Divisive mergers have been around since Texas adopted a divisive merger statute in 2006.
Texas’s law allows a variety of business entities organized in Texas, including limited liability companies, limited partnerships and corporations (a Dividing Company) to divide into two or more entities (a Division Company), and to allocate the assets, liabilities, rights, and duties of the Dividing Company among the Division Companies.
Since that time, a few other states, including Delaware in 2018, adopted similar restructuring mechanisms. Delaware’s divisive merger section, however, is limited to Delaware limited liability companies.
These divisive merger statutes provide additional flexibility in separating and disposing of assets and liabilities of a company. The following describes the Delaware approach.
The Delaware Approach
As an example: LLC1 has two equal owners (A and B), and LLC1 owns two pieces of real estate, property C and property D. If the owners of LLC1 desire to separate, with A taking property C and B taking property D, both in LLCs, a common way to achieve the division would be to either:
drop property C into a new LLC2 and drop property D into a new LLC3, and liquidate LLC1 by transferring LLC2 to A and LLC3 to B; or
drop property C into a new LLC2 and redeem out A for LLC2.
Both involve deeds and possibly bills of sale and assignments. In the second scenario, the pre-closing liabilities of property C remain liabilities of LLC1 (although the parties by contract would likely adopt contractual indemnification for pre-closing liabilities).
Using a divisive merger, LLC1 would be split into two entities by operation of law – resulting in either:
LLC1 owning property C and LLC2 owning property D (the surviving entities, collectively referred to as the Division Companies, consisting of the preexisting entity, referred to post-division as the Surviving Company, and one new entity, referred to as a Resulting Company); or
LLC2 owning property C and LLC3 owning property D (i.e., the Division Companies consisting of two new Resulting Companies).
In addition to interests in the Resulting Companies, the statute also authorizes interests in the Dividing Company to be exchanged for other consideration, such as cash, property, or interests in the Surviving Company.
The Opposite of a Merger
Conceptually, a divisive merger is similar to but the opposite of a merger.
The Dividing Company (LLC1 in the above example) must first adopt a plan of division that sets forth the terms and conditions of the division of assets, liabilities, rights and duties among the Division Companies and the conversion or exchange of the interests in the Dividing Company for interests in one or more of the Division Companies or other consideration. The Division Companies may be:
The plan of division may provide for changes in the limited liability company agreement of the Dividing Company or the replacement of the limited liability company agreement of the Dividing Company with a new limited liability company agreement. The plan shall provide for the adoption of a limited liability company agreement for each Resulting Company.
A plan of division is not required to list each individual asset, liability, right, or duty of the Dividing Company that is to be allocated among the Division Companies. Rather, it is sufficient if the plan reasonably identifies the assets and liabilities in a way that the items so allocated are objectively determinable.
If debts or liabilities are not allocated by the plan, the debts or liabilities are deemed to be joint and several obligations of all of the Division Companies.
If properly allocated, and the plan of division does not constitute a fraudulent conveyance under applicable law, all liens are preserved, and all debts and liabilities are obligations of the Division Company to which they are allocated, with no other Division Company having liability therefor.
The plan of division is not filed with the Secretary of State of Delaware and therefore cannot be publicly obtained. Rather, a certificate of division must be filed, along with certificates of formation for the newly-created Resulting Companies. The certificate only provides limited information, such as the names and addresses and a statement that the plan is on file at a certain business location.
A contact in the State of Delaware must agree to maintain a copy of the plan for a minimum of six years, and provide upon the request of any creditor of the Dividing Company during the six-year period the name and business address of the Division Company to which their claim was allocated pursuant to the plan.
When a Divisive Merger Is Useful
Divisive mergers may be particularly useful when trying to transfer assets by operation of law without the transfer constituting an assignment or transfer.
On that point, the Delaware statute says the allocated items “shall remain vested in each Division Company and shall not be deemed, as a result of the division, to have been assigned or transferred.” The statue provides certain transitional rules for contracts or agreements entered into prior to Aug. 1, 2018.
An example of the use of a divisive merger in an IRC Section 355 tax-free spinoff setting is set forth in IRS Revenue Ruling 20203509 (Aug. 28, 2020). In that ruling, a group of corporations wanted to spin off to their shareholders a portion of their operations. It appears that the state law did not allow a divisive merger of corporations (presumably they were Delaware corporations).
Accordingly, the taxpayer converted one of its corporate subsidiaries to an LLC (LLC1) and checked the box to treat LLC1 as a corporation for income tax purposes. The taxpayer then divided LLC1 into two LLCs, LLC1, and LLC2 (also treated for tax purposes as a corporation by checking the box) via a divisive merger, and distributed LLC2 to its shareholders.
The IRS held that the divisive merger was treated as if LLC1 transferred business assets to LLC2 in exchange for the equity of LLC2 (a tax-free D reorganization) and the transfer of the interests in LLC2 to the shareholders constituted a tax-free spinoff.
Conclusion: Another Option
The divisive merger statutes give parties another option to restructure their operations. Conversely, they will require careful drafting to make sure that parties who intend to limit all types of transfers by operation of law tailor their contracts accordingly, as existing provisions may not be broad enough to encompass divisive mergers.
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