Drop-and-Check F Reorganizations and Transferee Liability 

In his 1987 work, “Divided Minds and the Nature of Persons,”¹ the philosopher David Parfit posited a thought experiment, often referred to as the teletransportation paradox. The teletransportation paradox imagines a device (a teletransporter) that can transport a person from one planet to another. The erstwhile space traveler would enter a cubicle containing:

Parfit further refined the experiment to consider the situation in which instead of destroying the space traveler’s cells before reconstituting them as the Replica, the “Replica might be created while [the original person] were still alive, so that [they] could talk to one another.”

The question raised by these thought experiments is whether the Replica is the same person who entered the teletransporter. While one might be comfortable considering the Replica as the same person in the first instance (in which the original person is eliminated and reconstituted as the Replica), determining the identity of the Replica in the second instance, in which the original person remains in existence, presents a philosophical conundrum.

Lest anyone believe that the practical import of the teletransportation paradox is limited to philosophy and science fiction, tax attorneys confront a version of this paradox in the mergers and acquisitions context in the drop-and-check F reorganization. In a drop-and-check transaction, instead of a teletransportation cubicle, the means of replication is a transaction whereby the stock of a corporation (the original corporation) is transferred to a newly formed corporation (the new corporation), and the original corporation converts or merges into a state law limited liability company that is disregarded as an entity separate from the new corporation.

Under state law, the LLC has the same identity as the original corporation. The LLC inherits the original corporation’s assets and liabilities as a matter of state corporate law. As a matter of federal income tax law, the new corporation, as the survivor of an F reorganization, is viewed as the same taxpayer as the original corporation. In short, we are left in the same situation as with duplicate teletransportation travelers — there are two entities, both of which have a claim to the continued identity of the original corporation. This paradox of two entities with the same potential corporate identity raises the very practical question of which entity (the new corporation or the LLC) retains primary liability for any pre-reorganization federal income taxes owed by the original corporation. This determination can have significant consequences in the M&A context when a purchaser acquires the interests in the LLC as a means of structuring an acquisition of the original corporation while leaving the new corporation as a separate stand-alone entity.

Ordinarily, questions of primary and transferee liability for federal income tax are determined under state law — it being the general policy under the Internal Revenue Code that once a tax liability attaches, its collection, subject to federal procedural statutes,² is essentially a matter of debt collection determined under state law.³ However, this general paradigm can create distorted results when applied to a situation in which a transaction is characterized in a manner that is fundamentally different for state and federal purposes.

The purpose of this article is to examine these distortions, and to suggest an alternative framework for analyzing drop-and-check transactions. To that end, Section I explains the mechanics and legal underpinnings of a drop-and-check transaction, and discusses its use in the M&A context (particularly in transactions involving S corporations); Section II examines the authorities governing the survival of tax attributes and liabilities in the F reorganization context; Section III examines more generalized principles of primary and transferee liability for federal income taxes; and Section IV attempts to apply the relevant authorities to drop-and-check transactions, demonstrating the myriad difficulties raised by the conflicting federal and state characterization of the transactions.

I. Drop-and-Check Transactions and the Specter of Corporate Income Tax Liability

A drop-and-check F reorganization generally follows the following steps. First, the shareholders of the corporation that is to be reorganized (T) contribute 100 percent of the stock of T to a newly formed corporation (Newco). Next, immediately following the contribution of T, Newco causes T to either convert or merge into a new LLC that is disregarded as an entity separate from Newco. Under Treasury Regulations 301.7701-3(g)(1)(iii), T’s transition to a disregarded entity is treated as a tax-free liquidation of T into Newco under section 332.⁴ T will retain its same employer identification number for purposes of payroll and excise taxes (it is not disregarded for purposes of such taxes)⁵ but will generally use the EIN of Newco for other purposes.⁶

Drop-and-check F reorganizations are often used to facilitate the purchase of S corporations. When a financial buyer wishes to acquire an entity taxed as an S corporation under IRC section 1361, there are only limited means by which the buyer can obtain a step-up in the basis of the entity’s assets and the ability for the shareholders of the S corporation to continue their investment on a tax-deferred basis (a rollover) and, in many cases, to continue to hold that investment in a passthrough structure notwithstanding that new co-owners may not be eligible S corporation shareholders. Within the past decade, the S corporation drop-and-check F reorganization has become a frequently used technique, allowing for an effective “drop down” of assets to a subsidiary LLC without the need to move assets or contracts as a matter of state law.⁷ Because an S corporation drop-and-check F reorganization is a “mere change in identity, form or place of organization of one corporation,” Newco will be treated as the continuing corporation, and it will not be required to make a new election to be an S corporation.⁸

Because T will be a disregarded LLC upon an acquisition of its equity, the buyer will be treated as having purchased assets from Newco. To the extent that Newco retains any interest in T, the company will be treated as a newly formed partnership between Newco and the purchaser.⁹

Once T is a disregarded LLC, there are several structures by which a purchaser (P) might consummate the acquisition. The specific structure will depend on a variety of factors, including (i) the status of P as a corporation or a partnership for tax purposes and (ii) the desired level of seller rollover and the potential application of the “anti-churning” rules of IRC section 197(f)(9).¹⁰

A drop-and-check transaction is viewed as an efficient and (relatively) simple means of shifting ownership. Likewise, these transactions generally do not cause substantial consternation from the perspective of purchasers seeking to avoid successor or transferee liability for federal income tax because of the nature of an S corporation as a flowthrough entity not subject to federal income tax at the entity level. However, this lack of concern presupposes that the target is a valid S corporation, has made a valid S election, and has not made some misstep in the past that may have terminated its S election.

As most tax practitioners are aware, there are several requirements for a corporation to constitute a valid S corporation. These requirements are set out in section 1361. To become and continue operating as an S corporation, a corporation must not:

• have over 100 shareholders;

• have as a shareholder any person (other than some estates and trusts) that is not an individual;

• have as a shareholder any person that is a nonresident alien; or

• have more than one class of stock.¹¹

If an S corporation violates any of these restrictions, then, without any further action by the corporation or its shareholders, it will cease to be an S corporation and revert to a C corporation.¹² It is possible that a purported S corporation target may, in reality, be a C corporation that has not paid any corporate income tax during the time that it believed itself to be an S corporation, thus creating a historic corporate income tax liability.¹³ This possibility (however remote) raises the question of whether a buyer of T following a drop-and-check transaction would inherit this historic liability, or whether primary liability would remain with Newco as the survivor of the F reorganization.¹⁴

II. F Reorganizations and Corporate Identity

A drop-and-check transaction is not always an F reorganization. When the requirements of an F reorganization are not met, a contribution of all the stock of a corporation (target) to a corporation (acquiring) followed by an entity conversion or election to treat the target as disregarded will often qualify as a “D reorganization” under section 368(a)(1)(D).¹⁵ However, when a drop-and-check transaction meets the requirements of both an F reorganization and a D reorganization, it will be treated as an F reorganization.¹⁶ Both a D reorganization and F reorganization are tax-free transactions. However, an F reorganization is not only tax free by statute, but also is treated as a transaction in which, notwithstanding the technical steps of reorganization, the reorganized corporation retains its taxpayer identity.

Section 368(a)(1)(F) provides that a “mere change in identity, form or place of organization of one corporation however effected” is a tax-free reorganization. This general concept has been a part of the federal tax code since it was introduced as section 202(c)(2) of the Revenue Act of 1921 (the 1921 code), and the language of the statute has remained largely unchanged since that time.¹⁷

Before the 1921 code, under section 202(b) of the Revenue Act of 1918 (the 1918 code), reorganizations and consolidations of corporations were taxable to the extent that the par or face value of stock received in the reorganization exceeded the par or face value of stock relinquished in the reorganization.¹⁸ However, even under the 1918 code and its predecessors, U.S. tax administrators had recognized the notion that some changes to a single corporation ought not have any tax impact to shareholders or the corporation. In one 1920 ruling,¹⁹ the Bureau of Internal Revenue (the predecessor to the IRS) found that the reincorporation of a corporation in a new state in order to effectuate a change of domicile would not change the amount of its invested capital or terminate its tax year, noting that:

Thus, in all likelihood, the 1921 code’s introduction of the tax-free “mere change in identity, form or place of organization” was intended to codify existing agency practice rather than to create a new law. Indeed, in the committee reports accompanying the passage of the IRC of 1954, the House bill suggested removal of the F reorganization, calling it “unnecessary.”²⁰

Thus, since its inception, the F reorganization, unlike other corporate reorganizations, has represented a nonevent for tax purposes. That is, the corporation that “survives” the reorganization is treated as the same corporation as the one that undertook the reorganization. As noted by the Tax Court in Berghash v. Commissioner²¹:

In 2015, the IRS finalized regulations setting out the requirements for a transaction or series of transactions to constitute an F reorganization. The regulations lay out seven requirements for a series of transactions to constitute an F reorganization:

• all the stock of the resulting corporation (that is, the post-reorganization corporate entity — other than de minimis stock issued to organize the entity) must be distributed in exchange for the stock of the transferor corporation (the pre-reorganization corporate entity);

• the same person or persons must own all of the stock of the transferor corporation, determined immediately before the potential F reorganization, and of the resulting corporation, determined immediately after the potential F reorganization, in identical proportions;

• the resulting corporation may not hold any property or have any tax attributes (including those specified in section 381(c))²² immediately before the potential F reorganization;

• the transferor corporation must completely liquidate, for federal income tax purposes, in the potential F reorganization, but the transferor corporation is not required to dissolve under applicable law and may retain a de minimis amount of assets for the sole purpose of preserving its legal existence;

• immediately after the potential F reorganization, no corporation other than the resulting corporation may hold property that was held by the transferor corporation immediately before the potential F reorganization, if such other corporation would, as a result, succeed to and take into account the items of the transferor corporation described in section 381(c); and

• the transferor corporation is the only acquired corporation.

• Immediately after the potential F reorganization, the resulting corporation may not hold property acquired from a corporation other than the transferor corporation if the resulting corporation would succeed to and take into account the items of such other corporation described in section 381(c).²³

Thus, these requirements focus on the notion that any new corporation created as the resulting corporation have no outstanding stock, assets, or history other than that of the transferor corporation, and that it be the sole corporate entity holding those attributes. This is consistent with the notion set forth in section 381 that following an F reorganization, the resulting corporation succeeds to all the tax attributes of the transferor corporation without any change in the tax year.²⁵

The special status of an F reorganization as a mere change, in which the surviving corporation is the same corporation as before the F reorganization suggests that, just as tax attributes survive the reorganization without any change to use, tax liabilities existing before the reorganization should be unaffected by the reorganization. In the context of a drop-and-check transaction, this would mean that Newco, the corporate survivor of the reorganization, should inherit all prior tax liabilities of the now-disregarded predecessor entity, and any collection of those liabilities should treat Newco as the same entity as its corporate predecessor. However, despite the F reorganization principles that would appear to make this construct self-evident, the weight of authority governing successor liability for income taxes generally relies on state law to determine liability. This can create odd contradictions.

III. Liability for Federal Income Taxes

There are two primary ways in which a person may be liable for federal income taxes. First, a person may be primarily liable for the taxes as a taxpayer.²⁶ Second, a person may be secondarily liable for taxes of another as a “transferee” under IRC section 6901.

Section 6901 is a procedural statute providing a means for the IRS to collect a tax liability from a transferee who is liable for the taxes of another person as a matter of state law.²⁷ Critically, section 6901(c) extends the statute of limitations for collection of a tax liability from a transferee. As a result, a substantial body of common law has arisen to define the distinction between primary liability and liability as a transferee. This distinction generally relies on state law. When state law imposes primary liability on a successor by operation of law, that successor will often be treated as a primary obligor for tax purposes. By contrast, when state law imposes transferee liability on a successor, that successor may also be a transferee for tax purposes, subject to a finding that the person is a transferee as a matter of federal tax law.

A. Primary Liability

As a matter of state law, an entity, regardless of a change of its ownership, will generally retain all its historic liabilities. Likewise, an entity’s successor by merger or conversion in entity type will become fully liable for the predecessor entity’s liabilities as a matter of law.²⁸ This type of liability is generally considered primary liability under the federal income tax authorities.

In Commissioner v. Oswego Falls Corp.,²⁹ Oswego Falls Corp. (Oswego) was a new corporation formed under the New York Business Corporation Law to facilitate the consolidation of three existing New York corporations: Oswego Falls Pulp & Paper Co. (P&P Co.), the Skaneateles Paper Co., and the Sealright Co. Inc. Under state law, as the consolidated entity, Oswego became liable for all the liabilities of the predecessor corporations. After the merger, Oswego agreed to extend the statute of limitations regarding the collection of some taxes of P&P Co. One year after the expiration of this waiver, the commissioner issued a notice of deficiency to Oswego as a transferee of P&P Co. (as the statute of limitations for collection of a transferee liability expired one year after the statute of limitations for collection of a primary liability). The court found that Oswego was a not a transferee of P&P Co., but rather, that as a matter of New York law, it had become primarily liable for taxes of P&P Co., and that therefore, the collection action by the commissioner was barred by the statute of limitations.

Similarly, in Missile Systems Corp. of Texas. v. Commissioner,³⁰ Gulf Industries Inc., a Delaware corporation (referred to in the decision as Gulf-Delaware 1), acquired the stock of another corporation organized in Texas, also called Gulf Industries Inc. (Gulf Texas). Immediately thereafter, Gulf Texas was merged with and into Gulf-Delaware 1. Later, Gulf-Delaware 1 was merged with and into Hycon Aerial Surveys Inc., which changed its name to Gulf Industries Inc. (referred to as Gulf-Delaware 2). Gulf-Delaware 2 was then acquired by Missile Systems Corp., a Delaware corporation, and changed its name to Missile Systems Corp. of Texas.

The IRS mailed a notice of deficiency to Missile Systems Corp. of Texas claiming that it owed tax as a transferee of Gulf-Delaware 1. The company responded that while it may have primary liability for the taxes of Gulf-Delaware 1, it was not a transferee, and that because the IRS had made a claim based on transferee liability, the Tax Court was obliged to make its determination solely based on whether Missile Systems Corp. of Texas was liable as a transferee. The Tax Court, citing Commissioner v. Stern,³¹ noted that whether a person is liable as a transferee is to be determined as a matter of state law. It then found, citing Oswego Falls, that because as a matter of Delaware merger law, Missile Systems Corp. of Texas had succeeded to the liabilities of Gulf-Delaware 1 not as a transferee but as primary obligor on any tax debts of Gulf-Delaware 1, Missile Systems Corp. of Texas was not liable for tax as a transferee.

Interestingly, while both the Oswego Falls court and the Missile Systems court acknowledge that transferee liability is to be determined under state law, it would appear that the corollary is that at least in these cases primary tax liability was also determined under state law. That is, not only were the taxpayers in those cases not transferees under state law, the courts also determined that they were primarily liable for taxes based on a state law analysis.³² Of course, in both cases, this primary liability did not result in an actual tax payment obligation. In Oswego Falls, collection of the primary liability was barred by the statute of limitations, and in Missile Systems, collection would have required commencement of a new collection process by the IRS. However, both cases appear to stand for the notion that not only is transferee liability to be determined under state law, but also that primary liability may be determined under state law (at least regarding allocating liability between entities with a shared heritage). That is, when state merger law provides for an automatic assumption of all pre-merger liabilities by the merged entities, that entity will also be primarily liable for pre-merger federal income taxes of the merged entities.

Some courts have attempted to allow taxpayers with primary liability under state law to also qualify as transferees for purposes of section 6901. However, these courts have generally accepted the premise that an independent basis must be found under state law to render a primary obligor as a transferee for tax purposes.

In Southern Pacific Transportation Co. v. Commissioner,³³ Southern Pacific Co. was merged with and into a newly formed entity (Southern Pacific Transportation) with identical shareholders.³⁴ The IRS issued a notice of deficiency to Southern Pacific Transportation as a transferee of Southern Pacific Co. within the statute of limitations for transferee liability (but not within the statute of limitations for primary liability). Like in Oswego Falls, the taxpayer — while conceding that it was liable for the taxes at issue — argued that its liability was primary and not as a transferee as a matter of state law, and that the IRS was barred from collection under the statute of limitations. The court, like the Oswego Falls court, acknowledged that the taxpayer was primarily liable for the tax as a matter of state law. However, it noted that in addition to the assumption of liabilities that occurred as a matter of law, the merger agreement also contained an explicit contractual assumption of liabilities, and this contractual assumption of liabilities was sufficient to render Southern Pacific Transportation a transferee.³⁵

B. Transferee Liability

Transferee liability under state law encompasses a wide range of legal doctrines both at law and in equity. Attempting to distill the various laws of 50 states into a comprehensive synopsis of basic principles is a gargantuan task. Luckily, that task was undertaken by George W. Kuney in his 2007 article, “A Taxonomy and Evaluation of Successor Liability.”³⁶ While Kuney’s article is highly detailed and worth reading in its entirety, for purposes of this paper, the relevant rules governing an entity’s liabilities under most states’ laws can be summarized as follows:

The de facto merger and mere continuation doctrines are equitable doctrines that vary considerably by jurisdiction. A de facto merger often requires that there be significant continuity of shareholders, and that the purchase price be paid primarily in the form of stock of the acquirer.³⁹ A mere continuation also generally requires some form of a continuity of ownership, though the extent of continued ownership of the target business by the selling shareholders is less clear.⁴⁰ Thus, at a high level, one could consider the following set of principles fairly dispositive in analyzing state law liability in the mergers and acquisitions context:

• an entity will retain all its pre-transaction liabilities as a matter of law;

• a successor by merger or conversion will retain all the liabilities of its predecessor constituent corporations as a matter of law;

• an arms-length purchaser of substantially all an entity’s assets for full and adequate cash consideration will generally not be liable for that entity’s pre-transaction liabilities unless the purchaser assumes those liabilities as a matter of contract; and

• an arms-length purchaser of substantially all of an entity’s assets for full and adequate consideration consisting of both cash and equity of the purchaser may be liable for debts of the seller as a transferee if the elements of a de facto merger or mere continuation are present under applicable state law.

Transferee liability, while substantively determined under state law, is subject to special procedural rules for collection under section 6901. In recent years, courts have developed a two-step analysis for determining when a person might be liable for taxes of another under section 6901. The first step asks whether as a matter of state law, a person would bear substantive liability for the original taxpayer. If not, then the person cannot bear transferee liability as a matter of federal law. If so, then the second step is to determine whether the person is a transferee as a matter of federal law.⁴¹

Many modern transferee liability cases have arisen in the context of certain intermediary or “midco” transactions, in which taxpayers sell the stock of a C corporation with appreciated assets to an intermediary, which uses either its own tax attributes or dubious tax positions to create losses to absorb any corporate gain on a subsequent sale of assets.⁴² Generally, in these cases, courts will impose transferee liability on the original selling shareholders if the IRS can show that (i) the shareholders are liable as transferees under applicable state law and (ii) the shareholders should be viewed as transferees using an argument based on federal economic substance.

In Starnes, the taxpayers owned all the capital stock of Tarcon Inc., a C corporation. Tarcon Inc. had a trucking business and owned a warehouse. The taxpayers at issue (original shareholders) caused Tarcon Inc. to sell its warehouse, and then sold the stock of Tarcon Inc. to another company, Midcoast Investment Inc. Midcoast attempted to generate losses at Tarcon to offset the gain on the sale of the Tarcon warehouse, and then sold the Tarcon stock to a third-party buyer, which transferred all the Tarcon cash balances to its shareholders offshore. In auditing Midcoast as a promoter of abusive tax shelters, the IRS disallowed the losses claimed by Tarcon and sought to collect the resulting tax from the original shareholders as transferees under section 6901.

While conceding that the state law would not treat the original shareholders as transferees in their capacity as selling shareholders, the IRS argued that, as a federal tax matter, the transaction should be recast as a sale of assets by Tarcon, followed by a liquidation of Tarcon, and that, given that characterization of the transaction, the original shareholders would be transferees as a matter of state law.⁴³ The Fourth Circuit rejected this argument, finding that:

The court, did, however, note that had the IRS been able to show that the original shareholders were liable as transferees as a matter of state law, the substance-over-form analysis of the transaction might have been relevant in determining their status as transferees under section 6901.

Likewise, in Estate of Marshall v. Commissioner,⁴⁵ the Tax Court reviewed an intermediary transaction similar to the transaction at issue in Starnes. In Marshall, the Tax Court found that the petitioners were liable as transferees under Oregon law, and then proceeded to determine whether they were also transferees as a federal law matter under section 6901. In making its determination of transferee status as a federal matter, the Tax Court noted that a “court must consider whether to disregard the form of a transaction by which the transfer occurred when determining transferee status for Federal law purposes.”⁴⁶

The midco transaction authorities do provide some guidance as to the interplay of federal and state liability under section 6901. However, to this author’s knowledge, no court has yet addressed how state and federal law would be applied when their characterization of the transactions differs fundamentally.

The use of state law to determine liability for federal income taxes is fairly simple and administrable in transactions that are characterized in the same manner under federal and state law. The drop-and-check transaction, however, is characterized as a purchase and sale of equity for state law purposes but as a purchase and sale of assets for federal income tax purposes. Accordingly, the question arises as to whether — in determining transferee liability for federal income taxes — state law should be applied to the transaction as characterized for federal income tax purposes, or whether the state law characterization of the transaction should control.

C. Disregarded Entities and Primary Liability

One might think that disregarded entities should present an exception to the general rule that state law governs primary and transferee liability for federal income taxes. That is, one might assume that the federal disregard of disregarded entities for purposes of the federal income tax would trump the state law regard for such entities in evaluating questions of federal income tax liability. However, at least in some cases, what guidance there is appears to give priority to state law for purposes of determining such liability.

Treas. reg. 301.7701-2(c)(2)(iii), provides that a disregarded entity will retain liability for “federal tax liabilities of the entity with respect to any taxable period for which the entity was not disregarded.” Example 2 provides as follows:

In 2006, X, a domestic corporation that reports its taxes on a calendar year basis, merges into Z, a domestic LLC wholly owned by Y that is disregarded as an entity separate from Y, in a state law merger. X was not a member of a consolidated group at any time during its taxable year ending in December 2005. Under the applicable state law, Z is the successor to X and is liable for all of X’s debts. . . . In 2007, the IRS determines that X miscalculated and underreported its income tax liability for 2005. Because Z is the successor to X and is liable for X’s 2005 taxes that remain unpaid, the deficiency may be assessed against Z and, in the event that Z fails to pay the liability after notice and demand, a general tax lien will arise against all of Z’s property and rights to property.

Notably, in this example, because state law imposes liability for the taxes of X on Z, Z (the disregarded entity) is liable for the historic X liabilities. Despite Z being disregarded as separate from Y, Y’s other assets are insulated from liability for X’s historic liabilities caused by Z’s separate corporate existence. Thus, in this case, the state law regard for Z as the successor to the historic liabilities of X trumps its general disregard for federal income tax purposes.

Of course, it is unclear how this regard for a disregarded entity would be applied in the context of an F reorganization. In an F reorganization, the surviving corporation is treated as the same corporation as the predecessor. Thus, in a drop-and-check F reorganization, in which a T is contributed to Newco and then converts into an LLC, it is unclear whether liabilities of T preceding the F reorganization could be accurately viewed as liabilities “with respect to a taxable period for which the entity was not disregarded” as, for federal income tax purposes, even after the reorganization, the entity (the survivor of the F reorganization) remains regarded. Thus, unlike the example above, in which Z is the successor to X (and thus retains X’s identity in a manner analogous to a teletransportation device in which the original traveler and reconstitutes her in a separate location), in a drop-and-check F reorganization the original entity continues for federal income tax purposes as Newco, creating the same paradox as a teletransportation device that replicates the original traveler without eliminating her, and then reconstitutes her as a clone. To date, neither Treasury nor the courts have spoken to this issue.

IV. Application of Law

To try to make sense of this hodgepodge of legal rules and authorities, it is worthwhile to consider two alternative transactions and how they might be viewed under the applicable authorities. In each, X is an S corporation owned by two individuals, A and B. Y is an LLC backed by private equity that proposes to acquire the X business. Y would prefer to obtain a step-up in the basis of the X assets, and to provide A and B with the ability to continue their investment on a tax-deferred basis. Y would also prefer that the X business be housed in a flow-through structure, and thus does not wish to acquire the stock of X (which would cause X to become a C corporation because of Y not being a qualified S corporation shareholder). In each, after the transaction, X generates tax losses in 2020.

In a 2020 audit of X’s historic tax records, it is revealed that X has knowingly had a nonqualifying shareholder since 2010 and thus terminated its S election in 2010. This results in an historic corporate income tax liability that the IRS now seeks to collect.

A. Transaction 1: Asset Drop-Down

In this iteration, X contributes all of its assets and liabilities to a newly formed subsidiary LLC (X-2) in exchange for all of the interests in X-2. X-2 is disregarded as separate from X for federal income tax purposes. Y acquires 100 percent of the interests in X-2 for arms-length consideration consisting of a combination of cash and equity interests in Y (which are issued to and held by X). X agrees contractually to indemnify Y against any pre-closing income tax liability of X-2.⁴⁷

B. Transaction 2: Drop and Check

To avoid a lengthy process of assigning contracts and titled assets and to continue the use of X’s EIN for purposes of payroll and some state licenses, A and B contribute all the stock of X to a newly formed S corporation (Sellco). In exchange, A and B receive the stock of Sellco, which they own in the same proportions in which they owned the X stock. Sellco’s sole asset after this exchange is the stock of X, and Sellco has no liabilities. X then converts into a disregarded LLC under a state formless conversion statute. Y acquires 100 percent of the interests in X for arms-length consideration consisting of a combination of cash and equity interests in Y (which are issued to and held by Sellco). Sellco will continue to hold the Y equity as a member of Y. The pre-transaction reorganization of X is treated as an F reorganization. Sellco agrees contractually to indemnify Y against any pre-closing income tax liability of X or Sellco.

If full effect is given to the federal income tax disregard of the target entity, transactions 1 and 2 are identical for federal income tax purposes. Both are treated as a purchase of all the assets of X by Y (with a partial tax-free exchange under IRC section 721 to the extent of the in-kind consideration).⁴⁸ However, under state law, these two transactions are treated differently.

Transaction 1

In transaction 1, although X transferred its assets and liabilities to X-2, it has either contractually undertaken to indemnify against its historic federal income tax liabilities or has retained those liabilities at the outset. X-2 may be treated under a theory of de facto merger or mere continuation as a transferee subject to X’s retained or indemnified liabilities, but X’s continued separate existence and retained responsibility for historic tax liabilities, combined with the arms-length consideration paid by Y for the X-2 business, would present a serious legal challenge to the IRS in seeking to collect this liability from X-2 after its acquisition from X for full and adequate consideration.⁴⁹ Any historic tax liability imposed on X would, of course, be computed taking into account any applicable carryback of net operating losses allocated to X after the transaction.⁵⁰

If X paid its primary liability, the payment would simply be treated as a payment of its primary obligation for taxes, and would have no effect on X-2 or Y. If X were to breach its indemnity obligation under the purchase agreement, and the IRS were to seek collection from X-2, it is clear that its appropriate process would be to make a claim under section 6901 for transferee liability. In that case, as noted above, the IRS would be required to demonstrate (i) that X-2 is liable for the taxes of X as a matter of state law under a theory of de facto merger or mere continuation and (ii) that X-2 is liable as a transferee as a matter of federal law under section 6901. Even if it could establish the state law prong, it is not at all clear that the IRS could meet the standard of a transferee under the section 6901 regulations, as transferee does not generally include a purchaser of assets for full and adequate consideration.⁵¹

If X-2 paid the tax liability, its payment would constitute additional consideration paid by Y to X (assuming that it did not make an offsetting claim against X under the contract), thus generating additional basis in the X-2 assets and additional gain to X on the original transaction.⁵²

Transaction 2

Transaction 2 presents a much more difficult case. In transaction 2, the IRS could take any of three possible tacks to collect historic X tax liabilities from X⁵³:

• X remains primarily liable for the historic tax obligations of X;

• X is a transferee, with its transferee liability determined based on the state law characterization of the transaction; and

• X is a transferee, with its transferee liability determined based on the federal characterization of the transaction.

None of these three characterizations is easily defensible, as each presents contradictions and internal inconsistencies.

X has primary liability. As is noted above, as a matter of state law, X remains primarily liable for its debts even after the reorganization. Thus, based on many of the authorities cited above (Treasury Regulation 301.7701-2(c)(2)(iii), Oswego Falls and its progeny), it would be appropriate to treat any historic federal income tax liability of X in its life as a corporation as traveling with X. This argument, however, runs directly contrary to the entire notion of the effect of an F reorganization, which would treat Sellco as the surviving corporation and leads to distortions and contradictions.

Under the general principles of an F reorganization, Sellco is the continuing entity that underwent the reorganization. Thus, if X had a historically defective S election, Sellco is clearly the entity that would become a C corporation on a continuing basis (not X, which, though primarily liable for its historic tax obligations, is now a disregarded subsidiary of Y). As noted above, Sellco’s 2020 losses could be carried back to offset that taxable income in determining the amount of tax due. Yet, if X is the primary obligor for the historic tax, how can it benefit from the tax attributes of a separate entity (Sellco) to reduce those liabilities?

If X is the primary obligor, but Sellco pays the tax via its contractual obligations, it would seem that instead of being treated as having simply paid its federal income tax liabilities, the payment of the liability by Sellco would be treated, as to Sellco, as a reduction in the deal proceeds, thus reducing its capital gain on the sale.⁵⁴ This leads to a generalized contradiction: If the F reorganization authorities are applied to treat Sellco as a continuation of the original X corporation, this reduction in gain would effectively create a deduction for Sellco’s historic federal income tax liabilities (by way of a reduction in capital gain on the sale) notwithstanding the general bar on deducting federal income taxes under Section 275(a) of the code.⁵⁵

If Sellco did not pay the tax liability, and X paid the liability itself, the payment could be viewed as a nondeductible payment of federal income tax. However, as noted above, when Y purchased X, the transaction was treated as a purchase of all the assets of Sellco for tax purposes. To the extent that a contingent liability for federal income taxes was effectively assumed in that transaction by virtue of Y’s purchase of X, payment of that assumed liability would generally be capitalized by Y as additional basis, and recognized by Sellco as additional gain.⁵⁶ Thus, treating X as a primary obligor not entitled to capitalize its tax payment directly contradicts the treatment of the transaction as a purchase of the assets of Sellco, as, if such characterization is respected (thus disregarding X as a separate entity), then X’s responsibility for federal income taxes would be treated as an assumption by Y of Sellco’s contingent liability for federal income taxes. One is forced into an intellectual contortion whereby the primary federal tax liability is determined regardless of the federal characterization of the transaction. This would be a paradoxical and impractical way to enforce the federal income tax laws.

It baffles our general intuition in the same manner as if, in the teletransportation example in which both the Replica and the original traveler remain in existence, one were to treat the Replica as the original person and treat the original person as a new human being. Accordingly, it seems unlikely that any court would view X in this situation as the primary obligor for historic taxes of X while Sellco remains outstanding as the corporate successor by F reorganization to X.

This general contradiction could be mitigated by treating both Sellco and X as primarily liable for Sellco’s historic liability (on a joint and several basis). This would be consistent with the treatment of former members of consolidated groups of corporations,⁵⁷ and would elegantly avoid many of the complications raised by treating X as the only primary obligor for the past tax liability. However, there is nothing in the current code, regulations, or case law that appear to support this solution.⁵⁸

X has transferee liability based on state law characterization. A second, and more palatable, way to view X’s degree of liability would be to view X as a transferee under state law. Under this theory, effect is given to the federal income tax characterization of the transaction as a purchase and sale of assets. However, X is viewed as a transferee with full liability for the debts of the transferor as a matter of state law based on the statutes that require that a converted or merged entity retain all liabilities of its predecessor.⁵⁹ Thus, the IRS would acknowledge that, as the survivor of the F reorganization, Sellco is the primary obligor for the historic obligations of X, but because X retained liability for all of its historic liabilities as a matter of state law, it can be pursued as a section 6901 transferee.

This second option avoids several of the contradictions raised by treating X as the primary obligor. Effect is given to Sellco’s status as the surviving entity in the F reorganization, and to the treatment of Y’s purchase of X as a purchase and sale of assets. However, much of the case law appears to run contrary to treating X as a transferee. To be a transferee under section 6901, one must be a transferee as a matter of state law. Here, per the Oswego Falls and Missile Systems precedents, X is not a transferee as a matter of state law, but rather is the primary obligor.

Even if the more expansive view set forth in Southern Pacific Transportation is applied to treat X as both a primary obligor and a transferee, the explicit assumption of liabilities in that case is lacking in the present situation. The Southern Pacific Transportation court placed significant importance on the explicit assumption of liabilities because the liability assumed by operation of law, while making the successor liable for federal income taxes, did so as a matter of primary liability, not as a matter of transferee liability. Thus, the court had to find an independent basis under state law for transferee liability.

By contrast, in the present situation, the parties agreed that Sellco was to bear any historic federal income tax liabilities of X, making any residual liability to X a liability that arose as a matter of primary statutory liability, not as a matter of transferee liability. That is, there is no independent basis (outside the state law conversion) to treat X as a transferee rather than as a primary obligor. If X is not a transferee under state law, it is not at all clear that the IRS could effectively pursue X for Sellco’s liabilities under section 6901. Ironically, it would be X’s primary statutory liability for its historic liabilities that would prevent it from being a transferee as per Oswego Falls and Missile Systems. While treating X as the primary obligor is contradictory and nonsensical for the reasons set forth above, treating X as a transferee based on X’s statutory liability also does not appear appropriate, as that statutory liability makes X a primary obligor and not a transferee. Once again, we have reached a contradiction.

Transferee based on federal characterization. The final option would be to, in effect, ignore the state law treatment of the transaction and instead apply state law to its federal income tax characterization. That is, the purchase of X would be treated as a purchase of substantially all Sellco’s assets and analyzed in the same manner as transaction 1. This is the simplest means of treating the transaction, and achieves the result mandated by the federal characterization of the transaction, but it also appears to run afoul of the weight of precedent.

Generally, although a disregarded entity is disregarded, its status as a state limited liability entity is considered in analyzing federal tax consequences. By way of illustration, although disregarded as an entity separate from its owner, the IRS has taken the view that an individual’s tax liability cannot be collected from the assets of the individual’s disregarded entity.⁶⁰ Likewise, in the context of subchapter K, the IRS has promulgated regulations to the effect that because of its limitation of liability under state law, the guarantee of a partnership liability by a disregarded entity is only given effect for purposes of allocating basis to the extent of the disregarded entity’s asset value.⁶¹ Thus, to completely ignore the presence of a disregarded entity would be anathema.

Acknowledging the limited liability afforded by a disregarded entity does not necessarily mean that the state law characterization of a transaction as a purchase of equity should trump the federal income tax characterization of the transaction as a purchase of assets for purposes of applying state law to determine transferee liability. However, this idea of applying state law to federal characterization was precisely the theory that the Fourth Circuit rejected in Starnes, when it found that state law transferee liability must be present as a matter of state law “without an antecedent federal-law recasting of the disputed transactions.”

Of course, the federal-law recasting in Starnes was based on the application of a form-over-substance analysis, while the federal-law recasting of the sale of interests in a disregarded entity as a sale of assets is an administrative rule of construction that was known in advance by all parties to the transaction. While this distinction certainly creates more sympathy for the application of federal law to characterize the transaction, it is not clear that it should change the substantive analysis of whether state or federal law should apply to determine transferee status.

V. Conclusion

The treatment of drop-and-check transactions as F reorganizations is intellectually appealing. As in any F reorganization, the corporation that existed before the transaction continues to exist in a way that facilitates a nontax business objective without a fundamental change in form. However, when a drop-and-check F reorganization is used to facilitate an acquisition (as it often is), its status as an F reorganization creates substantial tension with the general use of state law to determine liability for taxes. As a policy matter, it seems clear that state law cannot govern liability in these situations without regard to federal characterization. However, to ignore state law in determining federal income tax liability is also unacceptable.

In the absence of guidance, one must assume that a purchased company that has undergone a drop-and-check reorganization will retain full liability for the past tax liabilities of the predecessor seller. However, this result is unclear, and it defies many tax professionals’ intuition that federal tax liability should follow federal tax characterization. Like the teletransportation paradox, any solution based on precedent or common sense is subject to attack. As such, buyers and sellers will not have clarity on this point unless and until Congress or Treasury establishes a rule.