LO 19-4
As part of their negotiations with Pam, Jim and Ginny look over WCR’s tax accounting balance sheet along with a recent valuation of the assets’ fair market values. Pam has held the WCR stock for 10 years and her tax basis in the stock is
$50,000. WCR is an accrual-method taxpayer, and as a result, the payables have a tax basis. That is, the corporation deducted the expenses related to the payables when the expenses were accrued. These facts are summarized as follows:
Jim and Ginny agree to pay Pam $300,000 for her business, an amount that is
$100,000 more than the net fair market value of the assets less the liabilities listed on the balance sheet ($235,000 − $35,000). The additional $100,000 reflects an amount to be
FMV Adjusted Basis Appreciation
Cash $ 10,000 $ 10,000
Receivables 5,000 5,000
Inventory 20,000 10,000 $ 10,000
Building 80,000 50,000 30,000
Land 120,000 60,000 60,000
Total $235,000 $135,000 $100,000
Payables 4,000 4,000
Mortgage* 31,000 31,000
Total $ 35,000 $ 35,000
*The mortgage was attached to the building and land.
continued from page 19-20 . . .
Taxable Acquisitions
A corporation can acquire an ongoing business through the purchase of its stock or as- sets in return for cash, debt, or equity or a combination thereof. Cash purchases of stock are the most common form of acquisition of publicly held corporations. Using cash to acquire another company has several nontax advantages; most notably, the acquiring corporation does not “acquire” the target corporation’s shareholders in the transaction and does not increase the denominator in its calculation of earnings per share. There are disadvantages to using cash, particularly if the acquiring corporation incurs additional debt to fund the purchase.
If SCR purchases the assets directly from WCR in return for cash (cell 1 in Exhibit 19-7), WCR will recognize gain or loss on the sale of each asset individually.
WCR may cease to exist as a separate corporation and might completely liquidate by transferring the net after-tax proceeds received from SCR to its shareholder. If WCR liquidates, Pam recognizes gain or loss on the exchange of her WCR stock for the cash received.
paid for the company’s customer list valued at $25,000, with the remaining $75,000 allocated to goodwill.
With the price settled, Jim, Ginny, and Pam now must agree on the form the transaction will take.
to be continued . . .
What if: Assume SCR will purchase WCR’s assets for $300,000 and assume the company’s liabilities of $35,000. WCR will realize $335,000 ($300,000 + $35,000), which it will allocate to each of the assets sold, as follows:
Allocation Adjusted Basis Gain Realized
Cash $ 10,000 $ 10,000 $ 0
Receivables 5,000 5,000 0
Inventory 20,000 10,000 10,000
Building 80,000 50,000 30,000
Land 120,000 60,000 60,000
Customer list 25,000 0 25,000
Goodwill 75,000 0 75,000
Total $335,000 $135,000 $200,000
What amount of gain or loss does WCR recognize on the sale of its assets, and what is the character of the gain or loss (ordinary, §1231, or capital)?
Example 19-20
(continued on page 19-24 )
If SCR acquires WCR by acquiring Pam’s stock for cash (cell 2 in Exhibit 19-7), WCR retains its tax and legal identity (unless SCR liquidates WCR into itself or merges it into an existing subsidiary). The tax basis of WCR’s assets, which will remain unchanged, will not reflect SCR’s tax basis (purchase price) in WCR’s stock.
Answer: WCR recognizes total gain of $200,000, and WCR pays a corporate-level tax of $42,000 (assuming a tax rate of 21 percent). The character of the gain will be as follows:
Gain Recognized Character
Inventory $ 10,000 Ordinary
Building 30,000 Ordinary (§291) and §1231
Land 60,000 §1231
Customer list 25,000 §1231
Goodwill 75,000 §1231
Total $200,000
What if: Suppose that WCR opts to go out of existence (liquidate) by exchanging the $258,000 net amount realized after taxes ($300,000 − $42,000) for Pam’s WCR stock.
What amount of gain or loss will Pam recognize on the exchange of her WCR stock for the after-tax proceeds from the sale ($258,000)?
Answer: Pam recognizes a long-term capital gain of $208,000 ($258,000 − $50,000 stock basis) and pays a shareholder-level tax of $31,200 ($208,000 × 15% assuming Pam’s total taxable income is not above the breakpoint for the 20% capital gains tax rate). The total tax paid using this form of acquisition is
$73,200 ($42,000 + $31,200). Pam is left with $226,800 after taxes ($300,000 − $42,000 − $31,200).
Although unattractive to Pam, this deal provides SCR (Jim and Ginny) with the maximum tax bene- fits. The building will have an increased tax basis of $30,000, which SCR can depreciate over 39 years. The customer list and goodwill will have a tax basis of $25,000 and $75,000, respectively, which SCR can amortize over 15 years on a straight-line basis.36
What if: Suppose instead that SCR purchases the WCR stock from Pam for $300,000. What amount of gain or loss does WCR recognize in this transaction?
Answer: WCR will not recognize gain on this form of acquisition because it has not sold any assets directly to SCR.
What amount and character of gain or loss does Pam recognize in this transaction?
Answer: Pam recognizes long-term capital gain of $250,000 ($300,000 − $50,000 stock basis) and pays a shareholder-level tax of $37,500 ($250,000 × 15%). Pam will be left with $262,500 after taxes ($300,000 − $37,500), which is $57,800 more than a direct asset sale ($262,500 − $204,700).
Although attractive to Pam, this deal will not be as attractive a direct asset sale to SCR (Jim and Ginny). The building will retain its same tax basis of $50,000, and the customer list and goodwill will have a tax basis of zero. The customer list and goodwill have a zero tax basis to WCR because they are self-created assets. The tax basis of WCR’s assets remain at $135,000. SCR has a tax basis in the WCR stock equal to the purchase price of $300,000.
Example 19-21
36§197. Note that goodwill is not amortized for financial accounting purposes, and the determination of goodwill for accounting purposes under ASC 805-30-30-1 differs from the determination of goodwill for tax purposes under §1060. Hence, even a taxable acquisition can give rise to a book–tax difference because different amounts of goodwill exist for tax and book purposes.
Tax nirvana will be achieved if Pam can treat the transaction as a stock sale and pay a single level of capital gains tax on the gain recognized from the sale, and if SCR can treat the transaction as an asset purchase and receive a step-up in basis of the assets to fair market value. This best of both tax worlds is sometimes available in transactions where a corporate taxpayer purchases 80 percent or more of another corporation’s stock within a 12-month period. In such cases, SCR can make a §338 election to treat the stock purchase as a deemed asset purchase.
Like most things that appear too good to be true, this election does not come without some cost. The calculation of these tax costs is extremely technical and be- yond the scope of this text. In big-picture terms, WCR is treated as if it is selling its assets prior to the transaction and then repurchasing them at fair market value. This deemed sale of assets causes WCR to recognize gain on assets that have appreciated in value. SCR, as the buyer, bears this tax cost because the fair market value of WCR will be reduced by the tax paid. In almost all cases, this tax cost negates the tax ben- efits of getting a step-up in basis in WCR’s assets and is rarely ever elected. For ex- ample, it rarely makes economic sense to pay income taxes on a $100 gain just to increase the basis of an asset by $100. The additional tax on the $100 gain would very likely outweigh the present value of the savings from an additional $100 of fu- ture depreciation deductions. However, this election might be tax-efficient if WCR has net operating losses or net capital losses that can be used to offset gain from the deemed sale of its assets.
If the target corporation is a subsidiary of the seller, the acquiring corporation and seller can make a joint §338(h)(10) election and have the seller report the gain from the deemed sale of the target corporation’s assets on its tax return in lieu of re- porting the actual gain from the sale of the target corporation stock. The technical rules that apply to §338(h)(10) elections are beyond the scope of this text. These elections, which are more common than a regular §338 election, often achieve tax savings to both parties to the transaction. For example, Dow Chemical sold its AgroFresh subsidiary to a group of investors in 2015. The buyer and seller made a joint §338(h)(10) election, which allowed AgroFresh to record a stepped-up tax basis for its asset. As you can see from the announcement reproduced in the nearby box, this provided almost $400 million in cash tax benefits from amortizing or depreciat- ing the step-up in basis.
TAXES IN THE REAL WORLD Dow Chemical’s Tax Receivable from a §338(h)(10)
On July 31, 2015, Dow Chemical sold its AgroFresh business to investors organized as Boulevard Acquisition Corporation. Under the agreement, Dow was to receive cash plus Boulevard common stock valued $1.056 billion.
The assets of AgroFresh were stepped up under a Section 338(h)(10) election, and under a tax re- ceivable agreement, Dow was entitled to future payments from AgroFresh in the amount of 85 percent of the tax savings resulting from the increased tax basis. AgroFresh estimated that the total undiscounted tax payments to Dow
would amount to $337 million over the term of the agreement, implying that the total tax savings from the step-up would amount to around $400 million ($337 million/85 percent). In addition, as a result of the transaction, Dow also reported a
$618 million gain from the sale in its financial re- sults for 2015.
Source: Boulevard Acquisition Corp Proxy dated July 16, 2015 and AgroFresh Solutions 10-K dated March 11, 2016 .
Tax-Deferred Acquisitions
As you learned previously in this chapter, the tax law allows taxpayers to organize a corporation in a tax-deferred manner under §351. The tax laws also allow taxpayers to reorganize their corporate structure in a tax-deferred manner. For tax purposes, reorganizations encompass acquisitions and dispositions of corporate assets (includ- ing the stock of subsidiaries) and a corporation’s restructuring of its capital structure, place of incorporation, or company name. The IRC provides tax deferral to the corporation(s) involved in the reorganization (the parties to the reorganization) and the shareholders if the transaction meets one of seven statutory definitions37 and satis- fies the judicial principles that underlie the reorganization statutes. As before, tax de- ferral in corporate reorganizations is predicated on the seller’s receiving a continuing ownership interest in the assets transferred, in the form of equity in the acquiring corporation.
The statutory language governing corporate reorganizations is rather sparse. It should not be surprising, then, that the IRS and the courts frequently must interpret how changes in the facts related to a transaction’s form affect its tax status. The end result has been the development of a complex and confusing legacy of IRS rulings and court decisions that dictate how a reorganization transaction will be taxed. Cor- porate reorganizations are best left to the tax experts who have devoted much of their professional lives to understanding their intricacies. Our goal is to acquaint you with the basic principles that underlie all corporate reorganizations and provide you with an understanding of the most common forms of corporate acquisitions that are tax-deferred.
Judicial Principles That Underlie All Tax-Deferred Reorganizations
Continuity of Interest (COI) Tax deferral in a reorganization is based on the pre- sumption that the shareholders of the acquired (target) corporation retain a continuing ownership (equity) interest in the target corporation’s assets or historic business through their ownership of stock in the acquiring corporation. The IRC does not provide a bright line test to establish that continuity of interest (COI) has been met, although the regula- tions provide an example that says COI has been satisfied when the shareholders of the target corporation, in the aggregate, receive equity equal to 40 percent or more of the total value of the consideration received.38
Continuity of Business Enterprise (COBE) For a transaction to qualify as a tax- deferred reorganization, the acquiring corporation must continue the target corporation’s historic business or continue to use a significant portion of the target corporation’s his- toric business assets. Whether the historic business assets retained are “significant” is a facts and circumstances test, which adds to the administrative and judicial rulings that are part and parcel of the reorganization landscape. Continuity of business enterprise (COBE) does not apply to the historic business or assets of the acquiring corporation;
the acquiring corporation can sell off its assets after the reorganization without violating the COBE requirement.
Business Purpose Test As early as 1935, the Supreme Court stated that transactions with “no business or corporate purpose” should not receive tax deferral even if they
THE KEY FACTS Forms of a Tax-Deferred
Asset Acquisition
• Statutory Type A merger
• Must meet state law re- quirements to be a merger or consolidation.
• Judicial requirements of COI, COBE, and business purpose must be met.
• Forward triangular Type A merger
• Must meet requirements to be a straight Type A merger.
• The target corporation merges into an 80- percent-or-more owned acquisition sub- sidiary of the acquiring corporation.
• The acquisition subsid- iary must acquire “substantially all” of the target corporation’s properties in the exchange.
• Reverse triangular Type A merger
• Must meet requirements to be a straight Type A merger.
• The acquisition subsid- iary merges into the tar- get corporation.
• The target corporation must hold “substantially all” of the acquisition subsidiary’s properties and its own properties after the exchange.
• The acquisition subsid- iary must receive in the exchange 80 percent or more of the target corpo- ration’s stock in ex- change for voting stock of the acquiring corporation.
37The “forms” of corporate reorganizations are defined in §368(a)(1).
38Reg. §1.368-1T(e)(2)(v), Example 10.
comply with the statutory requirements.39 To meet the business purpose test, the acquir- ing corporation must be able to show a significant business purpose for engaging in the transaction (other than tax avoidance).
Type A Asset Acquisitions
Type A reorganizations (cell 3 in Exhibit 19-7) are statutory mergers or consolidations.40 In a merger, either the acquired (target) corporation or the acquiring corporation will cease to exist. For example, SCR could acquire the assets and liabilities of WCR by trans- ferring SCR shares to Pam in exchange for her WCR stock, and WCR would no longer exist. This type of merger is an upstream or forward acquisition because the target is merged into the acquiring corporation. Alternatively, the target corporation could be the surviving entity, and this type of acquisition is a downstream or reverse acquisition. In a consolidation, SCR and WCR will transfer their assets and liabilities to a newly formed corporation in return for stock in the new corporation, after which SCR and WCR will both cease to exist.
In a Type A reorganization, the target corporation shareholders defer recognition of gain or loss realized on the receipt of stock of the acquiring corporation. Similar to a §351 transaction, if a target corporation shareholder receives money or other property (boot) from the acquiring corporation or its acquisition subsidiary, the shareholder recognizes gain to the extent of the money and fair market value of other property received (not to exceed the gain realized). The shareholder’s tax basis in the stock received is a substituted basis of the stock transferred plus any gain recognized less any money and the fair market value of other property received. The target corporation’s assets remain the same at their (historic) tax basis in a Type A merger.
Exhibit 19-8 provides an illustration of a Type A merger. The consideration that can be paid to Pam is relatively flexible in a Type A merger; the only limitation is that the transaction must satisfy the COI requirement (at least 40 percent of the consideration must be SCR stock). The stock used to satisfy the COI test can be voting or nonvoting, common or preferred.
39Gregory v. Helvering, 293 U.S. 465 (1935).
40“Type A reorganizations” are so named because they are described in §368(a)(1)(A). Likewise, Type B and Type C reorganizations are described in subparagraphs (B) and (C), respectively.
EXHIBIT 19-8 Form of a Type A Merger
WCR SCR
SCR stock and cash WCR stock
No gain or loss is recognized
No gain or loss is recognized unless cash is received
SCR stock and cash Assets and liabilities
No gain or loss is recognized
Pam
What if: Assume WCR will merge into SCR in a Type A reorganization. Under the terms of the deal, SCR will pay Pam $300,000 in SCR stock, after which WCR will merge into SCR. Pam’s tax basis in her WCR stock is $50,000. What amount of gain will Pam realize on the exchange of her WCR stock for SCR stock?
Answer: $250,000 ($300,000 − $50,000)
What amount of gain will Pam recognize on the exchange of her WCR stock for SCR stock?
Answer: $0. Because Pam receives only SCR stock, she defers the entire $250,000 gain realized.
What is Pam’s tax basis in her SCR stock?
Answer: $50,000. Because Pam defers the entire gain, her tax basis in the SCR stock is a substituted basis from her WCR stock. This preserves the gain deferred for future recognition if Pam should choose to sell her SCR stock in the future for its fair market value of $300,000.
What are SCR’s tax bases in the assets it receives from WCR in the merger?
Answer: SCR receives a carryover tax basis in each of the assets received (e.g., the tax basis of the goodwill and customer list will be zero).
Example 19-22
What if: Suppose instead Pam wants some cash as well as SCR stock in the transaction. What is the maximum amount of cash Pam can receive from SCR and not violate the COI rule as illustrated in the regulations?
Answer: $180,000 ($300,000 × 60%). Pam can receive a maximum of 60 percent of the consider- ation in cash and not violate the COI rule under the regulations.
What if: Assume Pam receives $100,000 plus $200,000 in SCR stock in exchange for all of her WCR stock in a Type A merger. What amount of gain will Pam realize on the exchange?
Answer: $250,000 ($300,000 − $50,000)
What amount of gain will Pam recognize on the exchange?
Answer: $100,000. Pam must recognize gain in an amount that is the lesser of the gain realized or the boot received. Pam defers recognizing $150,000 gain.
What is Pam’s tax basis in her SCR stock?
Answer: $50,000, computed as follows:
Adjusted basis of WCR stock exchanged $ 50,000
+ Gain recognized on the exchange 100,000
− Fair market value of boot (cash) received 100,000 Tax basis of stock received $ 50,000
This calculation preserves the gain deferred for future recognition if Pam should choose to sell her SCR stock in the future for its fair market value of $200,000 ($200,000 − $50,000 = $150,000).
Example 19-23
There are several potential disadvantages to structuring the transaction as a statutory merger. Pam will become a shareholder of SCR, and the historic tax basis of WCR’s assets and liabilities will carry over to SCR. Going back to the original set of facts in the above example, Pam will not owe any tax on the transaction but she will not receive any cash.
Finally, WCR will cease to exist as a separate corporation. Jim and Ginny expressed a desire to operate WCR as an independent corporation. To accomplish this, SCR will have
to transfer the WCR assets and liabilities to a newly created subsidiary under §351. SCR will incur the additional cost to retitle the assets a second time and pay any state transfer tax on the transfer of the assets. Jim and Ginny can avoid this latter cost by employing a variation of a Type A reorganization called a forward (upstream) triangular merger.
Forward Triangular Type A Merger In a forward triangular merger, the acquiring corporation creates a subsidiary corporation (called, perhaps, SCR Acquisition Subsidiary in our example) that holds stock of the acquiring corporation. The target corporation then merges into this subsidiary with its shareholders (Pam in this case) receiving stock of the acquiring corporation (SCR) in exchange for the stock of the target corporation (WCR). In our example, when the dust clears, WCR assets and liabilities are isolated in a wholly owned subsidiary of SCR. Exhibit 19-9 provides an illustration of a forward triangular Type A merger for determining the tax consequences to the parties in our fictional transaction.
This type of merger is a common vehicle for effecting mergers when the parent corpora- tion stock is publicly traded or the parent corporation is a holding company. For a forward triangular merger to be effective, the transaction must satisfy the requirements to be a straight Type A merger and one additional requirement: The acquisition subsidiary must acquire
“substantially all” of the target corporation’s properties in the exchange. The IRS interprets
“substantially all” to mean 90 percent of the fair market value of the target corporation’s net properties ($300,000 × 90% = $270,000) and 70 percent of the fair market value of the target corporation’s gross properties ($335,000 × 90% = $301,500). The technical tax rules that apply to determine the tax basis of the acquired assets after the merger are complex and be- yond the scope of this text.
Reverse Triangular Type A Merger Another variation of a Type A reorganization is the reverse (downstream) triangular merger. Suppose that WCR holds valuable assets that cannot be easily transferred to another corporation (perhaps employment contracts or licenses). In this scenario, it would not be prudent to dissolve WCR because these valuable assets would be lost. In a reverse triangular merger, the acquiring corporation still creates a subsidiary corporation that holds stock of the acquiring corporation. How- ever, it is the acquisition subsidiary that merges into the acquiring corporation. Again, the shareholders of the target corporation (Pam) receive stock of the acquiring corpora- tion (SCR) in exchange for the stock of the target corporation (WCR). When the dust clears, however, the target corporation (WCR) is still intact, albeit as a wholly owned subsidiary of the acquiring corporation. Reverse triangular Type A mergers are desirable because the transaction preserves the target corporation’s existence. Exhibit 19-10 pro- vides an illustration of a reverse triangular Type A merger for determining the tax con- sequences to the parties in our fictional transaction.
EXHIBIT 19-9 Form of a Type A Forward Triangular Merger
SCR WCR Acquisition
Subsidiary SCR
Controls
(≥80%) WCR stock
“Substantially all” of WCR’s properties
Must meet COI (40% SCR stock)
SCR stock and cash
Pam