Treas. Reg. § 1.368-2(b)(1)(iii), Example 7

Merger of a Corporation into a Disregarded Entity/Partnership

Corp Z merges under State W law into LLC X, a disregarded entity wholly owned by Corp Y, but the Z shareholders take back interests in X rather than Corp Y stock. Because X is no longer disregarded as an entity separate from Y — it becomes a partnership under § 301.7701-3(b)(1)(i) — Z’s assets and liabilities do not become the assets and liabilities of a member of a transferee unit, so the transaction fails to qualify as a statutory merger under § 368(a)(1)(A).

Treas. Reg. § 1.368-2(b)(1)(iii), Example 7; § 368(a)(1)(A)

Merger into a New Partnership Explained

The diagram walks through a three-step merger of a corporation into a disregarded entity that, as a result of the transaction, becomes a partnership. In the Initial Structure, Corp Y (the acquiror) owns 100% of LLC X, a disregarded entity, while the Z shareholders own Corp Z, the target. So long as X has a single owner, it is disregarded and its assets are treated as owned by Corp Y for Federal income tax purposes.

In the Merger step, Corp Z merges into LLC X under State W law and, simultaneously at the effective time, all of Z’s assets and liabilities become assets and liabilities of X and Z’s separate legal existence ceases. Critically, the Z shareholders surrender their Corp Z stock in exchange for interests in LLC X — not Corp Y stock. Because X now has more than one owner (Corp Y plus the former Z shareholders), it is no longer disregarded as an entity separate from Y.

At the Ending Point, LLC X is classified as a partnership under § 301.7701-3(b)(1)(i), owned by Corp Y and the former Z shareholders, and it holds the former Corp Z assets and liabilities.

The transaction does not satisfy paragraph (b)(1)(ii)(A) of the section: immediately after the merger X is not disregarded as an entity separate from Y, so all of Z’s assets and liabilities (the combining entity of the transferor unit) do not become the assets and liabilities of one or more members of a transferee unit. Accordingly, it cannot qualify as a statutory merger or consolidation under § 368(a)(1)(A).

Key Takeaways

Owner count is decisive

A merger into a disregarded entity works as an A reorganization only while the entity stays disregarded. When the target’s shareholders take interests in the LLC, the LLC gains a second owner and becomes a regarded partnership. Treas. Reg. § 1.368-2(b)(1)(iii), Example 7.

Transferee-unit test fails

Because X is not disregarded as separate from Y immediately after the merger, Z’s assets and liabilities do not become the assets and liabilities of a member of a transferee unit, so paragraph (b)(1)(ii)(A) is not met.

Result: a taxable exchange, not a statutory merger

The transaction cannot qualify as a statutory merger or consolidation under § 368(a)(1)(A); the exchange of Corp Z stock for LLC X partnership interests is tested under the partnership and general recognition rules instead.

Consideration drives classification

Had the Z shareholders received Corp Y stock (keeping X disregarded), the merger would have qualified. Taking LLC X interests instead converts X into a partnership under § 301.7701-3(b)(1)(i) and defeats reorganization treatment.

Related Tax Charts

Merging a corporation into an LLC where the target’s owners will hold LLC interests, and need to know whether it still qualifies as a tax-free statutory merger?

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