At Wit's End

Typically, I introduce each posting with a humorous (ok, an attempt at a humorous) caption. On January 24, the IRS issued temporary regulations dealing with the status under IRC § 368 of transactions involving disregarded entities. The temporary regulations are important. They are also impervious to comedic treatment.

In essence, the temporary regulations recognize the use in complex business planning of entities that are disregarded entities for federal income tax purposes. For the sake of brevity, I will describe some of the examples before dealing with the overriding framework established by the regulations.

In Example 2, Y, Inc. is the sole member of X, LLC, a disregarded entity. Z, Inc. merges into X pursuant to the law of State W. All of the following occur simultaneously: (i) Z's assets become assets of X, (ii) the Z shareholders receive Y stock in exchange for all of their Z stock, and (iii) Z's legal existence ceases for all purposes. On these facts, Y and Z are deemed to have effected an A reorganization. In fact, the temporary regulations provide that the result would be the same if Z owned Alpha, LLC, a single member LLC that is a disregarded entity, regardless of whether Alpha ended up as a subsidiary of X or a subsidiary of some other disregarded entity owned by Y.

In Example 3, Z, Inc. owns Beta, Inc. Z is an S corporation and Beta is a qualified S corporation subsidiary. As in Example 2, Y, Inc. is the sole member of X, LLC, a disregarded entity. Z, Inc. merges into X pursuant to the law of State W. As a consequence of this merger, Beta immediately ceases being a qualified S corporation subsidiary. However, the regulations take the position that the transaction is a valid A reorganization, with a deemed contribution of the assets of Beta to X and the immediate deemed contribution of those same assets by X to Beta.

However, as one would expect, the surviving entity cannot be something other than a corporation. Thus, a merger into a disregarded entity that is owned by a partnership doesn't qualify. And, a merger in which interests of the disregarded entity are distributed to the owners of the merged entity will not work.

The temporary regulations set forth two basic elements that must both be present simultaneously in order for a transaction to qualify under § 368.

First, all of the assets of the merged corporation and all of the liabilities of the merged corporation must become assets and liabilities, respectively, of some "unit" of the other entity. In this case, "unit" means either the acquiring corporation or some corporation or disregarded entity owned by it.

Second, the merged corporation (which may be the owner of a disregarded entity) must cease its separate legal existence for all purposes.

The temporary regulations will undoubtedly accelerate the use of disregarded entities in corporate planning. Among their other virtues, they allow businesses to build liability "firewalls" between different aspects of their operations without having to sacrifice being a single entity for income tax purposes.

The temporary regulations were published in the Federal Register on Friday, January 24, 2003 (Vol. 68, No. 16, pages 3384 et seq.). If you cannot locate a copy on the web, send me an e-mail and I will forward a copy to you.