IRS Faces "Historical Challenge" with Corporate Reorganization Regulations Charles E. Roberts McGuireWoods LLP Originally published in Tax Notes (October 16, 2001) In the novel 1984, George Orwell describes doublethink as "…the power of holding two contradictory beliefs in one's mind simultaneously, and accepting both of them." But for the fact Orwell wrote this in 1949, one might speculate that he was describing the state of mind a tax adviser must possess when analyzing transactions involving disregarded entities. Certainly one must "think twice" before reaching hard and fast conclusions in this area. A case in point is the proposed amendments to Treasury regulation 1.368-2(b)(1) ("Proposed Regulations") published in the Federal Register on May 16, 2000 that address whether a statutory merger between a corporation and a disregarded entity owned entirely by a single corporation can qualify as a reorganization under section 368(a)(1)(A).1 The Proposed Regulations apply to certain mergers under state or Federal law between two entities, one of which is a corporation and the other of which, for Federal income tax purposes, is disregarded as an entity separate from its owner (e.g., a qualified REIT subsidiary ("qualified REIT Sub"), a qualified S corporation subsidiary ("Q Sub"), or a limited liability company with a single corporate owner ("LLC") that does not elect to be treated as a separate corporation). These entities are hereinafter referred to as Disregarded Entities, and the corporate owner of a Disregarded Entity is hereinafter referred to as the Corporate Owner. Generally, for Federal 1 All section references are to the Internal Revenue Code of 1986, as amended. income tax purposes, all of the assets, liabilities and items of income, deduction and credit of a Disregarded Entity are treated as those of its Corporate Owner. The Proposed Regulations provide guidance on the tax treatment of two types of merger transactions: (1) the merger of a Disregarded Entity into an acquiring corporation, and (2) the merger of a target corporation into a Disregarded Entity. The Proposed Regulations reflect the Treasury's and the IRS' view that neither type of merger is a statutory merger qualifying as a reorganization under section 368(a)(1)(A). The Proposed Regulations do note that such transactions may qualify as a reorganization under subparagraph (C), (D) or (F) of section 368(a)(1) or under section 351. However, those sections impose additional requirements that a taxpayer may or may not be able to satisfy in a particular transaction. At the August 8, 2000 public hearing on the Proposed Regulations, representatives of the IRS and the Treasury Department posed a question that indicates they have been struggling to find a way to grant relief from the rules for qualified REIT Subs and Q Subs, notwithstanding the position they took in the Proposed Regulations. Specifically, the question was: "…should we have different rules depending upon if it's a Q sub or a qualified REIT sub or an LLC?"2 The question sheds some light on the dilemma that the IRS and Treasury face in finalizing the proposed regulations, at least as those regulations would apply to a merger transaction involving the merger of a target corporation into a Disregarded Entity.3 There appears to be no tax policy that would be violated by allowing the merger of a target corporation into a Disregarded Entity to be treated as a reorganization under section 2 See 2000 TNT 164-16 for an unofficial transcript of the public hearing. 3 There has not been much serious disagreement with the view that the merger of a Disregarded Entity into an acquiring corporation should not qualify as a reorganization under section 368(a)(1)(A). 368(a)(1)(A).4 Although structurally the target corporation merges into the Disregarded Entity, because the Disregarded Entity is in fact disregarded for Federal income tax purposes, the target corporation may be seen as merging into the Corporate Owner from a Federal income tax standpoint. Contemporaneously, the target corporation ceases to exist as a result of the merger under both Federal income tax and merger law principles. The risk of a divisive transaction is not present because the merger transaction results in all the assets and liabilities of the target corporation being transferred to the Disregarded Entity. From a Federal income tax standpoint, all the assets and liabilities of the Disregarded Entity are treated as belonging to the Corporate Owner. Consequently, the result from a Federal income tax standpoint is the same as if the Corporate Owner had acquired the assets and liabilities of the target corporation directly as a result of a merger. In fact, if structured slightly differently, there is little doubt that the transaction will qualify under section 368(a)(1)(A). If the target corporation merges directly into the Corporate Owner, that transaction qualifies as a reorganization under section 368(a)(1)(A). The Corporate Owner can then transfer the acquired assets to a Disregarded Entity and the result is the same as if the merger had occurred directly between the target corporation and the Disregarded Entity. Will the Corporate Owner lose its status as a "party to a reorganization" because of the asset transfer? Treas. Reg. 1.368-2(f) provides in relevant part that "…a corporation shall not cease to be a party to the reorganization solely by reason of the fact that part or all of the assets acquired in the reorganization are transferred to a partnership in which the transferor is a partner if the continuity of business enterprise requirement is satisfied." Consequently, it is doubtful that a transfer to a Disregarded Entity would lead to a worse result. In addition, because the 4 Prior to issuing the Proposed Regulations, the IRS had issued a series of private rulings approving the merger of a target corporation with a qualified REIT sub. See PLR 8903074, PLR 9411035 and PLR 9512020. Disregarded Entity must be disregarded, arguably the asset transfer should also be disregarded for Federal income tax purposes. So, for all practical purposes, there never occurs a transfer of assets by Corporate Owner that could jeopardize its status as a party to the reorganization. This structure, however, is not always desirable because it exposes the Corporate Owner to the liabilities of the target corporation, a result that can be avoided if the merger occurs directly with the Disregarded Entity. In addition, denying section 368(a)(1)(A) status to this type of merger transaction opens the door for taxpayers to structure what are essentially reorganization transactions as taxable transactions in order to recognize losses. Under the Proposed Regulations, if the taxpayer wants to receive tax-free treatment under Section 368(a)(1)(A), then the merger must be consummated directly with the Corporate Owner. By contrast, if the taxpayer wants to recognize losses, then the merger would instead be consummated with a Disregarded Entity that is wholly owned by the Corporate Owner. The taxpayer need only make sure that the transaction is also structured to remain outside the coverage of section 368(a)(1)(C), (D) and (F), and section 351. For example, to avoid C reorganization treatment, sufficient cash could be used in the merger to insure that the 80 percent voting stock requirement is not satisfied. So why then do the Proposed Regulations deny reorganization treatment to this transaction under section 368(a)(1)(A)? The answer lies in the historical background of the corporate reorganization statute, which the Treasury alludes to in the preamble to the Proposed Regulations: "Congress added the word 'statutory' in 1934 so that the definition 'will conform more closely to the general requirements of [state or Federal] corporation law.' See H.R. Rep. No. 704, 73rd Cong., 2nd Sess. 14 (1934). Treasury and the IRS believe that it is inappropriate to treat the state or Federal law merger of a target corporation into a Disregarded Entity instead as a statutory merger of the target corporation into the Owner, because the Owner, the only potential party to a reorganization under section 368(b), is not a party to the state or Federal law merger transaction. A reorganization under section 368(a)(1)(A) is a combination of the assets and liabilities of two corporations through a merger under state or Federal law. A merger of a target corporation into a Disregarded Entity differs from a merger of a target corporation into the Owner because the target corporation and the Owner have combined their assets and liabilities only under the Federal tax rules concerning Disregarded Entities, and not under state or Federal merger law, the law on which Congress relied in enacting section 368(a)(1)(A)." Stated in simpler terms, the merger of a target corporation into a Disregarded Entity is not a merger of the target corporation into the Corporate Owner as contemplated by the phrase statutory merger that appears in the statute. Consequently, it should be treated as simply a transfer of assets and liabilities to the Corporate Owner for Federal income tax purposes, not as a statutory merger. The legislative history provides some support for this view. The 1934 legislation was enacted to address a very specific problem in the interpretation of Section 203(h) of the 1926 Act that was highlighted by the Supreme Court and Second Circuit decisions in Pinellas Ice Co.5 and Cortland Specialty Co.6 Under the 1926 Act, tax-free reorganization treatment was available to a target only to the extent that (1) the transaction was pursuant to a plan of reorganization (i.e., a merger or consolidation, including the acquisition by one corporation of substantially all the properties of another corporation), and (2) the consideration for the transaction consisted of "stock or securities" of the acquirer (or another corporate party to the transaction). In each of the cited cases, the target corporation essentially engaged in an asset sale for cash and short-term notes of the acquirer corporation and then relied on a literal reading of the statute to claim "reorganization" treatment. The courts denied tax-free reorganization treatment, concluding that short-term notes are cash equivalents and not the type of "securities" required by the statute. While acknowledging that a merger or consolidation under state law was not required by the statute, the courts concluded that an asset transfer is a reorganization only if the target corporation receives consideration consistent with statutory 5 Pinellas Ice & Cold Storage Co. v. Commissioner, 57 F.2d 188 (5th Cir. 1932), aff'd 287 U.S. 462 (1933). mergers and consolidations (i.e., stock or securities) in order to distinguish the transaction from a sale. These court decisions left open the questions of what type and how much stock or securities would be required to qualify for reorganization treatment. Prior to adopting the 1934 legislation, a subcommittee of the House Ways and Means Committee considered a complete repeal of the reorganization provisions because of its fear that taxpayers might continue to pursue transactions like those addressed in the Pinellas and Cortland decisions, but Treasury opposed the repeal because of concerns that several reorganizations then in progress might generate taxable losses. In response to Treasury's concerns, the Ways and Means Committee proposed a more restrictive definition of reorganization that would have confined it to (1) statutory mergers and consolidations, (2) transfers to a controlled corporation, control being defined as 80 percent ownership, and (3) changes in the capital structure or form of organization. The Senate Finance Committee expressed concern that not all the states had adopted statutes providing for mergers and consolidations, especially mergers involving a corporation of another state, and proposed expanding the definition to permit certain stock-for-stock exchanges and certain asset transfers in exchange solely for the acquirer's voting stock. The Senate Finance Committee also restricted tax-free mergers and consolidations to those specifically provided for under state statutory law, although this was done primarily to exclude from coverage mergers pursuant to private legislation which at the time was a common practice. Congress passed the bill as modified by the Senate Finance Committee. The word "statutory" was expressly added to the statute because it was believed that transactions effected pursuant to state merger and consolidation laws would possess sufficient continuity of proprietary interest to not be tantamount to cash sales. The language in the 6 Cortland Specialty Co. v. Commissioner, 60 F.2d 937 (2d Cir. 1932). legislative history indicates that Congress wished to permit tax-free reorganization treatment only for asset acquisitions "sufficiently similar to mergers and consolidations as to be entitled to similar treatment." Congress was concerned about the use of short-term debt instruments to cash out shareholders of the target corporation on a tax-free basis, and it was searching for a way to distinguish a tax-free reorganization from an asset sale. At that time, with some exceptions, most state merger statutes required that the consideration in a statutory merger include stock or securities of the acquirer, and it was believed that an asset acquisition which complied with state merger requirements would be distinguishable from an outright sale transaction. Unfortunately, the statute has been strictly interpreted as requiring a statutory merger regardless of whether that results in preserving "continuity of interest." Consequently, notwithstanding Congress' primary concern with "continuity of interest," the legislative history does support the view that there must be a statutory merger of corporations in order to qualify for tax-free treatment under section 368(a)(1)(A), and that a combination which does not fit within the statutory merger pattern must qualify under some other provision of the corporate reorganization statute. In other words, it is apparently not enough to have a merger of corporations for Federal income tax purposes. There must also be a statutory merger of corporations under applicable state or federal merger law as Congress intended. Although not clearly indicated in the Proposed Regulations, the IRS and Treasury may think that the statute's legislative history precludes section 368(a)(1)(A) treatment in the circumstances addressed by the Proposed Regulations, and that a legislative solution is required. With this background, one begins to appreciate the dilemma that the IRS and Treasury face in deciding what to do with the Proposed Regulations. Logically, it seems that a Disregarded Entity should be disregarded in these circumstances for Federal income tax purposes. When the Disregarded Entity is disregarded, the "deemed" merger of the target corporation into the Corporate Owner appears to fit neatly within section 368(a)(1)(A). This, however, ignores the statute's legislative history. When Congress said statutory merger in 1934, when it amended the statute, did it intend for a statutory merger to include this type of "deemed" merger? Before answering this question, one must consider that one of the most significant consequences of a statutory merger is that the acquiring corporation assumes liability for the legal obligations of the target. One must also consider that the same statute that authorizes tax- free statutory mergers separately categorizes tax-free stock-for-stock exchanges and asset-for- stock exchanges. Finally, one cannot ignore that Congress later amended the statute to permit triangular mergers, the use of parent stock and drop-downs. Consequently, the legislative history seems to support a narrow reading of the phrase statutory merger insofar as mechanics are concerned. Despite numerous arguments to the contrary,7 the IRS and Treasury face a difficult historical challenge in deciding whether to change their view regarding the merger of a target corporation with a Disregarded Entity. Ironically, because a qualified REIT Sub and a Q Sub are Disregarded Entities, the merger of either with a target corporation cannot qualify as a forward subsidiary merger under section 368(a)(2)(D) which is exactly how it would be classified but for the characterization of the qualified REIT Sub or Q Sub as a Disregarded Entity. As a result the statutory merger requirement that was imposed by Congress in 1934 to insure continuity of interest can now be seen as denying reorganization treatment for transactions where continuity of interest may be indisputably present. One solution might be to treat the Disregarded Entity as a corporation solely for purposes of permitting a forward triangular merger, at least with respect to 7 The comments of the author are presented at 2000 TNT 130-21 and the comments of the National Association of Real Estate Investment Trusts are set forth at 2000 TNT 158-45. qualified REIT Subs and Q Subs. However, forward triangular mergers are not nearly as flexible as reorganizations under section 368(a)(1)(A). In addition, the subsidiary cannot be respected as a corporation under all of the reorganization provisions. For example, the corporate tax attributes of the target under section 381 would have to be inherited by the parent. If the parent must be recognized as the survivor of the merger for Federal income tax purposes, it just makes more sense to acknowledge the parent as a party to the reorganization for purposes of the statutory merger definition. It only increases the doublethink if a Disregarded Entity is to be regarded for some Federal income tax purposes and disregarded for others. Hopefully, the IRS will find a way to do this in the final regulations. However, because the statute's legislative history is the problem, it may take a legislative change to solve the problem.