The IRS has issued temporary regulations that treat the merger of a target corporation into a wholly owned limited liability company (an "LLC") of an acquiring corporation as a tax-free reorganization described under Internal Revenue Code Section 368(a)(1)(A) (a "direct merger"), provided the shareholders of the target corporation receive stock in the acquiring corporation sufficient to satisfy the judicially created "continuity of interest" requirement. The new rules treat the transaction as if the target corporation merged directly into the acquiring corporation. In the past, there was considerable uncertainty as to whether this transaction would qualify as a tax-free reorganization, except in narrow circumstances.

This treatment is significant because a direct merger, as distinguished from a merger of a target corporation into a corporate subsidiary of the acquiring corporation (a "forward triangular merger"), has relatively few statutory requirements that must be satisfied to qualify as a tax-free reorganization. On the other hand, to qualify as a tax-free reorganization, the surviving subsidiary corporation in a forward triangular merger generally must acquire "substantially all" of the target corporation's pre-merger assets. Thus, if a target corporation were to distribute a significant portion of its assets to its shareholders in connection with a merger, the transaction generally could not be structured as a forward triangular merger. The triangular merger structure, however, often is preferred by acquiring corporations because it isolates the target corporation's pre-existing liabilities and, in some cases, eliminates the need to obtain approval of the merger by the acquiring corporation's shareholders. Thus, the new rules permit the use of the triangular acquisition structure (involving a wholly owned LLC of the acquiring corporation) favored by acquiring corporations without the need to comply with the more restrictive statutory provisions applicable to forward triangular mergers. Accordingly, the new rules will be most useful where satisfaction of the "substantially all" requirement is in doubt.

It is important to note that the new rules do not cause all mergers between LLCs and corporations to be treated as direct mergers. For example, the merger of a wholly owned LLC of an acquiring corporation into a target corporation would not be treated as a direct merger under the new rules (although the transaction may qualify as another type of tax-free reorganization under pre-existing rules). Furthermore, a merger of a target corporation into an LLC that is not wholly owned by the acquiring corporation remains unaffected by the new rules.

The new rules also apply to mergers into corporate subsidiaries that are disregarded for federal income tax purposes, including certain wholly owned corporate subsidiaries of real estate investment trusts and S corporations.

The new rules are effective for transactions occurring on or after January 24, 2003. However, taxpayers may rely upon the new rules for transactions occurring prior to January 24, 2003, provided that the new rules are applied in whole by both the acquiring and target corporations and any affected shareholders.