Structuring Tax-Free M&A Deals Navigating IRC 368 and 351 and - - PowerPoint PPT Presentation

Structuring Tax-Free M&A Deals

Navigating IRC 368 and 351 and Selecting the Appropriate Structure

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Jonathan Golub, Attorney, Royse Law Firm, Palo Alto, Calif. Roger Royse, Attorney, Royse Law Firm, Palo Alto, Calif. Joseph C. Mandarino, Partner, Stanley Esrey & Buckley, Atlanta

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STRUCTURING TAX-FREE M&A DEALS

Royse Law Firm, PC 1717 Embarcadero Road Palo Alto, CA 94303 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.

Roger Royse rroyse@rroyselaw.com Skype: roger.royse Jonathan Golub jgolub@rroyselaw.com

February 4, 2014

OVERVIEW

• Types of Tax-Free Reorganizations:

– 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 – Net Value Requirement – Special Tests – Step Transaction Doctrine

• Consequences of Tax-Free Reorganizations:

– Buyer Entity – Target Entity – Target Shareholders

6

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

7

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

8

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
• 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

• 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 Buyer Shareholders

9

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

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
• 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

10

Newco Shareholders

TRIANGULAR OR SUBSIDIARY MERGERS

11

2. Reverse Subsidiary Merger

Target Buyer

Merger Sub

Buyer Target

Merger Sub

1. Forward Subsidiary Merger

TRIANGULAR OR SUBSIDIARY MERGERS

12

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

13

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

14

• 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

15

• Acquisition of substantially all of the assets
• f 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

Target Buyer Shareholders

Target Assets Buyer Stock Buyer Stock

• Reorganization Expenses – Buyer may

assume expenses (Rev. Rul. 73-54)

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

and source of funds

DOUBLE MERGER

16

Buyer

Target Shareholders

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

Target Buyer

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

Example #1

17

• 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

18

• 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:

Slide Intentionally Left Blank

REQUIREMENTS

• Continuity of Interest
• Continuity of Business Enterprise (COBE)
• Business Purpose
• Net Value Requirement
• 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

• 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

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

NET VALUE RULES

25

• 2005 Proposed Regulation 1.368-1(b)(1): Exchange of no net

value (liabilities exceed value) does not qualify as a reorganization

• Example:

– Buyer owns all of the stock of both Merger Sub and Target. Target has assets with FMV of $100 and liabilities of $160, all of which are owed to B. Target transfers all of its assets to S in exchange for the assumption of Target’s liabilities, and Target dissolves. The obligation to B is outstanding immediately after the transfer. Buyer receives nothing in exchange for its Target stock.

• Explanation:

– Under paragraph (f)(2)(i) of the Reg, Target does not surrender net value because the FMV of the property transferred by Target ($100) does not exceed the sum of the amount of liabilities of Target assumed by Merger Sub in connection with the exchange ($160). Therefore, under paragraph (f) of the Reg., there is no exchange of net value. See Prop. Reg. 1.368-1(f)(5) Example 3.

• Alabama Asphalt

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)

26

SPECIAL TESTS

27

• 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”

28

Slide Intentionally Left Blank

CONSEQUENCES

• Buyer Entity (loss importation rules)
• Target Entity
• Target Shareholders

30

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

31

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

• n 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

32

TARGET ENTITY CONSEQUENCES

• Target typically does not recognize gain or loss at the

corporate level

• Some COD income exceptions

33

TARGET DEBT SECURITIES

34

• 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
• f 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

35

DIVIDEND EQUIVALENCY

36

• 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

37

• 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

38

• 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

39

• 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

• ut 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

40

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Structuring Tax-Free M&A Deals: §351 Mergers

Joseph Mandarino February 4, 2014

Stanley Esrey & Buckley LLP Promenade II, Suite 2400 1230 Peachtree Street, N.E. Atlanta, Georgia 30309 www.seblaw.com jmandarino@seblaw.com (404) 835-6207

41

Disclaimer

IRS CIRCULAR 230 DISCLOSURE: 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 reorg.

• §351 provides an alternative method of acquiring an entity on a

tax-free or tax-deferred basis.

• May also facilitate 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 -- that 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 was 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 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.
• Does transaction qualify under §368?
• Does transaction qualify under §351?

NewCo $75 cash 50% of NewCo $75 cash 50% of NewCo

Slide Intentionally Left Blank

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 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
• wnership of stock counts (BUT – consolidated

groups can aggregate ownership).

Control Percentage -- NQPS

66

• NQPS – generally cannot achieve tax-free

treatment receive “nonqualified preferred stock”.

• 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 argue opposing

positions across the cases.

• If in doubt, get a ruling or prohibit future transfers.
• 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, then can trip up tax-free treatment.

• NQPS is not treated as “stock” for this test and requires

recognition of gain under the boot recognition rules (discuss 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
• r indirectly) with reference to interest rates, commodity prices,
• r 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%

• f the value of whose assets are held for investment and are

stocks or securities, or interests in RICs or REITs.

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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.

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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 recgonize 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: – short time period between incurrence of a liability and assumption by the corporation – 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 business

enterprise requirement for §368 reorgs also applies to §351 transactions.

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Structuring Tax-Free M&A Deals: §351 Mergers

Joseph Mandarino February 4, 2014

Stanley Esrey & Buckley LLP Promenade II, Suite 2400 1230 Peachtree Street, N.E. Atlanta, Georgia 30309 www.seblaw.com jmandarino@seblaw.com (404) 835-6207

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