New rules for qualifying a transaction as a statutory merger or consolidation under section 368(a) (1) (A) of the Internal Revenue Code.

• Author: Fienberg, Jeffrey B.

Section 368(a)(1)(A) of the Internal Revenue Code (1) provides that a statutory merger or consolidation qualifies as a reorganization. In a merger, one corporation acquires the assets and liabilities of another corporation that ceases to exist after the merger. In contrast, a consolidation occurs when two or more corporations combine to form a new corporation. (2) Generally, if a transaction qualifies as a statutory merger or consolidation and certain additional conditions are satisfied, gain or loss is not recognized for federal income tax purposes.

The Internal Revenue Code does not explain when a transaction qualifies as a statutory merger or consolidation. Instead, regulations promulgated under [section] 368 give guidance relative to making that determination. (3) Until recently, those regulations provided that a merger or consolidation must comply with the "corporation laws of the United States or a State or Territory or the District of Columbia." (4) Despite this broad language, it was not clear whether a transaction between a target corporation and a disregarded entity of an acquiring corporation would qualify under [section] 368(a)(1)(A).

The Internal Revenue Service and Department of the Treasury issued temporary regulations under [section] 368 on January 24, 2003, that clarify which types of transactions qualify as statutory mergers or consolidations under [section] 368(a)(1)(A). (5) Under the temporary regulations, [section] 368(a)(1)(A) may be satisfied if a target corporation merges, or consolidates, with an acquiring corporation or a disregarded entity of an acquiring corporation. (6) This conclusion is consistent with proposed regulations that were issued in November 2001. (7)

Accordingly, in a merger between a target corporation and a disregarded entity of an acquiring corporation, the acquiring corporation will obtain the tax benefits of the merger, and the disregarded entity will receive the detriments (i.e., the liabilities of the target corporation). Hence, because [section] 368(a)(1)(A) contains the least restrictive criteria of the tax-free reorganization provisions, taxpayers will be more inclined to engage in those types of reorganizations.

Section 1.368-2T Requirements & Examples

The temporary regulations contain two rules that explain when a transaction qualifies as a statutory merger or consolidation. Each rule is discussed below.

* The First Rule: The General Rule for Statutory Mergers or Consolidations

The first rule is described in [section] 1.368-2T(b)(1)(ii) of the temporary regulations. This article refers to that rule as the "general rule."

The general rule considers whether a transaction qualifies as a statutory merger under [section] 368(a)(1)(A) when a target corporation (in a state law merger) transfers its assets and liabilities, and the assets and liabilities attributed to any disregarded entity that the target owns, to an acquiring corporation or any disregarded entity that the acquiring corporation owns. Additionally, the general rule applies to a consolidation. (8)

A corporation is defined in the temporary regulations by reference to [section] 301.7701-2(b) of the Treasury Regulations. (9) That regulation provides eight different definitions for a corporation. (10) For the purpose of this article, only the first definition is relevant. Under that definition, an entity is a corporation if a statute so provides. (11)

A disregarded entity is a business entity (12) that is not treated as an entity that is separate from its owner for federal income tax purposes. (13) The temporary regulations list three examples of disregarded entities. (14)

A domestic limited liability company (LLC) that has one owner and that is not classified as a corporation for federal income tax purposes is the first example. (15) State law imposes the requirements for the formation of an LLC. (16) For example, Florida law provides that one or more persons may form an LLC. (17) Under Florida law, the definition of a "person" includes not only an individual, but an entity (18) such as a corporation. (19) Accordingly, Florida law provides that a corporation may own an LLC.

A qualified real estate investment trust subsidiary (QRS) that is a corporation is the second example. (20) A corporation is a QRS if 100 percent of its stock is owned by a real estate investment trust (REIT) that does not elect to treat its subsidiary as a taxable entity. (21) All of the assets, liabilities, and items of income, deduction mud credit of a QRS are treated as items that belong to the REIT. (22)

A qualified subchapter S subsidiary (QSub) is the third example. (23) A QSub is a corporation that is a wholly owned subsidiary of a subchapter S corporation that elects to treat the subsidiary as a QSub. (24) A QSub cannot be an ineligible corporation for purposes of subchapter S. (25) All of the assets, liabilities, and items of income, deduction and credit of a QSub are treated as items that belong to the subchapter S corporation. (26)

1. The Four Requirements.

   The general rule (of the temporary regulations) imposes the four requirements described below. A taxpayer must satisfy the "all assets/liabilities test" and ceasing to exist requirements simultaneously. (27)

   1) The Law Requirement. The general rule provides that a statutory merger or consolidation is a transaction that is effected pursuant to either the "laws" of...