Limit to a common restructuring transaction identified by the IRS
IRS declines to provide ruling on common restructuring
TAX ALERT |
Some corporate groups have used Upstream C with a Drop transactions described below to achieve tax-free asset distributions. The transaction involves reincorporating a subsidiary corporation’s non-distributed assets By declining to rule on a variation of this transaction, the IRS has indicated that a material difference between the original and reincorporated subsidiary should exist, aside from the distribution of assets to the parent corporation.
Background – asset distributions and the Upstream C with a Drop technique
Under United States tax rules, a subsidiary corporation’s opportunities to distribute appreciated assets to its parent corporation in a tax-free transaction are limited. One strategy that may permit a tax-free result involves a liquidation of the subsidiary followed by a reincorporation of its non-distributed assets. This transaction may be qualify as a tax-free upstream section 368(a)(1)(C) reorganization (an Upstream C), followed by a tax-free contribution of the subsidiary’s remaining assets to a new corporation (a Drop) for Federal income tax purposes.
The liquidation step of the Upstream C with a Drop technique does not require legal liquidation of the subsidiary. A liquidation deemed to occur for federal income tax purposes (a deemed liquidation) will suffice. A deemed liquidation could result from either (1) conversion of legal entity type (for example from corporation to limited liability company (LLC)), or (2) a check-the-box election to change the subsidiary’s tax classification for federal tax purposes. In one version of the Upstream C with a Drop utilizing the LLC conversion technique, the basic steps are:
- The subsidiary converts to an LLC that is disregarded as an entity apart from the parent; the conversion is treated as a deemed liquidation
- The subsidiary LLC distributes some of its assets to the parent
- The subsidiary LLC re-converts into a corporation or makes a check-the-box election to be treated as a corporation for U.S. federal income tax purposes
Prior IRS rulings
In previous letter rulings, the IRS has approved the Upstream C with a Drop technique as an effective tax-free asset distribution technique. See PLR 200952032, PLR 201127004, PLR 201224006, and PLR 210424007. In each of these rulings, the facts indicated some difference between the subsidiary before and after the transaction (other than the distribution of assets during the transaction). These changes were in one of three categories:
- The subsidiary changed the state of its incorporation
- The subsidiary was subject to a state’s corporation laws before the transaction, but a state’s LLC laws afterwards
- The subsidiary changed the number of classes of (or the governing terms of) its outstanding stock
The IRS did not explain in these rulings whether or why such differences may be necessary. The IRS concluded in each ruling that the transaction was a tax-free Upstream C with a Drop, even though the end result appeared similar to a distribution of assets from the subsidiary to the parent.
IRS no-rule decision and explanation
The IRS recently declined a request for an Upstream C with a Drop ruling. As an IRS official explained at a conference, the declined ruling request presented a situation where the only apparent difference between the subsidiary before and after the transaction was the distribution of assets during the transaction. The subsidiary, for example, neither reincorporated in a different state nor modified the legal terms governing its stock. The IRS therefore concluded that they could not provide the requested ruling.
In other words, for the IRS to provide a favorable ruling on an Upstream C with a Drop, a realization event needs to occur for federal tax purposes due to the subsidiary’s deemed liquidation and reincorporation. For example, a realization event may be triggered by making a change to the subsidiary’s jurisdiction of incorporation.
Corporate groups may use the Upstream C with a Drop technique to effectively accomplish a tax-free asset distribution from a subsidiary to its parent. Care should be taken to make sure that there is a material difference between the subsidiary before and after the transaction, aside from the distribution of assets to the parent during the transaction. Taxpayers who could benefit from tax-free treatment for a distribution within a corporate group may wish to consider the Upstream C with a Drop technique and should consult their tax advisors about it.