The New Parent F Reorganization ("NPFR")
by Alan S. Gassman and Kenneth J. Crotty , Gassman, Bates & Associates, P.A., Clearwater, FL
(New Parent F Reorganization is the name given by the authors to this powerful corporate tax tool that allows medical practices and other operating businesses to be divided into separate companies whereby valuable assets can be taken out of operating companies on a tax free basis without requiring change in provider number registration or practice or business entity.)
A TAX FREE METHOD OF TRANSFORMING AN OPERATING COMPANY WITH VALUABLE ASSETS INTO AN OPERATING SUBSIDIARY OWNED BY A NEW PARENT CORPORATION THAT HOLDS THE HISTORICAL VALUABLE ASSETS IN A "FIRE-WALL" PROTECTED MANNER.
For many years, physician clients and medical businesses have approached the authors' law firm requesting guidance on how to transfer valuable assets out of the operational entity or medical practice. The traditional answer has been that the transfer of appreciated assets from a corporation to its shareholders or an affiliated corporation would trigger taxable income. Recently, the Internal Revenue Service has begun to recognize that Internal Revenue Code Section 368(a)(1)(F) will allow what the authors call the "New Parent F Reorganization". This is a restructuring tool that is vastly underused by the asset protection and healthcare legal communities. Many clients who have valuable assets held in operating entities have been told in the past that they cannot move the assets out tax free. These clients may now separate their operating businesses from the valuable assets therein using the technique described in this article. By way of "tax background" entities which are taxed as corporations are basically characterized as C Corporations or S Corporations. C Corporations incur a corporate level tax on the net income of the company. Payments to shareholders may be characterized as deductible compensation or as dividends. S corporations are taxed in a manner similar to partnerships. An S corporation pays no corporate tax on the taxable income of the corporation, but each shareholder receives a "K-1" form and reports his or her pro rata share of income on his or her personal income tax return. These S Corporation "dividends" are not subject to self-employment tax.
Under Internal Revenue Code Section 368(a)(1)(F), an S corporation or a C corporation can be reorganized so that it is owned 100% by a new parent corporation that is in turn owned by the original owners of the pre-existing S corporation or C corporation.
Where the pre-existing company is an S corporation, the new parent company can be an S corporation, and the pre-existing company becomes a qualified subchapter S subsidiary (QSUB) within the meaning of Internal Revenue Code Section 1361(b)(3)(B).
Where the pre-existing company is a C corporation, the new parent company can also be a C corporation.
The new parent company can be a limited liability company, a limited partnership, or limited liability limited partnership that elects to be treated as a corporation for income tax purposes.
Once the new parent company is set up and proper elections are made with the Internal Revenue Service, then assets can be conveyed from the operating subsidiary company to the new parent company, or to other subsidiaries established by the new parent company, in order to segregate valuable assets and provide "firewall protection" from continuing business operations or similar business risks.
Here are some examples:
1. A client has an S corporation (Oldco) with a long operational history of owning and leasing properties.
- The client is concerned that there could be potential liability from past and future property ownership involving hazardous issues under one or more of the properties.
- The client has considered placing the various properties under separate subsidiary (disregarded entity) LLCs,
- The client instead establishes New Parent, a new LLC, which is taxed as an S corporation and is owned by the client shareholder individually. The client then conveys his or her stock in Oldco to New Parent and New Parent makes a QSUB election for Oldco. A QSUB is a "Qualified S Corporation Subsidiary" which is treated as a continuation of the original company for purposes of maintaining its tax identification number and identity. All income and deductions of the QSUB are reported on the tax return of the New Parent corporation.
- The New Parent establishes separate LLC subsidiaries for each of the buildings that have been owned by Oldco, except for one valuable building that is left in the company to assure that there are sufficient assets to satisfy any reasonably expected indebtedness.
2. A medical practice corporation has a longstanding track record in providing medical services. It also owns real estate, furniture and equipment associated with the medical practice.
- The doctors wish to segregate the real estate, furniture, and equipment from the practicing entity, but they have always been told that transferring the real estate from the company would trigger capital gains taxes and depreciation recapture as applicable.
- The new parent corporation is established and owned by the shareholders/physicians who then transfer their stock in the practice entity to the parent company in an F reorganization.
- The parent company makes a Sub-Chapter S election if the practice entity has been an S corporation.
If the medical practice entity is a professional corporation that cannot by state law be owned by another company, then it is first converted to a regular limited liability company using a state conversion statute before its ownership is conveyed to the new parent corporation.
HOW CAN A PLANNER BE SURE THAT THE REORGANIZATION WILL QUALIFY UNDER 368(a)(1)(F) WHEN IT MIGHT ALSO BE CONSIDERED A TYPE A REORGANIZATION, A TYPE C REORGANIZATION, A TYPE D REORGANIZATION, OR A TYPE G REORGANIZATION?
Pursuant to Revenue Ruling 57-276, 1957-1 CB 126, a Type F reorganization that also meets the requirements of a Type A, C or D reorganization will be treated as a Type F reorganization.
For example, when an existing corporation organizes a new corporation and the existing corporation merges into the new corporation, the merger would qualify as both a Type A and a Type F reorganization.
A Type C reorganization may also qualify as a Type F reorganization when an existing corporation establishes a new corporation and the new corporation acquires all of the assets of the old corporation in exchange for all of the stock of the new corporation, and the old corporation dissolves and distributes the stock of the new corporation to the shareholders of the old corporation.
In some cases, a Type D reorganization may also qualify as a Type F reorganization. When an existing corporation forms a new corporation and the existing corporation transfers all of its assets to the new corporation for all of the stock of the new corporation which is then distributed to the shareholders of the existing corporation, the transaction would qualify as both a Type D and a Type F reorganization.
In a bankruptcy scenario, however, a Type G reorganization will be considered to have occurred in lieu of a Type F reorganization pursuant to Internal Revenue Code Section 368(a)(3)(C).
A Type G reorganization is similar to a Type D reorganization, however, the transfer in a Type G reorganization occurs in a Title 11 or similar case.
WHAT IF LIABILITIES EXCEED THE BASIS OF ASSETS THAT ARE BEING TRANSFERRED?
Many tax lawyers are under the impression that transferring assets that have debt exceeding the tax basis of the assets in a "tax free reorganization" will trigger gain as if the property were sold for the amount of debt involved. But Internal Revenue Code Section 357(c), as amended in 2004 by the American Jobs Creation Act, Section 898, only applies to a Type D divisive reorganization for reorganizations that occur on or after October 22, 2004. Internal Revenue Code Section 357 DOES NOT apply to Type F reorganizations. When a transaction can be characterized as a Type D reorganization and a Type F reorganization, the transaction will be characterize as a Type F reorganization and Internal Revenue Code Section 357(c) will not apply to the transaction. See Rev. Rul. 79-289,1979-2 C.B. 145; Rev. Rul. 87-27, 1987-1 C.B. 134.
Out of caution, the authors would like to point out Treasury Regulation 1.1361-4(a)(2)(ii) Example 3, which seems to provide that a new Parent reorganization would be considered a D reorganization. This would still be tax free so long as the continuity of interest test discussed below has been satisfied. Under the Treasury Regulation example, individual A, pursuant to a plan, contributes all of the outstanding stock of Y to his wholly owned S corporation, X, and immediately causes X to make a QSub election for Y. The example concludes that the transaction is a Type D reorganization, and that Internal Revenue Code Section 357(c) applied to the transaction if the sum of the amount of the liabilities of Y treated as assumed by X exceeds the total of the adjusted basis of the property Y. The authors assume that the transaction would not have qualified as a Type F reorganization, because the transfer of Y's assets to X would not result in a mere change in form or identity for Y. However, it is unclear why Internal Revenue Code Section 357(c) would apply to the transaction.
As stated above, Section 898 of the American Jobs Creation Act amended Internal Revenue Code Section 357(c) so that it only applies to Type D divisive reorganizations. A Type D divisive reorganization must comply with the corporate division requirements of Internal Revenue Code Section 355. Internal Revenue Code Section 357(c) does not apply to Type D acquisitive reorganizations. Type D acquisitive reorganizations must satisfy Internal Revenue Code Section 354. The transaction described by Treasury Regulation 1.1361-4(a)(2)(ii) Example 3 appears to be an acquisitive Type D reorganization. See PLR 200430025. As such, Internal Revenue Code Section 357(c) should not apply to the transaction.
FOR MANY CLIENTS THE PLANNER WILL RECOMMEND A CHANGE IN WHO OWNS THE BUSINESS ENTITY OR ENTITIES - IS IT POSSIBLE TO CHANGE ULTIMATE OWNERSHIP WITHIN A REASONABLE PERIOD OF TIME BEFORE OR AFTER AN F REORGANIZATION?
The present Treasury Regulations at Section 1.368-1(b) which became effective on February 25, 2005, provide that there is no continuity of ownership requirement in a Type F reorganization. Therefore, for example, a company that has been owned by one spouse might engage in a New Parent F Reorganization where the new parent company is owned by both spouses and/or a gifting trust for children or in any other combination. If a New Parent Reorganization is considered to be a D Reorganization then the continuity of ownership requirement would apply.
WILL THE TRANSFER OF VALUABLE ASSETS FROM AN EXISTING OPERATIONAL COMPANY BE CONSIDERED A FRAUDULENT TRANSFER THAT COULD BE "CHASED" BY PRESENT OR FUTURE CREDITORS OF THE PRE-EXISTING COMPANY?
This will depend upon the facts and circumstances at the time of the transfer. Where there are valid business reasons to insulate future operations from asset management, and where the assets left in the company, along with existing insurance coverages, are reasonably expected to be sufficient to handle any expected liability claim, then based upon the facts and circumstances it would be.
WHAT IS NEEDED TO EFFECTUATE A TYPICAL NEW PARENT F REORGANIZATION:
- A New Parent Corporation is formed and owned by the shareholders of Oldco.
- If Oldco is an S corporation then New Parent Corporation makes an S election.
- The shareholders transfer all of the stock of Oldco to New Parent Corporation and maintain ownership of Oldco under a Plan of Reorganization which satisfied the following requirements:
- Business purpose–to protect capital assets from liabilities of the business, and to provide for separate accountability and segregated management thereof.
- Not a devise to avoid income taxes-no income taxes are saved by this technique
- If Oldco has been an S corporation, then New Parent Corporation immediately files a Form 8869 to elect to have Oldco treated as a QSUB. Oldco can continue using its name and tax identification number, pursuant to Treasury Regulation Section 301.6109-1(i)(1).
- Assets are transferred from Oldco to New Parent Corporation, or to subsidiary disregarded LLC's, other QSUB's, consolidated return subsidiaries of C corporations, or whatever other entities New Parent Corporation may own.
- Appropriate changes to insurances, loan arrangements, and operational formalities are instituted at the time of the reorganization.
- New Parent Corporation and its shareholders live happily ever after.