7-1 Chapter 7 Corporations: Reorganizations (2010 edition) updated: February 19, 2010 Learning Objectives: Understand the basic tax consequences arising from corporate reorganizations, including corporate mergers, acquisitions, and divisions. Discuss the tax treatment of the Acquiring corporation, the Target corporation, and the Target‟s shareholders. Describe the seven different types of reorganizations and the requirements that must be met for nontaxable treatment. Explain the judicial and administrative conditions for a nontaxable reorganization. Explain the rules governing the carryover of tax attributes from one corporation to another. I. Corporate Reorganizations – In General A. The term reorganization refers to any corporate restructuring that may be tax- free under Sec. 368. To qualify for nonrecognition treatment, the reorganization must meet certain general requirements: 1. Must have a “plan” of reorganization and the plan must be adopted by each corporation involved in the reorganization. 2. Must meet certain tests in the Regulations regarding “continuity of interest” and “continuity of business enterprise”. 3. Must meet judicial doctrine of having a “sound business purpose”. 4. Must be conducted according to one of several acceptable patterns (there are seven forms or types of reorganizations). 5. The court-imposed step transaction doctrine should not apply to the reorganization (otherwise tax-free status may be denied). B. There must be a plan of reorganization that contemplates a restructuring falling under one of the Code sanctified reorganizations. It is specifically required by Secs. 354 and 361. 1. The plan does not have to be formally written but the parties to the reorganization must be able to demonstrate a plan. Written communications to shareholders and evidence in the corporate meeting minutes will qualify as evidence of a plan. 2. The plan distinguishes transactions that are integral to the reorganization from those that are not part of it, but may be in close proximity as to time. C. Besides meeting the statutory requirements, reorganizations must meet several judicially created doctrines. 7-2 1. The reorganization must exhibit a sound business purpose (i.e., a bona fide business purpose or economic consequence other than tax avoidance) This requirement limits tax-favored treatment to only those restructurings that meet the valid needs of the corporation. The fact that there is no tax avoidance motive does not establish that there is a sound business purpose. The sound business purpose should be that of the corporation. However, it is often difficult to distinguish between a corporation‟s and the shareholders‟ purposes. The lack of a sound business purpose cannot be used as an argument by the taxpayer to destroy the tax-free nature of a reorganization. For example, the taxpayer may not want a restructuring to qualify as a reorganization if a step-up in the assets‟ bases is desired. Closely related to the substance over form principle. Note: This is not a well defined test. 2. Continuity of interest (test) – requires that the Target‟s shareholders receive a substantial equity interest in the Acquiring corporation in order for the reorganization to be tax-free. (This concept was first developed in the courts, but is now contained in the Regulations.) The purpose of this requirement is to prevent transactions that resemble sales from qualifying as tax-free reorganizations. The Regulations deem that if Target shareholders receive Acquiring stock equal in value to at least 50% of all Target stock formerly outstanding, this test is satisfied. The test is applied in aggregate to shareholders; thus, not all shareholders must receive stock in the acquiring corporation to meet this test. If the continuity of interest test is met at the time of the reorganization, a stock sale immediately before or after by a shareholder to an unrelated party will not affect this requirement. 3. The continuity of business enterprise doctrine (test) ensures that the Target business continues after the reorganization. The ownership but not the business of the Target has changed. The test can be met by the acquiring corporation by either: continuing Target‟s historic business (business test), or continuing to use a significant portion of Target‟s assets (asset use test). 7-3 Note: The continuity of interest and continuity of business doctrines apply only to reorganizations where two or more corporations are involved. Accordingly, these doctrines do not apply to Type E and Type F reorganizations. 4. In addition, the step transaction doctrine was created by the courts to ensure that transactions performed in a series of steps result in the same tax consequences as if the plan was executed in a single step. In the reorganization area, the doctrine is used to determine whether a series of transactions results in a tax-free restructuring (can be good (help) or bad (hurt) the companies involved). The Target and the Acquiring corporations‟ ownership may be compared before and after the series of transactions to determine whether the steps in the transactions should be collapsed. A problem may exist when Acquiring does not want substantially all of the Target‟s assets, a requirement in a Type C and acquisitive Type D. Without evidence to the contrary, the IRS generally views transactions occurring within one year as part of the same restructuring. Step transaction doctrine may be applied to reorganizations to benefit corporations involved, rather than just to their detriment. 7-4 D. General tax treatment – Tax-free reorganizations are a form of nontaxable exchanges. The tax treatment parallels almost exactly the Sec. 1031 like-kind exchange provisions and the Sec. 351 corporate formations provisions. The purpose of Sec. 368 is to insure that the tax law will not impeded corporate realignments – mergers, acquisitions and divisions – that are often necessary for economic survival and growth. 1. In general, security holders – stockholders and bondholders – of corporations involved in a tax-free reorganization: recognize no gain or loss when they exchange their ownership interests and securities for stocks and bonds in the other corporation (based, in part, on the wherewithal to pay concept) their bases in the new stocks or bonds received will be a carryover basis (which preserves the unrecognized gain or loss) 2. If a security holder – stockholders and bondholders – receives property other than stock or bonds, the other property is treated as boot. the amount of gain recognized is the lesser of realized gain or boot received losses are not recognized regardless of the boot received basis in the stock or bonds received is equal to their fair market value less the realized gain postponed or plus the realized loss postponed E. Under Sec. 368 there are seven different types of term reorganizations: 1. Type A: Statutory merger or consolidation (stock for assets). 2. Type B: Stock for stock exchange (solely voting stock for stock). 3. Type C: Stock for assets exchange (some other assets and voting stock for stock). 4. Type D: Acquisitive and divisive exchanges include a spin-off, a split- off, and a split-up (assets for stock control). 5. Type E: Recapitalization – exchanges of stock for stock, bonds for bonds, and bonds for stock are permissible. 6. Type F: Change in identity, form, or place of organization. 7. Type G: Transfers in a Federal or state bankruptcy, or receivership. Note: The big challenge is to differentiate Type A, B, and C reorganizations (see diagram – chapter seven web site). 7-5 II. Tax Free Reorganizations – Consequences to the Acquiring Corporation, the Target Corporations and their Shareholders A. Consequences to the Acquiring corporation: 1. no gain or loss recognized unless it transfers property to the Target corporation as part of the transaction then gain, but not loss, may be recognized (this follows the general rule regarding the distribution of appreciated property – see chapter 5 notes) 2. basis of property received retains basis it had in hands of the Target corporation plus any gain recognized by the Target corporation (i.e., if Target retains some of the “other property” received in the exchange) B. Consequences to Target corporation: 1. no gain or loss recognized unless it retains “other property” received in the exchange or it distributes its own property to shareholders other property is defined as anything received other than stock or securities (treated as boot) gain, but not loss, may be recognized C. Consequences to Target or Acquiring company shareholders: 1. no gain or loss recognized unless shareholders receive cash or other property in addition to stock cash or other property is considered boot gain recognized by shareholders is the lesser of the boot received or the realized gain 2. character of the recognized gain dividend income from E&P (proportionate share) long-term capital gain 3. basis of shares received is same as basis of those surrendered, decreased by boot received, increased by gain and dividend income, if any, recognized in the transaction D. Tax consequences diagram (see diagram chapter seven web site): 1. general rule – no gain or loss recognized & carryover bases 2. exceptions – what circumstances/events cause the recognition of gain 7-6 III. Type A: Statutory Merger or Consolidation A. Type A reorganizations include mergers and consolidations. 1. A merger is union of two or more corporations. One corporation retains its existence and absorbs the others. 2. A consolidation occurs when a new corporation is created to take the place of two or more corporations. B. Two steps to complete a corporate merger: 1. Target corporation: a. transfers assets and all liabilities to the Acquiring corporation b. in return for stock and securities. Note: Target can sell or otherwise dispose of unwanted assets. 2. Target corporation (which now contains solely the stock and securities of the Acquiring corporation) dissolves by exchanging the acquiring corporations stock for its own stock. 3. As a result the former shareholders of Target corporation become shareholders in Acquiring corporation. C. Two steps to complete a corporate consolidation: 1. Target corporations: a. transfer assets and all liabilities to the new Consolidated corporation b. in return for stock and securities. 2. Target corporations (which now contain solely the stock and securities of the new Consolidated corporation) dissolve by distributing the new Consolidated corporation‟s stock to their shareholders in return for their own stock. 3. As a result the former shareholders of the Target corporations become shareholders in the new Consolidated corporation. 7-7 D. Advantages: 1. Type A reorganizations are flexible. 2. Consideration need not be voting stock. 3. Money or “other property” received in the exchange will not destroy the tax-free treatment for stock received in the reorganization; if the “continuity of interest” test is met (at least 50% of the consideration used in the reorganization must be stock). 4. No requirement that “substantially all” of Target‟s assets be transferred to Acquiring Corporation (Target can sell or otherwise dispose of some assets). E. Disadvantages: 1. Money and other property received are considered “boot” so some gain may be recognized. 2. Complying with required laws may be problematic when laws require consent to the reorganization by majority shareholders of all corporations involved. Shareholders of either entity may dissent; in most states their shares must be redeemed. 3. Acquiring corporation must assume all liabilities of Target corporation. 4. Target corporation liquidates. 7-8 F. Diagram – Simple merger and consolidation 7-9 IV. Type B: Stock for Stock Exchange A. Type B reorganization 1. A corporation acquires a controlling stock interest in the Target corporation solely in exchange for its own voting stock (stock for stock). 2. Thus, the Target corporation becomes a subsidiary of the Acquiring corporation (a parent-subsidiary relationship is formed). B. There are two requirements of Type B reorganizations: 1. The Target‟s stock must be acquired using solely voting stock. Target shareholders can receive only Acquiring voting stock. 2. Immediately after the exchange the Acquiring corporation must be in “control” of Target corporation. Acquiring corporation (parent) must hold at least 80% of all classes of stock of Target corporation (subsidiary) after the reorganization. acquirer may add shares owned previously with shares acquired in reorganization (in order to obtain the full 80% controlling interest) parent may acquire shares in a series of acquisitions (often referred to as a “creeping “B” reorganization) as long as the plan is carried out over a short period of time (usually less than 12 months) C. Acquiring corporation may acquire shares from either: 1. shareholders of Target corporation, or 2. directly from Target corporation D. Acquiring corporation must use only voting stock as consideration. 1. Even a small amount of other property such as cash will destroy the tax-free benefits. 2. Exception to the “solely for voting stock” requirement is allowed when shareholders would otherwise receive fractional shares. These shareholders may receive cash rather than fractional shares in the Acquiring corporation. 7-10 E. Advantages: 1. Type B reorganizations are simple. 2. No gains or losses are recognized by the corporations or shareholders that are part of the reorganization. 3. Stock can be acquired from the shareholders of Target corporation F. Disadvantages: 1. Only voting stock of the acquiring corporation may be used as consideration. 2. Boot (other property) is prohibited. 3. Must have at least 80% control of the Target corporation. 4. If the Acquiring corporation does not obtain 100% of the Target‟s stock, problems may arise with the minority shareholders of the Target corporation. G. Diagram – Parent-subsidiary relationship 7-11 V. Type C: Stock for Assets Exchange A. In a Type C reorganization: 1. one corporation acquires substantially all the assets of another corporation in exchange for 2. voting stock and a limited amount of other property followed by liquidation of the Target corporation Note: Closely resembles a Type A merger except for the consideration that can be used by the Acquiring corporation & the amount of Target‟s assets acquired and liabilities assumed. In the end the Acquiring corporation holds Target corporation‟s assets & the Target corporation dissolves. B. “Substantially all” of Target‟s assets must be transferred to acquirer. 1. there is no statutory definition of „„substantially all‟‟ 2. to receive a favorable ruling from the IRS, the Target corporation must transfer at least: 90% of the fair market value of the net assets AND 70% of the fair market value of the gross assets to the acquiring corporation Note: This limits the amount of liquid assets that may be retained in the Target corporation to pay the remaining unassumed liabilities C. Consideration paid by acquirer normally consists only of voting stock. However, Acquiring corporation has some flexibility regarding the consideration it may use in the reorganization. 1. At least 80% must be acquiring voting stock, which allows up to 20% of the consideration to be cash, property, and/or assumption of Target‟s liabilities (= boot paid by Acquiring corporation). 2. The assumption of the Target corporation‟s liabilities, which is normally considered boot, is disregarded. 3. Exception – If any additional “other property” (boot paid) is used by Acquiring corporation then the liabilities assumed by Acquiring corporation are considered boot paid (and often causes the recognition of gain). D. Target corporation must distribute to its shareholders all stock and other assets received in the exchange as well as any of its assets not transferred to acquiring corporation. The Target corporation liquidates after the transaction is complete. E. Shareholders will recognize gain only to the extent they receive other assets (boot) in exchange for their stock in the Target corporation. 7-12 F. Acquiring corporation assumes only the Target‟s liabilities that it chooses; not all the liabilities as in a Type A reorganization. G. Acquiring corporation‟s prior ownership of Target corporation stock will not prevent the “solely for voting stock” requirement to be met in Type C reorganizations. H. Advantages 1. Less complex as to state law than Type A reorganizations. 2. Cash or other property is allowed as consideration if 20% or less of fair value of property transferred. 3. Acquiring corporation assumes only the Target corporation‟s liabilities that it chooses. Also, Acquiring corporation is not liable for unknown or contingent liabilities. I. Disadvantages 1. “Substantially” all assets of Target corporation must be transferred. 2. Liabilities count as “other property” for 20% test if any other consideration is used. So, if Target has significant liabilities which are assumed by Acquiring corporation it may prohibit the use of other property as consideration. 3. Target corporation must distribute assets received to shareholders. J. Diagram – Voting stock for asset exchange 7-13 VI. Type D: Acquisitive or Divisive Exchange A. Generally a mechanism for corporate division, but can be used to carry out a corporate combination. There are two kinds of Type D reorganizations: Acquisitive and Divisive. B. Acquisitive “D” Reorganization: Two corporations are combined into one. The Target corporation absorbs the Acquiring corporation (sometimes called the minnow swallowing the whale). (Entity transferring assets is considered the Acquiring corporation. Corporation receiving the property is the Target corporation.) 1. Unlike other reorganizations, Target corporation transfers a controlling interest in its stock for the assets of Acquiring corporation. Thus, it is Acquiring corporation that is transferring assets rather than the Target corporation. The Target stock received by Acquiring corporation must be distributed to its shareholders in a transaction qualifying under Secs. 354, 355, or 356. 2. For acquisitive D reorganizations, Sec. 354 requires that substantially all of the property of the Acquiring corporation be transferred to the Target corporation for control of Target. a. Acquiring corporation must be in control – Control is defined as owning: at least 50% of total voting stock or 50% of total value of all stock classes. Note: No ownership attribution is permitted in determining whether the control test is met. b. All stock and property received from the Target corporation as well as property retained by the Acquiring corporation (i.e., not transferred to the Target) must be distributed to its shareholders. The Acquiring corporation then terminates. 3. If an acquisitive Type D reorganization could also qualify as a Type C, the Code provides that the reorganization will be treated as a Type D. This ensures that distribution of stock and securities will comply with Sec. 354 or Sec. 355. 7-14 C. Divisive D Reorganizations: Division of a corporation into two or more distinct corporations. One or more new corporations are formed to receive assets of the original corporation; original corporation must receive stock representing control (80%) of new corporation; and stock of new corporation is then distributed to shareholders of original corporation. 1. Most typical divisive D reorganizations are spin-offs, split-offs, or split-ups. a. In a spin-off the distributing corporation transfers some of its assets to a newly formed corporation in exchange for all of the subsidiary‟s stock. The new corporation stock is transferred to the distributing corporation‟s shareholders. The shareholders of the original corporation are still shareholders of the original corporation as well as shareholders of the newly formed subsidiary. b. A split-off is similar to a spin-off but some of the shareholders of the distributing corporation must surrender some of their distributing corporation stock upon receipt of the new corporation stock. As a result, the two corporations are held by the original shareholders but in a proportion that differs from that which they held in the original corporation. c. In a split-up the distributing corporation transfers all of its assets to two or more new corporations in exchange for their stock. The stock of the new corporations is exchanged for the stock of the distributing corporation, and the distributing corporation liquidates. 2. In the divisive reorganizations the distributing corporation must obtain control of the new (Target) corporation. The Sec. 368(c) control requirement applies which defines control as at least 80% of the total voting stock and at least 80% of the total number of shares of all other classes of stock. 3. All stock and other property received by the distributing corporation must be transferred to its shareholders. 4. To meet the Sec. 355(b) requirements the distributing corporation and the new controlled corporations must, after the reorganization, both be actively engaged in a trade or business previously conducted in by the distributing corporation for at least five years prior to the restructuring. D. Advantages – Division (generally) – Permits corporate division without tax consequences if no boot is involved. 7-15 E. Diagram – Acquisitive reorganization F. Diagram – Divisive reorganizations 7-16 F. (continued) Diagram – Divisive reorganizations 7-17 F. (continued) Diagram – Divisive reorganizations 7-18 VII: Type E: Recapitalization A. A Type E reorganization is a recapitalization; it involves a major change in the character and/or amount of outstanding stock, securities, or paid-in capital of a corporation (it affects only the right-hand side of the balance sheet). B. The following changes in capital structure qualify as Type E reorganizations. 1. Stock for stock. This includes common stock for common, preferred stock for preferred, common for preferred, and preferred for common. Also, differences in voting rights, dividend rates, and preferences in liquidation are ignored. 2. Bonds for bonds. If the principal amount of the bonds received is greater than the principal amount of the bonds surrendered, gain must be recognized by the bondholder (the excess amount will be taxable as boot). 3. Surrendering bonds for stock. This effectively allows a corporation to pay off its debts with stock. To the extent that stock is received for interest in arrears, the recapitalization is not tax free. Note: Surrendering stock for bonds does not qualify since the shareholder has upgraded their investment position. C. Only one corporation is involved in a Type E restructuring. D. In general there are no tax implications for: 1. the corporation, or 2. its security holders E. Advantage – Allows for major change in makeup of the right-hand side of the balance sheet (liabilities and stockholders‟ equity) without tax consequences. 7-19 VIII: Type F: Change in Identity, Form, or Place of Organization A. A Type F reorganization is a mere change in name, form, or state of incorporation, or other change in the corporate charter. 1. Tax treatment – a deemed transfer from the old corporation to the new corporation. 2. Although the reorganization is limited to a single corporation, this limitation does not preclude the use of more than one corporation in the restructuring. For example, a corporation operating in New York creates a new corporation in Delaware, transfers all of its assets to the new corporation, and then liquidates. This re-incorporation in a new state is a Type F reorganization. 3. Changing from a Subchapter S to a Subchapter C (regular) corporation or vice versa qualifies as a Type F reorganization. 4. When a corporation changes its name, this is technically a Type F reorganization. 5. If a reorganization can qualify as a Type A, C, or D as well as a Type F reorganization, it is treated as a Type F. B. All tax attributes of the predecessor corporation carry over to the successor corporation. C. A Type F reorganization does not jeopardize the status of Sec.1244 stock or terminate a valid S election. D. Advantage – Survivor is treated as same entity as predecessor; tax attributes of predecessor can be carried back or forward. 7-20 IX. Type G: Transfers in Bankruptcy or Receivership A. In Type G reorganizations, substantially all of a debtor corporation‟s assets are transferred to an acquiring corporation under a court-approved reorganization in bankruptcy (e.g., under Title 11, U.S.C.), receiverships, and foreclosures. 1. Some of the debtor corporation‟s creditors must receive voting stock representing at least 80% of the total fair market value of the corporation‟s debt. There is no requirement that the former shareholders control the acquiring corporation after the exchange. 2. Must follow a plan approved in a bankruptcy proceeding, therefore, planning opportunities are very limited. 3. Acquiring corporation in a Type G reorganization must reduce the tax attributes carried over from the bankrupt corporation to the extent of the cancellation of debt income relief. The tax attributes are reduced in the following order. • Net operating losses (NOL) • General business credits (GBC) • Minimum tax credits (MTC) • Capital loss carryovers • Basis in property Note: The acquiring corporation may elect to reduce the basis in assets first. Note: The order in which the tax attributes are reduced in a Type G reorganization is not the same as the order under the Sec. 382 limitation. B. Advantages 1. Creditors can exchange notes for stock tax-free. 2. State merger laws need not be followed. C. Disadvantage – Limited use for tax planning purposes – must be involved in an legal bankruptcy proceeding. 7-21 XI. Carryover of Tax Attributes A. Assumption of liabilities – Since the Target continues in some manner after a reorganization, the Acquiring corporation generally assumes the Target‟s liabilities (or takes Target‟s assets subject to their liabilities). 1. In general, the liabilities assumed are not considered boot when determining gain recognized by the corporations who are parties to the reorganization. 2. Liabilities assumed can cause problems in Type C reorganizations when acquiring also transfers “other property” to Target. A Type C requires that at least 80% of the consideration must be voting stock. 3. Exception – In a Type G (bankruptcy), the Target‟s liabilities are not assumed by the acquiring entity. B. Carryovers – Sec. 381 lists the Target corporation‟s tax attributes that may be carried over to the successor corporation. Sec. 381 applies to the Type A, Type C, Type G, and the acquisitive Type D reorganizations. (See handout on web page.) The tax attributes are subject to the Sec. 382 limitations. Note: Sec. 381 does not apply to Type B, Type E, Type F (since the old corporation continues exactly as before) and divisive Type D reorganizations (since the transferor stays in business and continues an active business). C. Earning and profits – Target corporation E & P carries over to the Acquiring corporation. 1. If Target‟s E & P is positive, it is added to Acquiring‟s E & P. 2. If Target‟s E & P is negative, the deficit may only offset E & P created after the restructuring. Thus, Acquiring corporation will have two E & P accounts, one containing prior restructuring E & P and the other containing the deficit E & P from Target plus any post-restructuring E & P. 7-22 D. NOL carryovers 1. The amount of the NOL that can be used in year ownership change occurs is limited to a percentage representing the remaining days in the tax year over the total number of days in the year 2. An NOL can be further limited in the first and succeeding years when there is a more than 50-percentage-point ownership change an ownership change takes place on the day that either an equity structure shift or an owner shift occurs – an equity structure shift occurs when a tax-free reorganization causes an owner shift – an owner shift is any change in the common stock ownership of shareholders owning at least 5% 3. The NOL is also subject to the Sec. 382 limitation. The objective of the Sec. 382 limitation is to restrict the yearly NOL benefit available to the Acquiring corporation. Sec. 382 does not disallow any portion of the NOL; it merely limits the annual NOL benefit. The yearly Sec. 382 limit is computed as follows: Loss corporation‟s fair market value (both common and preferred) X Federal long-term tax exempt rate = Yearly Sec. 382 limit Note: While Sec. 382 does not disallow any portion of an NOL, it may cause the NOL to expire unused. It may also affect how much Acquiring corporation is willing to pay the Target corporation for the NOL (since it involves future tax savings it comes down to a present value computation).
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