Tax-Free Corporate Reorganizations: IRC Section 368 CPA REG Guide

Tax-Free Corporate Reorganizations Under IRC Section 368

Corporate reorganizations under Section 368 allow corporations to restructure without immediate tax consequences, provided the transaction meets specific statutory and judicial requirements. For CPA REG candidates, reorganizations are one of the most complex and heavily tested corporate tax topics. The Code defines seven types of reorganizations (Types A through G), each with distinct requirements and tax consequences.

Types of Reorganizations

Type A: Statutory Merger or Consolidation

A Type A reorganization is a merger or consolidation effected pursuant to state law (or federal or foreign law). In a merger, one corporation (the target) merges into another (the acquirer), with the target ceasing to exist. In a consolidation, both corporations combine into a new entity. The Type A is the most flexible because there is no statutory requirement regarding the type of consideration used; however, judicial doctrines (continuity of interest and continuity of business enterprise) apply.

Forward and reverse triangular mergers are variants of the Type A. In a forward triangular merger, the target merges into a subsidiary of the acquirer. In a reverse triangular merger, a subsidiary of the acquirer merges into the target, with the target surviving as a subsidiary. The reverse triangular merger requires the target shareholders to exchange at least 80% of the target stock for voting stock of the parent.

Type B: Stock-for-Stock Exchange

A Type B reorganization involves the acquisition of stock of the target corporation solely in exchange for voting stock of the acquiring corporation (or its parent). After the acquisition, the acquirer must hold at least 80% of the target's voting stock and 80% of all other classes of stock. The "solely for voting stock" requirement is extremely strict: no boot (cash or other property) may be used as consideration. Even minor amounts of cash will disqualify the transaction.

Type C: Stock-for-Assets Exchange

A Type C reorganization involves the acquisition of substantially all of the target's assets in exchange for voting stock of the acquiring corporation (or its parent). "Substantially all" generally means at least 90% of fair market value of net assets and 70% of gross assets (under IRS guidelines). Limited boot (up to 20% of the value of the target's assets) is permitted, but liabilities assumed count toward this boot threshold, which often consumes the boot capacity.

Type D: Divisive and Acquisitive

Type D reorganizations come in two forms. An acquisitive Type D involves a transfer of substantially all assets to a controlled corporation, typically in the context of a related-party acquisition. A divisive Type D is used in conjunction with Section 355 (spin-offs, split-offs, and split-ups) to separate a corporation into two or more entities. Divisive reorganizations are commonly tested on the CPA exam.

Type E: Recapitalization

A Type E reorganization is a recapitalization, which is a reshuffling of the capital structure of a single corporation. Examples include exchanging bonds for stock, exchanging preferred stock for common stock, or exchanging stock for bonds (though stock-for-bonds may trigger gain recognition because the bonds are treated as boot).

Type F: Mere Change in Identity, Form, or Place

A Type F reorganization involves a mere change in identity, form, or place of organization. The most common example is reincorporating in a different state. Only one corporation may be involved (a single operating corporation continues in a new form).

Type G: Bankruptcy Reorganization

A Type G reorganization involves a transfer of assets pursuant to a court-approved bankruptcy reorganization plan. Special rules relax some of the requirements that apply to other reorganization types.

Judicial Doctrines

Continuity of Interest (COI)

The target shareholders must receive a substantial equity interest in the acquiring corporation. Under IRS guidelines, at least 40% of the consideration must be stock of the acquirer. Cash, bonds, and other property (boot) can constitute up to 60%.

Continuity of Business Enterprise (COBE)

The acquiring corporation must either continue the target's historic business or use a significant portion of the target's historic business assets in a business. This requirement ensures the reorganization has a genuine business purpose.

Business Purpose

The reorganization must have a legitimate business purpose beyond tax avoidance. A transaction structured solely for tax benefits may be disqualified.

Tax Consequences

• Target shareholders: No gain or loss is recognized on the exchange of stock for stock. Boot received triggers gain recognition to the extent of the boot, characterized as dividend income or capital gain.
• Target corporation: Generally no gain or loss on the transfer of assets. However, if the target distributes boot (non-qualifying property) to its shareholders, it recognizes gain on the distributed property.
• Acquiring corporation: No gain or loss on the issuance of its own stock. Takes a carryover basis in the target's assets.
• Basis: Shareholders take an exchanged basis in the new stock (old basis minus boot received plus gain recognized). The acquiring corporation takes a carryover basis in acquired assets, increased by any gain recognized by the target.

CPA Exam Strategies

• Know the specific requirements for each type (A through G), especially the consideration restrictions for Types B and C.
• Apply the judicial doctrines: continuity of interest (40% stock), continuity of business enterprise, and business purpose.
• Boot received by shareholders triggers gain recognition up to the amount of boot.
• Basis is exchanged for shareholders and carries over for the acquiring corporation.
• Watch for Type D divisive reorganizations paired with Section 355.