IRS Approves 'C' Reorg for S Corp Unwinding Partnership Structure

S Corp Target Unwinds Partnership Interest via 'C' Reorganization

The IRS has ruled that an S Corporation (Target) can unwind its structure tax-free under Section 368(a)(1)(C) of the Internal Revenue Code. This section defines a "C" reorganization as an acquisition by one corporation of substantially all of the properties of another corporation in exchange solely for voting stock. The transaction involves Target (an S Corp), Partnership (Target's primary asset), and Acquiring (a publicly traded corporation partially owned by Partnership). The ruling allows Target to exchange its indirect holding in Acquiring for direct stock and then liquidate, without triggering corporate-level tax, subject to the rules regarding "boot," which is non-stock consideration.

The Mechanics: Share Exchange and Deemed Liquidation

The transaction unfolded in a series of pre-planned steps. First, in a 'Preparatory Transaction,' the Partnership distributed to Target all of the Acquiring shares attributable to Target’s interest in Partnership; these shares were termed the "Old Acquiring Shares". Next, under Section 368(a)(1)(C), regarding corporate reorganizations, Acquiring acquired all of Target's Old Acquiring Shares solely in exchange for newly issued Acquiring shares ("New Acquiring Shares"). Finally, and critically, immediately after this exchange, Target converted, under state law, into either a general partnership or a limited liability company. This conversion was treated as a liquidation for U.S. federal income tax purposes, pursuant to Section 368(a)(2)(G), which generally requires a target corporation to liquidate as part of a reorganization. Target then used its cash to pay reorganization expenses, reimburse Acquiring for its expenses, and distribute the remaining cash pro rata to its shareholders; this was labeled the "Residual Cash Distribution." This Residual Cash Distribution represented the only element of the transaction potentially subject to tax as "boot," under Section 356, where shareholders may recognize gain (but not loss) to the extent of the cash received.

IRS Analysis: Meeting the 'Substantially All' and Continuity Tests

To achieve tax-free reorganization status, the IRS scrutinized several representations made by the taxpayer. Critical among these was Representation #6, addressing the "substantially all" requirement under Section 368(a)(1)(C), which defines a 'C' reorganization as acquiring "substantially all" of the target's properties in exchange for voting stock. Revenue Procedure 77-37 provides a safe harbor, requiring the acquiring corporation to obtain at least 90% of the fair market value of the net assets and at least 70% of the fair market value of the gross assets held by the target immediately before the reorganization. Significantly, the representation included amounts paid to dissenters, reorganization expenses, reimbursements, payments to shareholders, and distributions (including the Residual Cash Distribution) in the calculation of the target's assets held "immediately prior" to the transfer.

The IRS also considered Representation #9, concerning the Continuity of Business Enterprise (COBE) requirement under Treasury Regulation § 1.368-1(d). This regulation mandates that the acquiring corporation either continue the target's historic business or use a significant portion of the target's historic business assets. Given that Target was essentially a holding company whose primary asset was stock in Acquiring, the IRS determined that the "business" being continued was the holding of that stock. Therefore, so long as Acquiring continued to hold that stock after the reorganization, the COBE requirement would be satisfied.

The Verdict: Tax-Free Treatment with Cash Boot Exception

The IRS concluded that the reorganization qualified under Section 368(a)(1)(C), which defines the requirements for a 'C' reorganization (stock-for-assets). As a result, both Target and Acquiring would be considered "parties to the reorganization" under Section 368(b). Specifically, the IRS ruled that Target would not recognize any gain or loss on the transfer of its Old Acquiring Shares to Acquiring in exchange for New Acquiring Shares, citing Section 361(a). Section 361(a) generally provides that no gain or loss is recognized by a corporation that is a party to a reorganization when it exchanges property for stock or securities of another corporation that is also a party to the reorganization. Further, Target would not recognize gain or loss on the deemed distribution of the New Acquiring Shares to its shareholders, as per Section 361(c)(1).

For Target's shareholders, the exchange of their Target shares for New Acquiring Shares was deemed tax-free under Section 354(a)(1), which allows for the tax-free exchange of stock and securities in a reorganization. However, the IRS made an important exception concerning the "Residual Cash Distribution." Under Section 356(a)(1), if shareholders receive "boot"—cash or other property that doesn't qualify for tax-free treatment—they must recognize gain to the extent of the boot received or the gain realized on the exchange, whichever is less. Therefore, Target's shareholders were required to recognize gain up to the amount of their proportionate share of this cash distribution. The shareholders' basis in the New Acquiring Shares was determined under Section 358(a)(1) to be equal to their basis in the old Target shares, adjusted for any gain recognized due to the cash distribution. Finally, under Section 1223(1), the holding period for the New Acquiring Shares would include the period during which the Target stock was held, provided the Target stock was held as a capital asset.

This ruling provides a roadmap for simplifying tiered ownership structures involving S Corps and partnerships, offering a tax-efficient way to consolidate ownership, subject to the 'boot' rules when cash is involved.