IRC Section 368: Corporate Reorganization Rules and Definitions

Corporate reorganizations under IRC Section 368 are vital for businesses seeking tax-efficient restructuring. These provisions enable companies to merge, acquire assets, or restructure operations without triggering immediate tax liabilities. A clear understanding of these rules is essential for corporations aiming to optimize their tax positions while adhering to IRS guidelines.

Statutory Definitions

IRC Section 368 provides specific criteria for transactions to qualify as reorganizations. For instance, the term “merger” encompasses traditional mergers, consolidations, and similar transactions, allowing flexibility in structuring deals. A fundamental requirement is continuity of interest, which mandates that a significant portion of the value received by shareholders—generally at least 40%—is in stock. This ensures shareholders retain a meaningful stake in the new entity, treating the reorganization as a change in form rather than a change in ownership. Additionally, the continuity of business enterprise rule requires the acquiring corporation to continue a significant part of the target’s operations, preventing these transactions from being used for asset liquidation without tax consequences.

Classification of Reorganizations

Type A

Type A reorganizations, or statutory mergers and consolidations, involve combining corporations into a single entity. These transactions allow for a mix of stock and cash as consideration, provided the continuity of interest requirement is met. For example, if Corporation X merges with Corporation Y, and Y’s shareholders receive 60% stock and 40% cash, it typically qualifies as a Type A reorganization, enabling tax deferral.

Type B

Type B reorganizations involve acquiring a target’s stock exclusively in exchange for voting stock of the acquiring corporation. The acquiring entity must gain control, defined as owning at least 80% of the target’s voting power and non-voting stock. For example, if Corporation A acquires 85% of Corporation B’s voting stock solely in exchange for its own voting stock, it qualifies as a Type B reorganization, deferring taxes.

Type C

Type C reorganizations involve acquiring substantially all of a target’s assets in exchange for voting stock. At least 80% of the consideration must be voting stock, and liabilities may also be assumed. For instance, if Corporation X acquires 90% of Corporation Y’s assets for voting stock and assumes liabilities, it qualifies as a Type C reorganization, offering flexibility for asset-focused transactions.

Type D

Type D reorganizations involve asset transfers to another corporation in exchange for stock, followed by distributing that stock to shareholders. These are commonly used in spin-offs, split-offs, or split-ups and must serve a legitimate business purpose. For example, if Corporation A transfers its manufacturing division to Corporation B and distributes B’s stock to its shareholders, it qualifies as a Type D reorganization, enabling tax-deferred restructuring.

Type E

Type E reorganizations involve recapitalizations, such as exchanging one class of stock for another to alter a corporation’s capital structure. For instance, if Corporation X exchanges preferred stock for common stock to reduce dividend obligations, it qualifies as a Type E reorganization, allowing tax-deferred capital adjustments.

Type F

Type F reorganizations involve changes in identity, form, or place of incorporation. For example, if Corporation X, incorporated in Delaware, reincorporates in Nevada without altering ownership, it qualifies as a Type F reorganization, facilitating tax-deferred legal structure changes.

Type G

Type G reorganizations involve bankruptcy-related asset transfers as part of a court-approved plan. For instance, if Corporation X transfers assets to Corporation Y under a Chapter 11 plan, it qualifies as a Type G reorganization, helping financially distressed companies restructure without immediate tax liabilities.

Continuity of Interest

The continuity of interest (COI) doctrine ensures that shareholders of a target company retain a substantial stake in the acquiring entity. This discourages transactions resembling outright sales by requiring a significant portion of the consideration—typically at least 40%—to be in stock. For example, if shareholders of the acquired company receive 45% of their consideration in stock during a merger, it likely meets the COI requirement, allowing tax deferral.

Continuity of Business Enterprise

The continuity of business enterprise (COBE) rule ensures that a reorganization represents a genuine restructuring of business operations. The acquiring corporation must continue a significant portion of the target’s business activities. For instance, if Corporation A acquires Corporation B and maintains B’s profitable manufacturing division, it satisfies COBE, reflecting an intent to integrate valuable operations.

Treatment of Shareholders

Shareholders generally benefit from tax deferral in reorganizations if statutory requirements are met. When stock is received, no immediate gain or loss is recognized, and the basis in the new stock carries over. However, if boot (cash or other property) is received, shareholders must report the lesser of the gain realized or the boot amount as taxable income. For example, if a shareholder receives stock valued at $15,000 and $5,000 in cash, they report a taxable gain up to the boot amount.

Reporting Compliance

Maintaining compliance with reporting requirements is critical to preserving a reorganization’s tax-deferred status. Corporations must file Form 1120 and include a statement detailing the transaction. Shareholders must report stock, boot, or other property received on their tax returns. Proper documentation is essential to substantiate the tax treatment in the event of an IRS inquiry.