Treas. Reg. § 1.368-2: Defining Corporate Reorganizations

When corporations undergo transactions like mergers or acquisitions, the financial consequences can be substantial. The Internal Revenue Code (IRC), through Section 368, provides a framework allowing these adjustments to occur without immediately triggering tax liability. This tax-deferred treatment is based on the principle that such transactions are a “readjustment of continuing interest in property under modified corporate forms,” not a final sale.

The specific rules for these tax-free reorganizations are in Treasury Regulation § 1.368-2. This regulation provides the detailed blueprint corporations must follow to ensure a transaction qualifies for nonrecognition of gain or loss. It defines the various types of reorganizations and the terms that govern them. Failure to adhere to these definitions can convert a planned tax-free event into a fully taxable one.

Foundational Concepts: Party and Plan of Reorganization

For a transaction to receive tax-free treatment, it must involve specific participants and follow a preconceived course of action. The regulation establishes two foundational concepts: the “party to a reorganization” and the “plan of reorganization.” Satisfying the requirements for these defined terms is a prerequisite for any reorganization.

The term “party to a reorganization” identifies the corporations that can participate in the tax-free exchange. This includes the corporation resulting from the reorganization, as well as both the acquiring and target corporations. The definition also extends to the parent of an acquiring corporation if the parent’s stock is used to acquire the target’s assets or stock.

A qualifying transaction must be executed pursuant to a “plan of reorganization.” While a formal document is not required, the regulations look for a series of interconnected steps that constitute the reorganization. The plan ensures the steps are part of an integrated transaction designed to achieve a legitimate business purpose.

The plan links the various exchanges of stock and assets, allowing them to be treated as a single event for tax purposes. It provides the framework for evaluating the actions of the corporate parties. Without a clear plan, a series of transactions could be viewed as separate, taxable events by the IRS.

Statutory Mergers and Consolidations (Type A)

A “Type A” reorganization is the most flexible type and is defined as a merger or consolidation carried out under U.S., state, or territory corporate law. This “statutory” requirement is its defining feature, meaning the transaction must follow the legal procedures for a merger or consolidation. In a merger, one corporation absorbs another, while in a consolidation, two or more corporations combine to form a new entity.

The primary advantage of the Type A structure is the flexibility of consideration that can be used. Unlike other reorganization types, it does not have a statutory limitation on using only voting stock. This allows the acquiring corporation to use a mix of stock, cash, and other property, known as “boot,” to acquire the target corporation.

This flexibility is limited by the “continuity of interest” doctrine, which ensures the transaction is not a disguised sale. It requires that a substantial part of the value of the interests in the target corporation be preserved through the receipt of stock in the acquiring corporation. For example, the requirement is met if former target shareholders receive acquiring corporation stock equal to at least 40% of their original stock’s value. Failure to meet this threshold will disqualify the transaction from tax-free status.

Acquisitive Reorganizations (Types B and C)

The regulations also define acquisitive reorganizations where one corporation obtains the stock or assets of another. These “Type B” and “Type C” reorganizations have stricter requirements regarding consideration compared to a Type A reorganization.

Type B Reorganization (Stock-for-Stock)

A Type B reorganization is the acquisition of another corporation’s stock. The first requirement is that the acquisition must be “solely for voting stock.” The acquiring corporation must use only its voting stock, or its parent’s voting stock, as consideration. The use of any cash or other non-stock consideration can invalidate the tax-free status.

The second requirement is that the acquiring corporation must have “control” of the target immediately after the acquisition. Control is defined as owning stock with at least 80 percent of the total voting power and at least 80 percent of the shares of all other classes of stock. This control can be acquired over time in a “creeping” acquisition, as long as the final transaction that achieves the 80% threshold is made solely for voting stock.

Type C Reorganization (Stock-for-Assets)

A Type C reorganization is an acquisition of assets, where one corporation acquires “substantially all of the properties” of another. The “substantially all” test is met if the acquirer obtains at least 90 percent of the fair market value of the target’s net assets and 70 percent of its gross assets. This prevents the target from distributing significant assets to shareholders before the reorganization.

The consideration rules for a Type C are more lenient than for a Type B. A “boot relaxation rule” permits some non-stock consideration, as long as the acquirer obtains at least 80 percent of the fair market value of the target’s property solely for voting stock. For this calculation, any target liabilities assumed by the acquirer are treated as boot.

A Type C reorganization also has a liquidation requirement. The target corporation must distribute all property it receives from the acquirer, plus any retained properties, to its shareholders. This ensures the target corporation ceases its corporate existence as part of the transaction.

Corporate Divisions and Restructurings (Types D, E, and F)

The framework also includes transactions involving internal restructurings or divisions of a single corporate enterprise. These are classified as Type D, E, and F reorganizations, each serving a distinct purpose.

Type D Reorganization (Transfer to a Controlled Corporation)

A Type D reorganization involves a corporation transferring assets to another corporation it controls immediately after the transfer. The controlled corporation’s stock must then be distributed to the original corporation’s shareholders in a transaction qualifying under IRC Section 355. This structure is the primary vehicle for tax-free corporate divisions like spin-offs.

To qualify, the transferor corporation or its shareholders must “control” the transferee corporation immediately after the asset transfer. As previously defined, this means owning at least 80% of the voting power and 80% of all other stock classes. The distribution of the new company’s stock allows the enterprise to be divided without triggering immediate tax.

Type E Reorganization (Recapitalization)

A Type E reorganization is defined as a “recapitalization,” which is a reshuffling of a capital structure within an existing corporation. This reorganization involves only one corporation and its shareholders or security holders, making it an internal adjustment.

Examples include a corporation issuing preferred stock to discharge bond debt or exchanging outstanding preferred stock for new common stock. A company might also issue new preferred stock for its outstanding common stock. These transactions allow a company to adjust its capital structure or shift control without immediate gain or loss recognition for shareholders.

Type F Reorganization (Mere Change in Form)

The Type F reorganization is a “mere change in identity, form, or place of organization of one corporation.” This transaction involves a single continuing corporate enterprise. The classic example is a corporation reincorporating in another state without any other changes to its business, assets, or ownership.

For a transaction to qualify as a Type F reorganization, the regulations outline several requirements. The new “resulting corporation” cannot have prior assets, the “transferor corporation” must liquidate for tax purposes, and stock ownership must be identical in the new and old corporations. The resulting corporation is treated as the same entity as the transferor, allowing it to retain its tax history and attributes without interruption.