Structuring Tax-Free M&A Deals: Navigating IRC 368 and 351, Selecting the Appropriate Structure

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1 Presenting a live 90-minute webinar with interactive Q&A Structuring Tax-Free M&A Deals: Navigating IRC 368 and 351, Selecting the Appropriate Structure THURSDAY, JANUARY 11, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Jonathan Golub, Attorney, Royse Law Firm, Menlo Park, Calif. Joseph C. Mandarino, Partner, Smith Gambrell & Russell, Atlanta The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 1. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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4 STRUCTURING TAX-FREE M&A DEALS Royse Law Firm, PC 149 Commonwealth Dr. Suite 1001 Menlo Park, CA Jonathan Golub January 11, 2018 IRS Circular 230 Disclosure: To ensure compliance with the requirements imposed by the IRS, we inform you that any tax advice contained in this communication, including any attachment to this communication, is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to any other person any transaction or matter addressed herein.

5 Types of Tax-Free Reorganizations: OVERVIEW Type A Statutory Mergers, Consolidations & Triangular Mergers Type B Stock for Stock Type C Stock for Assets Double Merger Examples Requirements of Tax-Free Reorganizations: Continuity of Interest Continuity of Business Enterprise (COBE) Business Purpose Plan of Reorganization Special Tests Step Transaction Doctrine Consequences of Tax-Free Reorganizations: Buyer Entity Target Entity Target Shareholders Tax Reform Applicable to M&A: Reduced Corporate Tax Rate (21%). Opportunity Zone Re-Investment of gains (Section 1400Z). 5

6 TAXABLE VS. TAX FREE Type of Acquisition Currency Stock Securities/Debt Deferred payments, earn outs Compensatory Nature of the Buyers and Seller Foreign Parties Tax Attributes of Parties Shareholder Level Considerations Tax Sensitivity of Shareholders Appetite for Complexity & Risk 6

7 TYPES OF REORGANIZATIONS Type A Statutory Mergers and Consolidations Type B Stock for Stock Type C Stock for Assets Type D Spin Off, Split Off, Split Up, and Type D Acquisitive Reorganizations Type E Recapitalizations Type F Migrations 7

8 TYPE A REORGANIZATIONS SECTION 368(a)(1)(A) STATUTORY MERGER Shareholders Target Buyer Statutory Merger 2 or more corporations combined and only one survives (Rev. Rul ) Requires strict compliance with statute Target can be foreign; Reg (b)(1)(ii) No substantially all requirement No solely for voting stock requirement Requirements: Necessary Continuity of Interest Business Purpose Continuity of Business Enterprise Plan of Reorganization Tax Effect: Shareholders Gain recognized to the extent of boot Target No gain recognition Buyer takes Target s basis in assets plus gain recognized by Shareholders Busted Merger taxable asset sale followed by liquidation 8

9 TYPE A REORGANIZATIONS SECTION 368(a)(1)(A) STATUTORY CONSOLIDATION Shareholders Shareholders Target Buyer Statutory Consolidations 2 or more corporations combined to form a new corporation Requires strict compliance with statute Target can be foreign; Reg (b)(1)(ii) No substantially all requirement No solely for voting stock requirement Newco Requirements: Necessary Continuity of Interest Business Purpose Continuity of Business Enterprise Plan of Reorganization Tax Effect: Shareholders Gain recognized to the extent of boot Target No gain recognition Buyer takes Target s basis in assets plus gain recognized by Shareholders Busted Merger taxable asset sale followed by liquidation 9

10 TRIANGULAR OR SUBSIDIARY MERGERS 1. Forward Subsidiary Merger Target Buyer Merger Sub 2. Reverse Subsidiary Merger Target Buyer Merger Sub 10

11 TRIANGULAR OR SUBSIDIARY MERGERS Target Shareholders Target Buyer 80% Merger Sub Tax Consequences Merger Sub takes Target s basis in assets increased by gain recognized by Target Buyer takes drop down basis in stock of Merger Sub (same as asset basis) Section 368(a)(2)(D) Forward Triangular Merger A statutory merger of Target into Merger Sub (at least 80% owned by Merger Sub) Substantially all of Target s assets acquired by Merger Sub Would have been a good Type A merger if Target had merged into Merger Sub 11

12 TRIANGULAR OR SUBSIDIARY MERGERS Target Shareholders Target Buyer 80% Merger Sub Tax Consequences Non-taxable to Target and carryover basis No gain to Buyer and Merger Sub under Sections 1032 and 361 No gain to Target shareholders except to the extent of boot Buyer s basis in Target stock generally is the asset basis, but Buyer can choose to take Target shareholders basis in stock (if it is also a B) If transaction is also a 351, Buyer can use Target shareholders basis plus gain Section 368(a)(2)(E) Reverse Triangular Merger Merger of Merger Sub into Target where (i) Target shareholders surrender control (80% of voting and nonvoting classes of stock) for Buyer voting stock and (ii) Target holds substantially all the assets of Target and Merger Sub 12

13 TYPE B REORGANIZATIONS SECTION 368(a)(1)(B) STOCK FOR STOCK Shareholders Target Buyer Acquisition of stock of Target, by Buyer in exchange for Buyer voting stock Buyer needs control of Target immediately after the acquisition Control = 80% by vote and 80% of each class Buyer s basis in Target stock is the same as the Shareholder s Solely for voting stock No Boot in a B Reorganization Expenses distinguish between Target expenses and Target Shareholder expenses (Rev. Rul ) Creeping B old and cold stock purchased for cash should not be integrated with stock exchange 13

14 TYPE C REORGANIZATIONS SECTION 368(a)(1)(C) STOCK FOR ASSETS Shareholders Buyer Stock Buyer Stock Target Target Assets Buyer Acquisition of substantially all of the assets of Target, by Buyer in exchange for Buyer voting stock Substantially All at least 90% of FMV of Net Assets and at least 70% of FMV of Gross Assets Target must liquidate in the reorganization 20% Boot Exception Buyer can pay boot (non-stock) for Target assets, up to 20% of total consideration; liabilities assumed are not considered boot unless other boot exists Reorganization Expenses Buyer may assume expenses (Rev. Rul ) Assumption of stock options not boot Bridge loans by Buyer are boot Redemptions and Dividends who pays and source of funds 14

15 DOUBLE MERGER REV. RUL Step 1: Reverse Triangular Merger Target Shareholders Step 2: A-type Forward Merger Target Shareholders Target Buyer Buyer 80% Merger Sub Target+Sub Merger Sub Survives Merger Sub Tax Benefit: A taxable reverse merger has just one tax on the shareholders, while a taxable forward merger has two taxes (one on shareholders and one on corporation). Intended that entire transaction be a tax-free A-type merger (where 20% boot limitation does not exist). Pairing the two reduces the risk of incurring the corporate level tax in the event the entire transaction is not treated as an A-type merger. 15

16 Example #1 Facts: You represent target, a corporation. The buyer wants to acquire target for 50% cash and 50% buyer stock. A significant portion of the buyer stock consideration payable to founders of target is subject to claims for indemnification and forfeiture if founders do not maintain employment with buyer. Concerns and Recommendation: 16

17 Example #2 Facts: You represent target, a corporation. The buyer wants to acquire target s stock for 10% cash and 90% buyer stock. Target is worried that it cannot obtain consent of 100% of its shareholders. Concerns and Recommendation: 17

18 Example #3 Facts: You represent target, a corporation. The buyer wants to acquire target s stock for 80% cash and 20% buyer stock. Concerns and Recommendation: 18

19 Example #4 Facts: You represent target, a corporation. The buyer wants to acquire most, but not all of, target s assets for 10% cash and 90% buyer stock. Concerns and Recommendation: 19

20 REQUIREMENTS Continuity of Interest Continuity of Business Enterprise (COBE) Business Purpose Plan of Reorganization Special Tests (not applicable to all reorganizations) Step Transaction Doctrine 20

21 CONTINUITY OF INTEREST IRS 50% Safe Harbor, Rev. Proc IRS 40% in Temp. Reg T(e)(2)(v), example (1) John A. Nelson 38% Stock Miller v. CIR 25% Stock Kass v. CIR 16% Stock is Insufficient 2011 Regulations address changes in value between the date of signing and close; if fixed consideration (Consideration is fixed if contract states exact number of shares and other cash or property to be exchanged) Consideration is valued as of last business day before the first day the contract is binding and If a portion of the fixed consideration is other property identified by value, then the specified value is used for that portion (see Reg (e)(2)) Proposed Regulations (Prop. Reg (e)(2)(vi)) consideration that varies as the value of issuing corporation stock changes prior to closing will not fall below (or above) contractual floor (or ceiling) markers for purposes of continuity of interest. If binding contract uses average value of issuing corporation stock that average value can be used for continuity of interest. Post transaction sales and redemptions 21

22 NON-QUALIFIED PREFERRED STOCK Preferred Stock limited and preferred as to dividends; and does not participate in corporate growth if: (1) shareholder has right to require issuer to redeem (2) issuer is required to redeem (3) issuer has right to redeem and is more likely than not to exercise that right; or (4) dividend rate varies based on interest rate, or commodity price or other index Redemption right exercisable within 20 years and not subject to contingency that renders likelihood remote Excludes stock compensation that may be repurchased on separation from service Conversion feature not enough to participate in growth Generally treated as boot to shareholders 22

23 CONTINGENT STOCK, ESCROWS, AND EARN-OUTS Escrows: Target shareholders usually treated as owner of escrowed Buyer shares unless otherwise agreed Especially true if Target shareholders have right to vote and receive dividends Not clear who is owner if Target shareholders do not have right to vote or receive dividends Earn-Out Stock: Target shareholders not considered owners until Buyer shares are issued Not treated as boot Imputed Interest Rev. Proc Ruling Guidelines use of escrow or contingent stock (1) stock must be distributed within 5 years, subject to escrow or contingency (2) valid business purpose (3) maximum number of shares cannot exceed 50% (4) trigger event not controlled by Target shareholders and not based on tax liability (5) Formula is objective and readily ascertainable (6) Restrictions on assignment and substitution (7) In the case of escrows, Buyer shares shown as issued to Target shareholders, current voting and dividend rights, and vested 23

24 CONTINUITY OF BUSINESS ENTERPRISE AND BUSINESS PURPOSE Aquiror must either continue the target corporation s historic business or use a significant portion of the target s historic business assets in another business Remote COBE transfers to 80% affiliates and partnerships; Reg (d) Business Purpose substantial non-tax corporate level purpose 24

25 PLAN OF REORGANIZATION Section 354(a)(1) Requirement 2007 Regulations Require each corporation that is a party to the reorganization to adopt a plan of reorganization Prior regulations required a written document Courts are more flexible with respect to the requirements Relevant for Step Transaction Doctrine; see J.E. Seagram Corp. v. Comr., 104 T.C. 75 (1995) 25

26 SPECIAL TESTS Type B-Reorganizations No Boot Control Requirement: Buyer must control Target immediately after the acquisition; meaning 80% of voting power and 80% of each class Type C-Reorganizations 20% boot limitation (i.e. 80% COI Requirement) Substantially All Test: Buyer must obtain least 90% of FMV of Net Assets and at least 70% of FMV of Gross Assets Liquidation Requirement Forward Triangular Merger Substantially all of Target s assets acquired by Merger Sub Reverse Triangular Merger Target shareholders surrender control (80% of voting and nonvoting classes of stock) for Buyer voting stock (i.e. 80% COI Requirement) Substantially All Test: Target must obtain least 90% of FMV of Net Assets and at least 70% of FMV of Gross Assets of Target and Merger Sub 26

27 STEP TRANSACTION Judicially developed substance over form argument More than one test has been applied by courts, but most common test is the mutual interdependence test Interdependent steps would have been fruitless without completion of the entire series Regulation (k) and other regulations provide exceptions to the step transaction doctrine IRS or court takes the several transactions or steps and integrates them into a single transaction Not to be confused with economic substance 27

28 BUYER ENTITY CONSEQUENCES Buyer generally takes a carryover basis (assets or stock basis, depending on the transaction) and adds the gain recognized by Target shareholders Subject to loss importation rules NOL limitations often apply under Section

29 PROPOSED REGULATIONS ON LOSS IMPORTATION General Rule: The Buyer's basis in assets acquired under Section 368 is usually the transferor s basis Section 362(e)(1) provides an exception for assets with built-in losses on the date of the transfer The IRS has issued Proposed Regulations explaining how these antiloss importation rules apply (also applies to Section 334(b) transactions) Under the Proposed Regulations, if the aggregate basis of all Importation Property is greater than the aggregate value of such property then the basis of all the Importation Property is its value on the date of transfer Importation Property is property where: (1) the gain or loss is not subject to US tax in the hands of the transferor on a hypothetical sale immediately before the transfer; and (2) the gain or loss is subject to US tax in the hands of the transferee on a hypothetical sale immediately after the transfer 29

30 TARGET ENTITY CONSEQUENCES Target typically does not recognize gain or loss at the corporate level Some COD income exceptions 30

31 TARGET DEBT SECURITIES Exchange of Target securities for Buyer securities is tax free under Sections 354 and 356, to the extent that the principal amount of Buyer debt is less than the principal amount of Target debt Portion attributable to cash basis accrued interest is taxable Possible COD income Example: Target bonds with an issue price (stated principal amount) of $1,000 exchanged for Buyer stock or debt worth $900; Target has COD of $100 31

32 TARGET SHAREHOLDER CONSEQUENCES Target shareholders recognize gain only to the extent of boot (cash consideration) received Loss typically cannot be recognized Character of gain or loss (dividend or capital gain) Section 83 compensation concerns with unvested stock consideration Stock options 32

33 DIVIDEND EQUIVALENCY Section 356(a)(2) Boot as dividend or capital gain; postreorganization redemption test of Rev. Rul Clark hypothetical post-reorganization redemption reduced shareholder s interest from 1.32% to.92% - substantially disproportionate under Section 302(b)(2) Section 302(b)(1) redemption that results in meaningful reduction in voting power is redemption and not essentially equivalent to a dividend Section 302(b)(2) greater than 20% reduction is substantially disproportionate E&P Limitation on Dividend should be Target s E&P but unclear if Merger Sub s E&P counted; PLR , PLR , and PLR

34 UNVESTED STOCK RECEIVED IN A TAXABLE OR NON-TAXABLE DEAL Rev. Rul The revenue ruling addresses: (1) the exchange of fully vested stock for unvested stock of an acquiring corporation in a tax-free reorganization, and (2) the exchange of fully vested stock for unvested stock of an acquiring corporation in a taxable exchange Under either (1) or (2), the Rev. Rul. provides that the exchange constitutes a transfer of property subject to Section 83. The service provider would need to file an 83(b) election to avoid the recognition of compensation income in the future as the shares vest. The Rev. Rul. also provides that the spread will be zero, so there is no downside to the service provider s 83(b) election. 34

35 OPTIONS Assumption or Substitution No tax on substitution of NSO No tax on substitution of ISO, so long as the substitution is not a modification. There is no modification so long as: (1) the aggregate spread in new option does not exceed the spread in the old; and (2) the new option does not have more favorable terms than the old; see Sections 424(a) and 424(h)(3) 35

36 OPTIONS CASH OUT Cancel options for cash payment NSO ISO Ordinary income compensation withholding or 1099 Deduction to Target or Buyer? FICA TAM employer deducts based on method of accounting; not clear if cash out at close is pre-acquisition Target deduction or post-close Buyer deduction in absence of scripting the timing Under the cash method, the deduction generally arises when the employer has paid the property to the employee. See Regs (a)(1). Under the accrual method, the deduction arises when the employer's obligation to make the property transfer becomes fixed, the property's value is determinable and economic performance occurs. See Regs (a)(2) and -4(d)(2)(iii)(B) Exercise and disqualifying disposition treated differently 36

37 2018 TAX REFORM Reduced corporate tax rate (21%) makes certain taxable transactions more tolerable. Applicable to taxable spin-offs, failed forward merger, sale of corporate assets. 37

38 2018 TAX REFORM Tax Cuts and Jobs Act: New Section 1400z Deferral (and potential reduction ) of gains from sale of property that are reinvested in qualified opportunity zones (or funds that invest in qualified opportunity zones ) within 180-days of sale. qualified opportunity zones are low income communities that are designated by the governor of each state (for certification by the Treasury Secretary) within 90 days of the enactment of the Tax Cuts and Jobs Act (30-day extension); limit on number designated by each state is 25% of the low income communities in that state (each state gets 25 even if they don t have 100 low income communities ). Basis increased: By 10% if reinvestment held for at least 5 years; and By 15% if reinvestment held for at least 7 years. Deferred gain (as adjusted) is triggered at the earlier of (i) sale of reinvestment or (ii) December 31, Post-investment gain with respect to the reinvestment in the qualified opportunity zone can be fully excluded if the reinvestment is held for at least 10 years. 38

39 MENLO PARK 149 Commonwealth Dr. Suite 1001 Menlo Park, CA LOS ANGELES 520 Broadway Suite 200 Santa Monica, CA ORANGE COUNTY 135 S. State College Blvd. Suite 200 Brea, CA

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41 Structuring Tax-Free M&A Deals: 351 Mergers Joseph Mandarino January 11, 2018 Smith, Gambrell & Russell, LLP Promenade II, Suite Peachtree Street, N.E. Atlanta, Georgia

42 Disclaimer IRS CIRCULAR 230 DISCLOSURE: Unless explicitly stated to the contrary, this outline, the presentation to which it relates and any other documents or attachments are not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. 42

43 1. Using 351 to Facilitate M&A Deals 2. Basics of Control Issues 4. Solely for Stock 5. Investment Company rule 6. Boot Transactions 7. Liability Issues 8. Basis and Holding Period 9. Interaction with 368 Rules 43

44 Using 351 to Facilitate M&A Deals Depending on the specifics of the transaction, it may be difficult or impractical to satisfy the technical requirements of a 368 reorganization. 351 provides an alternative method of acquiring an entity on a tax-free or tax-deferred basis. Structuring an acquisition under 351 may also facilitate certain non-tax issues (merger of equals, holding company formation, etc.) 44

45 Basics of 351 Property is transferred to a corporation The transfer is made by one or more persons. The transferors have or obtain control of the transferee corporation. The transferors control the transferee corporation immediately after the exchange. The exchange is solely for stock other than nonqualified preferred stock (NQPS). The transaction has a business purpose. (NB -- if boot is issued, the transfer may still qualify for tax-free treatment, but the recipients may be required to recognize gain.) 45

46 Basics of Chart BigCo Shareholders TargetCo Shareholders BigCo TargetCo BigCo would like to acquire TargetCo. 46

47 Basics of Chart BigCo Shareholders TargetCo Shareholders BigCo NewCo TargetCo A new company, NewCo is formed. 47

48 Basics of Chart BigCo Shareholders BigCo stock TargetCo stock TargetCo Shareholders NewCo stock NewCo stock BigCo NewCo TargetCo The shareholders of BigCo and TargetCo contribute their shares to NewCo in exchange for shares in NewCo (and, possibly, cash, etc.) 48

49 Basics of Chart BigCo Shareholders TargetCo Shareholders NewCo BigCo TargetCo At the end of the transaction, NewCo owns both companies and the shareholders of BigCo and TargetCo own NewCo. 49

50 351 vs. 368 Some transactions that would not qualify under 368 will qualify under

51 Rev. Rul Shareholder Group A Shareholder Group B BigCo 10% 90% BigCo would like to acquire TargetCo. Group A wants BigCo stock. Group B wants cash. TargetCo 51

52 Rev. Rul Shareholder Group A Shareholder Group B BigCo 10% 90% Generally, the issuance of all cash to 90% of the shareholders would preclude a transaction under 368. Such a transaction can fit within 351. TargetCo 52

53 Rev. Rul Shareholder Group A Shareholder Group B BigCo 10% 90% SubCo TargetCo BigCo forms a new corporation, SubCo. 53

54 Rev. Rul Shareholder Group A Shareholder Group B BigCo 10% 90% SubCo TargetCo Under a written agreement, Group A contributes 10% of the stock of TargetCo to SubCo in exchange for stock in SubCo. BigCo contributes cash to SubCo in exchange for the rest of the stock of SubCo. 54

55 BigCo Rev. Rul Shareholder Group A Shareholder Group B SubCo 90% NewCo TargetCo BigCo and Group A have 100% control of SubCo. SubCo forms NewCo and contributes all the cash from BigCo. 55

56 BigCo Rev. Rul Shareholder Group A Shareholder Group B SubCo 90% NewCo cash merger TargetCo Newco and TargetCo merge, with TargetCo surviving. Under the terms of the merger, Group B s stock is converted into cash. 56

57 BigCo Rev. Rul Shareholder Group A Shareholder Group B SubCo TargetCo At end of day, BigCo and Group A have stock. Group B has cash. 57

58 Double Dummy Alpha Shareholders NewCo Beta Shareholders AlphaCo BetaCo Alpha and Beta are public companies of equal value that want to merge. Each is worth $100. Each set of shareholders want $75 of cash. NewCo formed to facilitate the transaction 58

59 Double Dummy Alpha Shareholders NewCo Beta Shareholders AlphaCo Sub1 Sub2 BetaCo NewCo forms Sub1 and Sub2. Sub1 merges into AlphaCo AlphaCo survives. Sub2 merges into BetaCo BetaCo survives. 59

60 Double Dummy Alpha Shareholders NewCo Beta Shareholders AlphaCo BetaCo Each set of shareholders receive $75 in cash and $25 worth of NewCo stock. 60

61 Double Dummy $75 cash 50% of NewCo Alpha Shareholders Beta Shareholders $75 cash 50% of NewCo NewCo AlphaCo BetaCo At end of day, shareholders get cash and stock. Could this transaction qualify under 368? Does transaction qualify under 351? 61

62

63 Control Issues 1. Control Group 2. Control Percentage 3. Immediately After Requirement 63

64 Control Group Generally, any type of taxpayers can make up the control group individuals, trusts, corporations, partnerships, etc. Often the control group is defined in the operative transactional documents. The members of the control group do not have to make their transfers simultaneously so long as the transfers are set out in a contract or agreement, are made pursuant to a plan, etc. The cases are more forgiving than the regulations. 64

65 Control Percentage In order to qualify under 351, the control group must possess control of the corporation immediately after the transfers. Control = ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation. Stock attribution rules do not apply only actual ownership of stock counts (BUT consolidated groups can aggregate ownership). 65

66 Control Percentage -- NQPS NQPS generally cannot achieve tax-free treatment for receipt of nonqualified preferred stock ( NQPS ). But if the corporation has non-voting NQPS, then control group must acquire 80% of that class. Trap for the unwary eliminate or modify any classes of non-voting NQPS before transaction? 66

67 Immediately After Requirement To come within 351, the control group must satisfy control immediately after the transfer. Subsequent distributions of stock by members of the control group or issuance of new stock by the corporation could change whether the 80% control test is satisfied. The cases, unfortunately, are all over the map and do not apply a consistent standard. Moreover, both the IRS and taxpayers have argued opposing positions across the cases. If in doubt, get a ruling or prohibit future transfers. NOTE -- If a corporate member of the control group distributes the stock to its shareholders, 351(c) permits the transfer. 67

68 Solely for Stock To qualify for tax-free treatment under 351, a transferor must transfer property solely for stock of the corporation. Stock warrants and stock rights generally would not qualify as stock for this test. A hybrid instrument presents a challenge if the instrument is characterized as debt it may trip up tax-free treatment. NQPS is not treated as stock for this test and requires recognition of gain under the boot recognition rules (discussed below). The solely-for-stock requirement is for a clean 351 transaction. If there is boot, then the parties may recognize gain, but 351 may otherwise apply (as discussed below). 68

69 Solely for Stock NQPS NQPS is defined under 351 as preferred stock with any of the following rights: the holder of the stock has the right to require the issuer or a related person to redeem or purchase the stock, the issuer or a related person is required to redeem or purchase such stock, the issuer or a related person has the right to redeem or purchase the stock and, as of the issue date, it is more likely than not that such right will be exercised, or the dividend rate on the stock varies in whole or in part (directly or indirectly) with reference to interest rates, commodity prices, or other similar indices. 69

70 Investment Company Rule Certain transfers to a corporation that meets the definition of an investment company will not qualify for tax-free treatment. A transfer comes within this exclusion if two requirements are met: the transfer results, directly or indirectly, in a diversification of the transferor s interests; and the transfer is to a RIC, a REIT, or a corporation more than 80% of the value of whose assets are held for investment and are stocks or securities, or interests in RICs or REITs. 70

71 Investment Company Rule If the transfer itself does not create diversification, subsequent actions by the corporation could be viewed as creating diversification. Not clear whether step transaction applies and what standard to be used. Significant exception if transferor is contributing an alreadydiversified portfolio in that case, the transfer itself does not create diversification so the exclusion does not apply. 71

72 Boot Transactions Boot Defined NQPS Calculation of Gain Built-in Loss Basis Effect 72

73 Boot Defined If a transaction otherwise comes within 351, the presence of boot does not disqualify it. Instead, the parties receiving the boot must recognize gain. For these purposes, boot is cash, property, NQPS, or anything that does not meet the solely for stock test. NB a transferor who receives boot and stock of the corporation is still covered by 351 that is, the transferor only recognizes gain to the extent of the FMV of the boot. However, if a transferor receives only boot and not stock of the corporation, then the transfer does not come within 351 and is taxed as if the transaction were a taxable sale under

74 NQPS As noted, NQPS is treated as boot for purposes of the boot-gain rule. Thus, a transferor who receives NQPS and good stock, recognizes gain on the transaction to the extent of the FMV of the NQPS. However, NQPS is treated as stock for purposes of the 80%- control test. Suffice to say, this is not an intuitive result and is a trap for the unwary. 74

75 Boot Gain Calculation Generally, the recipient of boot must recognize the smaller of the following amounts: the gain the recipient would have recognized if the transaction were treated as a taxable sale, or the FMV of the boot 75

76 Boot Gain Calculation Example 1: Eve contributes property with a basis of $100 to Newco and receives stock in Newco worth $500. Assume the transaction is otherwise covered by 351. In this case, Eve receives no boot, so she recognizes no gain. 76

77 Boot Gain Calculation Example 2: Eve contributes property with a basis of $100 to Newco and receives stock in Newco worth $250 and $250 in cash. Assume the transaction is otherwise covered by 351. In this case, Eve receives $250 of boot. If this were a taxable transaction, she would recognize $400 of gain ($500 FMV of consideration less $100 tax basis). Because the FMV of the boot is less than the inherent gain, she only has to recognize the FMV of the boot ($250) 77

78 Boot Gain Calculation Example 3: Eve contributes property with a basis of $300 to Newco and receives stock in Newco worth $250 and $250 in cash. Assume the transaction is otherwise covered by 351. In this case, Eve receives $250 of boot. If this were a taxable transaction, she would recognize $200 of gain ($500 FMV of consideration less $300 tax basis). Because the inherent gain is less than the FMV of the boot, she recognizes only the smaller of the two, or $

79 Boot Gain Calculation Example 4: Eve contributes property with a basis of $1,000 to Newco and receives stock in Newco worth $250 and $250 in cash. Assume the transaction is otherwise covered by 351. In this case, Eve receives $250 of boot. If this were a taxable transaction, she would recognize a loss of $500 of gain ($500 FMV of consideration less $1,000 tax basis). Because the inherent gain is zero and is less than the FMV of the boot, she recognizes only the smaller of the two, or $0. She is explicitly not permitted to recognize the loss. 79

80 Liability Issues Basic rule (a) Example Abuse Rule (b) Liabilities in Excess of Basis (c) Techniques 80

81 Liability Issues Under the partnership tax rules, the assumption of a contributor s liabilities is treated as a deemed cash distribution to the contributor. In the corporate context, this could be viewed as the receipt of boot and trigger gain recognition. However, this rule does not apply in the context of a 351 contribution. Subject to certain exceptions, 357(a) provides that if a corporation assumes a transferor s liabilities as part of a transfer, the assumption is not treated as boot for purposes of

82 Liability Issues Example: Adam contributes real estate worth $100 to Newco in exchange for 50% of the stock of Newco. The real estate is subject to a $50 mortgage. As part of the same plan, Eve contributes $50 to Newco in exchange for 50% of the stock of Newco. If Newco were a partnership, the applicable tax rules would treat Adam as receiving a deemed cash distribution at the time of the contribution. Under 357(a), the corporation s assumption of the mortgage is not treated as boot to Adam. 82

83 Abuse Rule An exception to this general rule is 357(b) which is triggered if: (1) the principal purpose of the taxpayer with respect to the assumption of any liability was to avoid federal income tax on the exchange; or (2) a bona fide business purpose does not exist for the assumption. Note that if 357(b) is triggered then ALL of the liabilities are treated as boot, not just the abuse liabilities. 83

84 Abuse Factors There are not clear standards for application of 357(b), but the following factors invite scrutiny: there is a short time period between incurrence of a liability and assumption by the corporation the purpose of the liability is not business-related the collateral that secured the liability is not transferred to the corporation By statute, the taxpayer has the burden of proof on this issue and must prove his/her case by a clear preponderance of all the evidence. 84

85 Liability in Excess of Basis Another exception to the general rule is found in 357(c). It provides that if the amount of liabilities exceeds the total basis of the contributor s property that is transferred to the corporation, then the difference is recognized as gain. Example: Adam contributes real estate worth $100 to Newco in exchange for 50% of the stock of Newco. The real estate is subject to a $50 mortgage and has a tax basis of $25. As part of the same plan, Eve contributes $50 to Newco in exchange for 50% of the stock of Newco. The liability assumed by Newco ($50) exceeds Adam s basis in the property ($25). Under 357(c), Adam recognizes $25 of gain (the excess of the assumed liabilities over the tax basis). 85

86 Basis and Holding Period 86

87 Basis to the Transferor The transferor s basis in the stock received is equal to: the basis of the property transferred to the corporation LESS the FMV of any boot received LESS the amount of any liabilities assumed PLUS the amount of gain recognized by the transferor (The basis of any boot received by the transferor is its FMV.) 87

88 Basis to the Corporation The corporation s basis in the contributed property is equal to: the transferor s basis in the property PLUS the amount of gain recognized by the transferor NB if the contributed property is transferred subject to a liability, the basis cannot be greater than the property s FMV. 88

89 Holding Period Rules The transferor s holding period for the stock received in a 351 transaction will generally include the holding period of the contributed property. However, if the contributed property was not a capital asset or a 1231 asset in the contributor s hands, then the capital gains holding period will generally commence with the receipt of the stock. The corporation s holding period for the property received in a 351 transaction will generally include the transferor s holding period. 89

90 Interaction with

91 Reorganization Doctrines Business Purpose Continuity of Interest Continuity of Business Enterprise 91

92 Business Purpose The IRS takes the position that in order to qualify under 351, a transaction must have a valid business purpose 92

93 Continuity of Interest Generally, the continuity of interest requirement for 368 reorgs does not apply to 351 transactions. 93

94 Business Enterprise The IRS takes the position that the continuity of business enterprise requirement for 368 reorgs also applies to 351 transactions. 94

95 Thank You Joseph Mandarino Smith, Gambrell & Russell, LLP Promenade II, Suite Peachtree Street, N.E. Atlanta, Georgia