It is well established that a merger of a parent corporation into a subsidiary corporation can be treated as a downstream reorganization pursuant to Section 368(a) (see, e.g., Rev. Rul. 85-197 and Rev. Rul. 85-198). However, in the case where the same corporation instead converts to a limited liability company treated as a disregarded entity or a partnership for U.S. federal income tax purposes, the answer is much less clear. Such a conversion could be treated as a liquidation of the corporation, a potentially taxable transaction.
In PLR 202601012, the Service has provided helpful insight into such a fact pattern, ruling that a recapitalization of a subsidiary corporation followed by the conversion of the parent corporation into a partnership is treated as a downstream reorganization under Section 368(a)(1)(C) (a C Reorganization).
Facts and Proposed Transaction
In the ruling, parent corporation (Target) is a State A corporation treated as an S corporation for U.S. federal income tax purposes. As its primary asset, Target owns an interest in a domestic partnership (Partnership). Target’s other assets are cash and cash equivalents. Partnership itself owns outstanding shares of a publicly traded State A corporation (Acquiring), which has one class of stock outstanding.
In a preparatory transaction, Partnership would distribute to Target all Acquiring shares attributable to Target’s interest in Partnership (the Old Acquiring Shares). Following this step, Acquiring would acquire all the Old Acquiring Shares owned by Target solely in exchange for newly issued Acquiring shares (the “New Acquiring Shares” and such exchange, the “Recapitalization”) and immediately thereafter, Target would convert under state law into either a general partnership or a limited liability company treated as a partnership for U.S. federal income tax purposes (collectively, the “Reorganization”).
Income Tax Rulings
The Service ruled in PLR 202601012 that the Reorganization qualifies as a C Reorganization. As such, Target would also not recognize gain or loss on its transfer of the Old Acquiring Shares to Acquiring in exchange for the New Acquiring Shares under Section 361(a), and Target would not recognize any gain or loss on the deemed distribution to its shareholders as a result of the conversion under Section 361(c)(1).
The ruling is subject to many key representations, including that (i) Acquiring would acquire assets of Target solely in exchange for the New Acquiring Shares; (ii) Acquiring would acquire from Target assets with a fair market value of at least 90 percent of the fair market value of the net assets and at least 70 percent of the fair market value of the gross assets held by Target immediately prior to the Reorganization (the Sub All Representation); and (iii) Acquiring would continue the historic business of Target or use a significant portion of Target's historic business assets in a business within the meaning of Treas. Reg. §1.368-1(d).
BDO Insight
The Service has previously issued favorable guidance on the tax treatment of downstream reorganizations when the parent entity merges out of existence in the transaction. PLR 202601012 indicates that a parent-subsidiary transaction may be treated as a downstream reorganization notwithstanding the fact that the parent entity retains its legal existence after the transaction. Absent this ruling, it is reasonable to conclude that a recapitalization and conversion could each be viewed independently, which could cause the conversion to be treated as a taxable liquidation of Target.
Presumably, the ability of the taxpayer to make the Sub All Representation gave the Service comfort to treat the Recapitalization as an exchange under Section 361(a). Specifically, the Old Acquiring Shares accounted for the vast majority of the value of Target’s assets such that surrendering those shares in the Recapitalization satisfied the requirement in Section 368(a)(1)(C) that Acquiring must acquire substantially all of the assets of Target. The Service has issued three favorable rulings (see, e.g., PLRs 200910026, 200747006, and 200037001) in which the recapitalization is treated as part of the downstream C Reorganization, but, in each of those rulings, the parent corporation legally dissolved after the recapitalization. PLR 202601012 may be the first PLR in which the parent entity survives.
It is also noteworthy that the Service ruled (at least implicitly) that the Reorganization satisfied the continuity of business enterprise requirement set forth in Treas. Reg. §1.368-1(d). In Rev. Rul. 85-197, the Service ruled that a downstream reorganization satisfies that requirement because the parent corporation is treated as operating the business conducted by its wholly owned subsidiary corporation. This conclusion has been tested in the private letter ruling practice by various taxpayers that have sought favorable rulings when the parent corporation only owns a minority interest in the subsidiary corporation (i.e., how low can you go?). That minority interest has varied from 14 percent (PLR 9506036) to less than 5 percent (PLR 200747006).
The facts in PLR 202601012 do not indicate the percentage interest that Target owns of Acquiring after the preparatory transaction, but it is likely a minority interest given that Acquiring is a publicly traded company. Given that Target’s only other assets are cash and cash equivalents, it seems clear that the taxpayer relies on the holding of Rev. Rul. 85-197 to support its position that the Reorganization should satisfy the continuity of business enterprise requirement.
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