The Solvency Problem and Tax-Free Mergers

Most transactions generally result in a taxable event, unless they qualify for nonrecognition treatment under the Internal Revenue Code (IRC). IRC Sections 332 and 368, specifically, provide for nonrecognition treatment of qualifying liquidations and reorganizations. But a conflict is brewing. There are proposed regulations that have been in the works for a decade that, if finalized, will potentially cause complications among certain mergers. The trouble began with an effort to create uniform prerequisites for nonrecognition treatment of most corporate transactions under IRC Sections 332 and 368. In 2005, the IRS and US Treasury Department issued proposed regulations to clarify the requirements for nonrecognition treatment. Regarding Section 368, the net value requirement controversy sprung from the issuance of Revenue Ruling 59-296. Revenue Ruling 59-296 held that the relevant principles under Section 332 applied to Section 368 reorganizations. As to a merger involving one or more insolvent corporations, the logic underpinning a solvency requirement is less compelling, and the IRS's position is less defensible.