Understanding Type B Tax-Free Reorganizations: Structure, Rules, and Benefits

Internal Revenue Code (IRC) provides several avenues for corporations to reorganize in a manner that defers tax consequences. One of these options is the Type B reorganization, governed under IRC § 368(a)(1)(B). This structure allows an acquiring corporation to obtain control of another corporation (the target) by exchanging its voting stock – no boot allowed.

What is a Type B Reorganization?

A Type B reorganization is a type of stock-for-stock exchange in which one corporation acquires another with only an exchange for its voting stock, without using any cash or other forms of consideration (commonly referred to as “boot”) IRC § 368(a)(1)(B).

To qualify, the acquiring corporation must obtain "control" of the target corporation, which the IRC defines as at least 80% of both the voting power and the total number of shares of each class of nonvoting stock. IRC § 368(c). This reorganization allows the target company to become a subsidiary of the acquiring company without triggering immediate tax liability for either the corporations involved or the target’s shareholders. IRC § 354(a).

Statutory Authority and Legal Framework

The legal foundation for a Type B reorganization is primarily found in the following provisions:

• IRC § 368(a)(1)(B): Defines a Type B reorganization.

• IRC § 368(c): Defines "control" as ownership of at least 80% of voting stock and 80% of all other classes of stock.

• IRC § 354(a): Provides for the nonrecognition of gain or loss on certain exchanges of stock in a reorganization.

• IRC § 356(a): Covers the consequences of receiving non-qualifying property ("boot").

• IRC § 357: Addresses the assumption of liabilities in reorganizations.

• Treas. Reg. § 1.368-2(b): Elaborates on the structure and requirements of a Type B reorganization.

• Rev. Rul. 70-140, 1970-1 C.B. 73: Provides guidance on when acquisitions meet the requirements of §368(a)(1)(B).

Key Requirements for a Valid Type B Reorganization

 1. Stock Acquisition Only. The acquiring corporation must acquire stock, not assets, of the target corporation as directed by IRC § 368(a)(1)(B). This differentiates a Type B reorganization from asset-based reorganizations like Type A or Type C.

2. Sole Use of Voting Stock. Only voting stock of the acquiring corporation (or its parent) can be used as consideration. The inclusion of any other form of consideration such as cash, property, or debt would disqualify the transaction from tax-free treatment. IRC § 368(a)(1)(B); Rev. Rul. 66-284, 1966-2 C.B. 115.

3. Immediate Control. The acquiring company must obtain control of the target corporation immediately after the exchange. “Control” is defined in IRC § 368(c) as owning 80% of the voting stock and 80% of each class of nonvoting stock. This control must be the result of the exchange of voting stock and not obtained through previous ownership or unrelated transactions. Treas. Reg. § 1.368-2(b).

4. Continuity of Interest. The transaction must preserve a substantial part of the shareholder interest in the continuing enterprise. Treasury Regulation § 1.368-1(e) interprets this to mean that shareholders of the target must retain a continuing interest in the acquiring corporation.

5. Continuity of Business Enterprise. The acquiring company must either continue a significant part of the target’s historical business or use a significant portion of its assets in a business. Treas. Reg. § 1.368-1(d).

How a Type B Reorganization Works: An Example

Purchaser wants to acquire Target through a Type B Tax-Free Reorganization. Target have a fair market value (“FMV”) of $250,000 in assets and an adjusted basis (“A.B.”) of $75,000 in those same assets. Purchaser will finance this purchase through a stock for stock exchange of 500 shares of Purchaser in exchange for 100 shares of Target.

Those shares will go to the Target Shareholder (“Shareholder”) does not recognize a taxable gain for this transaction, but instead receives a substituted basis in its stock value. IRC § 354(a). As in this example, Shareholder has a $100,000 A.B. in its shares and this becomes its substituted basis now in the 500 shares of Purchaser. Target’s A.B. in assets also remains the same as the A.B. in Shareholder’s stock and does not receive a step up in basis.

Strategic Advantages of a Type B Reorganization

 1. Tax Deferral. Perhaps the greatest advantage is that the transaction is tax-free to all parties involved—target shareholders, the acquiring company, and the target itself. IRC § 354(a), § 361(a).

2. Preservation of Target as a Legal Entity. Because the reorganization is structured as a stock acquisition rather than a merger, the target continues as a separate entity. This means that existing contracts, licenses, tax attributes, and regulatory statuses can remain in place, which may be desirable in many industries.

3. Avoidance of Asset Transfers. Since no assets are transferred, the process avoids complex issues related to title transfers, contract assignments, and sales taxes that might otherwise apply to asset purchases.

4. Simplified Regulatory Approval. In certain jurisdictions or under corporate bylaws, stock purchases may not require the same shareholder or regulatory approvals as statutory mergers. This can speed up the transaction and reduce costs.

5. Use of Holding Companies. The voting stock used in a Type B reorganization may be that of the acquiring corporation’s parent company, offering additional structuring flexibility. Treas. Reg. § 1.368-2(b)(1).

Limitations and Challenges to the Type B

 1. Strict Use of Voting Stock. A major constraint is that only voting stock can be used. Any introduction of boot (even a small amount) will result in gain recognition or failure to qualify. See IRC § 368(a)(1)(B); Rev. Rul. 66-284.

2. Immediate Acquisition of Control. The acquiring corporation must obtain control immediately as a result of the exchange. If the 80% threshold is achieved through a series of independent transactions, the reorganization may fail to qualify. Treas. Reg. § 1.368-2(b)(1).

3. No Tax Basis Step-Up. Unlike asset purchases, a Type B reorganization does not allow for a step-up in the basis of the target corporation’s assets. This could reduce future depreciation and amortization tax benefits.

4. Limited to Stock Acquisitions. Because Type B applies only to stock acquisitions, it may not be suitable when the buyer wants to cherry-pick specific assets or avoid assuming liabilities.

5. Anti-Abuse Scrutiny. IRS scrutiny applies to ensure the transaction is not merely a façade to achieve tax benefits. Prearranged steps, side agreements, or other economic substance issues can cause disqualification.

The Type B tax-free reorganization, as codified under IRC § 368(a)(1)(B), is a valuable tool in the corporate restructuring and acquisition landscape. It offers a path to consolidation without immediate tax consequences, provided that the transaction adheres to strict statutory and regulatory requirements—most notably, the exclusive use of voting stock and the immediate acquisition of control.

While not as flexible as other forms of reorganization, the Type B structure offers strategic advantages such as preserving corporate entities, avoiding complex asset transfers, and simplifying approval processes. Businesses contemplating this approach should consult with legal and tax professionals to ensure compliance and optimize the structure to meet both business and tax planning goals.

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