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Tax-free* Acquisitions of Freestanding C Corporations

Basic types: IRC 368(a)(1)(A)Statutory merger IRC 368(a)(1)(B)Stock-for-stock acquisition IRC 368(a)(1)(C)Stock-for-asset acquisition Other: Forward and reverse triangular mergers
* These transactions are not actually tax-freethey only provide target shareholders with tax-deferral of the gain on the acquisition. Also, each of these tax-free reorganization structures requires shareholders to recognize a taxable gain to the extent they receive cash or other forms of boot.

General Requirements for Taxfree Treatment Under IRC 368


Continuity of interest must be maintained by target shareholders in the assets of the target target shareholders must receive stock of the acquirer. The principle of continuity of business interest requires the assets of the target to be used in a productive capacity post-acquisition. An acquirer cannot liquidate the targets assets after purchase. The acquirer must have a valid business purpose, not just a desire to avoid taxes.

IRC 368 A Reorganization Statutory Merger


The acquirer exchanges its stock (and possibly some boot) for the assets and liabilities of the target. The target corporation must distribute to its shareholders in return for their target stock the consideration received from the acquirer.
This liquidating distribution is tax-free if target shareholders receive stock of the acquirer; cash received is taxable even if the transaction is tax-free. Gain recognized by target shareholders is the lesser of the gain realized or the boot received. Gain realized is equal to the purchase price (value of consideration received) less the selling shareholders tax basis in the stock. Losses realized are not recognized.

Requirements to Qualify for Tax-free Treatment Under IRC 368(a)(1)(A)


Reorganizations must qualify as statutory mergers under applicable state lawthe merger must be
approved by both the acquirers and the targets shareholders.

A reorganizations usually require that at least 50%* of the total consideration received by target shareholders in the acquisition is acquirer stock
acquirers can use either voting or non-voting stock and either common or preferred stock.
* 40% acquirer stock is sufficient in some transactions.

Tax Consequences of a 368 A


Target shareholders take a substituted basis in the acquiring firm stock received in the transaction:
Substituted basis = same basis as had in T stock + any gain recognized boot received

The acquirer takes a carryover basis in the assets of the target. The tax attributes of the target will carry over to the acquirer, but they will be limited by IRC 382.

Given Information for Examples


Given Information Purchase Price Target Shareholder Stock Basis Net Tax Basis of Target's Assets* Corporate Tax Rate Capital Gains Tax Rate* Discount Rate $1,370.00 $200.00 $200.00 35% 20% 10%

Assume that any acquirer stock received by T's shareholders in the transaction is held until death and that all shareholders receive an equal portion of stock and boot. *Historical cost equals $200, and there is no accumulated depreciation. *T's shareholders have held the stock of T for more than 12 months.

Tax Implications of a 368 A Reorganization


Given Information Purchase Price Target Shareholder Stock Basis Net Tax Basis of Target's Assets Corporate Tax Rate Capital Gains Tax Rate Discount Rate $1,370.00 $200.00 $200.00 35% 20% 10%

Purchase Price: Cash Stock Target Corporation Tax Liability Target Shareholder Gain Recognized Target Shareholder Tax Liability Target Shareholder After-tax Wealth: Cash Stock Total Acquirer Net After-tax Cost: Pre-tax Cost Less: Incremental Tax Savings Net After-tax Cost

Tax-free Acquisitions Taxable Acquisitions Stock Sale w/o a 338 Election 368 "A"* $1,370.00 $1,370.00 548.00 1,370.00 822.00 0.00 0.00 548.00 109.60 0.00 1,370.00 234.00

$438.40 822.00 $1,260.40

$1,136.00 0.00 $1,136.00

$1,370.00 0.00 $1,370.00

$1,370.00 0.00 $1,370.00

*Assumes that the mix of consideration is 60% stock and 40% cash.

Tax-free Merger Under IRC 368(a)(1)(A)Statutory Merger


Target: Receives $1,370 of consideration from acquirer and distributes all of the consideration to shareholders in liquidation. Assets and Liabilities of Target $548 Cash $822 Stock Acquirer: Transfers $1,370 to target for its assets and liabilities. Target is merged into acquirer under state law.

$548 Cash $822 Stock

All of Targets Stock Acquirer Shareholders: No direct tax effect.

Target Shareholders: Basis in target stock = $200. Gain realized is $1,170 ($1,370 received - $200 stock basis). Gain recognized is $548 (lesser of gain realized or boot received).

Post-acquisition Structure: Statutory Merger


Acquirer: Holds the assets and liabilities of the target. Has a carryover basis in the targets assets.

Target Shareholders: Now own acquirer stock and have some boot.

Acquirer Shareholders: Remain owners of the acquirer.

Non-tax Issues Associated w/ the 368 A Structure


The acquirer obtains all the liabilities (including contingent and unrecorded liabilities) of the target. Some of the targets assets may be non-transferable based on laws and/or contracts. Qualifying as a statutory merger can involve significant non-tax costs for both the acquirer and target, i.e., shareholders of both the acquirer and target have to approve the transaction. The acquirer can use up to 60% cash in the transaction. Acquiring is not required to take all targets assets.

Forward Triangular Merger


Forward Triangular Merger--the acquirer establishes a subsidiary through which it acquires the target (and its assets and liabilities) for stock (voting and non-voting) of the acquiring firm. The surviving entity is the subsidiary of the acquirer, i.e., targets liabilities are isolated. The acquirer must acquire substantially all* of the targets assets. Acquiring firm shareholders do not have to formally approve a triangular merger (unless required by the corporate charter). Up to 50% of consideration may be in the form of cash.
* 90% of net fair market value of the targets assets and 70% of gross fair market value of those assets.

Tax-free Forward Triangular Type-A Merger


Acquirer: Transfers $1,370 in consideration to subsidiary for all of subsidiarys stock.
$548 Cash $822 acquirer stock Target: Receives $1,370 of consideration from the acquirer and distributes all of the consideration to shareholders in liquidation. $548 Cash $822 acquirer stock Substantially All of the targets assets and liabilities. $548 Cash $822 acquirer stock

Acquirer Shareholders: No direct tax effect.

100% of subsidiarys stock Acquirer Subsidiary: Transfers $1,370 (cash and acquirer stock) for all of the assets and liabilities of the target.

All of targets stock

Target Shareholders: Basis in target stock = $200. Gain realized is $1,170 ($1,370 - $200). Gain recognized is $548 (lesser of gain realized or boot received).

Post-acquisition Structure: Forward Triangular Type-A Merger


Acquirer: Subsidiary of the acquirer owns substantially all of the assets of the target. The acquirer has a basis in acquirer subsidiary stock of $200.

Target Shareholders: Own stock of the acquirer and some boot.

Acquirer Subsidiary: Takes a carryover basis in the targets assets ($200).

Acquirer Shareholders: Maintain ownership of the acquirer.

IRC 368 B Reorganization Stock-for-Stock Acquisition


The acquirer exchanges its voting stock directly with that of target shareholders, obtaining ownership of the targets assets through ownership of its stock. The target becomes a subsidiary of the acquirer and, thus, maintains its legal identity while the owners of the targets stock change (much like a reverse triangular merger under 368 A).

Requirements to Qualify for Tax-free Treatment Under IRC 368(a)(1)(B)


100% of the consideration used in the acquisition must be voting stock of the acquirer. The deals tax-free treatment is disqualified if any cash (except cash paid for fractional shares) is used. The acquirer must obtain 80% control of the target.

Tax Consequences of a 368 B


Target shareholders take a substituted basis in the acquiring firm stock received in the transaction:
Substituted basis = same basis as had in T stock + any gain recognized boot received

The acquirer takes a carryover basis in the assets of the target and in the stock of the target equal to the target shareholders basis in the targets stock pre-acquisition. The tax attributes of the target will carry over to the acquirer, but they will be limited by IRC 382.
Gain realized by Ts shareholders = value of the consideration received - target shareholders basis in the target stock. Gain recognized by Ts shareholders = lesser of gain realized or boot received.

Tax Implications of a 368 B Reorganization


Given Information Purchase Price Target Shareholder Stock Basis Net Tax Basis of Target's Assets Corporate Tax Rate Capital Gains Tax Rate Discount Rate $1,370.00 $200.00 $200.00 35% 20% 10%

Purchase Price: Cash Stock Target Corporation Tax Liability Target Shareholder Gain Recognized Target Shareholder Tax Liability

Tax-free Acquisitions Taxable Acquisitions Stock Sale w/o 368 "A" 368 "B" * a 338 Election $1,370.00 $1,370.00 $1,370.00 548.00 0.00 1,370.00 822.00 1,370.00 0.00 0.00 548.00 109.60 0.00 0.00 0.00 0.00 1,370.00 234.00

Target Shareholder After-tax Wealth: Cash $438.40 $0.00 Stock 822.00 1,370.00 Total $1,260.40 $1,370.00

$1,136.00 0.00 $1,136.00

Acquirer Net After-tax Cost: Pre-tax Cost Less: Incremental Tax Savings Net After-tax Cost

$1,370.00 $1,370.00 0.00 0.00 $1,370.00 $1,370.00

$1,370.00 0.00 $1,370.00

*Assumes that 100% of the consideration is voting common stock.

Tax-free Merger Under IRC 368(a)(1)(B)-Stock-for-Stock Acquisition


Target: Owners of targets stock change. Tax basis in the targets assets is unchanged. Acquirer: Transfers $1,370 in acquirer stock directly to target shareholders for all of the targets stock. Target becomes a wholly owned subsidiary of the acquirer.

$1,370 of Acquirer Stock


100% of Targets Stock Acquirer: Transfers $1,370 in acquirer stock directly to target shareholders for all of the targets stock. Target becomes a wholly owned subsidiary of the acquirer.

Acquirer Shareholders: No direct tax effect.

Post-acquisition Structure: Stock-for-Stock Acquisition


Acquirer: Owns all of the stock of the target. Target is a wholly owned subsidiary of the acquirer. The acquirers basis in the target stock is $200 (same as target shareholders basis).

Target Shareholders: Own stock of the acquirer and some boot.

Target (now a subsidiary of the acquirer): Asset basis carries over ($200).

Acquirer Shareholders: Maintain ownership of the acquirer.

Non-tax Issues Associated w/ the 368 B Structure


The acquirer is liable for all of the targets liabilities, but . . The acquirers liability is limited to its investment in the target since the target is a subsidiary of the acquirer. Title to the targets assets does not change since the target retains its corporate identity. (This is a benefit if the target has assets that are difficult to transfer.) Targets intangibles, contracts, goodwill, preserved. Difficult to force out dissident shareholders of the target. Dilution may be a problem for acquiring firms shareholders.

Reverse Triangular Merger


Reverse Triangular Merger--the surviving
entity is the target corporation, which is a subsidiary of the acquirer after the transaction. Target must retain substantially all of Ts assets* At least 80% of consideration must be in the form of acquiring firms voting stock. Functionally similar to B reorganization except can force out dissenters and use more cash.
* 90% of net fair market value of the targets assets and 70% of gross fair market value of those assets.

Reverse Triangular Merger


-TRANSACTION-

A
A Voting Stock A Voting Stock

T S/Hs
A Voting Stock

Acq. Sub.

Merged

T S/Hs Transfer Control (80%) for A Voting Stock. T must hold Sub-all of Acquisition Sub and Ts Assets.

Reverse Triangular Merger


-RESULT-

Former T S/Hs

Same result as a Type B.

IRC 368 C Reorganization-Stock-for-Assets Acquisition


The acquirer exchanges its voting stock (and possibly some boot) for the targets assets. The target distributes the acquirers stock and other consideration received in the acquisition to its shareholders in liquidation.

Requirements to Qualify for Tax-free Treatment Under IRC 368(a)(1)(C)


The acquirer must purchase substantially all* of the targets assets but is not required to assume all of the targets liabilities. At least 80% of the total consideration used must be voting stock of the acquiring firm. If the acquirer uses any boot in the transaction, the liabilities of the target assumed by the acquirer count as boot in the 80% test.
* 90% of net fair market value of the targets assets and 70% of gross fair market value of those assets.

Tax Consequences of a 368 C


Target shareholders take a substituted basis in the acquiring firm stock received in the transaction:
Substituted basis = same basis as had in T stock + any gain recognized boot received

The acquirer takes a carryover basis in the assets of the target. The tax attributes of the target will carry over to the acquirer, but they will be limited by IRC 382.
Gain realized by Ts shareholders = value of the consideration received - target shareholders basis in the target stock. Gain recognized by Ts shareholders = lesser of gain realized or boot received.

Tax Implications of a 368 C Reorganization


Given Information Purchase Price Target Shareholder Stock Basis Net Tax Basis of Target's Assets Corporate Tax Rate Capital Gains Tax Rate Discount Rate
Tax-free Acquisitions

$1,370.00 $200.00 $200.00 35% 20% 10%


Taxable Acquisitions Stock Sale w/o a 338 Election $1,370.00 1,370.00 0.00 0.00 1,370.00 234.00

Purchase Price: Cash Stock Target Corporation Tax Liability Target Shareholder Gain Recognized Target Shareholder Tax Liability Target Shareholder After-tax Wealth: Cash Stock Total Acquirer Net After-tax Cost: Pre-tax Cost Less: Incremental Tax Savings Net After-tax Cost

368 "A" 368 "B" 368 "C" * $1,370.00 $1,370.00 $1,370.00 548.00 0.00 274.00 822.00 1,370.00 1,096.00
0.00 548.00 109.60 0.00 0.00 0.00 0.00 274.00 54.80

$438.40 $0.00 $219.20 822.00 1,370.00 1,096.00 $1,260.40 $1,370.00 $1,315.20

$1,136.00 0.00 $1,136.00

$1,370.00 $1,370.00 $1,370.00 0.00 0.00 0.00 $1,370.00 $1,370.00 $1,370.00

$1,370.00 0.00 $1,370.00

*Assumes that the mix of consideration is 20% cash and 80% acquiring firm voting stock.

Tax-free Merger Under IRC 368(a)(1)(C) Stock-for-Asset Acquisition


Target: Receives $1,370 of consideration from acquirer and distributes all of the consideration to shareholders in liquidation. $274 Cash $1,096 Stock Substantially All of the Assets and Liabilities of Target Acquirer: Transfers $1,370 in consideration to target for its assets and liabilities.

$274 Cash $1,096 Stock

All of Targets Stock

Target Shareholders: Basis in target stock = $200. Gain realized is $1,170 ($1,370 received - $200 stock basis). Gain recognized is $274 (lesser of gain realized or boot received).

Acquirer Shareholders: No direct tax effect.

Post-acquisition Structure: Stock-for-Asset Acquisition


Acquirer: Holds substantially all of the assets and liabilities of the target. Has a carryover basis in the targets assets.

Target Shareholders: Now own acquirer stock and have some boot.

Acquirer Shareholders: Remain owners of the acquirer.

Non-tax Issues Associated w/ the 368 C Structure


The acquirer is not required to assume all of the targets liabilities since the deal is done by contract instead of under state merger laws. Consent of acquiring firms shareholders not required. Possible dilution of acquiring firms stock because at least 80% of consideration must be stock. Unwanted assets may be a problem. Ts shareholders must approve liquidation of T.

Limitations on Target Firm Tax Attributes


Under IRC 382, any transaction after 1986 that results in a 50% change in ownership of a corporation triggers a limitation on the firms tax attributes. The annual limitation on the amount of the firms tax attributes that can be used equals the market value of the subject firms equity at the date of the ownership change times the long-term tax-exempt rate of return.
Note: Losses generated by a target firm postacquisition can be offset by profits of the acquirer.

More Rules on Target Firm Tax Attributes


The target firms NOLs can be used to offset the corporate level gain on the actual or deemed asset sale in taxable transactions in which the tax basis of the targets assets are stepped-up. However, the valuable tax attributes of the target that are not used to offset the gain on the step-up are lost.

Example of Tax Implications of Tax-free Acquisitions of Free-Standing C Corporations


Given Information Value of Target's Stock (and Purchase Price) Target Shareholder Stock Basis Tax Basis of Target's Net Assets Corporate Tax Rate Capital Gains Tax Rate Discount Rate $1,370.00 $200.00 $200.00 35% 20% 10%

The target corporation and the acquiring firm are C corporations. The target is owned by individual investors and has no liabilities. The acquirer's stock does not pay dividends, and the acquirer does not intend to pay dividends anytime in the future.

Comparison of Tax Implications of Tax-Free Acquisitions of Free-Standing C Corporations


Purchase Price: Cash Stock Target Corporation Tax Liability Taxable Acquisitions Stock Sale w/o 368 "A"* 368 "B"* 368 "C"* 351* a 338 Election $1,370.00 $1,370.00 $1,370.00 $1,370.00 $1,370.00 548.00 0.00 274.00 822.00 1,370.00 822.00 1,370.00 1,096.00 548.00 0.00 0.00 0.00 0.00 0.00 0.00 Tax-free Acquisitions

Target Shareholder Gain Recognized Target Shareholder Tax Liability


Target Shareholder After-tax Wealth: Cash Stock Total Acquirer Net After-tax Cost: Pre-tax Cost Less: Incremental Tax Savings Net After-tax Cost Pre-Tax Price to Leave Target Shareholders Indifferent

548.00 109.60

0.00 0.00

274.00 54.80

822.00 164.40

1,370.00 270.00

$438.40 $0.00 $219.20 $657.60 822.00 1,370.00 1,096.00 548.00 $1,260.40 $1,370.00 $1,315.20 $1,205.60

$1,100.00 0.00 $1,100.00

$1,370.00 $1,370.00 $1,370.00 $1,370.00 0.00 0.00 0.00 0.00 $1,370.00 $1,370.00 $1,370.00 $1,370.00

$1,370.00 0.00 $1,370.00

$1,195.66 $1,100.00 $1,145.84 $1,250.00

$1,370.00

60% stock & 40% cash

100% stock

80% stock & 20% cash

40% stock & 60% cash