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.
2.
3.
4.
5.
6.
7.
Tax-free mergers and consolidations (IRC § 368(a)(1)(A));
Stock-for-stock exchanges (IRC § 368(a)(1)(B));
Stock-for-asset exchanges (IRC § 368(a)(1)(C));
Divisive reorganizations (IRC § 368(a)(1)(D));
Recapitalizations (IRC § 368(a)(1)(E));
Changes in the place of corporate organization (IRC § 368(a)(1)(F)); and
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 under applicable
state business organization laws, are described in IRC § 368(a)(2)(E). The consideration
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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. § 1.3681(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 shortterm 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. § 1.3681(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. § 1.3586(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
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be allocated to the new shares in proportion to the value of the stock of each class owned by the
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 taxfree 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 taxfree 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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acquiring corporation. Alternatively, for a purchase by a corporation, an IRC § 338 election might
be made to treat the acquisition as an asset purchase.
Cash for Assets
The bulk of a corporation's assets could be acquired for cash. The shareholders of the selling
corporation would ordinarily be required under applicable state law to approve the disposition,
but they would not be otherwise directly involved in the transaction. The purchasing corporation
may be concerned about unidentified and contingent liabilities that could subsequently arise if
the corporate entity were acquired. Of course, under applicable state creditors' rights laws, these
liabilities might follow the bulk of the operating business assets, but this is a matter of liability
assumption to be resolved in the asset acquisition agreement.
One way to structure a cash for assets merger is to have the seller transfer the assets being
acquired into a newly created limited liability company (LLC) prior to the transaction, but retain
certain liabilities, such as contingent and unascertained liabilities, except to the extent associated
with the transferred assets. The units in the LLC could thereafter be acquired for cash by the
purchasing corporation. If the LLC is treated as a disregarded entity, the transfer of the units in
the LLC would be treated as an asset purchase, assuming this arrangement is permitted under
applicable state law. Whether the LLC has noncorporate status will not be relevant for enabling
liability protection for state law purposes.
Assuming no corporate status election has been made for the LLC, the sale of the assets (or the
units of the disregarded LLC created for purposes of this transaction) will cause the selling
corporation to recognize gain or loss on the various assets deemed transferred. After the
completion of these deemed asset transfers, the selling corporation may retain the cash
proceeds remaining after the corporate-level liabilities (including income taxes) are paid,
thereafter functioning as an investment company. Alternatively, the corporation might liquidate,
distributing its cash and any remaining assets to its shareholders. If the selling corporation
liquidates, the selling shareholders will recognize gain or loss, thereby incurring a second level of
income tax attributable to this transaction.
Installment Sales
An installment sale might be used to defer gain recognition until payments are actually or
constructively received, whether the transaction is a stock or asset sale. The consideration could
be paid in the form of promissory notes, and the gain would only be recognized at the time of
the payment of those notes (or their earlier disposition). See generally IRC § 453. Various
limitations apply to installment sales, such as whether the consideration received (e.g., debt
securities) is publicly traded or is a cash equivalent. Furthermore, a required interest charge is
imposed in some circumstances.
Fractional Shares
An acquisition agreement involving an exchange of stock ordinarily provides that fractional
shares will not be issued to the selling shareholders. If the stock of the acquiring corporation is
publicly held and traded, the most common method of avoiding fractional share issuances is to
appoint an agent who, at the option of the shareholder, either will sell the fractional interest for
the shareholder's account or will purchase an additional fraction to complete a whole share.
Ordinarily, if no instruction is received by the agent, the fractional interest is sold and the
proceeds are paid to the shareholder. A simpler but less common solution is to aggregate all
fractional interests into the nearest whole number, sell the resulting shares, and pay each
shareholder the pro rata amount attributable to his or her fractional interest. Still simpler is the
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method that dispenses with an actual sale in favor of a payment of cash by the acquiring
corporation in an amount determined by the current market value of the shareholder's fractional
interest. The cash received is usually treated under IRC § 302 as a redemption of the fractional
interest and not as an event violating statutory requirements that prohibit the delivery of cash in
a reorganization (where only stock is permitted).
The first two methods above presuppose that the shares are either listed on a securities
exchange or traded over the counter, so that the requisite number of shares can either be sold
or purchased by the agent. If no market exists for the shares, or if sales are not feasible because
of Securities and Exchange Commission (SEC) restrictions, the third method (i.e., payment of
cash in lieu of fractional interests) will be appealing, since it does not depend on the stock
market. However, if the stock is not traded, the value adopted by the corporation in fixing the
amount to be paid for fractional interests can invite controversy, particularly when the value per
share is significant. For this reason, and in the interest of simplicity, acquisition agreements
covering closely held corporations often provide that fractional interests will be rounded off to
the nearest whole number or, if the acquiring corporation is in a generous mood, to the next
highest whole number. This amount could be significant if the value per share is substantial.
Agreements sometimes provide that, regardless of the rounding-off process, the number of
shares to be issued will not exceed a specified maximum amount. Of course, the target
corporation (especially if closely held) may eliminate many of these issues concerning fractional
shares by a stock split in advance of the proposed acquisition or other reorganization.
Preferred Stock
Certain preferred stock—“nonqualified preferred stock”—received in an acquisition may be
treated as “boot,” rather than as consideration qualifying as stock. IRC § 351(g). Previously,
preferred stock could be received in an acquisition even though it was often functionally
equivalent to debt securities. However, limitations in IRC §§ 351, 354, 355, 356, and 1036 treat
certain preferred stock as “other property” (i.e., boot). IRC § 354(a)(2)(C) specifies that
“nonqualified preferred stock” received in exchange for stock (other than nonqualified preferred
stock) shall not be treated as stock or securities. However, “nonqualified preferred stock”
continues to be treated as stock for purposes of determining whether the “control” test of IRC
§ 368(c) is satisfied.
“Nonqualified preferred stock” is preferred stock that satisfies any of the following conditions:
1. The holder of the stock has the right to require the corporation that issued the stock, or a
person “related” to the issuer, to redeem or purchase the stock;
2. The issuer or a person “related” to the issuer is required to redeem or purchase the
stock;
3. The issuer or a person “related” to the issuer has the right to redeem or purchase the
stock and, as of the issue date of the stock, it is more likely than not that the right will be
exercised; or
4. The dividend rate on the stock varies in whole or in part with reference to interest rates,
commodity prices, or similar external indexes. See IRC § 351(g)(2).
Pursuant to IRC §§ 351(g)(2)(B) and 351(g)(2)(C), made applicable by IRC § 356(e), the first
three conditions above do not apply if any of the following exceptions applies:
1. The right or obligation may be exercised only within the twenty-year period beginning on
the date the stock is issued and the right or obligation is not subject to a contingency
that, as of the date the stock is issued, makes the likelihood of the redemption or
purchase remote;
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2. The right or obligation may be exercised only upon the death, disability, or mental
incompetency of the holder; or
3. The stock was issued as reasonable compensation for services performed for the issuer or
a “related” person, and the right or obligation to purchase or redeem the stock may only
be exercised upon the holder's separation from the service of the issuer or the “related”
person.
Options
If options are received in an acquisition, they cannot be treated as stock but are treated as
taxable boot if the target shareholder exchanges target stock for options issued by the acquirer
to acquire stock of the acquiror. See Reg. § 1.354-1(d), Ex. 4. The target shareholders must
recognize gain up to the fair market value of the options. See IRC § 356(a); Reg. § 1.356-1(a).
Tax Treatment of Reorganization Expenses
Ordinarily, the expenses incurred in a corporate tax-free reorganization must be capitalized and
are ineligible for a current deduction for federal income tax purposes. Corporate reorganization
costs may be eligible for the IRC § 197 amortization of intangibles. See IRC § 197(e)(8).
Preliminary expenses, such as the preparation of financial statements, legal research expenses,
costs of shareholder meetings, etc., might be accorded different treatment.
Certain corporate acquisition expenses may be currently deductible if they are incurred to avoid
a hostile takeover. In , the Tax Court, in a reviewed opinion, found the expenses incurred by the
taxpayer in a hostile takeover to be nondeductible, based on the future benefit theory enunciated
in . The Seventh Circuit reversed that decision in , drawing a line between friendly and hostile
takeovers. The court required capitalization of only a small part of the expenses (the fees for the
evaluation of the target corporation's stock relative to the offer), but permitted deductibility of
fees to resist the takeover (the vast majority of the cost) as ordinary and necessary business
expenses (cost “directed towards defeating a hostile tender offer…reap no revenues to match”
and are an immediate loss in the year incurred). In , the court determined that an acquired bank
was entitled to deduct as ordinary business expenses the entire salaries of officers who
participated in the consideration of a proposed merger. The court determined that the salary
expenses were directly related to, and arose from, the employment relationship and were only
indirectly related to the acquisition itself. The court determined that requiring capitalization of
the expenses at issue in this matter simply because they were incidentally connected with a
future benefit was incorrect.
This is an area where the IRS is prepared to challenge the aggressive expensing of costs
associated with acquisitions. The usual analysis is that these costs must be capitalized. However,
where lack of any benefit for these expenses can be demonstrated, they should be able to be
currently deducted as ordinary and necessary business expenses.
Acquisition Termination Fees
The parties to a merger or similar acquisition may include a specific termination fee in the
agreement in the event that one of them fails to proceed with the transaction. Termination fees
are usually meant to discourage the seller from soliciting higher offers after negotiating an
agreement with the original purchaser. Sometimes, the seller will pay the termination fee in
order to obtain the benefit of a better offer. In Priv. Ltr. Rul. 200823012, the IRS indicated that
termination fees received in connection with an abandoned merger are ordinary income, not
capital gain. Because the purpose of the termination fees was not specified, the IRS reasoned
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that case law supports the conclusion that they must be treated as lost profits. This reasoning
rests on the rule that the character of proceeds from a judgment or settlement depends on the
nature of the claim and the basis of the recovery under the origin-of-the-claim doctrine.
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