Estimating the Basis of Stock Acquired in a Type B Reorg.

Editor: Frank J. O’Connell Jr., CPA, Esq.

Corporations & Shareholders

A large corporation is acquiring a target corporation in a type B stock-for-stock reorganization. The tax basis of the target stock acquired in the reorganization must be determined, but where should one begin to look for information? What if some of the shareholders do not respond to requests for information? How time consuming and burdensome will the project be? These are questions and concerns that the IRS has dealt with over the years regarding type B reorganizations. It recently issued Rev. Proc. 2011-35 to address some of these issues.

Type B Reorgs.

A type B reorganization as defined in Sec. 368(a)(1)(B) occurs when a parent corporation or its controlled subsidiary acquires the stock of a target corporation solely in exchange for voting stock of the parent corporation. However, to qualify as a type B reorganization, immediately after the reorganization the parent corporation or its subsidiary must own at least 80% of the combined voting power of the target stock and at least 80% of the number of shares in each class of the target’s nonvoting stock. In that case, under Sec. 362(b), the acquiring parent or subsidiary’s tax basis in the target corporation stock acquired in the reorganization is the same as the basis the former target shareholders held in their target stock. However, obtaining such basis information from the target shareholders is not always possible, particularly when the target stock is widely held.

Previous Methods of Calculating the Basis of Stock

Years ago, recognizing the burden of calculating the basis of stock in a type B reorganization, the IRS issued Rev. Proc. 81-70 to establish procedures that an acquiring corporation could use to estimate the basis of the acquired target stock. In the event that the acquiring corporation was unable to obtain information on the basis of stock from a shareholder of the target corporation, it could estimate the value of the stock based on the stock transfer records. This revenue procedure also provided guidelines on how to administer a statistical sample to establish the basis of the target stock.

Since the IRS issued the 1981 revenue procedure, the stock market has changed. Most stock of public companies no longer is held by individual owners, but rather by nominees, such as clearinghouses and financial institutions. The transfer records therefore do not list the names of the actual owners of the stock. There are usually multiple levels of ownership within nominee ownership, and getting down to the individual owners could violate confidentiality rules. There is an additional constraint of how far back nominee owners keep a record of stock ownership. Therefore, to address the increased complexities in determining the basis of the target stock in a type B reorganization, the IRS issued Notice 2009-4, which expanded Rev. Proc. 81-70 to include safe-harbor provisions that could be relied on to establish tax basis as long as the basis calculation was done timely and diligently. However, the notice also provided that if actual basis was known, the acquiring corporation should use the actual basis instead of an estimate.

Rev. Proc. 2011-35

More recently, the IRS issued Rev. Proc. 2011-35, which expands Notice 2009-4 and sets forth four procedures that an acquiring corporation should use to calculate the basis of the target stock:

• Surveying;
• Statistical sampling;
• Estimation methodology for shares of a registered shareholder; and
• Estimation methodology for shares surrendered by a nominee shareholder.

The acquiring corporation may use one method or a combination of methods to calculate the basis. These procedures should be identified and used for any stock-for-stock reorganization that is completed on or after June 20, 2011.

Surveying: The first method explained in the new revenue procedure is to survey either all target shareholders or a sample of the group. An acquiring corporation has to complete a survey in a timely manner. For purposes of the procedure, timely is defined as being completed within two years of the transaction. The survey must encompass all registered and nominee owners of the target stock unless they are included in one of the sample groups of another method used under this revenue procedure.

The survey should be sent to the last known address of each shareholder and should ask for such information as the number of shares of the target corporation that the shareholder owned, the basis of target shares, and whether the shareholder is a nominee owner. If the shareholder is a nominee owner, he or she should be asked to provide the identity and contact information of the beneficial owner or owners of the shares surrendered, the aggregate number of common and preferred shares surrendered, and the aggregate basis (by class) of those shares, or forward the request for information to the beneficial owner. The acquiring corporation must state why it is sending the survey and must also explain to the shareholder how to calculate basis properly. If the acquiring corporation receives no response within 30 days, it must make an attempt to contact the shareholder at least two more times by whatever means are appropriate. The basis provided by the shareholder should be deemed to be the actual basis unless it appears inaccurate on its face, in which case the response should be disregarded.

Statistical sampling: The second method used to calculate the basis of the target stock is statistical sampling. An acquiring corporation should use this procedure when the time, burden, and cost of doing a full survey of all shareholders is too high, the actual cost of the shares is not known, or the shares were not surrendered by or on behalf of a reporting shareholder. An acquiring corporation should use separate samples for common shares and preferred shares, and it should perform the sampling in accordance with the survey method as described above and any previously published guidance (Rev. Procs. 2004-29, 2007-35, 2002-55, or 72-36). The acquiring corporation’s allowable basis is a valid estimate calculated at the least advantageous 95% one-sided confidence limit.

Estimation methodology for shares of a registered shareholder: The third method used is an estimation of basis for shares of registered shareholders. The shares in this group are those in which the actual basis is not known and the shareholder is not a reporting shareholder, or the shareholder is a reporting shareholder but fails to respond to the survey. An acquiring corporation calculates the basis by determining the adjusted closing price on the date that the shareholder was issued the stock and then adjusting for all subsequent events that would normally cause an adjustment to the basis.

Estimation methodology for shares surrendered by a nominee shareholder: The fourth and final method to determine the basis of stock acquired from a target shareholder is an estimation procedure for shares that were surrendered by nominees. This method uses information from target Security Position Reports (SPRs) or from filings of SEC Form 13F, Information Required of Institutional Investment Managers Pursuant to Section 13(f) of the Securities Exchange Act of 1934 and Rules Thereunder. The calculation should be done separately for common shares and preferred shares. To calculate the initial estimated basis, the acquiring corporation should obtain copies of the SPRs or Forms 13F beginning with the later of the first day of the target corporation’s first year and:

• The later of the first date that the shares to be modeled are publicly traded and the date that is seven years before the transaction if the acquiring corporation is using SPR data; or
• The date that is ten years before the transaction if the acquiring corporation is using Form 13F data.

Conclusion

Over the years, the stock market and the financial environment have changed, and the IRS has followed with changes in calculating the stock basis in type B reorganizations. It has listened to the concerns of taxpayers and appears to have responded adequately with four different methods for determining the stock basis when the actual information is not readily available.

EditorNotes

Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or frank.oconnell@crowehorwath.com.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.