An all-cash D reorganization is the IRS’s recharacterization of a cash-only asset transfer between two commonly controlled corporations as a tax-deferred reorganization under Section 368(a)(1)(D), even though no stock actually changes hands. The label matters because it strips the transaction of the treatment the parties expected. Cash the shareholders thought was sale proceeds gets retested for dividend treatment against the corporation’s accumulated earnings and profits, and the buying corporation loses the stepped-up basis it would have gotten in a real purchase.
The pattern the rule targets is familiar. A shareholder owns two corporations. One sells its assets to the other for cash and then liquidates. On paper, the shareholder reports a capital gain and walks away. Economically, the same person still controls the same business assets through the surviving corporation, and the cash looks a lot like a dividend from earnings the corporations had accumulated. The reorganization framework exists to stop that bailout.
When the IRS Will Recharacterize a Cash Deal
Section 368(a)(1)(D) requires that one corporation transfer assets to another, that the transferor or its shareholders control the transferee immediately after the transfer, and that the transferor distribute what it receives to its shareholders under a plan of reorganization.1Office of the Law Revision Counsel. 26 U.S. Code 368 – Definitions Relating to Corporate Reorganizations Control under Section 368(c) means at least 80 percent of the combined voting power and at least 80 percent of the shares of every other class.2Internal Revenue Service. Revenue Ruling 2015-10
Section 354(b)(1) adds two gatekeeping tests. The transferee must acquire substantially all of the transferor’s assets, and the transferor must distribute everything it received along with any remaining property.3Office of the Law Revision Counsel. 26 U.S. Code 354 – Exchanges of Stock and Securities in Certain Reorganizations For ruling purposes, the IRS treats “substantially all” as 90 percent of net asset value and 70 percent of gross asset value, though courts often focus on whether the core operating assets moved rather than on rigid percentages. In the all-cash setting, the control test is usually satisfied before anyone signs a document, because the same shareholders already own both sides.
The Deemed Nominal Share
The obvious objection is that a pure cash deal has no stock exchange, and reorganization treatment traditionally required one. Treasury Regulation 1.368-2(l) closes that gap. When the cash paid matches the fair market value of the transferred assets, the transferee is deemed to issue a nominal share of stock to the transferor, which is then deemed distributed to the transferor’s shareholders as part of the reorganization plan.4eCFR. 26 CFR 1.368-2 – Definition of Terms The nominal share carries no economic value. It exists solely to supply the structural link the statute demands.
The old continuity of interest requirement, which used to demand that target shareholders receive meaningful equity in the acquirer, no longer applies to D reorganizations between commonly controlled corporations. The IRS eliminated it in TD 9303 on the theory that shared ownership already demonstrates continuity.5Internal Revenue Service. TD 9303 – Corporate Reorganizations; Distributions Under Sections 368(a)(1)(D) and 354(b)(1)(B) Between the deemed nominal share and the relaxed continuity rule, the IRS has the tools it needs to pull a cash-only transaction into the reorganization framework.
Multi-Step Deals and the Step Transaction Doctrine
Splitting the deal into pieces will not necessarily keep it out. The step transaction doctrine lets the IRS collapse formally separate events into a single integrated transaction when they were designed to produce a unified result. Courts apply an end-result test, an interdependence test, and a binding-commitment test. The end-result test is the broadest and the one most commonly invoked. The most vulnerable pattern is a sale of assets to a related corporation followed by liquidation of the seller: collapsed, that becomes an asset transfer followed by a distribution, which is the shape of a D reorganization.
What Changes for the Shareholders
The sharpest consequences fall on the shareholders. Once the transaction is recharacterized, the cash they received is no longer sale proceeds. It is “boot” under Section 356: non-stock consideration received alongside a deemed stock exchange.6Office of the Law Revision Counsel. 26 USC 356 – Receipt of Additional Consideration Gain is recognized up to the amount of boot. Loss cannot be recognized at all, even if a shareholder’s basis exceeds the cash received.
The recognized gain then goes through a second test. Section 356(a)(2) treats the gain as a dividend, to the extent of the shareholder’s ratable share of accumulated earnings and profits, if the exchange has “the effect of a dividend distribution.” Whether it does is decided by the stock redemption rules of Section 302, which ask whether the distribution meaningfully reduced the shareholder’s proportional interest in the continuing enterprise.7Office of the Law Revision Counsel. 26 U.S. Code 302 – Distributions in Redemption of Stock In an all-cash D reorganization between commonly controlled corporations, the shareholder’s proportional ownership almost never changes. The same person owns the same percentage of the surviving entity. Dividend treatment is very hard to avoid.
The rate difference between qualified dividends and long-term capital gains is often zero for individual shareholders, so the sticker-shock is not really about the rate. The cost is structural. Dividend income cannot be offset by capital losses. And the pool that governs how much of the boot is taxed as a dividend is the corporation’s entire accumulated E&P, which can be much larger than the gain a shareholder would have reported on a clean sale. The total tax bill often ends up higher even when the per-dollar rate is the same.
What Changes for the Corporations
At the corporate level, the transaction switches from taxable to tax-deferred. Under Section 361, the transferor recognizes no gain or loss on the asset transfer as long as it distributes the cash it received to shareholders or creditors. Gain is recognized only on cash the transferor keeps.8Office of the Law Revision Counsel. 26 USC 361 – Nonrecognition of Gain or Loss to Corporations
Carryover Basis Instead of Step-Up
Section 362(b) gives the transferee a carryover basis in the acquired assets: the transferor’s old basis, increased by any gain the transferor recognized.9Office of the Law Revision Counsel. 26 U.S. Code 362 – Basis to Corporations This is one of the most consequential effects of recharacterization. In a real taxable purchase, the buyer’s basis would step up to fair market value. With a carryover basis, the transferee inherits the unrealized appreciation, and that built-in gain will be taxed when the assets are sold or depreciated. For appreciated assets, the future tax difference can be substantial.
Attribute Carryovers
Section 381 carries the transferor’s tax attributes over to the transferee as of the close of the transfer date, but only when the Section 354(b)(1) tests are met.10Office of the Law Revision Counsel. 26 U.S. Code 381 – Carryovers in Certain Corporate Acquisitions The attributes that carry over include net operating loss carryovers (subject to any Section 382 limitation from an ownership change), capital loss carryovers, and accumulated earnings and profits. A deficit in one corporation’s E&P can only offset earnings the other corporation accumulates after the transfer.
The E&P carryover deserves attention on its own. Because the amount of boot treated as a dividend is measured against accumulated E&P, combining two pools expands the amount potentially taxed as dividend income in future distributions, not just in the current transaction.
Transaction Costs
Professional fees, due diligence, and advisory costs paid to facilitate the reorganization generally have to be capitalized rather than deducted. Treasury Regulation 1.263(a)-5 applies whether or not any gain is recognized on the deal.11eCFR. 26 CFR 1.263(a)-5 – Amounts Paid or Incurred to Facilitate an Acquisition of a Trade or Business
Reporting Obligations
Both corporations that are parties to the reorganization, and any significant shareholder, must attach a statement to the return for the year of the transaction under Treasury Regulation 1.368-3. The corporate statement covers the names and EINs of the parties, the date of the reorganization, the value and basis of assets transferred (broken out into required categories), and any private letter ruling reference.12eCFR. 26 CFR 1.368-3 – Records to Be Kept and Information to Be Filed With Returns
A significant holder is any shareholder owning at least 5 percent (by vote or value) of a publicly traded corporation, or at least 1 percent of a non-publicly traded corporation. Significant holders file their own statement disclosing the value and basis of the stock or securities they were treated as transferring.
If the transferor is dissolving as part of the reorganization, it also has to file Form 966 after adopting its plan of dissolution or liquidation.13Internal Revenue Service. About Form 966, Corporate Dissolution or Liquidation Missing these filings will not undo the reorganization, but it can extend the statute of limitations and draw closer IRS review of the whole transaction.