Type F reorganizations and the impact of the 'Jobco Manufacturing Company' decision. (Cover Story)by Colburn, Steven C.
Type F reorganizations permit the carryover and carryback of NOLs precluded in other types of reorganizations. In Jobco, the taxpayer lost the use of a carryover by failing to structure the reorganization to qualify as an F reorganization.
C corporations are reorganized for many different reasons: as a means of preventing the impending extinction of a financially vulnerable business, an instrument in acquiring a target company, or a means of absorbing a subsidiary into a parent. A reorganization, if properly carried out, results in no taxable gain or loss at the time of reorganization and preserves favorable tax attributes of the old corporation. Consequently, it is important to view provisions of corporate reorganizations in conjunction with criteria allowing the carryover of tax attributes. The necessity for considering these provisions together is further underscored by a recent judicial decision disallowing the carryover of net operating losses in what was seemingly a reorganization transaction.
The requirements, attributes, and benefits of Type F corporate reorganizations can be analyzed and explained in a discussion of the recent Jobco Manufacturing Company case (951 F2d 1259- aff'g TC Memo 1990-385). Of particular interest is the carryover of net operating losses (NOLs) in F reorganizations. Definition of Type F Reorganizations
Under IRC Sec. 368(a) (1) (F), a Type F reorganization is a "mere change in identity, form, or place of organization of one corporation, however effected." The Type F reorganization is not explained further either in the code or regulations. Most guidance regarding F reorganizations must be obtained through IRS revenue rulings and judicial holdings.
Typically, an F reorganization involves no more than reincorporation of the same corporate business with the same shareholders and assets under a new corporate charter either in the same or different state. The presumption is the surviving Corporation is the same corporation as its predecessor in every respect except for minor technical differences.
In 1954, Congress failed in its attempt to repeal the F reorganization provisions. It felt F reorganizations were unnecessary because such reorganizations would often qualify as a Type A, C, or D reorganization. As late as 1965, the F reorganization was referred to "as encompassing only the simplest and least significant of corporate changes." Nonetheless, the F reorganization provisions were retained, and have played an important role primarily because of the enactment of Secs. 381 and 382 regarding carryover of tax attributes to an acquiring corporation.
As discussed later, Sec. 381(b) distinguishes between Types A-D reorganizations and Type F reorganizations for the purposes of allowing NOL carrybacks and closing the taxable year. In addition, the IRS ruled where there is an overlap between a Type F reorganization and other types of reorganizations, the transaction should be treated as a Type F reorganization. As a result, it became essential to determine whether a transaction met the conditions of an F reorganization, notwithstanding the fact the transaction qualified as some other type of transaction.
Advantages of Type F Reorganizations
Sec. 381 outlines the primary advantages of an F reorganization over other types of reorganizations. In the case of a Type F reorganization, the acquiring corporation is to be treated (for purposes of Sec. 381) just as the transferor corporation would have been treated if there had been no reorganization. Therefore, the taxable year of the transferor does not end on the date of transfer merely because of the transfer. Such is not the case for other types of reorganizations.
More importantly, a net operating loss of the acquiring corporation for any taxable year ending after the date of transfer may be carried back (in accordance with Sec. 172(b)) in computing the taxable income of the transferor corporation for a taxable year ending before the date of the transfer. Furthermore, the tax attributes of the transferor corporation enumerated in Sec. 381(c) are to be taken into account by the acquiring corporation as if no reorganization had occurred. Thus, the transferor corporation is deemed to continue to exist, and any NOL of the acquired corporation may be carried forward to offset subsequent income of the acquiring corporation.
Example: In 1993, P Corporation, merges into a shell corporation, S, formed solely for the purpose of taking over P's business. This could qualify as a Type A or a Type F reorganization. During 1993, S Corporation incurs a net operating loss. If the transaction is viewed as a Type A reorganization, the NOL must be carried forward by S Corporation to be set off against its future taxable income. On the other hand, if the merger is considered a Type F reorganization, the NOL may be carried back to be offset against P Corporation's income in prior years (i.e. 1990, 1991, and 1992), and a refund of prior year's taxes may be obtained. Thus, the new corporation realizes an immediate income tax benefit if the transaction is deemed an F reorganization. If the merger is treated as a Type A reorganization, the tax benefit is deferred to future years. Requirements for a Type F Reorganization
An F reorganization provides for the continuation of the same business activities in a corporation substantially owned by the same shareholders with a mere technical change occurring. As indicated in Sec. 368, an F reorganization may be effected by changing the identity, form, or place of organization of a corporation. Thus, a change in the name of a corporation could qualify as an F reorganization.
Regarding changes in form, the IRS has ruled the renewal of a corporate charter having a limited life may qualify as an F reorganization. It has ruled similarly on the conversion of a U.S. chartered savings and loan association into a state chartered institution. A change in form of organization from a corporation to a business trust, taxable as a corporation, and from a business trust to a corporation, have also been approved as F reorganizations. The term "place of organization" in Sec. 368 refers to the state of incorporation. Therefore, a change in the state of incorporation or a merger of an existing corporation into a new shell corporation formed in a different state would qualify as an F reorganization. Again, the change would be merely technical. The business of the new corporation would be the same as that of the old corporation, and the new corporation would be owned by the same stockholders.
In such transactions, the tax attributes of the old corporation are preserved and assumed by the new corporation as if no reorganization had taken place. However, strict adherence to the form and substance of the reorganization is essential to preserve the tax attributes. Even an extra step in the transaction or a premature disposition of the old corporation could taint the transaction resulting in disqualification of the F reorganization status.
Plan of Reorganization. A basic requirement under Sec. 361 for corporations to avoid recognition of gain or loss for all types of reorganizations, including Type F reorganizations, is the existence of a plan of reorganization. For example, the plan may be a written communication to shareholders setting forth the steps to be undertaken in a planned reorganization. The plan may be evidenced by recording the plan in the corporate minutes. There is no requirement the plan be in writing. However, this is clearly the safest course. The plan must be adopted by each of the parties involved. The adoption must be shown by the acts of the responsible officers and appear on the official records of the corporation.
Number of Corporations Involved. Until 1982, the IRC, as well as the regulations, was silent on whether a Type F reorganization could apply to the merger of two or more active corporations or whether such reorganizations were restricted to the restructuring of a single corporation. The Tax Court and the IRS initially held a Type F reorganization could involve only one active corporation. The IRS took this stance primarily to attack liquidation-reincorporation schemes in which the new corporation received a step-up in basis for the transferred assets and the shareholders received capital gain treatment rather than dividend treatment for distributions received from the liquidating corporation. The IRS was successful in having such transactions treated as Type F reorganizations by invoking the step- transaction doctrine. However, other courts applied the F reorganization definition to combinations of active affiliated corporations if there was 1) continuity of ownership and 2) uninterrupted business continuity. The effect of these rulings was to qualify the mergers of brother-sister corporations and parent-subsidiary corporations as F reorganizations.
Under TEFRA in 1982, Congress settled this controversy by adding the words "of one corporation" to Sec. 368(a)(1)(F). However, the Conference Report noted such reorganizations may include more than one entity as long as only one operating company is involved. For example, an existing corporation may reincorporate in another state by first creating a new entity in the other state and then transferring the assets of the old corporation to the new corporation in exchange for stock of the new corporation. The stock of the new corporation is distributed to the shareholders of the old corporation, and the old corporation is liquidated.
Continuity of Interest Requirement. To effect a reorganization, the regulations require there be a continuity of interest in the business enterprise on the part of those persons who, directly or indirectly, were the owners of the enterprise prior to the reorganization. To qualify for an advance ruling from the IRS that the continuity of interest requirement is met, the shareholders of the transferor corporation must maintain at least a 50% equity interest in the stock of the transferee corporation. As to length of ownership, the IRS will ordinarily treat five years of unrestricted ownership after the reorganization as sufficient. The continuity of interest requirement is more relevant for Type A reorganizations where securities other than stock may be exchanged for the assets of another corporation. Accordingly, this requirement will not be discussed further.
Continuity of Business Enterprise Requirement. Under the continuity of business enterprise requirement, the acquiring corporation must either continue the acquired corporation's historic business or use a significant portion of the acquired corporation's historic business assets in a business. This requirement would be satisfied, for example, if a new corporation was formed, acquired the assets of the old corporation, and continued the historic business of the old corporation. If the transferor corporation has more than one line of business, the transferee must continue a significant line of the transferor's business. The significance of a line of business is determined by the facts and circumstances of each case. Business assets may include stock and securities, and intangible operating assets such as goodwill, patents, and trademarks. The Jobco Manufacturing Company Case
This decision illustrates how a taxpayer may lose NOL carryover benefits by not properly structuring a reorganization. This case 'also indicates how strictly the courts view Type F reorganizations.
Background. John Bewley formed a sole proprietorship in Tulsa on October 31, 1973, to operate a machine tool shop known as Bewley Manufacturing Company. This business was incorporated in 1981 under the laws of the State of Oklahoma as Bewley Manufacturing Co., Inc. (Bewley). John and his wife, Delores, were the sole shareholders of all the issued and outstanding stock. In 1982, the Bewleys incorporated another business in Oklahoma, Majco, Inc. (Majco), with the Bewleys as sole shareholders. In March 1983, certain principal operating assets of Bewley were repossessed by a creditor, causing Bewley to cease all operations. In July 1983, the Bewleys transferred all their Bewley stock to Majco, Inc. Majco's charter was amended in September 1983 to change its name to Jobco Manufacturing Company, Inc. (Jobco). No other change to Majco's original charter was made. The intention of the shareholders that Bewley be operated as a subsidiary of Jobco or that Bewley be liquidated was recorded in the minutes of the annual shareholders meeting of Bewley in March 1983.
After the transfer of Bewley stock, Majco (later Jobco) conducted the machine tool business at the same location in the same manner as had previously been conducted by Bewley. During 1983, Jobco purchased a piece of equipment to help replace some of the repossessed equipment. The balance due on the repossessed equipment was never paid by the Bewleys or any of their corporations. Majco or Jobco may have acquired some of the equipment retained by Bewley after the repossession. However, no consideration was ever paid for the equipment, and there was no formal transfer or exchange of property between Bewley and Jobco/Majco in exchange for stock or securities.
The Bewleys deducted a long-term capital loss of $130,288 on their joint 1983 income tax return due to the claimed worthlessness of their Bewley stock that year. Jobco filed a consolidated income tax return for 1983 including the respective income and net operating loss of Bewley, Inc. of $13,240 and $136,016. In 1984, Bewley was notified by the Oklahoma State Tax Commission that its right to operate within the State of Oklahoma had been suspended and its charter forfeited.
The Taxpayer's Position. The taxpayer argued the transfer of Bewley, stock to Majco and the subsequent change of Majco to Jobco constituted a Type F reorganization within the meaning of Sec. 368(a)(1)(F). Thus, Jobco should be allowed to include in its 1983 income tax return the income and net operating loss of Bewley. The taxpayer further contended that, for all practical purposes, Jobco was Bewley, and Bewley had ceased all operations.
IRS Position. The IRS disputed the right of Jobco to include in its 1983 return the NOL of Bewley on the grounds no reorganization had taken place under Sec. 381(a)(1)(F). The IRS argued that for the transaction to be classified as a Type F reorganization, there should be only one surviving corporation. In the instant case, the IRS concluded Bewley did not cease to exist. The Court's Holding. The court held there was no reorganization between Bewley and Jobco pursuant to Sec. 368(a)(1)(F) because there was no change: 1) of identity of Bewley or Jobco, 2) in their forms, nor 3) in their places of incorporation. After the Bewley stock was acquired by Jobco (formerly Majco), Bewley continued to exist as the wholly-owned and inactive subsidiary of Majco/Jobco until Bewley's demise in 1984. Throughout 1983, both corporations continued to exist; there was no liquidation of Bewley and no merger or consolidation of one corporation into another.
In addition, the court concluded there was no plan of reorganization following Sec. 361 involving the exchange of property by one corporation solely for the stock or securities of the other corporation. The facts show the Bewley stock was transferred to Majco. However, there is no record of any consideration being received by the Bewleys in exchange for the stock. Furthermore, there is no proof any property was ever transferred by Bewley to Majco/Jobco. The court reasoned that property was not transferred to Majco/Jobco to avoid any transferee liability claims by creditors of Bewley. This conclusion was supported by testimony from Bewley's and Jobco's principal officer and shareholder, John Bewley, that it was not intended for Jobco to be liable for Bewley's debts.
The court reiterated that the carryover of a net operating loss under Sec. 381(c) (1) requires the acquisition of the assets of a corporation by another corporation in a transfer to which Sec. 361 applies. Because there was no acquisition of assets by Majco/Jobco from Bewley, and no reorganization under Sec. 368(a) (1) (F), the NOL carryover by Jobco from Bewley was denied.
Tax Implications of Jobco
This case illustrates how a poorly structured transaction can result in a significant tax liability.
The Court disallowed Jobco's inclusion of both the income and NOL of $13,240 and $136,016, respectively. The resulting increase in Jobco's income tax liability was $33,433. Although the transaction satisfied the requirements of continuity of ownership interest and continuity of business activity, the form of the transaction precluded it from being classified as a Type F reorganization. If the Bewley shares had been transferred under a plan of reorganization, and if the defunct Bewley had been subsequently liquidated, Jobco may have succeeded in preserving the NOL carryover. Accordingly, the additional tax liability of $33,433 could have been avoided.
Tax Planning Strategies for Type F Reorganizations
One of the primary goals of a Type F reorganization is to effect a change in identity, form, or place of organization of a corporation while retaining any favorable tax attributes of the old corporation. While the requirements to effect such a reorganization are not complex, taxpayers must be careful all steps in the process are adhered to strictly. As illustrated in Jobco, the importance of the form and nature of a transaction cannot be overemphasized. This is especially true when a simple technical change, such as a Type F reorganization, is involved.
Specifically, for a Type F reorganization, due care must be exercised in the following areas:
1. A plan of reorganization must be adopted, clearly setting out the companies involved and the tentative reorganization schedule. To avoid any ambiguity, the plan must clearly state the purpose of the transaction is to effect a Type F reorganization.
2. In a Type F reorganization, it must be ensured only one operating company is involved. In the case of more than one operating company, a Type A, C, or D reorganization may be used. The accompanying table compares characteristics of Type F reorganizations with those of other types of reorganizations.
3. It is extremely important that continuity of ownership is maintained throughout the transaction. Even a temporary change of ownership during the transaction could taint the entire transaction, and F status may be disallowed. 4. Liquidation of the subsidiary is essential. The old and new corporations must not exist at the same time.
5. Continuity of the business enterprise is essential. The new corporation must continue at least one significant line of the business of the old corporation or must employ a significant portion of the old business assets in a business. Taxpayers who satisfy these requirements when structuring Type F reorganizations will be successful in effecting such reorganizations.
Ted D. Englebrecht PhD, CPA, is KPMG Peat Marwick Professor of Accounting at Georgia State University. Govind Iyer is a doctoral candidate at Georgia State University. Steven C. Colburn, PhD, CPA, is an assistant professor of accounting at the University of Maine.
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