributed (or deemed distributed) in exchange for stock of the transferor corporation. An exception allows for a de minimis amount of stock to be issued by the resulting corporation to facilitate its organization or maintain its legal existence. This exception is discussed in Example 3 of the final regulations, whereby the stock of the resulting corporation issued before the F reorganization makes up 1% or less of the stock in the resulting corporation after the transaction, with the other 99% held by the shareholders of the transferor corporation. The issuance of the stock to the 1% shareholders would not cause the transaction to be disqualified as an F reorganization. Under the second requirement of the final regulations, the ownership of the transferor corporation and resulting corporation immediately before and immediately after the F reorganization must be identical, but the same de minimis exception in the first requirement applies to the second requirement.
Under the third requirement of the final regulations, the resulting corporation may not hold any property or have any tax attributes immediately before the F reorganization, including those attributes specified in Sec. 381(c). This requirement, however, is not violated if the resulting corporation holds or has held a de minimis amount of assets (and tax attributes related to holding those assets) to facilitate its organization or maintain its legal existence. However, no examples are provided in the final regulations regarding how the exception might work in this requirement. Accordingly, there is no apparent 1% rule regarding the transferee's assets or attributes in relation to the transferor or an indication of temporal requirements for the transferee. While these sorts of 1% exceptions abounded in private letter rulings in the past, the IRS later decided to limit letter rulings on which transactions would qualify as F reorganizations (Rev. Proc. 77-37 and Rev. Proc. 91-3).
F Reorganizations and Reverse Mergers
Typically, the public shell corporation in a reverse merger is held by a third party to the company that wants to take the back door into public filing and trading. This may cause difficulty in ensuring that the reverse merger qualifies as an F reorganization.
For example, any stock issued before a reverse merger, and any stock held by the historic shareholders of the resulting corporation, may prevent the reverse merger from meeting the first and second requirements of the final regulations. Taxpayers may be able to resolve this problem by issuing enough stock of the resulting corporation in the reverse merger to preexisting shareholders of the transferor corporation to ensure that the de minimis exceptions apply.
The third requirement of the final regulations, however, may be harder to meet if the public shell corporation had any historic assets or attributes that have been gutted before the reverse merger. Although nothing in the final regulations specifically excludes the use of a resulting corporation that had historic activities, the explanation to the final regulations states that F reorganization treatment generally does not apply to resulting corporations with "preexisting activities." However, when a public shell corporation has no historic business activity or assets, a tax adviser may be sufficiently confident that the reverse merger can meet the third requirement of the final regulations.
Many firms can help find a public shell corporation that can create a quick market maker for a company's shares or a back door to public reporting. Finding the right shell corporation to fit a company's tax profile can be tricky, but a skilled tax adviser can achieve an optimal outcome. As with many kinds of corporate life events, the tax consequences may dictate the form of the transaction. An F reorganization may be one step in a long process of restructuring involved in the transaction, but if timed appropriately, it can have a substantial effect on filing requirements and the ability to use carrybacks that may be generated by planned investments in operations. Finally, even if the reverse merger fails to qualify as an F reorganization, it may qualify as another type of tax-free reorganization.
EditorNotes
Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.
