Merger of Target into Acquiring Corporations SMLLC Is an
A Reorganization

In Letter Ruling 200236005, the IRS held for the first time that the merger of a target into an acquiring corporations wholly owned single-member limited liability company (SMLLC) qualified as a tax-free A reorganization. An SMLLC is the most common type of disregarded entity. Due to the increased use of disregarded entities (especially SMLLCs) in mergers and the fact that some states allow such entities to merge with corporations, the IRS has started to address when and whether such arrangements are Sec. 368(a)(1)(A) tax-free statutory mergers. This item discusses only SMLLCs that do not elect to be classified as corporations for Federal tax purposes.

The Merger Rules

The IRS issued proposed regulations in 2001 on how the merger rules apply to transactions involving disregarded entities. In general, it accepted the idea that a corporation could merge into a disregarded entity and qualify as a statutory merger, but that the merger of a disregarded entity into a corporation would not qualify. Although no public hearings were requested or held, the IRS received numerous written comments and, in response, issued temporary regulations that retain the proposed regulations general framework, with some modifications. Temp. Regs. Sec. 1.368-2T is effective for transactions occurring after Jan. 23, 2003. Taxpayers, however, may apply the rule to transactions occurring before that date in certain situations.

According to the temporary regulations logic, a statutory merger that meets the Sec. 368 terms and conditions is consistent with, for Federal tax purposes, the general treatment of an SMLLC as a division of its owner. Under those regulations, for A reorganization purposes, a statutory merger or consolidation must be effected pursuant to the laws of the U.S., or a state or the District of Columbia. As such, the following events must occur simultaneously under Temp. Regs. Sec. 1.368-2T(b)(1)(ii) at the effective time of the transaction:

1. All of the assets (other than those distributed in the transaction) and liabilities (except to the extent satisfied or discharged in the transaction) of each member of one or more combining units (transferor units) become the assets and liabilities of one or more members of one other combining unit (transferee unit); and

2. The combining entity of each transferor unit ceases its separate legal existence.

Temp. Regs. Sec. 1.368-2T(b)(1)(iv) provides eight examples of how the rules apply when an SMLLC is a party to a merger. This item covers two key examples. In each, Y and Z are domestic corporations. X is a domestic LLC, wholly owned by Y and disregarded as an entity separate from Y for Federal tax purposes.

Example 2: Z, a domestic corporation, merges into X under state W law. Under W law (and at the effective time of the transaction), all of Zs assets and liabilities become Xs assets and liabilities, and Z ceases to exist as a separate legal entity for all purposes. Further, the Z shareholders exchange their Z stock for Y stock. Prior to the transaction, Z is not treated as owning any assets of a disregarded entity for Federal tax purposes.

This transaction meets the requirements of a statutory merger, because:

1. It is effective under state law;

2. All of assets and liabilities of Z, the combining entity and sole member of the transferor unit, become the assets and liabilities of one or more members of the transferee unit, which comprises Y, the combining entity and X, a disregarded entity, whose assets are treated as owned by Y for Federal tax purposes; and

3. Z ceases its separate legal existence for all purposes.

Example 6: The facts are the same as in Example 2, except that X merges into Z under W law. Pursuant to such law and at the effective time of the transaction, all of Xs assets and liabilities (but not Ys assets and liabilities, other than those of X) become Zs assets and liabilities, and Xs separate legal existence ceases for all purposes.

This transaction is not a valid statutory merger, for two reasons:

1. All the assets and liabilities of Y (a transferor unit) do not become the assets and liabilities of one or more members of the transferee unit.

2. Although Xs legal existence ceases to exist, it does not qualify as a combining member.

These conclusions are based on the fact that X is disregarded as an entity separate from Y for Federal tax purposes.

Facts

In Letter Ruling 200236005, a domestic publicly traded corporation (Acquiring) was the common parent of an affiliated group of corporations filing a consolidated return. Acquiring formed a wholly owned domestic SMLLC, treated as a disregarded entity for Federal tax purposes. It planned to merge with another publicly owned domestic corporation (Target) that was the parent of an affiliated group of corporations filing a consolidated return. Targets business was different from Acquirings.

According to the ruling, Target would merge with, and into, the SMLLC (for valid business reasons) under the state General Corporation Law and Limited Liability Company Act, with the SMLLC surviving. The SMLLC would acquire all of Targets assets and assume all of its liabilities. Target shareholders would receive the acquiring corporations common stock (and cash for partial shares) equal in value to the Target shares they would give up in the merger.

Conclusion

This favorable letter ruling is factually comparable to Temp. Regs. Sec. 1.368-2T(b)(1)(iv), Example (2), except that (1) the entities in the ruling file consolidated returns, but those in Example (2) do not; and (2) the SMLLC in the ruling was newly formed, but in Example (2), no indication is given as to when the SMLLC was formed. Despite these differences, the temporary regulations and ruling both reach the conclusion that the merger is a valid A reorganization, as neither of these two differences is relevant.

Letter Ruling 200236005 states that the merger is being done for valid business reasons. It should be easy to meet the business-purpose requirement in this type of merger, as it will reduce income-tax-filing requirements, while providing the SMLLCs parent with liability protection. This type of merger may also reduce state taxes. For instance, New York state and New York City tax on subsidiary capital would be eliminated by merging a target corporation into an SMLLC owned by an acquiring corporation that is the parent corporation, instead of merging the target corporation into the acquiring corporations newly created subsidiary.

According to the ruling, the merger of the SMLLC and the corporation will occur under state General Corporation Law and the Limited Liability Company Act. Because this is a new area, practitioners should consult with corporate counsel to ensure that the merger of the corporation into the SMLLC is effective under state law.

As the IRS has now issued favorable temporary regulations, the merger of corporations into SMLLCs should become much more popular.

From Charles Daniel, CPA, New York, NY