When to use a tax-free reorganization

Editor: Albert B. Ellentuck, Esq.

The main use and advantage of a tax-free reorganization is to acquire or dispose of the assets of a business without generating the income tax consequences that would result in a straight sale or purchase of those assets. A tax-free reorganization may also be deemed to have occurred in other situations, such as the change of the corporate name or state of incorporation, or as a result of a bankruptcy or receivership proceeding. However, in these types of situations the rules for tax-free reorganizations are normally taken advantage of rather than planned for.

Observation: The fact that a transaction qualifies as tax-free does not necessarily mean that none of the parties recognize any taxable gain. For example, shareholders of the target are permitted to receive boot (property other than stock of the acquiring corporation) in a type A reorganization. A target shareholder who receives boot in a type A reorganization recognizes gain to the extent of the lesser of the boot or the gain realized upon the exchange of the stock. If other shareholders do not receive boot, they do not recognize gain. Thus, the transaction is still termed tax-free.

Acquisitive reorganizations: There are many reasons for pursuing a tax-free acquisitive reorganization, such as (1) increasing revenue; (2) improving financial performance (particularly if not possible through organic growth); (3) achieving economies of scale; (4) improving technological capabilities; or (5) expanding into new areas, products, or customer base. A type A reorganization is of particular benefit to the target's shareholders, who can receive cash, debt, or preferred stock as part of the purchase price, while retaining tax-deferred status on the purchase price paid with the acquiring corporation's stock. It is not commonly used when there are valuable contracts in place, which may be terminated when the target is liquidated at the end of the reorganization.

While other consideration besides stock can be paid under a type A reorganization, the price paid under a type B reorganization must be solely in stock. And while the target is dissolved in a type A reorganization, it can be retained in a type B reorganization. A type B reorganization is most useful when the target must be retained, usually because it has valuable contracts that would otherwise be terminated if the entity were to be liquidated.

A triangular merger is a reorganization in which a subsidiary owned by the acquiring corporation merges with the target, with the target going out of business. Since it is a merger and not an acquisition, it eliminates the minority stockholders, who are legally required to accept the buyer's purchase price. In a reverse triangular merger, a subsidiary of the target is the surviving entity. A triangular merger is commonly used to keep the liabilities of the target in a separate corporation (which protects the parent from any contingent or unknown liabilities, or any future liabilities that may arise from the acquired business). A reverse triangular merger is commonly used when the target has valuable contracts that would otherwise be canceled if it did not survive the transaction.

Divisive reorganizations: There are many reasons for pursuing a tax-free divisive reorganization, such as (1) abandoning certain businesses that are losing money; (2) changing strategy; (3) refocusing on core business operations; (4) an inability or unwillingness to provide the money or other resources needed for the business to be successful; (5) meeting regulatory requirements; and (6) for closely held corporations, solving management or family disagreements by splitting the business geographically or separating one or more units or lines of business.

Considering other ways to acquire a corporate business

When an existing corporation (buyer) wants to acquire the business of a target corporation, it has several choices:

  • The buyer can make a direct purchase of the target's business assets in exchange for cash or a combination of cash and other property;
  • The buyer can purchase the target's stock directly from the target's shareholders for cash or a combination of cash and other property (the buyer could then decide whether to make the Sec. 338 election to treat the stock purchase as an asset purchase);
  • The buyer can purchase the target's stock for cash and then merge the target into the buyer. Such transactions are forward cash mergers and are treated for tax purposes as if the target sold its assets directly to the acquiring corporation and then liquidated by distributing the sales proceeds to the target's shareholders (Rev. Rul. 69-6); or
  • The buyer can undergo an acquisitive tax-free reorganization.

From a purchasing corporation's standpoint, a taxable purchase of the target's stock or assets may be necessary if the target's shareholders want to receive only cash, or are unwilling to accept the buyer's stock in an exchange (due to the lack of a ready market or doubt about the future profitability of the company). In that situation, the buyer will have to decide whether to purchase the assets or stock of the target corporation. Normally the buyer will prefer to purchase the assets of the target to obtain a step-up in the basis of those assets. Of course, the target's shareholders will prefer to sell their stock, so they can avoid double taxation and obtain full capital gain treatment.

Recognizing when a tax-free reorganization makes sense

The primary tax difference between a taxable stock sale or purchase (to which the Sec. 338 elections do not apply) and a tax-free acquisitive reorganization is that the selling shareholders can defer the gain on the disposition of their target shares when they participate in a tax-free reorganization. Tax-free acquisitive reorganizations are normally attractive in the following circumstances:

  • The shareholders of the target are unwilling to accept a direct asset sale because of the double-taxation problem, and the acquiring corporation is able to negotiate a purchase price that accounts for the potential for future corporate-level income recognition by the target;
  • The shareholders of the target will recognize significant taxable gains if their stock is sold in a taxable transaction;
  • The shareholders of the target are willing to accept stock of the acquiring corporation rather than cash (this is most likely to occur when a ready market exists for the acquiring corporation's shares);
  • The acquiring corporation prefers to or must use stock rather than cash to make the acquisition;
  • The target holds depreciated assets (basis greater than fair market value), so the issue of stepping up the basis of the assets does not apply;
  • The target has tax attributes (net operating loss (NOL) carryover, etc.) that have some value even after application of the limitation rules of Secs. 382—384; or
  • The target has a substantial number of assets, making the transfer of title to those assets a complex and costly matter, or the target has favorable contracts or permits that are nonassignable but that would continue in force if a tax-free transaction occurred.
Recognizing when a taxable stock sale makes sense

For a selling shareholder, a taxable stock sale (as opposed to a tax-free reorganization) makes sense in the following situations:

  • The selling shareholder can shelter gains from the stock sale with NOLs or capital loss carryovers;
  • The seller can recognize a loss (perhaps even an ordinary loss under Sec. 1244) on the sale of the target's stock;
  • A tax-free reorganization is unattractive to the seller because he or she does not desire to invest in the stock of the acquiring corporation (i.e., the seller wants cash, or no market exists for the stock of the acquiring corporation); or
  • The buyer is not a corporation, so the tax-free reorganization option is not available.

This case study has been adapted from PPC's Tax Planning Guide — Closely Held Corporations, 30th Edition, by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2017 (800-431-9025; tax.thomsonreuters.com).



Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va. For more information about this column, contact thetaxadviser@aicpa.org.


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