Accounting 6073
Fall, 2010

Lesson 9—Introduction to Corporate Reorganizations

I.	In General

A.	The disposition of property is generally a taxable event.  The amount of gain or loss is generally determined under Section 1001 IRC.

B.	However, as we have seen, there are exceptions to this general rule. 

1.	  E.G. Section 351.
2.	  E.G. Section 1031.

C.	Another group of exceptions to the general rule is the corporate reorganization provisions, Sections 354 thru 368 IRC.

D.	Why not just allow under Section 1031 (like kind exchange of stock for stock)?  

1.	  To limit tax free treatment for stock sales (e.g. I hold 	
	appreciated Exxon stock, I could theoretically exchange that for 	
	Valero stock tax free).  Stock is specifically excluded from “like 	
	kind” treatment under Section 1031.  

2.  To allow treasury to be very specific about the types of 	transactions that will and will not qualify for tax free treatment.

E.	The term “reorganization” is defined in 368(a)(1) to include 

1.	 statutory mergers or consolidations 
2.	 recapitalizations
3.	 acquisitions by one corporation of the stock or assets of another
4.	 divisions
5.	 changes in form or place of organization

F.	If the transaction qualifies as a reorganization,
1.	  the transferring corporation 	recognizes neither gain nor loss on the transfer of its property for stock or securities in another corporation that is party to the reorganization.	

2.	  the tax attributes (e.g. loss carryovers, earnings and profits, accounting method) of the transferring corporation are ordinarily inherited by the acquiring corporation.

G.	Why are these transactions tax free?  --The theory is that the acquiring 	
	corporation is substantially a continuation of the business of the 	
	transferring corporation.		

	
II.   Statutory Framework 

A.	Section 368(a)(1)—defines 7 (and only 7) types of transactions that qualify as 		tax free reorganizations:
	
1.	Statutory merger or consolidation (Type A)
2.	Acquisition by one corp. of stock of another corp. (Type B)
3.	Acquisition by one corp. of the assets of another corp. (Type C)
4.	Transfers to controlled corporations (Type D)
5.	Recapitalizations (Type E)
6.	Changes in form or place of organization (Type F)
7.	Insolvency reorganizations (Type G)

B.	Section 354—provides (with qualifications) that no gain or loss will be 	
	recognized if	
	
1.	Stock or securities in a corporate “party” to the 	reorg. (368(b))
2.	are exchanged
3.	under a plan of reorganization
4.	solely
5.	for stock or securities in
6.	the same corp. or another corporate  “party” to the reorganization.		

C.	Section 361—provides that a corp. that is a party to a reorganization 		
	recognizes no gain or loss if

1.	it exchanges property
2.	under the plan of reorganization
3.	for stock, securities or other property
4.	with another corporate party to the reorganization.

	Also protects corporation on certain distributions to s/hs under plan of reorg.

D.	Sections 356/357—provide for treatment of boot, assumed liabilities and 	
	liabilities to which property is subject in reorganization transactions.

E.	Sections 358/362(b)—provide derivative-basis rules in reorganization 	transactions.

F.	Section 381—provides for transfer of a corporations’ NOL c/o, earnings and 	
	profits, and other tax attributes to a successor corporation, subject to the 	
	rules of Sections 269, 382 and 384.

G.	Section 1032—provides that a corporation does not recognize gain or loss 	
	upon exchanging its own stock (including treasury stock) for property.

III. Continuity of Interest—

	“The term reorganization presupposes a continuance of interest on the part of the 	
		transferor in the properties transferred”  Cortland Specialty Co. v. CIR   60 		F2d 937 (2d Cir.), cert. denied 288 US 599 (1932).  See also Regs. 1.368-	
		(1)(e)(i).

	A.  Purpose—to distinguish transactions that represent a continuation of business 	
		by the transferring corporation and the shareholders of that corporation 	
		from transactions that are really disguised sales.

B.	Two types of continuity are required:

1.	Continuity of Propriety Interest—satisfied if there is at least 40% 	
	continuity of interest by value, i.e. shareholders of the acquired 	
	corporation in the aggregate receive stock of the acquiring 	corporation equal in value to at least 40% of the acquired 	corporation’s stock.  Temp Reg. 1.368-1T (e)(2)(v), Example 1.

2.	Continuity of Business Enterprise—the acquiring corp. must either—
	
a.	Continue the acquired corporation’s “historic business” or

b.	Use a significant portion of the acquired corporation’s “historic business assets” in another business.  Regs. 1.368-1(d)(1).

c.	If the acquired corp. has more than one line of business, the acquiring corporation must only continue a significant line of business.

d.	Requirement not met if acquired corporation sells all its historic business assets immediately prior to the reorganization, even if the acquiring corporation uses the proceeds in its business.

IV. Types of Transactions that Qualify---See Illustrations 

V.  Tax Consequences

	We will look at the tax consequences of the following three dispositions.  One or 	
	more of these dispositions (but not necessarily all) occurs in every reorganization:

1.	Exchange by the target corporation of its assets principally for stock of another corporation.

2.	Distribution of acquiring corporation’s stock and possibly other property by the target corporation to its shareholders and possibly to creditors.

3.	Exchange with the target corporation by its shareholders and creditors for the stock of the acquiring corporation and any other property.

	We will use the following facts:

	Shareholder S owns all the stock of corporation X, the only asset of which is land 	
		that has been used in a farming business.  The adjusted basis of the land is 	
		50,000 and its fair market value is $200,000.   S’s basis in his X stock is 	
		$10,000.  Corporation Z is a publicly held agriculture business that is 	
		willing to give either $200,000 of voting common stock in exchange for 	
		the land in a taxable transaction or $170,000 of voting stock in a 
		transaction that will be tax free to S and X.

	Since the Type C reorganization illustrates the consequences of the three 	dispositions most clearly, we will assume the parties agree on a Type C 	reorganization.

	Disposition 1:   How much gain will X realize and recognize?

			Amount realized $170,000   (fmv of Z stock)
			Less basis	     - 50,000
			Gain Realized 	      120,000

	Gain recognized is 0.  Section 361(a) says that a corporate party to a 
		reorganization recognizes no gain or loss on exchange of property for 
	stock, securities or other property of another corporate party to the 	
	reorganization.	

	What if X received 5,000 cash in addition to Z stock?  	

	Still no gain or loss recognized.  Section 368(a)(2)(B) says that limited boot 
	received will not change tax free status of C reorganization.  Will still qualify as 	
	long as at least 80% of the gross fmv of X property is acquired in exchange for 	
	voting stock.  Thus, as long as X receives stock with fmv of at least $160K in 
	exchange for the land, the transaction will still qualify as a type C reorg. 

	What if the property X transfers is subject to a liability of $5,000?

	Same result as above.  Section 368(a)(1)(C) provides that the assumption of 	
	liabilities by the acquiring corporation is disregarded.  However, this is true only 	
	for purposes of determining whether the transaction qualifies as a reorganization.  
	The liabilities may still be considered boot under the principles of Section 357(b).  	In addition, if the assumption of liabilities by the acquiring corporation “so 	
	alter(s) the character of the transaction as to place the transaction outside the 
	purposes and assumptions of the reorganization provisions, the transaction may 	
	fail to qualify as a reorganization due to a lack of continuity of interest on the part 	of the transferor or its shareholders.  The 80% rule discussed above also applies in 	the case of assumption of liabilities by the acquiring corporation.

	Disposition 2:  On Dist. of Z stock to S, how much g/l will X recognize?

			Amount realized $170,000  (fmv of Z stock)
			Less basis	       -50,000  (c/o basis from land  Section 358(a)(1)	
			Gain Realized      120,000

	No gain recognized.  361(c) says no g/l to corporate party to reorganization on the
	distribution of “qualified property” (even if appreciated).  Qualified property 	
	includes stock in another corporation that is a party to the reorganization.	

	Disposition 3:  On Dist. of Z stock to S, how much g/l will S recognize?

			Amount realized 	$170,000 	(fmv of Z stock)
			Less basis		-   10,000  	(of X stock given up)
			Gain Realized		  160,000

	No gain recognized.  Section 354(a)(1) says no gain/loss if stock/securities of a 	
	corporation who is party to a reorganization is exchanged solely for 	stock/securities in such corporation or another corporation who is party to the 
	reorganization.

	S basis in Z stock is $10,000  (c/o basis from X stock.  Section 358(a)(1)

	What if S also received $5,000 cash?

	S would recognize $5,000 gain.  Gain is recognized to extent of boot received, but 		limited by gain realized. (Section 356).

	S basis in Z stock (Section 358): 	10,000 basis of X stock given up
						-5,000 boot received
						+5,000 gain recognized
						10,000

	

	Consequences to Z:

	-Z has no gain or loss on the exchange of its own stock for the land (Section 	
		1032). 	Note:  This is true whether or not the transaction qualifies as a 
		reorganization.

	--Z’s basis for the land is the same it was for X, 50,000.   Section 362(b).

	--If Z gave an extra $5,000 cash for the land, it would not increase the basis of the 		land because X recognized no gain.  Section 362(b).

	--Z takes over any tax attributes of X (e.g. NOL, earnings and profits).  Section 
		381(a)(2)

End result: Non recognition of gain, but 
	
	--corporate level gain potential is preserved in c/o basis of land in Z and in c/of of 	
		X’s corporate tax attributes.

	-- s/h level gain potential is preserved in c/o basis of Z stock in S’s hands.