For a variety of business and tax reasons, often business owners want to segregate certain assets and/or business activities. This is easy to accomplish while planning the initial formation and structure of a new business. However, when an established company (“Oldco”) has combined assets and activities inside a single entity, separating the assets or activities (such as for liability protection) can cause adverse tax consequences. In the past, the solutions were complicated, limited and seldom implemented. Now business owners can take advantage of the new “Parent F reorganization” option.
Prior options: traditional “F reorgs”
Prior to Parent F reorgs, a typical tax-free “F reorg” under IRC Sec. 368(a)(1)(F) would involve a statutory conversion of corporation to an LLC, which was then taxed as corporation. Another option was for a merger of the old corporation (“Oldco”) into a newly formed LLC, which would then be taxed as corporation. In these reorgs,, a corporation would convert to an LLC, which was taxed as an S corporation, and the reorg would be “nontaxable” (would not result in any gain or loss on the conversion, and no termination of the S election), and the new entity (“Newco”) would be able to use the old corporation’s EIN.
These “tax-free” “F reorgs” can be a good strategy in some cases, because they offer asset protection, simplified corporate governance and, and in some states, lower state and local franchise taxes.
Recently, in PLR 200701017, the IRS approved an ingenious strategy (under IRC section 368(a)(1)(F)) that allows a tax‐free transfer of valuable assets trapped in an established operating company (“Oldco”) into separate creditor-protected entities. This New “Parent F Reorganization” allows an owner of an established business to use a new tax‐free structure to segregate high risk assets and activities from less risky assets and activities. This strategy is significant because, before this strategy, for various reasons an established company (“Oldco”) would not segregate assets and activities without incurring significant tax liabilities. The risk is that an asset to be transferred from Oldco to Newco would have “appreciation” and that the transfer would be “deemed” a sale by the IRS, with the difference between the fair market value of the asset transferred and the tax basis of that asset constituting taxable income.
In PLR 200701017, the IRS “deemed” that a Type F reorganization occurred even though the assets of an existing company were split between the existing company and a newly formed parent company as a result of the reorganization. For business purposes, the shareholder of Oldco split Oldco’s assets between two separate state law entities which would be treated as one entity for federal income tax purposes.
The reorganization involved the following steps:
Step One: Shareholder of Oldco transferred all the outstanding stock in Oldco to a newly formed parent company (“Newco”) and owned all of the outstanding stock of the newly formed parent company. Thus, Oldco became a wholly owned subsidiary of Newco and Newco was an S corporation wholly owned by the shareholder.
Step Two: Oldco transferred the assets the shareholder wished to protect to Newco.
Step Three. Newco filed an election to have the existing company treated as a qualified Subchapter S subsidiary, (“QSUB”) (IRC section 1361(b)(3)(B)). Through this election, Newco and Oldco were treated as a single entity for federal income tax purposes. Oldco was deemed to have liquidated into Newco and was treated as having transferred all of its assets to Newco in exchange for stock of Newco and the assumption by Newco of Oldco’s existing liabilities, followed by a distribution of Newco’s stock to Oldco’s existing shareholder. The IRS ruled that the transaction qualified as a “tax-free” Type F reorganization.
Thus, a “Parent F reorg” of OldCo to NewCo requires that:
- all of the stock of NewCo is issued in respect of the stock of Oldco;
- there is no change of ownership as a result of the reorganization (other than a partial redemption);
- Oldco must be completely liquidated (for tax purposes);
- Newco must not hold any property or have any tax attributes immediately before the reorg
- there must be a business purpose for the reorg.
Why “Parent F reorgs” might be the best option
Option 1: distribute assets and set up new LLCs?
One option would be to distribute assets the shareholders want to segregate who then contribute those assets to new LLCs. This provides asset protection by “compartmentalizing” liabilities, and it allows the old corporation (“Oldco”) to keep its corporate name and identity. However, this plan would cause recognition of gain on the distribution of appreciated assets, unless a “D reorganization” could be structured. In many cases, however, a D reorg is impossible or impracticable. Further, a D reorg requires continuity of ownership and a “dividing” D reorg may trigger gain on the transfer of assets where those assets have liabilities in excess of basis.
Option 2: set up new LLC “subsidiaries” and create a new single member LLC as the “operating business”
This also provides asset protection by segregating assets and compartmentalizing liabilities. It also does not result in any taxable gain. However, Oldco has to change its name, and this can affect goodwill, reputation, credit and result in extraneous costs (e.g., printing and advertising costs).
Option 3: continue to use Oldco and create new single member LLC subsidiaries
This option is similar to option 2; it segregates high liability assets and activities, and there is no gain in transferring assets to the new single member LLCs. However, this plan does not protect the assets of Oldco, which might be the most vulnerable to creditors.
Best option: Parent F reorganization. Using this option, a new holding LLC (Newco) is taxed as an S corporation and owns the old operating company (Oldco) and the new “sister” companies:
This is the best solutions because it achieves segregation of assets and compartmentalization of liabilities; continuation of OldCo’s corporate identity and EIN; removal of valuable assets from future liability exposure of Oldco; and the event is “nontaxable” if the reorganization complies with IRC Sec. 368(a)(1)(F), even if debt exceeds basis.