Question

After operating a successful US hotel corporation (H Corp) for several years, Donald decides to set up a wholly owned subsidiary in the export business (X Corp). His initial investment in this corporation is $1,000. Through a stroke of luck, the US tax laws change and X Corp becomes worth $100,000 overnight, even though its balance still only reflects $1,000 cash and $1,000 equity.

Donald is considering selling the operation but is concerned about the tax ramifications.

a. What would H Corps gain be if it sold the stock of X Corp for $100,000?

b. Instead, Donald has offered to sell X Corp to Bill Corp in a tax free exchange of 100% of       X Corp for $100,000 of Bill Corp stock. Assuming Bill Corp accepts this offer, what is Bill Corps basis in X Corp stock? What is H Corps gain, if it immediately sells its stock in Bill Corp for $100,000?

c. What alternative structure might Bill Corp offer which might provide additional tax benefits to Bill Corp? Explain and show calculations

d. What might Bill Corp do to entice H Corp to accept the revised deal?

Answer 1

Part a:

In case the stock of X Corp is sold at $100,000 then H Corp will make a gain of (100,000 – 1,000) =$99,000 from the sale of such stock.

Part b:

In this case the basis of Bill Corp in the stock is the amount paid to acquire the stock, i.e. $100,000. In case H Corp sale the stock immediately to Bill Corp for $100,000 then gain of H Corp would be (100,000 – 1,000) = $99,000.         

Part c:

In case of acquiring the entire stock in X Corp the Bill Corp should purchase the stock in X Corp by instalments. As a result the gain would be reduced and H Corp will have to pay low amount of tax. For example sale of one quarter of entire stock would reduce the gain to (25000 – 250) =$24750. As a result the tax rate would be reduced on such gain and accordingly, H Corp would be required to pay less tax on such gain.

Part d:

The Bill Corp would explain that as a result of sale in parts H Corp would not be required to pay tax at a higher rate since the gain would be significantly less. Thus, the tax liability of H Corp would be far less than what it would have been in case the entire stock is sold.