TEI 56th Midyear Conference
Federal Tax Seminar
ACQUISITIONS OF PRIVATE COMPANIES
(INCLUDING DUE DILIGENCE ISSUES)
March 27, 2006
Mark J. Silverman
Steptoe & Johnson LLP
Aaron P. Nocjar
Steptoe & Johnson LLP
Copyright © 2006 Mark J. Silverman
1
Internal Revenue Service Circular 230 Disclosure
• As provided for in Treasury regulations, advice
(if any) relating to federal taxes that is
contained in this communication (including
attachments) is not intended or written to be
used, and cannot be used, for the purpose of
(1) avoiding penalties under the Internal
Revenue Code or (2) promoting, marketing or
recommending to another party any plan or
arrangement addressed herein.
2
Mark J. Silverman
1330 Connecticut Avenue, NW
Washington, DC 20036
Tel: 202.429.6450
Fax: 202.429.3902
msilverman@steptoe.com
AREAS OF PRACTICE
Tax
Corporate Transactions
Mergers, Acquisitions, and
Joint Ventures
Legislative & Administrative
Audit and Controversy
HONORS AND DISTINCTIONS
Named Among the “Top Ten Tax
Lawyers in Washington, DC” by Legal
Times, 2005
Ranked Attorney Chambers USA
2005, America’s Leading Business
Lawyers; DC Tax
Former advisor to Committee on
Ways & Means Counsel, ABA, Tax
Section
Chair, Corporate Tax Committee,
ABA, Tax Section
Advisory Board Member, NYU
Institute and BNA Tax Management
Mark J. Silverman heads Steptoe & Johnson's tax practice. Mr. Silverman was named one of
the top ten tax lawyers in Washington in 2005 by Legal Times. He is a member of The
American Law Institute, Tax Advisory Group for the Study of Subchapter C of the Internal
Revenue Code. He was formerly an advisor to the Committee on Ways and Means during
their consideration of revisions to the corporate tax provisions of the Internal Revenue Code.
He is a Fellow of the American College of Tax Counsel. Mr. Silverman was formerly a
Council member of the American Bar Association, Section of Taxation and was formerly Chair
of the Corporate Tax Committee. He chaired the Tax Section Task Force on Leveraged
Buyouts. Mr. Silverman co-authored the Tax Advisors Planning Series on Financially
Troubled Businesses, he was formerly Corporate Tax Editor of The Journal of Taxation, and
is a member of the advisory boards of NYU Institute on Federal Taxation, BNA Tax
Management, Consolidated Returns Tax Report, M&A Tax Report and Corporate Taxation
magazines. Mr. Silverman is on the Editorial Board of The American Journal of Tax Policy,
and is on the Board of Trustees of the Southern Federal Tax Institute. Mr. Silverman chairs
the ALI-ABA annual consolidated returns program. Mr. Silverman was formerly a member of
the Executive Committee of the New York State Bar Association. In addition, he is an Adjunct
Professor of Law at Georgetown University Law Center and was formerly attorney- advisor to
Judge Samuel B. Sterrett of the United States Tax Court. Mr. Silverman is a frequent speaker
on tax matters and has published numerous articles on the subject.
Planning and Transactional Practice
Mr. Silverman focuses on planning and transactional matters. He has extensive experience
in structuring acquisitions, mergers, and spin-off transactions for large public corporations, as
well as closely held businesses. He has authored a book on the tax consequences of
financially troubled businesses and advises corporations on consolidated return issues. Mr.
Silverman advises leverage buyout groups, venture capitalists and privately held commercial
real estate developers with respect to various transactional matters. He is often called upon
to advise the Internal Revenue Service, Treasury Department, and the staffs of the
Congressional tax writing committees with respect to corporate tax issues.
3
Mark J. Silverman (cont.)
HONORS AND DISTINCTIONS (cont.)
Member, Board of Trustees, Southern
Federal Tax Institute
Adjunct Professor, Georgetown
University Law Center
Chair, ALI-ABA Consolidated Returns
Program
Advisor to the Federal Bar
Association Section of Taxation
Law Conference
Co-author of Tax Advisors Planning
Series on Financially Troubled
Businesses
Former attorney-advisor to Judge
Samuel B. Sterrett of US Tax Court
Tax Policy Practice
A significant part of Mr. Silverman's practice involves the resolution of tax policy issues before
Congress and the Treasury Department. These issues arise in the context of pending or
proposed legislation and proposed Treasury Department regulations. Mr. Silverman is
currently meeting with members of Congress and their staffs on many of the corporate tax
provisions proposed by the Administration and by members of Congress (including corporate
spin-offs, financial product provisions, and corporate capital gains).
Audit and Controversy
Mr. Silverman also handles audit and controversy matters. He has extensive experience
negotiating with field agents, appeals officers and district counsel in settling significant audit
issues. Mr. Silverman frequently prepares technical advice requests and often meets with
National Office officials with respect to audit and tax litigation matters. Recently, Mr.
Silverman was successful in negotiating global tax shelter settlements with the IRS. In
addition, he convinced the National Office to reverse its position with respect to a technical
advice memorandum involving the deduction of environmental clean-up costs.
ADMITTED TO THE BAR
District of Columbia
New York
4
Aaron P. Nocjar
anocjar@steptoe.com
TEL: 202.429.6211
FAX: 202.261.0601
1330 Connecticut Avenue, NW
Washington, DC 20036
AREAS OF PRACTICE
Tax
HONORS & DISTINCTIONS
Chair, New Tax Practitioners
Committee, D.C. Bar, Tax Section
Aaron P. Nocjar is an associate in the Washington, DC office of Steptoe & Johnson LLP. He
is a member of the firm's Business Solutions group, focusing on federal income taxation
issues, with particular emphasis on the taxation of pass-through entities, including
partnerships and S corporations.
Prior to joining Steptoe & Johnson LLP, Mr. Nocjar earned his LL.M. in Taxation from
Georgetown University Law Center. Mr. Nocjar received the Thomas Bradbury Chetwood,
S.J. Prize for attaining the highest academic average in his graduating class.
Prior to his LL.M. studies, Mr. Nocjar served as the law clerk to Judge Irvin G. Condon at the
Charleston County Probate Court in Charleston, South Carolina.
EDUCATION
Georgetown University Law Center
LL.M., Taxation, with distinction, 2001
Case Western Reserve University
J.D., magna cum laude, 1998
Order of the Coif
Executive Articles Editor, Case
Western Reserve Journal of
International Law
University of Notre Dame
B.B.A., Accountancy, magna cum
laude, 1995
PUBLICATIONS
Co-author, The S Corporation Rules and the Use of S Corporations as Acquisition Vehicles, Practising
Law Institute (2005)
Co-author, Section 197 and Partnership Transactions, Practising Law Institute (2005)
Co-author, Partnership Disguised Sale Rules, Practising Law Institute (2005)
Co-author, Establishing Business Purpose in a Transparent World, 2004 USC Tax Institute
Author, The 2000 Proposed Regulations on Corporate Sponsorship Payments: A Step Toward
Restoring the Public's Trust in Charitable Organizations , 54 Tax Law. 357 (Winter 2001)
SPEAKING ENGAGEMENTS
Mr. Nocjar has spoken on a number of partnership tax topics for the Tax Executives Institute
and ALI-ABA.
PROFESSIONAL AFFILIATIONS
American Bar Association, Section of Taxation
D.C. Bar, Section of Taxation
MEMBERSHIP IN STATE BARS
District of Columbia
South Carolina
5
Acquisitions of Private
Companies
• Private companies operating in disregarded entities
• Private companies operating in partnership entities
• Private companies operating in corporate entities
– S corporation issues
– Taxable transactions - sections 1060/338(h)(10)
– Amortization of intangibles - section 197
– Contingent liabilities
– Tax-free transactions
• Additional Selected Issues – COBE, COI, Step Transaction
• Troubled Company Issues
• Due Diligence Issues
Slide #
7
34
52
67
99
109
127
146
171
188
6
Acquisitions of Private Companies
Operating in Disregarded Entities
7
Sale of All of the
Membership Interests
100% of LLC
P
X
Cash
100%
LLC
Facts: P owns all of the outstanding interests in LLC, which is treated as a disregarded
entity for tax purposes. P sells all of the outstanding membership interests in LLC to X,
an unrelated party.
Results: Because P is treated as owning all of the assets of LLC rather than LLC
interests, P is treated as selling all of the assets of LLC to X.
8
Sale of Less than All of
the Membership Interests
P
50% of LLC
Cash
X
100%
LLC
Facts: P owns all of the outstanding interests in LLC, which is treated as a disregarded entity
for tax purposes. P sells 50 percent of the outstanding membership interests in LLC to X, an
unrelated party.
Results: P is treated as having sold 50% of LLC’s assets to X, followed by a contribution by X
of the purchased assets and by P of the retained assets to a newly formed partnership. Treas.
Reg. § 301.7701-3(g)(1)(iv), (g)(3)(i); Rev. Rul. 99-5 (Sit. 1).
What are the results if, instead of P’s selling the interests to X, X contributes cash to LLC in
exchange for interests? See Rev. Rul. 99-5 (Sit. 2). However, if that cash is distributed to P
within 2 years, P will be subject to the disguised sale rules under section 707(a)(2)(B). What if P
9
sells 50 percent of the LLC’s interests in a public offering? See section 7704.
B Reorganization
P
T
Shareholders
LLC
T
100%
Facts: P would like to acquire the stock of T in a tax-free reorganization.
Accordingly, P forms a wholly owned LLC, which is treated as a disregarded entity.
LLC acquires the T stock from T’s shareholders in exchange for P voting stock.
Result: The transaction should qualify as a tax-free B reorganization.
10
C Reorganization
T
Shareholders
P
P Voting
Stock
100%
P Voting Stock
LLC
T Assets &
Liabilities
T
Facts: P would like to acquire the assets and operating liabilities of T in a tax-free
reorganization, but T has certain liabilities that P wants to leave behind. Accordingly,
P forms a wholly owned LLC, which is treated as a disregarded entity. T transfers
its assets and operating liabilities to LLC in exchange for P voting stock and distributes
the P stock to its shareholders in complete liquidation (subject to satisfaction of any
remaining liabilities).
Result: The transaction should qualify as a tax-free C reorganization, with P as the
acquiring corporation. See Rev. Rul. 70-107; cf. G.C.M. 39,102.
11
D Reorganization
P
P
T Stock
100%
T
100%
100%
A
A
100%
T
Merger
LLC
Facts: P owns all of the stock of two corporations, T and A. P contributes all of its T stock to A.
Immediately thereafter, A forms a wholly owned LLC, and T merges into LLC.
Result: The contribution of T stock and the subsequent merger of T into LLC should be integrated and
treated as if T transferred all of its assets directly to A in exchange for A stock and then distributed the
A stock to P in complete liquidation. The transaction, as recharacterized, should qualify as a tax-free
acquisitive D reorganization. See P.L.R. 200445016 (Jul. 20, 2004); see also Rev. Rul. 2004-83 (taxable sale of
subsidiary stock to another subsidiary followed by an actual liquidation treated as a D reorganization); P.L.R.
200430025 (Apr. 2, 2004) (transfer of stock followed by a QSub election treated as a D reorganization).
Note that, as a result of the AJCA, section 357(c) no longer applies when T’s liabilities exceed T’s aggregate basis in
its assets as long as the D reorganization is acquisitive. See section 357(c)(1)(B).
12
T
Shareholder
2) Merger
T
F Reorganization
3) LLC
Interests
T
Shareholder
HC
1) Business A
HC
Bus. A
4) Merger
P
100%
LLC
100%
Bus. B/Cont. Liab.
LLC
Facts: T conducts two businesses, Business A and Business B. P would like to acquire Business A in a tax-free
reorganization in exchange for 80% P stock and 20% cash. T has contingent liabilities that P wants to leave
behind. Further, assume for simplicity that the Business B assets have little or no built-in gain and T has a
single shareholder. Accordingly, T forms a new corporation, HC, which in turn forms a wholly owned LLC
treated as a disregarded entity. T transfers Business A to HC and then merges into LLC. HC then distributes
the LLC interests to its shareholder in a taxable distribution. HC then merges into P, with the T shareholder
receiving P stock and cash.
Result: Steps 1 and 2 should qualify as a tax-free F reorganization; step 3 should be treated as a taxable
distribution of LLC’s assets to T’s shareholder; step 4 should qualify as a tax-free A reorganization. See
Prop. Reg. § 1.368-2(m)(3)(ii); Rev. Rul. 96-29; PLRs 199902004, 199939017. What if, instead of a
merger, the T shareholder sells the HC stock to P? See Prop. Reg. § 1.368-2(m)(2).
13
Merger Into LLC
P
T
100%
LLC
Facts: P forms a wholly owned LLC. LLC is treated as a disregarded entity. T merges into
LLC pursuant to a state statutory merger, with the T shareholders receiving P voting stock.
See Former Prop. Treas. Reg. § 1.368-2(b)(1) (2000).
14
LLC Merger Into Corporation
T
P
100%
LLC
Facts: T owns all of the interests of LLC. LLC is treated as a disregarded entity. LLC
operates a business. LLC merges into P pursuant to a state statutory merger. See Former
Prop. Treas. Reg. § 1.368-2(b)(1) (2000).
15
Final Regulations on Statutory Mergers and
Consolidations under Section 368

On January 23, 2006, the IRS and Treasury issued final regulations defining the
term “statutory merger or consolidation” as that term is used in the definition of an
“A” reorganization under section 368(a)(1)(A) of the Code. These final regulations
were the result of several iterations of proposed and temporary regulations and
modifications made in response to comments.
 The 2000 proposed regulations (May 16, 2000) provided that neither the merger of a
disregarded entity into a corporation nor the merger of a target corporation into a
disregarded entity could qualify as an A reorganization.
 On November 15, 2001, the IRS and Treasury withdrew the 2000 proposed regulations
and issued new proposed regulations that permitted certain statutory mergers involving
disregarded entities to qualify as A reorganizations.
 On January 24, 2003, the IRS and Treasury made certain minor clarifications to the new
proposed regulations and issued them as temporary regulations.
 On January 5, 2005, the IRS and Treasury issued proposed regulations that would
expand the temporary regulations to include mergers involving foreign entities and
mergers effected pursuant to foreign laws within the scope of the phrase “statutory
merger or consolidation.”
16
Final Section 368 Regulations
Definition of Terms
•
A “statutory merger or consolidation” is defined as a transaction effected
pursuant to the statute or statutes necessary to effect the merger or
consolidation, in which, as a result of the operation of such statute or
statutes, the following events occur simultaneously at the effective time of
the transaction:
– All of the assets (other than those distributed in the transaction) and liabilities
(except to the extent such liabilities are satisfied or discharged in the transaction
or are nonrecourse liabilities to which assets distributed in the transaction are
subject) of each member of one or more combining units (each a transferor unit)
become the assets and liabilities of one or more members of one other
combining unit (transferee unit), and
– The combining entity of each transferor unit ceases its separate legal existence
for all purposes.
• This requirement will be satisfied even if, under applicable law, after the effective time of
the transaction, the combining entity of the transferor unit (or its officers, directors, or
agents) may act or be acted against, or a member of the transferee unit (or its officers,
directors, or agents) may act or be acted against in the name of the combining entity of
the transferor unit, provided that such actions relate to assets or obligations of the
combining entity of the transferor unit that arose, or relate to activities engaged in by
such entity, prior to the effective time of the transaction, and such actions are not
inconsistent with the combination requirement above.
•
The final regulations adopt the change in the proposed regulations to permit
mergers or consolidations involving foreign entities and mergers and
consolidations effected pursuant to foreign laws.
17
Final Section 368 Regulations
Definition of Terms

The following terms are defined in the final regulations for purposes of
defining statutory merger or consolidation:
 Disregarded entity - Business entity (as defined in Treas. Reg. §
301.7701-2(a)) that is disregarded as an entity separate from its
owner for federal income tax purposes. Examples include domestic
single-member LLCs that do not elect to be treated as corporations,
qualified REIT subsidiaries, and qualified subchapter S
subsidiaries.
 Combining entity - Business entity that is a corporation that is not a
disregarded entity.
 Combining unit - Comprised solely of a combining entity and all
disregarded entities, if any, the assets of which are treated as
owned by the combining entity for federal income tax purposes.
18
Final Section 368 Regulations
Merger of Target into Disregarded Entity
P
T
100%
LLC
Facts: P and T are domestic corporations and LLC is a domestic limited liability company. LLC
is wholly owned by P. LLC is treated as a disregarded entity. P and T are combining entities. P
and LLC comprise a combining unit, and T is a combining unit. T merges into LLC under state
statutory merger law, with the T shareholders receiving P voting stock.
Result: The transaction qualifies as a tax-free A reorganization under Treas. Reg. § 1.3682(b)(1)(ii). See Treas. Reg. § 1.368-2(b)(1)(iii), ex. 2.
19
Final Section 368 Regulations
Divisive Mergers
P
100%
100%
Merger
LLC1
LLC2
T
Merger
Facts: P, LLC1, LLC2, and T are domestic entities. LLC1 and LLC2 are wholly owned by P and are treated
as disregarded entities. T merges into LLC1 and LLC2 under state statutory merger law, with the T
shareholders receiving P stock.
Result: The transaction qualifies as a tax-free A reorganization because P, LLC1, and LLC2 comprise a
combining unit, and all of the assets and liabilities of T are transferred to one or more members of that
combining unit, and T ceases to exist. Treas. Reg. § 1.368-2(b)(1)(ii).
20
Final Section 368 Regulations
State Law Consolidation
T SHs
P SHs
T
P
T SHs
P SHs
Newco
Consolidation
Facts: Under state W law, T and P consolidate. Pursuant to such law, the following events occur at the
effective time of the transaction: all of the assets and liabilities of T and P become the assets and
liabilities of Newco, an entity that is created in the transaction, and the existence of T and P continues in
Newco. In the consolidation, the T and P shareholders exchange their stock of T and P, respectively, for
stock of Newco.
Result: Under the final regulations, the consolidation qualifies as an “A” reorganization, because it is a
transaction effected pursuant to the statute or statutes necessary to effect the merger or consolidation (i.e.,
state W consolidation law), all of the assets and liabilities of each member of one or more combining
units (i.e., P and T) become the assets and liabilities of one or more members of another combining unit
(i.e., Newco). See Treas. Reg. § 1.368-2(b)(1)(ii). The fact that the existence of the consolidating
corporations (T and P) continues in Newco under state W law will not prevent the consolidation from
qualifying as a statutory merger or consolidation. See Preamble to Treas. Reg. § 1.368-2(b); Treas. Reg.
§ 1.368-2(b)(1)(iii), Ex. 12.
21
Final Section 368 Regulations
State Law Consolidation = “F” followed by “A”?
T SHs
P SHs
T
P
Consolidation
T
P
2
T Assets/
Liab.
Merger
1
Newco
Facts: T and P are state W corporations with operating businesses. Under state W law, T and P
consolidate. Pursuant to such law, the following events occur at the effective time of the transaction: all
of the assets and liabilities of T and P become the assets and liabilities of Newco, an entity that is created
in the transaction, and the existence of T and P continues in Newco. In the consolidation, the T and P
shareholders exchange their stock of T and P, respectively, for stock of Newco.
Result: Under the final regulations, the consolidation qualifies as an “A” reorganization. Treas. Reg. §
1.368-2(b)(1)(iii), Ex. 12. However, the IRS and Treasury intend to study whether this consolidation
could be treated as an “F” reorganization of T into Newco immediately followed by a merger of P into
Newco in an “A” reorganization (or vice versa). See Preamble to Treas. Reg. § 1.368-2(b).
22
Final Section 368 Regulations
Merger of Disregarded Entity into Corporation
P
T
100%
LLC
Facts: P and T are domestic corporations and LLC is a domestic limited liability company. LLC is
wholly owned by P. LLC is treated as a disregarded entity. P and LLC comprise a combining unit,
and T is a combining entity and combining unit. LLC merges into T under state statutory merger
law.
Result: The transaction does not qualify as a tax-free A reorganization under Treas. Reg. § 1.3682(b)(1)(ii) because all of the assets and liabilities of the combining unit of P and LLC do not become
assets of T, and LLC is not a combining entity. See Treas. Reg. § 1.368-2(b)(1)(iii), ex. 6.
23
Final Section 368 Regulations
Merger of Foreign Entities Under Foreign Law
Y SHs
Z SHs
Y Shares
Z
Foreign
Y
Merger
Foreign
Facts: Z and Y are entities organized under the laws of Country Q and classified as corporations for
Federal tax purposes. Z merges into Y under Country Q law. Pursuant to statutes of Country Q the
following events occur simultaneously: (i) all of the assets and liabilities of Z become the assets and
liabilities of Y, (ii) Z’s separate legal existence ceases for all purposes, and (iii) Z shareholders receive
Y voting stock.
Result: Under the final regulations, this transaction qualifies as an “A” reorganization. See Treas. Reg.
§ § 1.368-2(b)(1)(ii), -2(b)(1)(iii) Ex. 13.
24
Final Section 368 Regulations
Mergers Involving Foreign Disregarded Entities
P
US
Merger
LLC1
LLC2
US
Foreign
T
Foreign
Facts: P owns 100% of the outstanding units of LLC1 and LLC2. Both LLCs are treated as
disregarded entities for Federal tax purposes. LLC2 and T are entities organized under the
laws of Country Q. P and its LLCs comprise a combining unit. T is a combining entity and
combining unit. Pursuant to Country Q law, T merges with and into LLC2.
Result: This transaction should qualify as an “A” reorganization under Treas. Reg. § 1.3682(b)(1)(ii).
25
Final Section 368 Regulations
Merger Preceded by Distribution
T SHs
$
P
T
Business Q
X
Business R
Business Q
100%
$
LLC
STEP TWO
STEP ONE
Facts: P and T are domestic corporations. LLC is a domestic limited liability company. LLC is wholly owned by P
and is treated as a disregarded entity. T operates two unrelated businesses, business R and business Q, each of which
represents 50 percent of the value of the assets of T. P desires to acquire and operate business R but not business Q.
Pursuant to a single plan, T sells business Q to X, which is unrelated to P or T, in a taxable transaction, and then
distributes the proceeds of the sale to its shareholders. T then merges into LLC under state statutory merger law, with T
shareholders receiving P voting stock.
Result: The transaction qualifies as a tax-free A reorganization under Treas. Reg. § 1.368-2(b)(1)(ii). The fact that the
transaction would not satisfy the “substantially all” requirement applicable to certain other types of reorganizations is
not material because it satisfies the “all of the assets” requirement of Treas. Reg. § 1.368-2. See Treas. Reg. § 1.3682(b)(1)(iii), ex. 8.
26
Final Section 368 Regulations
Triangular Merger of Target into Disregarded Entity
R
T SHs
P
T
100%
100%
LLC
Facts: R, P and T are domestic corporations and LLC is a domestic limited liability company. LLC is
wholly owned by P. LLC is treated as a disregarded entity. P and LLC comprise a combining unit, and T
is a combining entity and combining unit. T merges into LLC under state statutory merger law, with the T
shareholders receiving R voting stock.
Result: The transaction qualifies as a tax-free A reorganization under Treas. Reg. § 1.368-2(b)(1)(ii) if
the transaction also meets the requirements of Section 368(a)(2)(D). In the above example, the T
shareholders that receive R voting stock will be treated as receiving stock of a corporation that is in
control of P, the combining entity of the transferee unit that is the acquiring corporation for purposes of
section 368(a)(2)(D). Accordingly, the merger will satisfy the requirements of section 368(a)(2)(D). See
27
Treas. Reg. § 1.368-2(b)(1)(iii), ex. 4.
Final Section 368 Regulations
Merger of Target into Disregarded Entity Owned by
Partnership
P
100%
T SHs
T
LLC
Facts: P, LLC, and T are domestic entities. LLC is wholly owned by P, a partnership under state law. LLC is treated
as a disregarded entity. T merges into LLC under state statutory merger law, with the T shareholders receiving P
partnership interests.
Result: The transaction does not qualify as a tax-free A reorganization because neither P nor LLC qualifies as a
combining entity under Treas. Reg. § 1.368-2(b)(1)(i)(B), and P and LLC are not a combining unit under Treas. Reg. §
1.368-2(b)(1)(i)(C). See Treas. Reg. § 1.368-2(b)(1)(iii), ex. 5. The transaction should be treated as a contribution of
T assets and liabilities to P in exchange for P partnership interests, followed by the transfer of such interests from T to
T shareholders in liquidation of T. See PLR 200214016; PLR 9404021. The transaction should be tax-free to P and
LLC pursuant to section 721. Whether and to what extent the transaction is taxable to T and its shareholders depends
upon a variety of factors, such as (i) the amount of liabilities transferred to P, (ii) who bears the economic risk of loss
with respect to such liabilities, and (iii) whether T has an “80% corporate distributee” shareholder. Sections 731, 752,
28
331, 332, 336, 337.
Final Section 368 Regulations
Merger of Corporation into Disregarded Entity
in Exchange for Interests in the Disregarded Entity
P
100%
LLC
T SHs
T SHs
P
T
LLC
Facts: P and T are domestic corporations and LLC is a domestic limited liability company. LLC is wholly owned by P.
LLC is treated as a disregarded entity. T merges into LLC under state statutory merger law, with the T shareholders
receiving interests in LLC. After merger, LLC is not disregarded as an entity separate from P and is treated as a
partnership under state law.
Result: The transaction does not qualify as a tax-free A reorganization because assets of T do not become assets of a
combining unit. LLC cannot be a combining entity as a partnership and, thus, is not part of a combining unit. See Treas.
Reg. § 1.368-2(b)(1)(iii), ex. 7. From T’s perspective, the transaction should be treated as a contribution of T assets and
liabilities to LLC in exchange for LLC interests, followed by the transfer of such interests from T to T shareholders in
liquidation of T. See PLR 200214016; PLR 9404021. From P’s perspective, the transaction should be treated as a transfer
of LLC assets and liabilities to LLC taxed as a partnership in exchange for LLC interests. See Rev. Rul. 99-5. Whether
and to what extent the transaction is taxable to P, T, and T’s shareholders depends upon a variety of factors, such as (i) the
amount of liabilities transferred to LLC, (ii) who bears the economic risk of loss with respect to such liabilities, and (iii)29
whether T has an “80% corporate distributee” shareholder. Sections 731, 752, 331, 332, 336, 337.
Final Section 368 Regulations
Merger of Corporate Partner Into a Partnership
P
T
P
X
X
Facts: P and T, both corporations, together own all of the membership interests in X, a limited liability company that is
treated as a partnership for federal income tax purposes. Under state W law, T merges into X. Pursuant to such law, the
following events occur simultaneously at the time of the transaction: all of the assets and liabilities of T become the assets
and liabilities of X, and T ceases its separate legal existence for all purposes. In the merger, the shareholders of T
exchange their T stock for P stock. As a result of the merger, X becomes an entity that is disregarded as an entity separate
from P.
Result: Under the final regulations, the transaction satisfies the requirements of a statutory merger or consolidation
because the transaction is effected pursuant to state W law and the following events occur simultaneously at the effective
time of the transaction: all of the assets and liabilities of T, the combining entity and sole member of the transferor unit,
become the assets and liabilities of one or more members of the transferee unit that is comprised of P, the combining
entity of the transferee unit, and X, a disregarded entity the assets of which P is treated as owning for tax purposes
immediately after the transaction, and T ceases its separate legal existence for all purposes. See Treas. Reg. § 1.3682(b)(1)(iii), ex. 11. The existence and composition of the transferee unit are determined immediately after (but not
30
immediately before) the merger. See Preamble to Treas. Reg. § 1.368-2(b)(1).
Final Section 368 Regulations
Merger of Corporate Partner Into a Partnership
P
T
P
X
X
Issues: In this transaction, X terminates as a partnership under section 708(b)(1)(A).
The preamble to Treas. Reg. § 1.368-2(b)(1) notes that this transaction “raises
questions as to the tax consequences of the transaction to the parties, including
whether gain or loss may be recognized under the partnership rules...as a result of the
termination of” X. The preamble also inquires whether the principles of Rev. Rul.
99-6 should apply to this transaction.
31
Final Section 368 Regulations
Merger of Corporate Partner Into a Partnership
P Stock
P
T
P
Assets/Liab.
(other than X
interest)
Partnership
Liquidation
X
T
X
Issues: In this transaction, X terminates as a partnership under section 708(b)(1)(A). The preamble to Treas. Reg. §
1.368-2(b)(1) notes that this transaction “raises questions as to the tax consequences of the transaction to the parties,
including whether gain or loss may be recognized under the partnership rules...as a result of the termination of” X. The
preamble also inquires whether the principles of Rev. Rul. 99-6 should apply to this transaction.
Possible Approach: In order to read the Code as a whole (i.e., avoiding subchapter C rules from completely overriding
subchapter K rules), the following deemed transactions could be viewed as occurring: (i) X liquidates by distributing its
assets pro rata to P and T under the rules of subchapter K, and (ii) T transfers all of its remaining assets and liabilities to P
in exchange for P stock under the rules of subchapter C. The first step would occur immediately before the second step.
It seems that T still would be viewed as engaging in an A reorganization, and, in addition, the fact that X terminated as a
partnership in the transaction would be taken into account for tax purposes.
32
Final Section 368 Regulations
Step Transaction Issues
T Stock
T SHs
P
100%
P
50% P Stock
50% Cash
LLC
T
LLC
T
Facts: P and T are domestic corporations. P owns all of the interests in LLC, a domestic limited liability company that is
disregarded for federal tax purposes. T’s shareholders transfer their T stock to P in exchange for 50% P stock and 50% cash.
Immediately after the acquisition, T engages in one of the following alternative transactions.
(1) T merges into P.
(2) T merges into LLC.
(3) T files a form in Delaware to become an LLC.
(4) T liquidates into P.
Results: Under the final regulations, alternatives 1 and 2 should be treated as if T merged into P in a tax-free A
reorganization. See King Enterprises, Inc. v. United States, 418 F. 2d 511 (Ct. Cl. 1969); Rev. Rul. 2001-46, 2001-2 C.B.
321; P.L.R. 9539018 (June 30, 1995). Alternative 4 should be treated as a qualified stock purchase followed by a section 332
liquidation. See Rev. Rul. 90-95, 1990-2 CB 67. Under the final regulations, alternative 3 does not satisfy the definition of
statutory merger or consolidation, because T, the combining entity of the transferor unit, does not cease its separate legal
existence. Although T becomes a disregarded entity, it continues to exist as a juridical entity. See Preamble to Treas. Reg. §
33
1.368-2(b)(1). Therefore, it should be treated the same as Alternative 4.
Acquisitions of Private Companies
Operating in Partnership Entities
34
Taxable Sale of Assets from LLC
P
X
50%
50%
Assets
LLC
Y
Cash or Note
Facts: P and X each own a 50% interest in LLC. Y believes that LLC has certain contingent
liabilities. In order to reduce the risk that Y could be liable for such liabilities, Y purchases only
certain assets of LLC in exchange for cash.
Results: LLC recognizes gain or loss pursuant to section 1001. Such gain or loss is allocated to P and
X under the LLC’s operating agreement and section 704. Note that, if Y issued a note in exchange for
the assets, section 453 could apply to defer the recognition of any income realized upon the disposition
of the assets. But see section 453(b)(2) (installment method does not apply to dealer property or
personal property inventory). What if LLC distributed the note to P and X immediately after the asset
sale? Note also that such a transaction may constitute an “applicable asset acquisition” under section
1060. Note that, if the assets sold to Y are part of an ongoing business, there is some authority (the
“sale of a going business doctrine”) that would treat the transaction as a sale of P’s and X’s interests in
LLC to Y. See, e.g., Barran v. Comm’r, 334 F.2d 58 (5th Cir. 1964).
35
Taxable Sale of Assets from LLC
Isolating LLC Liabilities
P
X
50%
50%
Interests
LLC
100%
LLC2
Cash or Note
Y
100%
LLC2
Facts: Same as the previous slide, except that LLC drops all of its assets and liabilities into a
Delaware LLC (“LLC2”), and Y purchases 100% of the interests in LLC2 in exchange for
cash.
Results: The same Federal tax results and issues exist with respect to LLC as in the previous
slide, since LLC2 is disregarded as separate from LLC. The primary difference is that Y is
able to acquire all the assets and liabilities of the business conducted by LLC in a manner that
isolates LLC’s liabilities from Y’s other assets. What if LLC drops its assets and liabilities
36
into a newly-formed corporation? See Rev. Rul. 70-140.
Distribution Followed By Taxable Sale of
Assets by LLC Members
Y
50% of LLC
Assets
50% of LLC
Assets
P
Cash
50%
Assets
Cash
X
50%
LLC
Assets
Facts: P and X each own a 50% interest in LLC. LLC liquidates. Immediately thereafter, P and X
sell to Y the assets (subject to related liabilities) they received upon LLC’s liquidation.
Results: If the distribution is respected as separate from the members’ asset sales, the transfers of
assets and liabilities from LLC to P and X should be treated as liquidating distributions subject to
sections 731, 732, and 735. See also sections 704(c)(1)(B), 737, 751(b), 752. The subsequent asset
sales should be treated as taxable sales under section 1001. See also section 453. However,
substance over form principles may apply to recast this transaction as an asset sale by LLC
followed by a liquidation of LLC (of the cash sale proceeds). See Rev. Rul. 75-113; TAM 9645005.
37
Cf. Comm’r v. Court Holding Co., 324 U.S. 331 (1945).
Distribution Followed By Taxable Sale of Assets by
LLC Members – Isolating Liabilities
Y
LLC1
Interests
LLC2
Interests
P
Cash
50%
LLC1 Interests
Cash
X
50%
LLC
100%
LLC1
LLC2 Interests
100%
LLC2
Facts: P and X each own a 50% interest in LLC. LLC drops 50% of its assets and liabilities into LLC1 and 50%
of its assets and liabilities into LLC2. LLC then liquidates by distributing all of its LLC1 interests to P and all of
its LLC2 interests to X. P and X then sell their interests in LLC1 and LLC2, respectively, to Y.
Results: The same Federal tax results and issues exists as in the previous slide, since LLC1 and LLC2 are
disregarded as separate from LLC. The primary differences are that the assets and liabilities of LLC do not run
through P, X, and Y for state law purposes, thereby reducing the risk that their directly-held assets will be subject
to LLC’s liabilities and reducing the number of transfers for state transfer tax purposes. What if LLC drops its
38
assets and liabilities into two newly-formed corporations? See Rev. Rul. 70-140.
Sale of Membership Interests to
Third Party
Y
Y
50% of LLC
P
Cash
50%
50% of LLC
X
50%
Cash
100%
LLC
LLC
Facts: P and X each own a 50% interest in LLC. P and X sell their 50% LLC interests to Y. After
the sale, Y is the sole owner of LLC, which is disregarded as an entity separate from Y.
Results: The partnership terminates under section 708(b)(1)(A) when Y purchases P’s and X’s
interests. P and X treat the transaction as a sale of partnership interests. However, for purposes of
determining the consequences to Y, LLC is deemed to make a liquidating distribution of all of its
assets to P and X, and Y is treated as acquiring the assets distributed to P and X. See Rev. Rul. 99-6.
Query whether section 1060 applies to Y’s deemed acquisition of LLC’s assets. See Treas. Reg. §
1.1060-1(b)(4). If so, any premium paid for the LLC interests may create amortizable goodwill
39
under section 197.
Transfer of Membership Interests to
Third Party
Y
Y
Merger
P
Y stock
50%
Merger
X
50%
Y stock
100%
LLC
LLC
Facts: P and X each own a 50% interest in LLC. P and X merge into Y in “A” reorganizations. Afterward, Y is
he sole owner of LLC, which is disregarded as an entity separate from Y.
Results: The partnership terminates under section 708(b)(1)(A) when Y acquires P’s and X’s interests in LLC by
peration of law. Does Rev. Rul. 99-6 apply to this type of partnership termination? Rev. Rul. 99-6 involved a taxable
ale of partnership interests from P and X to Y. All the authorities cited in Rev. Rul. 99-6 involve taxable sales of
artnership interests. See Rev. Rul. 67-65; Rev. Rul. 55-68; McCauslen v. Comm’r, 45 T.C. 588. Further, the primary
ase law authority for Rev. Rul. 99-6 addressed a holding period issue only. Id. Accordingly, neither Rev. Rul. 99-6
or McCauslen appear to apply to these facts. Does it matter? See sections 362(b), 735(b), 1223(2). Treasury and the
RS have requested comments on whether “the principles of Revenue Ruling 99-6” apply to similar facts. T.D. 9242
40
Jan. 23, 2006).
Replacing Actual Termination with Technical Termination
To Avoid Asymmetric Treatment of Rev. Rul. 99-6
Y
Y
Interest
Interest
P
Cash
Y Sub
X
Y Sub100%
Cash
50%
50%
LLC
New
LLC
Facts: P and X each own a 50% interest in LLC. P sells its interest in LLC to Y, and X sells its interest in LLC to
Y Sub, a newly-formed subsidiary of Y. Y and Y Sub join in the filing of a consolidated return.
Results: LLC does not terminate as a partnership under section 708(b)(1)(A), since it continues to have two
members that are treated as separate from each other for Federal tax purposes. However, LLC technically terminates
as a partnership under section 708(b)(1)(B), since 50 percent or more of the interests in LLC were sold within 12
months. However, such a termination should not trigger the application of Rev. Rul. 99-6. The parties on both sides
of the transaction should be treated as selling and purchasing, respectively, partnership interests subject to section
741, 751(a), and 1001, followed by LLC contributing its assets to a newly-formed LLC and liquidating by distributing
he interests in the new LLC. Treas. Reg. § 1.708-1(b)(4). What if LLC made a section 754 election? See Treas. Reg.
41
§ 1.708-1(b)(5).
Merger of LLC into Acquiring LLC
Y
P
X
50%
Y Sub
50%
50%
50%
Merger
LLC
LLC1
Facts: P and X each own a 50% interest in LLC. Y and YSub form LLC1 for purposes of acquiring LLC’s business.
Y and Y Sub each own a 50% interest in LLC1. LLC merges into LLC1 under Delaware law.
Results: If Y and Y Sub own more than 50% of LLC1 after the merger, then LLC is treated as transferring all of its
assets and liabilities to LLC1 in exchange for interests in LLC1 and liquidating by distributing LLC1 interests to P
and X (i.e., an “assets-over” transaction). Section 708(b)(2)(A); Treas. Reg. § 1.708-1(c); see also sections 721, 731.
However, if P and X own more than 50% of LLC1 after the merger, the merger into LLC1 is treated as an assets-over
transaction into LLC with LLC1 (and not LLC) terminating under section 708. Id. What if LLC is merged into
LLC1 under Delaware law by P and X contributing their interests in LLC to LLC1? See Treas. Reg. § 1.708-1(c)(5)
ex. 4. What if LLC is merged into LLC1 under Delaware law by LLC liquidating followed by P and X contributing
LLC assets to LLC1? See Treas. Reg. § 1.708-1(c)(3)(ii), (5) ex. 3. What if P wants to be cashed out rather than
42
continuing its investment in the resulting LLC? See Treas. Reg. § 1.708-1(c)(4), (5) ex. 5.
Section 1031
Y
P
X
50%
Y Sub
50%
50%
50%
Exchange
LLC
LLC1
Facts: P and X each own a 50% interest in LLC. Y and Y Sub each own a 50% interest in LLC1. LLC and LLC1
conduct similar businesses (e.g., television stations in different geographic markets), and both believe that they could
manage each other’s business in a more profitable manner. So, LLC exchanges the assets and liabilities with respect
to its business for the assets and liabilities with respect to LLC1’s business.
Results: Section 1031 generally should permit LLC and LLC1 to defer the built-in gain and loss realized on their
dispositions of their businesses. See Treas. Reg. § 1.1031(j)-1 (permitting multiple property exchanges); see also Rev.
Rul. 89-121; Rev. Rul. 85-135. Such built-in gain and loss should continue in the assets that each party is treated as
acquiring in the exchange. However, if the parties want to structure the transaction as a disposition and acquisition
of partnership interests, section 1031 treatment will be unavailable. Section 1031(a)(2)(D).
43
“Mixing-Bowl” Transaction
P
Y
X
50%
50%
50%
Y Sub
50%
LLC
1
1
Bus. A
LLC1
Bus. B
Bus. B
2
Mix
Bus. A
2
Facts: Same facts as the previous slide, except for the following. LLC’s and LLC1’s businesses are not like kind.
LLC and LLC1 contribute their businesses to a new LLC (“Mix”). Bus. A profits, losses, and cash flow are
allocated/distributed 25% to LLC and 75% to LLC1. Bus. B profits, losses, and cash flow are allocated/distributed
75% to LLC and 25% to LLC1. Daily operations of Bus. A are managed by LLC1, and daily operations of Bus. B are
managed by LLC. Liquidating distributions from Mix will be made in accordance with capital accounts. Upon
liquidation, to the extent possible, LLC will receive Bus. B assets, and LLC1 will receive Bus. A assets. The Mix
operating agreement prohibits sales or distributions of business assets for at least 7 years.
Results: If the businesses are not like-kind and the parties are willing to share the benefits and burdens of both
businesses for at least 7 years, a “mixing-bowl” transaction could produce a tax result similar to the section 1031
transaction in the previous slide. See sections 704(c)(1), 707, 721, 731, 737.
44
Tax-Free Acquisition via Section 721
Y
Y Sub
T
Mbr Int.’s
Mbr. Int. entitles T to
convert Mbr. Int. to Y stock
or cash following 2 year
period.
Bus.
LLC
Facts: T constitutes a group of individuals who conduct a start-up business as a sole proprietorship. Y
and Y Sub are members of a pre-existing LLC, which has a large amount of cash that Y raised and
contributed to LLC. Y wants to acquire and develop the business. T wants to defer the tax on the
built-in gain in the business assets. T contributes all the assets and liabilities of the business to LLC in
exchange for membership interests. Y is the managing member, and each former sole proprietor is
entitled to convert his member interests to Y stock or cash following a 2-year lock-up period.
Issues:
1. Should T recognize any gain upon the contribution? See sections 721(b), 351(e), 752, 731.
2. What if LLC was treated as a corporation? See sections 351, 368(c).
45
Tax-Free Acquisition via Section 351
P S/H’s
T Owner
T Int.’s
HC Stock
30% Stock
P
T
P S/H’s
T Owner
70% Stock
HC
Merge
HC
T
P
S1
Facts: P wants to acquire T, a business conducted in an LLC that is disregarded as separate
from its owner. T’s assets have a substantial amount of built-in gain. So, P shareholders
form HC, and HC forms S1. Then, S1 merges into P with P shareholders receiving HC
stock, and T’s owner contributes all of its interests in T to HC in exchange for HC stock.
Issues:
Does the fact that T’s owner only receives 30% of the HC stock in the exchange cause T’s
owner to fail the control requirement of section 351?
Even if the control requirement is met, could T’s owner recognize gain upon the
contribution?
46
Section 197 and Partnerships
B
A
A Sub
LLC
GW:
V 30M
B0M
 A has operated Bus. A since 1990 and has built up a
substantial amount of goodwill
 How should B acquire a portion of Bus. A?
 Alt. 1: If B purchases a portion of Bus. A and then
contributes it to LLC, the anti-churning rules of
section 197 will preclude B from taking amortization
deductions for its portion of the Bus. A goodwill.
 Alt. 2: If A (and A Sub.) form LLC with Bus. A first, B
purchases an interest in LLC from A, and LLC has a
section 754 election, the anti-churning rules of
section 197 will not apply to B’s portion of the Bus. A
goodwill that is stepped-up via section 743(b)
 How much time should pass between formation
of LLC and sale of interest to B? Cf. Rev. Rul.
70-140
 B cannot be otherwise related to LLC or A
 See section 197(f)(9); Treas. Reg. § 1.197-2(k) exs.
18, 19
47
Section 197 and Partnerships
B
A
Bus. A
Cash
LLC
 How should B acquire a portion of Bus. A? (cont.)
 Alt. 3: If A contributes Bus. A and B contributes other
property to LLC, LLC can make remedial allocations of
amortization to B
 However, if LLC distributes B’s assets to A shortly after
formation of LLC, could have disguised sale of
property between A and LLC
 See Treas. Reg. § 1.197-2(g)(4), (h)(12)(vii), (k) ex. 17
 Note that, if LLC is an existing tax partnership, a
subsequent distribution of property to A may be
treated as a disguised sale of A’s interest in LLC to B.
If LLC makes a section 754 election, see Alt. 2.
GW:
V 30M
B0M
48
Partnership to LLC Conversions
P
Q
50%
50%
GP
Liability
Allocation
LP
PQ
Lim P/S
Facts: P and Q have operated PQ for several years. PQ has liabilities that
have been allocated to P due to P’s general partner status. Due to prior
allocations of partnership loss, P would have a “negative” outside basis
without the allocation of the liabilities.
49
Partnership to LLC Conversions
Partial Shift of Liability
Allocation
P
Q
50%
50%
PQ
LLC
Conversion from
LP to LLC
Facts: PQ converts under state law from a limited partnership to a limited liability company. P no longer is liable
for the debts of PQ.
Results: Without regard to the liability shift, the conversion should not cause P, Q, or PQ to recognize gain or loss.
Rev. Rul. 95-37. However, since P no longer is liable for the debts of PQ, no partner bears the economic risk of loss
for the PQ liabilities. Thus, the PQ liabilities should be allocated in accordance with the non recourse liability rules
of section 752 (i.e., generally in accordance with profit-sharing ratios). Treas. Reg. § 1.752-3. Accordingly, the PQ
liabilities should be reflected equally in the outside bases of P and Q. Since P’s share of PQ’s liabilities decreases
due to the conversion, P is treated as receiving a deemed distribution of cash equal to 50% of such liabilities.
Section 752(b). To the extent that the deemed distribution exceeds P’s pre-conversion outside basis, P will
recognize gain under section 731.
50
Partnership to LLC Conversions
Partial Shift of Liability
Allocation
P
Q
50%
50%
PQ
LLC
Conversion from
LP to LLC
How avoid section 731 gain recognition?
1. Rely on argument that P as a former general partner is still ultimately liable for
all liabilities incurred by PQ prior to the conversion?
2. Have P guarantee repayment of PQ liabilities at time of conversion?
Do third-party creditors need to be notified of the guarantee?
51
Acquisitions of Private Companies
Operating in Corporate Entities
S Corporation Issues
52
Taxable Asset Acquisitions by S Corporations
Cash/Notes
S
T
Assets
1. An S corporation may acquire target assets directly for cash or notes.
Alternatively, T may merge into S in a cash merger.
2. The transaction should not, in general, affect the S election.
3. Income (loss) generated by the acquired assets will be blended in with
other S corporation income (loss) and allocated according to the usual
per-day per-share rule.
4. Section 1374 should not apply because the assets will have a cost
basis.
53
Tax-Free Asset Acquisitions by S Corporations
Stock
S
T
Assets
1.
2.
3.
4.
5.
An S corporation may make a tax-free asset acquisition using several formats – A, C, or acquisitive D
reorganizations, for example.
The tax-free asset acquisition should not alone terminate the S election.
a. This is true with a merger and consolidation, and certain acquisitive D reorganizations.
b. There was concern that a C reorganization would terminate the S election because a corporate
shareholder would be present. However, G.C.M. 39768 allays that concern.
Income (loss) items generated during the acquisition year by T assets may be shifted among the
shareholders: pre-acquisition income (loss) to former T shareholders and post-acquisition income (loss)
to S shareholders (new and historic).
S will succeed to T's historic asset bases, earnings and profits, and other tax attributes. Thus, Section
1374 may apply.
Pre- and post-reorganization distributions by S should be governed by Section 1368. It is unclear
whether distributions pursuant to the plan of reorganization are taxed under Sections 356 or 1368.
54
Taxable Stock Acquisitions by S Corporations
SH
T Stock
T
1.
2.
3.
4.
5.
S
T
Prior to the Small Business Act of 1996, an acquisition of T stock could terminate S’s S election. However, if T were
immediately liquidated or spun-off, S status could be preserved.
A stock purchase followed by a liquidation of T could be treated as an asset acquisition. Alternatively, the transaction
could be treated as a qualified stock purchase followed by a liquidation under Section 332. Compare PLR 8818049 with
PLR 9323024 (revoking PLR 8818049).
a. However, in Rev. Rul. 90-95, the Service held that an acquiring corporation that makes a qualified stock purchase of
stock of a target corporation and immediately liquidates the target as part of a plan to acquire the assets of the target is
treated as having made a qualified stock purchase followed by a liquidation, rather than having made an asset
acquisition. In TAM 9245004, the Service concluded that the purchase of target corporation stock by an S corporation,
followed immediately by the liquidation of the target into the S corporation, is treated as a qualified stock purchase of the
target stock followed by a liquidation under Section 332. See also PLR 9323024.
Structurally, S also could merge downstream into T immediately after the acquisition of T stock. T should be able to elect
S corporation status.
The Small Business Act of 1996 repealed the affiliation limitation for S corporations. Thus, S would be allowed to own up
to 100 percent of T, though S could not be included in a group filing a consolidated return.
Furthermore, the Small Business Act of 1996 permitted S to treat T as a disregarded entity if (i) S owned 100 percent of
the T stock and (ii) S elected to treat T as a QSub. The QSub election transaction generally should be treated as a
complete liquidation of T into S to which Sections 332 and 337 would apply. However, step transaction principles could
recharacterize the transaction. See Treas. Reg. § 1.1361-4(a)(2).
55
Tax-Free Stock Acquisitions by S Corporations
S Stock
SH
S
T Stock
T
1.
2.
3.
4.
5.
6.
T
A tax free stock acquisition may be accomplished as a B reorganization or under Section 368(a)(2)(E).
Prior to the Small Business Act of 1996, a tax-free stock acquisition was likely to terminate the S
election. Was it possible that S corporation status could be preserved if the target was liquidated
immediately? This should cause the transaction to be viewed as a C reorganization.
Because the Small Business Act of 1996 repealed the affiliation limitation for S corporations, it is less
likely that a tax-free stock acquisition will terminate the acquiring corporation's S election. However, the
S election may still be terminated due to the number or status of shareholders that receive stock of the
acquiring S corporation in the transaction.
Pre-reorganization distributions by S should be governed by Section 1368.
Post-reorganization cash distributions may be tax-free under Section 1371(e) (assuming S corporation
status is terminated).
Distributions made contemporaneously with the reorganization should emanate from T – neither Section
1368 nor 356 should apply.
56
Taxable Asset Dispositions by S Corporations -Taxable Merger
SH
Cash/Notes
S
Assets
P
1. An S corporation may effect an asset sale to a purchaser in a taxable merger.
For example, S merges into P, with P surviving. S's shareholders receive cash
or P notes.
2. The transaction should be viewed as an asset sale by S followed by a complete
liquidation of S.
3. As to the asset sale, gain or loss will flow through to the shareholders. The
usual allocation rules will apply.
4. The deemed liquidation may cause all gain inherent in the P notes to be
accelerated under Section 453B. However, Section 453B(h) would allow gain
deferral to continue (subject to Section 1374).
5. Section 1374 may apply to the asset sale.
57
Tax-Free Asset Dispositions by S Corporations
P Stock
S
1.
2.
3.
4.
5.
6.
7.
S Assets
P
An S corporation may also dispose of its assets in a tax-free transaction. This may occur in an A, C, or D
reorganization.
Effect on S election
a. A merger or consolidation will terminate the S corporation's existence. However, the S corporation’s
election does not terminate with respect to the final taxable year. See Rev. Rul. 70-232; Rev. Rul. 64-94.
Section 1362(g) should not apply to P as a result of the merger.
b. A C reorganization should not terminate the S election. G.C.M. 39768. However, the corporate
existence of the S corporation will terminate upon the liquidation.
The allocation of income (loss) items should not be affected by the asset disposition. However, if the
reorganization terminates the corporate existence in mid-year, an acceleration of the pass-through of
income (loss) items will occur.
P should inherit the Section 381(c) attributes, if any, possessed by S. It is unclear whether the AAA
carries over to P if P is a C corporation.
If the shareholders of the S corporation have losses suspended under Section 1366(d)(2), the rules in
Treas. Reg. § 1.1366-2(b) and (c) apply.
Distributions
a. Pre-reorganization distributions by S should be governed by Section 1368.
b. It is unclear whether distributions pursuant to the plan of reorganization are covered by Section 1368
or Section 356.
The treatment of post-reorganization distributions by P is uncertain because it is unclear whether the AAA
carries over from S to P. But see Treas. Reg. § 1.1368-2(d)(2) (AAA carries over to P if P is also an S
58
corporation).
Taxable Stock Dispositions
SH
Cash/Notes
Stock
S
1.
2.
3.
4.
5.
6.
P
The shareholders of an S corporation may sell their stock to a purchaser.
Such a sale will affect the S election only if the stock is sold to an ineligible shareholder or too many
shareholders.
If S corporation status continues, income (loss) items are allocated under the usual per-day per-share
rule, unless a Section 1377(a)(2) election is made. If the S election is terminated, income (loss) items
will be allocated between the resulting S short year and C short year under Section 1362(e).
The allocation of income (loss) items in the year of sale will increase (decrease) the basis of the S stock
sold, thus affecting the amount of gain on the sale of the stock. The gain on the sale of stock generally
should be capital gain.
If the election is not terminated, post-sale distributions should be governed by Section 1368 – tax-free to
the extent of basis or AAA, whichever is less. If the election is terminated, Section 1371(e) may apply to
cash distributions.
Pre-sale distributions by the S corporation should be governed by Section 1368.
59
Taxable Stock Dispositions – Section 338
SH
Cash/Notes
Stock
S
1.
2.
3.
4.
•
•
•
•
•
•
•
P
A corporation may acquire the stock of an S corporation in a transaction governed by section 338.
A section 338(g) election by P will produce a double-tax, even though the S corporation is a passthrough entity.
A section 338(h)(10) election generally avoids a double-tax. But, note that the deemed liquidation
generally is taxable under sections 331 and 336. However, the tax consequences from the deemed
asset sale usually adjust stock basis enough to prevent additional tax upon the deemed liquidation.
Note the following special issues regarding S corporation acquisitions subject to section 338(h)(10):
“Creeping” qualified stock purchases unavailable – P must make qualified stock purchase at one moment in time
All shareholders must consent to the election, even shareholders that do not sell stock to P
The tax consequences of the deemed asset sale and liquidation are taken into account by all shareholders, including
shareholders that do not sell stock to P
Nonselling shareholders are treated as acquiring their S stock immediately after the acquisition date – fair market value
basis with new holding period
S election does not terminate until close of acquisition date (i.e., S election continues through deemed asset sale and
liquidation)
If S has any subsidiaries treated as QSubs, those subsidiaries remain QSubs until close of acquisition date as well
If notes are used to acquire S stock, the installment method is available to defer gain
•
installment method defers gain from deemed asset sale for all shareholders
60
•
installment method defers gain from deemed liquidation only for shareholder who actually receives note from P
Sale of Portion of QSub Stock
Sale of 50% S Stock
P
X
Cash
S
Facts: Corporation P, an S corporation, owns all of the outstanding stock of S, a corporation for which a QSub election has
been made. The aggregate fair market value of S’s assets is $100, and their aggregate adjusted basis is $50. P sells 50
percent of its S stock to X corporation, an unrelated party, for $50 cash.
Tax Consequences:
• Under Section 1361(b)(3) and the QSub regulations, a QSub is not treated as a separate corporation, and all assets and
liabilities of the QSub are treated as assets and liabilities of its parent corporation. See Treas. Reg. § 1.1361-4(a)(1). Upon
the sale by P of any of its S stock, S ceases to be a QSub, and P is treated as if it transferred the S assets and liabilities to a
newly formed corporation (new S), and then sold the new S stock to X. See Treas. Reg. § 1.1361-5(b).
• The tax treatment of this deemed exchange will be determined under the Internal Revenue Code and general principles of
tax law, including the step transaction doctrine. See Treas. Reg. § 1.1361-5(b)(1)(i). Since more than 20 percent of the S
stock is being sold, the deemed exchange should not qualify as a Section 351 exchange, because P will not be in “control” of
new S within the meaning of Section 368(c). See Treas. Reg. § 1.1361-5(b)(3) ex. 1; see also Rev. Rul. 70-140, 1970-1 C.B.
73.
• Thus, P must recognize all of the gain attributable to the S assets ($50), even though it only sold one-half of S’s stock. See
Treas. Reg. § 1.1361-5(b)(3) ex. 1; Section 1239. If P had incurred a loss upon the constructive transfer of assets to new S,
such loss would have been subject to the limitations of Section 267. See Treas. Reg. § 1.1361-5(b)(3) ex. 1.
61
Sale of All of QSub Stock
Sale of 100% S Stock
P
X
Cash
S
Facts: Same facts as previous slide, except P sells 100 percent of its S stock to X for $100 cash.
Tax Consequences:
• As noted in the previous example, under the general rule provided in the QSub regulations, upon the sale by P of any of its
S stock, S ceases to be a QSub, and P is treated as if it transferred the S assets and liabilities to a newly formed corporation
(new S), and then sold the new S stock to X. See Treas. Reg. § 1.1361-5(b)(1).
• However, the QSub regulations provide that if 100 percent of the stock of a QSub is sold to an unrelated corporation, the
deemed formation of a new corporation (as a consequence of the termination of the QSub election) is disregarded for federal
income tax purposes. The transaction is treated as a transfer of the S assets by P to X, followed by X's transfer of those
assets to the capital of a new C corporation subsidiary in exchange for its stock. See Treas. Reg. § 1.1361-5(b)(3) ex. 9.
3. P will have $50 of gain on the deemed sale of the S assets.
62
Merger of Target Corporation into QSub
T
S
Merger
QSub
Facts:
S owns a QSub. T corporation, which is a domestic entity, merges into S’s QSub. In the
merger, T’s shareholders receive only S voting stock.
Tax Consequences:
Pursuant to Treas. Reg. § 1.368-2(b)(1), S, T, QSub, and T shareholders may treat the merger
as a transaction to which section 368(a)(1)(A) applies. See Treas. Reg. § 1.368-2(b)(1)(iv).
The result would be the same if T owned a disregarded entity and the disregarded entity’s
assets and liabilities were treated as assets and liabilities of S immediately after the merger
(e.g., if the disregarded entity became a QSub). Id.
63
Merger of QSub
T
S
Merger
QSub
Facts:
S owns a QSub. QSub merges into T. In the merger, S receives only T voting stock.
Tax Consequences:
Pursuant to Treas. Reg. § 1.368-2(b)(1), S, T, and QSub cannot treat the merger as a
transaction to which section 368(a)(1)(A) applies. See Treas. Reg. § 1.368-2(b)(1)(iv).
Instead, the merger is treated as a taxable sale of QSub’s assets by S to T.
64
Merger of Target S Corporation That Owns a QSub into Disregarded Entity
Y
S
Merger
X
QSub
•
Facts: S owns a QSub. Y corporation owns a disregarded entity, X (e.g., a wholly owned limited liability company). All
entities are domestic. S merges into X. In the merger, the shareholders of S receive only Y voting stock.
•
Tax Consequences: Treas. Reg. § 1.1361-5(b)(1)(i) generally would treat S as transferring its QSub’s assets to a wholly
owned C corporation subsidiary in exchange for stock immediately prior to the merger. Nevertheless, Treas. Reg. § 1.368-2
treats S as transferring the assets of its QSub to Y, and then treats Y as contributing those assets to a new C corporation
subsidiary in exchange for stock. See Treas. Reg. § 1.1361-5(b)(3) ex. 9. Thus, pursuant to Treas. Reg. § 1.368-2(b)(1), the
merger can be a transaction to which section 368(a)(1)(A) applies. See Treas. Reg. § 1.368-2(b)(1)(iv).
65
Conversion of Acquired Corporation to S Status
SH
New SHs
T Stock
T
T
Facts: A group of individuals purchases all the stock of T. The new shareholders want passthrough treatment without shedding T’s state-law corporate shell. Thus, the new shareholders
make an S election for T.
Issue: Although S status usually eliminates entity-level taxes, there are exceptions.
Built-in Gains Tax (section 1374) - corporate-level tax generally triggered if pre-conversion
assets disposed by T within 10 years of conversion
What is NUBIG? Need contemporaneous valuation
LIFO Recapture (section 1363(d)) – corporate-level tax incurred in last C year of T and paid
over 4-year period attributable to the tax benefit gained from using LIFO inventory method
Tax on Excess Net Passive Income (section 1375) – corporate-level tax on excess passive
income of T if T has C corporation earnings and profits
66
Acquisitions of Private Companies
Operating in Corporate Entities
Taxable Transactions
Sections 1060, 338, and 338(h)(10)
67
Asset Purchase
T S/H’s
P S/H’s
T S/H’s
P S/H’s
T
P
$
T
T Assets
•
•
•
T Assets
P
P Assets
$
P Assets
T Assets
T recognizes gain or loss equal to difference between the purchase price
and the basis of the T assets.
P takes a basis in the T assets equal to the fair market value of the
consideration it pays to acquire them (“cost” basis).
Under section 1060, the consideration is allocated to 7 classes of assets
(the residual method of allocation).
68
Stock Purchase
P S/H’s
T S/H’s
P S/H’s
$
T
T Stock
P
P
T
T Assets
•
•
•
•
•
T Assets
T does not recognize any gain or loss (unless P makes a § 338 election).
T shareholders recognize gain or loss on the sale of their stock
T’s basis in the T assets (referred to as “inside basis”) is unaffected
(unless P makes a § 338 election).
P takes a basis in the T stock equal to the fair market value of the
consideration paid to acquire it.
P may make an election under section 338 to treat the stock purchase as
an asset purchase. This election has consequences for both P and T.
69
Section 1060
•
Section 1060 applies to any "applicable asset acquisition." Section 1060(a).
–
An applicable asset acquisition is any transfer of assets constituting a trade or
business if the purchaser's basis in the acquired assets is determined wholly by
reference to the consideration paid for such assets. Section 1060(c).
–
Regulations broadly define "assets constituting a trade or business" as
consisting of any group of assets (i) the use of which would constitute an active
trade or business for purposes of section 355, or (ii) to which goodwill or going
concern value could under any circumstances attach. Treas. Reg. § 1.10601(b)(2)(i).
–
Prior to the enactment of section 1060 as part of the 1986 Act, taxpayers and
the government had frequently skirmished over purchase price allocations.
•
If section 1060 applies to a transaction, the "consideration received" for the
acquired assets must be allocated among the assets in accordance with
regulations under section 338(b)(5). Section 1060(a). See also Treas. Reg. §
1.1060-1(c)(2).
–
The regulations require that the consideration be allocated among the assets
under the "residual method."
If the transaction is an applicable asset acquisition, each party must satisfy certain
reporting requirements. Section 1060 also imposes certain reporting requirements
with respect to specific transactions that are not applicable asset acquisitions.
•
70
Section 1060 Regulations
•
•
•
Regulations were issued to clarify the treatment of, and provide consistent rules (where possible)
for, both deemed and actual asset acquisitions under sections 338 and 1060.
Treas. Reg. § 1.1060-1(c)(2) incorporates the residual method by cross reference to the final
section 338 regulations (Treas. Reg. §§ 1.338-6 and 1.338-7).
The regulations provide:
– A trade or business is present if goodwill or going concern value could attach to the group of
assets, regardless of whether any value will eventually be allocated to the residual class
(Class VII). Treas. Reg. § 1.1060-1(b)(2)(iii).
– The presence of section 197 intangibles is a factor to be considered in determining whether
goodwill or going concern value could attach. Treas. Reg. § 1.1060-1(b)(2)(iii)(A).
– A purchaser is subject to section 1060 even if the seller in the transaction is treated as selling
something different than the purchaser is treated as purchasing. Treas. Reg. § 1.10601(b)(4).
– In determining whether a group of assets constitute a trade or business, all
transfers from the seller to the purchaser in a series of related transactions are aggregated.
Treas. Reg. § 1.1060-1(b)(5).
– As long as any part of the assets are a trade or business, all of the assets are to be treated
as a single trade or business for purposes of applying the residual method. Treas. Reg. §
1.1060-1(b)(6).
– If, in connection with the applicable asset acquisition, the seller enters into a covenant not to
compete with the purchaser, that covenant is treated as an asset transferred as part of a
trade or business. Treas. Reg.§ 1.1060-1(b)(7).
– The regulations allow the buyer and seller to adjust their allocation of consideration to
particular assets for costs incurred which are specifically identified with those assets. Thus,
the total amount the seller allocates to an asset for which it incurs specifically identifiable
costs would be less than its fair market value and, for the purchaser, greater than its fair
market value. Treas. Reg. § 1.1060-1(c)(3).
71
Section 1060 Regulations
•
Seven asset classes under the final section 338 regulations (cross-referenced in the 1060 regulations).
•
Class I -- cash and general deposit accounts (including savings and checking accounts)
other than certificates of deposit held in banks, savings and loan associations, and
other depository institutions.
•
Class II -- actively traded personal property within the meaning of section 1092(d)(1)
and Treas. Reg. § 1.1092(d)-1, certificates of deposits, and foreign currency. Class II
assets do not include stock of target affiliates, other than actively traded stock described
in section 1504(a)(4).
•
Class III -- assets that the taxpayer marks to market at least annually for Federal income
tax purposes and debt instruments (including accounts receivable but excluding certain
other debt instruments).
•
Class IV -- stock in the trade of the taxpayer or other property of a kind which would
properly be included in the inventory of taxpayer if on hand at the close of the taxable
year, or property held by the taxpayer primarily for sale to customers in the ordinary
course of its trade or business.
•
Class V -- all assets other than Class I, II, III, IV, VI, and VII assets.
•
Class VI -- all section 197 intangibles, as defined in section 197, except goodwill and going
concern value.
•
Class VII -- goodwill and going concern value (whether or not the goodwill and going concern
value qualifies as a section 197 intangible).
72
Example Allocation
T S/H’s
P S/H’s
$
T
T Assets
T Assets
•
P
•
•
Purchase Price = $1000
T Assets include:
–
–
–
–
–
–
Cash:
Stock portfolio
Accounts Receivable
Inventory
Land
Building
$100
$125
$100
$150
$150
$200
P Assets
Allocation using Residual Method:
– Class I (cash)
– Class II (stock)
– Class III (accounts receivable)
– Class IV (inventory)
– Class V (land + building)
= $100
= $125
= $100
= $150
= $350
–
Total FMV of Assets in classes I-V
= $825
–
Class VII (goodwill and going concern) = $1000 - $825
= $175
73
•
•
•
•
•
Reporting Requirements
Form 8594. The parties to an applicable asset acquisition are each required to file an information statement:
Who Must File
– Both the purchaser and seller are required to file Form 8594.
– The Form 8594 must be attached to each filer’s timely filed Federal income tax return.
– Taxpayers are not required to file Form 8594 if, pursuant to section 1031, the assets of a trade or business are
exchanged for the assets of another trade or business.
When and Where to File
– The seller and purchaser must file Form 8594 as an attachment to their respective income tax return for the year in
which the sale date occurred.
– If any amount allocated to an asset is either increased or decreased in a subsequent year, the seller and/or purchaser
(whoever is effected by the increase or decrease) must complete Parts I and III of Form 8594 and attach the Form to
the income tax return for the year in which the increase or decrease is taken into account.
Required Information
– Form 8594 requires the following information:
• The name, address, and taxpayer identification number of the seller and the purchaser, and the date of the
sale/purchase.
• The total amount of consideration for the assets.
• The actual amount of Class I assets, and the aggregate fair market value of the assets included in each of Class
II, III, IV, V, and VI and VII; Class VI and VII are grouped together on Form 8594.
• The sum of the aggregate fair market values of all of the Class I - VII assets.
• The amount of the sales price allocated to each asset Class (i.e., Class I - VI and VII).
• Whether the allocation of purchase price was provided for in a sales contract or other written document signed
by both parties; if the answer is yes, whether the aggregate fair market values for each asset class as listed on
Form 8594 are same as the amounts agreed upon in the sales contract or other written document.
• Whether there is a related covenant not to compete, employment or management contract, or similar
arrangement with the seller (or managers, directors, owners, or employees of the seller); if so, the parties must
attach a schedule specifying the type of agreement and the maximum consideration (exclusive of interest) to be
paid pursuant to such agreement.
Other Specified Transactions
– The reporting requirements also apply to certain transactions that ordinarily are not applicable asset acquisitions.
These transactions include:
– A distribution of partnership property or a transfer of a partnership interest where section 755 applies (section
1060(d)(2)); and
– A transfer by a 10-percent (by value) owner of an entity of any interest in such entity if, in connection with the transfer,
the owner (or a related person) enters into an employment contract, covenant not to compete, royalty or lease
agreement, or other agreement with the transferee (section 1060(e)(1)); the information to be provided in a section 74
1060(e) transaction is to be set forth in regulations, which have yet to be issued.
Section 338
T S/H’s
T S/H’s
P S/H’s
P S/H’s
P
$
T
T Stock
T Assets
•
•
P
Old
T
Asset Sale
New
T
T Assets
Requirements: To make a § 338 election, the purchasing corporation (P) must make a
“qualified stock purchase” (QSP) of T. To make a QSP, P must purchase at least 80%
of the total voting power and at least 80% of total value of T stock during a 12 month
acquisition period.
Tax Consequences: If P makes a § 338 election, the original target corporation (old T)
is deemed to sell its assets to a new corporation (new T).
– This results in a double tax
• T recognizes gain or loss as if it had sold the assets to New T.
• Selling shareholders (T S/H’s) pay tax on gain from sale of T stock.
– New T takes a basis in the T assets determined by reference to the purchase
price.
75
Section 338(h)(10)
P S/H’s
P S/H’s
$
S
P
T Stock
T
T Assets
•
•
P
S
§ 332
liquidation
Old
T
Asset Sale
New
T
T Assets
Requirements: If P purchases the stock of T from a member of T’s affiliated group (S),
then a joint §338(h)(10) election may be made to treat the stock purchase as an asset
purchase.
Tax Consequences: If a § 338(h)(10) election is made, the stock purchase is
recharacterized as an asset sale followed by a liquidation. The original target
corporation (old T) generally is deemed to sell its assets to a new corporation (new T)
and then liquidate into S under § 332 .
– T recognizes gain or loss as if it had sold the assets to New T.
– S does not recognize gain or loss on the sale of T stock.
– New T takes a basis in the T assets determined by reference to the purchase
price.
76
Section 338 Regulations: Organization
•
§ 1.338-1 General principles; status of old and new T
•
§ 1.338-2 Nomenclature and definitions; mechanics of the section 338 election.
•
§ 1.338-3 Qualification
•
§ 1.338-4 Seller’s side; ADSP
•
§ 1.338-5 Buyer’s side; AGUB
•
§ 1.338-6 Allocation
•
§ 1.338-7 Redeterminations
•
§ 1.338-8 Consistency
•
§ 1.338-9 International
•
§ 1.338-10 Returns
•
§ 1.338(h)(10)-1 Section 338(h)(10)
77
•
Section 338 Regulations:
Accounting Rules
Under the regulations ADSP is the sum of:
•
(1) the grossed-up amount realized on the sale to P of P's recently purchased T stock; and
(2) the liabilities of old T.
•
The amount realized is determined as if old T itself were the selling shareholder. Old T may use
the installment method of section 453 in the calculation of the first element of ADSP.
General principles of tax law apply in determining the timing and amount of the elements of ADSP.
ADSP is redetermined at such time and in such amount as an increase or decrease would be
required, under general principles of tax law, to the individual elements of ADSP.
The same rules apply for purposes of determining (and redetermining) AGUB.
These changes replace the “fixed and determinable” standard of the old regulations.
The regulations make clear that, old T's tax liability incurred on its deemed asset sale is deemed
assumed unless the parties have agreed (or the tax or non-tax rules operate such that) the seller,
and not T, will bear the economic cost of that tax liability.
The amount of liabilities of old T taken into account to calculate ADSP is determined as if old T
had sold its assets to an unrelated person for consideration that included the unrelated person’s
assumption of, or taking subject to, the liability.
In order to be taken into account in AGUB, a liability must be a liability of T that is properly
taken into account under general principles of tax law that would apply if new T had acquired its
assets from an unrelated person for consideration that included the assumption of, or taking
subject to, the liability.
•
•
•
•
•
•
•
78
Section 338 Regulations
•
•
•
Definition of “Purchase”
•
The regulations include a single definition of purchase applicable to both targets and target affiliates. Under this
definition, stock in a target (or target affiliate) may be considered purchased if, under general principles of tax
law, the purchasing corporation is considered to own the stock of the target (or the target affiliate) meeting the
requirements of section 1504(a)(2), notwithstanding that no amount may be paid for (or allocated to) the stock.
–
Section 338(h)(3)(A) defines the term "purchase" as "any acquisition of stock," subject to the following
conditions:
• The basis of the T stock in the hands of P is not determined (i) in whole or part by reference to the
adjusted basis of such stock in the hands of T's former shareholders, or (ii) under section 1014(a)
(property acquired from a decedent);
• The T stock is not acquired in an exchange to which section 351, 354, 355 or 356 applies or in any other
transaction described in the regulations in which the transferor recognizes less than all of its realized gain
or loss; and
• The T stock is not acquired from a person the ownership of whose stock would, under section 318(a)
(other than paragraph (4) -- the option attribution provision), be attributed to P. The regulations provide that
the relationship between the purchaser and seller is tested immediately after the transaction. See Treas.
Reg. § 1.338-3(b)(3)(ii).
Allocation Rules
•
The regulations use the top-down allocation method.
•
The scope Class II assets does not include stock of target affiliates, whether or not of a class that is actively
traded, other than actively traded stock described in section 1504(a)(4).
First Year Price Adjustments
•
•
The regulations do not include rules providing special treatment for changes in ADSP or AGUB occurring before
the close of new target’s first taxable year and instead apply the general rule that governs the allocation of all
changes in ADSP or AGUB after the acquisition date.
Reporting Requirements: Forms 8023 and 8594
•
The allocation of ADSP and AGUB is submitted by the purchaser and seller(s) separately on their income tax
returns. The information about ADSP and AGUB is reported by each party separately on Form 8594.
79
Treas. Reg. § 1.338(h)(10)-1
Deemed Asset Sale and Liquidation
• Treas. Reg. § 1.338(h)(10)-1 describes the model on which taxation of the section 338(h)(10) election is
based. Under the regulations:
(1)
Old T is treated as transferring all of its assets by sale to an unrelated person.
(2)
Old T recognizes the deemed sale gain while a member of the selling consolidated group, or
owned by the selling affiliate, or owned by the S corporation shareholders (both those who
actually sell their shares and any who do not).
(3)
Old T is then treated as transferring all of its assets to members of the selling consolidated
group, the selling affiliate, or S corporation shareholders and ceasing to exist.
(4)
If T is an S corporation, the deemed asset sale and deemed liquidation are considered as
occurring while it is still an S corporation.
• The preamble to the proposed regulations indicates the regulations were intended to treat all parties
concerned as if the transactions that are deemed to occur under section 338(h)(10) actually did occur, or as
closely thereto as possible.
• Old T generally may not obtain any tax benefit from the section 338(h)(10) election that it would not
obtain if it actually sold the assets and liquidated. Treas. Reg.§ 1.338(h)(10)-1(d)(9).
80
Treas. Reg. § 1.338(h)(10)-1
Deemed Asset Sale and Liquidation Continued
•
When T is an S corporation, any direct or indirect subsidiaries of T which T has elected to treat as
qualified subchapter S subsidiaries under section 1361(b)(3) remain qualified subchapter S subsidiaries
through the close of the acquisition date. However, no similar rule applies when a qualified
subchapter S subsidiary, as opposed to the S corporation that is its owner, is the target the stock of
which is actually purchased. Treas. Reg. § 1.338(h)(10)-1T(d)(3).
•
In the case of parent-subsidiary chains of corporations making section 338(h)(10) elections, the
deemed asset sale at the parent level is considered to precede that at the subsidiary level. Treas. Reg. §
1.338(h)(10)-1(d)(3)(ii).
•
However, the deemed liquidation of the subsidiary is considered to precede the deemed liquidation of
the parent. Treas. Reg. § 1.338(h)(10)-1(d)(4)(ii).
•
Under the regulations, the section 453 installment method is available to old T in its deemed
asset sale, as long as the deemed asset sale would otherwise qualify for installment sale reporting.
Treas. Reg. § 1.338(h)(10)-1(d)(8).
•
The regulations extend the use of the term "aggregate deemed sales price" or "ADSP" generally
applicable to section 338 transactions to section 338(h)(10).
81
Section 338 -- Purchase
Has a Corporation Made the Purchase
•
Section 338(d)(3)
– “The term ‘qualified stock purchase’ means any transaction or series of
transactions in which stock (meeting the requirements of section 1504(a)(2)) of 1
corporation is acquired by another corporation by purchase during the 12-month
acquisition period.”
•
Treas. Reg. § 1.338-3(b)(1)
– “An individual cannot make a qualified stock purchase of target. Section
338(d)(3) requires, as a condition of a qualified stock purchase, that a
corporation purchase the stock of target. If an individual forms a corporation (new
P) to acquire target stock, new P can make a qualified stock purchase of target if
new P is considered for tax purposes to purchase the target stock. Facts that
may indicate that new P does not purchase the target stock include new P's
merging downstream into target, liquidating, or otherwise disposing of the target
stock following the purported qualified stock purchase.”
82
Section 338 -- Purchase
Has a Corporation Made the Purchase
S
$
P
P
332
liquidation
Newco
T
Newco
T
1. Newco buys T stock from S.
2. Newco is liquidated into P.
83
Section 338 -- Purchase
Has a Corporation Made the Purchase Continued
P
P
T Stock
X
X
$
T
GP
GP
Liquidate
T
T
3. P and X form a partnership. P transfers the T stock to the partnership.
4. T is liquidated.
84
Application of Section 338 to the Purchase of an Insolvent
Corporation -- Insolvent Target Corporation
A
T
T stock
P
$
Assets
1,000,000
Liabilities 1,000,001
Facts
Corporation T owns assets with a value of $1,000,000 and has liabilities of $1,000,001.
P purchases all the stock of T from individual A for $1 and attempts to make a section 338(g) election with respect to T.
Questions
1. What are the results of this election?
2. Would the results be different under the section 338 regulations?
References
Section 338(h)(3)(A)
Treas. Reg. § 1.332-2(b)
New Treas. Reg. § 1.338-3(b)(2)
Rev. Rul. 56-387, 1956-2 C.B. 189
85
Application of Section 338(h)(10) to the Purchase of an
Insolvent Corporation -- Insolvent Target Subsidiary
T stock
S
P
$
T
T1
Assets 10,000,000
Liabilities 6,000,000
T2
Assets
1,000,000
Liabilities 1,000,001
Assets 1,000,000
Liabilities 900,000
T3
Assets
100,000,000
Liabilities 99,900,000
86
Section 338 -- Purchase
Cash Investment
A
P
$
T
1. A owns all T stock.
2. P transfers cash to T for 90% of T stock.
3. Has P purchased the T stock?
4. What if T also has non-voting preferred stock
that is not bought?
87
Section 338 -- Purchase
Cash Investment Followed by Redemption
A
T Stock
P
$
$
T
1. A owns all T stock.
2. P transfers cash to T for 1 share of T stock.
3. A is redeemed by T (using funds other than those provided by P.)
4. Has P purchased the T stock?
88
Section 338
Deemed Purchase Rule
•
Section 338(h)(3)(B)
– “The term "purchase" includes any deemed purchase under subsection (a)(2).”
– “Purchase" includes new T's deemed purchase of all the assets of old T under
section 338(a)(1), including all of the stock held by old T on the acquisition date.
– Thus, if P purchases 80 percent of T's stock and makes an election, new T is
deemed to "purchase" 100 percent of the stock held by old T in its subsidiary X
on the acquisition date.
– If old T held 80 percent of the stock of X, then new T is deemed to have made a
QSP of the same 80 percent, thereby entitling T to make an election with respect
to X.
89
Section 338 Election Rules -- Chain of Corporations
$
S
T stock
P
T
X
Y
Z
1. P purchases the stock of T from S and makes a section 338 election for T.
2. May P make a section 338 election for X, Y and Z?
3. May P make a section 338(h)(10) election for X, Y and Z?
90
Section 338(h)(10) and “Busted 351” Transaction
P
X
Y
Z
Facts
1. P, X, Y, and Z file a consolidated return.
2. P wishes to sell X and Y to the public and to step up the basis of the X and Y assets.
91
Section 338(h)(10) and “Busted 351” Transaction Continued
PUBLIC
P
Z
(1) Newco formed
(2)
X&Y
Stock
N
X
3. P forms Newco (N) and P transfers the X and Y stock to N.
Pursuant to a prearranged plan, P sells the N stock to the Public.
Y
92
Section 338(h)(10) and “Busted 351” Transaction Continued
Results
1. The transfer of the X and Y stock to N should not qualify as a section 351 transaction. P is not in control of N
immediately after the transfer. See Rev. Rul. 79-194, 1979-1 C.B. 145; TAM 9747001 (July 1, 1997); PLR 9541039
(July 20, 1995), as modified by PLR 9549036 (Sept. 12, 1995); PLR 9142013 (July 17, 1991).
2. Thus, N is deemed to purchase the X and Y stock.
3. In this event, P and N can file a section 338(h)(10) election to treat the transaction as a sale of assets by X and Y
followed by section 332 liquidations.
4. The 338 regulations contain a similar example. See Treas. Reg. § 1.338-3(b)(3)(iv), Ex. 1.
5. How much stock does P have to sell?
•
P must sell more than 20% of N stock for section 351 not to apply. See sections 351(a), 368(c).
•
P must sell at least 50% of the N stock so that P and N are not related for purposes of section 338(h)(3)(A)(iii).
•
P must sell more than 80% of the N stock to avoid the application of the anti-churning rules of section 197(f)(9).
•
Prior to the effective date of Treas. Reg. § 1.197-2 it was possible that the anti-churning rules could have applied
even if P sold all of the N stock because of the momentary relationship between P and N. See Old Prop. Treas.
Reg. § 1.197-2(h)(6)(ii).
93
Section 338(h)(10) and “Busted 351” Transaction Variation
PUBLIC
P
Z
(1) Newco
formed
(2)
X&Y
Stock
N
X
Y
Facts
1. Same as above, except that both P and N sell stock to the public.
Results
1. Does section 351 apply? If so, section 338(h)(10) is not available.
2. Does the answer change if P and N each use different investment bankers?
94
PLR 200427011
Newco Stock, Convertible
Instruments & Non-Cash
Consideration
30% Newco
Common Stock
S1, S2, and
S3 Stock
Newco
P
S1
Public
S2
S3
Facts: P forms Newco with a minimal amount of capital. P executes a “firm commitment”
underwriting agreement to sell Newco stock and convertible instruments in an IPO. P then
contributes the shares of subsidiaries S1, S2, and S3 to Newco in exchange for all of the
outstanding Newco common stock, Newco convertible instruments, and other non-stock
consideration (e.g., short-term promissory notes or cash). Pursuant to the underwriting
agreement, P sells 30% of the common stock to the public. P also represents that, although
not legally obligated to do so, it fully intends to reduce its interest in Newco below 50% within
two years of completing the sale of the 30% of the common stock to the public.
Issue: Can P and Newco make a section 338(h)(10) election with respect to the contributed
subsidiaries? See P.L.R. 200427011 (October 6, 2003); Merril Lynch & Co., Inc. v.
Commissioner.
95
Basis Allocation in a Bargain Purchase
Facts
Corporation S owns all of the stock of Corporation T ("T"). Because of poor management, T is
under strong pressure from S to dispose of its business and liquidate. P is interested in acquiring T's
business, but realizes the pressure that T is under, and hence will only pay 75 cents on the dollar for
T's assets. T’s assets include cash, equipment and the stock of T1, and they have a combined fair
market value of $2,000. P purchases the T stock from S for $1,500 and the parties make joint section
338(h)(10) elections for T and T1.
T stock
Asset
FMV
Cash
$1000
Equipment $500
T1 Stock
$500
Cash
$300
U.S. Gov’t
Securities $100
Equipment $100
S
$1500
P
T
T1
Questions
1.
How will basis be allocated among T and T1's assets under the regulations?
2.
Does the basis allocation follow the class system described in Treas. Reg. § 1.338-6
(i.e., do all Class I and Class II assets receive basis before Class V assets?).
96
Basis Allocation in a Bargain Purchase Continued
Result
Under Treas. Reg. § 1.338-6, basis is allocated under the residual method. Consideration is first allocated to Class I
assets, then to Class II, then to Class III assets, then to Class IV assets, then to Class V assets, then to Class VI assets,
and finally to Class VII assets. Basis is allocated to each class up to its fair market value and then to the next class of
assets. Basis is allocated to the assets within a Class up to their fair market value (and in proportion to their fair
market value, if the total consideration is less than their fair market value).
T Assets -- Total basis to be allocated $1500
FMV of Individual Asset x Amt. to be allocated
FMV of all assets in Class
to the Class
Class I $1000
FMV
Cash
$1000
= Basis of Individual Asset
Basis
$1000
Classes II, II, and IV $0
None
Class V $500
Equipment $500 x
$1000
T1 Stock
$500 x
$1000
$500 =
Basis
$250
$500 =
$250
97
Basis Allocation in a Bargain Purchase Continued
T1 Assets -- Total basis to be allocated $250
Class I $250
FMV
Cash
$300
Basis
$250**
Class II $0
U.S. Gov’t
Securities $100
$0
Class V $0
Equipment $100
$0
** See Treas. Reg. § 1.338-6(b)(1) (new T1 immediately realizes ordinary income equal to $50).
98
Acquisitions of Private Companies
Operating in Corporate Entities
Section 197
99
Section 197 Overview
•
•
•
Section 197 has a profound effect on acquisition transactions. By its terms, the 15-year
amortization period applies to any "amortizable section 197 intangible" that (i) is acquired
after August 10, 1993, and (ii) "is held in connection with the conduct of a trade or
business or any activity described in section 212." Section 197(c)(1).
An "Amortizable Section 197 Intangible.“ Section 197(c) defines the term "amortizable
section 197 intangible" as referring to a section 197 intangible that is
– acquired after the date of enactment of the statute (except for the special elections
noted below), and
– held in connection with the conduct of a trade or business or an activity described in
section 212. See Treas. Reg. § 1.197-2(d)(1).
The term does not include certain section 197 intangibles created by the taxpayer (selfcreated intangibles). See Section 197(c)(2); Treas. Reg. § 1.197-2(d)(2)(i).
– An intangible is self-created to the extent the taxpayer makes payments or otherwise
incurs costs for its creation or improvement, whether the actual work is done by the
taxpayer or by another person under a contract with the taxpayer. Treas. Reg.
§ 1.197-2(d)(2)(ii).
– The following self-created intangibles are excluded from the definition of amortizable
Section 197 intangibles:
• goodwill;
• going concern value;
• workforce in place;
• information-based intangibles;
• know-how intangibles;
• customer-based intangibles;
• supplier-based intangibles; and
• any similar items.
100
• Section 197(c)(2), (d)(1).
Section 197 Regulations
•
On January 20, 2000, the Internal Revenue Service issued final regulations under section 197. 65
Fed. Reg. 3,820 (Jan. 25, 2000).
•
The exception for self-created intangibles does not apply if the intangible is created in connection
with a transaction involving the acquisition of assets constituting a trade or business or a substantial
portion thereof. Section 197(c)(2); see Treas. Reg. § 1.197-2(d)(2)(iii)(B). Thus, intangibles created
in connection with such an acquisition will be treated as amortizable section 197 intangibles.
•
•
The final regulations define a trade or business as it is defined in section 1060 (i.e., one
to which goodwill or going concern value could, under any circumstances, attach).
•
Whether acquired assets constitute a "substantial portion" of a trade or business is
based on all the relevant facts and circumstances. Treas. Reg. § 1.197-2(e)(4).
A qualified stock purchase treated as an asset purchase under section 338 constitutes the acquisition
of a trade or business or a substantial portion thereof only if the direct acquisition of the assets of the
corporation would have been treated as the acquisition of assets constituting a trade or business.
Treas. Reg. § 1.197-2(e)(5).
101
Section 197 Intangibles: In General
•
For purposes of section 197, acquired intangible assets generally can be
grouped into three categories:
– Intangibles that will always be treated as a "section 197 intangible"
• Examples: goodwill; going concern value; workforce intangibles; informationbased intangibles; know-how intangibles, customer-based intangibles,
supplier-based intangibles, licenses, permits, or other rights granted by a
governmental unit; and franchises, trademarks, or trade names
– Intangibles that will be treated as a section 197 intangible if there is a
related direct or indirect acquisition of a trade or business or substantial
portion thereof
• Examples: a covenant not to compete; specialized computer software; any
interest in a film, sound recording, video tape, book, or similar property; a
contractual right to receive tangible property or services; any interest in a
patent or copyright; any right to service mortgage indebtedness secured by
residential real property; and insurance contracts acquired in assumption
reinsurance transactions)
– Intangibles that will never be treated as a section 197 intangible
• Examples: a financial interest; an interest in land; off-the-shelf computer
software; an interest in a tangible property lease or a debt instrument; a
professional sports franchise; and certain transactional costs. See Section
197(d), (e).
102
Section 197 Regulations: Anti-churning Rules
•
The amortization rules described above do not apply to goodwill, going concern value or any other
section 197 intangible that would not be amortizable but for Section 197, if acquired by a taxpayer
after August 10, 1993, and:
•
(1) the taxpayer or a related person held or used the intangible at any time on or after July
25, 1991, and on or before August 10, 1993;
•
(2) the taxpayer acquired the intangible from a person who held it at any time on or after July
25, 1991, and ending on or before August 10, 1993, and, as part of the transaction, the user
of the intangible does not change; or
•
(3) the taxpayer grants the right to use the intangible to a person (or a person related to such
person) who held or used the intangible at any time on or after July 25, 1991, and on or
before August 10, 1993 (Section 197(f)(9)(A)).
•
The regulations expressly state the purpose of the anti-churning rules and provide that the antichurning rules are to be applied in a manner that carries out their purpose.
•
The final regulations modify the definition of a related person for purposes of the anti-churning
rules in the case of a series of related transactions. The final regulations test relatedness for
purposes of the anti-churning rules only immediately before the first transaction and immediately
after the last transaction, not during the period in between as in the proposed regulations. The
final regulations also apply this rule to a series of transactions that together comprise a qualified
stock purchase within the meaning of section 338(d)(3).
–
The regulations also provide that any relationship created as part of a series of related
transactions in which a person acquires stock of a corporation constituting 80 percent
followed by a liquidation of the corporation under section 331 is generally disregarded.
103
Section 197 -- Covenant Not To Compete
A
T Stock &
Covenant Not To Compete
P
$
100%
T
Facts: A owns all of T’s stock. P purchases all of T’s stock, and A enters into a covenant not to compete
with the business of T for 3 years within a prescribed geographical area.
Issues:
1. How much of the cash is allocated to the purchase of A’s T stock and how much is allocated to A’s
covenant not to compete?
2. If there is clear evidence that the parties intended to allocate a certain amount of cash to the covenant, will
such allocation be respected by the IRS?
3. Does P have an incentive to allocate consideration to the covenant? Does it matter whether the transaction
is a stock acquisition or a deemed asset acquisition under section 338?
104
4. Does A have an incentive to allocate consideration to the covenant?
Section 197 -- Covenant Not to Compete
Acquired in Connection with Stock Redemption
Other SHs
A
90%
10%
$
T
Facts
1. A owns 10 percent of T’s stock.
2. T redeems all of its stock owned by A. T and A have no business relationship other than the corporationshareholder relationship.
3. In connection with the stock redemption, T and A enter into a covenant not to compete, pursuant to which A agrees
that he will not compete with the business of T within a prescribed geographical territory for a period of three
years. T pays A consideration for this agreement in addition to the amount paid for the stock redeemed.
Questions
1. Does section 197 apply to the amount paid for the covenant not to compete?
105
Section 197 -- Anti-Churning Rules
Series of Transactions
A
T Stock
P
$
100%
T
Facts
1. A owns all of T’s stock.
2. P purchases 25 percent of the T stock from A in January of Year 1.
3. P purchases the remaining 75 percent of the T stock in June of Year 1 and makes a section 338
election.
Questions
1. Are P and T considered related for purposes of the anti-churning rules?
106
Section 197 -- Anti-Churning Rules
Series of Transactions
60% T Stock
A
X
$
100%
$
Y
60%
T
40%
Facts
1. A owns all of T’s stock.
T
2. A sells all of T’s stock -- 60 percent to X and 40 percent to Y.
3. X and Y liquidate T under section 331.
Questions
1. Do the anti-churning rules apply to this transaction?
107
Section 197 -- Anti-Churning Rules
Series of Transactions
A
Y
X
$
100%
60%
40%
P-SHIP
T
T
Facts
1. A owns all of T’s stock.
2. A sells all of T’s stock to P-SHIP, in which X has a 60-percent interest and Y has a 40-percent interest.
3. T liquidates into P-SHIP under section 331.
Questions
1. Do the anti-churning rules apply to this transaction?
108
Acquisitions of Private Companies
Operating in Corporate Entities
Contingent Liabilities
109
Contingent Liabilities in Taxable Asset Acquisitions
•
Unfortunately almost every deal involves contingent liabilities
– Examples
• Environmental liabilities
• Tort liabilities
• Warranty claims
• Retiree medical expenses
– Complex area with very few answers
– Conflicting authority
•
Issue arises when a buyer purchases assets of a business and after the
acquisition the buyer pays or incurs a liability that is attributable to the
acquired business
– It is not clear whether that liability is a liability of the seller that is assumed by the
buyer;
OR
– Whether it is simply a liability that arose after the acquisition and is properly
treated as the buyer’s liability
110
Contingent Liabilities in Taxable Asset Acquisitions
•
Whose liability is it?
– Is it a seller liability assumed by the buyer?
– Or a liability of the buyer arising after closing?
•
If the buyer is not assuming a debt of the seller
– Buyer should get a deduction on the payment of the liabilities. (Under normal
rules of the all events test and economic performance. See section 461(b))
– Ability to get a deduction is subject to the capitalization rules.
•
If the liability is the seller’s liability assumed by the buyer, there are
numerous issues
– Income to the seller
– Offsetting deduction to the seller
– Basis to the Buyer
•
Threshold question is when will contingent liability be treated as a seller
liability assumed by the buyer and when will it be treated as the buyer’s
liability
– Each case decided on its own facts and circumstances
– Cases and rulings provide some guidance on factors as to when a liability will be
treated as assumed by the buyer
111
Contingent Liabilities: Assumed Obligation?
Factors
•
Results from Buyer’s Operations
•
Arises Out of Post-Acquisition Events
•
Buyer Aware of Liability
•
When Did Legal Liability Arise
•
Reflection in Price
•
Express Assumption by the Buyer
•
Balance Sheet Reserve
112
•
Contingent Liabilities: Assumed Obligation?
First factor – Results from Buyer’s Operations
–
Whether the liability relates to
•
•
•
•
–
–
–
Goal is to separate the occurrence of the liability from the seller and the acquisition (i.e., not a seller
liability)
If it does not relate to the seller’s operation of the business, then the Buyer can deduct the payment
Holdcroft Transportation Co. v. Commissioner, 153 F.2d 323 (8th Cir. 1946)
•
•
•
–
Buyer’s operation of the business
Activity performed by the buyer
Events under the buyer’s control
Liability arising from buyers decision
Corporation acquires assets of partnership in exchange for stock and assumption of liabilities—including two tort
claims filed against the partnership
Corporation pays on the claims and deducts the payments
– Corporation argues it should be treated as stepping into the shoes of the partnership and therefore should
be able to deduct the payments
– Corporation also argues it should be able to deduct the payments because the claims were contingent
Court holds: (i) claims did not arise out of buyer’s business; (ii) rather, expenses related to the seller’s business;
(iii) buyer cannot deduct costs relating to seller; (iv) fact that liability was contingent did not matter; (v) buyer
assumed the liability as part of the cost of the assets; and (vi) section 381 – step into the shoes.
Other authorities
•
•
•
•
Albany Car Wheel v. Commissioner, 333 F.2d 653 (2nd Cir. 1964) – liability arose after acquisition due to buyer’s
decision to close plant
Rev. Rul. 76-520 – buyer acquired a newspaper business
– Costs of filling prepaid subscriptions was assumed liability because it relates to seller’s operations
– Costs incurred to sell newspapers at newsstand were deductible because they related to the buyer’s
operations
TAM 9721002 – acquisition and severance pay
– “[A]lthough severance payments here were coincidental with Buyer's acquisition of Target, the severance
payments had their origin in Buyer's termination of Target employees. While the acquisition may have been
the catalyst for the employees' receipt of the severance payments, the acquisition was not itself the basis
for the payments. Accordingly, the severance payments need not be capitalized and added to the basis of
the stock purchased.”
Illinois Tool Works v. Commissioner, 355 F.3d 997 (7th Cir. 2004)
– Because the taxpayer knew of the pending patent infringement lawsuit, and agreed to pay that contingent
liability in exchange for purchasing the company, the taxpayer was not entitled to currently deduct the
113
judgment as a business expense.
Contingent Liabilities: Assumed Obligation?
•
Second factor – Arises Out of Post-acquisition Events
– A closely related factor is whether the liability arises out of post-acquisition events
– For example, employee benefit cases
• Where there is a contract in place at the time of the acquisition to pay death
benefits when an employee dies
• If employee dies after closing, then the liability should be a buyer liability
– Even though contract in place, it’s contingent because you don’t know when
death will occur
• If employee has already died and seller is obligated to pay, the buyer assumes
the obligation—No deduction.
– M. Buten & Sons, Inc. v. Commissioner, 31 T.C.M. (CCH) 178 (1972)
• Corporation agreed to assume liabilities of partnership in section 351 transaction,
including death benefits to surviving widows
– Court held no deduction for payments to widow of employee who died before
the acquisition; Payments were deductible if employee died after the
acquisition
– David R. Webb Compay, Inc. v. Commissioner, 708 F.2d 1254 (7th Cir. 1983)
• Buyer assumed seller’s obligation to make pension payments to wife of previously deceased
employee
• Court held no deduction for buyer
114
Contingent Liabilities: Assumed Obligation?
•
Third factor – Buyer Aware of Liability
– The third factor is whether the buyer was aware of the liability.
– In Pacific Transport v. Commissioner, 29 T.C.M. 133 (1970), rev’d per curiam 483 F.2d
209 (9th Cir. 1973), a parent corporation liquidated its subsidiary (section 334(b)(2))
and took assets and assumed the liabilities of the subsidiary, including a lawsuit that
was asserted against the subsidiary.
• The parent corporation believed its risk exposure on the claim was remote.
• The parent corporation’s risk assessment was wrong and it ultimately had to pay
the claim.
• Tax court held that a deduction should be allowed because the claim was
speculative and remote.
• Appeals court reversed and held that contingency was irrelevant. Because the
buyer was aware of the liability, payment of the claim was a cost of acquiring the
assets.
– No exception to capitalization for bad bargains.
– Therefore, if buyer is aware of the claim at the time of the acquisition, there
is no deduction for payment of the claim
– On the other hand, if buyer is not aware of the claim, then the court might
permit the buyer to deduct
– But see Holdcroft Transportation v. Commissioner. Court might not care
whether the buyer knew of the liability and may instead look to when the
liability arose. If the liability relates to the seller, then no deduction
115
Contingent Liabilities: Assumed Obligation?
•
Fourth Factor: When did legal liability arise?
– The fourth factor used by some courts to determine if a liability has been
assumed is when the legal liability arose.
– This factor can be used to explain the tort cases. Courts have stated that
legal liability for a tort arises when the tort occurs.
• Therefore using this factor would lead a court to conclude that a pre-closing
cause of action is a liability of the seller. If the buyer pays the liability, there is no
deduction.
• Holdcroft and Pacific Transport support the notion that the contingent nature of
the tort is not relevant
– Compare this result to the contract cases where the liability represents a
contractual claim, not a tort.
– Albany Car Wheel Co. v. Commissioner, 40 T.C. 831 (1963), aff’d 333 F.2d
653 (2nd Cir. 1964)
• There was a collective bargaining agreement that required payment of severance
wages to employees upon a plant shutdown.
• The purchase agreement called for an express assumption of the severance pay
liabilities.
• After the assets were transferred, the plant was shut down and severance
payments were made by the buyer.
• Court held that the liability did not arise until after the closing when the plant shut
down. Therefore the liability arose on the buyer’s side.
– Contract required payment upon certain contingent, future events. Liability arose when
the event occurred.
116
– Event was post-closing.
Contingent Liabilities: Assumed Obligation?
•
Fifth Factor: Liability Reflected in Price
– The next factor is whether the contingent liability is reflected in the price
– Courts look to see if the purchase price was reduced on account of the contingent
liability.
– If the purchase price was reduced, then the liability looks like an assumed liability
– This factor comes up often where
• Purchase price based on balance sheet
• Reserve on balance sheet (e.g., for employee medical benefits)
– Allows IRS to argue that the liability was reflected in the price
•
Sixth Factor: Liability Expressly Assumed by the Buyer
– The sixth factor is whether the buyer expressly assumed the liability.
– If the buyer expressly assumes a liability of the seller, courts generally conclude that
the buyer is assuming the liability
– However, this factor alone is not fatal. In Albany Car Wheel the buyer expressly
assumed a collective bargaining liability (severance pay in the event of a plant
shutdown). However, the court said that the liability in fact was not assumed
117
Consequences of an Assumed Liability
To the Seller:
•
Income Inclusion – When
What Amount
•
Installment Reporting
•
Offsetting Deduction
•
Imputed Interest Income
To the Buyer
•
Capitalize Payment
•
Deduct Payment
•
Report Income
•
Imputed Interest Expense
118
Consequences of an Assumed Liability: To the Seller
•
First Issue: Income Inclusion
– Seller is being relieved of a liability
– Seller’s amount realized is increased
• Not clear when amount realized increased and by how much
• One approach is to value the liability at closing and increase the amount
realized by that amount
• Second approach is to increase seller’s amount realized only when the
contingency becomes fixed and determinable (however that standard is
defined). This is sometimes referred to as the “Wait and See” approach.
•
Second Issue: Installment Reporting
– If the “wait and see” approach is taken, then the issue arises as to whether the
sale is converted to an installment sale because of the possible future payment
when liability becomes fixed
• Section 453 regulations (relating to installment sales) do not discuss
assumption of contingent liabilities
• However, if you treat the payment of the liability as a payment of the
purchase price, then the sale literally falls within the definition of contingent
payment installment sale.
119
Consequences of an Assumed Liability: To the Seller
•
Third Issue: Does the Seller get an offsetting deduction against the amount
realized resulting in no net income?
– Most practitioners would conclude the seller should get a deduction under James
M. Pierce Corp. v. Commissioner, 326 F.2d 67 (1964) and Commercial Security
Bank v. Commissioner, 77 T.C. 145 (1981).
– In Pierce, the seller operated a newspaper business.
• Seller received prepaid subscription fees
• Seller initially set up a reserve and deferred the income under section 453
• Court said that when seller sold the business the seller must accelerate the
reserve into income
• But, the court also gave the seller a deduction
– Buyer paid cash for reserve
– Seller turned around and paid buyer for assuming the liability to fill
newspaper subscriptions
– Thus income was offset with a deduction
– In Commercial Security Bank there was a slightly different rationale.
• Court said that liability assumed by the buyer reduced the cash received by the
seller
• Such reduction in cash received treated as if seller actually paid the liability
• Seller gets a deduction to offset income
120
Consequences of an Assumed Liability: To the Seller
•
Third Issue (continued): Does the Seller get an offsetting deduction against
the amount realized resulting in no net income?
– Problem arises because a seller can have all kinds of liabilities and the timing
rules for deductions must be considered.
• For example, if the all events test is satisfied but there is no economic performance,
does the seller still get a deduction?
• Section 461(h) regulations reserve treatment of contingent liabilities. See Treas. Reg. §
1.461-4(j).
• Section 461 regulations do provide that in a sale of a business if the buyer “expressly
assumes” a fixed liability then economic performance occurs as the liability is included
in the seller’s amount realized.
• Problem is that the regulation is too narrow because it requires an express assumption.
• If the regulation test is failed, then the seller may have income without a matching
deduction.
– Presumably the deduction is deferred until the buyer makes payment
» This is the wrong answer – in the acquisition context the seller should not be subject to
economic performance.
» Section 461(h) was intended to prevent premature accrual. If the seller has income
recognition, then accrual is not premature.
» If the seller doesn’t get a deduction at the time of the acquisition, then there is not a clear
reflection of income.
» Query whether Pierce and Commercial Security Bank apply if the requirements of
section 461(h) are not met.
– Similar problem arises where the liability is to make payment to nonqualifying
deferred compensation plan
• Section 404(a)(5) – employer gets deduction when employee has income
• IRS position in TAM 8939002 is that deemed payment found in Commercial Security
Bank, Pierce, etc. Doesn’t support a deduction without income to the employee
121
Consequences of an Assumed Liability: To the Seller
•
Fourth Issue: Whether Interest Imputed on Deemed Payment
– This issue should only apply to the “wait and see” approach
• Arguably there is no imputed interest because section 1274 does not apply
to assumed debt. See section 1274(c)(4).
122
Consequences of an Assumed Liability: To the Buyer
•
First Approach: Capitalization
– Treat liability as cost of the assets.
– Add to the assets’ basis when the liability becomes fixed.
– Capitalization approach has the greatest support in the case law
• See Webb v. Commissioner, 77 T.C. 1134 (1981), aff’d, 708 F.2d 1254 (7th
Cir. 1983).
– Unfunded pension liability assumed in asset acquisition
– Payments treated as cost of acquired assets
• See also Holdcroft, Pacific Transport, M. Buten & Sons.
– Uncertain whether buyer can treat a portion of the payments as interest
123
Consequences of an Assumed Liability: To the Buyer
•
Second Approach: Deduction
– This method says that, even if the liability is assumed by the buyer, the buyer
should still get a deduction when the liability is fixed
– There is some support for this approach in the case law
• Albany Car Wheel, 333 F.2d 653 (2d Cir. 1964)
– Agreement specifically said liability to pay severance pursuant to
collective bargaining agreement in the event of a plant shutdown was
assumed
– But court said that facts showed that the liability was not assumed and
the buyer had made a decision that resulted in the liability to pay
severance (i.e., shutting down the plant).
• United States v. Minneapolis and St. Louis Railway Co., 260 F.3d 663 (8th
Cir. 1958)
– Suggests deductibility method
– But case can also be read as saying nothing was assumed
• F&D Rentals, Inc., 365 F.2d 64 (7th Cir. 1966)
– Court said in dicta that taxpayer could deduct if payment had been
made
– ABA and NYSBA support the deductibility approach.
124
Consequences of an Assumed Liability: To the Buyer
•
Third Approach: Income Approach
– The third approach is the income approach. This approach comes from the
Pierce case.
• Seller sold a newspaper
• Court required seller to include reserve for prepaid subscriptions in income
on sale
• Court permitted seller an offsetting deduction
• Court’s theory was to construe a deemed payment from seller to buyer in an
amount equal to the reserve
– The income approach has not received much support outside of the publication
industry
• Doesn’t make sense to say buyer has income on a purchase
125
Contingent Liabilities: Section 338(h)(10)
Result under the Section 338 Regulations
SELLER’S ADSP
ADSP = G + L
•
•
•
Regulations eliminate the “Fixed and Determinable” standard for determining the
Liabilities of Old T.
General principles of tax law apply in determining the timing and the amount of
liabilities to be included in ADSP.
ADSP is redetermined at such time and in such amount as an increase or
decrease would be required, under general principles of tax law, for the
elements of ADSP.
BUYER’S BASIS
•
•
Use AGUB Formula
Regulations eliminate the “Fixed and Determinable” standard.
•
In order to be taken into account for AGUB, a liability must be a liability of T that
is properly taken into account in basis under general principles of tax law.
126
Acquisitions of Private Companies
Operating in Corporate Entities
Tax-Free Transactions
127
Reorganizations in General
•
•
An acquisition will be tax-free if it qualifies as a “reorganization” under
section 368.
An acquisition will qualify under section 368 if it satisfies one of the
definitions listed in that section (see following slide). In addition, the
acquisition must meet the following requirements:
– Continuity of Interest
– Continuity of Business Enterprise
– Business Purpose
•
•
•
No gain or loss will be recognized at either the corporate level or the
shareholder level if stock or securities of a corporation are exchanged for
stock or securities of another corporation pursuant to a plan of
reorganization.
Gain will be recognized to the extent that property in addition to stock or
securities is used as consideration in the reorganization (referred to as
“boot”). The gain recognized is limited to the amount of the boot. The
presence of boot does not trigger the recognition of loss.
The unrecognized gain or loss is preserved in the carryover basis of
qualifying property received in a reorganization and will be recognized upon
a subsequent taxable disposition.
128
Reorganizations under Section 368
•
•
•
•
•
•
•
•
§ 368(a)(1)(A) – “A” Reorg – statutory merger or consolidation
§ 368(a)(1)(B) – “B” Reorg – acquisition of target stock constituting control
of target in exchange solely for voting stock of acquiring
§ 368(a)(1)(C) – “C” Reorg – acquisition of substantially all of the assets of
target in exchange for voting stock of acquiring
§ 368(a)(1)(D) – “D” Reorg – corporation transfers all or part of its assets to
another controlled corporation and distributes stock in controlled corporation
either in non-divisive § 354 transaction or divisive § 355 transaction
§ 368(a)(1)(E) – “E” Reorg – Recapitalization
§ 368(a)(1)(F) – “F” Reorg – “mere change in identity, form, or place of
organization of one corporation, however effected.”
§ 368(a)(2)(D) – Forward Subsidiary Merger – “A” reorganization (statutory
merger) where the target is merged into a subsidiary of acquiring and the
target shareholders receive stock of acquiring.
§ 368(a)(2)(E) – Reverse Subsidiary Merger – “A” reorganization (statutory
merger) where a subsidiary of acquiring is merged into the target and the
target shareholders receive stock of acquiring.
129
General Reorganization
Requirements
• Continuity of Interest
– Continuity of interest requires that a substantial part of the value
of the proprietary interests in the target corporation be preserved
in the reorganization through acquisition of acquiring company
stock.
– The continuity requirement is generally 40%.
• Continuity of Business Enterprise
– The acquiring corporation must either (1) continue the
transferor’s historic business or (2) continue to use a significant
portion of the transferor’s historic business assets in its
business.
• Business Purpose
– The reorganization must be for a corporate business purpose
other than tax avoidance.
130
Tax Consequences of a
Reorganization
•
Stock Reorganizations
–
Consequences to Stockholders and Security Holders
•
•
–
Consequences to Corporate Transferee
•
•
•
•
If consideration given by transferee (acquiring) consists exclusively of its own stock, transferee
recognizes no gain or loss under § 1032.
If acquiring corporation transfers some boot, it recognizes gain or loss under § 1001, but does not
receive any increase in the basis of the acquired property as a result of the gain recognized. See §
362(b).
Generally takes basis in property acquired equal to its basis in the hands of the acquired corporation,
increased by any gain recognized by the acquired corporation on the exchange.
Asset Reorganizations
–
Consequences to Corporate Transferor
•
•
–
•
No gain or loss is recognized if stock or securities of one corporate party to a reorganization is
exchanged solely for stock or securities of another corporate party to the reorganization. See §
354(a)(1)
If boot received, the shareholder must recognize any realized gain to the extent of the boot under §
356. No loss is recognized.
Corporate party to a reorganization recognizes no gain or loss on an exchange of property, pursuant to
the reorganization, solely for stock or securities of another corporate party to the reorganization. See
§ 361(a).
Corporate transferor also recognizes no gain on any other consideration received in addition to stock
and securities as long as the transferor distributes the boot pursuant to the reorganization.
Consequences to Corporate Transferee
Single Entity Reorganizations
131
•
Tax Consequences of a
Reorganization
Stock Reorganizations
– No tax to Acquired Corporation
– No tax to Acquired Corporation Shareholders
– Acquired Corporation Shareholders Take a Substituted Basis in the Acquiring
Corporation’s Stock
– Acquiring Corporation Takes a Carryover Basis in the Acquired Corporation’s
Stock
– Tax attributes of Acquired Corporation (e.g., net operating losses) are
Unchanged
•
Asset Reorganizations
– No tax to Acquired Corporation on the Exchange or the Liquidation
– No tax to Acquired Corporation Shareholders
– Acquired Corporation Shareholders Take a Substituted Basis in the Acquiring
Corporation’s Stock
– Acquiring Corporation Takes a Carryover Basis in the Acquired Corporation’s
Assets
– Tax attributes of Acquired Corporation (e.g., net operating losses) carry over to
Acquiring Corporation
132
“A” Reorganization
T S/H’s
T S/H’s
P S/H’s
P S/H’s
P Stock
T
T Assets
•
•
•
Merge
P
P
P Assets
T Assets
P Assets
Definition: An “A” reorganization is a statutory merger or consolidation.
Requirements: The requirements of an “A” reorganization are that it must be (1) a merger or
consolidation under a state or foreign law and it must satisfy (2) continuity of interest, (3) continuity
of business enterprise, and (4) business purpose.
Tax Consequences:
– No tax to T
– No tax to T shareholders
– T shareholders take a substituted basis in the P stock
– P takes a carryover basis in the T assets
– T’s tax year ends on the date of the merger
– Tax attributes of T (e.g., net operating losses) carry over to P
133
“A” Reorganization – Cash Option Merger
T S/H’s
T S/H’s
P S/H’s
P S/H’s
P Stock/Cash
T
T Assets
Merge
P
P
P Assets
T Assets
P Assets
Issue: What if some T shareholders want cash or part cash/part P stock?
The merger can still qualify as a reorganization as long as enough P stock is exchanged
for T stock to satisfy COI.
What are the tax results to T shareholders that elect to receive a combination of P stock
and cash?
What are the tax results to T shareholders that elect to receive cash only?
134
“B” Reorganization
T S/H’s
T
T Assets
•
•
•
P
Voting
Stock
T Stock
T S/H’s
P S/H’s
P S/H’s
P
P
T
T Assets
Definition: Acquisition of stock of one corporation (T) in exchange solely for voting stock of the
acquiring corporation (P), provided that the acquiring corporation has control of the acquired
corporation immediately after the transaction.
Requirements: P must acquire (1) “control” of T (2) “solely for voting stock.”
– “Control” for this purpose means ownership of at least 80% of the total combing voting power
of voting stock and at least 80% of each class of nonvoting stock.
Tax Consequences:
– No tax to T
– No tax to T Shareholders
– T shareholders take a substituted basis in the P stock
– P takes a carryover basis in the T stock
– Tax attributes of T (e.g., net operating losses) are unchanged
135
“C” Reorganization
T S/H’s
P
Voting
Stock
T Assets
T Assets
•
T
P
T
•
P S/H’s
T S/H’s
P S/H’s
P
T Assets
T S/H’s
P S/H’s
Liquidates
P
T Assets
Definition: Acquisition of substantially all of the assets of target corporation (T) solely in exchange
for voting stock of the acquiring corporation (P).
Requirements: P must acquire (1) “substantially all the assets” of T (2) “solely for voting stock.” In
addition, (3) T must liquidate.
– “Substantially all” means 90% of the net assets and 70% of the gross assets of T
– “Solely for voting stock” has two exceptions for purposes of a C reorganization:
• P may assume liabilities of T in any amount as long as other consideration is only voting
stock.
• Cash or other property may be used as consideration in addition to voting stock,
provided voting stock is used to acquire at least 80% of the T’s assets (measured by
gross FMV).
136
“C” Reorganization
T S/H’s
P S/H’s
T S/H’s
P S/H’s
T
P Stock
T Assets
T Assets
•
Liquidates
P
T
T S/H’s
P S/H’s
P
T Assets
P
T Assets
Tax Consequences:
– No tax to T on the exchange or the liquidation
– No tax to T shareholders
– T shareholders take a substituted basis in the P stock
– P takes a carryover basis in the T assets
– Tax year of T ends on liquidation
– Tax attributes of T (e.g., net operating losses) carry over to P
137
“D” Reorganization
T/P S/H’s
T/P S/H’s
T
P Stock
T Assets
T Assets
•
•
P Stock
P
T
T/P S/H’s
P
T Assets
P
T Assets
Definition: Transfer by a corporation of all or part of its assets to a corporation controlled
(immediately after the transfer) by the transferor or its shareholders, but only if stock or securities of
the controlled corporation are distributed in pursuance of the plan of reorganization either in a nondivisive § 354 transaction or a divisive § 355 transaction.
Requirements: (1) P must be “controlled” by T (or T’s shareholders) immediately after the asset
transfer and (2) T must distribute P stock in a distribution that qualifies as either (a) a non-divisive §
354 transaction or (b) a divisive § 355 transaction.
–
–
“Control” for purposes of a D reorganization means ownership of 50% of the voting stock or 50% of the FMV
of all classes of stock
A transaction will qualify as a nondivisive D reorganization only if it satisfies the requirements of § 354: (i) the
transferee corporation acquires “substantially all” of the assets of the transferor corporation and (ii) the
transferor distributes any retained assets, as well as the stock and securities received from the transferee,
pursuant to a plan of reorganization
138
“D” Reorganization
T/P S/H’s
T/P S/H’s
T
P Stock
T Assets
T Assets
•
P Stock
P
T
T/P S/H’s
P
T Assets
P
T Assets
Tax Consequences:
– No tax to T on the exchange or the liquidation
– No tax to T shareholders
– T shareholders take a substituted basis in the P stock
– P takes a carryover basis in the T assets
– Tax year of T ends on distribution
– Tax attributes of T (e.g., net operating losses) carry over to P
139
“E” Reorganization
B
B
pref.
stock
A
common
stock
common
stock
common
stock
debentures
T
•
•
C
A
common
stock
C
common
stock
common
stock
T
Definition: A recapitalization. For example, in the picture above, B receives common stock in
exchange for preferred stock and C receives common stock in exchange for debentures.
Tax Consequences:
– No tax to B
– No tax to C
– No tax to T
– B and C take a substituted basis in the common stock
140
“F” Reorganization
A
A
Old
T
New
T
Alabama
•
•
Delaware
Definition: An F reorganization is a “mere change in identity, form, or place of organization of one
corporation, however effected” (e.g., a corporation reincorporating in another state).
Tax Consequences:
– No tax to T or A
– T’s tax attributes remain the same
– T’s tax year continues
141
Forward Subsidiary Merger (§ 368(a)(2)(D))
P Stock
T S/H’s
T
T Assets
•
•
•
Merge
P S/H’s
T S/H’s
P S/H’s
P
P
S
S
T Assets
Definition: “A” reorganization (statutory merger) where the target is merged into a subsidiary of
acquiring.
Requirements: (1) Substantially all the properties of the target corporation are acquired by the
subsidiary; (2) the target is merged into the subsidiary; (3) the merger would have qualified as an
“A” reorganization if the target had merged directly into the parent; and (4) no stock of the
subsidiary is used in the transaction.
Tax Consequences:
– No tax to T
– No tax to T Shareholders
– S takes a carryover basis in the T assets
– T shareholders take a substituted basis in the P stock
– Tax attributes of T (e.g., net operating losses) carry over to S
142
Forward Subsidiary Merger (§ 368(a)(2)(D)) – Use
of Restricted Stock or Options
T S/H’s
T
T Assets
P Stock/
P Restricted Stock/
P Options
Merge
P S/H’s
T S/H’s
P S/H’s
P
P
S
S
T Assets
Issue: What if, as part of the merger transaction, P issues to certain T
shareholders P stock that does not vest for 10 years? What if the T
shareholders make a section 83(b) election?
Issue: What if, as part of the merger transaction, P issues to certain T
shareholders options to acquire P stock in 10 years in exchange for
their options to acquire T stock in 5 years?
143
Reverse Subsidiary Merger (§ 368(a)(2)(E))
T S/H’s
T
T Assets
•
•
•
P
Voting
Stock
Merge
P S/H’s
T S/H’s
P S/H’s
P
P
S
T
T Assets
Definition: “A” reorganization (statutory merger) where a subsidiary is merged into the target.
Requirements: (1) The subsidiary is merged into the target; (2) the surviving target corporation
holds substantially all of its properties and substantially all of the properties of merged subsidiary
after the transaction; and (3) the target’s shareholders before the transaction (T S/H’s) must
receive, in the transaction, voting stock of the merged subsidiary’s parent (P) in exchange for stock
constituting control of target.
– “Control” for this purpose means ownership of at least 80% of the total combing voting power
of voting stock and at least 80% of the total number of shares of nonvoting stock.
Tax Consequences:
– No tax to T
– No tax to T Shareholders
– T shareholders take a substituted basis in the P stock
– Tax attributes of S (e.g., net operating losses), if any, carry over to T
144
Avoiding COI with Section 351 - National Starch
A
Public
(1)
86%
(2)
N
PS
14%
T
P
N
CS
Cash
N
(3)
Cash
Merger
S
Facts: P wishes to acquire Target (T). Most of the T shareholders want to sell their stock to P for cash, but, A, who
owns 14 percent of T’s stock, insists on a tax-free transaction. P transfers cash to a newly formed corporation (N)
in exchange for voting common stock of N. A transfers its T stock to N in exchange for N preferred stock, which
is convertible into P stock. N forms a wholly owned subsidiary S, by transferring cash to S in exchange for all of
the S common stock. S is merged into T. The shareholders of T, other than A, exchange their T stock for cash. T
becomes a wholly owned subsidiary of N.
Results: This transaction should satisfy the requirements of section 351. See Rev. Rul. 84-71. However, note that
the preferred stock received by A will be treated as boot if it meets the definition of nonqualified preferred stock
145
under section 351(g). The investment company rules of section 351(e)(1) could be triggered as well.
Acquisitions of Private Companies
Operating in Corporate Entities
Tax-Free Transactions
Additional Selected Issues –
COBE, COI, Step Transaction
146
Prop. Treas. Reg. § 1.368-2(k)
•
Section 368(a)(2)(C) provides that a transaction otherwise qualifying as an "A," "B,"
"C," or "G" Reorganization will not be disqualified as such reorganization because any
assets of the acquired corporation or stock are transferred to a corporation controlled
by the acquiring corporation.
•
In 2004, the IRS proposed additional regulations to amend Treas. Reg. § 1.368-2(k)
to provide that a transaction otherwise qualifying as a reorganization under section
368(a) would not be disqualified from such treatment because of a subsequent
transfer or successive transfers of part or all of the assets or stock of any party to the
reorganization (except, in the case of stock, the issuing corporation as defined in
Treas. Reg. § 1.368-1(b)) if certain conditions are satisfied.
– Prop. Regs. §1.368-2(k)(1)(ii) would require either:
• (i) that, in the subsequent transfer(s), a person not be the transferee of
– (a) substantially all of the acquired assets,
– (b) substantially all of the assets of Target immediately after a
transaction otherwise qualifying as a "B" Reorganization,
– (c) substantially all of the assets of Acquiror immediately after a
transaction otherwise qualifying as a Reverse Triangular Merger, or
– (d) control of Target's stock; or
• (ii) that the transfer is to one or more corporations controlled in each transfer
by the transferor corporation or to a partnership in which the transferor has
an ownership interest immediately after the transfer.
147
Asset Transfers to
Corporations
(1)
P Stock
T
P
Merge
(2) T Assets transferred to S
S
(3) T Assets transferred to S1
S1
Facts: T merges into P and T shareholders exchange their T stock for P stock. P transfers
the T assets to S, which immediately transfers them to S1.
Result: Transaction satisfies COBE and the transaction is tax-free.
148
Asset Transfers to NonControlled Corporations
(1)
P Stock
T
P
X
50%
(2)
T Assets
50%
(2)
Cash
Y
Facts: T merges into P and T shareholders exchange their T stock for P stock. P transfers
the T assets to Y in exchange for 50% of the stock of Y, and unrelated X transfers cash to Y
in exchange for 50% of the stock of Y.
Result: Transaction does not meet section 368(a)(2)(C).
149
COBE and Drop-Down of Assets Following
Tax-Free Reorganization; Example 1
“B” reorganization
T S/H’s
T
P
50%
T stock
50%
T stock
S1
S2
T
Facts: P owns more than 80 percent of the stock of S1 and S2. P acquires T in tax-free reorganization
qualifying under section 368(a)(1)(B) (“B” reorganization). Immediately after the reorganization, P
contributes 50 percent of the T stock to S1 and 50 percent of the T stock to S2.
Does the transaction satisfy COBE? See Prop. Treas. Reg. §§ 1.368-1(d)(4)(i)(B), -2(k).
Does the transaction meet section 368(a)(2)(C)?
150
COBE and Drop-Down of Asset Following Tax-Free
Reorganization; Example 2
“C” reorganization
T
50%
T assets
P
S1
50%
T assets
S2
50% 50%
50%
T assets
S3
50%
T assets
Facts: P owns more than 80 percent of the stock of S1 and S2. T transfers its assets to P in tax-free reorganization qualifying
under section 368(a)(1)(C) (“C” reorganization). Immediately after the reorganization, P contributes 50 percent of the T
assets to S1 and 50 percent of the T assets to S2. S1 and S2 form S3, and S1 and S2 each contribute to S3 their respective 50
percent of T assets in exchange for 50 percent of the S3 stock.
Does the transaction satisfy COBE? See Treas. Reg. §§ 1.368-1(d)(4), -2(k); Prop. Treas. Reg. §§ 1.368-1(d)(4)(i)(B), -2(k).
Does the transaction meet section 368(a)(2)(C)?
151
COBE and Drop-Down of Asset Following Tax-Free
Reorganization; Example 3
P
All T Assets
P Shares & Cash
Public
T
S
Merge
33 ⅓%
PRS
Facts: S acquires all of the T assets in the merger of T into S. In the merger, the T shareholders receive P stock and cash.
Pursuant to the plan of reorganization, S transfers all of the T assets to PRS, a partnership in which S owns a 33 1/3
percent interest. S does not perform active and substantial management functions as a partner with respect to PRS’s
business.
Analysis: Under Prop. Treas. 1.368-2(k), the transaction, which otherwise qualifies as an “A” reorganization by reason
of section 368(a)(2)(D), is not disqualified by the transfer of T assets from S to PRS because S has an ownership interest
in PRS immediately after the transfer, S is a member of the qualified group and is treated as conducting the business of
PRS under Treas. Reg. § 1.368-1(d)(4)(iii), and the transaction satisfies the COBE requirements of Treas. Reg. § 1.368152
1(d). See Prop. Treas. Reg. 1.368-2(k)(3), ex. 5.
Continuity of Business Enterprise: Cross-Chain Transfers
T
P
Merge
P Stock
S
X
T Assets
Facts: P owns 100% of the stock of S. T, an unrelated corporation, merges into S, with the T
shareholders receiving P stock for their T stock. Immediately thereafter, S transfers the T assets to X.
153
Cross-Chain Transfers: COBE vs. Step Transaction
P
Merge
T
S
X
P Stock
T Assets
Y
Facts: P owns 100% of the stock of S and X. X owns 100% of the stock of Y. T, an unrelated
corporation, merges into S, with the T shareholders receiving P stock for their T stock. Immediately
thereafter, S transfers the T assets to Y.
154
Rev. Rul. 2001-24
(2)
P
P
S Stock
S1
(1)
X
Merge
S
S1
S
Facts: Pursuant to a plan of reorganization, X merges into S, P’s newly formed wholly owned
subsidiary, in a transaction that is intended to qualify as a reorganization under sections 368(a)(1)(A)
and 368(a)(2)(D). S continues the historic business of X. As part of the reorganization plan, P then
transfers the S stock to S1, P’s pre-existing wholly owned subsidiary. Without regard to P’s transfer of
the S stock to S1, X’s merger into S qualifies as a reorganization under sections 368(a)(1)(A) and
368(a)(2)(D).
Result: Prop. Treas. Reg. § 1.368-2(k) confirms that the merger of X into S is not disqualified by the
transfer of S stock to S1 following the merger.
155
Rev. Rul. 2002-85
A
(2)
70% P Stock
30% Cash
(1)
T Assets
T
70% P Stock
30% Cash
P
(3)
T Assets
S Stock
S
Facts: A, an individual, owns 100 percent of T, a state X corporation. A also owns 100 percent of P, a state Y
corporation. First, pursuant to a plan of reorganization, T transfers all of its assets to P in exchange for
consideration consisting of 70 percent P voting stock and 30 percent cash. Second, T liquidates, distributing
the P voting stock and cash to A. Third, P transfers all of the T assets to S, a preexisting, wholly owned
subsidiary of P, in exchange for S stock.
Result: The transaction qualifies as a “D” reorganization even though P does not retain the assets of T. Prop.
Treas. Reg. § 1.368-2(k) confirms this result.
156
Rev. Rul. 2001-25
P voting stock for 90% of T stock
Cash for 10% T stock
P
(2)
Shareholders
T stock
X
(3)
(1)
S
Merge
T
Facts: P and T are manufacturing corporations organized under the laws of state A. S, P’s newly
formed wholly owned subsidiary, merges into T in a statutory merger under the laws of state A. In
the merger, P exchanges its voting stock for 90% of the T stock, and tenders cash for the remaining
10% of T stock. As part of the merger plan, T sells 50% of its operating assets to X, an unrelated
corporation, for cash. T retains the sales proceeds. Without regard to the requirement that T hold
substantially all of the assets of T and S, the merger satisfies all the other requirements applicable to
reorganizations under sections 368(a)(1)(A) and 368(a)(2)(E).
157
Push-up of Assets To a Corporation Following
Tax-Free Reorganization
(2)
Less Than
Substantially All T Assets
P
S
(1)
Merge
T
Facts: P owns 100 percent of S. S merges into T in a reverse triangular merger qualifying under
section 368. Immediately after the merger of S into T, T distributes to P less than substantially all of its
assets.
Result: Under Prop. Treas. Reg. § 1.368-2(k), the reorganization is not disqualified by the transfer of
less than substantially all T assets from T to P.
Alternative 1: Same facts as above, except T merges into S in a forward triangular merger and S
distributes substantially all of the T assets to P.
Alternative 2: Same facts as alternative 1, except S liquidates into P.
158
Push-up of Assets to Partnership Following Tax-Free
Reorganization
P
80%
80%
PRS
20%
(2)
Less than
substantially all
of T assets
S
(1)
Merge
T
Facts: P owns 80 percent of S and PRS. PRS owns the remaining 20 percent of S. T merges into S in
a merger qualifying under section 368(a)(1)(A) by reason of section 368(a)(2)(D). Immediately after
the merger of T into S, S distributes to PRS less than substantially all of T’s assets in redemption of 5
percent of the stock of S owned by PRS.
Result: Under Prop. Treas. Reg. § 1.368-2(k), the reorganization is not disqualified by the transfer of
T assets from S to PRS.
159
Elkhorn Coal
Shareholders
P stock
Shareholders
C stock
T
P
T stock
Unwanted
assets
T
P
T
C
Liquidate
Facts: The shareholders of T agree to exchange all of their T stock for voting stock of P. Prior to the
acquisition by P, T distributes unwanted assets to its shareholders in a tax-free transaction under
section 355. Immediately following the exchange, and as part of the overall plan, P causes T to
liquidate.
Result: If the transaction is tested as a “C” reorganization under Rev. Rul. 67-274, it would likely
fail since P would not be acquiring “substantially all” of T's assets. Helvering v. Elkhorn Coal Co.,
95 F.2d 732 (4th Cir. 1937), cert. denied, 305 U.S. 605 (1938).
160
Rev. Rul. 2003-79
The Spin
S/Hs
D
(1)
Business X
The Acquisition
Business
X&Y
C
S/Hs
(2)
C Stock
P
(3)
Business X
A Stock
(3)
C
Business X
(4)
Liquidates
Facts: Domestic corporation D conducts Business X and Business Y; D’s assets are equally divided between the two
businesses. Domestic corporation P, which is unrelated to D, conducts Business X. P wishes to acquire D's Business X, but no
D's Business Y. Accordingly, D and P undertake the following transaction: First, D transfers its Business X assets to C, a
newly formed domestic corporation, in exchange for 100 percent of the stock of C. Second, D distributes the C stock to the D
shareholders. Third, P acquires all of the assets of C in exchange solely for voting stock of P. Fourth, C liquidates.
Result: C should be considered independently from D in determining whether P’s acquisition of C qualifies as a reorganization
under section 368. Accordingly, the acquisition by P of all the properties held by C immediately after the distribution by D
satisfies the substantially all requirement of section 368(a)(1)(C).
Note: The result is different if D contributes business Y to C, D distributes the C stock to the D shareholders, and D
the X assets to P in exchange for P stock. See Helvering v. Elkhorn Coal Co., 95 F.2d 732 (4th Cir. 1937).
transfers
161
“F” Reorganization, Step Transaction, and COI
Date 1
A
Date 2
A
T Stock
Cash
X
T
Alabama
Delaware
Z
Facts: A is the sole shareholder of Corporation X, an Alabama corporation. On Date 1, X changes its state of incorporation
to Delaware and its name to T Corporation in a reorganization intended to qualify under section 368(a)(1)(F). Immediately
after the reorganization (on Date 2), A sells 100 percent of the T stock to Z for cash.
Issue: Is COI satisfied? On August 12, 2004, the IRS and Treasury issued proposed regulations stating that the application
of the COI requirements to a “F” reorganization is not required to protect the policies underlying the reorganization
provisions. See Prop. Treas. Reg. § 1.368-2(m)(2). This aspect of the proposed regulations was made final on February 24,
2005. See Treas. Reg. § 1.368-1(b). In addition, the proposed regulations provide that related events that precede or follow a
transaction or series of transactions that constitutes a “mere change in corporate form” will not cause that transaction or
series of transactions to fail to qualify as a “F” reorganization. Prop. Treas. Reg. § 1.368-2(m)(3)(ii).
162
“Mere Change” Requirements
• Proposed regulations issued by Treasury and the IRS on August
12,,2004, provide that, to qualify as a “F” reorganization, a
transaction must result in a “mere change in identity, form, or place
of organization of one corporation.” Prop. Treas. Reg. § 1.368-2(m).
• A transaction constitutes a “mere change” only if the following four
requirements are satisfied. See Prop. Treas. Reg. § 1.3682(m)(1)(i)(A)-(D).
– All of the stock of the resulting corporation, including stock issued
before the transfer, must be issued in respect of stock of the transferring
corporation.
– There must be no change in the ownership of the corporation in the
transaction, except a change that has no effect other than that of a
redemption of less than all the shares of the corporation.
– The transferring corporation must completely liquidate in the
transaction.
– The resulting corporation must not hold any property or have any tax
attributes (including those specified in section 381(c)) immediately
before the transfer.
163
“E” Reorganization, COI, and COBE
• On August 12, 2004, the IRS and Treasury issued proposed
regulations stating that the application of the COI and COBE
requirements to an “E” reorganization is not required to protect the
policies underlying the reorganization provisions. See Prop. Treas.
Reg. § 1.368-1(b).
• These regulations were made final on February 24, 2005. See
Treas. Reg. § 1.368-1(b).
164
King Enterprises Transaction
Step 1
Step 2
Public
50% P voting stock
and 50% cash
Public
P
Merge
T
100% T stock
P
T
Facts: The shareholders of T exchange all of their T stock for consideration consisting
of 50% P voting stock and 50% cash. Immediately following the exchange, and as
part of the overall plan, P causes T to merge upstream into P.
Result: The transaction should qualify as an “A” reorganization. See King
Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969); Rev. Rul. 2001-26,
2001-1 C.B. 1297 (May 11, 2001).
165
Rev. Rul. 2001-46 - Situation 1
Step 2
Step 1
100% T stock
T Shareholders
70% P voting
stock and
30% cash
P
P
100%
T
Merge
S
Merge
T
Facts: P owns all of the stock of S, a newly formed wholly owned subsidiary. Pursuant to an integrated plan, P acquires
all of the stock of T, an unrelated corporation, in a statutory merger of S into T, with T surviving. In the merger, the T
shareholders exchange their stock for consideration of 70% P voting stock and 30% cash. Immediately thereafter, T
merges upstream into P.
Result: If the acquisition were viewed independently from the upstream merger of T into P, the result should be a QSP
of T stock followed by a section 332 liquidation. See Rev. Rul. 90-95, 1990-2 C.B. 67. However, because step
transaction principles apply, the transaction is treated as a single statutory merger of T into P under section 368(a)(1)(A).
See King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969). P acquires the T assets with a carry-over basis
under section 362, and P may not make a section 338 election for T.
Note: On July 8, 2003, the Service issued new final and temporary regulations that permit taxpayers to turn off the step
transaction doctrine and to make a section 338(h)(10) election in the transaction described above. See Treas. Reg. §
1.338-3(c)(1)(i), (2), Temp. Treas. Reg. § 1.338(h)(10)-1T.
166
New Temp. Treas. Reg. § 1.338(h)(10)-1T(c)(2), (e)
• The temporary regulations provide that “a section 338(h)(10) election may be made for T where
P’s acquisition of T stock, viewed independently, constitutes a qualified stock purchase and, after
the stock acquisition, T merges or liquidates into P (or another member of the affiliated group that
includes P) . . . ” Temp. Treas. Reg. § 1.338(h)(10)-1T(c)(2).
• This rule applies regardless of whether, under the step transaction doctrine, the acquisition of T
stock and subsequent merger or liquidation of T into P (or P affiliate) qualifies as a reorganization
under section 368(a). Id.
• If a section 338(h)(10) election is made under these facts, P’s acquisition of T stock will be treated
as a QSP for all Federal tax purposes and will not be treated as a reorganization under section
368(a). See Temp. Treas. Reg. § 1.338(h)(10)-1T(e) exs. 12, 13.
• However, if taxpayers do not make a section 338(h)(10) election, Rev. Rul. 2001-46 will continue
to apply so as to recharacterize the transaction as a reorganization under section 368(a). See id. at
ex. 11.
• The regulations are effective for stock acquisitions occurring on or after July 8, 2003.
167
Rev. Rul. 2001-46 - Situation 2
Step 1
Step 2
T Shareholders
100% T stock
100% P voting
stock
P
P
100%
Merge
Merge
T
S
T
Facts: Same facts as in Situation 1, except that the T shareholders receive solely P stock in exchange for
their T stock, so that the merger of S into T, if viewed independently of the upstream merger of T into P,
would qualify as a reorganization under section 368(a)(1)(A) by reason of section 368(a)(2)(E).
Result: Step transaction principles apply to treat the transaction as a merger of T directly into P.
Note: The taxpayers cannot change this result under the new section 338 regulations, because (standing
alone) P’s acquisition of T does not constitute a qualified stock purchase.
168
King Enterprises Transaction - Variation
Step 1
Public
100% P
voting stock
Step 2
Public
Step 3
P
T assets
Merge
P
X
Cash
T
100%
T stock
P
T
Facts: Same facts as in Variation 1, except P sells T’s assets to X a third party immediately after the
merger of T into P.
Questions: (1) Does the Step-Transaction Doctrine apply?
(2) What is the result of this transaction for Federal income tax
purposes?
169
King Enterprises Transaction – Variation
Step 1:
S/H’s
C
Stock
T
Businesses
1+2
C
Step 3:
Step 2:
P
Voting
Stock
S/H’s
100% T Stock
Business 2
assets
C
T
Business 2
Business 1
S/H’s
P
S/H’s
C
Business 2
S/H’s
P
T
Liquidates
T
Business 1
Facts: T currently operates two businesses. T contributes all of its Business 2 assets to C, a newly formed wholly owned subsidiary. T distributes
the stock of C to T shareholders in a spin-off. P acquires T from the T shareholders in exchange for P stock. Immediately thereafter, T is
liquidated into P.
Form: The above steps in form constitute a section 355 transaction, a B reorganization, and a section 332 liquidation.
Result: Step transaction principles apply to treat P’s acquisition of T as if: (1) P acquired a portion of T’s assets (Business 1) and (2) T liquidated.
See Rev. Rul. 67-274; Elkhorn Coal. Under Rev. Rul. 67-274, P’s acquisition of T is not a valid B reorganization. Because T liquidates into P,
Rev. Rul. 67-274 combines the steps and treats the transaction as an acquisition by P of T’s Business 1 assets. In this transaction, the acquisition
does not qualify as a C reorganization because Elkhorn Coal steps together the spin-off and the acquisition such that P cannot be said to acquire
substantially all of T’s assets. Therefore, the transaction will be a taxable acquisition and not a tax-free reorganization.
Issue: Can P’s acquisition of T be treated as a qualified stock purchase followed by a section 332 liquidation? See Rev. Rul. 2001-46; Treas. Reg.
§ 1.338-3(c)(1)(i), (2); Temp. Treas. Reg. § 1.338(h)(10)-1T(c)(2), (e).
170
Acquisitions of Private Companies
Operating in Corporate Entities
Tax-Free Transactions
Troubled Company Issues
171
Debtor Consequences
•
•
•
•
•
If the debtor issues stock or securities to a creditor, it will not recognize gain or
loss. Section 1032(a).
If a debtor corporation transfers its assets to another corporation in an asset
reorganization, including an A, C, D, or G reorganization, solely in exchange for
stock or securities of the acquiring corporation, the debtor will not recognize
gain or loss. Section 361(a).
Where property other than stock or securities (i.e., “boot”) is received, gain
must be recognized, unless the debtor distributes the boot to its shareholders or
creditors. Section 361(b)(1), (3).
In general, the assumption of a liability of the debtor corporation by the acquiror
will not be treated as boot. Section 357(a). However, in the case of a divisive D
reorganization or section 351 transaction, the debtor must recognize gain to the
extent the liabilities assumed exceed the debtor’s basis in the transferred
assets. Section 357(c)(1).
The acquiror succeeds to the tax attributes enumerated in section 381(c).
– Section 382 may apply to limit the use of the corporation’s NOLs after the
acquisition.
172
Creditor Consequences
•
If the creditor is a security holder, it will not recognize gain or loss when it
exchanges its securities for stock or securities of the debtor corporation
pursuant to a recapitalization under section 368(a)(1)(E) or for stock or
securities of the acquiror pursuant to a reorganization under section 368.
Section 354(a)(1).
•
However, the creditor recognizes gain currently with respect to any property
other than stock or securities (i.e., boot) received in the exchange. Section
356(a), (c).
– In addition, if the principal amount of the security received in the exchange
exceeds the principal amount of the security surrendered, then gain will be
recognized to the extent of the excess. Sections 354(a)(2)(A);
356(d)(2)(B).
•
Basis – The creditor’s basis in the new security will equal its basis in the old
security, increased by any gain recognized and reduced by the FMV of any
boot received. Section 358.
•
Holding Period – The creditor’s holding period in the new security will include
its holding period in the old security. Section 1223(1).
173
Creditor Continuity of Interest
•
General Rule – In order to have a tax-free reorganization, there must be a
continuity of interest (“COI”) on the part of those “persons who, directly or
indirectly, were the owners of the enterprise prior to” the reorganization. Treas.
Reg. §1.368-1(b).
– For advance ruling purposes, the IRS requires that the former owners receive stock
of the acquiring corporation equal to 50 percent of the value of the formerly
outstanding stock of the acquired corporation. Rev. Proc. 77-37, 1977-2 C.B. 568.
•
In Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179 (1942), the
Supreme Court held that creditors of an insolvent corporation would be treated
as equity holders for purposes of the COI requirement.
– The Court held that the creditors stepped into the shoes of the shareholders at the
time they instituted bankruptcy proceedings, because from that time on, they had
effective command over the disposition of the property. See also Palm Springs
Holding Corp. v. Commissioner, 315 U.S. 185 (1942); G.C.M. 33,859 (June 25,
1968).
•
In determining whether the 50% COI threshold is met, begin with the most
senior class of creditors that actually receive stock in the reorganization and
end with the last group of creditors or shareholders that receive any
consideration in the reorganization. H.R. Rep. No. 96-833, at 31-32 (1980); S.
Rep. No. 96-1035, at 36 (1980); Atlas Oil & Refining Corp. v. Commissioner, 36
174
T.C. 675 (1961), acq., 1962-2 C.B. 3.
Norman Scott, Inc.
B
$150
Debt
A stock
T
A
Merger
$25 Debt
Facts: Individual B owns all of the stock of A and T. T has assets worth $100 and is indebted to B
in the amount of $150 and to A in the amount of $25. A is solvent. T merges into A, with B
receiving additional A stock in the merger.
Result: The transaction should qualify as a tax-free A reorganization under current law. See
Norman Scott, Inc. v. Commissioner, 48 T.C. 598 (1967), acq. in result only, AOD 1967-104 (Dec.
7, 1967); Rev. Rul. 54-610, 1954-2 C.B. 152; see also G.C.M. 33,859 (June 25, 1968).
175
Norman Scott, Inc.
•
IRS Argument: Because the target was insolvent, any stock that the
shareholder exchanged was worthless; therefore, the shareholder could not
obtain a proprietary interest in the acquiror.
– The Tax Court rejected this argument, concluding that the COI requirement
was satisfied because the shareholders received a proprietary interest in
the acquiror either as a shareholder or as a creditor.
– In G.C.M. 33,859 (June 25, 1968), the IRS analyzed the Tax Court’s
decision.
• The IRS disagreed with the court’s broad conclusion, taking the position that
unless affirmative steps are taken by the creditors to assert their proprietary
interest, the shareholders remain the equity holders of the corporation.
• Nonetheless, the IRS concluded that because of the significant overlap between
the shareholders and creditors, the shareholders satisfied the COI requirement
in their capacity as shareholders, and their status as creditors did not affect that
proprietary interest. See Seiberling Rubber Co. v. Commissioner, 189 F.2d 595
(6th Cir. 1948); Rev. Rul. 54-610.
176
Norman Scott, Inc.
• Alternative IRS Argument: Since the acquiror was also a substantial
creditor of the target, the merger was in reality a satisfaction of
indebtedness (citing Rev. Rul. 59-296, 1959-2 C.B. 87).
– The Tax Court disagreed, distinguishing Hill Stores, Inc. v. Commissioner, 44 B.T.A.
1182 (1941), on which Rev. Rul. 59-296 relied. Hill Stores held that section 332 did
not apply to the liquidation of an insolvent corporation, because there could be no
distribution of assets in cancellation or redemption of the parent’s stock. By
contrast, there is no specific requirement in section 368(a)(1)(A) that there must be
a cancellation or redemption of stock to qualify for a statutory merger.
– The IRS also disagreed with this holding, arguing that sections 354 and 361, the
operative reorganization provisions, require that there be an exchange of property
solely for stock or securities of the transferee corporation. A discharge of debt is
insufficient to satisfy this standard. However, the IRS conceded that the upstream
merger involved in Rev. Rul. 59-296 was distinguishable from a brother-sister
merger.
177
Proposed No Net Value Regulations
•
On March 10, 2005, Treasury and the IRS issued proposed regulations
regarding corporate formations, reorganizations, and liquidations of insolvent
corporations. The proposed regulations generally require the exchange (or, in
the case of a section 332 liquidation, the distribution) of net value for the
nonrecognition rules of sections 332, 351, and 368 to apply. Thus, the
proposed regulations would reverse the result in Norman Scott, Inc.
•
For tax-free reorganizations under section 368, the proposed regulations
require that there be both a surrender and a receipt of net value. Prop. Treas.
Reg. §1.368-1(f)(1).
– Whether net value is surrendered is determined by reference to the assets
and liabilities of the target corporation.
– Whether net value is received is determined by reference to the assets and
liabilities of the issuing corporation.
178
Proposed No Net Value Regulations
• Asset Reorganizations
– There is a surrender of net value if the FMV of the property transferred by
the target exceeds the sum of (i) the target liabilities assumed by the
acquiror in connection with the exchange and (ii) the amount of money and
the FMV of any other property received by the target in connection with the
exchange. Prop. Treas. Reg. §1.368-1(f)(2)(i).
• Any liability that the target owes the acquiror that is extinguished in the
exchange is treated as assumed in connection with the exchange.
– There is a receipt of net value if the FMV of the assets of the issuing
corporation exceeds the amount of its liabilities immediately after the
exchange. Prop. Treas. Reg. §1.368-1(f)(2)(ii).
179
Proposed No Net Value Regulations
• Stock Reorganizations
– There is a surrender of net value if the FMV of the assets of the target
exceeds the sum of (1) the amount of the target liabilities immediately prior
to the exchange and (ii) the amount of money and the FMV of any other
property received by the target shareholders in connection with the
exchange. Prop. Treas. Reg. §1.368-1(f)(3)(i).
• Assets of the target that are not held immediately after the exchange
and liabilities of the target that are extinguished in the exchange are
disregarded.
– There is a receipt of net value if the FMV of the assets of the issuing
corporation exceeds the amount of its liabilities immediately after the
exchange. Prop. Treas. Reg. §1.368-1(f)(3)(ii).
180
Proposed No Net Value Regulations
• Exceptions
– The net value requirement does not apply to E and F reorganizations.
Prop. Treas. Reg. §1.368-1(b)(1).
– The net value requirement does not apply to acquisitive D reorganizations,
provided the FMV of the property transferred to the acquiror by the target
exceeds the amount of target liabilities immediately before the exchange
(including any liabilities cancelled, extinguished, or assumed in connection
with the exchange), and the FMV of the assets of the acquiror equals or
exceeds the amount of its liabilities immediately after the exchange. Prop.
Treas. Reg. §1.368-1(f)(4); see also Rev. Rul. 70-240.
181
Sideways Asset Reorganization -- Parent Debt
P
$160
Debt
A stock
T
Merger
A
Assets = $100
Facts: P owns all of the stock of T and A. T has assets with a fair market value of $100 and liabilities of $160, all of which
are owed to P. T merges into A, with P receiving $100 worth of additional A stock in exchange for its T debt. A is solvent
both before and after the merger.
Result: The transaction should qualify as a tax-free A reorganization under current law. See Norman Scott, Inc., 48 T.C. 598;
Rev. Rul. 54-610, 1954-2 C.B. 152; see also G.C.M. 33,859 (June 25, 1968). The result is the same under the proposed no
net value regulations, because (i) T surrendered net value in that the FMV of the property transferred by T ($100) exceeds the
sum of the liabilities assumed by A ($0) and the amount of money and fair market value of other property received by T in
connection with the exchange ($0), and (ii) T received net value in that the FMV of A’s assets exceeds its liabilities
immediately after the exchange. Prop. Treas. Reg. §1.368-1(f)(2), (f)(5), ex. 2.
What if A issues no stock to T in the reorganization? Compare Laure v. Commissioner, 653 F.2d 253 (6th Cir. 1981) and Rev.
Rul. 64-155, 1964-1 C.B. 138 with Warsaw Photographic Associates, Inc. v. Commissioner, 84 T.C. 21 (1985); see also Prop.
Treas. Reg. §1.368-1(f)(5), exs. 2, 3.
182
Sideways Asset Reorganization -- Third-Party Debt
P
A stock
Creditor
$160 Debt
T
Merger
A
Assets = $100
Facts: P owns all of the stock of T and A. T has assets with a fair market value of $100 and liabilities of $160, all of
which are owed to Creditor. T merges into A, with P receiving $100 worth of additional A stock. A is solvent both
before and after the merger.
Result: The transaction is distinguishable from Norman Scott, Inc., but it should qualify as a tax-free A reorganization
under the IRS’s reasoning in G.C.M. 33,859 (June 25, 1968) that because Creditor had not taken affirmative steps to
assert its proprietary interest, P remains the holder of the proprietary interest. However, the merger does not satisfy the
net value requirement of the proposed regulations, because T does not surrender net value—the FMV of the property
transferred by T ($100) does not exceed the sum of the liabilities assumed by A ($160) and the amount of money and
fair market value of other property received by T in connection with the exchange ($0). Prop. Treas. Reg. §1.3681(f)(2)(1).
183
Sideways Asset Reorganization -- Brother-Sister Debt
P
A stock
T
Assets = $100
Merger
A
$160 Debt
Facts: P owns all of the stock of T and A. T has assets with a fair market value of $100 and liabilities of $160, all of which
are owed to A. T merges into A, with P receiving $100 worth of additional A stock. Assume further that the T debt is worth
$100, and A has other assets worth $400, so A is solvent both before and after the merger.
Result: The transaction should qualify as a tax-free A reorganization under current law. See Norman Scott, Inc., 48 T.C. 598;
G.C.M. 33,859 (June 25, 1968). However, the merger does not satisfy the net value requirement of the proposed regulations,
because T does not surrender net value. The proposed regulations treat debt owed by the target to the acquiring corporation
that is extinguished in an exchange as if it were assumed by the acquiring corporation. Prop. Treas. Reg. §1.368-1(f)(2)(i).
Thus, the FMV of the property transferred by T ($100) does not exceed the sum of the liabilities assumed by A ($160) and the
amount of money and fair market value of other property received by T in connection with the exchange ($0). Prop. Treas.
Reg. §1.368-1(f)(2)(1).
What if the direction of the merger were reversed, so that A merged into T?
See Prop. Treas. Reg. §1.368-1(f)(5) ex. 6.
184
Sideways Asset Reorganization -- D Reorganization
P
$160
Debt
Cash
T
Assets
A
Assets = $100
Facts: P owns all of the stock of A and T. T has assets worth $100 and is indebted to P in the amount of $160. A
is solvent. T transfers all of its assets and liabilities to A in exchange for $100 cash. T distributes the cash to P in
complete liquidation.
Result: The transaction should be a tax-free D reorganization under current law. See Rev. Rul. 70-240, 1970-1
C.B. 81; Rev. Rul. 2004-83, 2004-32 I.R.B. 157. Although the proposed regulations exclude D reorganizations
from the net value requirement, they do so only if the target is solvent immediately before the exchange and the
acquiror is solvent immediately after. Because T is insolvent before the exchange, the exclusion does not apply.
The transaction would not qualify as tax free, because T does not surrender net value – the FMV of the property
transferred by T ($100) does not exceed the sum of the liabilities assumed by A ($0) and the amount of money and
fair market value of other property received by T in connection with the exchange ($100). Prop. Treas. Reg.
§1.368-1(f)(2)(1); see Prop. Treas. Reg. §1.368-1(f)(5) ex. 8.
185
Proposed Creditor Continuity of Interest Regulations
•
Proposed Creditor Continuity Regulations – Along with the no net value regulations proposed
on March 10, 2005, Treasury and the IRS proposed rules regarding creditor COI.
– Treating Creditors’ Claims as Proprietary Interest
• The proposed regulations treat a creditor’s claim against a target corporation as a
proprietary interest if (i) the target is in a title 11 or similar case, or (ii) the target is insolvent
immediately before the reorganization. In such cases, if any creditor receives a proprietary
interest in the issuing corporation in exchange for its claim, then every claim of that class of
creditors and every claim of all equal and junior classes of creditors is a proprietary interest
in the target corporation. Prop. Treas. Reg. §1.368-1(e)(6)(i).
• Shareholders retain their proprietary interest in the target corporation notwithstanding that
creditors are treated as having a proprietary interest. Prop. Treas. Reg. §1.368-1(e)(6)(iv).
– Measuring COI
• Senior Creditors – The claims of the most senior class of creditors to receive a proprietary
interest and all other equal creditors (together the “senior creditors”) represent, in part, a
creditor claim and, in part, a proprietary interest. The portion of the claim treated as a
proprietary interest is equal to (Prop. Treas. Reg. §1.368-1(e)(6)(ii)(B)):
FMV of creditor’s claim x
FMV of proprietary interests issued to senior creditors
Total consideration paid to senior creditors
• Junior Creditors – The claims of the junior creditors are treated as a proprietary interest in
full. Prop. Treas. Reg. § 1.368-1(e)(6)(i).
186
Creditor Continuity of Interest
T Shareholders
$55 A stock
$95 Cash
Secured
$20 Claim
Unsecured
$30 Claim
$24 Cash/$6 Stock
T
Merger
A
Junior
$150 Claim
Facts: T is in bankruptcy and has assets with a fair market value of $150 and liabilities of $200. T has three classes of
creditors: senior secured with claims of $20, senior unsecured with claims of $30, and junior unsecured with claims of $150.
Pursuant to the plan of reorganization, T transfers its assets to A in exchange for A stock worth $55 and $95 cash. T
distributes $16 cash and $4 stock to the senior secured creditors; $24 cash and $6 stock to the senior unsecured creditors; and
$55 cash and $45 stock to the junior unsecured creditors. T’s shareholders receive nothing.
Result: Applying current law, the most senior class of creditors to receive stock is the senior secured and the most junior
class to receive any consideration is the junior unsecured creditors, so all classes count toward COI. The COI requirement is
likely not satisfied because only $55 out of the total $150 consideration, or 36.6%, consisted of A stock.
Under the proposed regulations, the senior creditors together receive $40 cash and $10 in A stock. The value of their
proprietary interest is $10 (i.e., $50 value of claims x ($10 stock received by senior creditors ÷ $50 total consideration). The
value of the junior creditors’ claims is $100. The COI requirement is satisfied, because A is treated as acquiring $55 of the
total $110 claims , or 50%, in exchange for stock. See Prop. Treas. Reg. §1.368-1(e)(7) ex. 10.
187
Acquisitions of Private Companies
Due Diligence Issues
188
Due Diligence Issues
• Importance of Tax Due Diligence Investigation
– Identifies latent tax liabilities in pre-acquisition
years
• stock acquisition – these liabilities come with target
• asset acquisition – tax liens on acquired assets
– Identifies future tax issues
• Aggressive income tax accounting positions
– May affect acquisition price
– Affects representations and warranties in
acquisition agreement
– May affect structure of acquisition transaction
189
Due Diligence Issues
• Factors that can make complete tax due
diligence investigation impracticable
– Compressed timetable for acquisition
– Missing documents
• Closely-held companies often do not generate detailed
workpapers
– Uncooperative/unavailable seller personnel
• Can reduce exposure by capturing infirmities
of investigation in tax indemnification
agreement
– Discussed later
190
Due Diligence Issues
• Typical Items to Review
– Structure of target
• Subsidiaries?
• Pass-through entities, including disregarded entities?
– Tax and book bases for all target assets, including
interests in subsidiaries and pass-through entities
– Stated value for all target assets
• Any appraisals?
– Financial statements (if any)
– Liabilities
• Existing contingent liabilities
• Potential issues that may bloom into liabilities in future
191
Due Diligence Issues
• Typical Items to Review (cont.)
– All tax returns (and workpapers) for all open years
• In closely-held companies, this may include personal returns of
owners as well.
• Aggressive positions?
• What (if any) information supports numbers on return?
– Tax-planning memoranda (if any)
– Accountant’s workpapers (if any)
– All correspondence between company/owners and IRS
•
•
•
•
IDRs/RARs/Appeals Protests/Requests for Refund/PLRs/etc.
Extensions of SOLs
Closing Agreements
Target or its owners regularly audited?
192
Due Diligence Issues
• Typical Items to Review (cont.)
– State/local/int’l tax exposure – same review required as for
Federal tax exposure
• Any potential property tax issues?
– Property tax bills
– Real estate appraisals
• Any sales/use tax issues?
– Income tax accounting methods
•
•
•
•
•
•
Any change in prior years?
Depreciation methods
Inventory methods
Capitalization methods
Installment sales
All tax elections
193
Due Diligence Issues
• Typical Items to Review (cont.)
– How was Target or assets of Target acquired by
current owners/sellers?
• Is reported tax basis proper?
– Transactions between Target and its owners
• Distributions really compensation?
• Compensation really distributions?
• Contributions and related distributions really sales?
– Employment tax compliance?
194
Due Diligence Issues
• Typical Items to Review (cont.)
– Special items to review if Target is S corporation:
• Initial S election
– All required shareholder consents?
– Timely?
• List of all shareholders (current and previous)
– Determine whether ineligible shareholder
• All governing documents
– Determine whether have second class of stock
• Prior conversion from C corporation status
– Proper valuation/appraisal performed?
– Is valuation/appraisal consistent with financial statements (if any)?
– Can you readily identify which assets were acquired in C status and
which assets were acquired in S status?
• Prior acquisitions from C corporations
• Amount and type of passive income
195
Due Diligence Issues
• Acquisition Agreement
– Remember that tax issues are just a subset of the
issues addressed by the agreement
– Who drafts the agreement?
• Drafter can control negotiation process to an extent
• But, drafter will incur more transaction costs
• Typical Tax-Related Provisions
– Tax Representations/Warranties
– Tax Covenants
– Tax Indemnities
• What type of taxes will be addressed?
196
Due Diligence Issues
• Acquisition Agreement – Rep.’s & Warranties
– Tax returns have been “properly” filed in past
• How far in past?
• What tax returns?
• “Proper” measured by reflection of all facts regarding
Target matters?
• “Proper” measured by fact that all tax positions have
substantial authority?
• Seller may want to reduce exposure by inserting
“materiality” qualifier
197
Due Diligence Issues
• Acquisition Agreement – Rep.’s & Warranties
– Tax has been paid in past
•
•
•
•
•
How far in past?
What type of tax?
Tax only with respect to assets acquired?
Tax shown on a return only?
Tax shown on a return plus any tax attributable to
disclosed items?
• Tax shown on a return plus any tax relating to audit
issues attributable to pre-closing period?
• Payment of interest and penalties as well?
• Seller may want to reduce exposure by inserting
“materiality” qualifier
198
Due Diligence Issues
• Acquisition Agreement – Rep.’s & Warranties
– All prior or current audit issues disclosed
• Disclose which years are closed, being audited,
unaudited
• Seller may want to reduce exposure by inserting
“materiality” qualifier
– No waivers of SOLs made, except to extent
disclosed
– No tax liens on Target assets, except to extent
disclosed
– All tax elections of Target disclosed
199
Due Diligence Issues
• Acquisition Agreement – Rep.’s & Warranties
– Attached schedule sets forth:
•
•
•
•
tax and book bases of Target assets
value of Target assets
earnings and profits (current and accumulated)
tax attributes (e.g., NOLs)
– Each Target asset is owned for tax purposes by
Target
– Attached schedule sets forth:
• Target liabilities, including contingent liabilities
200
Due Diligence Issues
• Acquisition Agreement – Rep.’s & Warranties
– If section 338(h)(10) transaction, seller and buyer
are eligible to make section 338 election
– If section 338(h)(10) or section 1060 transaction,
purchase price shall be allocated among the
purchased assets in accordance with the residual
method under section 338
• Attached schedule lists FMV of assets (other than
GW/GCV) for this purpose; or
• Seller accepts buyer’s determination of FMV of each
asset unless objects within certain time period
– Seller and buyer will make required tax disclosures in
consistent manner
201
Due Diligence Issues
• Acquisition Agreement – Rep.’s & Warranties
– Target is the type of entity that you think it is
• E.g., Seller represents that it is an S corporation for all
tax purposes
– Target owners are the type of owners you think
they are
• E.g., Owners are not foreign persons
• E.g., Owners are eligible to own stock in an S
corporation for all tax purposes
202
Due Diligence Issues
• Acquisition Agreement – Rep.’s & Warranties
– Should restate/update representations and
warranties as of time of closing
– Should survive for appropriate period of time after
closing
• E.g., period tied to expiration of all relevant SOLs
• E.g., fixed time period – not recommended for
purchaser since SOLs can remain outstanding
indefinitely for failure to file a return or fraudulent
returns
203
Due Diligence Issues
• Acquisition Agreement – Covenants
– Address straddle period issues
• Time between signing agreement and closing
– Who prepares and files tax returns?
» If seller, make subject to purchaser’s consent?
– Who pays taxes?
» Who has the right to the income of the relevant Target
assets?
– Notice of initiation of/participation in tax proceedings regarding
Target or Target’s assets
– Making tax elections
» Subject to purchaser’s consent?
– Who will pay transfer taxes at closing?
204
– Who will handle employment tax issues?
Due Diligence Issues
• Acquisition Agreement – Indemnities
• Indemnities should be structured to make purchaser
whole upon breach of representation, warranty, or
covenant of seller
• Typical Issues
– Time period?
• At least as long as rep.’s/warranties/covenants survive (i.e., some
time beyond expiration of all relevant SOLs)
– From whom can purchaser seek payment?
• In asset purchase, selling entity may not have resources to pay
indemnity – must get owners on the hook
• Should purchaser escrow portion of purchase price to fund
indemnity?
205
Due Diligence Issues
• Acquisition Agreement – Indemnities
• Typical Issues (cont.)
– Indemnified amount?
• Cap on aggregate claims and/or individual claims? -reduces risk to seller
• Floor on individual claims? – avoids immaterial
disputes
– Gross-up of indemnification payment?
206
Due Diligence Issues
• Acquisition Agreement – Indemnities
• Typical Issues (cont.)
– What process should be used to determine whether a
claim qualifies for indemnification?
• Committee of representatives from buyer and seller?
• Third-party mediator?
– Who controls underlying controversy?
• Purchaser must challenge IRS claims in good faith
• Purchaser’s advisor fees reimbursed currently by Seller
– When does claim ripen?
• After RAR issued?
• After IRS Appeals?
• After final determination by courts?
– How far must purchaser pursue – denial of cert. from U.S. Supreme
Court?
• Must take refund route only (i.e., cannot go to Tax Court)?
207