chapter 7a. corporate reorganizations c9-chp-07-1a-acq-reorgs-taxable--tax-free-2009 edited february 14, 2009 howard go

1. 1 Chapter 7A.Corporate ReorganizationsC9-Chp-07-1A-Acq-Reorgs-Taxable--Tax-free-2009Edited February 14, 2009

3. In order to understand the general rules for taxable acquisitions, it is important to understand: Code sections dealing with gains and losses on exchanges of property. Code sections dealing with distributions of cash and other property by corporations to their shareholders. (Chapter 5). Code sections covering corporate liquidations (Chapter 6). Please use following file along with these slides. C9-Chp-07-5A-Reorganization-JCorp-Big Corp

5. Need to understand: 1. Tax rules for the two taxable types of acquisition of JCorp or its assets by Big Corp – See slides 11 & 12+later. 2. Tax rules for the two tax-deferred types of acquisition of JCorp or its assets by Big Corporation – See slides 59 & 63+ later. Type B and C reorgs. See Second PowerPoint file for Ch. 7: 3. Tax rules for divisive reorgs. See Local Corp and New Corp. Slides 7+ 4. General principles for reorganizations: Continuity, Step Transactions, etc.

6. Preview of things to come 1. In a type B reorganization, as defined by the Internal Revenue Code, the I. Stock of the target corporation is acquired solely for the voting stock of either the acquiring corporation or its parent.  II.Acquiring corporation must have control of the target corporation immediately after the acquisition. a. I only. b. II only. c. Both I and II d. Neither I nor II  (CPAN94)

7. Please study the slides on the following pages. They provide the basis for illustrating many of the tax rules of this chapter.

10. Payment of cash for corporate assets or corporate stock (Slide 1B) will prevent the transaction from being tax-free or tax-deferred for the selling entity (Jan or JCorp) (Transactions 1 & 2). Lets determine the tax impact on all parties for the acquisition of JCorp assets by paying cash of $2,000,000, and Jan’s later liquidation of JCorp.

13. The student should be able to: 1. Explain the types of taxable acquisition transactions. 2. Explain differences between taxable and tax-free acquisition transactions. 3. Explain the types of tax-free reorganizations & their requirements. 4. Determine the tax consequences of a tax-free reorganization to target corp.

14. The student should be able to: Determine the tax consequences of a tax-free reorganization to the acquiring corp. 6. Determine the tax consequences of a tax-free reorganization to the target's shareholders and security holders. 7. Explain how judicial doctrines can restrict a taxpayer's ability to use corporate reorganizations. 8. Determine which reorganization forms permit the carryover of tax attributes. 9. Explain how NOL carryovers are restricted following an acquisition.

15. 15 1. Explain the types of taxable acquisition transactions.

16. 16 Taxable Acquisition Transactions. Acquiring corps have two primary ways to acquire the assets of a target corp. Acquiring corp. can acquire the needed assets directly from the target. The acquiring corp. can acquire an indirect interest in the assets by purchasing a controlling (more than 50%) interest in the target's stock.

17. 17 Taxable Acquisitions. Asset Acquisitions. The selling corp recognizes gain or loss recognized on the sale of each individual asset. Sale of depreciable assets may give rise to recapture. Purchaser's bases for the assets are their acquisition cost. Purchaser can claim depreciation based upon the property's total acquisition cost.

18. 18 Asset Acquisitions. There are several advantages to an asset acquisition. First, a significant portion of the acquisition can be debt-financed. Second, only those assets and liabilities that are designated in the purchase-sale agreement are acquired. Target corp may be liquidated after the asset sale takes place. Target corp recognizes gain or loss with respect to the assets that are sold as well as any properties that are retained by the target corp and sold to third parties or distributed to the shareholders as part of the liquidation. Both the liquidating corp and the target's shareholders report gain or loss on the liquidation.

19. 19 Stock Acquisition with No Liquidation. A stock acquisition is the simplest of the acquisition transactions. If part of the consideration is deferred until a later year, the seller's gain can be reported using the installment method. If part of the consideration received by the seller represents an agreement with the purchaser not to compete, the consideration received is ordinary income. The purchaser's basis for the stock is its acquisition cost.

20. 20 Stock Acquisition Followed By Liquidation. If the parent owns at least 80% of the sub's stock, then the liquidation of the acquired sub into the acquiring parent is tax-free under Sec. 332 and 337. Sub's basis for the assets on its books carries over to the parent. If the parent paid a premium for the assets then this premium is lost when the liquidation occurs because the parent's basis for the stock disappears when the tax-free liquidation occurs. This disappearing basis provides no tax benefit.

21. 21 Sec 338 Deemed Liquidation Election. The Sec. 338 deemed liquidation election permits the acquiring and target corporations to elect an indirect (two-step) acquisition of the target corporation's assets. First the target's shareholders sell their stock to the acquiring corp. The acquiring corp. makes a deemed liquidation election with respect to the acquisition of the target corporation's stock. The transaction requires that the "old" target corporation recognize gain and loss on the hypothetical sale of the assets from the "old" target corporation to the "new" target corporation. The "new" target corporation is treated as a new entity for tax purposes.

22. 22 Eligible Stock Acquisitions. In order to elect under Sec. 338, the acquiring corp must buy 80% or more of the target's voting stock and 80% of the total value of all classes of stock (except certain nonvoting preferred stock) during a 12-month acquisition period beginning on the day the first purchase is made. The Election. A Sec. 338 election must be made by the 15th day of the n9th month, beginning on the acquisition date. Acquisition date is the first day of the 12-month acquisition period on which the 80% stock ownership requirement is met.

23. 23 Deemed Sale Transaction. When a Sec. 338 election is made, the target corporation is treated as having sold all of its assets at their FMV in a single transaction at the close of the acquisition date. The asset sale is taxable with gain or loss being recognized by the target corporation. Basis of Assets After Deemed Sale. The basis of the acquiring corporation's assets are stepped-up to the amount paid by the acquiring corporation for the target's stock plus an adjustment for the target's debt on the day following the acquisition date and other relevant items. This amount is called the adjusted grossed-up basis.

24. 24 Allocation of Basis to Individual Assets. The adjusted grossed-up basis is allocated among four classes of assets using residual method. Any amount not allocated to tangible or intangible assets of the target corp. is allocated to goodwill and going concern value. The Tax Act of 1993 provides that intangible property acquired after August 6, 1993 is amortizable over a 15-year period if used in the active conduct of a trade or business. Sec. 197 intangibles include: goodwill, going concern value, covenants not to compete, etc.

25. 25 Tax Accounting Elections for the New Corp. The "new” target corp. continues to file a tax return and is treated as a new tax entity. Elections can be made with respect to the corp's tax year & accounting methods. New MACRS depreciation deductions can be taken without regard to the ACRS or MACRS elections made by the old corp. Holding period for assets begins on the day after the acquisition date. New corp is not considered a continuation of the old corporation for purposes of the tax attribute carryover rules, thus any loss carryovers of the "old" target corp are lost. Gain recognized on the deemed sale transaction can reduce the amount of any target corporation loss and credit carryovers that might otherwise be lost.

26. 26 2. Explain the differences between taxable and tax-free acquisition transactions.

27. 27 First, consider taxable and tax-free asset acquisitions.

28. 28 Taxable and Tax-free Asset Acquisitions. Tax Consequences for Target Corp. Taxable sale. All gains and losses realized by Target on selling its assets are recognized. In a reorganization, gains realized by Target on disposition of its assets are generally not recognized because it is liquidated and gain is recognized only if boot property received in the reorganization is retained by the target. Losses realized on asset dispositions are not recognized.

29. 29 Tax Consequences for Target Corp. … In a reorganization, when Target is liquidated, it recognizes no gain or loss when making a distribution of stock or debt received in the reorganization to its shareholders or creditors. It must recognize gain (but not loss) when other property (e.g., nonmoney boot property) is distributed to a shareholder or creditor.

30. 30 Tax Consequences for Acquiring Corp. Acquiring Corp does not recognize gain or loss when its stock is issued in exchange for property in either a taxable or tax-free transaction. Assets received in a taxable transaction have their tax basis adjusted upward or downward to their acquisition cost. Holding period for the acquired assets commences on the day after the transaction date.

31. 31 Tax Consequences for Acquiring Corp. … When assets are acquired in a tax-free reorganization, their bases are generally the same as they were on Target's books because a basis step-up is permitted only when the target corporation receives boot property that it retains, and thereby recognizes a gain. The retention of boot by the target corporation generally does not occur since most acquisitive reorganizations result in the target corporation being liquidated. Acquiring's holding period tacks on to Target's holding period.

32. 32 Because a taxable acquisition is treated as a purchase transaction, all of Target's tax attributes disappear when it is liquidated. On the other hand, tax attributes are acquired in a tax-free reorganization.

33. 33 Tax Consequences for Target's Shareholders. In a taxable acquisition, when Target is liquidated its shareholders recognize gain or loss from the surrender of their stock. Assets received have basis equal to their FMV. A tax-free reorganization requires the shareholder to recognize gain only to the extent that boot is received. The gain is generally taxed as a capital gain, although dividend income may be reported in certain situations. The stocks and securities received take a substituted basis that references the basis of the Target stock and securities surrendered. The basis of any boot property is its FMV.

34. 34 Accounting for the Acquisition. A taxable acquisition is reported for financial accounting purposes using purchase accounting.

35. 35 Now, consider taxable and tax-free stock acquisitions.

36. 36 Comparison of Taxable and Tax-Free Stock Acquisitions. Assume Acquiring Corp acquires all of Target's stock & Target becomes a controlled subsidiary. If Acquiring Corp uses cash, debt obligations and its stock to make the purchase, the acquisition is taxable. If Acquiring Corp acquires all of Target's stock using solely its voting stock or voting stock of its parent corporation to effect the transaction, the acquisition qualifies as a tax-free reorganization.

37. 37 Comparison of Taxable and Tax-free Asset Acquisition Transactions. 1. Tax Consequences for Target Corp. Target's basis for its assets does not change as a result of either a taxable or tax-free transaction. 2. Tax Consequences for Acquiring Corp. Acquiring Corp does not recognize gain or loss when its stock is issued for property in either a taxable or tax-free transaction. Acquiring Corp's basis for the stock in a taxable acquisition is its acquisition cost. In a tax-free transaction, basis for the stock is the same as it was in the hands of Target's shareholders.

38. 38 Taxable & Tax-free Asset Acquisitions. 3. Tax Consequences for Target's Shareholders. Shareholder's gain is recognized in a taxable acquisition. In a tax-free transaction, it is only recognized to the extent that boot is received. Gain recognized on a taxable stock transaction is capital gain if the stock is a capital asset in the seller's hands. In a tax-free reorganization the gain can be either dividend income or capital gain, although the latter result usually occurs. The seller's gain can be reported using the installment method of accounting if part or all of the consideration is deferred into a later year.

39. 39 Taxable &Tax-free Asset Acquisitions. 4. Accounting for the Transaction. A taxable acquisition of Target stock is reported for financial accounting purposes using purchase accounting.

40. 40 3. Explain the types of tax-free reorganizations and their requirements.

41. 41 Taxable & Tax-free Asset Acquisitions. Types of Reorganizations. Sec. 368 authorizes 7 types of reorgs. The different types of reorgs are generally referred to by the subparagraph letter of Sec. 368. An acquisitive reorganization is a transaction where the acquiring corporation obtains part or all of the assets of the target corporation. Types A, B, C, D, and G reorgs can be classified as acquisitive transactions.

42. 42 Taxable & Tax-free Asset Acquisitions. Types of Reorganizations. A divisive reorganization is a transaction in which part of a transferor corp's assets are transferred to a second, newly-created corp that is controlled by either the transferor or its shareholders. Type D or G reorganizations can be either acquisitive or divisive. A Type E reorg is a recapitalization of an existing corp. A Type F reorg changes the identity, legal form, or state of incorporation.

43. 43 Tax Consequences of Reorganizations. Target or Transferor Corporation. 1. Recognition of Gain or Loss on Asset Transfer. Section 361(a) prevents a target corp. from recognizing gain or loss on any exchange of property that occurs as part of a tax-free reorg. in order to prevent the transferee corp. from increasing its basis for the assets it acquires. Receipt of money or other property does not disqualify the transaction or trigger the recognition of gain if the money or boot is distributed to shareholders or creditors. Retention of boot by target generally does not occur since most acquisitive reorganizations result in the target corporation being liquidated.

44. 44 4. Determine the tax consequences of a tax-free reorganization to the target corporation.

45. 45 Consequences of Reorganizations. Target or Transferor Corporation. Depreciation Recapture. The depreciation recapture rules do not override the nonrecognition of gain provisions of Sec. 361. Depreciation recapture potential carries over to the acquiring corporation.

46. 46 Tax Consequences of Reorganizations. Target or Transferor Corporation. Assumption of Liabilities. The acquisition or assumption of liabilities of the target by the acquiring corp will not trigger the recognition of gain. Target recognizes gain if the liabilities assumed or acquired exceed the total adjusted bases of the properties transferred and the tax-free reorganization is either an acquisitive or divisive Type D reorganization.

47. 47 Tax Consequences of Reorganizations. Target or Transferor Corporation. Recognition of Gain or Loss on Distribution of Stock and Securities. No gain or loss is recognized by corp when it distributes the stock and securities received in a tax-free reorganization to its shareholders or creditors as part of the reorganization plan. Distributions of boot property made pursuant to the reorganization plan require the recognition of gain, but not loss. If property is distributed to a shareholder or creditor subject to a liability, the FMV of the property is considered to be not less than the amount of the liability.

48. 48 5. Determine tax consequences of a tax-free reorganization to acquiring corporation.

49. 49 Tax Consequences of Reorganizations. Acquiring or Transferee Corporation. 1. Amount of Gain or Loss Recognized. No gain or loss is recognized by the acquiring corp when it receives money or other property in exchange for its stock as part of a tax-free reorganization. 2. Basis of Acquired Property. Basis of property received in a tax-free reorganization is its basis in target's hands increased by any gain recognized by the target. Generally there is no step-up in basis because gain or loss is usually not recognized by the target corporation. 3. Holding Period of Acquired Property. The holding period includes the target's holding period for the acquired property.

50. 50 6. Determine the tax consequences of a tax-free reorganization to the target corporation's shareholders and security holders.

51. 51 Tax Consequences of Reorganizations. Shareholders and Security Holders. Amount of Gain or Loss Recognized. No gain or loss is recognized when stock or securities of the target are exchanged for stock or securities, either in the acquiring corp or in another corp that is also a party to the reorg. Section 356(a) requires that gain be recognized to the extent of the lesser of the realized gain or the amount of money plus the FMV of other boot property received.

52. 52 Tax Consequences of Reorganizations. Shareholders and Security Holders. … Nontraditional preferred stock (for example, preferred stock that must be redeemed or purchased by the issuer) may also be considered boot property. Gain is also recognized if the principal amount of the securities received exceeds the principal amount of the securities surrendered. The boot amount is the FMV of the excess principal amount.

53. 53 Tax Consequences of Reorganizations. Shareholders and Security Holders. Character of the Recognized Gain. Section 356(a)(2). Gain recognized is a dividend if the receipt of property has the effect as a dividend. Sec. 302(b) stock redemption rules determine whether the exchange has the effect of a dividend. Tax-free reorgs do not generally involve actual redemptions of the stock of the target corp's shareholders. Instead, the shareholder is treated as having exchanged his target stock in a tax-free reorg solely for stock in the acquiring corp. After having received the acquiring corp's stock, a hypothetical redemption of a portion of the acquiring corp's stock occurs in exchange for the boot property. Capital gain treatment results only if the boot that is received causes the hypothetical redemption to qualify for exchange treatment under Sec. 302(b).

54. 54 Tax Consequences of Reorganizations. Shareholders and Security Holders. Basis of Stocks and Securities Received. If no gain or loss is recognized by the shareholders or security holders, the stock and securities received take a substituted basis from the stock and securities exchanged. If gain is recognized, the substituted basis is increased by the amount of the gain recognized and reduced by the amount of money plus the FMV of any other boot property received.

55. 55 Tax Consequences of Reorganizations. Shareholders and Security Holders. Holding Period. Holding period for stocks and securities that are nonrecognition property includes the holding period for the stocks and securities that are surrendered. Holding period for stocks and securities that are boot property and any other boot property begins on the day after the transaction date.

56. 56

57. 57

58. 58 JCorp owns buildings with a basis of $400,000 and a FMV of $1,400,000 – which sets the stage for a $1,000,000 possible gain for JCorp. on disposal of those assets. Jan’s basis in her JCorp. stock is $100,000. Her JCorp. stock has a value of $2,000,000. This sets the stage for a possible gain of $1,900,000 for Jan upon disposal of her stock.

59. 59 JCorp. – Slide 3D Big Corporation gives Big Corp. stock worth $2,000,000 to JCorp in exchange for all of JCorp’s assets. JCorp distributes all of the Big Corporation stock to Jan.

60. 60 1. What is JCorp’s gain or loss on the exchange if its assets for Big stock worth $2,000,000? Sec. 361(a) 2. What is JCorp’s gain or loss on the distribution of the Big stock worth $2,000,000 to Jan? Sec. 362(b) 3. What happens to JCorp’s tax attributes? Sec. 381

61. 61 4. What is Big’s gain or loss on the exchange if its Big stock worth $2,000,000 for JCorp’s assets? Sec. 1032 What is Big’s basis in the assets received from JCorp? Sec. 362(b) 6. What does Big’s holding period start? Sec. 1223(2)

62. 62 7. What is Jan’s gain or loss on receipt of the distribution of the Big stock worth $2,000,000? Sec. 354(a) 8. What is Jan’s basis in the Big stock (worth $2,000,000)? Sec. 358(a)(1). 9. When does Jan’s holding period start? Sec. 1223(1)

63. 63 Big Corporation gives Big Corp. stock worth $2,000,000 to Jan in exchange for all of her JCorp stock.

64. 64

65. 65 1. What is Jan’s gain or loss on the exchange of her JCorp stock for the Big stock worth $2,000,000? Sec. 354(a)(1) What is Jan’s basis in Big stock worth $2,000,000 to Jan? Sec. 358(a)(1) 3. When does Jan’s holding period for the Big Corp stock start? Sec. 1223(1)

66. 66 4. What is Big’s gain or loss on the exchange if its Big stock worth $2,000,000 for Jan’s JCorp’s stock? Sec. 1032(a) 5. What is Big’s basis in the JCorp stock? Sec. 362(b) 6. When does Big’s holding period start? Sec. 1223(2)

67. 67 Acquisitive Reorganizations. A. Type A Reorganization. Three types of A reorganizations: mergers or consolidations, triangular mergers, and reverse triangular mergers. 1. Merger or Consolidation. Type A is a merger or a consolidation that satisfies the corporation laws of the U.S., a state, or the D.C. A tax-free reorganization also allows the transfer of the assets and liabilities acquired from the acquiring corp to a controlled subsidiary. No gain is recognized by the parent or the controlled sub on the transfer. The bases of the individual assets carryover from the parent to the sub.

68. 68 Acquisitive Reorganizations. Advantages and Disadvantages of a Merger Transaction. A merger allows greater flexibility than other types of reorganizations because there is no restriction that the consideration be solely voting stock as in the case of some other reorganization forms. There is no requirement that "substantially all" of the assets of the target corporation be acquired. Disadvantages include the need to comply with state corporation laws which usually include approval of the plan by shareholders of both corporations. All debt of the target corporation must be assumed including unknown and contingent liabilities.

69. 69 Acquisitive Reorganizations. Triangular Mergers. Triangular mergers are similar to the conventional Type A merger forms except the parent uses a controlled subsidiary to act as the acquiring corp. The target is merged into the subsidiary. Triangular mergers must satisfy state law. In addition, the stock used to acquire the target is limited to the parent corporation's stock. The sub must acquire substantially all of the target's assets as part of the plan of reorganization.

70. 70 Acquisitive Reorganizations. Reverse Triangular Merger. Reverse triangular mergers are similar to triangular mergers except that the subsidiary is merged into the target, and the target stays alive as a subsidiary of the parent.

71. 71 Acquisitive Reorganizations. Type C Reorganization. In a Type C reorganization, acquiring corp obtains substantially all of the target's assets in exchange for its voting stock and a limited amount of other consideration. The acquired corp must distribute the stock, securities, and other property received in the reorganization, plus any other property that it retained, to its shareholders as part of the plan of reorganization. The acquired corp may retain its corporate charter and other assets, if any, needed to satisfy the minimum capital requirements under state law to maintain its corporate existence.

72. 72 Consideration Used to Effect Reorganization. Consideration used to effect the reorg. must be solely voting stock. The acquisition of the target corporation's liabilities or property subject to liabilities is disregarded for this purpose. Other consideration may be used provided at least 80% of the target corporation's property is acquired for voting stock. A triangular Type C reorganization allows the voting stock of the parent corporation to be used by a controlled subsidiary corporation to acquire substantially all of the target corporation's assets. The stock used must be solely the voting stock of the parent corporation. The subsidiary can provide additional consideration in the form of securities, money or other property.

73. 73 Type D Reorganization. Type D reorgs can be acquisitive or divisive. An acquisitive Type D reorg involves the transfer by a corp. of substantially all of its assets to a controlled corp. in exchange for such corp's stock in a plan of reorganization. Stock, securities and other property received, plus any property retained must be distributed pursuant to a complete liquidation of the transferor corp. 1. Control Requirement. Transferor corp. and/or one or more of its shareholders must control transferee corp immediately after the asset transfer. Control is defined as either 50% or more of the total combined voting power of all classes of voting stock, or 50% or more of the total value of all classes of stock. The transferor's shareholders must maintain a continuing equity interest in the transferee corporation. 2. Tax Consequences of a Type D Reorganization. Tax consequences of an acquisitive Type D reorg. are the same as for a Type C reorg. If the reorganization satisfies both the requirements of a Type C and a Type D reorganization, the transaction will be treated as a Type D.

74. 74 Type B Reorganization. Type B reorg is one in which the target corporation's stock is exchanged for voting stock of the acquiring corp and target remains in existence as a sub of the acquiring corp. Basis of the target corp's assets and the amount of its tax attributes remain unchanged. After the reorg, the parent and target can file a consolidated tax return.

75. 75 Type B Reorganization. .. 1. Solely for Voting Stock Requirement. The requirement that only voting stock be used in the acquisition precludes the use of other property except to redeem fractional shares or to pay certain reorganization expenses. Voting stock can be common or preferred. Control is defined as 80% of the total combined voting power of all classes of voting stock and 80% of each class of nonvoting stock. Minority shareholders can be bought out with cash used by the target corporation to redeem its stock without destroying the tax-free nature of the transaction. 2. Triangular Type B Reorganizations. This reorg form is similar to the other triangular reorgs. The stock of the acquiring corporation's parent is exchanged for a controlling stock interest in the target.

76. 76 Type B Reorganization. Advantages of a Type B Reorganization. Type B reorg. usually requires no formal shareholder approval. A tender offer can be made directly to the target's shareholders even if management does not approve the transaction. Target's tax attributes are not lost or reduced as in some reorganizations. Corporate name, goodwill, licenses, and rights of the target company can continue on after the acquisition. Acquiring corp. does not directly acquire the target corporation's liabilities as is the case with some of the other acquisitive reorganizations.

77. 77 Type B Reorganization. Disadvantages of a Type B Reorg. Consideration used in the transaction is limited to voting stock. At least 80% of the target's stock must be acquired to effect control. The acquisition of less than 100% of the stock may lead to a vocal minority group. Basis of the target corporation's assets is not stepped-up to their FMV when the ownership change occurs.

78. 78 Type G Acquisitive Reorganization. Type G reorg takes place according to a court-approved plan in bankruptcy, receivership, or other similar situation. In an acquisitive Type G reorganization, the financially troubled company might transfer substantially all of its assets to an acquiring corp. according to a court-approved plan and then distribute all the stock, securities, and other property received in the exchange, plus any property retained, to its shareholders, security holders, and other creditors in exchange for their stock and debt interests.

79. 79