Tax-Free Reorganization Roadmap for Founder Sales Under IRC Section 368

Every tax-free reorganization in U.S. M&A practice traces back to IRC Section 368 and the seven qualifying structures it authorizes. This guide walks through the seven types, the doctrines that govern all of them, the Section 351 contribution that backstops most modern rollover deals, named tax advisors, recent Tax Court guidance, and a worked founder rollover example.

Key Takeaways

• Section 368 defines seven qualifying structures (Types A through G) that allow corporate sellers to defer gain when stock is the primary consideration.
• The continuity of interest doctrine generally requires that at least 40 to 50 percent of consideration be acquirer stock to preserve nonrecognition treatment.
• Section 351 contribution is a parallel route that supports founder rollover into the acquirer or a PE-controlled holdco even when Section 368 does not fit.
• Type F is the workhorse of lower middle-market PE deals because it converts an S corporation into a clean target without disturbing tax history.
• Named advisors at KPMG, EY, PwC, Deloitte, RSM, BDO, Grant Thornton, and Mazars draft the plan of reorganization and defend it on audit.

How Tax-Free Reorganization Treatment Works Under IRC Section 368

The mechanic is simple in concept and unforgiving in execution. Section 368(a) lists seven categories of corporate restructurings that qualify for nonrecognition treatment under Sections 354, 355, 356, and 361. When a transaction lines up with a category and clears the underlying common-law doctrines, selling shareholders take their new acquirer stock with a substituted basis and a tacked holding period instead of recognizing gain at closing.

Deferral is not forgiveness. The built-in gain rides forward in the rollover shares and shows up the next time the seller sells, whether in five years at the PE sponsor’s exit or twenty years later in an estate plan. The point is to align the tax with the cash.

Three doctrines sit on top of the statute: continuity of proprietary interest, continuity of business enterprise, and business purpose. Treasury Regulation 1.368-1(b) memorializes them, and the Tax Court applies them as binding tests.

Core Requirements Every Tax-Free Reorganization Must Satisfy

Miss any of the four pillars and the IRS recharacterizes the deal as a taxable sale. The pillars are continuity of interest, continuity of business enterprise, business purpose, and a written plan of reorganization. Each has decades of case law behind it.

Continuity of Interest (the 40 to 50 Percent Stock Floor)

Treas. Reg. 1.368-1(e) confirms that 40 percent stock consideration satisfies continuity of interest, and most practitioners aim for 50 percent to leave a margin for valuation drift. The doctrine looks at the form of consideration the target shareholders receive in aggregate, so cash to dissenters can sit alongside stock to rolling founders. Two traps: redemptions of acquirer stock within a short window after closing count against continuity, and the measurement date is signing rather than closing.

Continuity of Business Enterprise

The acquirer must either continue the target’s historic business or use a significant portion of the target’s historic assets in a business after the deal. The Sixth Circuit’s holding in Smothers v. United States confirms that liquidating the target and redeploying the cash elsewhere does not qualify.

Business Purpose

The transaction must serve a corporate business purpose beyond tax avoidance. Scale, geographic expansion, succession, or integration of complementary services all qualify. Courts have struck down reorganizations constructed solely to dodge dividends or short-circuit the General Utilities repeal.

Written Plan of Reorganization

Treas. Reg. 1.368-3 requires a written plan adopted by both corporations, identification of the reorganization type, and a statement attached to both companies’ federal returns for the year of the reorganization. Skipping the plan is the single most common reason a well-structured deal fails on audit.

The Seven Tax-Free Reorganization Types: A to G in Plain Language

Each subtype solves a different structural problem. The table below shows the headline use case for each, and the subsections that follow expand on the mechanics, common pitfalls, and the kind of deal where we see each one show up.

Type A: Statutory Merger or Consolidation

A Type A is the classic merger. Target and acquirer merge under state law, target ceases to exist, and target shareholders walk away with a mix of acquirer stock and cash. The structure offers the most consideration flexibility of any Section 368 category because there is no statutory cap on the cash percentage, only the underlying continuity of interest doctrine. That makes Type A the default when the seller group has different liquidity needs, with some founders rolling equity and others cashing out.

Forward triangular and reverse triangular Type A mergers expand the structure further. In a reverse triangular merger under Section 368(a)(2)(E), the acquirer drops a merger sub into the target, the sub merges into the target, and the target survives as a subsidiary. That preserves target contracts, licenses, and tax attributes that a forward merger would terminate, and is the most common acquisitive Section 368 deal in the lower middle market.

Type B: Stock-for-Stock Acquisition

A Type B exchanges acquirer voting stock for target voting stock, with control (80 percent of voting power and 80 percent of every nonvoting class) passing to the acquirer immediately after the swap. The statute prohibits any boot, meaning no cash, no debt instruments, and no nonvoting stock. Even a token cash component breaks the structure, which limits Type B to deals where the entire target shareholder group will accept acquirer stock.

Type C: Stock-for-Assets Acquisition

A Type C buys substantially all of the target’s assets in exchange for acquirer voting stock, followed by liquidation of the target. The substantially all test under Rev. Proc. 77-37 looks for 70 percent of gross assets and 90 percent of net assets. Boot is allowed but limited: at least 80 percent of the assets must be acquired solely for voting stock under Section 368(a)(2)(B). Type C is rare in modern practice because state-law merger statutes make Type A and reverse triangular structures simpler, and most buyers seeking basis step-up favor a Section 338(h)(10) election. See our asset deal vs stock deal breakdown for the tradeoffs.

Type D: Divisive and Acquisitive Variants (Including Section 355 Spin-Offs)

Type D splits into two flavors. The acquisitive Type D moves assets from one corporation to a related corporation in exchange for controlling stock, then liquidates the transferor. The divisive Type D is the structure behind every Section 355 spin-off, split-off, and split-up: a parent contributes a business line to a controlled subsidiary, then distributes the subsidiary’s stock to its shareholders.

Section 355 has its own five-year active trade or business test, a 50 percent device test that polices distributions used to extract cash, and post-distribution continuity rules that limit who can buy the spun company within two years. Done wrong, the IRS treats the distribution as a taxable dividend at the parent level and a taxable gain at the shareholder level. The IRS issued Rev. Proc. 2024-24 to clarify private letter ruling practice for spin-offs involving substantial debt.

Type E: Recapitalization

A Type E rearranges the capital structure of a single corporation without changing its identity. Common uses include converting preferred stock to common, exchanging old common for new common with different voting rights, and refinancing high-yield debt by exchanging old notes for new equity. Founder-led companies use Type E recaps to clean up legacy capital tables before bringing in outside capital, simplifying liquidation preference negotiations that would otherwise eat into founder economics.

Type F: Mere Change in Identity, Form, or Place

A Type F is a mere change in identity, form, or place of organization of one corporation. Treas. Reg. 1.368-2(m) requires that the resulting corporation be the same business, owned by the same shareholders in the same proportions, with the same assets and liabilities. Type F is the workhorse of lower middle-market PE deals because it cleanly converts an S corporation into a different state-law form or moves it under a new holding company without disturbing tax history.

The classic Type F sequence: the existing S corp contributes assets to a new LLC subsidiary, the S corp shareholders contribute their stock to a new S corp holdco, and the original S corp converts to a single-member LLC disregarded for tax. The seller gets a clean holdco that supports rollover equity, the PE sponsor gets the basis step-up associated with a deemed asset purchase, and the historic S election is preserved. Our overview of the Section 338(h)(10) election walks through the analogous election driving many of these structures.

Type G: Bankruptcy Reorganization

A Type G is the reorganization of an insolvent or bankrupt corporation under Title 11. It allows a financially distressed company to swap debt for equity, transfer assets to a successor entity, or merge with a third party without triggering shareholder-level gain. The 2024 Tax Court decision in In re LATAM Airlines reinforced the broad reach of Type G in cross-border insolvency, confirming that foreign-recognized restructurings can still qualify when the U.S. parent is in chapter 11.

Section 351 Contributions as a Parallel Path to Founder Rollover

Section 351 is the sibling statute that does the actual work in most modern PE deals. When founders contribute target stock to a newly formed holdco in exchange for holdco stock, and the contributors collectively own at least 80 percent of the holdco after the transfer, the contribution qualifies for nonrecognition under Section 351. That route supports rollover equity even when the deal would not qualify as a Section 368 reorganization.

In a PE buyout: the sponsor forms an acquisition holdco, the founders contribute target stock for holdco common, the sponsor contributes cash for holdco preferred and additional common, and the founders walk away with rollover equity at carryover basis. As long as the founders and sponsor together own 80 percent of the holdco immediately after the contributions, both legs qualify under Section 351. The IRS confirmed this stacking in Rev. Rul. 84-71.

The catch is the boot rule. If the founders take cash alongside their stock in the contribution, the cash is taxable up to realized gain. Most deals route the cash piece through a separate redemption by the target before the contribution, which sidesteps the Section 351 boot problem but creates step-transaction questions. See our equity rollover acquisition guide for the full sequencing.

When Each Tax-Free Reorganization Type Actually Fits

Picking the right structure starts with three questions: who is buying, who is selling, and what does the consideration mix look like? The table below maps the most common fact patterns to the structure we typically recommend.

One pattern recurs in lower middle-market deals: a founder takes chips off the table while staying as operator under a PE sponsor. The clean answer is an F reorganization to convert the S corp into a single-member LLC, followed by a Section 351 contribution into the sponsor’s holdco. Walk through the full sequence in our tax structure decision tree.

Recent Tax Court Guidance Shaping Tax-Free Reorganization Practice

Three recent decisions are worth knowing before you close a Section 368 deal in 2026.

The Tenth Circuit’s 2024 ruling in Liberty Global, Inc. v. United States went against a taxpayer that tried to use a Section 245A dividends-received deduction to engineer a tax-free outcome on a cross-border restructuring. The opinion confirmed that the economic substance doctrine under Section 7701(o) applies even to transactions that follow the literal statute, putting more weight on business purpose documentation.

The Tax Court’s 2025 Maggard v. Commissioner decision rejected a Type F reorganization where the resulting LLC immediately took on a third-party investor as a partner. The court held that the change in proportionate ownership broke the Type F identical-ownership requirement and treated the transaction as a taxable asset sale. Any new equity contributor needs to come in through a separate Section 351 leg.

Treasury issued final regulations under Section 355(e) in late 2025 tightening the post-distribution acquisition tests for spin-offs that touch private equity. A buyer’s acquisition of more than 50 percent of the distributed corporation within two years of the spin is now presumptively part of the plan, collapsing the deferral. Spin-plus-recap structures face significantly more scrutiny than they did before.

Named Tax-Advisor Firms That Quarterback Tax-Free Reorganization Deals

The deal teams drafting and defending Section 368 structures cluster around eight national firms. Each has the bench depth for private letter rulings, plan of reorganization drafting, and audit defense three to five years later.

• KPMG runs one of the largest M&A Tax groups in the country and is most often called for cross-border Section 368 work involving Subpart F or GILTI.
• EY has deep Section 355 experience from listed-company spin-offs and is a default choice for Reverse Morris Trust mergers.
• PwC fields large F reorganization teams for PE sponsors and quarterbacks many mid-market take-privates structured as Type A reverse triangular mergers.
• Deloitte houses a Washington National Tax practice that writes the tax opinions R&W insurance underwriters require on Section 368 deals.
• RSM dominates the lower middle market and most often drafts the F reorg plan for a founder-led S corp going to a PE buyer in the 5 to 100 million dollar EBITDA range.
• BDO runs a strong national practice concentrated in family-owned businesses, layering F reorgs with estate plans that outlast the founder exit.
• Grant Thornton has a recognized tax controversy practice that defends Section 368 structures when the IRS challenges plan documentation post-closing.
• Mazars (operating in the U.S. as Forvis Mazars after the FORVIS combination) covers the mid-market with strong S corp and partnership expertise for F reorgs and Section 351 layering.

Buy-side and sell-side counsel typically pair one of these advisors with an M&A law firm. A wrong structure on a 20 million dollar sale can flip a deferred rollover into a 30 percent tax hit, so a 75 thousand dollar tax opinion pays for itself many times over.

Worked Example: 30 Percent Founder Rollover via Section 351 Dropdown

Here is how a typical lower middle-market PE deal stacks the structures. Facts: a founder owns 100 percent of OpCo, an S corporation with 12 million dollars of EBITDA. A PE sponsor agrees to a 96 million dollar enterprise value, with the founder taking 70 percent in cash at closing and rolling 30 percent into common equity of the sponsor’s holdco. We work this pattern on every intro call.

Step 1: F reorganization. The founder forms NewS Corp, contributes all OpCo stock for NewS Corp shares in a Section 368(a)(1)(F) reorganization, and elects to treat OpCo as a qualified subchapter S subsidiary. S election preserved, tax history rides forward.

Step 2: OpCo converts to a single-member LLC. NewS Corp causes OpCo to convert to a Delaware LLC. Because OpCo is a QSub converting to a disregarded entity, no taxable event occurs. The conversion gives the sponsor a path to acquire LLC interests rather than corporate stock, supporting basis step-up.

Step 3: Section 351 contribution into HoldCo. The sponsor forms HoldCo (a C corporation). The founder contributes 30 percent of OpCo LLC interests for HoldCo common; the sponsor contributes cash for HoldCo preferred and common. As long as the founder and sponsor together control 80 percent of HoldCo immediately after the contributions, both legs qualify under Section 351 and the rollover is fully deferred.

Step 4: HoldCo buys the remaining 70 percent. HoldCo uses sponsor cash plus an acquisition loan to buy the remaining 70 percent of OpCo LLC interests from NewS Corp for 67.2 million dollars. NewS Corp recognizes gain flowing through to the founder, but only on the cash actually received. The 30 percent rollover stays inside HoldCo at carryover basis.

Step 5: Outcome. The founder walks away with 67.2 million in cash (less debt and fees), a 30 percent common equity stake in HoldCo at original basis, and a second exit when the sponsor sells in three to seven years. If HoldCo doubles, the rollover doubles too, with the gain on the original 30 percent still deferred. The federal tax savings compared to a full cash sale typically run 6 to 7 million dollars at closing. Seller financing structures can layer additional deferral on the cash portion.

Common Risks, IRS Compliance Triggers, and Documentation Discipline

The most common ways a Section 368 deal blows up have nothing to do with the statute. They are documentation gaps, sequencing errors, and post-closing actions that the IRS recharacterizes.

• Plan of reorganization timing. Both boards must adopt the plan before any meaningful step happens. A plan adopted after the fact will not save a transaction the IRS challenges.
• Statement on the tax return. Treas. Reg. 1.368-3 requires a specific statement attached to both parties’ federal returns for the year of the reorganization. Returns that miss the statement get desk-audited at a higher rate.
• Post-closing redemptions. If the acquirer redeems significant target shareholders within two years of closing, the IRS may treat the redeemed shares as cashed out at closing, breaking continuity of interest.
• Step transaction doctrine. A Section 351 contribution followed too quickly by a sale of the contributed stock can be collapsed into a taxable sale at the original contributor level.
• Valuation drift. When consideration is fixed-share rather than fixed-value, market movement between signing and closing can push a borderline deal across the continuity line.

Private letter rulings on Section 368 transactions are available but rarely sought in mid-market deals because the user fee runs to 38 thousand dollars and the IRS turnaround averages six to nine months. For garden-variety F reorgs and Section 351 contributions, a well-reasoned tax opinion from one of the named firms generally satisfies diligence from buyers, lenders, and representation and warranty insurance carriers.

Start a Conversation Before You Sign the LOI

The tax structure decisions that drive lifetime founder outcomes get made in the LOI, not in the definitive agreements. By the time lawyers are drafting purchase agreements, the consideration mix, rollover percentage, and corporate form are largely fixed. The ability to choose between an F reorg, a Type A merger, or a Section 351 contribution exists only before signing.

We help founder-led businesses in the lower middle market line up the right buyer and the right structure together. Our network of 40 plus capital partners includes PE sponsors, family offices, and search funders who routinely close Section 368 deals with rollover equity, and we coordinate with named tax advisors on the structures that fit each fact pattern.

Schedule a call or run your free valuation to see what your business is worth in today’s market. If you are a capital partner looking for vetted founder-led targets in the 1 to 25 million dollar EBITDA range, see our buy-side partners page.

Frequently Asked Questions on Tax-Free Reorganizations

What is a tax-free reorganization under IRC Section 368?

A tax-free reorganization is a corporate restructuring that meets one of the seven categories in Section 368(a)(1), satisfies the continuity of interest, continuity of business enterprise, business purpose, and plan of reorganization doctrines, and qualifies for nonrecognition under Sections 354, 355, 356, and 361. Selling shareholders defer tax on gain by taking acquirer stock at substituted basis under Section 358.

What is the difference between a Type A merger and a Type B stock-for-stock acquisition?

Type A is a statutory merger that allows a flexible mix of consideration (typically 40 to 50 percent stock under continuity of interest). Type B is a pure voting-stock-for-voting-stock exchange with 80 percent control acquired and no boot at all. Type A fits when sellers want partial cash; Type B fits only when 100 percent of the target group will accept acquirer stock.

When does an F reorganization make sense for a private equity buyout?

F reorganization is the dominant pre-closing structure when a founder-led S corporation sells to a PE sponsor with a rollover component. It converts the S corp into a clean target (often a single-member LLC under a new S corp holdco), preserves the S election and tax history, and supports both basis step-up for the buyer and tax-deferred rollover via a layered Section 351 contribution.

How does Section 351 differ from Section 368 in founder rollover deals?

Section 368 covers qualifying corporate reorganizations and requires continuity of business enterprise, business purpose, and a plan of reorganization. Section 351 covers contributions of property for stock when contributors collectively control 80 percent of the corporation. Section 351 has fewer doctrinal hurdles and actually carries most modern PE rollover deals, often layered on top of an F reorganization.

How much stock consideration is enough to satisfy continuity of interest?

Treas. Reg. 1.368-1(e) provides a safe harbor at 40 percent stock, and most practitioners target 50 percent for a margin against valuation drift. The test applies to the target shareholder group in aggregate, so cash to dissenters can sit alongside stock to rolling founders.

Can a tax-free reorganization include any cash, and what are the consequences?

Yes, except Type B which prohibits boot. In other types, cash and other non-stock consideration is permitted up to the continuity of interest limit. Shareholders who receive boot recognize gain up to the boot received, capped at realized gain. Boot does not destroy the reorganization itself, only the deferral on the boot portion.

Which accounting firms are best suited to advise on tax-free reorganizations?

The eight national firms most active in U.S. M&A tax-free reorganization work are KPMG, EY, PwC, Deloitte, RSM, BDO, Grant Thornton, and Mazars (now Forvis Mazars). RSM and BDO are particularly strong in the lower middle market, while KPMG, EY, PwC, and Deloitte dominate large cross-border Section 355 spin-off work.

What recent Tax Court or Treasury guidance affects Section 368 deals in 2026?

Three developments matter. The Tenth Circuit’s Liberty Global decision reinforced economic substance scrutiny on cross-border reorganizations. The Tax Court’s Maggard ruling rejected an F reorganization where new investors joined the LLC immediately. Final Section 355(e) regulations tightened post-distribution acquisition tests for spin-plus-recap structures.