Chapter 11 Flashcards
Examples of Reshuffling the Corporate Structure
E Reorganization
Reshuffling of the Corporate Structure
Examples:
- Voting common for nonvoting common
- Common for a combination of common and preferred
- Preferred for common
- Preferred for preferred (with different terms)
- Common for debt securities
- Securities for securities (with different terms)
Primary Concern of Government:
E Reorganization will be used as a “bail-out” of corporate earnings!!
Facts of Bazley v Commissioner
Bazley v. Commissioner
Facts:
- Bazley and his wife owned a family corporation (note that one share out of 1,000 was owned by an unrelated party – we will ignore this unrelated party)
- Under the plan of reorganization (for an E reorganization), the shareholders would receive 5 shares of new common and new debenture bonds. Such bonds were payable in 10 years but were callable at any time by the corporation
- The corporation had significant retained earnings
- Thus, the taxpayer received bonds with a principal amount of $319,200
- The IRS treated the debentures as a dividend and the tax court affirmed the Commissioner’s position
- The tax court found that the reorganization had no business purpose
- The court held that the recapitalization was a disguised dividend to the extent of the bonds distributed
- The Circuit Court of Appeals affirmed the lower court’s decision
- The Supreme Court agreed to hear the case
Issue:
Was this a valid E reorganization or was the recapitalization nothing more than a bail-out of E&P?
Holding:
It was an impermissible bail-out of earnings
Note that today, issuing securities in exchange for common stock is taxable since the securities will be treated as boot. The same is true of issuing NQPS since the NQPS is treated as a debt instrument rather than a equity instrument.
In the world of E reorganizations, there is a small exception which allows NQPS to be issued in a recapitalization of a family corporation (see §354(a)(2)(C)(ii)).
What is a security?
What is a Security?
- The code does not provide a definition
- Based on tax cases and rulings, securities are:
- Debt instruments with a life at issuance of at least 5 years
- Type of instrument held as an investment in the debtor’s business
- Clearly, short-term notes, accounts payable, other short-term liabilities are not treated as securities
What is the ‘non-qualified preferred stock bail-out’?
Nonqualified Preferred Stock “Bail-Out”
- Prior to 1997, transactions similar to the Bazley transaction were effected with Nonqualified Preferred Stock (NQPS)
- In 1997, Congress passed §351(g)
- NQPS is generally treated as boot in an E reorganization
What judicial doctrines DO NOT apply to an E reorg?
E Reorganization
The following judicial doctrines do NOT apply to an E reorganization:
- Continuity of shareholder interest
- Continuity of business enterprise
Generally, if these tests were required of an E reorganization, most E reorganizations would still qualify. One exception may be a corporation that sells off its business immediately before effecting the E reorganization
Facts of Rev Ruling 82-34
Revenue Ruling 82-34
- As it relates to reorganizations in general, the regulations (§ 1.368-1(d)) require “that the transferee in a corporate reorganization must either (i) continue the transferor’s historic business or (ii) use a significant portion of the transferor’s historic business assets in a business.”
- Similar provisions exist as it relates to the continuity of shareholder interest requirement in a transfer of stock or assets of one corporation to another corporation. (see § 1.368-1(b)).
- In an E reorganization there is no transferee. As such, continuity of business enterprise and continuity of shareholder interest do not apply.
- Note that in 2005, § 1.368-1(b) was amended to provide that the doctrines of continuity of shareholder interest and continuity of business enterprise are not required for a transaction to qualify as an E reorganization.
What are the issues of 306 stock in a recapitilization?
§306 Stock in a Recapitalization
- If a common shareholder receives preferred stock (not NQPS) in an E reorganization, the potential exists that such preferred stock will be treated as §306 stock.
- If cash had been distributed to the shareholder in the E reorganization instead of preferred stock and such cash would have been taxable as a dividend, then the preferred stock will be treated as §306 stock.
- If prior to the E reorganization, a shareholder holds preferred stock in the corporation and such preferred stock is §306 stock, then the preferred stock received by the shareholder in the E reorganization will also be treated as §306 stock.
- If the §306 preferred stock held prior to the E reorganization is traded for common stock in the reorganization, such common stock will NOT be treated as §306 stock
- If in an E reorganization, boot is received in exchange for §306 stock, such boot is treated as a dividend distribution under §301.
What is an F reorganization?
F Reorganization
Reincorporation in a Different State
- Old corporation (in State X) merges into New corporation (formed in State Y)
- For income tax purposes, the merger is ignored.
- As such, though two corporations are involved in the reorganization, the income tax law treats the reorganization as though only one corporation is involved – i.e., the reorganization is a “single corporation” reorganization!!
- For the year of the reorganization, only one tax return is filed for the two corporations – the corporation does NOT file two stub period returns (one for the old corp and one for the new corp)
- The old corporation’s tax attributes (NOLs, credit carryovers, E&P, etc.) and elections (accounting method, depreciation methods, year-end, etc.) carryover to the new corporation
- Only one “old” corp and one “new” corp can be involved in a given F reorganization. In other words, an F reorganization only involves one operating company.
- Frequently, F reorganizations are combined with other reorganizations – this is permissible even though they may appear to create step transactions
Facts of Rev Ruling 96-29 Situation 1
Revenue Ruling 96-29
Two Situations:
Situation 1:
- Q is a manufacturing corporation.
- All of its common stock is owned by 12 individuals; a variety of corporate and noncorporate shareholders own its nonvoting preferred stock (which makes up about 40% of its equity structure by value)
- Q desires to go public to raise additional capital
- Q enters into an underwriting agreement providing for a public offering and a change in its state of incorporation
- The plan was to reincorporate in State N to take advantage of its “public offering” laws
- Q was reincorporated in State N and immediately thereafter went public and redeemed the outstanding preferred stock
- The newly issued public stock amounted to 60% of all outstanding stock following the public offering
Issue:
Is this a valid F reorganization given that the reorganization was coupled with two other significant steps – redemption of the preferred stock amounting to 40% of the corporation’s capital and the issuance of additional shares which ultimately amounted to 60% of the corporation’s capital?
Holding:
Yes, even though it appears to be a step transaction type problem, the reorganization is valid
Facts of Rev Ruling 96-29 Situation 2
Revenue Ruling 96-29
Two Situations:
Situation 2:
- W is a manufacturing corporation incorporated in State M
- All of W’s stock is owned by two individuals
- W conducts its business through several wholly owned subsidiaries
- W desired to acquire the business of Z, an unrelated corporation and combine it with the business of Y (a wholly owned subsidiary of W)
- W desired to change its state of incorporation
- Z was merged into Y in a forward triangular merger and immediately thereafter (and as part of the same overall plan) W was reincorporated in State R under an F reorganization
Issue:
Is this a valid F reorganization given that the reorganization was coupled with the triangular merger?
Holding:
Yes, even though it appears to be a step transaction type problem, the reorganization is valid
Issues of a Nondivisive D Reorg
Nondivisive D Reorganization
- Very simple reorganization
- Corporation 1 forms corporation 2 (it is permissible for corporation 2 to be an existing corporation)
- Corporation 1 drops “substantially all” of its assets and liabilities into corporation 2 as a tax-free transaction
- Corporation 1 now owns 100% of corporation 2 (note that it doesn’t have to own 100%. It is required that corporation 1 “control” corporation 2 – a 50% test)
- Corporation 1 liquidates distributing 100% of the stock of corporation 2 to the shareholders of corporation 1 in exchange for the shareholders’ corporation 1 stock
The end result is similar to that of an F reorganization
What are the issues of a Liquidation Reorganization?
Liquidation-Reincorporation
IRS has attacked such transactions by trying to force them into one of the tax-free reorganizations thus:
- Shareholders holding stock with a built-in loss (stock basis in excess of FMV of stock) could recognize their stock loss – no loss allowed since tax-free reorganization precludes such losses
- Bail-out excess liquid assets at capital gains rates – the “bail-out” of these excess assets would be treated as boot and likely result in a dividend once the §302(b) tests are failed
- Corporate parent could use expiring capital losses (such losses would offset the capital gain generated from the liquidation) – since there is no gain on liquidation (i.e., there is no liquidation), the expiring capital losses will not be used
- Shareholders could use expiring NOLs (the trade-off would be an increased basis in the new corporation’s stock) – since there is no gain on liquidation, the expiring NOLs will not be used
Why does a liquidation-reorg have little value today?
Liquidation-Reincorporation
Today, this strategy has little value for two reasons:
- It’s expensive. With the repeal of General Utilities in 1986, the liquidating corporation must pay corporate tax on the built-in gain resident in the corporate assets. For most corporations, this functionally precludes considering a liquidation – it’s too expensive.
- The dividend rate is relatively low at 15% (same as capital gain rate). Why not simply take the income as dividend income (yes, you don’t recover basis!!).
