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Advanced Tax Considerations for Negotiating, Structuring and Documenting M&A Transactions

Evaluating Taxable Versus Tax-Free Deals, Stock Sales Versus Asset Sales, Tax-Free Reorganizations, Earnouts and More

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUESDAY, SEPTEMBER 12, 2017

Jonathan Golub, Attorney, Royse Law Firm, Palo Alto, Calif. Roger Royse, Attorney, Royse Law Firm, Menlo Park, Calif.

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M&A TAX CONSIDERATIONS FOR BUYERS AND SELLERS

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.

Roger Royse Royse Law Firm, PC Silicon Valley San Francisco Los Angeles Orange County rroyse@rroyselaw.com www.rroyselaw.com Skype: roger.royse Twitter @rroyse00 Jonathan Golub Royse Law Firm, PC Silicon Valley San Francisco Los Angeles Orange County jgolub@rroyselaw.com www.rroyselaw.com

OVERVIEW OF TRANSACTIONS

• Tax Free Reorganizations:

– Type A – Merger – 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

• Compensation Issues
• Taxable Transactions:

– Stock Sale – Asset Sale

• S Corporation Strategies
• Use of LLCs
• Foreign Corporations

6

TAXABLE VS. TAX FREE

• Type of Acquisition Currency

– Stock – Securities/Debt – Deferred payments, earn out provisions – Compensatory

• Nature of the Buyers and Seller

– Foreign Parties – Tax Attributes of Parties

• Shareholder Level Considerations

– Tax Sensitivity of Shareholders – Appetite for Complexity & Risk

• Some taxes subject to indemnification

7

CONTINUITY OF INTEREST

8

• 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

TAX FREE REORGANIZATIONS

• Type A – Merger
• 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
• Ruling Guidelines

– Rev. Rul. 77-37 – Rev. Proc. 86-42 – Rev. Rul. 73-54 (terms) – Rev. Proc. 89-50 – Rev. Proc. 96-30 (Type D Checklist)

9

TYPE A REORGANIZATIONS – SECTION 368(a)(1)(A) STATUTORY MERGER

Requirements:

• Necessary Continuity of Interest
• Business Purpose
• Continuity of Business Enterprise
• Plan of Reorganization
• Net Value

Tax Effect:

• Shareholders – Gain recognized to the extent of boot
• Target – No gain recognition
• Acquiror 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

• ne 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 Acquiror Shareholders

10

TYPE B REORGANIZATIONS – SECTION 368(a)(1)(B) STOCK FOR STOCK

11

• Acquisition of stock of Target, by

Acquiror in exchange for Acquiror voting stock

• Acquiror needs control of Target

immediately after the acquisition

• Control = 80% by vote and 80% of

each class Target Acquiror Shareholders

• Acquiror’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

12

• Acquisition of substantially all of the assets
• f Target, by Acquiror in exchange for

Acquiror 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 – Acquiror can pay

boot (non-stock) for Target assets, up to 20% of total consideration; liabilities assumed are not considered boot unless

• ther boot exists

Target Acquiror Shareholders

Target Assets Acquiror Stock Acquiror Stock

• Reorganization Expenses – Aquiror may

assume expenses (Rev. Rul. 73-54)

• Assumption of stock options not boot
• Bridge loans by Acquiror are boot
• Redemptions and Dividends – who pays

and source of funds

TYPE D REORGANIZATIONS – SECTION 368(a)(1)(D) DIVISIVE SPIN OFF, SPLIT OFF, SPLIT UP

13

• Control rules: Transfer by a corporation of all or part of its assets to another

corporation if, immediately after the transfer, the transferor or its shareholders are in control of the transferee corporation.

• Distribution Rules: Stock or securities of the transferee must be distributed under

the plan in a transaction that qualifies under Section 354, 355, or 356.

• Must satisfy business purpose, transfer long-lived business, and not fail numerous

anti-abuse provisions.

• Precaution: Protectively file §336(e) election in case this fails to be a tax-free

reorganization, to at least get inside basis step-up (see later slide) Transferor Transferee Shareholders

Transferee Stock Transferee Stock Transferor Assets

TYPE D REORGANIZATIONS – SECTION 368(a)(1)(D) NON-DIVISIVE

14

• If shareholders of Transferor stock receive

Acquiror stock and own at least 50% of Acquiror stock, the transaction may be treated as a non-divisive D REORG even if it fails as an A REORG for lack of continuity

Transferor Acquiror Shareholders with 20%

Acquiror Stock Acquiror Stock Transferor Assets Merger

Merger Treated as Acquisitive D Failed Type C Treated as D

Shareholders

Transferor Acquiror

Assets Cash & Stock

Liquidation / Reincorporation

Shareholders

Transferor Acquiror

NON-QUALIFIED PREFERRED STOCK

15

• 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

• ther 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

TRIANGULAR OR SUBSIDIARY MERGERS

16

2. Reverse Subsidiary Merger

Target Acquiror

Merger Sub

Acquiror Target

Merger Sub

1. Forward Subsidiary Merger

TRIANGULAR OR SUBSIDIARY MERGERS

17

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 Acquiror

Target Shareholders

80%

Tax Consequences

• Merger Sub takes Target’s

basis in assets increased by gain recognized by Target

• Acquiror takes “drop

down” basis in stock of Merger Sub (same as asset basis)

Merger Sub

TRIANGULAR OR SUBSIDIARY MERGERS

18

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 Acquiror voting stock and – (ii) Target holds substantially all the assets of Target and Merger Sub – Shareholder loan issues

Target Acquiror

Target Shareholders

80%

Tax Consequences

• Non-taxable to Target and carryover

basis

• No gain to Acquiror and Merger Sub

under Sections 1032 and 361

• No gain to Target shareholders except

to the extent of boot

• Acquiror’s basis in Target stock

generally is the asset basis, but Acquiror can choose to take Target shareholders basis in stock (if it is also a B)

• If transaction is also a 351, Acquiror can

use Target shareholders’ basis plus gain

Merger Sub

HORIZONTAL DOUBLE DUMMY

19

• Employs with two interim (‘dummy’) subsidiaries, which participate in

reverse triangular mergers to create final structure.

• Each side potentially qualifies for §§368(a)(1)(B) (due to subsidiary being

ignored) or (a)(2)(E).

• Special feature: Shareholders of Acquiror and Target control Holdco under

§368(c); overall transaction therefore generally a good Code §351 exchange, and even very high boot will generally not break transaction.

Target Acquiror Merger Sub New Holdco Merger Sub

Merger Acquiror survives Merger Target

Survives

Acquiror Shareholder Target Shareholder

Target Stock New Holdco Stock + $ New Holdco Stock Acquiror Stock

DOUBLE MERGER

20

Acquiror

Target Shareholders

Step 2: A-type Forward Merger Step 1: Reverse Triangular Merger

Target Acquiror

Merger Sub

Target Shareholders

80%

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

DOUBLE MERGER – WHOLLY OWNED LLC

21

Target+Sub

Acquiror LLC

Merger LLC Survives

Step 2: A-type Forward Merger Step 1: Reverse Triangular Merger

Target Acquiror

Merger Sub

Target Shareholders

80%

Second step is merger into LLC under Reg 1.368-2(b)(1) (good forward merger)

• REV. RUL. 2001-46

Target Shareholders

TYPE E REORGANIZATIONS – SECTION 368(a)(1)(E) RECAPITALIZATIONS

• Useful for single company restructuring
• Often used to transfer control of a company from one generation to the next
• Typical situation = founders of business want to pass on control to children. They

engage in a Type E recapitalization to change their voting common stock to non- voting common stock or preferred stock, leaving children with voting control of the company – There may be estate and/or gift tax consequences to such a transaction

• An important requirement to qualify for tax free treatment under a Type E

recapitalization is that the old stock/securities must have the same value as the new stock/securities for which they are exchanged – A recent IRS Memo (Legal Advice Issued by Field Attorneys 20131601F) stated that where the value of the stock received was in excess of the value of the stock surrendered, there was no Type E recapitalization and therefore the excess amount of stock received was taxable

22

VOTING POWER

Issues to consider in calculating voting power: “Control” relevant in sections 269, 304, 355(e), 368, 382, 957 and 1504

• What sort of capital structure does the company have? For example:

– One or more classes of stock with the same voting rights; – Separate classes of stock that vote for different directors; – Separate classes with a different number votes per share; – Supermajority provisions; – Veto powers.

• How do you determine voting power when shareholders have agreement
• n voting?

– e.g. shareholders agree to abstain from voting, vote together, or transfer shares to a voting trust

• How do you determine voting power with regard to foreign entities that

are treated as a corporation for U.S. tax purposes?

23

FINAL REGULATIONS ON LOSS IMPORTATION

• General Rule: The acquirer’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

• n the date of the transfer

– The IRS has issued Final Regulations explaining how these “anti-loss importation” rules apply (also applies to Section 334(b) transactions)

• Under the Final 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

24

FINAL REGULATIONS ON LOSS IMPORTATION

Issues to Consider

• Flow-through entities

– For flow-through entities such as a partnerships or S Corps, the importation property test is made by reference to the partners or shareholders, not the entity itself – The hypothetical sale will consider allocations of gains and losses as per the organizing instrument – The Final Regulations contain an anti-avoidance principal for REITs and RICs which applies the look-through principal above if the REIT/RIC acquired the property as part of a plan to avoid the anti-importation rules (same as Proposed Regulations)

• Controlled Foreign Companies (CFCs) and Passive Foreign Investment

Companies (PFICs) – Under the Importation Property test, a gain or loss on the sale of an asset by a PFIC or CFC is not considered subject to US tax even though it may result in an inclusion under Section 951(a) or Section 1293(a) – Comments were specifically requested on this approach – It was adopted in the Final Regulations

25

TARGET DEBT SECURITIES

26

• Exchange of Target securities for Acquiror securities

is tax free under Sections 354 and 356, to the extent that the principal amount of Acquiror 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 Acquiror stock or debt worth $900; Target has COD of $100

DIVIDEND EQUIVALENCY

27

• 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

CONTINGENT STOCK, ESCROWS, AND EARN-OUTS

28

• Escrows:

– Target shareholders usually treated as owner of escrowed Acquiror shares unless

• therwise 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 Acquiror 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, Acquiror shares shown as issued to Target shareholders, current voting and dividend rights, and vested

UNVESTED STOCK RECEIVED IN A TAXABLE OR NON-TAXABLE DEAL

29

• 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

30

• 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
• ld; see Sections 424(a) and 424(h)(3)

OPTIONS – CASH OUT

31

• Cancel options for cash payment

– NSO

• Ordinary income – compensation – withholding or 1099
• Deduction to Target or Acquiror?

– TAM 9024002 – employer deducts based on method of accounting; not clear if cash

• ut at close is pre-acquisition Target deduction or post-close Acquiror 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

SECTION 409A

32

• Deferred compensation

— A deferral of compensation occurs whenever the service provider (employee) has a legally binding right during a taxable year to compensation that will be paid to such person in a later year. Treasury Regulation Section 1.409A-1(b)

• Consequences of violating 409A

— Amounts which were to be deferred are subject to immediate taxation — Additional 20% penalty on such amounts — Interest penalty — CA state tax penalty

• Bonus or Carve Out Plans
• Participation in Earn Outs (Reg. 1.409A-3(i)(5)(iv))

— Payments of compensation in this context may be treated as paid at a designated date

• r pursuant to a schedule that complies with 409A if the transaction-based

compensation is paid on the same schedule and under the same terms and conditions as apply to payments to shareholders generally pursuant to the change in control event

EARN OUT PROVISIONS

33

• Bridge a valuation gap between seller and buyer

─ Additional financing option ─ Payment/tax deferral ─ Reduce risk of overpaying

• Earn outs usually based on

─ Financial Targets

• Earnings before interest, tax, depreciation and amortization (EBITDA);

Revenue; Net income; Earnings per share ─ Non-Financial Targets

• Regulatory approval; Increase in customer base/sales;

Product development milestones

• Key Considerations: Terms, time period, payout structure, security for payments,

allocation of control of the acquired business, level of support (if any) committed

280G GOLDEN PARACHUTE RULES

34

• 20% excise tax and loss of deduction on Excess Parachute Payment

– “Excess Parachute Payment” means the amount by which the Parachute Payment exceeds the Base Amount – “Parachute Payment” means a payment, the present value of which, exceeds three times the Base Amount – “Base Amount” means the average annual compensation for past 5 years – Must be paid to a disqualified individual (meaning employee, officer, shareholder,

• r highly compensated individual)

– As compensation, AND – Contingent on a change in control (50% change ownership or effective control, or

• wnership change in a substantial portion of the company’s assets)
• Reduce Excess for reasonable compensation
• Exclude reasonable compensation for future services
• Exception for small business corporation and non publicly traded

corporation that has 75% uninterested shareholder approval

• Withholding requirement

280G – OTHER ISSUES

35

• Non-Publicly Traded Stock

– Approval of 75% of shareholders after adequate disclosure – Vote determines the right of the shareholder to the payment – Ignore shares held by persons receiving the payment

• Reduction for Excess (299% of payments)
• Reduction for Reasonable Compensation
• Reduction for Future Services

TAXABLE STOCK PURCHASES

36

Cash Reverse Triangular Merger

• Treated as Stock Sale
• Shareholders have gain or loss
• Acquiror takes cost basis in Target shares

Merger Sub Target Shareholders

Target Acquiror

PERSONAL GOODWILL

• Key questions: (1) Who owns the goodwill (individual or company)? And

(2) Was that goodwill ever transferred?

• Two key cases:

– Bross Trucking, Inc. – goodwill may be transferred to a company via an employment contract if that employment contract grants the company a right to future services (e.g., through a non-compete provision)

• Note: non-compete provisions are generally invalid in California absent the sale of a

business

– Martin Ice Cream – the court held that customer relationships and distribution lists were an asset of the shareholder because they were never transferred to the company (the business began as a sole proprietorship and then part of the business was specifically transferred to a new company)

37

PERSONAL GOODWILL

• Issues:

– Is a buy/sell non-compete sufficient to satisfy the right to future services?

• What does the scope of the non-compete need to be? (geographic

area, time, etc.) – Is a fiduciary obligation not to compete sufficient? – Is a non-solicitation and/or non-use of trade secrets provision sufficient?

• Best practice = shareholders should sell their “personal goodwill” separate

from the stock/asset sale

38

PERSONAL GOODWILL CASES

• Estate of Franklin Z. Adell v. Comm’r (Tax Court 2014)

– Case about the treatment of the goodwill provided by the son of decedent’s company

• The son did not transfer his goodwill through an employment or noncompete agreement
• The Court held that the IRS’s value for the son’s goodwill was not high enough
• Kennedy v. Comm’r (Tax Court 2010)

– Kennedy sold his corporation; 25% of the purchase price was payment for consulting services and 75% was payment for Kennedy’s goodwill

• The Court held that the identification of personal goodwill is not enough to conclude that the

goodwill was sold

• The Court found the payments to Kennedy were consideration for services because the

contractual allocation did not genuinely reflect the relative value of his customer relationships compared to the value of the his ongoing personal services

• Solomon v. Comm’r (Tax Court 2008)

– Solomon sold its corporate division; the purchase agreement included a customer list and a covenant not to compete

• Nothing in the agreement made reference to the sale of personal goodwill and the acquiring

party continued to do business under its own name

• The Court held that the proceeds paid directly to the shareholders were actually attributable to

their covenant not to compete rather than for a customer list or personal goodwill

39

Qualified Small Business Stock (QSBS)

• Benefits

– Reduced federal income tax for non-corporate stockholders on capital gains from QSBS held for more than five years – Gain exclusion is limited to $10 million or 10x the taxpayer’s aggregate adjusted bases in the stock – Potential to roll QSBS proceeds into new QSBS and tack holding period

• Eligibility

– Stock in a C-corporation originally issued to the taxpayer after August 10, 1993 in exchange for money or property (not stock) or as compensation for services – Corporation is a “qualified small business”

• Original issuance exceptions

– Acquired on conversion of other stock in the same corporation – Certain carryover basis transactions

40

QSBS ISSUE FOR CASH FREE STOCK SALES

• Target companies may be acquired on a cash free/debt free basis,

however this often necessitates a cash dividend to shareholders immediately prior to the sale

• During negotiations, both Acquiror and Target shareholders typically treat

this dividend as part of the acquisition price, however the form of the transaction is a dividend

• This pre-sale dividend can create problems for shareholders’ QSBS relief:

– Under the QSBS rules, the maximum taxable gain considered available for relief is the higher of $10 million or ten times stock basis – If the dividend payment is treated as a pre-sale distribution then it will reduce the basis of the stock and may therefore reduce the amount of gain available for QSBS relief

• Taxpayer may choose to file on the basis that the dividend is, in substance,

part of the sale proceeds, however this could be subject to challenge by the tax authorities

41

CASH FORWARD MERGER

42

Asset Sale Followed by Liquidation of Target

• Target has gain on sale
• Target shareholders have

gain on liquidation (unless 332 applies)

• Acquiror takes cost basis

in Target assets

• S corporations with no

h10 election

Target Shareholders

Merger Acquiror Survives

Target Shareholders Variation with Merger Sub:

Target Target Acquiror Acquiror

Merger Sub

SECTION 382 – LIMITATION ON LOSSES AFTER CHANGE IN OWNERSHIP

43

• Section 381 – Survival of Tax Attributes
• Section 382

– When there has been an ownership change of a corporation with loss carry forwards, use of Net Operating Losses (NOLs) against future income is limited to the product of the value of the Target and the long term interest rate. – “Ownership Change” occurs if, within a 3 year testing period, the percentage of stock of Target held by 5 Percent Shareholders increases by more than 50% over lowest percentage held by such shareholders during the test period.

BUSTED 351

44

Shareholders Target Shareholder Business Acquiror Target Stock Merger

Acquiror Stock

• Rev. Ruling 70-140

Weikel v CIR, 51 TCM 432 (1986) Substantial business purpose Step 1: Incorporate Target Step 2: Merge Target into Acquiror

USE OF WHOLLY OWNED LLC

45

Target Acquiror LLC

T Shareholders

Merger of Corporation into LLC

• Reg. 1.368-2(b)(1) – by operation of law, all assets and liabilities of

Target become those of LLC, and Target ceases legal existence

• A Type Reorganization

“CHECK AND MERGE” TRANSACTION

46

• The Code provides for tax-free mergers of corporations into other

corporations and partnerships into other partnerships, but there is no provision for a tax free merger of a partnership (or an LLC taxable as a partnership) into a corporation

• However, an LLC taxable as a partnership can merge directly into a

corporation on a tax free basis if adopts a two-step process:

– (1) the LLC elects to change its entity classification from a partnership to a corporation; and – (2) the LLC (now taxable as a corporation) merges into another corporation

• Will the step-transaction doctrine merge the two steps?

– An entity classification does not need a business purpose and applies to all parts

• f the Code including the step transaction doctrine (Reg. 301.7701-3(g)(2)(i))

– Courts will presumably respect the entity classification election and therefore the two steps

SECTION 351 / 721 ROLLOVER

47

Target

Target Shareholders

PEG

• 80% vote & value
• Taxation of boot
• Debt + non-qualified

voting stock

• Assumption of liabilities

Cash out some and rollover

Target Target

Target Shareholders

PEG PEG NewCo NewCo

Target Shareholders

Target Shares Cash Cash Cash Cash Cash Assets Assets

LLC TECHNIQUES

48

Acquiror

Step 1 Step 2

LLC

Former Target Shareholders

Target

$

Target

Target Corp.

LLC

T Shareholders

INSTALLMENT METHOD

49

• Gain on each payment = gross profit ratio times payment

– Gross profit ratio = ratio of total gain to purchase price – Pre-transaction planning opportunities to utilize basis

• Section 453A – interest charge to the extent taxpayer holds

more than $5 million face amount of Section 453 obligations

• Section 453 Limits

– Not available for publicly held stock or securities, or inventory – Not available for sales for demand notes or readily tradable notes – Not available for instruments secured by cash or cash equivalents – Obligor must be purchaser (cannot use parent debt)

• Section 453 applies unless taxpayer affirmatively elects out
• Section 453(h) – Target shareholders who receive Acquiror debt

in liquidation of Target allowed to use installment reporting

CONTINGENT PAYMENTS AND EARN-OUTS

50

• Distinguish Equity vs. Debt
• 3 Issues

– (1) allocation between interest and sales proceeds; – (2) timing of realization of sales proceeds; and – (3) timing of basis recovery

• Interest

– 1.1275-4(b)

• Contingent payment debt for cash or publicly traded property – use

non-contingent bond method; projected non-contingent and contingent payments

– 1.1275-4(c)

• Contingent debt instrument issued for non-publicly traded property –

bifurcate into non-contingent debt instrument and contingent debt instrument; contingent payment treated as principal based on present value, excess is interest

• Buyer’s basis is non-contingent portion plus contingent payments

treated as principal

CONTINGENT PAYMENTS AND GAIN RECOGNITION

51

• Reg. 15A.453-1(c)
• If capped by maximum amounts, assume maximum for

purposes of gross profit percentage (accelerates gain, backloads basis)

– If no cap, but term, basis recovered ratably over term – If neither time nor amount is capped, basis recovered ratably over 15 years

• Election out of Section 453 – FMV of contingent
• bligation is amount realized
• Open transaction treatment – rare and extraordinary

situations only

SECTION 338 ELECTION

52

• Section 338(g) – Target in stock sale treated as selling all its

assets followed by liquidation post close (soaks up NOLs)

• Section 338(h)(10) – Sale and liquidation deemed to occur

pre-close; joint election; S corporation or sale out of a consolidated group

• Adjusted Grossed-Up Basis – New Asset basis is basis in

recently purchased stock (last 12 months) grossed up to reflect minority shareholder’s basis + liabilities of Target (including taxes in 338(g))

• Adjusted Deemed Sale Price – grossed up amount realized
• f recently purchased stock plus liabilities of old T (on day

after acquisition date)

Partnership Structure with Profits Interest

53

Target

Acquisition Structure:

Hold Co, LLC

Post Acquisition:

Target converts to wholly-owned LLC - treated as a tax- free liquidation into Hold Co, LLC if a single member LLC

Target Shareholders

100% 100% 100% Merger $$

Merger Co Acquiror Hold Co, LLC Target Shareholders

100% less profits interest 100% Issuance of unvested profits interest

Acquiror Target, LLC

338(g) ELECTIONS

54

• If there is a US Buyer of a foreign owned foreign

target, then 338(g) election steps up basis and eliminates E&P and foreign tax credits

• Target may be able to offset 338(g) gains with NOLs

PURCHASE PRICE ALLOCATION

55

• Asset Sale or 338 Election

– Sections 1060 and 338 classes based on FMV – Class I – cash and equivalents – Class II – actively traded personal property under 1092 – Class III – debt instruments and marked to market – Class IV – inventory – Class V – assets other than those in I-IV or VI – Class VI – goodwill and going concern

• Agreement Allocations – Danielson Rule

– Parties bound by agreement unless IRS determines that the allocation is NOT appropriate

• SFAS 141R – Purchase Price Allocations

– Assets booked at FMV as of closing date (not signing date) – Bargain purchase results in accounting gain – Earn Outs – estimated and recorded – Deferred tax assets for excess tax deductible goodwill over book value – Transaction related costs recognized (expensed)

S CORPORATIONS AND 338(h)(10)

56

T (S Corp) Acquiror

Merger Sub Target Shareholders

• Character difference – ordinary

income assets

• California – 1.5% tax on S

corporations

• New York – gain from 338(h)(10)

sale of New York S corporation is New York-source income

• All Target shareholders must

consent on Form 8023

• Deemed 338 election for

subsidiaries

• 1374 – BIG Tax
• Minority shareholders in rollover
• Hidden tax in liquidation or

deemed liquidation in installment sale.

• 3.8% NIIT Tax

S CORP 338(h)(10) ELECTION AND 453B(h) BASIS ALLOCATION ISSUE

57

• Gain to Shareholders in year of sale: $1 million x 80% = $800,000; A/B of

Shareholder = $1.8 million

• No 331 liquidation: $1 million cash decreases A/B by $1 million to $800,000;

$800,000 A/B in Note = $3.2 million gain

• 331 liquidation – apportion basis: $1.8 million basis apportioned $360,000 to cash

and $1,440,000 to Note; Gain in cash of $640,000 and gain in note of $2,560,000 for a total of $3.2 million gain (GP % on liquidation is 64%)

• Defer cash portion and include in installment obligation: gain on liquidation equal

to zero; Shareholder A/B in note of $1 million; profit % is 80% Target Acquiror Shareholders

$1 million cash $4 million 453 Note Stock Sale $1 million basis Cash - $1 million / $1 million A/B Assets - $4 million / zero A/B

• Reg. 1.338(h)(10) – 1(e) Example 10

S CORP NO 338(h)(10) ELECTION – DISAPPEARING BASIS

58

Liquidate Target into Merger Sub or check the box Q-Sub T (S Corp) Acquiror

Merger Sub T Shareholders Carryover Basis

S CORP INVESTMENT STRUCTURE

59

Holdings, Inc. (S Corp) Target, Inc. (QSSS)

T Shareholders Step One:

Holdings, Inc. (S Corp) Target, LLC (QSSS)

Step Two: T Shareholders

Holdings, Inc. (S Corp) Target, LLC (QSSS)

T Shareholders Step Three: Investor

$$ Membership interest

Step One: Shareholders of Target, Inc. transfer all Target, Inc. stock to Holdings, Inc. in exchange for Holdings, Inc. stock. Holdings, Inc. makes an S election and Target, Inc. elects to be treated as a qualified subchapter S subsidiary (QSSS). Step Two: Target, Inc. converts to an LLC for state law purposes (Target, LLC). Step Three: Investor purchases a membership interest in Target, LLC from Holdings, Inc.

Section 336(e)

60

Acquiror

Shareholder $

Target Stock

Basic Model (for stock sales): Target is treated as selling all of its assets to an unrelated person while owned by its former shareholders and then reacquiring same upon acquisition by Acquiror. $ $

Assets Assets = Actual Component = Deemed Component

Acquiror Shareholder

Target Target

3rd Party Section 336(e) does not apply to sales to a “related person.” The attribution rules could give rise to an unexpected “related person” situation where the seller acquires at least 5% of the acquiring partnership as part of the

• transaction. For example, where an investment partnership acquires a target

and provides a modest partnership interest to the selling shareholders.

SECTION 336(E) DETAILS

61

Tax Consequences

• Old target recognizes gain or loss

from the deemed asset and then is deemed to liquidate into seller

• New target is treated as a new

corporation for federal income tax purposes but remains liable for the tax liabilities of old target

• Seller does not recognize gain or

loss on the disposition of target stock

• No effect upon a purchaser
• No effect upon minority

shareholders, or shareholders other than seller, except in the case of S corporation targets Section 336(e) Basic Model

• Old target is treated as selling all of its assets

to an unrelated person in exchange for the “aggregate deemed asset disposition price” (ADADP)

• New target is treated as acquiring all of the

assets from an unrelated for an amount equal to the “adjusted grossed up basis” (AGUB)

• After the deemed asset disposition, but

before the close of the disposition date, while

• wned by seller(s), old target is treated as

transferring to seller all of the consideration deemed received from new target, generally in complete liquidation of old target

• For dispositions involving a distribution, seller

is treated as acquiring the stock of new target from an unrelated person and distributing the new target stock, immediately after the deemed liquidation of old target

FOREIGN CORPORATIONS

62

• Section 367(a) – outbound transactions

– Foreign corporation not treated as a corporation except as provided in regulations – Generally, gain recognized unless:

• No more than 50% of stock of foreign Acquiror received by US transferors,
• No more than 50% of stock of foreign Acquiror owned after the transfer by US persons that are
• fficers or directors or 5% Target shareholders,
• Gain Recognition Agreement ("GRA") is entered into by 5% US transferee shareholders
• 36 month active trade or business test met,
• No intent to substantially dispose of or discontinue such trade or business,
• FMV of the assets of transferee must be at least equal to the FMV of the US target, and
• Tax reporting
• Section 367(b) – inbound and foreign to foreign transfers

– US Acquiror and foreign Target

• Target can be treated as a corporation
• May be income to Target’s US shareholders to extent of Target’s accumulated E&P

FOREIGN GOODWILL REGULATIONS

63

• “Intangible property” under Section 936(h)(3)(B) does not

include foreign goodwill or going concern

• Section 1.367(a)-1T(d)(5)(iii)

– Foreign goodwill or going concern value is the residual value of a business operation conducted outside of the United States after all

• ther tangible and intangible assets have been identified and valued

– For purposes of section 367 and regulations thereunder the value of the right to use a corporate name in a foreign country shall be treated as foreign goodwill or going concern value

• Cross-border transactions

– Transfers of foreign goodwill and going concern value are taxable

FOREIGN CORPORATIONS

64

• Anti-Inversion Rules – tax outbound reorganization and/or tax foreign

Acquiror as a U.S. taxpayer; Code Section 7874

– If ownership of former U.S. Target shareholders in foreign Acquiror is 80% or more; foreign Acquiror is treated as a U.S. company – If ownership continuity is between 60-80%; foreign Acquiror is NOT treated as a U.S. company, but U.S. tax attributes cannot be used to offset gains – 20% excise tax on stock-based compensation upon certain corporate inversion transactions – 7874 exception available for companies with “substantial business activities” in the foreign jurisdiction which exist when:

• (1) The number of employees and the amount of employee compensation in the

foreign jurisdiction is at least 25% of the number of employees and amount of employee compensation in the total group;

• (2) The value of group assets (only tangible property held for use in the trade or

business) located in the foreign jurisdiction is at least 25% of the total group assets; and

• (3) The income derived from the foreign jurisdiction is at least 25% of the group income

FOREIGN CORPORATIONS

65

• Controlled Foreign Corporations (“CFCs”)

– A foreign entity is classified as a CFC if it has “United States Shareholders” who collectively own more than 50% of the voting power or value of the company. For the purposes of the CFC rules, a “United States Shareholder” is defined as US persons holding at least a 10% interest in the foreign corporation.

1248 AMOUNT ON SALE OF CONTROLLED FOREIGN CORPORATION

66

Section 1248

• Seller of Controlled Foreign Corporation (CFC) must

treat as dividend gain to extent of E&P

• 1248 inclusion carries foreign tax credits
• 1248 amount determined at year end and pro rated

based on day count, so post closing events can have an effect on the 1248 amount

JOINT VENTURE STRUCTURES

67

• Section 367 Issues
• Disguised Sale

– Effect of assumed liabilities US Company Foreign Company LLC

US & Foreign Assets

TRANSACTION COSTS

68

• Must capitalize “Facilitative Costs” that relate to a “Categorized Transaction”

unless an exception applies

• Categorized Transactions

– (1) Acquisition of assets constituting a trade or business – (2) Acquisition of an ownership interest in an entity if the acquirer and target are related after the transaction – (3) Acquisition of an ownership interest in the taxpayer – (4) Restructuring, recapitalization, or reorganization of the capital structure of the entity – (5) A Section 351 transfer – (6) Formation of a disregarded entity – (7) Acquisition of capital – (8) Stock issuance – (9) A burrowing; and – (10) Writing an option

TRANSACTION COSTS

69

• “Facilitative Costs”

– Costs incurred in the process of investigating or pursuing a Categorized Transaction

• Includes valuation costs and registrar and transfer agent fees
• Excludes consideration for the transaction (not a Facilitative Cost, but may be

capitalized under other principles) and business integration costs – Exceptions

• Does not include costs relating to a “Covered Transaction”

– Covered Transaction » Taxable acquisition by the taxpayer of assets constituting a trade or business » Taxable acquisition of ownership interest, regardless of whether taxpayer is the target or acquirer, if the two parties are related after the transaction » Type A, B, C, or Acquisitive D reorganizations

TRANSACTION COSTS

70

• “Facilitative Costs” cont.

– Exceptions cont.

• Bright Line Date

– Unless the cost is an “Inherently Facilitative Cost” then costs incurred before the “Bright Line Date” are not Facilitative Costs – The Bright Line Date is the earlier of: (a) the execution of the letter of intent (or similar document); or (b) the authorization of the company’s board of directors – Inherently Facilitative Costs are: (1) valuation; (2) costs to structure the transaction; (3) draft and review of documents; (4) regulatory approval; (5) shareholder approval; and (6) conveyance of property – Success-Based Fees

• Costs for which the obligation to pay is contingent upon a successful closing are

presumed to be Facilitative Costs, however the taxpayer may overcome this presumption by maintaining sufficient documentation

• Rev. Proc. 2011-29 provides a safe harbor permitting taxpayers to treat 70% of the

success-based fees as being non-Facilitative Costs and treating the remaining 30% as Facilitative Costs.

INDEMNITY

71

• Key Provisions

– What Taxes are subject to indemnification?

• Stock Sale – pre-closing taxes, generally
• Asset Sale – all of Seller’s taxes
• Transfer Taxes

– Taxation of Escrow Release / Revision of Purchase Allocation – Survival of Tax Representations and Warranties

• How long should they survive the closing?

– Tax Gross-up – Characterization of Indemnification Payments

72

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