Three Statutory Options for Tax Free Corporate Reorganizations
Structured properly, corporate reorganizations can assist in solving business problems.
What are the benefits to a corporate reorganization?
A properly structured reorganization can be tax-free under the Internal Revenue Code. In addition, reorganizations provides businesses the opportunity to protect assets, avoid liabilities and transfer contracts by savvy use of the provisions of Subchapter C of the Internal Revenue Code. For example, a business may want to isolate the liabilities of a certain sector of their business to insolate the remainder of the business. Reorganizations can also be structured to allow the Acquiring entity to utilize the Target entity’s tax attributes, most notably its net operating losses (NOLs). The Internal Revenue Code puts certain limitations on these uses so proper guidance is needed for businesses to fully take advantage of these aspects of the tax code.
Any business looking to expand or merge with another business will need advisors to review the reorganization options and craft a plan to accomplish corporate planning and structuring goals. Below is a brief summary of commonly used reorganization devices.
The Internal Revenue Code § 368 is the statutory basis to accomplish tax-free corporate reorganizations. The tax code provides a multitude of options and compliance rules. Federal tax law generally provides certain mergers and acquisitions will be a Tax-Free event only if the transaction possesses the following attributes:
- Plan of Reorganization
- Business Purpose
- Continuity of Business Enterprise
- Continuity of Proprietary Interest
Plan of Reorganization – Typically, a Plan of Reorganization consists of a formal written agreement between the parties. The agreement can outline the intentions of the parties and there should be evidence that the reorganization was duly approved by the appropriate officers upon the official corporate records.
Business Purpose – The reorganization must be completed to have a business objective. The reorganization cannot be a device to merely avoid taxation where the resulting entity has no business purpose aside from avoiding a taxable event.
Continuity of Business Enterprise – The resulting entity of reorganizations must acquire the historical business assets of the predecessor entity. In addition, these assets must be used in the course of business. This distinguishes the reorganization from a straight asset sale.
Continuity of Proprietary Interest – Tax-Free reorganizations require that the shareholder stake in the resulting entity remains consistent. Each type of reorganization has different quantitative standards. For example, “B” Reorganizations requires 100% of voting stock (without any cash exchanged) to be exchanged for a Target Stock. Whereas, “A” reorganizations require as little as 38% of stock consideration to satisfy the continuity of proprietary interest, however, the IRS safe-harbor is 50%.
“A” Reorganization (Stock-for-Assets)
A type A reorganization is known as a “statutory merger” because it is provided by state statute. The Target Shareholders transfer their Target Stock to the Acquiring entity in exchange for Acquiring Stock and, possibly Cash Equivalents. The Acquiring Stock received by the Target Shareholders may be voting and non-voting common stock or qualified preferred shares. The Acquiring entity then liquidates the Target entity and receives all the Target assets and liabilities. In “A” reorganizations, approximately 60% of the exchange can be for cash. Thus, if the merger is valued at $1MM, Acquiring Stock worth $400,000 must be received by the Target Shareholders to maintain the continuity of proprietary interest. If cash is part of the exchange, the Former Target Shareholders must recognize gain on that portion of the transaction.
In a standard statutory merger, the acquiring entity will not be protected from the former Target’s liabilities. Furthermore, the acquiring shareholders will need to approve the merger. These two aspects can be avoided by structuring the transaction as either a Forward Triangular Merger or a Reverse Triangular Merger. If this is done properly, the Target’s liabilities are shielded from the Acquiring entity because the Target is actually merged into a subsidiary formed by the Acquiring entity.
“B” Reorganization (Stock-for-Stock)
In a “B” reorganization, the Acquiring entity exchanges solely voting common stock and/or qualified preferred stock for at least 80% of the Target’s stock. The Acquiring entity does need to acquire the full 80% in the transfer, but must hold 80% of the Target’s shares when the tax-free transaction is completed. A “B” reorganization allows the Acquiring entity to keep the Target as a subsidiary.
“C” Reorganization (Stock-for-Assets)
In a “C” Reorganization, the Acquiring entity exchanges Acquiring voting common stock and/or preferred stock (and up to 20% boot) for “substantially all” the Target’s assets. The Target then liquidates the Acquiring Stock and any boot to the Target Shareholders. The result is that the Acquiring entity owns the Target assets and the Former Target Shareholders hold stock. This type of transaction allows the Acquiring entity to choose which liabilities to assume.