Time For A Change?

At some point in its existence, a corporate-owned business– even one that is closely held– may have to reconsider its corporate structure. What may have started out as a single corporation, with one line of business, and operating at one location, has grown into a holding company with multiple corporate and LLC subsidiaries, each operating a separate function within a unitary business, or each operating a different line of business or out of a different location.

As the business develops, and as its shareholders change, as the relationships among the various subsidiaries and the owners evolve, the structure into which the business has grown may no longer be efficient or optimal from an operational or managerial perspective, from a profit-generating perspective, or from the perspective of a potential buyer.


At that point, the corporation’s directors, officers and shareholders may decide (after consulting with their accountants, bankers and other advisers) to adopt a different corporate structure. This may involve the creation of new entities, the elimination of some entities, and the “relocation” of others. It also may involve the relocation, within the corporate structure, of certain assets or lines of business.

Whatever the form of the restructuring, provided it is undertaken for a bona fide business purpose, it may be possible to effect the desired change without incurring an income tax liability for either the entities involved or for their ultimate owners. Generally, this may be accomplished by complying with the statutory and regulatory requirements for a so-called “tax-free” reorganization. Simply put, these requirements seek to ensure that the taxpayer is not exchanging property for other property that differs materially in kind – rather, the taxpayer’s investment in the business is continuing, albeit in a different form.

Step Transaction

I say “generally” because, over the years, the IRS has often applied various judicially-developed doctrines that ignore the form of the transaction chosen by the taxpayer and, by doing so, disqualify the transaction, in whole or in part, from tax-free treatment. One doctrine, in particular, has played an active role in the reorganization arena: the step transaction doctrine. steps

Under this doctrine, a set of pre-arranged transactional steps (some of which may lack economic substance) may be collapsed or stepped together to arrive at the same end-result, though with a less favorable income tax outcome for the taxpayer.

The problem from the taxpayer’s perspective is the uncertainty inherent in the application of the doctrine. Those transactions that include steps that are undertaken solely for their tax consequences are clear candidates. Others are more difficult to ascertain, and that uncertainty as to tax result could have a freezing effect on bona fide business reorganizations .

The IRS Relents, A Bit

However, the IRS gave taxpayers some relief when it refused to apply the step transaction doctrine in a recently-issued public ruling.

In the ruling, corporate Taxpayer was a holding company that owned two direct subsidiaries (brother-sister corporations S1 and S2), one of which (S2) owned three direct subsidiaries (X, Y and Z, also brother-sister corporations). For good business reasons, Taxpayer decided to combine the operations of S1, X, Y and Z into a new subsidiary formed by S2 (Newco).

In furtherance of that plan, Taxpayer transferred all of the S1 stock to S2 in exchange for additional S2 shares. S1, X, Y and Z (all of which were owned by S2 at that point) then transferred all of their assets to Newco in exchange for Newco stock, and then liquidated, distributing Newco stock (their only asset) to S-2 (basically, a sideways merger of S1, X, Y and Z into Newco). Newco (now a subsidiary of S2) continued to operate the business formerly conducted by S1, X, Y and Z.

In an earlier ruling, involving identical facts, the IRS did not respect the Taxpayer’s transfer of the S1 stock to S2  as a tax-free contribution to S2’s capital [IRC 351]; instead, it ignored that step and treated the transaction as a direct acquisition by Newco of the S1 business assets in exchange for Newco stock. As a result, it became more difficult (though not impossible) for the recast transaction to qualify as a tax-free exchange.

In reversing its position, as set forth in the earlier ruling, the IRS held that a transfer of property to a corporation in exchange for its stock may be respected as a tax-free exchange even if it is followed by a subsequent transfer of the property as part of a pre-arranged, integrated plan.

The IRS quickly added, however, that the transfer will not be respected “if a different treatment is warranted to reflect the economic substance of the transaction as a whole” – for example, where an exchange is without substance for tax purposes and was entered into for the purpose of enabling a taxpayer to achieve a favorable tax result.


How much comfort can a taxpayer take from the IRS’s ruling? The ruling seems to say that the IRS will respect the form of a taxpayer’s transaction, and that it will not seek to recharacterize the transaction under the step transaction doctrine, except where it has a good reason to do so.

OK, so what has changed? The IRS will not ignore or collapse steps that have economic (as opposed to mere tax) significance solely because doing so may generate more revenue for the federal coffers.  That’s good to hear, but what guidance does this provide to the closely held business that is thinking about reorganizing its business structure?

As a general rule, the guiding principle for taxpayers and their advisers remains the same: Figure out what needs to be done from a business perspective first. Where do you want to end up? How can you get there? What is the economic, including tax, cost of doing so? Is there a transaction by which the tax cost may be reduced? If a certain transaction step generates a tax benefit, be certain that it also has independent economic substance, or a bona fide business purpose, in order for the transaction to withstand IRS scrutiny. One must be especially diligent where the transaction involves a series of related steps among related parties, as in the context of a non-acquisitive reorganization.

The bottom line, as always: consult your tax advisers early on.