Tax Free Corporate Reorganization Under Section 368
The buyer and seller of a company may prefer a merger, where neither party pays tax at the time of disposition, and tax is effectively deferred, except for cash or boot taken in the transaction. Tax free mergers are considered “reorganizations” under the tax code.
In such a deal, acquirer (A) would use its stock as a significant portion of the consideration paid to shareholder (SH) rather than cash or debt. The issue is to understand the deferral of tax under Section 368, the four major requirements to be eligible for tax free treatment, and Section 354, 355, 356 relating to exchanges of stock, distribution of stock, and other consideration taxable in the transaction.
Section 368(a)(1)(A)-(B) defines a statutory merger or consolidation as a reorganization. A reorganization is “the acquisition by one corporation, in exchange solely for all or a part of its voting stock…of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation.”
Section 368(a)(1)(D) also defines a reorganization as “a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355, or 356[.]” I leave out the further intricacies of Sections 354,355,356.
Reg. Sec. 1-368-1 requires that four criteria are met to be non-taxable:
1. Continuity of ownership interest exists under the code such that at least 40% of the consideration is acquirer stock. The code states 50% limit on boot, but case precedent establishes that up to 60% boot has been allowed.
2. The acquirer must either continue the target’s historical business or use a significant portion of target’s assets in an existing business for 2 years after the transaction.
3. The transaction must serve a valid business purpose beyond tax avoidance, and
4. The transaction cannot be part of a larger plan, taken in its entirety, would constitute a taxable acquisition.
Acquirer (A) and shareholders (SH) could pursue a non-taxable exchange of stock under a Section 368 statutory merger transaction. If the continuity and non-tax avoidance criteria are met, A and SH can pursue a reorganization such that A will be required to continue with target (T) business for a minimum of 2 years, A will defer taxes on the asset acquisition of T, SH will defer taxes until it sells its stock and will pay taxes on the amount of boot taken in the deal.
A will assume the tax structure of the assets of T, take all carryover bases in those assets, and thus if and when A sells those assets it will realize taxable gain inherent in those assets bases. Up to 60% of the aggregate deemed asset disposition price (ADADP) can be money or other property received by SH. Under a statutory merger type reorganization SH would be required therefore to take equity in A, for 40% or more of the ADADP. SH will pay higher ordinary rates of income on the boot received, up to the extent of accumulated C-Corp earnings and profits of T.
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