Temp. Regs. on Mergers Involving Disregarded Entities

The IRS issued Temp. Regs. Sec. 1.368-2T, which addresses mergers involving disregarded entities and generally focuses on limited liability companies. The temporary regulations replace proposed regulations (REG-126485-01), but are consistent with them, each permitting the merger of a target corporation into a disregarded entity of an acquiring corporation to qualify as an A reorganization, if the transaction otherwise meets certain requirements. Although the Service and Treasury are continuing to study comments on the proposed regulations, they issued the temporary regulations to provide immediate guidance. The temporary regulations are effective for transactions occurring after Jan. 24, 2003. This item reviews their basic operating rules, clarifies some of the requirements and examines two of the eight examples.

The Rules

Under the temporary regulations, a corporate merger into a disregarded entity may be treated as a statutory merger (an A reorganization) if two conditions are met. First, according to Temp. Regs. Sec. 1.368-2T(b)(1)(ii)(A), all of the assets and liabilities of each member of a combining unit (i.e., a transferor unit) must become the assets and liabilities of one or more members of the other combining unit (i.e., a transferee unit). Second, under Temp. Regs. Sec. 1.368-2T(b)(1)(ii)(B), the combining entity of each transferor unit must cease its separate legal existence for all purposes. Temp. Regs. Sec. 1.368-2T(b)(1)(i)(B) defines a combining entity as a business entity that is a corporation (as defined in Regs. Sec. 301.7701-2(b)) that is not a disregarded entity. Finally, Temp. Regs. Sec. 1.368-2T(b)(1)(i)(C) defines a combining unit as a combining entity and its disregarded entities.

Clarifications

According to the temporary regulations, the requirement that a transferor combining entity cease its legal existence will be met if it continues to exist for certain limited legal purposes, such as to defend itself against, or bring legal actions for, activities it engaged in before the mergers effective date.

According to Temp. Regs. Sec. 1.368-2T(b)(1)(iii), for transferor units with foreign disregarded entities, the domestic-entity requirement (i.e., that the transferor units assets be held by the transferee units domestic entities after the merger) will not be violated if a foreign disregarded entity is part of a transferor unit and, as a result of a merger of the transferor combining entity, the foreign disregarded entity becomes a disregarded entity of the transferee unit.

The temporary regulations examples clarify certain aspects of the proposed regulations. One of these, Example (8), addresses the all of the assets requirement noted above, pointing out that it does not invoke the more rigid substantially all requirement applicable to certain other reorganizations (e.g., C reorganizations).

Example (8): A target operates two unrelated business, A and B. An acquiring corporation wants to acquire A, but not B. Pursuant to a plan, the target sells B for cash and distributes the proceeds to its shareholders. The target then merges into the acquiring corporation, ceasing to exist as a legal entity.

In Example (8), the transaction satisfies the all-of-the-assets requirement. Thus, the sale and distribution before the merger is essentially ignored in determining whether the merger satisfies the requirement, which would not likely happen in a reorganization subject to the substantially-all-of-the-assets requirement.

Example (3): A transferor unit comprises S corporation S and a qualified subchapter S subsidiary (QSub), Q. S merges into a disregarded entity of a transferee unit. In connection with the merger, Q loses its QSub status and is thereafter treated as a new C corporation.

Consistent with the tax fiction of treating a QSub as a C corporation, Example (3) treats the transaction as if the transferee unit acquired all of the assets of S and Q and then transferred Qs assets to a new corporation under Sec. 368(a)(2)(C). As such, the merger of S into the disregarded entity may qualify as an A reorganization.

Conclusion

The IRS noted in the preamble to the temporary regulations that it is considering further changes, which will address statutory mergers that entail foreign corporations and/or disregarded entities. Thus, the final word on this subject is yet to come.

From Maureen McGetrick, CPA, New York, NY, and Mark A. Schneider, J.D., LL.M., Washington, DC