This chart follows Example 3, which uses the same facts as Example 2 except that the target, Corp Z, is an S corporation that owns all of the stock of Corp U, a qualified subchapter S subsidiary (QSub). In the Initial Structure, Corp Y (the acquiror and combining entity) owns 100% of LLC X, a disregarded entity — together they form the transferee combining unit. Separately, the Z shareholders own Corp Z, which owns 100% of Corp U; Corp Z and Corp U form the transferor combining unit.
In the Merger step, Corp Z merges into LLC X under State W law. The Z shareholders surrender their Corp Z stock and receive Corp Y stock. Because LLC X is disregarded, its assets are treated as owned by Corp Y for Federal income tax purposes, so all of the assets and liabilities of Corp Z and Corp U — the members of the transferor unit — become assets and liabilities of the transferee unit.
Termination of U’s QSub election is treated as a deemed formation by Z of U under § 1.1361-5(b)(1), which is disregarded for Federal income tax purposes. The transaction is treated as a transfer of U’s assets to X, followed by X’s transfer of those assets to U in exchange for U stock (see § 1.1361-5(b)(3), Example 9). That deemed asset transfer for U stock does not cause the transaction to fail to qualify as a statutory merger. See § 368(a)(2)(C).
At the Ending Point, the former Z shareholders own Corp Y, which owns 100% of LLC X, which in turn owns 100% of Corp U — now a regular C corporation. The transaction satisfies paragraph (b)(1)(ii) and qualifies as a statutory merger or consolidation under section 368(a)(1)(A).
A statutory merger of an S corporation into a disregarded entity qualifies as an A reorganization because the DRE’s assets are treated as owned by its regarded corporate owner, Corp Y. Treas. Reg. § 1.368-2(b)(1)(iii), Example 3.
The transferor combining unit is Corp Z together with its QSub, Corp U; the transferee unit is Corp Y and its disregarded LLC X. All assets and liabilities of both transferor members must become those of the transferee unit.
Loss of Corp Z as U’s S corporation parent terminates U’s QSub election, treated as a deemed formation of U under § 1.1361-5(b)(1) that is disregarded; the deemed asset transfer for U stock does not disqualify the merger. See § 368(a)(2)(C).
After the merger, Corp U is no longer a QSub — it is a C corporation held under LLC X, which is held by Corp Y, now owned by the former Z shareholders who surrendered their Corp Z stock for Corp Y stock.
