Treatment of intercompany debt in a reorganization.

• Author: Tansey, Jim

Suppose Corporation B lends $25,000 to Corporation A. Later, A and B merge under state law, in a transaction that qualifies as an A reorganization. In the merger, B obtains all of A's assets and assumes A's $25,000 debt. B cannot owe itself money; therefore, the debt is extinguished. As a result, will A have to realize the extinguishment of the debt as cancellation of debt (COD) income? Will B have any tax consequences? The answers to these questions can be surprising and can vary depending on whether the transaction also qualifies as a D reorganization or occurs between members of a consolidated group.

As a base case, suppose the two corporations do not join in filing a consolidated return and the merger of A and B does not qualify as a D reorganization. A similar situation was addressed in Rev. Rul. 72-464. That ruling involved Corporation X, which acquired $25,000 face amount of notes from (then-unrelated) Corporation Y for $20,000. Later, in an unrelated transaction, Y merged into X in a transaction that qualified as an A reorganization. By operation of state merger law, X received all of Y's assets and assumed all of Y's liabilities, including the notes (which were worth $25,000 at the time of the merger). The IRS considered whether X or Y would recognize income as a result of an extinguishment of the notes.

Under Sec. 361(a), a corporation that is a party to a reorganization will not recognize gain or loss if it exchanges its properties solely for stock or securities of a second corporation that is also a party to the reorganization. Sec. 357(a) extends the Sec. 361(a) nonrecognition provisions to include assumptions of the transferring corporation's debt by the transferee corporation. In Rev. Rul. 72-464, the IRS questioned whether Y's transfer of its assets to X should be viewed as a transfer in settlement of its debt to X, and if so, whether that transfer could fall outside of Sec. 361.

To determine whether the extinguishment of Y's debt to X in the merger should be part of the merger (and therefore protected under Sec. 361), the IRS looked to Kniffen, 39 TC 553 (1962). Kniffen was engaged in a real estate business through a sole proprietorship. Through his proprietorship, he owed approximately $45,000 to a controlled corporation. Kniffen transferred the assets of his sole proprietorship, which had a basis of approximately $286,000, to the controlled corporation in a Sec. 351 transaction. The controlled corporation assumed...