Tax-efficient dispositions of assets

In preparing for the purchase or sale of a valuable asset such as a corporation, most people would want to compare their options. What are the different tax costs if the transaction is structured one way rather than another?

The end result may be the same but with different tax costs. In planning for the taxable sale of a corporation, it makes sense to consider different ways to structure the transaction to minimize tax costs.

Much of tax law applies “substance over form” principles. However, the scenarios below illustrate that tax results under Subchapter C frequently depend on the “form” that the transaction takes. Taxpayers can often meet their objectives by structuring their transactions according to the form that has the most beneficial tax result.  

Facts

Suppose that Corporation D owns an unincorporated business (B), and D also owns 70% of Corporation C. An unrelated corporation (P) wants to purchase C stock. In all five scenarios below, P ends up owning C stock. However, the total tax costs are highest for Scenario 1 and lowest for Scenario 5, with the tax costs of Scenarios 2, 3, and 4 being in between.  

Alternative ways of structuring

Scenario 1: D distributes C stock to D‘s shareholders, then D‘s shareholders sell the C stock to P in exchange for cash.

Scenario 2: D sells the C stock to P for cash, then D distributes the after-tax sales proceeds to D‘s shareholders.

Scenario 3: D incorporates the B business, then D spins off B Corporation to D‘s shareholders in exchange for (aka, in redemption of) some of D‘s shares. D‘s shareholders then sell their remaining shares in D (which continues to own C stock) to P in exchange for cash.

In Scenarios 1, 2, and 3, P uses cash to make the acquisition. In Scenarios 4 and 5, P acquires the D stock by paying with P stock (instead of with P‘s cash).

Scenario 4: This is the same as Scenario 3, except that P acquires the shares of D (which continues to own C) by using P‘s own voting shares (instead of cash).

Scenario 5: This is the same as Scenario 4, except that D owns 80% (not 70%) of C.

In all five scenarios, D ends up owning (directly or indirectly) C shares. In Scenarios 1 through 3, P‘s shareholders end up with cash, and in Scenarios 4 and 5, they end up owning P stock.

The result of each scenario — namely, the value of cash or property (net of tax) owned by D‘s shareholders (based on the below assumptions) — is as follows:

Scenario 1: $1,865

Scenario 2: $1,920

Scenario 3: $2,000

Scenario 4: $2,360

Scenario 5: $2,500

The taxes paid in Scenario 5 are $635 less than the taxes in Scenario 1. However, if instead the difference was $635,000 or even $63.5 million, the tax dollar difference becomes large enough to make the tax adviser a valuable member of the planning team!

Assumptions about the transaction’s “players”:

B: The fair market value (FMV) of B = $700, and D‘s basis in B‘s assets = $700.

D: The FMV of D (excluding its ownership of C) = $700, which is the FMV of B. D‘s basis in C corporation stock is $700.  

C: C‘s FMV is $1,800; C‘s basis in its assets = $0.

D: D‘s shareholders’ basis in D stock = $0

Tax rates: D‘s = 25%; D‘s shareholders’ = 20%.

Analysis

Scenario 1 (D distributes C stock to its shareholders; shareholders sell C stock to P).

D‘s results: When D distributes the C stock to D‘s shareholders, D incurs a $275 tax as a result of a Sec. 311(b) gain of $1,100 ($1,100 = C‘s $1,800 FMV less D‘s $700 basis in C). The $275 tax reduces D‘s FMV from $700 to $425.  

D shareholders’ results: When they receive as a dividend the C stock worth $1,800, they must pay $360 tax (20% times $1,800), netting them $1,440 cash. (However, they would have no further tax or gain when they sell the C stock to P, because their basis in C stock is the $1,800 FMV.)

The $1,865 value to D‘s shareholders = $425 FMV of D plus $1,440 cash.

Scenario 2 (D sells C stock to P; D distributes the after-tax sales proceeds to D‘s shareholders).

D‘s results: D incurs a $275 tax on $1,100 gain when it sells the C stock ($1,800 FMV basis in C less D‘s $700 basis in C).

D shareholders’ results: The shareholders receive $1,525 dividend (D‘s sales proceeds of $1,800 less $275 tax paid by D) and pay $305 tax (20% tax rate times $1,525 dividend).

The $1,920 value to D‘s shareholders = $700 FMV of D plus $1,220 ($1,525 dividend less $305 tax on the $1,525 dividend).

Scenario 3 (D incorporates B by contributing the B assets to a newly formed B corporation; D spins out new B Corp. to D‘s shareholders in partial redemption of D‘s shares; D‘s shareholders sell the stock of D (which continues to own C) for cash).

D‘s results: D has no gain when D contributes the B assets to the newly formed B corporation; D‘s basis in the B stock is $700 (“transferred” basis under Sec. 362).

D has no Sec. 311(b) gain when D distributes the B stock to D‘s shareholders because B‘s FMV is $700 and D‘s basis in B is also $700.

D shareholders’ results: When they receive the B stock in redemption for some of their D shares, the shareholders recognize a $700 capital gain under Sec. 302(b)(3) (Sec. 302(b)(3) would apply because, after integrating the shareholders’ sale of D shares, their interest in D stock will have been completely terminated). Because the value of B stock they received is $700, and the shareholders had zero basis in the D stock that was redeemed, this results in a $140 tax.

Note that the distribution of B stock is not a Sec. 355 tax-free distribution because the “spin” is a “device” to facilitate a cash sale (taxable transaction of D). In addition, the “active trade or business” (ATB) rules under Sec. 355 would require that D itself immediately after the transaction be engaged in an ATB. D fails this ATB test; C‘s ATB would not get attributed to D because C (being owned less than 80% by D) is not part of D‘s “separate affiliated group.”

When the D shareholders sell their D shares worth $1,800 ($2,500 FMV of D before the “spin” of B shares less the $700 FMV of B corporation shares they received), their tax will be $360 (20% tax rate on $1,800).

The $2,000 value to the D shareholders = the $700 value in B stock they received, minus the $140 tax, plus the $1,800 from selling D shares, minus the $360 tax.

The consequences to P under Scenario 3 may be less attractive to P than under Scenario 1 and Scenario 2. Under Scenarios 1 and 2, P owns the stock of C directly. Under Scenario 3, P owns D, which owns C. Because D owns less than 80% of C, D cannot qualify for a Sec. 332 liquidation so as to collapse C into D. Also, under Scenarios 1 and 2, P‘s $1,800 basis is in C stock. Under Scenario 3, P‘s $1,800 basis is in D stock. If, under Scenario 3, P wanted to later sell the C stock, it would be better (because P would pay fewer taxes on the disposition) for P to try to convince a buyer to acquire the D stock, which has a higher basis ($1,800) in P‘s hands, rather than the C stock, which has only a $700 basis in D‘s hands. Yet another disadvantage to P under Scenario 3 could be the possibility that D has contingent liabilities as a result of having owned the B business; however, these contingent liabilities could be dealt with through indemnification provisions in the purchase-sale contract.

Scenario 4 (same as Scenario 3, except that P uses its voting stock (not cash) to acquire D).

D‘s results: As in Scenario 3, D has no tax on the distribution of B corporation stock to D‘s shareholders because under the facts, the FMV of B = $700, and D‘s basis in B = $700.

D shareholders’ results: When they receive the B stock (worth $700) in redemption for some of their D shares (which have a zero basis), the shareholders recognize a $700 capital gain under Sec. 302(b)(3).

The complete termination of interest rules of Sec. 302(b)(3) apply even though the historic D shareholders will own the stock of P, which in turn owns D stock. Under the facts assumed and as provided by Sec. 318(a)(2)(C), P‘s ownership of D shares would not be attributed to the historic D shareholders since no one shareholder will own 50% or more of P. Because there will be no attribution from P to the shareholders of P‘s shares in D, the partial redemption of D shares will qualify as a complete termination of the shareholders’ interest in D, just as in Scenario 3.

Applying the 20% tax rate to the $700 capital gain results in a $140 tax.

When they exchange their remaining D stock for P stock, the exchange will qualify as a tax-free B reorganization.

The $2,360 value to the historic D shareholders = the $700 value in B stock they received, plus the $1,800 value of P stock, minus $140 tax paid on the $700 that was subject to the Section 302(b)(3) taxable transaction.

Scenario 5 (same as Scenario 4, except that D owns 80% (not 70%) of C).

D‘s results: As in Scenario 3, D has no tax on the distribution of B corporation stock to D‘s shareholders because under the facts, the FMV of B = $700, and D‘s basis in B = $700.

D shareholders’ results: Unlike in Scenario 3 and Scenario 4, where the D shareholders recognize gain of $700 and incur $140 tax on the $700 gain as a result of receiving B stock, the transaction under Scenario 5 constitutes under Sec. 355(a) a valid spinoff of B stock so that the D shareholders would not recognize gain on the receipt of B stock. The transaction is a valid spinoff because: (1) The subsequent transaction (exchange of D stock for P stock) is not a “device” that is a taxable transaction (because it is instead a tax-free B reorganization, unlike in Scenario 3, and also assuming that the historic D shareholders do not have a plan for turning around and selling the P stock they received); (2) Unlike in Scenario 3 and Scenario 4, immediately after the transaction D is engaged in an ATB because the ATB of C gets attributed to D (as a result of D owning 80% of C); and (3) The spinoff is supported by a good business purpose, namely that P does not want to own the B business.   

The $2,500 value to the historic D shareholders results from their owning the B shares worth $700 plus the P shares worth $1,800, and no tax having been paid by D or by the D shareholders.

Scenario 5 results in zero tax being paid.

Different tax results

All five scenarios accomplish the objective of P‘s owning (directly or indirectly) C. However, the tax results are different in each scenario. Scenario 5 results in zero tax. If several more zeros were added to the numbers in the scenarios, there would indeed be significant tax savings opportunities! It certainly pays to consider different ways that a transaction can be structured.

Bob Aukerman, CPA, J.D., LL.M. is a principal at T.C. Tax Law and CPA in Traverse City, Mich., with over 30 years’ experience. To comment on this article or suggest an idea for another article, contact Sally Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com.