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  • 1. Chapter 7 Corporations: Reorganizations
  • 2. The Big Picture (slide 1 of 3)
    • Rock & Water Corporation (R&W) specializes in industrial park landscaping.
    • One of R&W’s central missions is to cause as little negative impact on the environment as possible.
      • Until recently, R&W applied this policy only to its own work, but the new CEO, Tony Turner, wants to extend this policy to its suppliers.
      • R&W is aware that 3 of its suppliers do not use environmentally sound practices.
    • Realizing that simply changing suppliers will not eliminate these polluting practices,
      • R&W is considering acquiring these three suppliers.
      • Using this strategy, R&W would control the production practices of these corporations.
  • 3. The Big Picture (slide 2 of 3)
    • R&W is unsure of how to structure these potential acquisitions of its suppliers and seeks your advice.
    • R&W gives you the following information about these potential acquisitions.
      • BrineCo is a profitable corporation that has been owned predominantly by the Adams family since its incorporation in 1950.
  • 4. The Big Picture (slide 3 of 3)
      • AcidCo started up in 1967.
        • AcidCo has been having legal troubles and has continually been fined since more stringent EPA standards came into existence.
        • Besides chemicals used by R&W, AcidCo produces acids for the mining industry.
      • Lastly, ChemCo is a new fertilizer producer with the technology to produce environmentally safe products.
        • Its management is inexperienced, however, and the result has been inefficiencies in production and unintended harm to its surroundings.
        • ChemCo has yet to show a profit.
    • How will you advise R&W to approach each of these acquisitions?
    • Read the chapter and formulate your response.
  • 5. Reorganizations—In General
    • Refers to any corporate restructuring that may be tax-free under §368
      • To qualify, must meet certain general requirements:
        • Must be a plan of reorganization
        • Must meet continuity of interest and continuity of business enterprise tests
        • Must have a sound business purpose
        • Tax-free status can be denied under step transaction doctrine
  • 6. Summary of Different Types of Reorganizations
    • The term reorganization includes:
      • Statutory merger or consolidation
      • Stock for stock exchange
      • Stock for assets exchange
      • Divisive exchange
      • Recapitalization
      • Change in identity, form, or place of organization
      • Transfers in bankruptcy or receivership
  • 7. Tax Free Reorganization Consequences, in General (slide 1 of 3)
    • Consequences to Acquiring Corporation
      • No gain or loss recognized unless it transfers property to the Target corporation as part of the transaction
        • Then gain, but not loss, may be recognized
      • Basis of property received retains basis it had in hands of Target corp plus any gain recognized by the target
  • 8. Tax Free Reorganization Consequences, in General (slide 2 of 3)
    • Consequences to Target Corporation
      • No gain or loss unless it retains “other property” received in the exchange or it distributes its own property to shareholders
        • Other property is defined as anything received other than stock or securities
          • Treated as boot
        • Gain, but not loss, may be recognized
  • 9. Tax Free Reorganization Consequences, in General (slide 3 of 3)
    • Consequences to Target or Acquiring Co. Shareholders
      • No gain or loss unless shareholders receive cash or other property in addition to stock
        • Cash or other property is considered boot
          • Gain recognized by the stockholder is the lesser of the boot received or the realized gain
      • Basis of shares received is same as basis of those surrendered, decreased by boot received, increased by gain and dividend income, if any, recognized in the transaction
  • 10. The Big Picture – Example 4 Gain On Exchange Of Stock (slide 1 of 2)
    • Return to the facts of The Big Picture on p. 7-2.
    • R&W proceeds with its acquisition of BrineCo.
    • Sam acquired a 30% interest in BrineCo 15 years ago for $80,000.
      • He exchanges his BrineCo stock for $25,000 cash and stock in R&W worth $125,000.
      • At the time of the reorganization, BrineCo’s E & P is $50,000.
    • Sam has a $70,000 realized gain
      • $150,000 cash and stock received - $80,000 BrineCo stock basis.
    • Sam has a $25,000 recognized gain (cash boot received).
      • The first $15,000 ($50,000 BrineCo E & P X 30%) is taxable as a dividend, and
      • The remaining $10,000 is treated as capital gain.
      • Both are taxed at special tax rates.
  • 11. The Big Picture – Example 4 Gain On Exchange Of Stock (slide 2 of 2)
    • Suppose instead that Sam receives 10% of the R&W stock with a $100,000 fair market value and $50,000 cash.
      • If Sam had received solely stock, he would have received 15% of the R&W stock.
      • Since Sam owns less than 80% of the stock he would have owned if solely stock had been distributed (10% ÷ 15% = 67%) and less than 50% of R&W, he qualifies for sale or exchange treatment under § 302(b)(2).
    • Therefore, Sam’s $50,000 recognized gain is a long-term capital gain.
  • 12. Type A Reorganization
    • Includes mergers and consolidations
      • Merger is union of two or more corporations
        • One corporation retains it existence and absorbs the others
      • Consolidation occurs when a new corporation is created to take the place of two or more corporations
  • 13. Type A Reorganization (slide 1 of 2)
  • 14. Type A Reorganization (slide 2 of 2)
  • 15. The Big Picture – Example 11 ‘‘Type A’’ Reorganization
    • Return to the facts of The Big Picture on p. 7-2.
    • The Rock & Water Corporation (R&W) formation occurred as follows.
      • Roca and Agua Corporations were united under state law into new R&W Corporation by transferring all of their assets to R&W in exchange for all of R&W’s stock.
      • By operation of state law, Roca and Agua liquidated by distributing R&W stock to their shareholders in exchange for the shareholders’ stock in Roca and Agua.
      • This ‘‘Type A’’ reorganization is a consolidation.
  • 16. Type A Reorganization Issues (slide 1 of 2)
    • Advantages:
      • Type A reorganization is flexible
      • Consideration need not be voting stock
      • Money or other property can be transferred without disqualifying the transaction, as long as “continuity of interest” is met
  • 17. Type A Reorganization Issues (slide 2 of 2)
    • Disadvantages:
      • Money or other property transferred is “boot” so some gain may be required to be recognized
      • Shareholders of either entity may dissent; in most states their shares must be redeemed
      • Acquiring entity must assume all liabilities of Target
  • 18. Type B Reorganization (Stock-for-Stock Reorganization)
  • 19. The Big Picture – Example 12 ‘‘Type B’’ Reorganization
    • Return to the facts of The Big Picture on p. 7-2.
    • R&W Corporation proceeds with the acquisition of AcidCo.
      • In the transaction between R&W and AcidCo shareholders, 20% of R&W voting stock is exchanged for 90% of all classes of stock in AcidCo.
    • The exchange qualifies as a ‘‘Type B’’ reorganization.
    • R&W becomes the parent of AcidCo.
  • 20. Type B Reorganization Requirements (slide 1 of 4)
    • Corporation acquires stock of Target solely in exchange for its own voting stock (stock for stock)
      • Acquiring corporation must acquire “control” of Target
        • Control is ownership of at least 80% of all classes of stock of target
        • Acquirer may add shares owned previously with shares acquired in reorganization
  • 21. Type B Reorganization Requirements (slide 2 of 4)
    • Acquiring corporation may acquire shares from either:
      • (1) Shareholders of Target, or
      • (2) Directly from Target
    • Exception to the “solely for voting stock” requirement when shareholders must receive fractional shares
      • May receive cash rather than fractional shares in the acquiring corporation
  • 22. Type B Reorganization Requirements (slide 3 of 4)
    • Example: Assume Target has 100 shares outstanding:
      • Acquirer may obtain 80 shares from current Target shareholders in exchange for Acquirer’s voting stock
      • Target may also issue 400 new shares to Acquirer in exchange for Acquirer’s voting stock (500 shares would be outstanding)
  • 23. Type B Reorganization Requirements (slide 4 of 4)
    • Consideration paid by Acquirer can only include Acquirer’s voting stock or transaction does not qualify
  • 24. Type C Reorganization (Stock-for-Assets Reorganization)
  • 25. Type C Reorganization Requirements (slide 1 of 3)
    • A ‘‘Type C’’ reorganization is essentially an exchange of voting stock for assets followed by liquidation of the target corporation
      • Called a “Stock-for-Assets” reorganization
      • Transfer is generally between the entities, not the shareholders
  • 26. Type C Reorganization Requirements (slide 2 of 3)
    • Consideration paid by Acquirer normally consists only of voting stock
      • However, if at least 80% of FMV of Target is acquired with voting stock, cash or other property can be used for remainder
      • Limitation: liabilities assumed by Acquirer are considered “other property” if any additional “other property” is used
  • 27. Type C Reorganization Requirements (slide 3 of 3)
    • “Substantially all” of Target’s assets must be transferred to Acquirer
    • There is no statutory definition of ‘‘substantially all’’
      • To receive a favorable ruling from the IRS, the target must transfer at least 90% of net asset value or 70% of the gross asset value to the acquiring corporation
  • 28. The Big Picture – Example 14 ‘‘Type C’’ Reorganization
    • Return to the facts of The Big Picture on p. 7-2.
    • R&W Corporation proceeds with the acquisition of ChemCo.
      • R&W transfers voting stock representing a 30% ownership interest to ChemCo for substantially all of ChemCo’s assets.
      • After the exchange, ChemCo’s only assets are cash and R&W voting stock.
      • ChemCo distributes the R&W stock and cash to its shareholders in exchange for their ChemCo stock.
    • The exchange qualifies as a ‘‘Type C’’ reorganization if ChemCo liquidates after the distribution.
    • The exchange is taxable to the shareholders to the extent of the cash they received.
  • 29. Type D Reorganization (slide 1 of 4)
    • Generally a mechanism for corporate division
      • Called a “divisive reorganization” but can be used to carry out a corporate combination
      • In a Type D acquisitive reorganization
        • Entity transferring assets is considered the acquiring corporation
        • Corporation receiving the property is the target
  • 30. Type D Reorganization (slide 2 of 4)
    • In an acquisitive Type D reorganization
      • Substantially all of acquiring corp’s property must be transferred to target corporation
      • The acquiring corp must be in control (at least 50%) of the target
      • Target stock received by the acquiring corp and any remaining assets of acquiring corp must be distributed to its shareholders
      • Acquiring corporation must liquidate
  • 31. Type D Reorganization (slide 3 of 4)
    • In a divisive Type D reorganization
      • A corporation is divided
      • One or more new corps are formed to receive assets of original corp
      • Original corp must receive stock representing control (80%) of new corps
      • Stock of new corps is then distributed to shareholders of original corp
  • 32. Type D Reorganization (slide 4 of 4)
    • Three types of divisive “Type D” reorganizations
      • Spin-Off and Split-Off
        • A new corporation is formed to receive some of the assets of the original corporation in exchange for the new corporation's stock
      • Split-Up
        • Two or more corporations are formed to receive substantially all of the assets of the original corporation
  • 33. Type D Reorganization Spin-Off (slide 1 of 2)
  • 34. Type D Reorganization Spin-Off (slide 2 of 2)
  • 35. Type D Reorganization Split-Off (slide 1 of 2)
  • 36. Type D Reorganization Split-Off (slide 2 of 2)
  • 37. Type D Reorganization Split-Up (slide 1 of 2)
  • 38. Type D Reorganization Split-Up (slide 2 of 2)
  • 39. The Big Picture – Example 23 ‘‘Type D’’ Split-up (slide 1 of 2)
    • Return to the facts of The Big Picture on p. 7-2.
    • R&W Corporation proceeds with its acquisition of AcidCo.
    • Gail and Gary are equal shareholders of AcidCo, which was organized six years ago.
    • To prepare for the restructuring transaction with R&W, AcidCo creates two new corporations to receive its business lines.
      • AbraseCo will receive all of the assets related to the landscaping chemical business.
        • These are the assets desired by R&W.
      • The remaining mining acid assets are transferred to MineCo.
  • 40. The Big Picture – Example 23 ‘‘Type D’’ Split-up (slide 2 of 2)
    • The AbraseCo and MineCo stock received in exchange for AcidCo’s assets is transferred equally to Gary and Gail in exchange for all of their shares in AcidCo.
      • Gail and Gary now are 100% owners of both AbraseCo and MineCo.
    • Having no assets, AcidCo liquidates.
    • This transaction qualifies as a ‘‘Type D’’ split-up.
      • Neither Gary nor Gail recognizes any gain or loss on the exchange.
      • Gary and Gail take a basis in the AcidCo stock equal to their basis in the stock of AbraseCo and MineCo.
      • The allocation between AbraseCo and MineCo is performed in the manner utilized in Examples 21 and 22.
  • 41. Type E Reorganization (slide 1 of 2)
    • Type E reorganization is a recapitalization
      • Involves a major change in character and amount of outstanding stock, securities, or paid-in-capital
    • The following exchanges qualify:
      • Bonds for stock
      • Stock for stock
      • Bonds for bonds
  • 42. Type E Reorganization (slide 2 of 2)
    • Corporation can exchange its common stock for preferred stock or its preferred stock for common stock tax-free
      • The exchange of bonds for other bonds is tax-free when the debt received has a principal amount that is not more than the surrendered debt’s principal amount
  • 43. The Big Picture – Example 25 ‘‘Type E’’ Reorganization
    • Return to the facts of The Big Picture on p. 7-2.
    • BrineCo’s stock is owned 80% by Gomez Adams and 20% by his children.
      • Gomez wants to relinquish his corporate control to his children.
    • He exchanges his common voting stock for nonvoting preferred stock.
    • The exchange qualifies as a ‘‘Type E’’ reorganization.
      • However, any difference in value between stock received and stock surrendered could be treated as compensation to Gomez or as a gift to Gomez’s children.
  • 44. Type F Reorganization
    • A mere change in identity, form, or place of organization, however effected
      • Restricted to a single operating corporation
      • Tax characteristics of predecessor corp carry over to successor corp
      • Does not jeopardize status of §1244 stock or terminate a valid S corp election
  • 45. Type G Reorganization
    • Substantially all of the assets of debtor corp are transferred to an acquiring corp in exchange for its stock and securities
      • This stock and securities are distributed to the senior creditors in exchange for their claims against the debtor corporation
  • 46. Judicial Doctrines (slide 1 of 2)
    • Besides meeting specific requirements of reorganization, several judicially created doctrines must be met
      • Reorganization must exhibit a sound business purpose
        • Not a well defined test
      • Continuity of interest test
        • IRS deems this test met if shareholders of Target receive stock in Acquirer equal to at least 40% of their prior stock ownership in Target stock
  • 47. Judicial Doctrines (slide 2 of 2)
      • Continuity of business enterprise test
        • Requires the acquiring corp to either:
          • Continue the Target’s historic business, or
          • Use a significant portion of Target’s assets in business
      • Step transaction doctrine
        • Ensures that a series of transactions are not used to obtain tax benefits that would be unavailable if the transaction were accomplished in a single step
        • IRS generally views any transactions occurring within one year of reorganization as part of the restructuring
  • 48. Carryover of Corporate Tax Attributes (slide 1 of 4)
    • Assumption of liabilities
      • Acquiring corp either assumes liabilities of Target or takes property subject to liabilities
    • Allowance of Carryovers
      • In Type A, C, acquisitive D, and G reorganizations, the Target’s tax attributes are acquired
      • In Type B, E, and F reorganizations, Target corporation remains intact and retains its tax attributes
  • 49. Carryover of Corporate Tax Attributes (slide 2 of 4)
    • NOL Carryovers
      • Amount of NOL that can be used in year ownership change occurs is limited to a percentage representing the remaining days in the tax year over the total number of days in the year
  • 50. Carryover of Corporate Tax Attributes (slide 3 of 4)
    • NOL Carryovers (cont’d)
      • NOL can be further limited in first and succeeding years when there is a more than 50-percentage-point ownership change
        • An ownership change takes place on the day (change date) that either an equity structure shift or an owner shift occurs
          • An equity structure shift occurs when a tax-free reorganization causes an owner shift
          • An owner shift is any change in the common stock ownership of shareholders owning at least 5%
      • NOL can be used to the extent of the value of the loss corp’s stock on the date of the ownership change multiplied by the long-term tax-exempt rate
  • 51. Carryover of Corporate Tax Attributes (slide 4 of 4)
    • Earnings and Profits
      • Positive E & P of acquired corp carries over
      • E & P of a deficit corp is deemed received by acquiring corp as of change date
        • Deficit may only be used to offset E & P accumulated by successor corporation after the change date
  • 52. The Big Picture – Example 33 Net Operating Loss Carryovers
    • Return to the facts of The Big Picture on p. 7-2.
    • R&W Corporation proceeds with its acquisition of ChemCo.
    • Prior to the merger, ChemCo accumulated a $3 million NOL.
    • After the reorganization, R&W generates $5 million of taxable income.
      • ChemCo’s $3 million NOL carries over to offset the $5 million taxable income, reducing it to $2 million.
      • R&W saves $1,020,000 in Federal income taxes by being able to utilize ChemCo’s NOL carryover ($3 million NOL carryover X 34%).
    • Thus, the $3 million NOL is a valuable asset that may be worth more than $1 million to R&W.
  • 53. The Big Picture – Example 41 Carryovers Limited By § 382 (slide 1 of 2)
    • Return to the facts of The Big Picture on p. 7-2.
    • R&W Corporation proceeds with the acquisition of ChemCo.
      • It acquires $100,000 of general business credits from ChemCo.
    • Assume that the § 382 limitation for the year is $200,000.
      • R&W’s taxable income is $800,000 before applying this limitation.
    • If the full deduction allowable by § 382 were utilized, R&W’s taxable income would be $600,000 ($800,000 - $200,000).
  • 54. The Big Picture – Example 41 Carryovers Limited By § 382 (slide 2 of 2)
    • The amount of general business credit that R&W may take in the current year is $68,000, computed as follows.
      • Step 1. Regular tax liability
      • ($800,000 X 34% tax rate) $272,000
      • Step 2. Tax liability with full § 382
      • limitation ($600,000 X 34% tax rate) 204,000
      • Step 3. Subtract step 2 from step 1 $ 68,000
  • 55. Comparison of Reorganization Types (slide 1 of 5)
  • 56. Comparison of Reorganization Types (slide 2 of 5)
  • 57. Comparison of Reorganization Types (slide 3 of 5)
  • 58. Comparison of Reorganization Types (slide 4 of 5)
  • 59. Comparison of Reorganization Types (slide 5 of 5)
  • 60. Refocus On The Big Picture (slide 1 of 6)
    • Rock & Water Corporation (R&W) is unsure how to structure the potential acquisitions of its three suppliers.
    • The first target is BrineCo, a profitable corporation that has been owned predominantly by the Adams family since its incorporation in 1950.
    • In negotiations with BrineCo, R&W determines that
      • BrineCo has virtually no debt,
      • Senior Adams family members are ready to retire, and
      • The younger generation has no interest in the business.
    • Consequently, all members would like some cash in the transaction.
  • 61. Refocus On The Big Picture (slide 2 of 6)
    • The ‘‘Type A’’ reorganization would be a good choice for this acquisition.
      • R&W can exchange cash, preferred stock, and voting stock for only those assets it wants to acquire.
    • Since BrineCo has few liabilities, acquiring all of them will not be an issue nor will obtaining the approval of the BrineCo shareholders.
    • The assets not transferred to R&W will be distributed to the Adams family, along with the stock and cash received from R&W in complete liquidation of BrineCo.
  • 62. Refocus On The Big Picture (slide 3 of 6)
    • The next target, AcidCo, has been struggling financially and has legal liability issues related to its failure to meet environmental standards.
    • Its landscaping chemical and mining acid lines of business are active and have been in existence for more than five years,
      • AcidCo can, through a divisive ‘‘Type D’’ reorganization, spin off or split off its mining acid business and retain the landscaping chemical line.
    • Once this is accomplished, R&W can acquire AcidCo stock from its shareholders by exchanging R&W voting stock in a ‘‘Type B’’ reorganization.
      • This restructuring would protect R&W’s assets from AcidCo’s legal liability issues until R&W can clean up the environmental problems.
  • 63. Refocus On The Big Picture (slide 4 of 6)
    • Lastly, ChemCo has the technology to produce environmentally safe products, but its inexperienced management has resulted in it being unprofitable.
    • R&W can use a ‘‘Type C’’ reorganization to acquire substantially all of ChemCo’s assets and can select which liabilities it assumes.
      • To avoid having the liability assumption treated as boot, R&W should use solely voting stock for the exchange.
    • ChemCo must terminate after the reorganization.
  • 64. Refocus On The Big Picture (slide 5 of 6)
    • ChemCo has NOL, capital loss, and business credit carryovers
      • R&W must be sure to meet the continuity of business enterprise requirement for at least two years.
    • Most likely the § 382 limitation will apply
      • ChemCo shareholders will experience an equity structure shift of greater than 50 percentage points.
      • Thus, the amount of carryover tax attributes that R&W may use in any one year will be limited.
  • 65. Refocus On The Big Picture (slide 6 of 6)
    • A net present value analysis should be performed to determine what R&W is willing to pay for ChemCo’s tax attributes.
    • Finally R&W will need to keep two E & P accounts.
      • One for its pre-reorganization E & P, and
      • Another with ChemCo’s negative E & P that will be offset by future profits of the combined company.
  • 66.
    • If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:
    • Dr. Donald R. Trippeer, CPA
    • [email_address]
    • SUNY Oneonta