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Tax-free_ Acquisitions of Freestanding C Corporations

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									  Tax-free* Acquisitions of
Freestanding C Corporations
Basic types:
  IRC §368(a)(1)(A)—Statutory merger
  IRC §368(a)(1)(B)—Stock-for-stock acquisition
  IRC §368(a)(1)(C)—Stock-for-asset acquisition
Other:
  Forward and reverse triangular mergers
* These transactions are not actually “tax-free”—they only
  provide target shareholders with tax-deferral of the gain on the
  acquisition. Also, each of these “tax-free” reorganization
  structures requires shareholders to recognize a taxable gain to
  the extent they receive cash or other forms of boot.
General Requirements for Tax-
free Treatment Under IRC §368
• Continuity of interest must be maintained by
  target shareholders in the assets of the target—
  target shareholders must receive stock of the
  acquirer.
• The principle of continuity of business interest
  requires the assets of the target to be used in a
  productive capacity post-acquisition. An acquirer
  cannot liquidate the target’s assets after purchase.
• The acquirer must have a valid business purpose,
  not just a desire to avoid taxes.
IRC §368 “A” Reorganization—
      Statutory Merger
• The acquirer exchanges its stock (and possibly
  some boot) for the assets and liabilities of the
  target.
• The target corporation must distribute to its
  shareholders in return for their target stock the
  consideration received from the acquirer.
   – This liquidating distribution is tax-free if target shareholders
     receive stock of the acquirer; cash received is taxable even if the
     transaction is tax-free.
   – Gain recognized by target shareholders is the lesser of the gain
     realized or the boot received.
   – Gain realized is equal to the purchase price (value of consideration
     received) less the selling shareholder’s tax basis in the stock.
   – Losses realized are not recognized.
Requirements to Qualify for Tax-free
Treatment Under IRC §368(a)(1)(A)
• Reorganizations must qualify as statutory mergers
  under applicable state law—the merger must be
  approved by both the acquirer’s and the target’s
  shareholders.
• “A” reorganizations usually require that at least
  50%* of the total consideration received by target
  shareholders in the acquisition is acquirer stock—
  acquirers can use either voting or non-voting stock and
  either common or preferred stock.

   * 40% acquirer stock is sufficient in some transactions.
Tax Consequences of a §368 “A”

• Target shareholders take a substituted basis in the
  acquiring firm stock received in the transaction:
     Substituted basis = same basis as had in T stock + any
     gain recognized – boot received
• The acquirer takes a carryover basis in the assets
  of the target.
• The tax attributes of the target will carry over to
  the acquirer, but they will be limited by IRC §382.
               Given Information
                 for Examples
                          Given Information
Purchase Price                                                 $1,370.00
Target Shareholder Stock Basis                                   $200.00
Net Tax Basis of Target's Assets*                                $200.00
Corporate Tax Rate                                                  35%
Capital Gains Tax Rate*                                             20%
Discount Rate                                                       10%

Assume that any acquirer stock received by T's shareholders in the
transaction is held until death and that all shareholders receive an equal
portion of stock and boot.

*Historical cost equals $200, and there is no accumulated depreciation.
*T's shareholders have held the stock of T for more than 12 months.
Tax Implications of a §368 “A” Reorganization
                                           Given Information
                  Purchase Price                                             $1,370.00
                  Target Shareholder Stock Basis                               $200.00
                  Net Tax Basis of Target's Assets                             $200.00
                  Corporate Tax Rate                                              35%
                  Capital Gains Tax Rate                                          20%
                  Discount Rate                                                   10%


                                                     Tax-free Acquisitions Taxable Acquisitions
                                                                              Stock Sale w/o
                                                            368 "A"*          a 338 Election
        Purchase Price:                                          $1,370.00            $1,370.00
         Cash                                                       548.00             1,370.00
         Stock                                                      822.00                 0.00

        Target Corporation Tax Liability                             0.00                   0.00

        Target Shareholder Gain Recognized                         548.00                1,370.00
        Target Shareholder Tax Liability                           109.60                  234.00

        Target Shareholder After-tax Wealth:
         Cash                                                     $438.40            $1,136.00
         Stock                                                     822.00                 0.00
         Total                                                  $1,260.40            $1,136.00

        Acquirer Net After-tax Cost:
         Pre-tax Cost                                           $1,370.00            $1,370.00
         Less: Incremental Tax Savings                               0.00                 0.00
         Net After-tax Cost                                     $1,370.00            $1,370.00
        *Assumes that the mix of consideration is 60% stock and 40% cash.
         Tax-free Merger Under IRC
       §368(a)(1)(A)—Statutory Merger
             Target:                  Assets and                 Acquirer:
Receives $1,370 of consideration     Liabilities of   Transfers $1,370 to target for its
from acquirer and distributes all       Target         assets and liabilities. Target is
     of the consideration to          $548 Cash       merged into acquirer under state
   shareholders in liquidation.      $822 Stock                      law.

 $548 Cash
 $822 Stock
                  All of Target’s
                      Stock
                                                         Acquirer Shareholders:
                                                           No direct tax effect.
      Target Shareholders:
Basis in target stock = $200. Gain
    realized is $1,170 ($1,370
received - $200 stock basis). Gain
recognized is $548 (lesser of gain
    realized or boot received).
Post-acquisition Structure:
     Statutory Merger

                         Acquirer:
        Holds the assets and liabilities of the target.
        Has a carryover basis in the target’s assets.




 Target Shareholders:                 Acquirer Shareholders:
Now own acquirer stock                 Remain owners of the
  and have some boot.                        acquirer.
   Non-tax Issues Associated w/
     the §368 “A” Structure
• The acquirer obtains all the liabilities (including contingent
  and unrecorded liabilities) of the target.
• Some of the target’s assets may be non-transferable based
  on laws and/or contracts.
• Qualifying as a statutory merger can involve significant
  non-tax costs for both the acquirer and target, i.e.,
  shareholders of both the acquirer and target have to
  approve the transaction.
• The acquirer can use up to 60% cash in the transaction.
• Acquiring is not required to take all target’s assets.
   Forward Triangular Merger
• Forward Triangular Merger--the acquirer establishes a subsidiary
  through which it acquires the target (and its assets and liabilities) for
  stock (voting and non-voting) of the acquiring firm.

    – The surviving entity is the subsidiary of the acquirer, i.e., target’s
      liabilities are isolated.

    – The acquirer must acquire “substantially all”* of the target’s
      assets.

    – Acquiring firm shareholders do not have to formally approve a
      triangular merger (unless required by the corporate charter).

    – Up to 50% of consideration may be in the form of cash.

    * 90% of net fair market value of the target’s assets and 70% of gross fair
      market value of those assets.
         Tax-free Forward Triangular Type-“A” Merger
                                            Acquirer:                         Acquirer Shareholders:
                              Transfers $1,370 in consideration to              No direct tax effect.
                             subsidiary for all of subsidiary’s stock.

                                                   $548 Cash
                                               $822 acquirer stock         100% of
                                                                       subsidiary’s stock

             Target:                    “Substantially All”
Receives $1,370 of consideration        of the target’s assets          Acquirer Subsidiary:
from the acquirer and distributes          and liabilities.          Transfers $1,370 (cash and
all of the consideration to share-                                   acquirer stock) for all of the
                                            $548 Cash                 assets and liabilities of the
      holders in liquidation.
                                        $822 acquirer stock                     target.

    $548 Cash                All of target’s
$822 acquirer stock              stock


           Target Shareholders:
        Basis in target stock = $200.
Gain realized is $1,170 ($1,370 - $200). Gain
recognized is $548 (lesser of gain realized or
                boot received).
    Post-acquisition Structure: Forward
       Triangular Type-“A” Merger
                                    Acquirer:
                        Subsidiary of the acquirer owns
                   substantially all of the assets of the target.
                      The acquirer has a basis in acquirer
                           subsidiary stock of $200.


Target Shareholders:
                                                              Acquirer Shareholders:
   Own stock of the
                                                               Maintain ownership of
  acquirer and some         Acquirer Subsidiary:                   the acquirer.
        boot.            Takes a carryover basis in the
                            target’s assets ($200).
IRC §368 “B” Reorganization—
  Stock-for-Stock Acquisition
• The acquirer exchanges its voting stock directly
  with that of target shareholders, obtaining
  ownership of the target’s assets through ownership
  of its stock.
• The target becomes a subsidiary of the acquirer
  and, thus, maintains its legal identity while the
  owners of the target’s stock change (much like a
  reverse triangular merger under §368 “A”).
Requirements to Qualify for Tax-free
Treatment Under IRC §368(a)(1)(B)
• 100% of the consideration used in the
  acquisition must be voting stock of the
  acquirer.
• The deal’s tax-free treatment is disqualified
  if any cash (except cash paid for fractional
  shares) is used.
• The acquirer must obtain 80% control of the
  target.
Tax Consequences of a §368 “B”
• Target shareholders take a substituted basis in the
  acquiring firm stock received in the transaction:
     Substituted basis = same basis as had in T stock + any
     gain recognized – boot received
• The acquirer takes a carryover basis in the assets
  of the target and in the stock of the target equal to
  the target shareholder’s basis in the target’s stock
  pre-acquisition.
• The tax attributes of the target will carry over to
  the acquirer, but they will be limited by IRC §382.
        Gain realized by T’s shareholders = value of the consideration
        received - target shareholder’s basis in the target stock.
        Gain recognized by T’s shareholders = lesser of gain realized
        or boot received.
Tax Implications of a §368 “B” Reorganization
                                           Given Information
                  Purchase Price                                            $1,370.00
                  Target Shareholder Stock Basis                              $200.00
                  Net Tax Basis of Target's Assets                            $200.00
                  Corporate Tax Rate                                             35%
                  Capital Gains Tax Rate                                         20%
                  Discount Rate                                                  10%

                                                     Tax-free Acquisitions Taxable Acquisitions
                                                                              Stock Sale w/o
                                                      368 "A" 368 "B"   *     a 338 Election
        Purchase Price:                              $1,370.00 $1,370.00              $1,370.00
         Cash                                           548.00       0.00              1,370.00
         Stock                                          822.00 1,370.00                    0.00

        Target Corporation Tax Liability                  0.00      0.00                     0.00

        Target Shareholder Gain Recognized              548.00      0.00                 1,370.00
        Target Shareholder Tax Liability                109.60      0.00                   234.00

        Target Shareholder After-tax Wealth:
          Cash                                $438.40      $0.00                        $1,136.00
          Stock                                 822.00 1,370.00                              0.00
          Total                              $1,260.40 $1,370.00                        $1,136.00

        Acquirer Net After-tax Cost:
         Pre-tax Cost                                $1,370.00 $1,370.00                $1,370.00
         Less: Incremental Tax Savings                    0.00      0.00                     0.00
         Net After-tax Cost                          $1,370.00 $1,370.00                $1,370.00

        *Assumes that 100% of the consideration is voting common stock.
       Tax-free Merger Under IRC §368(a)(1)(B)--
               Stock-for-Stock Acquisition
            Target:                                           Acquirer:
Owners of target’s stock change.             Transfers $1,370 in acquirer stock directly
Tax basis in the target’s assets is          to target shareholders for all of the target’s
           unchanged.                          stock. Target becomes a wholly owned
                                                      subsidiary of the acquirer.

               $1,370 of Acquirer Stock


                                                  100% of Target’s Stock

                 Acquirer:
Transfers $1,370 in acquirer stock directly
to target shareholders for all of the target’s
  stock. Target becomes a wholly owned                          Acquirer Shareholders:
         subsidiary of the acquirer.                              No direct tax effect.
            Post-acquisition Structure:
            Stock-for-Stock Acquisition
                                       Acquirer:
                          Owns all of the stock of the target.
                       Target is a wholly owned subsidiary of
                       the acquirer. The acquirer’s basis in the
                         target stock is $200 (same as target
                                 shareholder’s basis).


Target Shareholders:
                                                              Acquirer Shareholders:
   Own stock of the
                                                               Maintain ownership of
  acquirer and some         Target (now a subsidiary of            the acquirer.
        boot.                      the acquirer):
                           Asset basis carries over ($200).
   Non-tax Issues Associated w/
     the §368 “B” Structure
• The acquirer is liable for all of the target’s liabilities, but . .
• The acquirer’s liability is limited to its investment in the
  target since the target is a subsidiary of the acquirer.
• Title to the target’s assets does not change since the target
  retains its corporate identity. (This is a benefit if the target
  has assets that are difficult to transfer.)
• Target’s intangibles, contracts, goodwill, preserved.
• Difficult to force out dissident shareholders of the target.
• Dilution may be a problem for acquiring firm’s
  shareholders.
   Reverse Triangular Merger
• Reverse Triangular Merger--the surviving
  entity is the target corporation, which is a subsidiary
  of the acquirer after the transaction.
• Target must retain substantially all of T’s assets*
• At least 80% of consideration must be in the form of
  acquiring firm’s voting stock.
• Functionally similar to “B” reorganization except can
  force out dissenters and use more cash.


   * 90% of net fair market value of the target’s assets and 70% of gross fair
     market value of those assets.
        Reverse Triangular Merger

                             -TRANSACTION-

                                                    T
                    A                              S/Hs
                                                           “A”
         “A”                                              Voting
        Voting                                            Stock
        Stock
                                “A” Voting Stock
                 Acq. Sub.          Merged          T

• T S/Hs Transfer Control (80%) for “A” Voting Stock.
• T must hold Sub-all of Acquisition Sub and T’s Assets.
Reverse Triangular Merger

          -RESULT-

                         Former
                           T
  A                       S/Hs


          • Same result as a Type
            B.
  T
IRC §368 “C” Reorganization--
 Stock-for-Assets Acquisition
• The acquirer exchanges its voting stock
  (and possibly some boot) for the target’s
  assets.
• The target distributes the acquirer’s stock
  and other consideration received in the
  acquisition to its shareholders in liquidation.
Requirements to Qualify for Tax-free
Treatment Under IRC §368(a)(1)(C)
• The acquirer must purchase “substantially all”* of
  the target’s assets but is not required to assume all
  of the target’s liabilities.
• At least 80% of the total consideration used must
  be voting stock of the acquiring firm.
• If the acquirer uses any boot in the transaction, the
  liabilities of the target assumed by the acquirer
  count as boot in the 80% test.

   * 90% of net fair market value of the target’s assets and 70% of gross fair
     market value of those assets.
Tax Consequences of a §368 “C”
• Target shareholders take a substituted basis in the
  acquiring firm stock received in the transaction:
     Substituted basis = same basis as had in T stock + any
     gain recognized – boot received
• The acquirer takes a carryover basis in the assets
  of the target.
• The tax attributes of the target will carry over to
  the acquirer, but they will be limited by IRC §382.
        Gain realized by T’s shareholders = value of the
        consideration received - target shareholder’s basis in
        the target stock.
        Gain recognized by T’s shareholders = lesser of gain
        realized or boot received.
Tax Implications of a §368 “C” Reorganization
                                              Given Information
                     Purchase Price                                                $1,370.00
                     Target Shareholder Stock Basis                                  $200.00
                     Net Tax Basis of Target's Assets                                $200.00
                     Corporate Tax Rate                                                 35%
                     Capital Gains Tax Rate                                             20%
                     Discount Rate                                                      10%

                                                        Tax-free Acquisitions          Taxable Acquisitions
                                                                                          Stock Sale w/o
                                                 368 "A"   368 "B"   368 "C" *            a 338 Election
      Purchase Price:                           $1,370.00 $1,370.00 $1,370.00                      $1,370.00
       Cash                                        548.00      0.00    274.00                       1,370.00
       Stock                                       822.00 1,370.00   1,096.00                           0.00

      Target Corporation Tax Liability                  0.00       0.00         0.00                   0.00

      Target Shareholder Gain Recognized           548.00          0.00     274.00                 1,370.00
      Target Shareholder Tax Liability             109.60          0.00      54.80                   234.00

      Target Shareholder After-tax Wealth:
       Cash                                       $438.40     $0.00   $219.20                     $1,136.00
       Stock                                       822.00 1,370.00   1,096.00                          0.00
       Total                                    $1,260.40 $1,370.00 $1,315.20                     $1,136.00

      Acquirer Net After-tax Cost:
       Pre-tax Cost                             $1,370.00 $1,370.00 $1,370.00                     $1,370.00
       Less: Incremental Tax Savings                 0.00      0.00      0.00                          0.00
       Net After-tax Cost                       $1,370.00 $1,370.00 $1,370.00                     $1,370.00

      *Assumes that the mix of consideration is 20% cash and 80% acquiring firm voting stock.
  Tax-free Merger Under IRC §368(a)(1)(C)—
          Stock-for-Asset Acquisition
             Target:
                                      $274 Cash                    Acquirer:
Receives $1,370 of consideration
                                     $1,096 Stock      Transfers $1,370 in consideration
from acquirer and distributes all
                                                           to target for its assets and
     of the consideration to
                                     “Substantially                liabilities.
   shareholders in liquidation.
                                       All” of the
                                       Assets and
  $274 Cash                           Liabilities of
 $1,096 Stock                            Target
                  All of Target’s
                      Stock
                                                           Acquirer Shareholders:
                                                             No direct tax effect.
      Target Shareholders:
Basis in target stock = $200. Gain
    realized is $1,170 ($1,370
received - $200 stock basis). Gain
recognized is $274 (lesser of gain
    realized or boot received).
Post-acquisition Structure:
Stock-for-Asset Acquisition

                            Acquirer:
           Holds substantially all of the assets and
       liabilities of the target. Has a carryover basis in
                        the target’s assets.




 Target Shareholders:                  Acquirer Shareholders:
Now own acquirer stock                  Remain owners of the
  and have some boot.                         acquirer.
  Non-tax Issues Associated w/
    the §368 “C” Structure
• The acquirer is not required to assume all of the target’s
  liabilities since the deal is done by contract instead of
  under state merger laws.
• Consent of acquiring firm’s shareholders not required.
• Possible dilution of acquiring firm’s stock because at least
  80% of consideration must be stock.
• Unwanted assets may be a problem.
• T’s shareholders must approve liquidation of T.
Limitations on Target Firm Tax Attributes
  • Under IRC §382, any transaction after 1986
    that results in a 50% change in ownership of
    a corporation triggers a limitation on the
    firm’s tax attributes.
  • The annual limitation on the amount of the
    firm’s tax attributes that can be used equals
    the market value of the subject firm’s equity
    at the date of the ownership change times
    the long-term tax-exempt rate of return.

      Note: Losses generated by a target firm post-
      acquisition can be offset by profits of the acquirer.
   More Rules on Target Firm
        Tax Attributes
• The target firm’s NOLs can be used to
  offset the corporate level gain on the actual
  or deemed asset sale in taxable transactions
  in which the tax basis of the target’s assets
  are stepped-up.
• However, the valuable tax attributes of the
  target that are not used to offset the gain on
  the step-up are lost.
  Example of Tax Implications of Tax-free
Acquisitions of Free-Standing C Corporations
                            Given Information
 Value of Target's Stock (and Purchase Price)                     $1,370.00
 Target Shareholder Stock Basis                                     $200.00
 Tax Basis of Target's Net Assets                                   $200.00
 Corporate Tax Rate                                                     35%
 Capital Gains Tax Rate                                                 20%
 Discount Rate                                                          10%

 The target corporation and the acquiring firm are C corporations.

 The target is owned by individual investors and has no liabilities.

 The acquirer's stock does not pay dividends, and the acquirer does not
 intend to pay dividends anytime in the future.
Comparison of Tax Implications of Tax-Free
Acquisitions of Free-Standing C Corporations
                                                    Tax-free Acquisitions        Taxable Acquisitions
                                                                                    Stock Sale w/o
                                          368 "A"* 368 "B"* 368 "C"*      351*      a 338 Election
 Purchase Price:                         $1,370.00 $1,370.00 $1,370.00 $1,370.00            $1,370.00
  Cash                                      548.00      0.00    274.00    822.00             1,370.00
  Stock                                     822.00 1,370.00 1,096.00      548.00                 0.00

 Target Corporation Tax Liability            0.00        0.00       0.00      0.00                 0.00

 Target Shareholder Gain Recognized        548.00        0.00     274.00    822.00           1,370.00
 Target Shareholder Tax Liability          109.60        0.00      54.80    164.40             270.00

 Target Shareholder After-tax Wealth:
   Cash                                    $438.40     $0.00   $219.20   $657.60            $1,100.00
   Stock                                    822.00 1,370.00 1,096.00      548.00                 0.00
  Total                                  $1,260.40 $1,370.00 $1,315.20 $1,205.60            $1,100.00

 Acquirer Net After-tax Cost:
  Pre-tax Cost                           $1,370.00 $1,370.00 $1,370.00 $1,370.00            $1,370.00
  Less: Incremental Tax Savings               0.00      0.00      0.00      0.00                 0.00
  Net After-tax Cost                     $1,370.00 $1,370.00 $1,370.00 $1,370.00            $1,370.00

 Pre-Tax Price to Leave Target
 Shareholders Indifferent                $1,195.66 $1,100.00 $1,145.84 $1,250.00            $1,370.00
        60% stock & 40% cash        100% stock   80% stock & 20% cash       40% stock & 60% cash

								
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