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Many entrepreneurs starting a small business do not intend to keep their businesses small. But as corporations grow, their exposure to liabilities often increases as well. Unfortunately, many corporations do not take sufficient steps to shelter their assets from potential liabilities.
Take, for example, a hypothetical real estate development corporation named Real Co., Inc. Assume that Real Co. owns a parcel of real estate where it conducts business, various pieces of heavy equipment and machinery, and significant cash reserves from a recent sale of a developed property. Let’s further assume that Real Co. employs a driver to pick up and deliver supplies. While out on an assignment, the driver causes an accident on the freeway involving several other vehicles. Because Real Co. owns all of its assets, these assets are all subject to potential liability.
While waiting until after the accident may be too late, how could Real Co. have transferred its assets to affiliate entities in order to protect its assets from potential liability without incurring a significant tax burden resulting from the asset transfer? The solution lies within the federal tax code. Tax-free Reorganization
Section 368(a)(1)(F) of the Internal Revenue Code provides a tax-free mechanism to reorganize a corporation in a manner that will enable the corporation to shield some of its assets from the liabilities associated with the corporation’s business or even other assets. A reorganization under this section, termed an F reorganization, is simply “a mere change in identity, form, or place of organization of one corporation, however effected.”
The specific mechanics of this type of reorganization depend on whether the corporation is a C corporation or S corporation. Because the steps are similar in each case, no distinction will be made here.
In the above illustration, Real Co. must form a new corporation, New Parent Co., Inc., to be a holding company for the entire business. The shareholders of Real Co. then transfer their shares of Real Co. to New Parent Co. to form a parent-subsidiary relationship. Real Co. will continue functioning as the operating company. Once this initial structure is properly formed, New Parent Co. must create various disregarded entities to be subsidiaries of New Parent Co. Each of these subsidiaries will be used to hold the various groups of assets of the company. For example, one subsidiary will own the real estate, another will hold the equipment and a third can be used to maintain the cash reserves.
Finally, each of the newly created subsidiaries will enter into an agreement where it will grant to the operating company access to the use of the assets it owns. While the subsidiaries owning the real estate and equipment would lease their respective assets to the operating company, the subsidiary maintaining the cash reserves would grant to the operating company a line of credit.
If this structure was in place at the time of the employee’s traffic accident, the assets of the operating subsidiary, which are likely minimal, would be subject to liability, but the high-value assets residing in the affiliate subsidiaries should be protected.
Additionally, because the subsidiaries are all disregarded entities, the income and expenses of the subsidiaries all flow up to New Parent Co. Accordingly, the lease and interest expenses are offset at the New Parent Co. level. Ultimately, the overall income tax effect of New Parent Co. is identical to Real Co.’s tax liability prior to the reorganization. However, the liabilities associated with the operations of New Parent Co.’s business will now be segregated from many of New Parent Co.’s high-value assets.
Corporations should note that the first steps of this process are crucial to complying with the F reorganization requirements, and the specific mechanics of these steps differ depending on whether Real Co. is a C corporation or an S corporation. Corporations desiring to implement an F reorganization should seek legal and tax advice to make sure the reorganization is structured properly. If the transfer is not done correctly, Real Co. may likely be subject to tax liabilities associated with the asset transfer.
Cover the Bases
While the corporate structure identified in this article can be set up upon commencement of operations, a newly formed corporation may not be able to justify the expense of organizing in such a manner. However, as the company grows, this structure becomes more sensible to protect the assets of the company, especially as the liability risk and exposure increases with the size of the company.
By implementing an F reorganization, a corporation can take advantage of this asset protection strategy without incurring the disadvantages of a tax liability from an asset transfer. Effectively implementing this strategy will help an entrepreneur ensure the continued growth of the company into the future.
David J. Langeland is a shareholder with the law firm of Callister Nebeker & McCullough in Salt Lake City.