Tax 4022/5022 Federal Income Tax II Corporate Acquisitions Chapter: None

1. Tax 4022/5022 Federal Income Tax II Corporate Acquisitions Chapter: None Dr. Robert R. Oliva Professor and Chairperson Department of Accounting University of Arkansas at Little Rock

2. Corporate Acquisitions • I. Taxable Acquisitions • II. Non-Taxable Acquisitions: Reorganizations

3. Taxable Acquisitions

4. Introduction • I. ASSET ACQUISITION • II.STOCK ACQUISITION

5. ASSET ACQUISITION (not a reorganization): • Two possibilities: • (1) • A. Purchasing Corporation (P) buys assets from Target Corporation (T) • B. T liquidates cash from sale of assets to T’s shareholders • (2) • A. T liquidates assets to its shareholders and • B. Pbuys assets from T’s shareholders

6. Tax effect • Two levels of taxation: corporate and shareholder • If so, P takes a cost AB • P could avoid the corporate-level tax on a stock purchase, but AB will be c/o.

7. Allocation • Sale of assets of a going business requires allocation • Buyers and sellers have conflicting interests.

8. Seller • Seller’s gain or loss and character may depend on how the sales price is allocated. • Favor allocation to assets yielding capital gains.

9. Buyer • Buyer’s AB and depreciation depends on how sales price is allocated. • Favor allocation of sales price to depreciable assets

10. Price allocations may be contractually specified, or may be imposed by IRC. • IRC 1060: Review it and its regulations

11. IRC 1060 • Where there is no agreement between the parties, or if there is one, IRS finds allocation not appropriate. • Outlines specific allocation method for applicable assets acquisitions. • Applicable asset acquisitions: Direct or indirect transfers of trade or business assets, where buyer’s (transferre) AB is determined by price paid for assets.

12. Treas. Reg. 1.1060-1: • Allocate as in Treas. Reg. 1.338-6: 7 classes of assets • 1.338-6(a)(1): Adjusted grossed-up basis (AGUB) is allocated among target's “acquisition date assets.” • Target’s assets held at the beginning of the day after the acquisition date. Reg §1.338-2(c)(2) .

13. 7 classes of assets • Class I: cash, savings accounts, checking accounts, but not CDs. • If Class I assets exceed AGUB, new target immediately realizes ordinary income in the amount of the excess. • Classes II through VII: • In proportion to, and not in excess of, their fair market value:

14. Class II - VII: In proportion to, and not in excess of, their fair market value: • Class II: CDs, foreign currency; US gov secs; publicly traded stock (not of target’s affiliate); actively traded personal property • Class III: mark-to-market assets and some debt instruments • Exceptions: debt instruments issued by related parties; contingent debt; convertible debt • Class IV: Inventory • Class V: Not in any of the classes above or below: furniture, buildings, land, actively traded T’s affiliate stock • Class VI: IRC 197 intangibles o/t goodwill and going concern value • Class VII: goodwill and going concern value.

15. Method of allocation • Asset by asset, starting first with I and down. • On the basis of FMV. • See Treas. Reg. 1.1060-1(d): Example 2.

16. STOCK ACQUISITION

17. Stock Acquisition • P buys stock of T from T’s shareholders. • If T is closely held, negotiation may be face to face. • But likely to be different if T is publicly or widely held.

18. Either way: • T’s shareholders recognize gain(loss) • P takes a cost AB

19. Kimbell-Diamond’’s transitory ownership doctrine • Some stock purchases had been treated as asset acquisitions when the stock purchase was followed by a liquidation of Target into Parent. • Codified into IRC 334(b)(2): Asset’s AB = c/s AB if 80% acquired by purchase w/i 12 month and plan of liquidation adopted w/i 2 years after acquiring control • However, in 1982: IRC 334(b)(2) was repealed

20. IRC 338: “Qualified stock purchase” (QSP) • Replaced IRC 334(b)(2) • Qualified purchase (control) requirement • Time requirement • Timely election requirement

21. The IRC 338 election • Actual election: IRC 338(a) • “… if a purchasing corporation makes an election … in the case of a qualified stockpurchase…. ” • Deemed election: IRC 338(e) • “… a purchasing corporation … treated as having made an election (the deemed election) … if … during the consistency period… acquires any asset of the target…. ”

22. “purchasing corporation”: IRC 338(d)(1) • one which makes a QSP of another corporation.

23. “target corporation”: IRC 338(d)(2) • one whose stock is acquired through a QSP

24. QSP: IRC 338(d)(3) • One or a series of transactions, where the purchasing corporation (not an individual) acquires by purchase • “sufficient target stock” • during a “12-month acquisition period”

25. How to “purchase” stock:IRC 338(h)(3)(a), (b) • Taxable stock “purchase” from an unrelated party. • Not by gift, inheritances, or tax-free/carry-over basis transactions. • Purchases by affiliates of purchaser are included • Effect of redemptions are included, e.g., redeeming of minority shareholders to bring purchasing corporation to 80%.

26. “Purchase” does NOT include stock acquisition from • persons whose stock will be attributed to purchasing corporation: IRC 338(h)(3)(A)(iii) • e.g., cant buy from yourself • Apply IRC 318(a) ignoring option attribution.

27. Exception: Acquisitions from persons that are “related corporations” • DO consider acquisitions from a related corporation if 50% or more of stock of related corporation was acquired by “purchase”. • “related corporation”: IRC 338(h)(3)(C)(iii): if stock owned by a related corporation treated as owned by the acquiring corporation.

28. Second element: “sufficient target stock” • > 80% of the voting power and • > 80% of the value of all classes of stock • except nonvoting, nonparticipating preferred stock, that is not counted for the > 80% test.

29. Third element: “12-month acquisition period”: IRC 338(h)1) • “12 month” is a moving parameter, ending on “acquisition date”.

30. Acquisition date/First day • “acquisition date”: the first day of the acquisition period that took P into an 80% ownership by purchase. It is not necessarily the last day of the 12-month period. • First day of 12 month period: Look back 12 month from acquisition date.

31. The election • Who makes it? • When is it made? • How is it made? • What is the effect of the election?

32. Who makes it? • By P • But there is a special case where T joins in the election.

33. When is it made? • Must be made on or before the 15th day of the 9th month beginning after the month during which the 80% control is satisfied.

34. How is it made? • File Form 8023 (Corporate Qualified Stock Purchase Election) with P’s IRS Service Center

35. What is the effect of the election? • Irrevocable • Effect on Target • Effect on Purchaser

36. Effect on Target • the “target” is treated as two: • the Old Target • the New Target

37. Effect on Old Target: IRC 338(a)(1) • Old Target treated as having sold ALL of its assets at FMV at the end of the day considered as the “acquisition date”. • Recognize gain or loss on the deemed sale • Use any tax attributes to offset gains; unused attributes are extinguished. • Recognize income earned to acquisition date-if not included in consolidated return.

38. Thus, a disadvantage: • there could be significant up-front tax costs

39. But there may not be up-front tax costs • Old Target may be able to use NOLs, which otherwise may be wasted, to offset recognized gains on the deemed sale. • In turn provided stepped-up AB to New Target.

40. At what price did the Old Target sell its assets? • IRC 338(a)(1): At FMV • But: Treas. Reg. 1.338-4(a): At the “aggregate deemed sales price” (ADSP)

41. “aggregate deemed sales price” (ADSP): 1.338-4(b) • ADSP: determined at the beginning of the day after the “acquisition date” • grossed up amount realized on the sale to the purchasing corporation of the purchasing corporation’s recently purchased stock (RPS), and • liabilities (including taxes from gain recognition in 338 election)

42. “Grossed up amount realized”: 1.338-4(c)(1) • Amount realized on the sale to P of the RPS / % of T stock, by value, attributable to the RPS stock • Less selling costs

43. Example: 1.338-4(c)(2) • Voting c/s; Pfd stock (not taken into account for > 80% test) • P buys c/s from 3 different parties when 100% FMV is $1250, and pfd FMV = $750: • From S1: 40% for $500; selling costs = $40 • From S2: 20% for $225; selling costs = $35 • From S3: 20% for $275; selling costs = $25

44. What is the “grossed up amount realized”? • Amount realized on the sale to P of the RPS = $1000 • % of T stock, by value, attributable to the RPS stock = $1000/(FMV c/s $1250 + FMV pfd $750) = 50% • Selling costs = $100 • Hence: GUAR: $1000/.50 - $100 = $1900

45. Note: About liabilities • In previous example there were no liabilities other any tax liability to be incurred by the deemed sale.

46. Example (1) in Treas. Reg. 1.338-4(g)(1): 1 of 4 • One asset (IRC 1245 property), bought for $80K (recomputed AB), AB = $50,400, FMV = $100,000. P purchases all 100% of the stock for $75,000 • ADSP = GUAR + L + MTR (ADSP-AB)

47. Example (1) continues: (2 of 4): GUAR • Amount realized on the sale to P of the RPS / % of T stock, by value, attributable to the RPS stock = $75,000/1.00 • Selling costs = $0 • Hence: GUAR: $75,000/1.0 - 0 = $75,000

48. Example (1) continues: (3 of 4): Solving for ADSP in ADSP = GUAR + L + MTR (ADSP-AB) • ADSP = $75,000 + 0 + 0.34 (ADSP - $50,400) • ADSP = 75,000 + 0.34 ADSP - 17,136 • ADSP -0.34 ADSP = $57,864 • ADSP = 57,864/0.66 = $87,672.73 • As ADSP < FMV of asset, then entire ADSP is allocated to the 1245 property

49. End result in example (1): (4 of 4) • Thus: Gain = 87,672.73 - 50,400 = 37,272.73 • But since 1245 property: • $80,000 - $50,400 = $29,600 ordinary income • 37,272.73 - 29,600 = $7,673.73 capital gain

50. Example (2) in Treas. Reg. 1.338-4(g)(1): 1 of 5 • P buys all stock for $140,000 • Other: • T’s Liabilities (other than the tax for deemed sale gain) = $50K • Cash (Class I) = $10K • Marketable securities (Class II) = FMV $10K, AB $4K • Goodwill (Class VII) = AB $3K