IRC Sec 361: Corporate Nonrecognition in a Reorganization

Internal Revenue Code (IRC) Section 361 governs the tax consequences for a corporation that transfers its assets as part of a corporate reorganization. The transfer of appreciated property is normally a taxable event, but Section 361 provides an exception. It allows the target, or transferor, corporation to avoid immediate taxation, which facilitates these complex transactions.

This tax treatment is based on the principle that the transaction is a continuation of the business in a modified form, not a final sale. This deferral ensures that capital remains available for business activities instead of being used for taxes. This rule only applies if the transaction qualifies as a “reorganization” under the tax code, ensuring only specific transactions receive this benefit.

The Core Nonrecognition Rule for Asset Transfers

Section 361(a) states that a corporation recognizes no gain or loss when it exchanges property for stock or securities in another corporation, provided both entities are parties to a qualifying reorganization and the exchange occurs pursuant to a plan of reorganization. This nonrecognition applies to the transferor corporation—the company selling or merging its operations. The logic behind this rule is that the transferor is changing the form of its investment, swapping direct ownership of assets for an indirect ownership interest through the stock of the acquiring company.

Proposed 2025 Treasury regulations introduced more stringent requirements for the “plan of reorganization.” If finalized, these rules would mandate a single document specifying all parties, the sequence of transactions, assumed liabilities, the business purpose for each step, and the intended tax outcomes. The entities involved must also qualify as a “party to a reorganization,” a term defined in the tax code to include the acquiring and target companies.

Consider an example where Corporation T, the target, agrees to be acquired by Corporation P, the acquirer. Corporation T transfers all of its business assets, such as buildings and equipment that have increased in value, to Corporation P. In return, Corporation P issues its own voting stock to Corporation T. Under Section 361(a), Corporation T is shielded from recognizing any taxable gain on the built-in appreciation of the assets it transferred.

This provision is limited to the exchange of property solely for stock or securities. The term “securities” refers to longer-term debt instruments, distinguishing them from short-term notes. The receipt of anything other than stock or securities can trigger tax consequences, a topic addressed by other parts of the statute.

Treatment of “Boot” and Assumed Liabilities

Many reorganizations involve more than a simple stock-for-assets exchange. The transferor corporation often receives other property, such as cash, in addition to stock and securities. This other property is commonly referred to as “boot.” Section 361(b) dictates that if a corporation receives boot, it does not automatically lose all nonrecognition benefits.

The transferor corporation must recognize gain, but only to the extent of the boot received that is not distributed to its shareholders or creditors as part of the plan of reorganization. If the target corporation receives cash and promptly distributes it to its shareholders, it can still avoid recognizing gain at the corporate level. However, if the corporation retains the cash, it must recognize and pay tax on its realized gain, capped at the amount of cash retained. Under no circumstances can a corporation recognize a loss on the exchange, even if boot is received.

A frequent component of these transactions is the assumption of the target corporation’s liabilities by the acquirer. Under IRC Section 357, the assumption of liabilities is not treated as boot and therefore does not trigger gain recognition for the transferor. This facilitates transactions where the acquirer takes over the target’s ongoing business operations, which includes its debts.

There are two exceptions to this general rule. The first applies if the principal purpose of the liability assumption was to avoid federal income tax or was not a bona fide business purpose, in which case the entire amount of the assumed liabilities is treated as boot. The second exception applies in certain types of reorganizations if the sum of the liabilities assumed exceeds the total adjusted basis of the property transferred, and the excess amount is treated as a recognized gain.

Corporate-Level Treatment of Distributions

After the initial exchange of assets for stock and other property, the transferor corporation distributes what it received to its own shareholders. Section 361(c) governs the tax consequences of this second step. The general rule provides that the corporation recognizes no gain or loss when it distributes “qualified property” to its shareholders pursuant to the plan of reorganization.

“Qualified property” is defined to include stock, rights to acquire stock, and obligations of the distributing corporation or another corporation that is a party to the reorganization, provided such property was received in the reorganization exchange. This means when the target corporation distributes the acquirer’s stock and securities it just received, it does so without triggering a corporate-level tax. This rule works in tandem with Section 361(a) to ensure the entire flow-through process is tax-efficient.

An exception arises if the corporation distributes property that is not qualified property. This could include appreciated boot it received and is now passing on to shareholders, or other assets it owned that were not part of the primary exchange. If the corporation distributes such appreciated property, it must recognize gain as if it had sold that property to the shareholder at its fair market value.

For instance, if the target corporation received cash (boot) and an appreciated parcel of land from the acquirer and then distributed both to its shareholders, it would have to recognize gain on the land. The gain would be calculated as the difference between the land’s fair market value and its adjusted basis. Losses on distributed property are not recognized at the corporate level, preventing corporations from selectively distributing loss assets to generate tax deductions.

Basis Consequences of the Transaction

The nonrecognition principles of Section 361 are a matter of tax deferral, not permanent tax exemption. This deferral is maintained through rules that determine the tax basis of the assets and stock. These basis rules ensure that the unrecognized gain or loss is preserved and can be recognized in a future taxable transaction, such as a subsequent sale.

The basis for the acquiring corporation in the assets it receives is determined by IRC Section 362. This section mandates a “carryover basis,” meaning the acquiring corporation’s basis in the assets is the same as the transferor corporation’s basis was immediately before the exchange. This basis is then increased by any gain the transferor corporation recognized on the transfer. This rule prevents the acquirer from getting a “stepped-up” basis equal to fair market value, thereby embedding the target’s original built-in gain into the assets now held by the acquirer.

The basis for the transferor corporation’s shareholders in the new stock they receive is governed by IRC Section 358. Shareholders receive an “exchanged basis” or “substituted basis.” Their basis in the new stock received from the acquiring corporation is the same as their basis was in their old target corporation stock.

This exchanged basis is then adjusted. It is decreased by the fair market value of any boot (like cash) they received and by any loss the shareholder recognized. The basis is then increased by any amount that was treated as a dividend and by any gain the shareholder recognized on the exchange. These adjustments ensure that any recognized gain is properly reflected in the new stock’s basis, preventing that same gain from being taxed again upon a future sale of the stock.