Question

When a corporation is sold, sellers often wish to defer the taxable gain on a sale of shares. Under the US tax code, such gain deferral may be accomplished through a tax-free reorganization pursuant to IRC Sec. 368(a)(1).

Please consider the common requirements (listed below) that each one of these reorganization types must meet to qualify for tax-free treatment.

Please select one requirement and discuss how failure to meet the requirement may preclude qualifying for a tax-free reorganization.

1.Pursuant to plan of reorganization 2.Continuity of interest 3.Continuity of business enterprise 4.Business purpose test

Answer 1

Tax free M&A transactions are considered 'reorganizations' and are similar to taxable deals except that in reorganizations the acquirer uses its stock as a significant portion of the consideration paid to the seller rather than cash or debt.

Four conditions must be made to qualify a transaction for tax-free treatment under Internal Revenue Code sec 368

1.Pursuant to plan of reorganization-section 368 of the Internal Revenue recognises three types of corporate acquisition structures that qualify as tax-free(or tax deferred) reorganizations.

Type ''A"-Reorganization(stock-for-assets acquisition)

• Statutory Merger-In a statutory merger,target shareholders exchange the shares for acquirer stock and upto 60% boot (continuity of interest requirement applies)
• Statutory Consolidation-In a statutory consolidation,two or more corporation contribute all of their assets and liabilities to a new corporation formed to effect the transaction and the preexisting corporations are dissolved.The structure is appropriate for mergers of equals.Aquirer target shareholders have the same voting and appraisal rights as in a statutory merger.
• Forward Triangular Merger-The target is merged into a subsidiary of the aquiring corporation,leaving subsidiary as the surviving entity. Beacause the target is eliminated,non-transferrable assets and contracts,such as patents or liscences may be lost.The buyer must aquire"Substantially All" of the targets assets.
• Reverse Triangular Merger:- In a reverse triangular merger a subsidiary of the aquirer is merged into the target,leaving the target as the surviving entity and a subsidiary of the aquirer and eliminating any minority shareholders in the target.

Type "B"-Reorganization(stock-for-stock acquisition):- In a "B" Reorganization the aquirer exchanges its voting common and /or qualified preferred stock(no boot,except for small amounts paid for fractional shares)for control of the target,defined as ownership of 80% of the "vote and value" of the target's stock

Type "C"-Reorganizations(stock-for-assets acquisition):-In a "C" Reorganization,The aquirer exchanges its voting common and/or preferred stock for "substantially All"of the targets assets.The target liquidates and transfers the acquirer shares and any remaining assets to its shareholders.Consideration paid in cash or securities other than voting common or preferred stock(boot) cannot exceed 20% of the FV of the target's pre-transaction assets.

A reorganization plan must be adopted by each corporate party to a reorganization.The acts of the corporation's officers must show that they adopted the plan,and its adoption must appear in the official records(minutes) of the corporation.Each corporate party to a reorganization must file a statement with its tax return for the year in which the reorganization occured.

2.Continuity Of Interest:- Atleast 50% of the consideration is acquirer stock (although transaction with as little as 40% stock cosideration have qualified for tax free treatment).

3.Continuity Of Business Enterprise: The Acquirer must either continue the target's historical business or use a significant portion of the target's assets in an existing business for 2 yrs after the transaction.

4.Business Purpose Test: The transaction must serve a valid business purpose beyond tax avoidance.

Reorganisations,while not generally taxable at the entry level, are not completely tax-free to the selling share holder.A reorganisation is immediately taxable to the target's share holders to the extent they receive non-qualifying consideration,or "boot".Also,tax on acquirer stock received by target shareholders as consideration is deferred rather than avoided altogether.

Failure to comply any of the required conditions will not allow the reorganization to seek "tax-free benefits".A reorganization must fullfil all the conditions mentioned above to be eligle as tax-free reorganizations.