CORPORATE REORGANIZATIONS

Transcription

1 H Chapter Seven H CORPORATE REORGANIZATIONS INTRODUCTION AND STUDY OBJECTIVES Many corporations have found that restructuring is an effective method for promoting economic growth. These corporate combinations and divisions involve exchanges of stock and property that normally would be taxable. Under the provisions of corporate reorganizations, the merger of two corporations and the acquisition of one corporation s stock or assets by another corporation can be tax-free. In addition to acquisitions and mergers, the changes in a single corporation s capital structure, place of business, or division of its business can also be tax-free. In studying the rules of corporate reorganizations, the student should have these objectives: 1. To learn the acceptable patterns of reorganizations discussed in 368(a). 2. To understand the tax consequences of a reorganization and ensure that the general requirements are met to achieve a tax-free transaction. 3. To become familiar with the status of the corporate attributes and what effect they will have on the new organization. STUDY HIGHLIGHTS TAX-FREE REORGANIZATIONS: GENERAL REQUIREMENTS 1. In order for a transaction to be given nonrecognition treatment, the reorganization must meet certain tests regarding continuity of interest and continuity of business enterprise. These tests require that the original owner of the acquired corporation retain a continuing proprietary interest in the reorganized corporation. This continuity must be in the form of an equity interest and not merely a creditor s interest. 2. No statutory requirement exists as to the number of former owners who must maintain a continuing proprietary interest in the reorganized corporation, nor is there any minimum amount of time after the reorganization that the proprietary interest must be maintained. 3. Continuity of business enterprise requires the acquiring corporation to continue its historic business or to use a significant portion of the target corporation s assets in a business. 4. To complete a reorganization, the Regulations generally require the acquiring corporation to obtain control. Control means at least 80 percent of the total voting power and at least 80 percent of all other classes of stock. 7-1

2 7-2 Corporate Reorganizations ACCEPTABLE PATTERNS OF REORGANIZATION: TYPES A-G 5. There are seven patterns of reorganizations. These include: Type A: Type B: Type C: Type D: Type E: Type F: Type G: a statutory merger or consolidation. stock for stock. A parent corporation trades its voting stock for either voting or nonvoting stock of a subsidiary. The parent must have at least 80 percent control after the trade. stock for property. A parent trades its voting stock (or voting stock of a subsidiary) for substantially all of another corporation s assets. property for stock. A transfer by a corporation of all or part of its assets to another corporation. Immediately after the transfer, the transferor or one of its shareholders must possess at least 80 percent control of the transferee corporation. a recapitalization. a change in identity, form, or place of incorporation. a transfer of all or part of the assets in a bankruptcy. 6. See Exhibit 7-1 in the textbook for an excellent chart of the reorganization characteristics. 7. The A merger occurs when one corporation absorbs all the assets and liabilities of another corporation, thereby continuing to operate as the acquiring corporation. In a consolidation, both original corporations disappear into a newly organized corporation. Example. Corporations S and T consolidate under state law to form Corporation N. All of the N stock is distributed to the shareholders of S and T in complete liquidation of those corporations. This is a Type A consolidation. 8. For ruling purposes, to be an A reorganization, the IRS insists that at least 50 percent of the consideration be paid in the form of stock to the shareholders of the original corporation. 9. The receipt of money or other property will constitute boot. Section 356 provides that gain is to be recognized to the extent that boot is received, but never in excess of the realized gain. 10. A two-party merger with a drop-down of assets allows one corporation to merge into a second corporation. The second corporation in turn drops all or part of the assets from the merged corporation into a newly formed or existing subsidiary of the second corporation. 11. A triangular merger allows a second corporation to merge into the subsidiary of a parent corporation. Instead of receiving stock of the subsidiary, the shareholders of the second corporation receive stock of the parent corporation. See Exhibit 7-4 of the textbook.

3 Study Highlights A reverse triangular merger is effectively a B reorganization. Under this technique, the subsidiary of a parent corporation is merged into a second corporation. Stock of the parent corporation is given to the shareholders of the second corporation in return for the second corporation s stock. See Exhibit 7-5 of the textbook. 13. A B reorganization is the acquisition by one corporation of all or part of the voting stock of a second corporation or its parent. The first corporation must be in control of the second corporation or its parent immediately after the acquisition. 14. No consideration other than the voting stock of the acquiring corporation or its parent (but not both) can be tendered in a B reorganization. The term solely for voting stock is strictly enforced and allows no leeway for even an insignificant amount of boot to be transferred. See Exhibit 7-6 of the textbook. Example. P Corporation exchanges 20% its voting stock for 80% the voting stock of S Corporation. P becomes the parent of S in a B reorganization and recognizes no gain. If any boot had been transferred on the exchange, this transaction would not qualify as a B reorganization. 15. A C reorganization is the acquisition by one corporation of substantially all of the properties of a second corporation, solely for the voting stock of the first corporation or its parent. A C reorganization allows a limited amount of boot (up to 20%). As a result of changes made by the DRA of 1984, the second corporation must liquidate as a part of the plan of reorganization. Example. J Corporation transfers all of its property with a basis of $40,000 and value of $100,000 to S Corporation in return for voting stock worth $80,000 and $20,000 in cash. J has a realized gain of $60,000, which must be recognized to the extent of boot 20,000. If, as part of the plan, J distributed the cash to its shareholders, it would not recognize gain since no boot would be retained. Instead, the shareholders would be charged with recognition of gain. 16. According to the IRS, substantially all means a transfer of assets representing at least 90 percent of the fair market value of the net assets, and at least 70 percent of the fair market value of the gross assets held immediately prior to the transfer. See Exhibit 7-7 in the textbook. 17. There are two types of D reorganizations: acquisitive and divisive. An acquisitive D is a transfer by one corporation of all or part of its assets to a second corporation in exchange for control of the second corporation. See Exhibit 7-8 in the textbook. 18. A divisive D is the separation of a single corporation into two or more distinct corporations. There are three types of divisive reorganizations: a spin-off, a split-off, and a split-up. 19. A spin-off is a distribution by a parent corporation of stock of an existing or newly created subsidiary to the shareholders of the parent corporation. See Exhibit 7-9 in the textbook. 20. A split-off is a transfer by a parent corporation of stock of an existing or newly created subsidiary to some of the shareholders of the parent corporation in exchange for all or part of their stock of the parent corporation. See Exhibit 7-10 in the textbook. 21. A split-up is a transfer by a parent corporation of stock in two or more subsidiaries in complete liquidation of the parent corporation. See Exhibit 7-11 in the textbook.

4 7-4 Corporate Reorganizations 22. To achieve a divisive D reorganization, the following requirements must be satisfied: l The original corporation must distribute to the shareholders controlling interest in the newly created subsidiary. l Property must consist solely of stock or securities. Distributions of boot will generate recognized gain. l Immediately after the reorganization, both the parent and the subsidiary must be engaged in the active conduct of a trade or business. l The reorganization must not have been a device for bailing out the earnings and profits of the original corporations. 23. If all the requirements of 355 are met, the shareholder recognizes no gain or loss upon the receipt of the subsidiary s stock or securities. If, however, the shareholder receives boot, the transaction will be a partially taxable one. The amount of gain to be recognized depends upon whether the boot is received in a split-off and split-up or in a spin-off. Example. T, an individual, exchanges stock in P, a parent corporation, for stock and securities in S, a subsidiary corporation, pursuant to 355. The exchange is a tax-free split-off except to the extent of the securities received. The securities in S have a principal amount of $1,000 and a FMV of $950 on the date of the exchange. T has boot of $950. Assume T also surrenders securities in P for the securities in S. The securities in P have a principal amount of $600. T has boot of $380 ([$1000 $600] [the ratio $950/ $1000]). 24. An E reorganization is defined as a recapitalization. This generally means a significant change in the character and amount of outstanding stock or paid-in capital of a corporation. Thus, an exchange of preferred stock for common stock would qualify as an E reorganization. 25. An F reorganization is a mere change in identity, form, or place of organization. The F rules apply when a corporation changes its name or state of operation or makes any other change in corporate charter. 26. A G reorganization transfers substantially all of the assets of a debtor corporation to a newly controlled corporation under a court-approved plan of bankruptcy. TAX CONSEQUENCES OF REORGANIZATION 27. No gain or loss is recognized by the acquired corporation if it receives only stock and securities in exchange for its assets. The receipt of boot by the acquired corporation causes recognition of gain or loss. However, the receipt of boot will not trigger recognition if the acquired corporation distributes the boot to the shareholders as part of the plan or reorganization. 28. The basis of stock and securities received by the acquired corporation is equal to the basis of property transferred, plus gain recognized, minus boot received. 29. Under 1032, the acquiring corporation recognized neither gain nor loss on the transfer of its stock or securities in exchange for property. The acquiring corporation uses a carryover basis for the property acquired.

5 Study Highlights The shareholders that are a party to the reorganization recognize no gain or loss if they exchange their stock solely for stock or securities of another corporation that is a party to the reorganization. The amount of securities that can be received is limited to the principal amount of securities surrendered. The receipt of boot causes the recognition of gain. 31. The basis of stock received by a shareholder is determined as follows: Basis of stock and securities transferred $ xxxx þ Gain recognized þxxxx þ Dividend income þxxxx Money received xxxx FMV property received xxxx Basis of stock and securities received xxxx CARRYOVER OF TAX ATTRIBUTES 32. When a corporation undergoes a reorganization, it must determine whether certain attributes (e.g., E&P, capital losses, recapture potential) carry over to the newly organized corporation. Section 381 provides a list of tax attributes of an acquired corporation that carry over to the successor corporation. Section 381 applies to A, C, acquisitive D, F, and G reorganizations. 33. Section 382, completely revamped by the Tax Reform Act of 1986, provides for limitations on the amount of the net operating loss (NOL) that can be used by a corporation with substantially new ownership. Limitations on the use of a loss carryover are imposed whenever a change in ownership occurs. A change in ownership can result from either an owner shift or an equity structure shift. Example. L corporation has been unprofitable for the past several years and has accrued, to date, a substantial net operating loss. T, an individual with a successful sole proprietorship, decides to purchase all the stock of L and operate his business through the corporation. It is T s desire to offset his profits with L s net operating loss carryforward. However, under new 382, only a portion of the net operating loss can be utilized to reduce current profits due to the change in ownership. 34. When one corporation acquires another corporation primarily to avoid income taxes, the IRS can utilize 269 to disallow the carryover of favorable tax attributes. Example. T purchases all the stock of L corporation with an NOL carryover of $100,000. Two weeks after the purchase, T contributes to L a profitable construction business to help absorb the losses. The IRS may consider the purchase and combined transfer an acquisition for tax avoidance purposes and deny use of the NOL carryover.

6 7-6 Corporate Reorganizations True or False STUDY QUESTIONS 1. The continuity of interest doctrine is designed to limit the type of consideration that an acquiring corporation can offer to the target s shareholders. 2. To meet the continuity of business enterprise requirement, the target corporation must continue all of the acquired corporation s lines of business. 3. The acquiring corporation gains control when it controls at least 80 percent of the voting stock and more than 50 percent of all other classes of stock. 4. A divisive reorganization is one in which a single corporation is divided into two or more corporations. The original corporation may or may not survive. 5. A triangular merger starts with a parent and subsidiary corporation and ends up with a parent and an enlarged subsidiary. 6. In a B reorganization, the target s stock must be acquired using only voting stock and no boot. 7. The acquisitive D reorganization results in the combination of two corporations, while the divisive reorganization results in the separation of a single corporation. 8. The F reorganization applies to a reorganization as part of a bankruptcy. 9. When a corporation changes its name for tax purposes, it is considered to have undergone a reorganization. 10. Section 381 specifies that in a Type A, C, and acquisitive D, F, and G reorganizations, the acquiring corporation receives the tax attributes of the target corporation. 11. If A Corporation merges with B Corporation under 368(a)(1)(A), an equity structure shift has taken place for purposes of To have a change in ownership under 382, there must be a 50 percent change in ownership. Multiple Choice 1. On December 15, 2009, T Corporation merges with A Corporation under a tax-free reorganization. T has E&P of $35,000 on the date of merger, while A has a deficit in E&P of $15,000. If A Corporation distributes $50,000 to its shareholders on December 31, 2009, how much dividend income will the shareholders have? a. $0. b. $20,000. c. $35,000. d. $50,000.

7 Study Questions On July 1, 2009, L Corporation merges with P Corporation under a tax-free reorganization. L has a net operating loss of $44,000, while P has taxable income of $85,000. How much of L Corporation s loss can be used to offset P s taxable income for calendar year 2009? (Assume the L shareholders own 60% P Corporation.) a. $0. b. $22,000. c. $42,500. d. $44, R Corporation transfers to S Corporation assets with a fair market value of $200,000 (basis of $110,000) in exchange for voting stock of S Corporation (worth $120,000), cash ($50,000) and the assumption by S of liabilities of R in the amount of $30,000. How much gain must R Corporation recognize? a. $0. b. $50,000. c. $80,000. d. $90, X has been engaged in two businesses for the past 20 years. On July 1, 2009, X transfers the assets from one of its businesses to new Corporation N and distributes the stock of N to the T shareholders. What has occurred? a. Break-off. b. Spin-off. c. Split-off. d. Split-up. e. Acquisitive reorganization. 5. R Corporation merged with T Corporation. As a result of the merger, R s shareholders received common stock in T with a FMV of $100,000 and cash of $900,000. What kind of reorganization took place? a. Type A. b. Type B. c. Type C. d. Type D. 6. On July 1, 2009, in connection with a recapitalization of Y Corporation, T, an individual, exchanged 1,000 shares of stock costing $95,000 for 1,000 shares of new stock worth $108,000 and bonds in the principal amount of $10,000 with a fair market value of $10,500. What is the amount of T s recognized gain during 2009? a. $0. b. $10,500. c. $23,000. d. $23,500.

8 7-8 Corporate Reorganizations 7. T Corporation desires to acquire all of the stock of M Corporation. Which one of the following combinations of T Corporation stock (and other considerations) cannot be used to effect the stock acquisition as a B reorganization? a. T Corporation common voting stock whereby the former M shareholders end up owning 3 percent of the outstanding stock of M Corporation. b. T Corporation common stock and nonvoting preferred stock. c. T Corporation voting preferred stock. d. C Corporation common voting stock if C owns all of the T Corporation stock. e. All of the above can be used. 8. Pursuant to a plan of reorganization adopted in 2009, S Corporation exchanged 1,000 shares of its common stock and paid $40,000 cash of H Corporation assets with an adjusted basis of $200,000 (fair market value of $300,000). The 1,000 shares of S common stock had a fair market value of $260,000 on the date of the exchange. What is the basis to S of the assets acquired in the exchange? a. $200,000. b. $240,000. c. $260,000. d. $300, Pursuant to a plan of corporate reorganization adopted in 2009, S exchanged 1,000 shares of T Corporation common stock, which she had purchased for $150,000, for 1,800 shares of M Corporation common stock having a fair market value of $172,000. As a result of this exchange, what should be S s recognized gain and her basis in the M Corporation common stock? Recognized Gain Basis a. $0 $150,000 b. $0 $172,000 c. $22,000 $150,000 d. $22,000 $172,000 e. None of the above 10. Pursuant to a plan of reorganization adopted in 2009, D Corporation exchanged property with an adjusted basis of $100,000 for 1,000 shares of the common stock of G Corporation. The 1,000 shares of G common stock had a fair market value of $110,000 on the date of the exchange. As a result of this exchange, what is D s recognized gain and what is its basis in the G common stock, respectively? a. $0 and $100,000. b. $0 and $110,000. c. $10,000 and $100,000. d. $10,000 and $110,000.

9 Study Questions R and S are equal shareholders of T Corporation. T has actively carried on two businesses for eight years. T transfers one business to newly formed X Corporation and the other business to newly formed Y Corporation. T then transfers the X stock to R and the Y stock to S in exchange for all of their stock in T. T is then dissolved. What has occurred? a. Spin-off. b. Split-off. c. Split-up. d. Taxable acquisition. 12. Assume the same facts as in Problem 11, except T only transfers one business to X Corporation and never creates Y Corporation. The stock of X is then transferred to R in exchange for all of her stock and S becomes the sole shareholder of T. What has occurred? a. Spin-off. b. Split-off. c. Split-up. d. Spin-up. 13. Generally, which one of the following is not a valid A reorganization? a. The combination of X and Y to form Z. b. The merger of S, a subsidiary of P, with K, using solely voting stock of S and P. c. The merger of L into N, followed immediately by a transfer of L s assets to new corporation S, a subsidiary of N. d. The merger of S, a subsidiary of P, into T, using P stock to acquire control of T, resulting in T becoming a subsidiary of P. 14. Which one of the following statements is not a step in an A reorganization by statutory merger? a. Target corporation transfers its assets and liabilities to acquiring corporation in exchange for part of acquiring corporation s stock. b. Target exchanges acquiring stock received for part of shareholders target stock. c. Target corporation shareholders become shareholders in acquiring corporation. d. Target dissolves. 15. Which one of the following statements concerning a reverse triangular merger is false? a. Subsidiary corporation is merged into target corporation. b. Voting stock of parent corporation is given to shareholders of target corporation in return for all of target s assets. c. Parent corporation must obtain at least 80 percent of voting and at least 80 percent of nonvoting stock of the target corporation. d. All of the above statements are true. 16. Which one of the following statements concerning a creeping B reorganization is true? a. An overall plan is required. b. The period of time for acquisition to be carried out is limited to five years. c. The acquisition may be made for cash as well as voting stock. d. Any prior cash purchase will invalidate the reorganization.

10 7-10 Corporate Reorganizations 17. Which one of the following statements concerning a C reorganization is true? a. Target s shareholders normally must approve the sale of assets and liquidation. b. Acquiring corporation shareholders need not formally approve the acquisition. c. C reorganization is sometimes called the practical merger. d. All of the above statements are true. Fill In the Blanks 1. In order for a transaction to be given nonrecognition treatment, it must meet both the continuity of and continuity of. 2. Control in a reorganization means at least percent of the total voting power and at least percent of all other classes of stock. 3. The Type A reorganization is a or. 4. The Type B reorganization is a for exchange. 5. The Type C reorganization is a for exchange. 6. Type D reorganizations can either be or in nature. 7. A name change would be an example of a Type reorganization. Code Section Recognition For each of the following Code sections, try to match the response that most properly identifies the underlying provision (1) (A) a. corporate stock exchanges (a) (1) (B) b. stock for property reorganization (a) (1)(C) c. statutory merger d. stock for stock reorganization e. divisive reorganization

11 Solutions to Study Questions 7-11 SOLUTIONS TO STUDY QUESTIONS True or False 1. True 2. False. Only a majority of the business must be continued. 3. False. Must have 80 percent of other classes of stock. 4. True. 5. True. 6. True. 7. True. 8. False. A G reorganization applies to a corporation in bankruptcy. 9. True. 10. True. 11. True. 12. False. A 50 percentage point increase. Multiple Choice 1. b. Corporate attributes carryover. 2. b. ø year¼ $22, d. Does not qualify as a C reorganization because cash and liabilities assumed exceed 20 percent. 4. b. 5. e. No continuity of interest. 6. b. Doesn t qualify for E reorganization because an equal amount of securities was not surrendered. 7. b. Nonvoting preferred stock cannot be used. 8. b. $200,000 basis ¼ $40,000 gain recognized. 9. a. No gain exists. Basis is a substituted basis.

12 7-12 Corporate Reorganizations 10. a. No gain exists. Basis is a substituted basis. 11. c. 12. b. 13. b. Stock must be from one or the other but not both. 14. b. All target stock must be surrendered. 15. b. Target becomes the controlled subsidiary. 16. a. A series of acquisitions that is part of an overall plan. 17. d. Fill In the Blanks 1. interest; business enterprise ; merger; consolidation. 4. stock; stock. 5. stock; property. 6. acquisitive; divisive. 7. F. Code Section Recognition 1. c. 2. d. 3. b. 4. e. 5. a.