June 6, 2000
CC:DOM:CORP:R (REG-106186-98)
Room 5226
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20044
RE:
Proposed Amendments to Treasury Regulation 1.368-2(b)(1)
Certain Corporate Reorganizations Involving Disregarded Entities
Dear Sir or Madam:
The following comments relate to the proposed amendments to Treas. Reg. 1.368-2(b)(1)
(the "Proposed Regulations") which address whether a statutory merger between a
corporation and a disregarded entity owned entirely by a single corporation can qualify as
a reorganization under section 368(a)(1)(A).
Specifically, the Proposed Regulations apply to certain mergers under state or Federal
law between two entities, one of which is a corporation and the other of which, for
Federal income tax purposes, is disregarded as an entity separate from its owner (e.g., a
qualified REIT subsidiary, a qualified subchapter S subsidiary, or a limited liability
company with a single corporate owner that does not elect to be treated as a separate
corporation). These entities are hereinafter referred to as Disregarded Entities, and the
corporate owner of a Disregarded Entity is hereinafter referred to as the Corporate
Owner. For Federal income tax purposes, all of the assets, liabilities and items of
income, deduction and credit of a Disregarded Entity are treated as those of its Corporate
Owner.
The Proposed Regulations provide guidance on the tax treatment of two types of merger
transactions: (1) the merger of a Disregarded Entity into an acquiring corporation, and
(2) the merger of a target corporation into a Disregarded Entity. The Proposed
Regulations reflect the Treasury's and the IRS' view that neither type of merger is a
statutory merger qualifying as a reorganization under section 368(a)(1)(A).
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The Merger of a Disregarded Entity into an Acquiring Corporation
I agree with the position taken by the Treasury and the IRS concerning the merger of a
Disregarded Entity into an acquiring corporation. The merger of a Disregarded Entity
into an acquiring corporation is not a statutory merger qualifying as a reorganization
under section 368(a)(1)(A) because the Corporate Owner does not merge into the
acquiring corporation and the Corporate Owner does not cease to exist as a result of the
merger transaction. Unless the Corporate Owner liquidates following the merger, it
continues to exist as a separate taxable entity. If the Corporate Owner has assets other
than the assets held in the Disregarded Entity, not only does the Corporate Owner
continue to exist as a separate taxable entity, but also it is in a position to remain an
operating business. In that case, the merger transaction is a divisive transaction and
should be tested under the rules of 355, 368(a)(1)(C) and 368(a)(1)(D). Consequently, I
agree with the Treasury's and the IRS' conclusion that the merger of a Disregarded Entity
into an acquiring corporation does not qualify as a reorganization under section
368(a)(1)(A).
The Merger of a Target Corporation into a Disregarded Entity
I disagree with the position taken by the Treasury and the IRS concerning the merger of a
target corporation into a Disregarded Entity. The merger of a target corporation into a
Disregarded Entity is a statutory merger because it is effected pursuant to state merger
law, though not state corporate merger law, and it should qualify as a reorganization
under section 368(a)(1)(A) because there is a complete merger or combination of two
corporations under Federal tax law principles as the result of a statutory merger
transaction. The target corporation merges into the Corporate Owner (from a Federal
income tax standpoint) and the target corporation ceases to exist as a result of the merger
(under both Federal income tax and state law principles). The risk of a divisive
transaction is not present because the merger transaction results in all the assets and
liabilities of the target corporation being transferred to the Disregarded Entity. From a
Federal income tax standpoint, all the assets and liabilities of the Disregarded Entity
belong to the Corporate Owner. Consequently, the result from a Federal income tax
standpoint is the same as if the Corporate Owner had acquired the assets and liabilities of
the target corporation directly as a result of a merger.
The explanation for the position taken by the Treasury and the IRS in the Proposed
Regulations is as follows:
Congress added the word "statutory" in 1934 so that the definition "will conform
more closely to the general requirements of [state or Federal] corporation law." See
H.R. Rep. No. 704, 73rd Cong., 2nd Sess. 14 (1934). Treasury and the IRS believe that it
is inappropriate to treat the state or Federal law merger of a target corporation into a
Disregarded Entity instead as a statutory merger of the target corporation into the
Owner, because the Owner, the only potential party to a reorganization under section
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368(b), is not a party to the state or Federal law merger transaction. A reorganization
under section 368(a)(1)(A) is a combination of the assets and liabilities of two
corporations through a merger under state or Federal law. A merger of a target
corporation into a Disregarded Entity differs from a merger of a target corporation into
the Owner because the target corporation and the Owner have combined their assets and
liabilities only under the Federal tax rules concerning Disregarded Entities, and not
under state or Federal merger law, the law on which Congress relied in enacting section
368(a)(1)(A).
While it may be true that Congress added the word "statutory" to the phrase "merger or
consolidation" in 1934 so that the term "reorganization" would "conform more closely to
the general requirements of [state or Federal] corporation law," a review of the legislative
history indicates that Congress was primarily concerned about disguised asset sales, and
not with compliance with statutory merger or consolidation laws for the sake of
compliance.
The 1934 legislation was enacted to address a very specific problem in the interpretation
of Section 203(h) of the 1926 Act that was highlighted by the Supreme Court and Second
Circuit decisions in Pinellas Ice Co.1 and Cortland Specialty Co.2 Under the 1926 Act,
tax-free reorganization treatment was available to a target only to the extent that (1) the
transaction was pursuant to a plan of reorganization (i.e., a merger or consolidation,
including the acquisition by one corporation of … substantially all the properties of
another corporation), and (2) the consideration for the transaction consisted of "stock or
securities" of the acquirer (or another corporate party to the transaction). In each of the
cited cases, the target corporation essentially engaged in an asset sale for cash and shortterm notes of the acquirer corporation and then relied on a literal reading of the statute to
claim "reorganization" treatment. The courts denied tax-free reorganization treatment,
concluding that short-term notes are cash equivalents and not the type of "securities"
required by the statute. While acknowledging that a merger or consolidation under state
law was not required by the statute, the courts concluded that an asset transfer is a
reorganization only if the target corporation receives consideration consistent with
statutory mergers and consolidations (i.e., stock or securities) in order to distinguish the
transaction from a sale. These court decisions left open the questions of what type and
how much stock or securities are required to qualify for reorganization treatment.
Prior to adopting the 1934 legislation, a subcommittee of the House Ways and Means
Committee considered a complete repeal of the reorganization provisions because of its
fear that taxpayers might continue to pursue transactions like those addressed in the
Pinellas and Cortland decisions, but Treasury opposed the repeal because of concerns
that several reorganizations then in progress might generate taxable losses. In response to
Treasury's concerns, the Ways and Means Committee proposed a more restrictive
definition of reorganization that would have confined it to (1) statutory mergers and
1
2
Pinellas Ice & Cold Storage Co. v. Commissioner, 57 F.2d 188 (5th Cir. 1932), aff'd 287 U.S. 462 (1933).
Cortland Specialty Co. v. Commissioner, 60 F.2d 937 (2d Cir. 1932).
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consolidations, (2) transfers to a controlled corporation, control being defined as 80
percent ownership, and (3) changes in the capital structure or form of organization.
The Senate Finance Committee expressed concern that not all the states had adopted
statutes providing for mergers and consolidations, especially mergers involving a
corporation of another state, and proposed expanding the definition to permit certain asset
transfers in exchange solely for the acquirer's voting stock. The Senate Finance
Committee also restricted tax-free mergers and consolidations to those specifically
provided for under state statutory law, but for the purpose of excluding from coverage
mergers pursuant to private legislation, which at the time was a common practice.
Congress passed the bill as modified by the Senate Finance Committee.
The word "statutory" was expressly added to the statute because it was believed that
transactions effected pursuant to state merger and consolidation laws would possess
sufficient continuity of proprietary interest to not be tantamount to cash sales. The
language in the legislative history indicates that Congress wished to permit tax-free
reorganization treatment only for asset acquisitions "sufficiently similar to mergers and
consolidations as to be entitled to similar treatment."3 It should not be concluded,
however, that Congress had any particular concern over whether assets and liabilities
were combined in strict accordance with state merger laws. Rather, Congress was
concerned about the use of short-term debt instruments to cash out shareholders of the
target corporation on a tax-free basis, and it was searching for a way to distinguish a taxfree reorganization from an asset sale. At that time, with some exceptions, most state
merger statutes required that the consideration in a statutory merger include stock or
securities of the acquirer, and it was believed that an asset acquisition which complied
with state merger requirements would be distinguishable from an outright sale
transaction.4
Unfortunately, the statute has been strictly interpreted in accordance with its literal terms
and it is generally accepted that to qualify for section 368(a)(1)(A) status, a merger must
be effected in accordance with state merger law. However, while admittedly not the law,
a merger-like transaction in which stock or securities of the acquiring corporation are
received would accomplish the purpose of the statute in this respect regardless of whether
it was effected pursuant to state merger laws. I am not suggesting that Treasury and the
IRS should permit every "merger-like" transaction to qualify under section 368(a)(1)(A).
However, I do believe that the merger of a target corporation into a Disregarded Entity
presents a strong case for section 368(a)(1)(A) treatment.
Obviously, Congress did not contemplate mergers involving Disregarded Entities when it
enacted the predecessor to section 368(a)(1)(A). However, the legislative record amply
suggests that Congress intended for transactions that are essentially equivalent to
3
H.R. Rep. No. 704, 73rd Cong., 2d Sess. 13 (1934).
For a more complete treatment of the continuity of interest doctrine and its background, see David S.
Miller, The Devolution and Inevitable Extinction of the Continuity of Interest Doctrine, 3 Fla. Tax Rev.
187.
4
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statutory mergers or consolidations to qualify for tax-free reorganization treatment.
Aside from insistence on a strict reading of the statutory language, there is no reason to
deny reorganization treatment under section 368(a)(1)(A) to the merger of a target
corporation with a Disregarded Entity. The fact that assets and liabilities of the target
corporation are absorbed by the Disregarded Entity, and not by the Corporate Owner,
does not change the nature of the target shareholders' investment in the transferred assets.
Moreover, the same result can be achieved as a tax-free merger by restructuring the
transaction.
To illustrate, consider the following. If target corporation merges directly into Corporate
Owner, and that transaction qualifies as a reorganization under section 368(a)(1)(A),
what is to prevent Corporate Owner from then transferring the acquired assets to a
Disregarded Entity? Corporate Owner is disregarded, so there is no transfer of the
acquired assets for Federal income tax purposes. Will Corporate Owner lose its status as
a "party to a reorganization?" Treas. Reg. 1.368-2(f) provides in relevant part that "…a
corporation shall not cease to be a party to the reorganization solely by reason of the fact
that part or all of the assets acquired in the reorganization are transferred to a partnership
in which the transferor is a partner if the continuity of business enterprise requirement is
satisfied." Will a corporation that transfers acquired assets to an entity that, by definition,
is disregarded be treated less favorably than a corporation that transfers acquired assets to
a partnership? Perhaps in the eyes of Treasury and the IRS, but I do not believe that
position can be sustained if challenged.
In the end, the two transactions are identical, yet, under the Treasury's and the IRS' view,
the merger with the Disregarded Entity fails to qualify as a reorganization under section
368(a)(1)(A). While I recognize that form is accorded more than usual importance in the
corporate reorganization area, this is an unwarranted elevation of form over substance.
In addition, denying section 368(a)(1)(A) status to this type of merger transaction opens
the door for taxpayers to structure what are essentially reorganization transactions as
taxable transactions in order to recognize losses. If the taxpayer wants to receive tax-free
treatment under section 368(a)(1)(A), then the merger must be consummated in
accordance with state corporate merger statutes. By contrast, if the taxpayer wants to
recognize losses, then the merger must be consummated with a Disregarded Entity that is
wholly owned by the acquiring corporation. Does this type of distinction serve any
purpose, other than to further a strict reading of the statute?
The Proposed Regulations do not identify any perceived abuse that will be avoided by
denying section 368(a)(1)(A) status to a merger with a Disregarded Entity, and I am
unaware of any abuse that might result from acknowledging section 368(a)(1)(A) status
for this type of transaction.
The explanation given by Treasury and the IRS for disallowing section 368(a)(1)(A)
status to this type of merger transaction does not directly pose the question of remote
continuity, but the stated concern that the Corporate Owner is not a party to the
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reorganization for state law purposes has a familiar ring. As has been noted by
commentators, the decision of the Supreme Court in the Groman5 case that adopted an
overly formalistic and restrictive view of the continuity doctrine has "plagued the
reorganization area with confusion and uncertainties for over a half-century."6
Whether the remote continuity doctrine continues to serve any useful purpose in the
reorganization area is debatable, given the numerous statutory amendments over the years
to counteract the effects of its application. However, it is fairly clear that it serves no
useful purpose in the present context. The remote continuity doctrine is a Federal tax
doctrine, not a state law doctrine. The theory behind the doctrine is that transferors who
receive stock of the transferee corporation's parent do not retain the requisite qualitative
interest in the transferred assets for Federal income tax purposes to qualify for
reorganization treatment. In other words, the interest they receive in the parent
corporation is too remote from their original investment in the assets to qualify as a mere
change in the form of their investment. Clearly, the tax-free reorganization rules do not
contain a blanket prohibition of investment diversification or otherwise it would be
impossible for shareholders to exchange stock of a closely-held corporation for stock of a
publicly-held corporation on a tax-free basis, or to exchange common voting stock for a
mixture of cash and non-voting preferred stock.
Without further debating the point, however, and acknowledging that some vestiges of
the remote continuity doctrine remain, the interposition of a 100 percent controlled
Disregarded Entity between the target corporation's shareholders and the transferred
assets does not materially affect the continuity of their investment in those assets and, for
Federal income tax purposes, should be completely ignored. For that matter, it is not a
three-party transaction for Federal income tax purposes, an essential element present in
all the remote continuity cases. It is a straight two-party merger for Federal income tax
purposes and the remote continuity doctrine should not even be applicable because the
Disregarded Entity must in fact be disregarded for Federal income tax purposes. While it
is true that a Disregarded Entity will be regarded as a separate entity for state law
purposes, no reason has been given why this calls for a different tax result.
If Treasury and the IRS have some pressing concern that Disregarded Entities will be
used to improperly exploit the tax-free reorganization rules, they should articulate that
reason. The only concern that has been expressed is that the statutory merger in this case
does not occur pursuant to the traditional corporate merger laws. As previously
discussed, the addition of "statutory" mergers to the statute in 1934 was a means to an
end, not an end itself. It does not further the advancement of the law in this area to
perpetuate distinctions, which are based on purely formalistic considerations.
Finally, treating the Disregarded Entity as a regarded entity for this limited purpose is
counter-intuitive and inconsistent with the treatment of the Disregarded Entity as a
5
Groman v. Commissioner of Internal Revenue, 302 U.S. 82 (1937).
Boris I. Bittker and James S. Eustice, Federal Income Taxation of Corporations and Shareholders (6th Ed.
1999).
6
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disregarded entity for other tax purposes. This type of inconsistency adds complexity to
the law and serves only to create problems for unsuspecting taxpayers.
Respectfully submitted,
McGuire, Woods, Battle & Boothe LLP
Charles E. Roberts
cer/hs
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