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BUYING AND SELLING A BUSINESS<br />Practical Tax Consequences<br />Roger Royse<br />Royse Law Firm, PC<br />2600 El Camino...
OVERVIEW OF TRANSACTIONS<br />Tax Free Reorganizations:<br />Type A – Merger<br />		Type B – Stock for Stock<br />		Type C...
TAXABLE VS. TAX FREE<br />Type of Acquisition Currency<br />	Stock<br />	Securities/Debt<br />	Deferred payments, earnouts...
CONTINUITY OF INTEREST<br />4<br />IRS – 50% Safe Harbor, Rev. Proc. 77-37<br />John A. Nelson – 38% Stock<br />Miller v. ...
TAX FREE REORGANIZATIONS<br /><ul><li>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
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)</li></ul>5<br />
TYPE A REORGANIZATIONS – SECTION 368(a)(1)(A) STATUTORY MERGER<br />Shareholders<br />Target<br />Acquiror<br />Requiremen...
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</li></ul>6<br />
TYPE B REORGANIZATIONS – SECTION 368(a)(1)(B) STOCK FOR STOCK<br />7<br />Shareholders<br />Acquiror Stock<br />Target Sto...
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</li></ul>Acquisition of st...
TYPE C REORGANIZATIONS – SECTION 368(a)(1)(C) STOCK FOR ASSETS<br />8<br />Shareholders<br />Acquiror <br />Stock<br />Acq...
“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 as...
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</li></li></ul><li>TYPE D REORGANIZATIONS – SECTION 368(a)(1)(D) D...
TRI-ANGULAR OR SUBSIDIARY MERGERS<br />11<br />1.		Forward Subsidiary Merger<br />T<br />P<br />S<br />2.		Reverse Subsidi...
TRI-ANGULAR OR SUBSIDIARY MERGERS<br />12<br />Tax Consequences<br /><ul><li> Merger Sub takes Target’s basis in assets in...
 P takes “drop down” basis in stock of Merger Sub (same as asset basis)</li></ul>T Shareholders<br />P Stock<br />T<br />P...
TRI-ANGULAR OR SUBSIDIARY MERGERS<br />13<br />Tax Consequences<br /><ul><li> Non-taxable to Target and carryover basis
 No gain to P and Merger Sub under Sections 1032 and 361
 No gain to Target shareholders except to the extent of boot
 P’s basis in Target stock generally is the asset basis, but P can choose to take Target shareholders basis in stock (if i...
 If transaction is also a 351, P can use Target shareholders’ basis plus gain</li></ul>T Shareholders<br />P Stock<br />T<...
TAXABLE STOCK PURCHASES<br />14<br />Cash Reverse Triangular Merger<br />Treated as Stock Sale<br />T Shareholders<br />Ca...
CASH FORWARD MERGER<br />15<br />T Shareholders<br />Asset sale followed by liquidation of Target<br />Target has gain on ...
NET VALUE RULES<br />16<br />2005 Proposed Regulation 1.368-1(b)(1): Exchange of no net value (liabilities exceed value) d...
SECTION 382 – LIMITATION ON LOSSES AFTER CHANGE IN OWNERSHIP<br />17<br /><ul><li>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) agai...
“Ownership Change” occurs if, within a 3 year testing period, the percentage of stock of Target held by 5 Percent Sharehol...
(2) issuer is required to redeem
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Sccba buying and selling a business practical tax consequences 110125

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Sccba buying and selling a business practical tax consequences 110125

  1. 1. BUYING AND SELLING A BUSINESS<br />Practical Tax Consequences<br />Roger Royse<br />Royse Law Firm, PC<br />2600 El Camino Real, Suite 110<br />Palo Alto, CA 94306<br />rroyse@rroyselaw.com<br />www.rroyselaw.com<br />www.rogerroyse.com<br />Skype: roger.royse<br />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.<br />
  2. 2. OVERVIEW OF TRANSACTIONS<br />Tax Free Reorganizations:<br />Type A – Merger<br /> Type B – Stock for Stock<br /> Type C – Stock for Assets<br /> Type D – Spin Off, Split Off, Split Up, and Type D Acquisitive Reorganizations<br />Taxable Transactions:<br />Stock Sale<br /> Asset Sale<br />Foreign Corporations<br />S Corporation Strategies<br />Partnership Techniques<br />2<br />
  3. 3. TAXABLE VS. TAX FREE<br />Type of Acquisition Currency<br /> Stock<br /> Securities/Debt<br /> Deferred payments, earnouts<br /> Compensatory<br />Nature of the Buyers and Seller<br /> Foreign Parties<br /> Tax Attributes of Parties<br />Shareholder Level Considerations<br /> Tax Sensitivity of Shareholders<br /> Appetite for Complexity & Risk<br />3<br />
  4. 4. CONTINUITY OF INTEREST<br />4<br />IRS – 50% Safe Harbor, Rev. Proc. 77-37<br />John A. Nelson – 38% Stock<br />Miller v. CIR – 25% Stock<br />Kass v. CIR – 16% Stock is Insufficient<br />Value – 2007 Regulations address changes in value between the date of signing and close; if fixed consideration, (1) stock consideration is valued as of last business day before the first day the contract is binding and (2) if a portion of the fixed consideration is other property identified by value, then the specified value is used for that portion (see Reg. 1.368-1T(e)(2)). Consideration is “fixed” if contract states exact number of shares and other cash or property to be exchanged<br />Post transaction sales and redemptions<br />
  5. 5. TAX FREE REORGANIZATIONS<br /><ul><li>Type A – Merger
  6. 6. Type B – Stock for Stock
  7. 7. Type C – Stock for Assets
  8. 8. Type D – Spin Off, Split Off, Split Up, and Type D Acquisitive Reorganizations
  9. 9. Ruling Guidelines
  10. 10. Rev. Rul. 77-37
  11. 11. Rev. Proc. 86-42
  12. 12. Rev. Rul. 73-54 (terms)
  13. 13. Rev. Proc. 89-50
  14. 14. Rev. Proc. 96-30 (Type D Checklist)</li></ul>5<br />
  15. 15. TYPE A REORGANIZATIONS – SECTION 368(a)(1)(A) STATUTORY MERGER<br />Shareholders<br />Target<br />Acquiror<br />Requirements:<br />Necessary Continuity of Interest<br />Business Purpose<br />Continuity of Business Enterprise<br />Plan of Reorganization<br />Net Value<br />Tax Effect:<br />Shareholders – Gain recognized to the extent of boot<br />Target – No gain recognition<br />Acquiror takes Target’s basis in assets plus gain recognized by Shareholders<br />Busted Merger – taxable asset sale followed by liquidation<br /><ul><li>Statutory Merger – 2 or more corporations combined and only one survives (Rev. Rul. 2000-5)
  16. 16. Requires strict compliance with statute
  17. 17. Target can be foreign; Reg. 1.368-2(b)(1)(ii)
  18. 18. No “substantially all” requirement
  19. 19. No “solely for voting stock” requirement</li></ul>6<br />
  20. 20. TYPE B REORGANIZATIONS – SECTION 368(a)(1)(B) STOCK FOR STOCK<br />7<br />Shareholders<br />Acquiror Stock<br />Target Stock<br />Target<br />Acquiror<br /><ul><li>Acquiror’s basis in Target stock is the same as the Shareholder’s Solely for voting stock
  21. 21. No Boot in a B
  22. 22. Reorganization Expenses – distinguish between Target expenses and Target Shareholder expenses (Rev. Rul. 73-54)
  23. 23. Creeping B – old and cold stock purchased for cash should not be integrated with stock exchange</li></ul>Acquisition of stock of Target, by Acquiror in exchange for Acquiror voting stock<br />Acquiror needs control of Target immediately after the acquisition<br />Control = 80% by vote and 80% of each class<br />
  24. 24. TYPE C REORGANIZATIONS – SECTION 368(a)(1)(C) STOCK FOR ASSETS<br />8<br />Shareholders<br />Acquiror <br />Stock<br />Acquiror Stock<br />Target<br />Acquiror<br />Target Assets<br /><ul><li>Acquisition of substantially all of the assets of Target, by Acquiror in exchange for Acquiror voting stock
  25. 25. “Substantially All” – at least 90% of FMV of Net Assets and at least 70% of FMV of Gross Assets
  26. 26. Target must liquidate in the reorganization
  27. 27. 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 other boot exists
  28. 28. Reorganization Expenses – Aquiror may assume expenses (Rev. Rul. 73-54)
  29. 29. Assumption of stock options not boot
  30. 30. Bridge loans by Acquiror are boot
  31. 31. Redemptions and Dividends – who pays and source of funds</li></li></ul><li>TYPE D REORGANIZATIONS – SECTION 368(a)(1)(D) DIVISIVE SPIN OFF, SPLIT OFF, SPLIT UP<br />9<br />Shareholders<br />Transferee <br />Stock<br />Transferee Stock<br />Transferor<br />Transferee<br />Transferor Assets<br /><ul><li>Divisive – 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. Stock or securities of the transferee must be distributed under the plan in a transaction that qualifies under Section 354, 355, or 356. </li></li></ul><li>TYPE D REORGANIZATIONS – SECTION 368(a)(1)(D) NON-DIVISIVE<br />10<br />Merger Treated as Acquisitive D<br />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<br />Shareholders with 20%<br />Acquiror<br />Stock<br />Acquiror Stock<br />Transferor<br />Acquiror<br />Transferor Assets<br />Merger<br />Failed Type C Treated as D<br />Liquidation / Reincorporation<br />Shareholders<br />Shareholders<br />50%<br />Assets<br />Stock<br />Assets<br />Stock<br />Assets<br />Transferor<br />Acquiror<br />Transferor<br />Acquiror<br />Cash & Stock<br />
  32. 32. TRI-ANGULAR OR SUBSIDIARY MERGERS<br />11<br />1. Forward Subsidiary Merger<br />T<br />P<br />S<br />2. Reverse Subsidiary Merger<br />T<br />P<br />S<br />Key:<br />T = Target P = Acquiror S = Merger Sub<br />
  33. 33. TRI-ANGULAR OR SUBSIDIARY MERGERS<br />12<br />Tax Consequences<br /><ul><li> Merger Sub takes Target’s basis in assets increased by gain recognized by Target
  34. 34. P takes “drop down” basis in stock of Merger Sub (same as asset basis)</li></ul>T Shareholders<br />P Stock<br />T<br />P<br />80%<br />Merger<br />Sub Survives<br />S<br />Section 368(a)(2)(D) Forward Triangular Merger <br />A statutory merger of Target into Merger Sub (at least 80% owned by P) <br /> Substantially all of Target’s assets acquired by Merger Sub<br />Would have been a good Type A merger if Target had merged into P<br />Key:<br />T = Target P = Acquiror S = Merger Sub<br />
  35. 35. TRI-ANGULAR OR SUBSIDIARY MERGERS<br />13<br />Tax Consequences<br /><ul><li> Non-taxable to Target and carryover basis
  36. 36. No gain to P and Merger Sub under Sections 1032 and 361
  37. 37. No gain to Target shareholders except to the extent of boot
  38. 38. P’s basis in Target stock generally is the asset basis, but P can choose to take Target shareholders basis in stock (if it is also a B)
  39. 39. If transaction is also a 351, P can use Target shareholders’ basis plus gain</li></ul>T Shareholders<br />P Stock<br />T<br />P<br />80%<br />Merger<br />Target Survives<br />S<br />Section 368(a)(2)(E) Reverse Triangular Merger <br />Merger of Merger Sub into Target where (i) Target shareholders surrender control (80% of voting and nonvoting classes of stock) for P voting stock and (ii) Target holds substantially all the assets of Target and Merger Sub<br />Key:<br />T = Target P = Acquiror S = Merger Sub<br />
  40. 40. TAXABLE STOCK PURCHASES<br />14<br />Cash Reverse Triangular Merger<br />Treated as Stock Sale<br />T Shareholders<br />Cash<br />T<br />P<br />Merger<br />Target Survives<br />S<br />Shareholders have gain or loss<br />P takes cost basis in Target shares<br />Key:<br />T = Target P = Acquiror S = Merger Sub<br />
  41. 41. CASH FORWARD MERGER<br />15<br />T Shareholders<br />Asset sale followed by liquidation of Target<br />Target has gain on sale<br />Target shareholders have gain on liquidation (unless 332 applies)<br />P takes cost basis in Target assets<br />T<br />P<br />Merger<br />P Survives<br />Variation with Merger Sub:<br />T Shareholders<br />T<br />P<br />Merger<br />Sub Survives<br />S<br />Key:<br />T = Target P = Acquiror S = Merger Sub<br />
  42. 42. NET VALUE RULES<br />16<br />2005 Proposed Regulation 1.368-1(b)(1): Exchange of no net value (liabilities exceed value) does not qualify as a reorganization<br />Example:<br />P owns all of the stock of both S and T. T has assets with FMV of $100 and liabilities of $160, all of which are owed to B. T transfers all of its assets to S in exchange for the assumption of T’s liabilities, and T dissolves. The obligation to B is outstanding immediately after the transfer. P receives nothing in exchange for its T stock. Under paragraph (f)(2)(i) of the Reg, T does not surrender net value because the FMV of the property transferred by T ($100) does not exceed the sum of the amount of liabilities of T assumed by S 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.<br />Alabama Asphalt<br />
  43. 43. SECTION 382 – LIMITATION ON LOSSES AFTER CHANGE IN OWNERSHIP<br />17<br /><ul><li>Section 381 – Survival of Tax Attributes
  44. 44. Section 382
  45. 45. 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
  46. 46. “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. </li></li></ul><li>NON-QUALIFIED PREFERRED STOCK<br />18<br /><ul><li>Preferred Stock – limited and preferred as to dividends; and does not participate in corporate growth; </li></ul>If:<br /><ul><li>(1) shareholder has right to require issuer to redeem
  47. 47. (2) issuer is required to redeem
  48. 48. (3) issuer has right to redeem and is more likely than not to exercise that right; or
  49. 49. (4) dividend rate varies based on interest rate, or commodity price or other index
  50. 50. Redemption right exercisable within 20 years and not subject to contingency that renders likelihood remote
  51. 51. Excludes stock compensation that may be repurchased on separation from service
  52. 52. Conversion feature not enough to participate in growth
  53. 53. Generally treated as boot to shareholders</li></li></ul><li>TARGET DEBT SECURITIES<br />19<br />Exchange of Target securities for P securities is tax free under Sections 354 and 356, to the extent that the principal amount of P debt is less than the principal amount of Target debt<br />Portion attributable to cash basis accrued interest is taxable<br />Possible COD income<br />Example:<br />Target bonds with an issue price (stated principal amount) of $1,000 exchanged for P stock or debt worth $900; Target has COD of $100<br />
  54. 54. DIVIDEND EQUIVALENCY<br />20<br /><ul><li>Section 356(a)(2) – Boot as dividend or capital gain; post-reorganization redemption test of Rev. Rul. 93-61
  55. 55. Clark – hypothetical post-reorganization redemption reduced shareholder’s interest from 1.32% to .92% - substantially disproportionate under Section 302(b)(2)
  56. 56. Section 302(b)(1) – redemption that results in meaningful reduction in voting power is redemption and not essentially equivalent to a dividend
  57. 57. Section 302(b)(2) – greater than 20% reduction is substantially disproportionate
  58. 58. E&P Limitation on Dividend – should be Target’s E&P but unclear if P’s E&P counted; PLR 9118025, PLR 9041086, and PLR 9039029</li></li></ul><li>CONTINGENT STOCK, ESCROWS, AND EARN-OUTS<br />21<br /><ul><li>Escrows:
  59. 59. Target shareholders usually treated as owner of escrowed P shares unless otherwise agreed
  60. 60. especially true if Target shareholders have right to vote and receive dividends
  61. 61. not clear who is owner if Target shareholders do not have right to vote or receive dividends
  62. 62. Earn-Out Stock:
  63. 63. Target shareholders not considered owners until P shares are issued
  64. 64. Not treated as boot
  65. 65. Imputed Interest
  66. 66. Rev. Proc. 84-42 Ruling Guidelines – use of escrow or contingent stock
  67. 67. (1) stock must be distributed within 5 years, subject to escrow or contingency
  68. 68. (2) valid business purpose
  69. 69. (3) maximum number of shares cannot exceed 50%
  70. 70. (4) trigger event not controlled by Target shareholders and not based on tax liability
  71. 71. (5) Formula is objective and readily ascertainable
  72. 72. (6) Restrictions on assignment and substitution
  73. 73. (7) In the case of escrows, P shares shown as issued to Target shareholders, current voting and dividend rights, and vested </li></li></ul><li>BUSTED 351<br />22<br />T Shareholder<br />Shareholders<br />P Stock<br />Stock<br />Business<br />P<br />Merger<br />T<br />Rev. Ruling 70-140<br />Step 1: Incorporate T<br />Step 2: Merge T into P<br />
  74. 74. Double Merger<br />23<br />REV. RUL. 2001-46<br />Step 2: A-type forward merger<br />Step 1: Reverse triangular merger<br />T Shareholders<br />T Shareholders<br />P Stock+cash<br />Acquiror<br />Target<br />Acquiror<br />Merger<br />Sub Survives<br />80%<br />Merger<br />Target Survives<br />Merger Sub<br />Merger Sub<br />Target+Sub<br />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.<br />
  75. 75. Double Merger – Wholly Owned LLC<br />24<br />REV. RUL. 2001-46<br />Step 2: A-type forward merger<br />Step 1: Reverse triangular merger<br />T Shareholders<br />T Shareholders<br />P Stock+cash<br />Acquiror<br />Target<br />Acquiror<br />Merger<br />LLC Survives<br />80%<br />Merger<br />Target Survives<br />LLC<br />Merger Sub<br />Target+Sub<br />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.<br />
  76. 76. USE OF WHOLLY OWNED LLC<br />25<br />T Shareholders<br />P Stock<br />Target<br />Acquiror<br />Merger<br />LLC Survives<br />LLC<br />Merger of Corporation into LLC<br /><ul><li> 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
  77. 77. A Type Reorganization</li></li></ul><li>SECTION 351 / 721 ROLLOVER<br />26<br />T Shareholders<br /><ul><li> 80% vote & value
  78. 78. taxation of boot
  79. 79. debt + non-qualified voting stock
  80. 80. assumption of liabilities</li></ul>PEG<br />Target<br />Cash out some and rollover<br />T Shareholders<br />Cash<br />T Shareholders<br />PEG<br />Cash<br />Cash<br />Target<br />PEG<br />T Shares<br />Cash<br />Assets<br />Cash<br />NewCo<br />NewCo<br />Target<br />Assets<br />
  81. 81. LLC TECHNIQUES<br />Step 1<br />Step 2<br />T Shareholders<br />Former T Shareholders<br />$<br />Target Corp.<br />Acquiror<br />LLC<br />Target<br />Merger<br />LLC Survives<br />LLC<br />Target<br />27<br />
  82. 82. FOREIGN CORPORATIONS<br />28<br />Section 367(a) – outbound transactions<br />Foreign corporation not treated as a corporation except as provided in regulations<br />Generally, gain recognized unless:<br />No more than 50% of stock of foreign Acquiror received by US transferors,<br />No more than 50% of stock of foreign Acquiror owned after the transfer by US persons that are officers or directors or 5% Target shareholders,<br />Gain Recognition Agreement ("GRA") is entered into by 5% US transferee shareholders <br />36 month active trade or business test met, <br />No intent to substantially dispose of or discontinue such trade or business,<br />FMV of the assets of transferee must be at least equal to the FMV of the US target, and<br />Tax reporting<br />Section 367(b) – inbound and foreign to foreign transfers<br />US Acquiror and foreign Target<br />Target can be treated as a corporation<br />May be income to Target’s US shareholders to extent of Target’s accumulated E&P<br />
  83. 83. FOREIGN CORPORATIONS<br />29<br />Anti-Inversion Rules – tax outbound reorganization and/or tax foreign Acquiror as a U.S. taxpayer; Code Section 7874<br />If ownership of former U.S. Target shareholders in foreign Acquiror is 80% or more; foreign Acquiror is treated as a U.S. company <br />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<br />20% excise tax on stock-based compensation upon certain corporate inversion transactions <br />7874 exception available for companies with “substantial business activities” in the foreign jurisdiction; facts and circumstances test compares activities of company in foreign jurisdiction with activities of company globally<br />Controlled Foreign Corporations (“CFCs”)<br />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. <br />
  84. 84. 1248 AMOUNT ON SALE OF CONTROLLED FOREIGN CORPORATION<br />30<br />Section 1248 <br />Seller of Controlled Foreign Corporation (CFC) must treat as dividend gain to extent of E&P<br />1248 inclusion carries foreign tax credits<br />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<br />
  85. 85. JOINT VENTURE STRUCTURES<br />31<br />Foreign Company<br />US Company<br />Cash<br />Assets & Liabilities<br />Section 367 Issues<br />Disguised Sale<br />LLC<br />US & Foreign Assets<br />
  86. 86. INSTALLMENT METHOD<br />32<br />Gain on each payment = gross profit ratio times payment<br />Gross profit ratio = ratio of total gain to purchase price<br />Pre-transaction planning opportunities to utilize basis<br />Section 453A – interest charge to the extent taxpayer holds more than $5 million face amount of Section 453 obligations<br />Section 453 Limits<br />Not available for publicly held stock or securities, or inventory<br />Not available for sales for demand notes or readily tradable notes<br />Not available for instruments secured by cash or cash equivalents<br />Obligor must be purchaser (cannot use parent debt)<br />Section 453 applies unless taxpayer affirmatively elects out<br />Section 453(h) – Target shareholders who receive Acquiror debt in liquidation of Target allowed to use installment reporting<br />
  87. 87. CONTINGENT PAYMENTS AND EARN-OUTS<br />33<br />Distinguish Equity vs. Debt<br />3 Issues<br />(1) allocation between interest and sales proceeds;<br />(2) timing of realization of sales proceeds; and <br />(3) timing of basis recovery<br />Interest <br />1.1275-4(b)<br />Contingent payment debt for cash or publicly traded property – use non-contingent bond method; projected non-contingent and contingent payments<br />1.1275-4(c)<br />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<br />Buyer’s basis is non-contingent portion plus contingent payments treated as principal<br />
  88. 88. CONTINGENT PAYMENTS AND GAIN RECOGNITION<br />34<br />Reg. 15A.453-1(c)<br />If capped by maximum amounts, assume maximum for purposes of gross profit percentage (accelerates gain, backloads basis)<br />If no cap, but term, basis recovered ratably over term<br />If neither time nor amount is capped, basis recovered ratably over 15 years<br />Election out of Section 453 – FMV of contingent obligation is amount realized<br />Open transaction treatment – rare and extraordinary situations only<br />
  89. 89. SECTION 338 ELECTION<br />35<br /><ul><li>Section 338(g) – Target in stock sale treated as selling all its assets followed by liquidation post close (soaks up NOLs)
  90. 90. Section 338(h)(10) – Sale and liquidation deemed to occur pre-close; joint election; S corporation or sale out of a consolidated group
  91. 91. 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))
  92. 92. Adjusted Deemed Sale Price – grossed up amount realized of recently purchased stock plus liabilities of old T (on day after acquisition date)</li></li></ul><li>338(g) ELECTIONS<br />36<br />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<br />Target may be able to offset 338(g) gains with NOLs<br />
  93. 93. PURCHASE PRICE ALLOCATION<br />37<br /><ul><li>Asset Sale or 338 Election
  94. 94. Sections 1060 and 338 classes based on FMV
  95. 95. Class I – cash and equivalents
  96. 96. Class II – actively traded personal property under 1092
  97. 97. Class III – debt instruments and marked to market
  98. 98. Class IV – inventory
  99. 99. Class V – assets other than those in I-IV or VI
  100. 100. Class VI – goodwill and going concern
  101. 101. Agreement Allocations – Danielson Rule
  102. 102. Parties bound by agreement unless IRS determines that the allocation is NOT appropriate
  103. 103. SFAS 141R – Purchase Price Allocations 
  104. 104. Assets booked at FMV as of closing date (not signing date)
  105. 105. Bargain purchase results in accounting gain
  106. 106. Earn Outs – estimated and recorded
  107. 107. Deferred tax assets for excess tax deductible goodwill over book value
  108. 108. Transaction related costs recognized (expensed)</li></li></ul><li>UNVESTED STOCK RECEIVED IN A TAXABLE OR NON-TAXABLE DEAL<br />38<br /><ul><li>Rev. Rul. 2007-49 - The revenue ruling addresses:
  109. 109. (1) the exchange of fully vested stock for unvested stock of an acquiring corporation in a tax-free reorganization, and
  110. 110. (2) the exchange of fully vested stock for unvested stock of an acquiring corporation in a taxable exchange
  111. 111. Under either (1) or (2), the Rev. Rul. provides that the exchange constitutes a transfer of property subject to Section 83. Thus, 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. </li></li></ul><li>OPTIONS<br />39<br />Assumption or Substitution<br />No tax on substitution of NSO<br />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 old; see Sections 424(a) and 424(h)(3)<br />
  112. 112. OPTIONS – CASH OUT<br />40<br />Cancel options for cash payment<br />NSO <br />Ordinary income – compensation – withholding or 1099<br />Deduction to Target or Acquiror?<br />TAM 9024002 – employer deducts based on method of accounting; not clear if cash out at close is pre-acquisition Target deduction or post-close Acquiror deduction in absence of scripting the timing<br />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)<br />ISO<br />FICA<br />Exercise and disqualifying disposition treated differently<br />
  113. 113. 409A<br />41<br /><ul><li>Deferred compensation
  114. 114. 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)
  115. 115. Consequences of violating 409A
  116. 116. Amounts which were to be deferred are subject to immediate taxation
  117. 117. Additional 20% penalty on such amounts
  118. 118. Interest penalty
  119. 119. CA state tax penalty
  120. 120. Bonus or Carve Out Plans
  121. 121. Participation in Earn Outs (Reg. 1.409A-3(i)(5)(iv))
  122. 122. Payments of compensation in this context may be treated as paid at a designated date or 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</li></li></ul><li>280G GOLDEN PARACHUTE RULES<br />42<br /><ul><li>20% excise tax and loss of deduction on Excess Parachute Payment
  123. 123. “Excess Parachute Payment” means the amount by which the Parachute Payment exceeds the Base Amount
  124. 124. “Parachute Payment” means a payment, the present value of which, exceeds three times the Base Amount
  125. 125. “Base Amount” means the average annual compensation for past 5 years
  126. 126. Must be paid to a disqualified individual (meaning employee, officer, shareholder, or highly compensated individual)
  127. 127. As compensation, AND
  128. 128. Contingent on a change in control (50% change ownership or effective control, or ownership change in a substantial portion of the company’s assets)
  129. 129. Reduce Excess for reasonable compensation
  130. 130. Exclude reasonable compensation for future services
  131. 131. Exception for small business corporation and non publicly traded corporation that has 75% uninterested shareholder approval
  132. 132. Withholding requirement</li></li></ul><li>280G – OTHER ISSUES<br />43<br />Non-Publicly Traded Stock<br />Approval of 75% of shareholders after adequate disclosure<br />Vote determines the right of the shareholder to the payment<br />Ignore shares held by persons receiving the payment<br />Reduction for Excess (299% of payments)<br />Reduction for Reasonable Compensation<br />Reduction for Future Services<br />
  133. 133. S CORPORATIONS AND 338(h)(10)<br />44<br />T Shareholders<br />Cash and Notes<br /><ul><li> Character difference – ordinary income assets
  134. 134. California 1.5% tax on S corporations
  135. 135. All Target shareholders must consent on Form 8023
  136. 136. Deemed 338 election for subsidiaries
  137. 137. 1374 – BIG Tax
  138. 138. Minority shareholders in rollover
  139. 139. Hidden tax in liquidation or deemed liquidation in installment sale.</li></ul>T (S Corp)<br />P<br />Reverse subsidiary cash merger<br />S<br />Key:<br />T = Target P = Acquiror S = Merger Sub<br />
  140. 140. S CORP 338(h)(10) ELECTION AND <br />453B(h) BASIS ALLOCATION ISSUE<br />45<br />Shareholders<br />$1 million basis<br />$1 million cash<br />$4 million 453 Note<br />Target<br />Acquiror<br />Stock Sale<br />Reg. 1.338(h)(10) – 1(e) Example 10<br />Cash - $1 million / $1 million A/B<br />Assets - $4 million / zero A/B<br />Gain to Shareholders in year of sale: $1 million x 80% = $800,000; A/B of Shareholder = $1.8 million<br />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<br />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%)<br />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%<br />
  141. 141. S CORP NO 338(h)(10) ELECTION – DISAPPEARING BASIS<br />46<br />T Shareholders<br />Cash<br />Liquidate Target into Merger Sub or check the box Q-Sub<br />T (S Corp)<br />P<br />S<br />Merger<br />Carryover Basis<br />Key:<br />T = Target P = Acquiror S = Merger Sub<br />
  142. 142. 47<br />PALO ALTO<br />2600 El Camino Real <br />Suite 110<br />Palo Alto, CA 94306<br />SAN JOSE<br />10 Almaden Blvd.<br />Suite 1250<br />San Jose, CA 95113<br />LOS ANGELES<br />10900 Wilshire Blvd.<br />Suite 300<br />Los Angeles, CA 90024<br />SAN FRANCISCO<br />155 Sansome Street<br />Suite 500<br />San Francisco, CA 94104<br />www.rroyselaw.com<br />

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