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CORPORATE TAX-FREE REORGANIZATION FUNDAMENTALS OBJECTIVES OF ...

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CORPORATE TAX-FREE REORGANIZATION FUNDAMENTALS. OBJECTIVES OF CORPORATE TAX-FREE REORGANIZATIONS. THIS CHAPTER IS DEVOTED TO THE RESTRUCTURING OF CORPORATE ...

    Corporate Tax-Free Reorganization

    Fundamentals

    Objectives of Corporate Tax-Free Reorganizations

    This chapter is devoted to the restructuring of corporate ownership through “tax-free

    reorganizations.” The stock ownership of both large and small corporations (or the bulk of a corporation's assets) is commonly transferred through dispositions and acquisitions. A tax-free reorganization can be accomplished, for example, through (1) the negotiated merger of a family business into a publicly held conglomerate, (2) the acquisition of one corporation by another through a bitterly fought tender offer to acquire the target's stock either for cash or for the stock of the acquirer, or (3) the purely formalistic consolidation of two wholly owned subsidiaries of a holding company. These types of transactions have limited comparability, except for the fact that they can be structured as tax-free reorganizations for federal income tax purposes within the meaning of IRC ? 368(a)(1).

    These transactions often involve sellers wanting to avoid income tax on the gain realized upon the disposition of their share interests in one corporation for shares in another corporation. A corporation transferring its assets would also like to avoid gain recognition. Income tax deferral can ordinarily be accomplished through the use of a qualifying corporate “reorganization” (as this term is defined for federal income tax purposes). Under Reg. ? 1.368-1(b), the exchange of

    property gain or loss must be accounted for if the new property differs in a material way, either in kind or in extent, from the old property. However, the purpose of the tax-free reorganization provisions of the Internal Revenue Code (the Code) is to except from this general rule of gain recognition certain exchanges that are incident to readjustments of corporate structures if the readjustments are made by using one of the methods specifically identified in the Code. These restructurings must stem from business exigencies and must effect only a readjustment of the owners' continuing interests in property under modified corporate form. At the end of the transaction, these interests must continue in some corporate form.

    For federal income tax purposes, tax-free reorganizations are not limited to acquisitions and dispositions. They can be arrangements where a corporation is separated into several components, where the form or place of the organization of a corporation is changed, or when a corporation is recapitalized. A tax-free reorganization might involve the restructuring of the capital of an insolvent corporation. However, Reg. ? 1.368-1(b) specifies that “section 368(a)(1)

    limits the definition of the term „reorganization' to six [actually, seven] kinds of transactions and excludes all others.” This regulation further states that a plan of reorganization must provide for the bona fide execution of one of the transactions specifically described as a reorganization in IRC ? 368(a) and for the bona fide consummation of each of the requisite acts under which nonrecognition of gain is claimed. The transactions and acts must be part of the ordinary and necessary conduct of the enterprise and must provide for a continuation of the enterprise. A scheme involving an abrupt departure from normal reorganization procedure in connection with a transaction on which the imposition of tax is imminent, such as a mere device that puts on the form of a reorganization as a disguise for concealing its real character and the object of which is the consummation of a preconceived plan having no business or corporate purpose, cannot be classified as a plan of reorganization.

    This chapter examines not only tax-free reorganizations but also mergers (as defined under applicable state business organization laws) that are not tax-free. A non-tax-free merger might be used when cash is the consideration paid for the acquisition, but the parties desire an expeditious transfer of the business assets being acquired.

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    As noted below, a variety of transactions can be tax-free reorganizations for federal income tax purposes. Various business objectives often are better served through the use of one type of reorganization over another. Although the discussion below is necessarily abbreviated and does not apply to all forms of reorganizations, it is intended to identify the various questions that must be confronted in examining the possible income tax consequences for particular types of reorganizations.

    The reader should note that throughout this chapter the corporation to be acquired and its shareholders are regularly referred to as the “target” and “target shareholders,” whether the proposed acquisition is friendly or hostile. The acquiring corporation is regularly referred to as the “acquirer” or the “purchasing corporation,” although the acquisition might mechanically be completed by a subsidiary corporation of the acquirer. “Purchasing corporation” is used even though many of the transactions described involve stock consideration, rather than cash (which might be contemplated by the use of the term “purchaser”).

    Identification of the Tax-Free Reorganization Alternatives Generally

    The various types of tax-free reorganizations (from the U.S. income tax perspective) are defined in IRC ? 368(a). They include the following:

    1. Tax-free mergers and consolidations (IRC ? 368(a)(1)(A));

    2. Stock-for-stock exchanges (IRC ? 368(a)(1)(B));

    3. Stock-for-asset exchanges (IRC ? 368(a)(1)(C));

    4. Divisive reorganizations (IRC ? 368(a)(1)(D));

    5. Recapitalizations (IRC ? 368(a)(1)(E));

    6. Changes in the place of corporate organization (IRC ? 368(a)(1)(F)); and

    7. Insolvency reorganizations (IRC ? 368(a)(1)(G)).

The acquisitive reorganizations (particularly those identified in IRC ?? 368(a)(1)(A),

    368(a)(1)(B), and 368(a)(1)(C)) are permitted in some situations to be accomplished through the use of acquisition subsidiaries, a situation that is described in various segments below. Acquisitive Reorganizations

    A tax-free corporate acquisition can be accomplished through a variety of structural arrangements, including the following:

    1. The tax-free merger and consolidation (IRC ? 368(a)(1)(A)). In a tax-free merger,

    which is accomplished under the applicable state law merger statute, one corporation

    disappears into another. In a consolidation, which is accomplished under the applicable

    state business organization law, two corporations disappear into a newly established

    corporation.

    2. The merger of the acquired corporation into a subsidiary of the acquiring

    corporation. The specific requirements for this type of merger, which is accomplished

    under applicable state business organization laws, are described in IRC ? 368(a)(2)(D).

    The consideration provided to the “selling” shareholders is the stock of the parent

    corporation of the acquisition subsidiary into which the acquired corporation disappears

    upon the completion of the merger. This type of merger is called the forward triangular

    merger.

    3. The merger of a subsidiary of the acquiring corporation into the acquired

    corporation. The specific requirements for this type of merger, which is accomplished

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    under applicable state business organization laws, are described in IRC ? 368(a)(2)(E).

    The consideration provided to the selling shareholders is the stock of the parent

    corporation whose acquisition subsidiary (often, newly organized for purposes of this

    transaction) disappears into the acquired corporation as a result of the merger. This type

    of merger is called the reverse triangular merger.

    4. Stock-for-stock exchanges. The specific requirements for this transaction are described

    in IRC ? 368(a)(1)(B). In this situation, the shareholders of the acquired corporation

    exchange their target company stock for voting stock of the acquiring corporation.

    Therefore, the acquired corporation is itself only indirectly affected and becomes a

    subsidiary of the acquiring corporation after the completion of the share-for-share

    exchange by the shareholders. For a discussion of this reorganization alternative, see

    ? 12.11. Alternatively, this exchange can be completed by a subsidiary of the acquirer for

    all or a part of the voting stock of the corporation controlling the acquiring corporation.

    This is known as a parenthetical B reorganization. See IRC ? 368(a)(1)(B) (parenthetical).

    5. Stock-for-asset exchanges. The specific requirements for this transaction are described

    in IRC ? 368(a)(1)(C). In this situation, the operating assets of a corporation are

    acquired in exchange for the stock of the acquiring corporation delivered to the target

    corporation. The target will ordinarily then distribute these shares to its shareholders in

    liquidation. For a discussion of this reorganization alternative, see ? 12.12. Alternatively,

    this exchange can be completed by an acquisition subsidiary delivering its parent

    corporation stock for the operating assets of the target corporation. This is known as a

    parenthetical C reorganization. See IRC ? 368(a)(1)(C) (parenthetical).

    For tax purposes, various statutory requirements apply to these acquisitive reorganizations, including (1) the amount of stock that must be received by the selling shareholders, (2) the type of stock that must be received by them (e.g., voting stock), and (3) whether any other nonstock consideration can be received. These requirements are not consistent for each type of reorganization.

    Divisive Reorganizations

    As the name suggests, a divisive reorganization entails a corporation being divided into several components on a tax-free basis. IRC ? 368(a)(1)(D) provides that the term “reorganization”

    includes a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred. However, this treatment applies “only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355, or 356.” IRC

    ? 354 permits the tax-free receipt of the replacement shares by the shareholders in a reorganization.

    Recapitalizations

    If a corporation is suffering from adverse economic circumstances, it may restructure its debt and equity, which is known as a recapitalization. In a downstream recapitalization, debt holders become shareholders and the corporate equity interests of existing shareholders become diluted or eliminated. In an upstream recapitalization, some common shareholders may become preferred shareholders. This latter recapitalization will often occur in closely held corporations where the equity ownership is restructured to facilitate estate planning (i.e., ownership of common stock by older family members is shifted to younger members and the older family members become preferred shareholders). IRC ? 368(a)(1)(E) specifies that the term

    “reorganization” includes a recapitalization.

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Changing Corporate Location or Form

    A corporation may change its place of organization or its form of organization, assuming the replacement entity is a corporation for federal tax purposes. Often, but not always, this is accomplished by the merger of the old entity into a new corporate entity, with ownership rights and shareholder percentages being unaffected. IRC ? 368(a)(1)(F) specifies that the term

    “reorganization” includes “a mere change in identity, form, or place of organization of one corporation, however effected.”

    Insolvency Reorganizations

    A corporation may need to reorganize itself to facilitate the completion of a bankruptcy or an insolvency proceeding. When the equity interests in the corporation are shifted, the exchange of some corporate interests for others could become income tax recognition events. IRC

    ? 368(a)(1)(G) specifies that the term “reorganization” includes “a transfer by a corporation of all or part of its assets to another corporation in a [U.S. Code] title 11 [i.e., bankruptcy] or similar case; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355,

    or 356.”

    Common-Law Tax Requirements for Tax-Free

    Reorganizations

    Nonstatutory Requirements

    A tax-free corporate reorganization must ordinarily satisfy certain common-law tax requirements, including the following:

    1. It must have a business purpose;

    2. It must facilitate continuity of shareholder ownership between the old and new entity;

    and

    3. It must continue the acquired business enterprise.

    Although Reg. ? 1.368-1(b) specifies that a reorganization must have a “continuity of the business enterprise” under the modified corporate form (described in Reg. ? 1.368-1(d)) and,

    except as provided in IRC ? 368(a)(1)(D), a “continuity of interest” (described in Reg. ? 1.368-

    1(e)), these requirements have evolved outside the statutory definition of “reorganization” through tax litigation. For this reason they are often described as the “common-law” tax

    requirements applicable to tax-free corporate reorganizations.

    The “continuity of interest” and the “continuity of business enterprise” tests have undergone significant changes during the past twenty years. The statutory definitions for certain types of reorganizations effectively mandate the satisfaction of one or more of these requirements. For example, in a stock-for-stock exchange (i.e., a B reorganization), the only type of consideration permitted to be received by the seller is voting stock, which satisfies the “continuity of interest” mandate. This “common-law” tax requirement is applicable where much greater flexibility is permitted (e.g., for a corporate merger).

    These requirements are inapplicable to certain types of reorganizations. For example, notwithstanding the requirements of Reg. ? 1.368-1(b), “continuity of interest” and “continuity of

    business enterprise” are not required for reorganizations under IRC ?? 368(a)(1)(E) and

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    368(a)(1)(F). In these reorganizations, the shareholders do not change, and, consequently, these requirements are not relevant.

    Business Purpose

    A tax-free reorganization must have a “business purpose,” and not just a tax purpose. Reg.

    ? 1.368-1(b) specifies that a reorganization must be “required by business exigencies.” Even though the continuity of interest and continuity of business enterprise requirements may not apply to all forms of corporate reorganizations, the business purpose requirement will generally be applicable. A corporate tax planner can ordinarily assure compliance with this requirement by having the reorganization documents recite the business and economic purposes of the corporation reorganization (e.g., to facilitate greater economic efficiency of the combined enterprises, to comply with changes in local law, and a variety of other objectives). Continuity of Shareholder Interest

    Reg. ? 1.368-1(e) notes that the purpose of the continuity of interest requirement is to prevent transactions that resemble sales from qualifying for nonrecognition of gain or loss available to reorganizations. This requirement has evolved from a long history of court decisions. The net result of this evolution can best be summarized by reference to the current regulations describing the continuity of interest requirement.

    Reg. ? 1.368-1(b) specifies that the merger of two enterprises under a single corporate structure is a reorganization if the new corporation maintains a continuity of interest with the shareholders of the old corporation. However, a reorganization does not occur if the shareholders of the old corporation are merely holding short-term notes in the new corporation. The reorganization provisions are detailed and precise, and their specifications, underlying assumptions, and purposes must be satisfied in order for a taxpayer to enjoy the benefit of the exception from the general rule of taxation of a gain realization transaction. Accordingly, under the Code, a short-term purchase money note is not a security of a party to a reorganization, an ordinary dividend is to be treated as an ordinary dividend, and a sale is nevertheless to be treated as a sale even though the mechanics of a reorganization have been satisfied (this latter observation being relevant, for example, to a cash merger).

    Under Reg. ? 1.368-1(e)(1)(i), a reorganization must preserve a substantial part of the value of the proprietary interests in the target corporation. A proprietary interest in the target corporation is preserved if it is exchanged for a proprietary interest in the issuing corporation, it is exchanged by the acquiring corporation for a direct interest in the target corporation, or it otherwise continues as a proprietary interest in the target corporation. However, a proprietary interest in the target corporation is not preserved if the target is acquired by the issuing corporation for consideration other than stock of the issuing corporation or stock of the issuing corporation furnished in exchange for a proprietary interest in the target is redeemed. All facts and circumstances must be considered in determining whether, in substance, a proprietary interest in the target corporation is preserved. However, a mere disposition of target corporation stock prior to a potential reorganization to persons unrelated to the target or the issuing corporation is disregarded, and a mere disposition of issuing corporation stock prior to a potential reorganization to persons unrelated to the issuing corporation is disregarded. This allows the stock of the target to be traded on a stock exchange without impacting the continuity of interest rule applicable at the time the target is acquired. In Notice 2010-25, 2010-14 IRB 527,

    the Service provided interim guidance concerning the continuity of interest test applicable in corporate tax-free reorganizations. This guidance has been provided since the prior temporary regulations (Temp. Reg. ? 1.368-1T(e)(2), published in TD 9316) expired on March 19, 2010.

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Continuity of Business Enterprise

    The continuity of business enterprise requirement specifies that the “issuing corporation” (defined in Reg. ? 1.368-1(b) as meaning the acquiring corporation) must either continue the target corporation's business or use a significant portion of target's assets in the new business. See Reg. ? 1.368-1(d)(1). The fact that the purchaser is in the same line of business as the target tends to establish the requisite continuity, but is not alone sufficient. Reg. ? 1.368-

    1(d)(2)(ii). If the target has more than one line of business, the purchaser needs only to continue the most significant line of business. Reg. ? 1.368-1(d)(2)(iii). In general, a target's

    historic business is the one conducted most recently. However, a business entered into as part of a plan of reorganization is not an historic business. Reg. ? 1.368-1(d)(2)(iii). All facts and

    circumstances are considered in determining when the plan of reorganization comes into existence and whether a line of business is significant. Reg. ? 1.368-1(d)(2)(iv).

    After completion of the reorganization, the acquired assets can be transferred by the acquiring corporation to certain other corporations and partnerships without violating the continuity of business enterprise requirement if specified ownership conditions are satisfied. See Reg.

    ?? 1.368-1(d)(3) and 1.368-1(d)(4), and the examples thereunder, detailing variations in factual situations where the requirement is deemed to be satisfied. See also Shores, “Continuity of Business Enterprise: A Concept Whose Time Has Passed,” 63 Tax Law. 471 (Winter 2010).

    Federal Income Tax Treatment of the Parties to an

    Acquisitive Reorganization

    Tax Postponement

    An acquisitive tax-free reorganization generally yields the following results:

    1. No income tax recognition to the sellers for their realized gain;

    2. No income tax recognition to the purchasing corporation when issuing its stock in the

    reorganization;

    3. No gain recognition to any acquisition subsidiaries being used in the transaction when

    they acquire stock or assets of the target corporation through the use of stock of the

    acquirer's parent corporation; and

    4. No gain recognition to the target corporation when transferring its assets in the

    reorganization.

Plan of Reorganization

    Reg. ? 1.368-2(g) specifies that a “plan of reorganization” refers to a consummated transaction specifically defined as a “reorganization” under IRC ? 368(a). Furthermore, this regulation states

    that IRC ? 368(a) contemplates reorganizations that are designed to readjust continuing interests under modified corporate forms. The term “plan of reorganization” is not to be construed as broadening the definition of “reorganization” as set forth in IRC ? 368(a), but is to

    be taken as limiting the nonrecognition of gain or loss to transactions that are genuine reorganizations. Moreover, the transaction, or series of transactions, embraced in a plan of reorganization must not only come within the specific language of IRC ? 368(a), but the

    readjustments involved in the exchanges or distributions effected in the consummation thereof must be undertaken for reasons germane to the continuance of the business of a corporation.

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Identifying a Party to a Reorganization

    A party to a reorganization may be an individual or an entity. See IRC ?? 354(a)(1) and 361(a).

    IRC ? 368(b) defines the term “a party to a reorganization” as including (1) a corporation formed as a result of a reorganization and (2) the two corporations entering into a reorganization whereby one corporation acquires the stock or properties of the other. Reg. ? 1.368-2(f) defines

    the term similarly. If a transaction otherwise qualifies as a reorganization, a corporation remains a party to the reorganization even though stock or assets acquired in the process are transferred within a corporate group (a situation described in Reg. ? 1.368-2(k)). For example, a corporation

    does not cease to be a party to a reorganization because some or all of the assets acquired in the process are transferred to a partnership in which the transferor is a partner. However, the continuity of business enterprise requirement must be satisfied. See Reg. ? 1.368-1(d).

    A corporation controlling an acquiring corporation is a party to the reorganization when the stock of the controlling corporation is used in the acquisition of properties from a target corporation. Reg. ? 1.368-2(e) lists various situations identifying where a participating corporation can be treated as a “party to the reorganization,” including the following:

    1. Corporation A is merged into Corporation B.

    2. Corporation C and Corporation D are consolidated into Corporation E.

    3. Corporation F transfers substantially all of its assets to Corporation G in exchange for all

    or a part of the voting stock of G.

    4. Corporation H transfers substantially all of its assets to Corporation K in exchange for all

    or a part of the voting stock of Corporation L, which controls K.

    5. Corporation M transfers all or part of its assets to Corporation N in exchange for all or a

    part of the stock and securities of N. However, (1) immediately after such transfer, M , or

    one or more of its shareholders (including persons who were shareholders immediately

    before such transfer), or any combination thereof, must control N, and (2) in pursuance

    of the plan, the stock and securities of N must be transferred or distributed by M in a

    transaction in which gain or loss is not recognized under IRC ? 354 or IRC ? 355, or is

    recognized only to the extent provided in IRC ? 356.

    6. Corporation O acquires the stock of Corporation P from Corporation S in exchange for

    part of O 's voting stock. However, (1) the stock of P cannot constitute substantially all of

    the assets of S, (2) S must not control O immediately after the acquisition, and (3) O

    must control P immediately after the acquisition. In this case O and P, but not S , are

    parties to the reorganization.

    7. If a transaction otherwise qualifies as a reorganization under IRC ? 368(a)(1)(B) or as a

    reverse triangular merger under Reg. ? 1.358-6(b)(2)(iii), the target corporation (in an

    IRC ? 368(a)(1)(B) reorganization) or the surviving corporation (in a reverse triangular

    merger) remains a party to the reorganization even though its stock or assets are

    transferred in a transaction described in Reg. ? 1.368-2(k).

    8. If a transaction otherwise qualifies as a forward triangular merger under Reg. ? 1.358-

    6(b)(2)(i), a triangular B reorganization under Reg. ? 1.358-6(b)(2)(iv), a triangular C

    reorganization under Reg. ? 1.358-6(b)(2)(ii), or a reorganization under IRC

    ? 368(a)(1)(G) by reason of IRC ? 368(a)(2)(D), the acquiring corporation remains a

    party to the reorganization even though its stock is transferred under Reg. ? 1.368-2(k).

    Ultimately, remaining a party to a reorganization will secure the postponement of recognition of the gain realized by that party in the reorganization exchange.

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Carryover of Tax Attributes in Tax-Free Reorganizations

    Ancillary results of postponed gain recognition.

    In a tax-free corporate reorganization, any potential for recognition of gain currently being postponed must be retained for the future. This will be accomplished through tax basis adjustments both for the selling shareholder and the acquiring corporation.

    Tax basis to the transferring shareholder.

    In a tax-free corporate reorganization, the exchanging shareholder will have the same basis for the shares received as the basis for the shares transferred to the purchaser. See IRC ? 358(a)(1).

    This basis will be decreased by the fair market value of any other property (except money) received, the amount of any money received, and any loss recognized, and it will be increased by any amount treated as a dividend and the amount of gain recognized by the taxpayer on the exchange. IRC ? 358(a)(1). Any boot received in the exchange will take its own fair market value basis. IRC ? 358(a)(2).

    Shares will ordinarily not be received on a one-for-one basis and, therefore, tax basis allocation rules must address apportionment of that basis when the total number of shares received is either less than or greater than the number of shares surrendered. This is important when the shareholder sells some, but not all, of the shares received in the exchange at some time in the future and may want to use a specific identification method for determining tax basis for the shares sold. See Reg. ? 1.1012-1(c). Under the regulations, taxpayers must trace tax basis from

    the old shares if possible or, if not, designate where the basis of such shares is to be allocated among the new stock or securities. An average basis method is considered inappropriate for this purpose.

    Reg. ? 1.358-2(a)(2)(i) provides that if one share of stock is received in exchange for one share of stock, the basis of that share of stock surrendered will be allocated to the share received. If more than one share of stock is received in exchange for one share of stock, the basis of the share of stock surrendered shall be allocated to the shares of stock received in proportion to the fair market value of the shares of stock received. If one share of stock is received in exchange for more than one share of stock, or if a fraction of a share of stock is received, the basis of the shares of stock surrendered must be allocated to the shares of stock received in a manner that reflects, to the greatest extent possible, that a share of stock received is exchanged in respect of shares of stock acquired on the same date and at the same price. If the shareholder is not able to allocate basis in this manner, the basis of the shares of stock surrendered must be allocated to the shares of stock received in a manner that minimizes the disparity in the holding periods of the surrendered shares of stock whose basis is allocated to any particular share of stock received. If a shareholder surrenders a share of stock in a tax-free reorganization and receives shares of stock of more than one class, or receives “other property” or money in addition to shares of stock, to the extent the terms of the exchanges specify that shares of stock of a particular class or “other property” or money is received in exchange for a particular class of stock, the contract terms shall control for purposes of allocating basis, provided such terms are economically reasonable. Reg. ? 1.358-2(a)(2)(ii). If the terms of the exchange do not specify particular

    allocations, a pro rata portion of the shares of stock of each class received and a pro rata portion of the “other property” and money received shall be treated as received in exchange for each share of stock surrendered, based on the fair market value of the stock surrendered. Stock in the same corporation will be treated as separate classes of stock if they have differing rights or preferences. If a shareholder owns multiple classes of stock, the basis from the old shares shall be allocated to the new shares in proportion to the value of the stock of each class owned by the

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    shareholder immediately prior to the transaction. Further allocation rules are prescribed in these regulations.

    Corporate transferor of property.

    When a corporation transfers its assets to a purchaser, it will not recognize gain or loss on the exchange of the property for stock of a party to the reorganization if the exchange is pursuant to a plan of reorganization. Under IRC ? 358, the transferor will receive a substituted basis in the

    acquirer's stock received. The transferor will not recognize gain or loss when subsequently distributing to its shareholders the stock received. IRC ? 361(c).

    Corporate acquirer.

    A corporation that acquires property in exchange for its stock is protected from the recognition of gain or loss rule under IRC ? 1032. This rule applies even if the exchange is not part of a

    reorganization. The property acquired by a corporation in a reorganization will take a carryover basis equal to the transferor's basis. IRC ? 362(b). Of course, if the acquisition fails to qualify as

    a reorganization, the transferee corporation will be a purchaser in a taxable transaction and, as such, will be entitled to a cost basis for the acquired properties under IRC ? 1012 (assuming IRC

    ? 1032 provides no relief).

    If a corporation acquires stock in a type B reorganization, it will have a carryover tax basis for that stock. IRC ? 362(b). That basis will be the basis of the exchanging shares. As noted in the discussion of B reorganizations at ? 12.11, establishing this basis is often a difficult task.

    Other participants.

    As described in ?? 12.07 and 12.09, a triangular acquisition involves a subsidiary using shares of its parent corporation as the consideration to complete the acquisition of the shares or assets of the target corporation. The parent corporation will determine its tax basis for the stock of its subsidiary, which is technically the acquiring corporation, as if the parent corporation (1) had directly acquired the target corporation's assets or stock in a two-party reorganization and (2) then transferred that property to its subsidiary (replicating the results that would apply in an IRC

    ? 351 tax-free incorporation asset dropdown).

    Applicability to S Corporations

    The tax-free corporate reorganization provisions apply to S corporations as well as C corporations. Under IRC ? 1371(a), except as otherwise provided and except to the extent

    inconsistent with subchapter S, “subchapter C shall apply to an S corporation and its shareholders.” No separate corporate reorganization provisions apply to S corporations. Certain subchapter S limitations do apply, however, such as only individuals and some trusts may be shareholders in an S corporation. Partnerships and corporations cannot be shareholders, and the number of S corporation shareholders must be limited.

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Corporate Acquisition Alternatives to Tax-Free

    Reorganizations

    Taxable Acquisitions

    Corporate acquisitions may be accomplished on a taxable basis, rather than pursuant to a tax-free corporate reorganization. If the selling shareholders receive cash for their shares, or the selling corporation receives cash for its assets, gain recognition cannot be postponed absent some special provision. Taxable acquisitions are preferred when the selling shareholders wish to deduct losses realized on their depreciated stock, when the selling shareholders have only a limited amount of accrued gain, or when the parties want a step-up in the tax basis of the corporate assets, even if some gain must be currently reported for tax purposes to achieve this result. If the gain to individual shareholders is taxable at a 15 percent capital gains rate and the acquiring corporation can obtain a tax basis for assets that permits significant depreciation deductions, then the parties might prefer a taxable asset acquisition. For the selling corporation, the gain realized on the disposition of assets might be absorbed by a current net operating loss (NOL) deduction or an NOL carryforward, thereby diluting the tax cost of a taxable acquisition. Various options exist for acquisitions producing gain recognition to the shareholders, the corporation, or both, including (1) a cash merger, (2) an acquisition of the target's stock for cash, and (3) an acquisition of corporate assets for cash (possibly followed by a corporate liquidation of the seller). These options are examined below. In some situations, the tax recognition of gain can be delayed through the use of installment notes.

    Cash Merger

    A merger can be effected under applicable state business organization laws, and yet not be a tax-free corporate reorganization. In fact, sound nontax reasons may exist for pursuing a merger. A corporation can be merged into an acquiring corporation with the selling shareholders receiving cash, installment notes, or both, from the acquiring corporation, depending on the merger agreement's provisions. If the sole (or predominant) consideration is cash, the continuity of interest requirement for a tax-free corporate reorganization will not be satisfied. A merger under state law eliminates the need for appropriate property conveyancing documents for each of the transferred assets.

    Rev. Rul. 69-6, 1969-1 CB 104, governs the federal income tax treatment of cash mergers. The essence of this ruling is that an all cash merger is constructively a corporate asset sale followed by a liquidation of the acquired corporation.

    Cash for Stock

    The shares of a company could be acquired directly from the shareholders with the consideration for these shares being cash or a cash equivalent. For a smaller company this stock acquisition might result from a negotiated purchase. For a larger corporation this acquisition might result from the successful completion of a public tender offer. This acquisition will not qualify as a tax-free B reorganization because in a B reorganization the only eligible consideration receivable is voting stock of the acquirer (or the parent corporation of the acquisition subsidiary). The selling shareholders will have to recognize gain or loss upon the sale of their shares, presumably as long-term capital gain eligible for the 15 percent rate for individuals. Thereafter, the acquired corporation might be liquidated into the acquiring corporation or a subsidiary of the

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