Chapter 19
Corporate Formation,
Reorganization, and Liquidation
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
1.
Recall the general tax rules that apply to
property transactions
2.
Compute the tax consequences to the parties to
a tax-deferred corporate formation
3.
Identify the different forms of taxable and taxdeferred acquisitions
19-2
Learning Objectives
4.
Compute the tax consequences to the parties to
a corporate acquisition
5.
Calculate the basic tax law consequences that
apply to the parties to a complete liquidation of a
corporation
19-3
Tax-Deferred Transfers of Property to a
Corporation

Without any tax provision to the contrary, transfers
of property to a corporation in return for the
corporation’s stock would be taxable events if the
property was appreciated or depreciated (§1001).
Gain/loss to the transferor
FMV of stock received
– Basis of property transferred
(+) Gain () Loss

A loss is disallowed under §267 if the transferor is
“related” to the corporation (owned more than 50% after
the transfer).
19-4
Tax-Deferred Transfers of Property to a
Corporation

§351 facilitates corporate formations by providing
for gain and loss deferral on property transfers
that meet its requisites.

§351 was enacted in 1921 to remove tax
consequences as an impediment to forming a
corporation and allow flexibility in choosing the
preferred form of doing business.
19-5
Tax-Deferred Transfers of Property to a
Corporation

§351 contemplates a transfer of property by a
person or persons who maintain a “continuity of
proprietary interest” in the assets transferred
(through stock ownership in the corporation now
holding the assets).
19-6
Tax-Deferred Transfers of Property
to a Corporation

Transactions Subject to Tax Deferral

Meeting the Section 351 Tax Deferral Requirements

Section 351 applies Only to the Transfer of Property to the
Corporation (Services are excluded)

Property transferred to the corporation must be exchanged solely
for stock of the corporation


Receipt of boot will cause the transferor to recognize gain,
but not loss, realized on the exchange

Boot – Adding additional property to equalize the exchange
Transferor(s) of property to the corporation must be in Control, in
aggregate, of the corporation immediately after the transfer.
19-7
Tax-Deferred Transfers of Property
to a Corporation

Tax consequences when a shareholder receives
other property (boot)

A shareholder recognizes gain (but not loss) in an
amount not to exceed the lesser of



Gain realized
The fair market value of the boot received
Boot in a §351 transaction must be allocated to the
property exchanged on a pro rata basis using the
relative fair market values of the properties.
19-8
Tax-Deferred Transfers of Property
to a Corporation


The character of gain recognized depends on the
nature of the asset transferred on which gain is
recognized.

§1231 (capital) gain

§1245 depreciation recapture

Ordinary income
Boot received has a tax basis equal to its fair
market value.
19-9
Tax-Deferred Transfers of Property to a
Corporation

Assumption of shareholder liabilities by the
corporation

General rule – a shareholder’s liability attached to
property transferred is not treated as boot received.

Two exceptions in which liability assumed by the
corporation is treated as boot


Tax-avoidance transactions
Liabilities in excess of Basis
19-10
Tax-Deferred Transfers of Property to a
Corporation

Other issues related to incorporating an ongoing
business

Depreciable assets transferred to a corporation


Practitioners often advise against transferring appreciated
property into a closely held corporation
 Helps shareholder in creating two assets with the same
built in gain as of the original property
The federal government can now collect taxes twice on the
same gain
 When the corporation sells the property received and
 When shareholder sells the stock
19-11
Tax-Deferred Transfers of Property to a
Corporation

Contributions to Capital




Transfer of property to a corporation by a
shareholder/nonshareholder for which no stock or other
property is received in return
When property is contributed by a shareholder,
corporation takes a carryover tax basis in the property
When property is contributed by a nonshareholder,
corporation’s tax basis in the property is zero
Shareholder making a capital contribution gets a
chance to increase the tax basis in existing stock to an
amount equal to the tax basis of the property
contributed
19-12
Tax-Deferred Transfers of Property to a
Corporation

Section 1244 Stock

Corporation is



Qualifying small business corporation (capitalized for less than
$1 million) and
Original holder of the stock
Corporation must meet the active trade or business
requirement for 5 years before the stock meets the
§1244 requirements
19-13
Tax-Deferred Transfers of Property to a
Corporation

If the §1244 requirements are met

The shareholder can recognize up to $50,000 per year of loss
($100,000 in the case of married, filing jointly) on subsequent
sale of the stock as an ordinary loss, rather than as a capital
loss

The balance amount of loss is treated as a capital loss, which
can offset other capital gains plus $3,000 of ordinary income.
19-14
Taxable and Tax-deferred Corporate
Acquisitions

Motivation for Business Acquisitions

Decision to acquire an existing business can be
motivated by many factors

Desire to diversify

Acquire a source of raw materials (vertical integration)

Expand into new product or geographic markets

Acquire specific assets or technologies

Providing improved distribution channels
19-15
Taxable and Tax-deferred Corporate
Acquisitions

Buyer can purchase either stock or assets in a
transaction that is either taxable or tax-deferred to the
seller

Allows the acquiring corporation to step-up the tax basis
of the assets acquired to fair value

Stock acquisitions and tax-deferred asset acquisitions

Tax basis of the target corporation’s assets remain at their
carryover basis (generally, cost less any depreciation)
19-16
Computing the tax consequences to the
parties from a Corporate Acquisition

Taxable Acquisitions


Cash purchases of stock are the most common form of
acquisition of publicly held corporations
Using cash to acquire another company has several
nontax advantages



Acquiring corporation does not “acquire” the target corporation’s
shareholders in the transaction
Does not increase the denominator in its calculation of earnings
per share
If one company acquires another company through a
stock acquisition for cash, then acquired company retains
its tax and legal identity unless acquiring company
liquidates acquired company into itself or merges it into
an existing subsidiary
19-17
Computing the tax consequences to the
parties from a Corporate Acquisition

Tax-Deferred Acquisitions

Tax law allows



Taxpayers to organize a corporation in a tax-deferred manner
under §351
Taxpayers to reorganize their corporate structure in a tax deferred
manner
For tax purposes, reorganizations encompass




Acquisitions and dispositions of corporate assets (including
subsidiaries stock)
Corporation’s restructuring of its capital structure
Place of incorporation
Company name
19-18
Computing the tax consequences to the
parties from a Corporate Acquisition

Judicial principles that underlie all Tax-deferred
Reorganizations

Continuity of Interest (COI)

Shareholders of the acquired corporation retain a continuing
ownership interest in the target corporation’s assets or historic
business through ownership of stock in the acquiring corporation
19-19
Computing the tax consequences to the
parties from a Corporate Acquisition

Continuity of Business Enterprise (COBE)


For a transaction to qualify as a tax-deferred reorganization, the
acquiring corporation must

Continue the target corporation’s historic business or

Continue to use a significant portion of the target
corporation’s historic business assets
Business Purpose Test

Acquiring corporation must be able to show a significant nontax
avoidance purpose for engaging in the transaction for meeting
business purpose test
19-20
Computing the tax consequences to the
parties from a Corporate Acquisition

Type A Asset Acquisitions

One corporation acquires the assets and liabilities of another
corporation in return for stock or a combination of stock and cash

Acquisition is tax-deferred if the transaction satisfies the
continuity of interest, continuity of business, and business
purpose requirements

Must meet state law requirements to be a merger or
consolidation
19-21
Computing the tax consequences to the
parties from a Corporate Acquisition

Forward Triangular Type A Merger





Acquiring corporation uses stock of its parent corporation to
acquire the target corporation’s stock, after which the target
corporation merges into the acquiring corporation
For tax-deferred purpose, the transaction must meet the
requirements to be a Type A merger
Acquiring corporation must use solely the stock of its parent
corporation and acquire “substantially all” of the target
corporation’s property in the transaction
Target corporation merges into an 80 percent or more owned
acquisition subsidiary of the acquiring corporation
Acquisition subsidiary must acquire “substantially all” of the target
corporation’s properties in the exchange
19-22
Computing the tax consequences to the
parties from a Corporate Acquisition

Reverse Triangular Type A Merger

Acquiring corporation uses stock of its parent corporation to
acquire the target corporation’s stock, after which the acquiring
corporation merges into the target corporation

For tax-deferred purpose, the transaction must satisfy three
requirements
 Surviving corporation must hold “substantially all” of the
properties of both the surviving and the merged corporations
 Target shareholders must transfer in exchange an amount
of stock in the target that constitutes control of the target (80
percent or more of the target’s stock)
 Target shareholders must receive parent corporation voting
stock in return
19-23
Computing the tax consequences to the
parties from a Corporate Acquisition

Type B Stock-for-Stock Reorganizations




Acquiring corporation must exchange solely voting stock for
stock of the target corporation
Acquiring corporation must control the target corporation after the
transaction
Acquiring corporation takes a carryover tax basis in the target
corporation stock received in the exchange
For tax-deferred purpose, the target shareholders must receive
solely voting stock of the acquiring corporation
19-24
Computing the tax consequences to the
parties from a Corporate Acquisition

Type C




Acquiring corporation uses its voting stock to acquire
“substantially all” of the target corporation’s assets
End result of a Type C reorganization resembles a Type A
reorganization
Major difference between Type C and Type A is that state law
governs the form of the Type A merger, while the IRC governs
the form of the Type C reorganization
Type D

Corporation transfers all or part of its assets to another
corporation, and immediately after the transfer the shareholders
of the transferor corporation own at least 50 percent of the voting
power or value of the transferee corporation and own at least 80
percent of the transferee corporation
19-25
Computing the tax consequences to the
parties from a Corporate Acquisition

Type E



Type F



Often referred to as recapitalizations
Recapitalizations can range from an amendment in the corporate
charter to a change in the redemption price or liquidating value of
stock to an actual exchange of stock between the corporation
and its shareholders
Described as a “mere change in identity, form, or place of
organization” of a single corporation
Corporation uses this type of reorganization to change its
corporate name or its state of incorporation
Type G

Often referred to as bankruptcy reorganizations
19-26
Computing the tax consequences to the
parties from a Corporate Acquisition

Cash mergers generally are carried out through an
acquisition (merger) subsidiary.

An acquisition subsidiary isolates the liabilities of T in a
separate corporation apart from the parent company.

The transfer of cash to the Target shareholders is
taxable to the shareholders.
19-27
Complete Liquidation of a Corporation

Occurs when a corporation acquires all of its
stock from all of its shareholders in exchange for
“all” of its net assets, after which time the
corporation ceases to do business

For tax purposes, Form 966 needs to be filed by
corporation in order to inform IRS of its intention
to liquidate its tax existence

Form should be filed within 30 days after the
owners resolve to liquidate the corporation
19-28
Complete Liquidation of a Corporation

Tax Consequences to the Shareholders in a
Complete Liquidation

Depends on


Shareholder’s identity
Ownership percentage in the corporation

All noncorporate shareholders receiving liquidating
distributions have a fully taxable transaction

Shareholders treat the property received as in “full
payment in exchange for the stock” transferred
19-29
Complete Liquidation of a Corporation

A noncorporate shareholder computes capital gain or
loss by subtracting the stock’s tax basis from the money
and FMV of property received in return

Shareholder’s tax basis in the property received equals the
property’s fair market value
19-30
Complete Liquidation of a Corporation

Corporate shareholders owning 80 percent or more of
the stock of the liquidating corporation do not recognize
gain or loss on the receipt of liquidating distributions.

The tax basis in the property transferred carries over to the
recipient which allows a group of corporations under common
control to reorganize their organizational structure without tax
consequences.
19-31
Complete Liquidation of a Corporation

Taxable Liquidating Distributions

Liquidating corporation recognizes all gains and certain
losses on taxable distributions of property to
shareholders

Liquidating corporation does not recognize loss if the
property is



Distributed to a related party
Distribution is non-pro rata
Asset distributed is disqualified property
19-32
Complete Liquidation of a Corporation

Disqualified property is property acquired within five
years of the date of distribution in a tax deferred §351
transaction or as a nontaxable contribution to capital.

Loss on the complete liquidation of such property is not
recognized if the property distributed was acquired in a
§351 transaction or as a contribution to capital, and a
principal purpose of the contribution was to recognize a
loss by the liquidating corporation.
19-33
Complete Liquidation of a Corporation

This rule prevents a built-in loss existing at the time of
the distribution from being recognized by treating the
basis of the property distributed as being its FMV at the
time it was contributed to the corporation.

This provision is designed as an anti-stuffing provision to
prevent shareholders from contributing property with
built-in losses to a corporation shortly before a liquidation
to offset gain property distributed in the liquidation.
19-34
Complete Liquidation of a Corporation
Nontaxable Liquidating Distributions


The liquidating corporation does not recognize gain or
loss on tax-free distributions of property to an 80
percent corporate shareholder.

Liquidation-related expenses, including the cost of
preparing and effectuating a plan of complete
liquidation, are deductible by the liquidating corporation
on its final Form 1120.

Deferred or capitalized expenditures such as
organizational expenditures also are deductible on the
final tax return.
19-35