Tax-Free Reorganizations: Section 368 Basics
How mergers, share exchanges, and changes of form can happen without triggering tax, the requirements every reorganization must meet, and a structure small businesses commonly use before a sale.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
A reorganization under Section 368 lets corporations merge, exchange shares, or change form without recognizing gain, provided the transaction fits a statutory type and meets the judicial requirements: continuity of shareholder interest, continuity of the business, and a real business purpose. Basis carries over, and cash or other property received is taxable to the extent of gain.
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What are the types?
| Type | What happens | Typical use |
|---|---|---|
| A — statutory merger | One corporation merges into another under state law | Acquisitions paid mostly in stock |
| B — stock for stock | Acquirer exchanges solely its voting stock for control of the target | Target stays a subsidiary |
| C — assets for stock | Acquirer exchanges voting stock for substantially all the target's assets | Target liquidates |
| D — transfer to a controlled corporation (often divisive, with Section 355) | A corporation transfers assets to a new corporation and distributes its stock | Spin-offs and split-offs |
| E — recapitalization | Exchange of stock or debt within one corporation | Converting common to preferred in an estate freeze |
| F — change of identity, form, or place | A new corporation steps into the old one's shoes | Pre-sale restructuring of an S corporation |
| G — insolvency | Transfers in bankruptcy | Reorganizations under court supervision |
What requirements apply to all of them?
- Continuity of interest. Target shareholders must receive a meaningful equity stake in the acquirer — the regulations give an example in which 40 percent of the consideration in stock is enough, and practitioners treat that as the benchmark.
- Continuity of business enterprise. The acquirer continues the target's historic business or uses a significant portion of its assets.
- Business purpose. A reason beyond tax avoidance.
- Plan of reorganization. Documented in the corporate records.
Fail any of these and the transaction is generally taxable as a sale or exchange. The two continuity requirements do not apply to E and F reorganizations.
Why does the F reorganization matter to small businesses?
Before selling an S corporation, the owners form a new holding corporation, contribute the old corporation's shares to it, make a qualified subchapter S subsidiary (QSub) election for the old corporation on Form 8869, and then convert it to an LLC under state law. The buyer then purchases the LLC interests — treated as an asset purchase for tax, giving the buyer a stepped-up basis, while the sellers get one level of tax and keep the historic S corporation intact for rollover equity or earnouts. It is a common pre-sale structure in small-company deals.
What about an LLC becoming a corporation?
Converting an LLC taxed as a partnership into a corporation is generally tax-free under Section 351, not Section 368 — the business is transferred for stock, and the transferors must control at least 80 percent of the corporation immediately afterward; liabilities exceeding the basis of the transferred assets can trigger gain. The conversion itself is simple; its consequences (losing pass-through losses, built-in gains if the corporation later elects S status) are what need planning.
What are the traps?
Boot — cash, assumed liabilities above basis in some types, or non-stock consideration — is taxable. Net operating losses of the target are limited after an ownership change. A reorganization that is really a device to distribute earnings can be recharacterized as a dividend. And state law must actually permit the merger or conversion used.
Frequently asked questions
Can an S corporation participate in a reorganization?
Yes, including as the surviving entity, subject to its eligibility rules after the transaction.
Is a reorganization reported to the IRS?
Yes. Each corporation that is a party to the reorganization, and each significant holder (generally an owner of at least 1 percent of a privately held target's stock, or 5 percent if publicly traded), attaches a statement to its return for the year of the exchange.
Does the buyer in an F reorganization deal get bonus depreciation?
Generally yes — 100 percent for qualifying property acquired after January 19, 2025 — on the stepped-up basis of qualifying assets, provided the buyer is not related to the sellers. Goodwill is instead amortized over 15 years.
Can a reorganization be undone?
Generally not. Apart from a narrow rescission doctrine for a transaction fully unwound within the same tax year (Rev. Rul. 80-58), a later transaction has its own tax consequences.
Official sources
Section 368(a)(1)(F) defines one type of reorganization as: “a mere change in identity, form, or place of organization of one corporation, however effected” — Legal Information Institute, Cornell Law School, 26 U.S. Code § 368 - Definitions relating to corporate reorganizations, https://www.law.cornell.edu/uscode/text/26/368
The regulation provides: “Continuity of interest requires that in substance a substantial part of the value of the proprietary interests in the target corporation be preserved in the reorganization.” — Legal Information Institute, Cornell Law School, 26 CFR § 1.368-1 - Purpose and scope of exception of reorganization exchanges., https://www.law.cornell.edu/cfr/text/26/1.368-1
Next step
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