The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 1. NOTE: If you are seeking CPE credit , you must listen via your computer — phone listening is no longer permitted. Structuring Tax-Free M&A Deals: Navigating IRC 368 and 351, Selecting the Appropriate Structure Today’s faculty features: 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific THURSDAY, JANUARY 11, 2018 Presenting a live 90-minute webinar with interactive Q&A Jonathan Golub, Attorney, Royse Law Firm, Menlo Park, Calif. Joseph C. Mandarino, Partner, Smith Gambrell & Russell, Atlanta
Transcript
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have any questions, please contact Customer Service at 1-800-926-7926 ext. 1.
NOTE: If you are seeking CPE credit, you must listen via your computer — phone listening is no
Presenting a live 90-minute webinar with interactive Q&A
Jonathan Golub, Attorney, Royse Law Firm, Menlo Park, Calif.
Joseph C. Mandarino, Partner, Smith Gambrell & Russell, Atlanta
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FOR LIVE EVENT ONLY
STRUCTURING TAX-FREE
M&A DEALS
Royse Law Firm, PC 149 Commonwealth Dr.
Suite 1001 Menlo Park, CA 94025 www.rroyselaw.com
IRS Circular 230 Disclosure: To ensure compliance with the requirements imposed by the IRS, we inform you that any tax advice contained in this communication, including any attachment to this communication, is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to any other person any transaction or matter addressed herein.
– Type A – Statutory Mergers, Consolidations & Triangular Mergers
– Type B – Stock for Stock
– Type C – Stock for Assets
– Double Merger
– Examples
• Requirements of Tax-Free Reorganizations: – Continuity of Interest
– Continuity of Business Enterprise (COBE)
– Business Purpose
– Plan of Reorganization
– Special Tests
– Step Transaction Doctrine
• Consequences of Tax-Free Reorganizations: – Buyer Entity
– Target Entity
– Target Shareholders
• Tax Reform Applicable to M&A: – Reduced Corporate Tax Rate (21%). Opportunity Zone Re-Investment of gains (Section 1400Z).
5
TAXABLE VS. TAX FREE
• Type of Acquisition Currency – Stock – Securities/Debt – Deferred payments, earn outs – Compensatory
• Nature of the Buyers and Seller – Foreign Parties – Tax Attributes of Parties
• Shareholder Level Considerations – Tax Sensitivity of Shareholders – Appetite for Complexity & Risk
6
TYPES OF REORGANIZATIONS
• Type A – Statutory Mergers and Consolidations
• Type B – Stock for Stock
• Type C – Stock for Assets
• Type D – Spin Off, Split Off, Split Up, and Type D Acquisitive Reorganizations
• Type E – Recapitalizations
• Type F – Migrations
7
TYPE A REORGANIZATIONS – SECTION 368(a)(1)(A) STATUTORY MERGER
Requirements: • Necessary Continuity of Interest
• Business Purpose
• Continuity of Business Enterprise
• Plan of Reorganization
Tax Effect: • Shareholders – Gain recognized to the extent of boot
• Target – No gain recognition
• Buyer takes Target’s basis in assets plus gain recognized by Shareholders
• Busted Merger – taxable asset sale followed by liquidation
• Statutory Merger – 2 or more corporations combined and only one survives (Rev. Rul. 2000-5)
• Requires strict compliance with statute
• Target can be foreign; Reg. 1.368-2(b)(1)(ii)
• No “substantially all” requirement
• No “solely for voting stock” requirement
Target Buyer
Shareholders
8
TYPE A REORGANIZATIONS – SECTION 368(a)(1)(A) STATUTORY CONSOLIDATION
Requirements: • Necessary Continuity of Interest
• Business Purpose
• Continuity of Business Enterprise
• Plan of Reorganization
Tax Effect: • Shareholders – Gain recognized to the extent of boot
• Target – No gain recognition
• Buyer takes Target’s basis in assets plus gain recognized by Shareholders
• Busted Merger – taxable asset sale followed by liquidation
• Statutory Consolidations – 2 or more corporations combined to form a new corporation
• Requires strict compliance with statute
• Target can be foreign; Reg. 1.368-2(b)(1)(ii)
• No “substantially all” requirement
• No “solely for voting stock” requirement
Target Buyer
Shareholders
9
Newco
Shareholders
TRIANGULAR OR SUBSIDIARY MERGERS
10
2. Reverse Subsidiary Merger
Target Buyer
Merger Sub
Buyer Target
Merger Sub
1. Forward Subsidiary Merger
TRIANGULAR OR SUBSIDIARY MERGERS
11
Section 368(a)(2)(D) Forward Triangular Merger
• A statutory merger of Target into Merger Sub (at least 80% owned by Merger Sub)
• Substantially all of Target’s assets acquired by Merger Sub
• Would have been a good Type A merger if Target had merged into Merger Sub
Target Buyer
Target Shareholders
80%
Tax Consequences • Merger Sub takes Target’s
basis in assets increased by gain recognized by Target
• Buyer takes “drop down” basis in stock of Merger Sub (same as asset basis)
Merger Sub
TRIANGULAR OR SUBSIDIARY MERGERS
12
Section 368(a)(2)(E) Reverse Triangular Merger
• Merger of Merger Sub into Target where – (i) Target shareholders surrender control (80% of voting and nonvoting classes of stock) for
Buyer voting stock and
– (ii) Target holds substantially all the assets of Target and Merger Sub
Target Buyer
80%
Tax Consequences • Non-taxable to Target and carryover
basis • No gain to Buyer and Merger Sub under
Sections 1032 and 361 • No gain to Target shareholders except
to the extent of boot • Buyer’s basis in Target stock generally is
the asset basis, but Buyer can choose to take Target shareholders basis in stock (if it is also a B)
• If transaction is also a 351, Buyer can use Target shareholders’ basis plus gain
Merger Sub
Target Shareholders
TYPE B REORGANIZATIONS – SECTION 368(a)(1)(B) STOCK FOR STOCK
13
• Acquisition of stock of Target, by Buyer in exchange for Buyer voting stock
• Buyer needs control of Target immediately after the acquisition
• Control = 80% by vote and 80% of each class
Target Buyer
Shareholders
• Buyer’s basis in Target stock is the same as the Shareholder’s Solely for voting stock
• No Boot in a B
• Reorganization Expenses – distinguish between Target expenses and Target Shareholder expenses (Rev. Rul. 73-54)
• Creeping B – old and cold stock purchased for cash should not be integrated with stock exchange
TYPE C REORGANIZATIONS – SECTION 368(a)(1)(C) STOCK FOR ASSETS
14
• Acquisition of substantially all of the assets of Target, by Buyer in exchange for Buyer voting stock
• “Substantially All” – at least 90% of FMV of Net Assets and at least 70% of FMV of Gross Assets
• Target must liquidate in the reorganization
• 20% Boot Exception – Buyer can pay boot (non-stock) for Target assets, up to 20% of total consideration; liabilities assumed are not considered boot unless other boot exists
Tax Benefit: A taxable reverse merger has just one tax on the shareholders, while a taxable forward merger has two taxes (one on shareholders and one on corporation). Intended that entire transaction be a tax-free A-type merger (where 20% boot limitation does not exist). Pairing the two reduces the risk of incurring the corporate level tax in the event the entire transaction is not treated as an A-type merger.
REV. RUL. 2001-46
Merger Sub Target+Sub
Merger Sub Survives
Example #1
16
• Facts: – You represent target, a corporation. – The buyer wants to acquire target for 50% cash and 50% buyer stock. – A significant portion of the buyer stock consideration payable to founders of
target is subject to claims for indemnification and forfeiture if founders do not maintain employment with buyer.
• Concerns and Recommendation:
Example #2
17
• Facts: – You represent target, a corporation. – The buyer wants to acquire target’s stock for 10% cash and 90% buyer stock. – Target is worried that it cannot obtain consent of 100% of its shareholders.
• Concerns and Recommendation:
Example #3
18
• Facts: – You represent target, a corporation. – The buyer wants to acquire target’s stock for 80% cash and 20% buyer stock.
• Concerns and Recommendation:
Example #4
19
• Facts: – You represent target, a corporation. – The buyer wants to acquire most, but not all of, target’s assets for 10% cash and
90% buyer stock.
• Concerns and Recommendation:
REQUIREMENTS
• Continuity of Interest
• Continuity of Business Enterprise (COBE)
• Business Purpose
• Plan of Reorganization
• Special Tests (not applicable to all reorganizations)
• Step Transaction Doctrine
20
CONTINUITY OF INTEREST
21
• IRS – 50% Safe Harbor, Rev. Proc. 77-37 • IRS – 40% in Temp. Reg. 1.368-1T(e)(2)(v), example (1) • John A. Nelson – 38% Stock • Miller v. CIR – 25% Stock • Kass v. CIR – 16% Stock is Insufficient • 2011 Regulations address changes in value between the date of
signing and close; – if fixed consideration (Consideration is “fixed” if contract states exact number of shares
and other cash or property to be exchanged) • Consideration is valued as of last business day before the first day the contract is binding and • If a portion of the fixed consideration is other property identified by value, then the specified
value is used for that portion (see Reg. 1.368-1(e)(2)). – 2011 Proposed Regulations (Prop. Reg. 1.368-1(e)(2)(vi)) – consideration that varies as
the value of issuing corporation stock changes prior to closing will not fall below (or above) contractual floor (or ceiling) markers for purposes of continuity of interest. If binding contract uses average value of issuing corporation stock that average value can be used for continuity of interest.
• Post transaction sales and redemptions
NON-QUALIFIED PREFERRED STOCK
22
• Preferred Stock – limited and preferred as to dividends; and does not participate in corporate growth if: – (1) shareholder has right to require issuer to redeem
– (2) issuer is required to redeem
– (3) issuer has right to redeem and is more likely than not to exercise that right; or
– (4) dividend rate varies based on interest rate, or commodity price or other index
• Redemption right exercisable within 20 years and not subject to contingency that renders likelihood remote
• Excludes stock compensation that may be repurchased on separation from service
• Conversion feature not enough to participate in growth
• Generally treated as boot to shareholders
CONTINGENT STOCK, ESCROWS, AND EARN-OUTS
23
• Escrows: – Target shareholders usually treated as owner of escrowed Buyer shares unless otherwise
agreed – Especially true if Target shareholders have right to vote and receive dividends – Not clear who is owner if Target shareholders do not have right to vote or receive
dividends
• Earn-Out Stock: – Target shareholders not considered owners until Buyer shares are issued – Not treated as boot – Imputed Interest
• Rev. Proc. 84-42 Ruling Guidelines – use of escrow or contingent stock – (1) stock must be distributed within 5 years, subject to escrow or contingency – (2) valid business purpose – (3) maximum number of shares cannot exceed 50% – (4) trigger event not controlled by Target shareholders and not based on tax liability – (5) Formula is objective and readily ascertainable – (6) Restrictions on assignment and substitution – (7) In the case of escrows, Buyer shares shown as issued to Target shareholders, current
voting and dividend rights, and vested
CONTINUITY OF BUSINESS ENTERPRISE AND BUSINESS PURPOSE
24
• Aquiror must either continue the target corporation’s “historic business” or use a significant portion of the target’s “historic business assets” in another business
• Remote COBE – transfers to 80% affiliates and partnerships; Reg. 1.368-1(d)
• Business Purpose – substantial non-tax corporate level purpose
PLAN OF REORGANIZATION
• Section 354(a)(1) Requirement
• 2007 Regulations – Require each corporation that is a party to the reorganization to adopt
a plan of reorganization
• Prior regulations required a written document
• Courts are more flexible with respect to the requirements
• Relevant for Step Transaction Doctrine; see J.E. Seagram Corp. v. Comr., 104 T.C. 75 (1995)
25
SPECIAL TESTS
26
• Type B-Reorganizations – No Boot – Control Requirement: Buyer must control Target immediately after the
acquisition; meaning 80% of voting power and 80% of each class
• Type C-Reorganizations – 20% boot limitation (i.e. 80% COI Requirement) – Substantially All Test: Buyer must obtain least 90% of FMV of Net Assets
and at least 70% of FMV of Gross Assets – Liquidation Requirement
• Forward Triangular Merger – Substantially all of Target’s assets acquired by Merger Sub
• Reverse Triangular Merger – Target shareholders surrender control (80% of voting and nonvoting
classes of stock) for Buyer voting stock (i.e. 80% COI Requirement) – Substantially All Test: Target must obtain least 90% of FMV of Net Assets
and at least 70% of FMV of Gross Assets of Target and Merger Sub
STEP TRANSACTION
• Judicially developed – substance over form argument – More than one test has been applied by courts, but most common test
is the “mutual interdependence” test
– Interdependent steps would have been fruitless without completion of the entire series
– Regulation 1.368-2(k) and other regulations provide exceptions to the step transaction doctrine
– IRS or court takes the several transactions or steps and integrates them into a single transaction
• Not to be confused with “economic substance”
27
BUYER ENTITY CONSEQUENCES
• Buyer generally takes a carryover basis (assets or stock basis, depending on the transaction) and adds the gain recognized by Target shareholders
• Subject to loss importation rules
• NOL limitations often apply under Section 382
28
PROPOSED REGULATIONS ON LOSS IMPORTATION
• General Rule: The Buyer's basis in assets acquired under Section 368 is usually the transferor’s basis
– Section 362(e)(1) provides an exception for assets with built-in losses on the date of the transfer
– The IRS has issued Proposed Regulations explaining how these “anti-loss importation” rules apply (also applies to Section 334(b) transactions)
• Under the Proposed Regulations, if the aggregate basis of all “Importation Property” is greater than the aggregate value of such property then the basis of all the Importation Property is its value on the date of transfer
– Importation Property is property where:
• (1) the gain or loss is not subject to US tax in the hands of the transferor on a hypothetical sale immediately before the transfer; and
• (2) the gain or loss is subject to US tax in the hands of the transferee on a hypothetical sale immediately after the transfer
29
TARGET ENTITY CONSEQUENCES
• Target typically does not recognize gain or loss at the corporate level
• Some COD income exceptions
30
TARGET DEBT SECURITIES
31
• Exchange of Target securities for Buyer securities is tax free under Sections 354 and 356, to the extent that the principal amount of Buyer debt is less than the principal amount of Target debt
• Portion attributable to cash basis accrued interest is taxable
• Possible COD income
– Example: • Target bonds with an issue price (stated principal amount) of
$1,000 exchanged for Buyer stock or debt worth $900; Target has COD of $100
TARGET SHAREHOLDER CONSEQUENCES
• Target shareholders recognize gain only to the extent of boot (cash consideration) received
• Loss typically cannot be recognized
• Character of gain or loss (dividend or capital gain)
• Section 83 compensation concerns with unvested stock consideration
• Stock options
32
DIVIDEND EQUIVALENCY
33
• Section 356(a)(2) – Boot as dividend or capital gain; post-reorganization redemption test of Rev. Rul. 93-61
• Clark – hypothetical post-reorganization redemption reduced shareholder’s interest from 1.32% to .92% - substantially disproportionate under Section 302(b)(2)
• Section 302(b)(1) – redemption that results in meaningful reduction in voting power is redemption and not essentially equivalent to a dividend
• Section 302(b)(2) – greater than 20% reduction is substantially disproportionate
• E&P Limitation on Dividend – should be Target’s E&P but unclear if Merger Sub’s E&P counted; PLR 9118025, PLR 9041086, and PLR 9039029
UNVESTED STOCK RECEIVED IN A TAXABLE OR NON-TAXABLE DEAL
34
• Rev. Rul. 2007-49 - The revenue ruling addresses: – (1) the exchange of fully vested stock for unvested stock of an
acquiring corporation in a tax-free reorganization, and
– (2) the exchange of fully vested stock for unvested stock of an acquiring corporation in a taxable exchange
• Under either (1) or (2), the Rev. Rul. provides that the exchange constitutes a transfer of property subject to Section 83. – The service provider would need to file an 83(b) election to avoid
the recognition of compensation income in the future as the shares vest.
– The Rev. Rul. also provides that the spread will be zero, so there is no downside to the service provider’s 83(b) election.
OPTIONS
35
• Assumption or Substitution
– No tax on substitution of NSO
– No tax on substitution of ISO, so long as the substitution is not a modification. There is no “modification” so long as:
• (1) the aggregate spread in new option does not exceed the spread in the old; and
• (2) the new option does not have more favorable terms than the old; see Sections 424(a) and 424(h)(3)
OPTIONS – CASH OUT
36
• Cancel options for cash payment
– NSO • Ordinary income – compensation – withholding or 1099
• Deduction to Target or Buyer? – TAM 9024002 – employer deducts based on method of accounting; not clear if cash
out at close is pre-acquisition Target deduction or post-close Buyer deduction in absence of scripting the timing
– Under the cash method, the deduction generally arises when the employer has “paid” the property to the employee. See Regs. §1.461-1(a)(1). Under the accrual method, the deduction arises when the employer's obligation to make the property transfer becomes fixed, the property's value is determinable and economic performance occurs. See Regs. §§1.461-1(a)(2) and -4(d)(2)(iii)(B)
– ISO • FICA
• Exercise and disqualifying disposition treated differently
2018 TAX REFORM
37
• Reduced corporate tax rate (21%) makes certain taxable transactions more tolerable.
• Applicable to taxable spin-offs, failed forward merger, sale of corporate assets.
2018 TAX REFORM
38
• Tax Cuts and Jobs Act: New Section 1400z – Deferral (and potential reduction ) of gains from sale of property that are
reinvested in “qualified opportunity zones” (or funds that invest in “qualified opportunity zones”) within 180-days of sale.
– “qualified opportunity zones” are low income communities that are designated by the governor of each state (for certification by the Treasury Secretary) within 90 days of the enactment of the Tax Cuts and Jobs Act (30-day extension); limit on number designated by each state is 25% of the “low income communities” in that state (each state gets 25 even if they don’t have 100 “low income communities”).
– Basis increased:
• By 10% if reinvestment held for at least 5 years; and
• By 15% if reinvestment held for at least 7 years.
– Deferred gain (as adjusted) is triggered at the earlier of – (i) sale of reinvestment or (ii) December 31, 2026.
– Post-investment gain with respect to the reinvestment in the “qualified opportunity zone” can be fully excluded if the reinvestment is held for at least 10 years.
Unless explicitly stated to the contrary, this outline, the presentation to which it relates and any other documents or attachments are not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
42
1. Using §351 to Facilitate M&A Deals
2. Basics of §351
3. Control Issues
4. Solely for Stock
5. Investment Company rule
6. Boot Transactions
7. Liability Issues
8. Basis and Holding Period
9. Interaction with §368 Rules
43
Using §351 to Facilitate M&A Deals
• Depending on the specifics of the transaction, it may be difficult or impractical to satisfy the technical requirements of a §368 reorganization.
• §351 provides an alternative method of acquiring an entity on a tax-free or tax-deferred basis.
• Structuring an acquisition under §351 may also facilitate certain non-tax issues (merger of equals, holding company formation, etc.)
44
Basics of §351
• Property is transferred to a corporation
• The transfer is made by one or more “persons.”
• The transferors have or obtain control of the transferee corporation.
• The transferors control the transferee corporation immediately after
the exchange.
• The exchange is solely for stock other than “nonqualified preferred
stock” (NQPS).
• The transaction has a business purpose.
(NB -- if boot is issued, the transfer may still qualify for tax-free
treatment, but the recipients may be required to recognize gain.)
45
Basics of §351 - Chart
46
BigCo TargetCo
BigCo
Shareholders
TargetCo
Shareholders
• BigCo would like to acquire TargetCo.
Basics of §351 - Chart
47
BigCo TargetCo
BigCo
Shareholders
TargetCo
Shareholders
• A new company, NewCo is formed.
NewCo
Basics of §351 - Chart
48
BigCo TargetCo
BigCo
Shareholders
TargetCo
Shareholders
• The shareholders of BigCo and TargetCo contribute their shares to NewCo in exchange for shares in NewCo (and, possibly, cash, etc.)
NewCo
BigCo stock
NewCo stock
TargetCo stock
NewCo stock
Basics of §351 - Chart
49
BigCo TargetCo
BigCo
Shareholders
TargetCo
Shareholders
• At the end of the transaction, NewCo owns both companies and the shareholders of BigCo and TargetCo own NewCo.
NewCo
§351 vs. §368
50
• Some transactions that would not qualify under
§368 will qualify under §351.
Rev. Rul. 84-71
51
BigCo
TargetCo
Shareholder
Group B
• BigCo would like to acquire TargetCo.
• Group A wants BigCo stock.
• Group B wants cash.
Shareholder
Group A
90% 10%
Rev. Rul. 84-71
52
BigCo
TargetCo
Shareholder
Group B
• Generally, the issuance of all cash to 90% of the shareholders would preclude a transaction under §368.
• Such a transaction can fit within §351.
Shareholder
Group A
90% 10%
Rev. Rul. 84-71
53
BigCo
TargetCo
Shareholder
Group B
• BigCo forms a new corporation, SubCo.
Shareholder
Group A
90% 10%
SubCo
Rev. Rul. 84-71
54
BigCo
TargetCo
Shareholder
Group B
• Under a written agreement, Group A contributes 10% of the stock of TargetCo to SubCo in exchange for stock in SubCo.
• BigCo contributes cash to SubCo in exchange for the rest of the stock of SubCo.
Shareholder
Group A
90% 10%
SubCo
Rev. Rul. 84-71
55
BigCo
TargetCo
Shareholder
Group B
• BigCo and Group A have 100% control of SubCo.
• SubCo forms NewCo and contributes all the cash from BigCo.
Shareholder
Group A
90% SubCo
NewCo
Rev. Rul. 84-71
56
BigCo
TargetCo
Shareholder
Group B
• Newco and TargetCo merge, with TargetCo surviving.
• Under the terms of the merger, Group B’s stock is converted into cash.
Shareholder
Group A
90% SubCo
NewCo cash
merger
Rev. Rul. 84-71
57
BigCo
Shareholder
Group B
• At end of day, BigCo and Group A have stock.
• Group B has cash.
Shareholder
Group A
SubCo
TargetCo
Double Dummy
58
AlphaCo BetaCo
Alpha
Shareholders
Beta
Shareholders
• Alpha and Beta are public companies of equal value that
want to merge. Each is worth $100.
• Each set of shareholders want $75 of cash.
• NewCo formed to facilitate the transaction
NewCo
Double Dummy
59
AlphaCo BetaCo
Alpha
Shareholders
Beta
Shareholders
• NewCo forms Sub1 and Sub2.
• Sub1 merges into AlphaCo – AlphaCo survives.
• Sub2 merges into BetaCo – BetaCo survives.
NewCo
Sub1 Sub2
Double Dummy
60
AlphaCo BetaCo
Alpha
Shareholders
Beta
Shareholders
• Each set of shareholders receive $75 in cash and $25
worth of NewCo stock.
NewCo
Double Dummy
61
AlphaCo BetaCo
Alpha
Shareholders
Beta
Shareholders
• At end of day, shareholders get cash and stock.
• Could this transaction qualify under §368?
• Does transaction qualify under §351?
NewCo
$75 cash
50% of NewCo $75 cash
50% of NewCo
Control Issues
63
1. Control Group
2. Control Percentage
3. “Immediately After” Requirement
Control Group
64
• Generally, any type of taxpayers can make up the
control group – individuals, trusts, corporations,
partnerships, etc.
• Often the control group is defined in the operative
transactional documents.
• The members of the control group do not have to
make their transfers simultaneously so long as the
transfers are set out in a contract or agreement, are
made pursuant to a plan, etc.
• The cases are more forgiving than the regulations.
Control Percentage
65
• In order to qualify under §351, the control group
must possess “control” of the corporation
immediately after the transfers.
• “Control” = ownership of stock possessing at least
80% of the total combined voting power of all
classes of stock entitled to vote and at least 80% of
the total number of shares of all other classes of
stock of the corporation.
• Stock attribution rules do not apply – only actual
ownership of stock counts (BUT – consolidated
groups can aggregate ownership).
Control Percentage -- NQPS
66
• NQPS – generally cannot achieve tax-free
treatment for receipt of “nonqualified preferred
stock” (“NQPS”).
• But – if the corporation has non-voting NQPS, then
control group must acquire 80% of that class.
• Trap for the unwary – eliminate or modify any
classes of non-voting NQPS before transaction?
Immediately After Requirement
67
• To come within §351, the control group must satisfy control
immediately after the transfer.
• Subsequent distributions of stock by members of the control
group or issuance of new stock by the corporation could
change whether the 80% control test is satisfied.
• The cases, unfortunately, are all over the map and do not
apply a consistent standard.
• Moreover, both the IRS and taxpayers have argued opposing
positions across the cases.
• If in doubt, get a ruling or prohibit future transfers.
• NOTE -- If a corporate member of the control group distributes
the stock to its shareholders, §351(c) permits the transfer.
Solely for Stock
• To qualify for tax-free treatment under §351, a transferor must transfer property solely for stock of the corporation.
• Stock warrants and stock rights generally would not qualify as stock for this test.
• A hybrid instrument presents a challenge – if the instrument is characterized as debt it may trip up tax-free treatment.
• NQPS is not treated as “stock” for this test and requires recognition of gain under the boot recognition rules (discussed below).
• The solely-for-stock requirement is for a “clean” §351 transaction. If there is boot, then the parties may recognize gain, but §351 may otherwise apply (as discussed below).
68
Solely for Stock – NQPS NQPS is defined under §351 as preferred stock with any of the following rights: • the holder of the stock has the right to require the issuer or a
related person to redeem or purchase the stock, • the issuer or a related person is required to redeem or purchase
such stock, • the issuer or a related person has the right to redeem or
purchase the stock and, as of the issue date, it is more likely than not that such right will be exercised, or
• the dividend rate on the stock varies in whole or in part (directly or indirectly) with reference to interest rates, commodity prices, or other similar indices.
69
Investment Company Rule • Certain transfers to a corporation that meets the definition of an
investment company will not qualify for tax-free treatment.
• A transfer comes within this exclusion if two requirements are met:
– the transfer results, directly or indirectly, in a diversification of the transferor’s interests; and
– the transfer is to a RIC, a REIT, or a corporation more than 80% of the value of whose assets are held for investment and are stocks or securities, or interests in RICs or REITs.
70
Investment Company Rule
• If the transfer itself does not create diversification, subsequent actions by the corporation could be viewed as creating diversification. Not clear whether step transaction applies and what standard to be used.
• Significant exception if transferor is contributing an already-diversified portfolio – in that case, the transfer itself does not create diversification so the exclusion does not apply.
71
Boot Transactions
• Boot Defined
• NQPS
• Calculation of Gain
• Built-in Loss
• Basis Effect
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Boot Defined • If a transaction otherwise comes within §351, the presence of boot
does not disqualify it. Instead, the parties receiving the boot must recognize gain.
• For these purposes, boot is cash, property, NQPS, or anything that does not meet the “solely for stock” test.
• NB – a transferor who receives boot and stock of the corporation is still covered by §351 – that is, the transferor only recognizes gain to the extent of the FMV of the boot.
• However, if a transferor receives only boot and not stock of the corporation, then the transfer does not come within §351 and is taxed as if the transaction were a taxable sale under §1001.
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NQPS • As noted, NQPS is treated as boot for purposes of the boot-gain
rule. Thus, a transferor who receives NQPS and good stock, recognizes gain on the transaction to the extent of the FMV of the NQPS.
• However, NQPS is treated as stock for purposes of the 80%-control test.
• Suffice to say, this is not an intuitive result and is a trap for the unwary.
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Boot Gain Calculation
• Generally, the recipient of boot must recognize the smaller of the following amounts:
– the gain the recipient would have recognized if the transaction were treated as a taxable sale, or
– the FMV of the boot
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Boot Gain Calculation • Example 1: Eve contributes property with a basis of $100
to Newco and receives stock in Newco worth $500. Assume the transaction is otherwise covered by §351.
– In this case, Eve receives no boot, so she recognizes no gain.
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Boot Gain Calculation • Example 2: Eve contributes property with a basis of $100
to Newco and receives stock in Newco worth $250 and $250 in cash. Assume the transaction is otherwise covered by §351.
– In this case, Eve receives $250 of boot. If this were a taxable transaction, she would recognize $400 of gain ($500 FMV of consideration less $100 tax basis). Because the FMV of the boot is less than the inherent gain, she only has to recognize the FMV of the boot ($250)
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Boot Gain Calculation • Example 3: Eve contributes property with a basis of $300
to Newco and receives stock in Newco worth $250 and $250 in cash. Assume the transaction is otherwise covered by §351.
– In this case, Eve receives $250 of boot. If this were a taxable transaction, she would recognize $200 of gain ($500 FMV of consideration less $300 tax basis). Because the inherent gain is less than the FMV of the boot, she recognizes only the smaller of the two, or $200.
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Boot Gain Calculation • Example 4: Eve contributes property with a basis of
$1,000 to Newco and receives stock in Newco worth $250 and $250 in cash. Assume the transaction is otherwise covered by §351.
– In this case, Eve receives $250 of boot. If this were a taxable transaction, she would recognize a loss of $500 of gain ($500 FMV of consideration less $1,000 tax basis). Because the inherent gain is zero and is less than the FMV of the boot, she recognizes only the smaller of the two, or $0. She is explicitly not permitted to recognize the loss.
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Liability Issues
• Basic rule -- §357(a)
• Example
• Abuse Rule -- §357(b)
• Liabilities in Excess of Basis -- §357(c)
• Techniques
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Liability Issues
• Under the partnership tax rules, the assumption of a contributor’s liabilities is treated as a deemed cash distribution to the contributor.
• In the corporate context, this could be viewed as the receipt of boot and trigger gain recognition.
• However, this rule does not apply in the context of a §351 contribution. Subject to certain exceptions, §357(a) provides that if a corporation assumes a transferor’s liabilities as part of a transfer, the assumption is not treated as boot for purposes of §351.
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Liability Issues
• Example: Adam contributes real estate worth $100 to Newco in exchange for 50% of the stock of Newco. The real estate is subject to a $50 mortgage. As part of the same plan, Eve contributes $50 to Newco in exchange for 50% of the stock of Newco.
• If Newco were a partnership, the applicable tax rules would treat Adam as receiving a deemed cash distribution at the time of the contribution.
• Under §357(a), the corporation’s assumption of the mortgage is not treated as boot to Adam.
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Abuse Rule
• An exception to this general rule is §357(b) which is triggered if:
– (1) the principal purpose of the taxpayer with respect to the assumption of any liability was to avoid federal income tax on the exchange; or
– (2) a bona fide business purpose does not exist for the assumption.
• Note that if §357(b) is triggered then ALL of the liabilities are treated as boot, not just the “abuse” liabilities.
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Abuse Factors
• There are not clear standards for application of §357(b), but the following factors invite scrutiny:
– there is a short time period between incurrence of a liability and assumption by the corporation
– the purpose of the liability is not business-related
– the collateral that secured the liability is not transferred to the corporation
• By statute, the taxpayer has the burden of proof on this issue and must prove his/her case by a clear preponderance of all the evidence.
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Liability in Excess of Basis • Another exception to the general rule is found in §357(c). It
provides that if the amount of liabilities exceeds the total basis of the contributor’s property that is transferred to the corporation, then the difference is recognized as gain.
• Example: Adam contributes real estate worth $100 to Newco in exchange for 50% of the stock of Newco. The real estate is subject to a $50 mortgage and has a tax basis of $25. As part of the same plan, Eve contributes $50 to Newco in exchange for 50% of the stock of Newco.
• The liability assumed by Newco ($50) exceeds Adam’s basis in the property ($25). Under 357(c), Adam recognizes $25 of gain (the excess of the assumed liabilities over the tax basis).
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Basis and Holding Period
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Basis to the Transferor
• The transferor’s basis in the stock received is equal to:
– the basis of the property transferred to the corporation
– LESS the FMV of any boot received
– LESS the amount of any liabilities assumed
– PLUS the amount of gain recognized by the transferor
• (The basis of any boot received by the transferor is its FMV.)
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Basis to the Corporation
• The corporation’s basis in the contributed property is equal to:
– the transferor’s basis in the property
– PLUS the amount of gain recognized by the transferor
• NB – if the contributed property is transferred subject to a liability, the basis cannot be greater than the property’s FMV.
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Holding Period Rules
• The transferor’s holding period for the stock received in a §351 transaction will generally include the holding period of the contributed property. However, if the contributed property was not a capital asset or a §1231 asset in the contributor’s hands, then the capital gains holding period will generally commence with the receipt of the stock.
• The corporation’s holding period for the property received in a §351 transaction will generally include the transferor’s holding period.
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Interaction with §368
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Reorganization Doctrines
• Business Purpose
• Continuity of Interest
• Continuity of Business Enterprise
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Business Purpose
• The IRS takes the position that in order to qualify
under §351, a transaction must have a valid
business purpose
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Continuity of Interest
• Generally, the continuity of interest requirement for
§368 reorgs does not apply to §351 transactions.
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Business Enterprise
• The IRS takes the position that the continuity of
