Mergers of entities and nonentities: the shape of things to come?

• Author: Liquerman, Robert

An emerging trend in recent tax legislation is the treatment of certain entities as nonentities for Federal income tax purposes. Examples of entities subject to such treatment include qualified real estate investment trust (REIT) subsidiaries (QRSs), qualified subchapter S subsidiaries (see Regs. Sec. 1.1361-1 through -6, issued 4/21/98) and single-member limited liability companies. Treating such entities as "nonentities" raises issues on the proper Federal income tax treatment of mergers and other asset transfers by or to such nonentities. The IRS has recently shed some light on these issues in Letter Ruling 9801012, which addresses the merger of a QRS. The letter ruling also discussed some interesting side issues.

A simplified version of the facts of Letter Ruling 9801012 is as follows:

P, a C corporation, owns virtually all of the stock of REIT. REIT owns all of the stock of a QRS (QRS1). QRS1 owns 100% of the stock of another QRS (QRS2). QRS1 and QRS2 are partners in partnership PS. QRS1 and PS have outstanding debt owed to REIT. P forms X (a non-REIT corporation) and transfers cash to X. QRS1 merges into X in exchange for X stock.

The Service ruled that the merger would be treated as a Sec. 351 transfer of assets by REIT to X. The IRS next acknowledged that the merger would cause QRS2 to fail to meet the requirements for QRS status, because X would become the owner of the QRS2 stock-The termination of QRS status would subject QRS2 to Sec. 856(i) (3), which provides that if a QRS corporation ceases to meet the QRS requirements, it will be treated as a new corporation acquiring all of its assets and assuming all of its liabilities from the REIT in exchange for its stock immediately before losing QRS status. In spite of this acknowledgment, the Service relied on Rev. Rul. 70-140, and applied step-transaction principles. As a result, the IRS ruled that the transfer of the stock of QRS2 to X by reason of the merger would be treated as a transfer of...