Certain Mergers Involving Disregarded Entities Qualify as A Reorganizations

On Nov. 15, 2001, the IRS issued Prop. Regs. Sec. 1.368-2(b)(1), allowing certain mergers involving disregarded entities to qualify as A reorganizations and partially reversing its previous position that maintained that neither the merger of a disregarded entity into an acquiring corporation nor one of a target corporation into a disregarded entity could qualify as an A reorganization.

The term "disregarded entities" includes qualified real estate investment trust subsidiaries, qualified subchapter S subsidiaries and entities disregarded as separate from their owners for Federal tax purposes under the "check-the-box" regulations.

The underlying premise of the proposed regulations is that an entity disregarded from its owner for Federal tax purposes is a division of that owner. As such, economic and business reality dictate that those divisions be able to acquire target corporations and qualify for nonrecognition treatment under Sec. 368(a)(1)(A), as long as the transaction is pursuant to Federal or state law. Further, a division of a corporation may be transferred to an acquiring corporation; however, that transaction would have to rely on the divisive reorganization provisions to qualify for nonrecognition treatment.

The proposed regulations set two requirements for nonrecognition treatment for transactions involving disregarded entities:

1. All of the assets and liabilities of each member of a combining unit (the transferor unit) become the assets and liabilities of one or more members of another combining unit (the transferee unit) (Prop. Regs. Sec. 1.368-2(b)(1)(ii)(A)).

2. The combining entity of the transferor unit ceases its separate legal existence for all purposes (Prop. Regs. Sec. 1.368-2(b)(1)(ii)(B)).

For purposes of the above language, the regulations introduced the concepts of a "combining entity," defined as a corporation not classified as a disregarded entity (Prop. Regs. Sec. 1.368-2(b)(1)(i)(B)), and a "combining unit," defined as a combining entity and any disregarded entities (Prop. Regs. Sec. 1.368-2(b)(1)(i)(C)).

According to the preamble, the IRS and Treasury did not address the treatment of transactions involving one or more foreign corporations. However, the body of the regulations clearly stated that for nonrecognition treatment of a transaction falling within the scope of the two requirements, all parties must be organized under Federal law, state law or the laws of the District of Columbia.

A set of examples clarifies the application of the proposed regulations in a variety of circumstances, indicating some nuances. In one example, a merger of a target corporation into a disregarded entity of another corporation, in which the target shareholders and the disregarded entity receive each other's stock and the disregarded entity ceases, thereby existing as "disregarded," does not qualify. In the example, a domestic corporation Y owns all the stock of X, which is treated as a disregarded entity. Under state law, an unrelated domestic corporation Z, merges into X in a transaction in which the Z shareholders receive X stock in exchange for their stock, and X ceases to exist as a disregarded entity. In this case, the first requirement is not met, because immediately after the merger, the assets and liabilities of the target do not become the assets and liabilities of one or more members of the transferee unit.

From Alejandro Ruiz de la Cuesta, New York, NY