Chapter 7 - Reorganizations Flashcards
Reorganization
Any corporate restructuring, including when one corporation acquires another, a single corporation divides into two or more entities, a corporation makes a substantial change in its capital structure, a corporation undertakes a change in its legal name or domicile, or a corporation goes through a bankruptcy proceeding and continues to exist. The exchange of stock and other securities in a corporate reorganization can be effected favorably for tax purposes if certain statutory requirements are followed strictly. Tax consequences include the nonrecognition of any gain that is realized by the shareholders except to the extent of boot received. § 368.
What are some requirements to qualify as a tax-free reorganization?
- There must be a plan of reorganization.
- The reorganization must meet the continuity of interest and the continuity of business enterprise tests provided in the Regulations.
- The judicial doctrine of having a sound business purpose must be met.
- The court-imposed step transaction doctrine should not be applicable.
What is the most important consideration of reorganization?
Does it qualify for nonrecognition status under section 368?
Type A
A statutory merger or consolidation.
Type B
The acquisition by a corporation of another using solely stock of each corporation (voting-stock-for-stock exchange).
Type C
The acquisition by a corporation of substantially all of the property of another corporation in exchange for voting stock (voting-stock-for-asset exchange). The target liquidates after distributing all assets received in the reorganization as well as any of its own property retained.
Type D
The transfer of all or part of a corporation’s assets to another corporation when the original corporation’s shareholders are in control of the new corporation immediately after the transfer (divisive exchange: spin-off, split-off, or split-up).
Type E
A recapitalization.
Type F
A mere change in identity, form, or place of organization.
Type G
A transfer by a corporation of all or a part of its assets to another corporation in a bankruptcy or receivership proceeding. The stock and securities are distributed to the senior creditors in exchange for their claims against the debtor.
The tax treatment for the parties involved in a tax-free reorganization almost parallels which other tax treatment?
like-kind exchange provisions of § 1031
When an investor exchanges stock in one corporation for another, the exchange generally constitutes…
a taxable transaction
Corporations meeting the § 368 requirements…
do not recognize current gains or losses on reorganizations (gain recognition may occur if other property is transferred by the acquiring corporation in the reorganization)
Other Property
In a corporate reorganization, any property in the exchange that is not stock or securities, such as cash or land. This amount constitutes boot. This treatment is similar to that in a like-kind exchange.
If boot is transferred…
gain but NOT loss may be recognized
What is the gain recognized by a stockholder in a reorganization?
The lesser of the boot received of the the realized gain
What is the only instance when shareholders may recognize (deduct) losses in reorganizations?
When they receive solely boot and no stock
Gain recognized
- The gain is taxed as a dividend to the extent of the shareholder’s proportionate share of E & P. The remaining gain generally is capital gain.
- If the requirements of § 302(b) can be met, the transaction is treated similarly to a stock redemption, receiving capital gain treatment
When do debt security holders recognize gain?
Only when the principal amount of the debt received is greater than the principal of the debt surrendered
Securities
Debt instruments with terms longer than 10 years (bonds)
NOT those with terms of five years or less (notes)
Carryover basis
The assets transferred from the target corporation to the acquiring corporation retain their basis
The acquiring corporation’s carryover basis is increased by any gain recognized by…
the target corporation on the reorganization
Substituted Basis
In a tax-free reorganization, the shareholder/bondholder starts with a tax basis in the stock and securities received that is equal to the basis of the stock and securities surrendered
Substituted basis is decreased by…
FMV of boot received
Substitued basis is increased by…
gain or dividend income recognized
Merger
The absorption of one corporation by another with the corporation being absorbed losing its legal identity. Flow Corporation is merged into Jobs Corporation, and the shareholders of Flow receive stock in Jobs in exchange for their stock in Flow. After the merger, Flow ceases to exist as a separate legal entity. If a merger meets certain conditions, it is not currently taxable to the parties involved. § 368(a)(1).
Consolidation
The combination of two or more corporations into a newly created corporation. Thus, Black Corporation and White Corporation combine to form Gray Corporation. A consolidation may qualify as a nontaxable reorganization if certain conditions are satisfied. §§ 354 and 368(a)(1)(A).
What are advantages of Type A reorganizations?
- Flexibility
- Does not need to be voting stock
- Need 40% stock, but can transfer money or other property to the target corporation
- No requirement of “substantially all” of the targets assets be transferred to the acquiring corporation
- Target can sell/dispose of assets not desired without affecting the tax-free nature of the restructuring
What are disadvantages of Type A reorganizations?
- The acquiring corporation must assume ALL liabilities of the target (state law)
- Each corporation involved must obtain the approval of the majority of shareholders
- Dissenting shareholders can require that their shares be appraised and bought back by the corporation
Is gain recognized in a Type B reorganization?
NEVER because the use of boot is precluded
What is an exception to the soley voting stock requirement of a Type B reorganization?
When the target shareholders receive fractional shares of the aquiring stock (Cash rather than fractional shares may be paid to the target shareholders)
What are the control requirements for a Type B reorganization?
The acquiring corporation must be in control of the target immediately after the reorganization (80% of all classes of the target’s stock). Stock previously purchased can be counted in the 80%.
What are advantages of a Type B reorganization?
- simplicity
- target shareholders act individually in transferring their stock to the acquiring corporation
- the target and the acquiring corporation’s shareholders are not directly involved
What are the disadvantages of a Type B reorganization?
- Solely voting stock consideration requirement
- If the acquiring corporation does not obtain 100% control of the target, problems may arise with the minority interest remaining in the target
When would a Type C reorganization not be tax-free?
If the target shareholders receive assets other than acquiring stock
Cash and other property do not destroy the classification of the transaction as a “Type C” reorganization if…
at least 80 percent of the fair market value of the target’s gross property is obtained with voting stock.
The acquiring corporation has more freedom in the consideration given in which type of reorganization: B or C?
Type C
What is the cost of more consideration freedom in Type C?
When the acquiring corporation gives solely voting stock for target assets, the target’s liabilities assumed by the acquiring corporation are not considered other property (i.e., they are not boot) in the exchange, and the 80%-of-property requirement is met.
When are liabilities assumed by the acquiring corporation treated as boot?
If the target also receives any property other than acquiring’s voting stock in the reorganization
Target liabilities assumed by the acquiring corporation are likely to exceed 20 percent of the fair market value of the target assets acquired and, consequently…
destroy the “Type C” reorganization.
What are the asset transfer rules for Type C reorganization?
The “Type C” reorganization requires that substantially all of the target corporation’s assets be transferred to the acquirer. (90% of its net asset value and 70% of its gross asset value)
Compare Type A and Type C Reorganizations
- similar results
- Type C has more restrictions regarding the consideration that may be used by the acquiring corporation
- Type C may be preferable; assumes only the target liabilities for which it negotiates
- Type C is not generally liable for unknown/contingent liabilities of the target where Type A is
Divisive Reorganization
A “Type D” spin-off, split-off, or split-up reorganization in which the original corporation divides its active business (in existence for at least five years) assets among two or more corporations. The stock received by the original corporation shareholders must be at least 80 percent of the other corporations.
Minnow swallowing the whale
When combining, it is the larger corporation (acquiring) that is transferring its assets to the smaller corporation (target). After restructuring, the smaller target continues to exist and the larger acquiring terminates.
When is Type D reorganization useful?
When the target corporation has a nontransferable license or right and therefore must be the entity that continues after restructuring
Why might division occur?
- Antitrust problems
- Differing opinions among shareholders
- Product liability concerns
- Increasing shareholder value
- Family tax planning
In divisive “Type D” reorganizations:
- Stock received by Original must constitute control (80 percent) of New.
- Stock of New must be transferred to Original’s shareholders.
- Both the assets transferred and the assets retained by Original must represent active businesses that were owned and conducted by Original for at least five years before the transfer.
Spin-Off
New is formed to receive some of Original’s assets in exchange for the New stock.Footnote Original’s shareholders receive the New stock without surrendering any of their Original stock. The shareholders’ basis in their Original stock is allocated between the Original stock and the New stock, based on the relative fair market value of each.
Split-off
resembles a spin-off except that in a split-off, the shareholders surrender Original stock in exchange for the New stock. The stock basis is computed in the same manner as for a spin-off.
Split-up
two or more corporations are formed to receive substantially all of Original’s assets. The stock of each New corporation is exchanged for Original stock, and then Original liquidates. The shareholders’ basis in the relinquished Original stock carries over as the basis of stock they receive in the New corporations.
What are advantages of divisive Type D reorganizations?
- Permits corporate division without tax consequences if no boot is involved
What are the disadvantages of divisive Type D reorganization?
- Control requirements of 50% for an acquisitive reorganization and 80% for a divisive reorganization must be met.
What are advantages of acquisitive Type D reorganization?
Allows smaller target to retain its existence
Recapitalization
A “Type E” reorganization, constituting a major change in the character and amount of outstanding equity of a corporation. Tax-free exchanges are stock for stock, bonds for bonds, and bonds for stock. For example, common stock exchanged for preferred stock can qualify as a tax-free “Type E” reorganization.
When is the exchange of bonds for other bonds tax-free under Type E reorganization?
When the principal amount of the debt received is NOT more than the surrendered debt’s principal amount
Type F reorganizations involve only slight changes to a single operating corporation, so the successor…
is the same corporation as its predecessor (the tax characteristics of the predecessor carry over to the successor)
Does Type F reorganization jeopardize the status of Section 1244 stock or terminate a valid S corporation election?
No. Not unless such an S corp election termination is desired.
How do you qualify for Type G treatment?
The debtor must be insolvent before the reorganization and may be in a bankruptcy or similar Federal/state court proceeding
Why is the contininuity of interest test more lenient with Type G reorganizations?
When a corporation is insolvent, the creditors become the true owners of the corporate assets; thus, they should be the ones with the continuing interest in the insolvent corporation.
Do the former shareholders have to receive tock in the acquiring corporation for the restructuring to qualify as a Type G reorganization?
NO
What is likely if insolvency is present?
The debtor corporation will have most or all of its liabilities discharged
Discharge of indebtedness is…
income
What is the exclusion to recognizing a gain because of the discharge of indebtedness?
- The exclusion is limeted to the degree to which the corporation is insolvent
- Cancellation of debt in excess of the amoung of insolvency is taxable
- The acquiring corporation must reduce certain tax attributes carried over from the bankrupt corporation to the extent of the excluded income
What is the result of the reduction of tax attributes?
Temporary deferral of cancellation of debt income rather than a permanent exclusion
The attributes are reduced in the following order, unless the corporation elects to first reduce its basis in any depreciable assets it receives from the bankrupt entity.
- Net operating losses (NOLs).
- Capital loss carryovers.
- Basis in property.
Excise Tax on Stock Repurchases
The Inflation Reduction Act of 2022 imposes a non-deductible excise tax on publicly traded U.S. corporations (and certain U.S. subsidiaries of publicly traded foreign corporations) of 1 percent of the fair market value of share repurchases made starting in 2023.
When does the excise tax not apply to share repurchases?
When share repurchases made as part of reorganization to the extent that no current year gain is recognized by reason of the application of § 368.
Sound Business Purpose - Judicial Doctrine
The business purpose requirement restricts nonrecognition treatment to transactions that are motivated by valid corporate, rather than shareholder, purposes that go beyond tax avoidance.
Why is sound business purpose relevant in reorganizations?
Shareholder and corporate purposes may be so closely aligned that it may seem the reorganization is motivated by one or more shareholder purposes.
Continuity of Interest - Judicial Doctrine
This requirement provides that a reorganization may qualify as a nontaxable event if the shareholders have a substantially similar investment after the restructuring as before.
To qualify for tax-favored status, the target corporation shareholders must…
receive an equity interest in the acquiring corporation.
When is the continuity of interest test met?
when the target shareholders receive acquiring stock that is at least 40 percent of their prior target stock ownership.
When calculating the 40 percent continuity of interest threshold, the FMV of the acquiring corporation’s stock is determined on…
the business day prior to the day the contract to reorganize becomes binding, if the consideration provided to the target shareholders is fixed.
If circumstances force a modification to the contract that results in a reduction in the FMV of shares, an increase in the FMV of cash or other property…
does not preserve continuity of interest.
Do all target shareholders need to receive stock in the surviving corporation to fulfill the continuity of interest?
No - the requirement is applied to the aggregate consideration given by the acquiring corporation
Continuity of Business Enterprise - Judicial Doctrine
In a tax-favored reorganization, the acquiring corporation must continue the historic business of the target or use a significant portion of the target’s assets in the new business.
What does the test of continuity of business enterprise require the acquiring corporation to do?
- Continue the target’s historic business OR
- Use a significant portion of the target’s assets in its business
Historic Business Test
In a corporate reorganization, a means by which to determine if the continuity of business enterprise requirement is met. The acquiring corporation must continue to operate the target entity’s existing business(es) going forward; if this is not the case, the requirement is failed.
Asset Use Test
In the context of a corporate reorganization, a means by which to determine if the continuity of business enterprise requirement is met. The acquiring corporation must continue to use the target entity’s assets in the acquiror’s business going forward; if this is not the case, the requirement is failed.
Step Transaction
Disregarding one or more transactions to arrive at the final result. Assume, for example, Beta Corporation creates Alpha Corporation by transferring assets desired by Beta’s sole shareholder, Carl. Carl then causes Alpha to liquidate to obtain the assets. Under these circumstances, the IRS may contend that the creation and liquidation of Alpha be disregarded. What really happened was a dividend distribution from Beta to Carl.
What type of reorganization has a problem with the step transaction doctrine?
Type C - they transferring corproation must transfer substantially all of its assets to the receiving corporation
If the transferring corporation attempts to dispose of its unwanted assets before a reorganization, the step transaction doctrine…
could ruin the reorganization’s tax-favored status.
The IRS generally views any transactions occurring within ________ of a reorganization as part of the restructuring.
one year
Which type of reorganizations do not fall under the § 381 carryover rules ?
“Type B,” “Type E,” and “Type F” - the original corporation remains intact and retains its own tax attributes.
Divisive “Type D” - in a spin-off or split-off the original entity retains its tax attributes and the new corporation starts fresh with regard to its tax attributes
A target’s NOL is one of the most beneficial tax attributes that may be carried over to the acquiring corporation. Can the NOL be carried back to aprior acquiring corporation tax year?
No. It is valuable because it can offset future income of the combined successor corproation
§ 382 limitation
When one corporation acquires another, the acquiring corporation’s ability to use the loss and credit carryovers of the target may be limited by this anti-abuse provision. For instance, the maximum NOL deduction available to the acquiring is the value of the target when acquired times the long-term tax-exempt interest rate on that date.
When does the section 382 limitation apply?
When there is more than a 50-percentage-point ownership change by value for the target common shareholders
Ownership Change
An event that triggers a § 382 limitation for the acquiring corporation. Determined by examining the common stock ownership during a 3 year testing period prior to the date of ownership change
NOL Limit from ownership change calculation
The limit is based on the fair market value of the loss corporation’s stock (both common and preferred) multiplied by the Federal long-term tax-exempt rate
When is the NOL carryover disallowed?
if the successor fails to continue the target’s business operations for at least two years following any ownership change.
When the successor holds several types of loss carryovers, the § 382 limitation is applied in the following order:
- Built-in capital losses.
- Capital losses.
- Built-in ordinary losses.
- NOLs.
