Ch. 8 - Taxable Corporate Acquisitions/Dispositions

Disposition options:

1)   Sale of stock – easy to accomplish; LT capital gain treatment to the individual seller; risk about unknown corporate liabilities.

2)   Sale of assets – more complicated transfer mechanics;  concerns about non-assignable assets; various tax characterizations, dependent upon allocation of the consideration received.

Four Alternatives:
Taxable Dispositions  p.364

Possible mechanical alternatives for the taxable disposition of a corporate business:

1. Sale by the corporation of its assets and the distribution of the proceeds in liquidation.

2. Distribution by the corporation of its assets “in kind” to the shareholders who then sell the assets.

3. Sale of the stock by the shareholders.

4. Sale of the assets at the corporate level and no liquidation of the corporation.

Taxable Asset Acquisitions    Consideration Paid     p.365

Sale of its assets by the target corporation to a purchaser for cash, notes, etc.  (but not for stock - which exchange could be eligible for tax-free corporate reorganization treatment).

Various types of consideration might be paid for these assets:  cash, promissory notes, bonds & other property (e.g., stock of other than the purchaser corporate entity).

Possible structures for the asset acquisition       p.365

1)  Forward cash merger of Target into Acquirer for cash (or merger into subsidiary of Acquirer).  Equivalent to a sale of assets and liquidation by the acquired corporation.  Rev. Rul. 69-6.

2)  Liquidation of the Target followed by the shareholder sale of the assets to Acquirer.

3) Sale of the assets by Target with subsequent distribution of the proceeds to shareholders.

4) Sale of assets, with the proceeds retained (avoiding shareholder level gain).

Issues Upon Retention of  Proceeds & Corporate Status

“Lock-in” effect because of retention of stock until death to enable §1014 basis step-up.

Possible personal holding company status risk – requiring current distributions of income to the shareholders to avoid the PHC penalty tax.

Possible conversion of the corporation to S corporation status (but note S Corporation provision limitations, e.g., too much investment income after being a C corp).

Allocation of the Purchase Price for Tax Purposes

§1060 requires an allocation of the purchase price paid for the assets acquired for cash.

Cf., William v. McGowan case re sale of separate assets and not the sale of the "business" enterprise as one unit.

Cf., the sale of shares of a corporation.

This fragmentation approach requires a purchase price/tax basis allocation among the various assets acquired by purchaser.

Tax Basis Allocation Planning Objectives   p.367

Seller: If a tax rate differential exists, a tax planning objective will be to allocate proceeds to those capital assets producing LTCG;  but,  no income tax rate differential exists for the selling corporation (all 35%; but consider possible NOL & capital loss carryover utilization).

Buyer: Wants to allocate the purchase price to inventory and other short lived assets - to enable a prompt income tax deduction of these costs.

Approaches to Allocation of the Purchase Price

1. Proportionate methods, based on the relative fair market values of all assets.

2. Residual method - allocation (in order) to: (1) liquid assets,  (2) tangible assets, (3) intangible assets and, (4) goodwill (i.e., based on the increasing difficulty of valuation).  

§1060 implements the residual method.

Also, an allocation is made to a "covenant not to compete,” treated as an acquired asset.

Amortization of Intangibles
p.368

§197 - Intangible assets are amortizable over a 15 year period without regard to their actual "useful life.”

§197 assets defined:  customer lists, patents, know-how, licenses, franchises, etc., including goodwill and going concern value;  also, “covenants not to compete” (even though the period of the non-compete covenant is actually much shorter than 15 years).

Allocation of Price - §1060 Asset Classes           p.370

Class 1 assets:          Cash & cash equivalents.

Class 2 assets:          Marketable securities.

Class 3 assets:          Accounts receivable.

Class 4 assets:       Inventory.

Class 5 assets:       Tangible property.

Class 6 assets:       Intangibles (§197).

Class 7 assets:           Goodwill & going concern                                                    value (also §197 assets).

Agreement for Allocation of the Purchase Price?   p.370

1)  Should the buyer and seller agree on a purchase price allocation?

2)  What is the binding nature of such a price allocation agreement on the IRS?

3)  Can the taxpayer reject the agreement and report another allocation?  See the Danielson case (p. 367 & 370). 

§1060 specifies the binding nature of this agreement for the taxpayers.

See IRS Form 8594, “Asset Acquisition Statement.”

Stock Acquisitions     p.371

Purchaser buys stock of a corporation from the shareholders.  Structuring options are:

1.  Direct purchase from the shareholders.

Similar to a “B” tax-free reorganization.

What about non-consenting shareholders?

Answer:  No deal unless super majority is obtained, followed by a “squeeze-out” merger to eliminate the remaining shareholders.

continued

Stock Acquisitions          p.371
cont.

Reverse D cash merger:    

1)            Purchaser forms a transitory subsidiary which merges into Target; and

2)  Target shareholders receive cash (and notes) of purchaser. Similar to tax-free “Reverse Triangular Merger.” Shareholders treated as selling stock to P.

3)            Purchaser receives Target stock.  Target thereby becomes a subsidiary of P.

Stock Acquisitions -
Income Tax Results

Results of a direct stock purchase or a reverse subsidiary cash merger:

1.  Selling shareholders - capital gain treatment upon sale of shares (& §453?).

2.  The purchaser takes a cost basis for the acquired shares in acquired corporation.

Impact to the Target Corp.?  Unaffected, except should this transaction actually be treated as a deemed asset acquisition?

Kimbell-Diamond case
Asset Purchase?        p.372

Corporation acquired stock of another corporation with involuntary conversion proceeds. Objective was to acquire assets.

Issue re tax basis of the assets acquired by the corporate transferee in the liquidation. 

Tax basis for assets was higher than asset FMV.

Was this a tax-free liquidation of wholly owned subsidiary into parent corporation, under §332?  No, held: cash asset acquisition.

Code §338 - Elective Asset Purchase Tax Treatment

Can a corporate shareholder get a tax basis step-up for indirectly acquired assets without the liquidation of the acquired corporation?

If treated as a liquidation - therefore, gain recognition results as if the appreciated assets had been (i) distributed in kind,  and

(ii) re-infused into a new corporation (§351).

But, the stock basis to the purchasing shareholder disappears.

Code §338 Objectives
in Stock Purchase           p.374

1.  Same federal income tax effects as if:

  (i) a sale by Target corporation of its assets,  followed by

  (ii) a corporate liquidation into parent corp.

2.  The buyer gets a cost basis in the assets acquired from Target.

3.  Tax attributes of the Target disappear (e.g.,  the e&p account and the holding periods for the various assets).

Share Purchase and Tax Planning Structural Options

1.  No §338 election and the asset tax bases inside the corporation are unaffected.

2.  Not elect §338, but liquidate under §332 - historic asset tax bases move upstream.

3.  Elect §338 and treat the stock transaction as a taxable asset acquisition (keeping corp).

4.  Elect §338, treat the acquisition as an asset acquisition, and then liquidate the acquired corporation upstream (under §332).

Qualification Requirements for §338 Election        p.376

1. Acquisition by the purchasing corporation of an 80% interest in another corporation during a 12 month acquisition period, i.e., a  "qualified stock purchase” has occurred.

2. Buyer must make an irrevocable election.

3. Treated as a hypothetical sale for asset fair market values as of the acquisition date.  Note: The purchasing corporation has the tax payment obligation for recognized gain.

Defining the Sale Price -Deemed Fair Market Value

“Aggregate deemed sale price”  (ADSP) - the price allocable to the assets deemed sold.

Target treated as selling assets for the ADSP.

This deemed sale price includes: 

  1) price of acquired stock (as grossed-up, to approximate the real price if not all stock was held by the purchaser);  and,

  2) the acquired liabilities (Crane case), including income tax liability incurred in the sale.

Consider the similarity to an asset sale/purchase.

Adjusted Grossed-up Basis of Acquired Assets (AGUB)

Tax basis to new Target for the assets deemed acquired by Purchaser consists of:

1.  Grossed-up price of P's recently purchased stock  (need to gross-up where not all shares have been acquired).

2.  P’s actual basis in non-recently purchased stock (more than 12 months holding period).

3.  Target liabilities, including tax liabilities resulting from the deemed asset sale.

Allocation of the Adjusted Grossed-up Basis            p.379

The objective of determining this basis is to determine the amount to be allocated to the Target’s various assets after the deemed purchase.

This tax basis is allocated to the various assets, as specified in the §338(b)(5) income tax regulations, similar to the §1060 approach to allocating purchase price. 

Subsidiary Sale - Possible §338(h)(10) Election   p.381

Acquisition of the stock of a corp. subsidiary.

Parent corporation is the seller of the target subsidiary corp. stock (keeping the sub alive).

Possible §338(h)(10) election - Treat the  transaction as (1) if it were a sale of T's assets while a member of the seller's consolidated group,  and, (2) S then liquidated tax-free into Acquiring Parent under §332.  Objective: To avoid two corporate level gain tax events.

When Use §338(h)(10) Election?                    p.383

1)  Large potential gain on the stock, but limited gain on the assets (as if (a) an actual §332 liquidation into parent and then (b) a sale of the subsidiary’s assets).

2)  Consolidated group has losses from other operations which can be used to offset the gain realized on the deemed asset sale.

Comparison of Acquisition Methods                      p.384

Probable alternatives: 

                1) Sell stock with no Section 338 election

                2) Make Section 338 election if Target corp. has net operating losses to offset recognized gains.

Special treatment where Target corp. is a subsidiary of another corporation –

                Code §338(h)(10) election possibility with gain reported on Seller’s consolidated tax return. 

Problem (a)                      p.386
Asset Sale and Liquidation

T:  (1) adopts a plan of complete liquidation,

(2) sells (at the corporate level) its 1.1 mil. non-cash assets (subject to 300x liabilities) to P for 800x cash (corporate level tax on gain), 

(3) distributes the after-tax proceeds (how much?) to the shareholders in proportion to their stockholdings (A&B have LTCG).

Next question: Basis to P for acquired assets?

Problem (b)                      p.386
Asset Liquidating Distribution

T (i) adopts plan of liquidation; (ii) transfers all assets (& liabilities) to shareholders; and

(iii) shareholders sell the assets to P.

Tax effects of the distribution to (i) corporation - treatment under §336(a); and

(ii) Shareholders – treatment under §331.

Also, income tax basis effects to P?  Tax basis of assets is $1.1 million (allocated per §1060).

Problem (c)                      p.386
Installment Note Distribution

P paid T $200,000 in cash and $600,000 in notes with market rate of interest payable annually and the entire principal payable in five years.  Issues re the availability of installment sale treatment upon: (i) T’s asset sale, and (ii) T’s immediate distribution of notes.

Further, may A and B (C having a loss) report their §331(a) gain on the installment method upon the liquidation of Target? See §453(h).

Problem (d)                      p.386
Asset Sale & No Liquidation

Target sells all its assets to P.

T does not liquidate but invests the after-tax proceeds in publicly traded securities.

T recognizes $150,000 of ordinary income and $350,000 net LTCG.

Increase to T’s E&P by $325,000 ($500,000 gain less 175,000 tax liability on sale).

No distribution of proceeds and §331 tax is avoided at the shareholder level.  What tax risks?

Problem (e)                      p.386
Stock Purchase- §338 Election

P purchases all the stock of T for $800 per share and makes a Code §338 election.

Shareholders recognize capital gain (or loss) on their share sales.

P is eligible to make a §338 election since a

“qualified stock purchase” has occurred.

New T treated as a new corporation which purchased all the old T assets on the day after the acquisition date.                        continued

Problem (e), continued              p. 386

New T’s basis in its acquired assets:

1)  $800,000 grossed up basis

2)  $300,000 bank loan

3)  $175,000 tax paid

Total “adjusted grossed-up basis” is $1,275,000.

This $1,275,000 is allocable among T’s assets under Code §338(b)(5).

Stock sale & §338 election same as asset sale.

Problem (f)                       p.386
Stock Purchase & No §338 

P purchases all the stock of T for cash but does not make the Code §338 election.

T is not deemed to have sold the assets and, therefore, recognizes no current gain or loss.  

T's same asset bases and other T tax attributes remain as prior to the sale.

A knowledgeable buyer would not pay $1 million for the stock because of the future income tax liability upon T’s asset sales.

Problem (g)                      p.386
Choice of Sales Method?

Method of choice is a purchase of stock without a §338 election.

If (1) Target sells assets and is liquidated,

or (2)  Target shareholders sell stock and a Code §338 election is made,

the transaction generates tax at both the shareholder and the corporation level.

Do not make §338 election and do not pay current tax merely to get a tax basis step-up!

Problem (h)                      p.386
Target With NOL Carryover

If T had a NOL carryover of $600,000:

T could shelter the $500,000 of gain on the deemed sale by using the NOL to offset the sales gain.

A §338 election enables new T to take a stepped up basis to fair market value for assets without any income tax cost resulting from the election.

Could P otherwise use the NOL?   Possible §382 limit?

Problem (i)                       p.386
Target as Subsidiary

Assume T is a wholly owned subsidiary of S, Inc. and S has 200x adjusted basis in T stock. 

1) T distributes all of its assets (subject to the liability) to S in complete liquidation. Liquidation of T is tax-free to S (under §332) and to T (under §337).

2)  S then sells the assets to P. On the sale of assets S recognizes $150,000 ordinary income and $350,000 net LTCG.  P has cost basis for the various acquired assets.

Problem (j)                       p.386
Acquisition of Target Stock

P insists that the transaction must be structured as an acquisition of T stock.

T is the subsidiary of corporate Seller (S) and a member of a consolidated group.

§338(h)(10) permits S and P to jointly elect to treat the transaction as a deemed sale of T's assets in a single transaction, rather than as a sale by S of the T stock. A lesser gain amount realized then.

S recognizes no gain or loss on the stock sale.

Tax Policy Issues – Stock vs. Asset Purchases   p.387 

Should the repeal of the General Utilities doctrine be reversed in the corporate liquidation/takeover context? 

Does a double tax (corporate and shareholder) encourage a “lock-in effect”?

Detriment only to closely held businesses?

How provide any relief?  At shareholder or corporate level?  Integrated treatment?

15% tax rate on shareholders’ capital gain?

Tax Treatment of Acquisition Expenses

Choices for the buyer: 

1) Immediate deduction (ordinarily preferred)

2) Amortization (e.g., debt financing)

3) Frozen in the buyer’s tax basis until the disposition of the asset (e.g., stock cost).

Tax treatment depends on the acquired assets & financing arrangements.

Cf.:  Target’s expenses (hostile or friendly?).

Possible Application of INDOPCO Decision     p.388

Holding that takeover costs in friendly takeover were nondeductible capital expenses – since cost produced a “future benefit.” 

Cost need not be related to a specific asset.

Different treatment for fees to prevent a hostile tender offer – only seeking to preserve the entity -  until changing (?) to a friendly transaction.  Staley (7^th Cir) case,  p. 389.

Acquisitions & Cost Recovery         p.390

Failed acquisitions:  Costs incurred in investigating an acquisition and transaction fails or is abandoned – §165 enables a loss deduction.

The §263 (Indopco) regulations -  Costs incurred to complete a transaction must be capitalized and amortized. But, current deduction for White Knight costs and hostile takeover defense costs.

LBOs – Types of Transactions              p.391

Objectives: Reduce equity and increase debt which facilitates (1) deductible interest and (2) greater income per share (and greater value based on the “earnings per share” probable multiple).

                - To facilitate a “going private” transaction.

                - To facilitate a “bootstrap acquisition” of another enterprise.

                - To facilitate a stock tender offer.

Recall:  Chap. 3 re debt-equity considerations.

Further benefit available: dividends taxed at low 15% rate (to individuals) & DRD; cf., interest.

LBOs & Tax Limitations on Excessive Debt          p.409

1) “Junk bond” - Applicable high yield discount (AHYDO) obligations - §163(e)(5).

                See §163(e)(5)(F)(iii) –temporary suspension, through 2010 because of financial market crash. Notice 2010-11.

                & payment in kind (PIK) bonds

2)  Limit use of an NOL attributable to debt leveraging interest expense. §172(h).

3)  Earnings stripping limitation  - deductible interest paid to foreign lender.  Code §163(j).  But, carryover of excess deduction for future.

4)   Other remedies?  Limit on PIK bonds

5)   Classification issues – debt for tax & equity for GAAP?