IRS Rules that “F” Reorganization Can Be Used to Strip Retained Assets Before Sale

March 15, 2011

The IRS has issued a private letter ruling (not yet released to the public) that permits a shareholder to sell the stock of a corporation immediately after stripping, on a tax-free basis, assets that the shareholder wishes to retain. While the private letter ruling (PLR) involves an S corporation, a similar transaction may be available to C corporations.

The facts in the PLR involve the sole shareholder of an S corporation, referred to as OldCo, who wishes to sell to an unrelated party most of the assets of OldCo that constitute OldCo’s business. The shareholder of OldCo proposed to create a new wholly owned corporation (NewCo) and contribute all of the stock of OldCo to NewCo in exchange for issuance by NewCo of all of its stock to the shareholder. NewCo would then make a qualified subchapter S subsidiary (QSub) election for OldCo. OldCo would distribute to NewCo the assets that the shareholder and NewCo wished to retain. NewCo would then sell the stock of OldCo.

The IRS concluded, among other things, that: (1) the contribution of the OldCo stock to NewCo followed by a QSub election for OldCo would qualify as an “F” reorganization; (2) OldCo’s S election would remain in effect for NewCo; (3) upon the filing of a QSub election for OldCo, NewCo and OldCo would be treated as a single entity that is an S corporation solely for federal income tax purposes (but not state corporate or liability purposes); (4) the distribution by OldCo to NewCo of the assets the shareholder and NewCo wished to retain would not cause OldCo, NewCo or the shareholder to recognize any gain or loss; and (5) the sale of the stock of OldCo would be treated as a sale of the assets retained by OldCo and would not affect the treatment of the proposed transaction as an “F” reorganization.

Because the sale of OldCo would be a stock sale for state law purposes, this reorganization and sale structure would avoid many, if not all, of the legal complexities that would have attended a sale of assets by OldCo.

While the structure in the PLR discussed above involves an S corporation, it should be possible to employ a somewhat similar structure for a C corporation, most easily if the C corporation were organized in a state such as Delaware that permits a corporation to convert to a limited liability company.

For example, the shareholders of an existing C corporation (Old C) might form a new C corporation (New C), contribute all of the stock of Old C to New C in exchange for issuance by New C of all its stock to the shareholders, and make an election under state law to convert Old C into a limited liability company (LLC). Under state law, LLC would presumably succeed to all of the assets and liabilities of Old C (i.e., be a successor to Old C), but for federal income tax purposes LLC would be treated as an entity disregarded as separate from its owner. These steps collectively should qualify as an “F” reorganization. LLC would then distribute to New C the assets that the shareholders and New C wish to retain. This distribution should be tax free. New C would thereafter sell its sole membership interest in LLC.

If the C corporation were not organized in a state that permits a corporation to convert to an LLC, it still might be possible to use this approach by first forming a new corporation in a state that does permit such a conversion, and merging the existing corporation into the new one. Properly structured, this should itself qualify as an “F” reorganization.

Converting a corporation to a limited liability company under a state law conversion statute should constitute an automatic transfer of assets to the LLC by operation of law (thus avoiding complexities that an asset sale would involve). It would still be necessary, however, to examine contractual, regulatory, and other provisions for possible restrictions that might apply on the conversion of an entity or on a change in ownership of the entity.

The reorganization and sale structure approved by the IRS in this PLR provides taxpayers a more efficient and flexible method for selling corporate assets for federal income tax purposes, but stock for state corporate law and liability purposes, without incurring current taxable gain or loss on the corporate assets the taxpayer wishes to retain.