On March 13, 2026, the Internal Revenue Service (the “Service”) released PLR 2026110021 (the “Ruling”) confirming treatment of a merger (the “Merger”) as a tax-free reorganization under section 368(a)(1)(A).
Facts of the Ruling
The facts of the Ruling are simple. A target corporation (“Target”), that was treated as an S corporation for U.S. federal income tax purposes, merged downstream with and into a less-than-wholly-owned corporate subsidiary (“Acquiring”) with Acquiring surviving2. The Ruling established that prior to the Merger, Acquiring had voting and non-voting common stock outstanding, and a portion of each was owned by Target. Specifically, Target owned “approximately j% of the value and k% of the voting power (as measured by ability to elect Acquiring’s board of directors).”
Target’s primary asset before the Merger was the common stock of Acquiring and its gross income—attributable to dividends from Acquiring—was routinely distributed to Target’s shareholder’s, which consisted of three primary shareholders as well as a number of minority shareholders. Consistent with past practice, the taxpayer stipulated that it would distribute cash to its shareholders in the “Pre-Merger Distribution” pursuant to its “regular and ordinary distribution procedures.” The Ruling contains a representation establishing that the Pre-Merger Distribution would occur irrespective of whether the Merger occurs.
The Merger would be effectuated pursuant state law whereby all assets of Target are transferred to and assumed by Acquiring, subject to Target’s outstanding liabilities. Each of the target shareholders would receive its pro rata share of (i) newly issued Acquiring stock (adjusted for cash paid in lieu of fractional shares3) as well as (ii) an amount of cash (the “Cash Boot”).
The Rules and Analysis
In order for a merger to qualify as a reorganization under section 368(a)(1)(A) certain statutory and non-statutory requirements must be satisfied. Most notably, the transaction must satisfy (i) the “continuity of interest” requirement and (ii) the “continuity of business enterprise” requirement.
Continuity of Interest Requirement
Generally, the continuity of interest requirement attempts to “prevent transactions that resemble sales from qualifying for nonrecognition” treatment and requires that “a substantial part of the value of the proprietary interests in the target corporation be preserved” in the transaction4. This requirement is satisfied if 40 percent of the value of the total consideration received by the target shareholders is in the form of acquiring corporation stock5.
In addition to certain customary taxpayer representations, the taxpayer in the Ruling represented that the aggregate fair market value of the Acquiring stock issued in connection with the Merger will be at least 40 percent of the fair market value of the total consideration received by the target shareholders in exchange for their Target stock “even if such total consideration included the Pre-Merger Distribution.”6 This representation conservatively takes the cash distributed in the Pre-Merger Distribution into account for continuity of interest purposes, even though there appears to be a factual basis for treating such cash as unrelated to the Merger.
Relatedly, the taxpayer represented that repurchases of Acquiring stock after the Merger will only occur pursuant to a previously adopted stock repurchase program meeting certain IRS requirements7. The taxpayer further representation that none of the primary shareholders had a plan or intention to utilize the stock repurchase program to have Acquiring redeem the Acquiring shares issued in connection with the Merger8. Finally, there is a representation establishing that salaries received by Target’s employee-shareholders would be attributable to services rendered in their capacities as employees and that no portion of the Acquiring stock would be attributable to an employment agreement, effectively ringfencing any Acquiring shares received by such employees as in consideration for their Target stock9. This was enough to get the Service comfortable that in the case of this closely held Target corporation, the continuity of interest requirement should not be violated on account of tangentially related transactions or payments received by shareholders in a non-shareholder capacity.
Continuity of Business Enterprise Requirement
The continuity of business enterprise requirement generally requires the acquiring entity to either (i) continue the target entity’s historic business or (ii) utilize a significant portion of the target entity’s assets in a business following the transaction10. In this regard, the taxpayer represents that following the Merger, Acquiring intends to continue its historic business. In accepting this representation as a sufficient basis for satisfying the continuity of business enterprise requirement, the Service implicitly confirms that it will look through Target’s underlying investment in Acquiring for purposes of identifying the business operated by Target that needs to be preserved and continued following the reorganization11. Further, the cash that is being distributed by Target (i.e., a historical asset of Target is being disposed of) ought not violate the continuity of business enterprise requirement. Similarly, the fact that Target’s principal asset, the shares of Acquiring that become treasury stock, effectively disappears for U.S. federal income tax purposes as result of the Merger, will not prevent the continuity of business enterprise requirement from being satisfied12.
Tax Treatment of the Pre-Merger Distribution and Cash Boot
Additionally, and perhaps somewhat uniquely, we note that the Service ultimately did not view the Pre-Merger Distribution as connected with the Merger despite the language in the taxpayer representations establishing continuity of interest. Specifically, “Cash Boot” and the “Pre-Merger Distribution” are defined as separate terms in the Ruling13. The Ruling’s ultimate conclusions, and specifically Rulings 2 and 3, suggest that no portion of the Pre-Merger Distribution is taxable under section 356 or gives rise to an adjustment under section 358 (i.e., only the Cash Boot amount does).14 This is particularly significant here, because in ruling that the Pre-Merger Distribution is not subject to section 356, the Service permitted the Pre-Merger Distribution to be received as a potentially tax-free return of capital distribution under the rules relevant to S corporations that prioritize basis first. That is, the Pre-Merger Distribution, treated separately, was not taxable as a dividend under section 301(c)(1) and could instead constitute a return of basis transaction under section 301(c)(2) (assuming no prior C corporation history).
By way of illustration, assume Target, which is an S corporation, is valued at $100 and the Target shareholders have an aggregate basis of $50 in their Target stock. In a baseline scenario in which no pre-merger distribution occurs, assume the Target shareholders receive $20 of cash boot and Acquiring stock with a fair market value of $80 in a merger transaction. Under section 356(a)(1), the shareholders recognize gain equal to the lesser of (i) the built-in gain in their Target stock (i.e. $50) and (ii) the cash boot received (i.e., $20), resulting in $20 of recognized gain due to recovery of basis (recognition of gain first).
By contrast, assume that $10 of cash is held by Target prior to the merger and is instead distributed in a pre-merger, ordinary course distribution. In that case, the $10 distribution is treated as a non-taxable return of basis under the rules relevant to S corporations, which prioritize basis recovery first15. This distribution reduces Target’s value from $100 to $90, and the shareholders’ aggregate stock basis from $50 to $40. The subsequent merger then involves $10 of cash boot and Acquiring stock with a fair market value of $80. Applying section 356(a)(1), the shareholders recognize only $10 of gain (i.e., the lesser of the remaining $50 built-in gain and the $10 of cash boot). Accordingly, treating the pre-merger distribution as separate from the merger reduces recognized gain from $20 to $10 by allowing the $10 pre-merger distribution to be received tax-free as a return of basis (return of basis first). As a resulting more after-tax cash is returned to S corporation shareholders.
The example above highlights one potential justification for seeking the Ruling, although other potential justification can arise in the context of an S corporation to C corporation reorganization with boot.
Implications
The Ruling is a good example of a way in which taxpayers may avail themselves of the benefits of the private letter ruling process, including optimizing their tax position with IRS assurance. WilliamsMarston has extensive experience advising on fundamental business transactions, including tax-free reorganizations under section 368, and it able to assist with structuring and implementing transactions to achieve optimal tax outcomes.
This article is for general information only and does not constitute valuation advice
1 Dec. 16, 2025.
2 The Merger was to be effectuated pursuant state law whereby all of the assets of Target are transferred to and assumed by Acquiring, subject to Target’s outstanding liabilities.
3 The payment of the cash in lieu of fractional shares was not to exceed one percent of the total consideration paid in the Merger.
4 Treas. Reg. § 1.368-1(e).
5Treas. Reg. § 1.368-1(e)(2)(v) provides examples of when the continuity of interest requirement is satisfied, indicating in the event 40 percent of the total consideration received is in the form of stock of the acquiring entity and 60 percent of the consideration received is cash, the requirement is satisfied. Alternatively, when the consideration paid for the target stock was comprised of 25 percent stock in the acquiring entity and 75 percent cash, the transaction failed to satisfy the continuity of interest requirement.
6 See Representation 13.
7 See Representation 14.
8 See Representation 28.
9 See Representation 29.
10Treas. Reg. § 1.368-1(d).
11 In the case where a parent holding entity, whose sole asset is stock in its operating subsidiary, merges with and into the subsidiary, the continuity of business enterprise requirement is satisfied by virtue of the parent holding entity’s historic business being the business of its operating subsidiary, which continues post-transaction. Rev. Rul 85-197, 1985-2 C.B. 120.
12The disappearance of the Acquiring stock does not prevent the merger requirement from being satisfied because that stock is technically transferred and acquired by operation of law despite its disappearance. Rev. Rul. 70-223, 1971 C.B. 79
13 Specifically, the “Pre-Merger Distribution” is defined as the distribution made by Target “to its shareholders pursuant to its regular and ordinary distribution procedures” prior to the Merger. Alternatively, the context of the Ruling suggests that “Cash Boot” only includes payments of cash to Target in the Merger, which is subsequently distributed “pro rata to shareholders of Target as [. . .] consideration in cancellation of Target stock.”
14 Cf. Rev. Rul. 71-364, 1971-2 C.B. 182.
15Section 1368(b)(1).
