Tax free asset protection: killing two birds with one reorganization.

• Author: Langeland, David J.
• Position: Legal Brief

Many entrepreneurs starting a small business do not intend to keep their businesses small. But as corporations grow, their exposure to liabilities often increases as well. Unfortunately, many corporations do not take sufficient steps to shelter their assets from potential liabilities.

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Take, for example, a hypothetical real estate development corporation named Real Co., Inc. Assume that Real Co. owns a parcel of real estate where it conducts business, various pieces of heavy equipment and machinery, and significant cash reserves from a recent sale of a developed property. Let's further assume that Real Co. employs a driver to pick up and deliver supplies. While out on an assignment, the driver causes an accident on the freeway involving several other vehicles. Because Real Co. owns all of its assets, these assets are all subject to potential liability

While waiting until after the accident may be too late, how could Real Co. have transferred its assets to affiliate entities in order to protect its assets from potential liability without incurring a significant tax burden resulting from the asset transfer? The solution lies within the federal tax code.

Tax-free Reorganization

Section 368(a)(1)(F) of the Internal Revenue Code provides a tax-free mechanism to reorganize a corporation in a manner that will enable the corporation to shield some of its assets from the liabilities associated with the corporation's business or even other assets. A reorganization under this section, termed an F reorganization, is simply "a mere change in identity, form, or place of organization of one corporation, however effected."

The specific mechanics of this type of reorganization depend on whether the corporation is a C corporation or S corporation. Because the steps are similar in each case, no distinction will be made here.

In the above illustration, Real Co. must form a new corporation, New Parent Co., Inc., to be a holding company for the entire business. The shareholders of Real Co. then transfer their shares of Real Co. to New Parent Co. to form a parent-subsidiary relationship. Real Co. will continue functioning as the operating company. Once this initial structure is properly formed, New Parent Co. must create various disregarded entities to be subsidiaries of New Parent Co. Each of these subsidiaries will be used to hold the various groups of assets of the company. For example, one subsidiary will own the real estate, another...