Mergers Involving Disregarded Entities

Until recently, the IRS offered scant guidance on the tax consequences of mergers involving disregarded entities. Qualified subchapter S subsidiaries (QSubs) are disregarded entities for Federal income tax purposes, but, because they are corporations, state merger laws generally permit them to merge with other corporations. In addition, many states permit mergers between a corporation and a limited liability company (LLC), even though the LLC may be a disregarded entity for Federal tax purposes.

Recently, the Service issued proposed regulations as to whether certain mergers under state or Federal law can be statutory mergers, qualifying as reorganizations under Sec. 368(a)(1)(A) when the transaction involves a disregarded entity. The proposed regulations provide guidance on the tax treatment of a merger of (1) a disregarded entity into an acquiring corporation and (2) a target corporation into a disregarded entity.

Merger of a Disregarded Entity into an Acquiring Corporation

Prop. Regs. Sec. 1.368-2(b)(1) provides that the merger of a disregarded entity into an acquiring corporation is not a statutory merger qualifying as a reorganization under Sec. 368(a)(1)(A), because the owner does not transfer assets (other than those held in the disregarded entity) to the acquiring corporation and it does not cease to exist as a result. The IRS views the merger of a disregarded entity into an acquiring corporation as a divisive transaction, not a transaction in which the assets of the owner and the acquiring corporation are combined. Sec. 355 is the sole means under which divisive transactions can receive tax-free status; Congress specifically requires the liquidation of the acquired corporation in Secs. 368(a)(1)(C) and (D) reorganizations, to prevent them from being used in divisive transactions not satisfying Sec. 355 requirements. Thus, the Service treats the merger as if the owner transferred the disregarded entity's assets to the acquiring corporation in a taxable transaction.

As the IRS points out, although the transaction does not qualify as a tax-free merger, it might qualify for reorganization treatment under Sec. 368(a)(1)(C) or (D), or be structured as a Sec. 351 transaction. From a practical perspective, C and D reorganizations are probably not viable alternatives, because they require an owner of a disregarded entity to transfer substantially all of its assets to the acquirer, leaving the owner to liquidate and distribute its assets to its shareholders. If the owner of a disregarded entity has any other trades or businesses that it wants to continue operating, it could not do so with a C or D reorganization.

Alternatively, a Sec. 351 transfer may be a viable alternative to an A reorganization for transferring a disregarded entity to an acquiring company in a tax-deferred transaction.

Example 1: Corporation A has agreed to acquire D, a disregarded entity, from Corporation T. A forms new subsidiary S to acquire D. A transfers cash to S; T transfers D to S for S voting stock. Because of this transaction, T has exchanged its interest in D for an interest in S, and S owns D.

In Example 1, a significant difference between a Sec. 351 transaction and a merger is that, in the Sec. 351 transaction, T receives stock in the acquirer's subsidiary, while, in a merger, T would receive acquiring company stock. Assuming that substituting the subsidiary stock for the parent's stock is acceptable from a business and economic perspective, a Sec. 351 transaction may be an acceptable tax-free alternative to a Sec. 368(a)(1)(A) reorganization.

Merger of a Target Corporation into a Disregarded Entity

Similarly, Prop. Regs. Sec. 1.368-2(b)(1) provides that the merger of a target corporation into a disregarded entity is not a statutory merger qualifying as a reorganization under Sec. 368(a)(1)(A). The IRS believes that it is inappropriate to treat a state or Federal merger as a statutory merger under Sec. 368(a)(1)(A), because the disregarded entity's owner (the only potential party to a reorganization under Sec. 368(b)) is not a party to the merger transaction.

When the disregarded entity is the acquirer, more flexibility exists to structure the transaction as a C reorganization or a Sec. 351 transfer.

Example 2: Corporation A owns D, a disregarded entity. D agreed to acquire Corporation T's assets in a statutory merger. As part of the transaction, T's shareholders receive an equity interest in D.

In Example 2, because T is merging into a disregarded entity, the transaction does not qualify for tax-free status under Sec. 368(a)(1)(A), and T and its shareholders recognize any gain realized on the transaction.

Example 3: The facts are the same as Example 2, except that, instead of merging into D, T transfers its assets to D and liquidates. Further, instead of an equity interest in D, T's shareholders receive A voting stock.

As a result of this transaction, D owns the assets that T previously owned, and T's shareholders own an equity interest in A. This transaction qualifies as a C reorganization; thus, T and its shareholders can defer any gain realized on the transaction.

Conclusion

When considering the use of a disregarded entity, taxpayers should assess the company's long-term plans in light of the proposed regulations. If the plans involve a tax-free reorganization (either as a means of acquiring a new business or as part of an exit strategy), a tax-free merger is not an option, but a transaction that qualifies as a tax-free C reorganization or a Sec. 351 transfer may work.

From Louis A. Panoutsos, CPA, Oak Brook, IL