As a general rule, the sale of assets or stock usually results in a taxable transaction to corporations. However, reorganizations create ways for entities to limit or reduce tax liabilities simply by restructuring the overall transaction. Tax free reorganizations should not be confused with eliminating tax entirely. Rather, tax free reorganizations prevent an immediate tax liability, but the tax will ultimately come due at a future point in time. These structuring techniques simply help to defer tax. The article below has been prepared by a Denver business attorney and tax attorney to discuss a few Issues related to tax free reorganizations.
What are the types of reorganizations?
There are a wide variety of reorganizations found in §368 of the Internal Revenue Code including A, B, C, D, spinoffs, split-offs, and others. Reorganizations can also be classified as either acquisitive reorganizations or divisive reorganizations. Acquisitive reorganizations result in one corporation acquiring another while a divisive reorganization results in a split of a current entity. This article focuses on the requirements and benefits of A reorgs which fall under an acquisitive reorganization.
How does an A Reorganization work?
First, you must have both an acquiring corporation and a target corporation. The acquiring corporation will pay consideration to the target corporation. Next, the target corporation liquidates and distributes the consideration from the acquiring corporation to the target’s shareholders. At this point, the target corporation no longer exists, but the shareholders of the target now retain an interest in the acquiring corporation.
What are the requirements of an A reorganization?
There are certain requirements for the consideration used to qualify as an A reorganization. First, under §368(a)(1)(A), a transaction may not qualify unless there is a merger. Second, one of the most notable requirements for an A reorganization is the continuity of interest requirement. The policy behind tax free treatment for a reorganization stems from the retained interest in the corporation. In other words, a reorganization merely restructures the corporate entities. The idea is that if shareholders continue to hold an interest in the entity involved in the transaction, then there should not be immediate tax consequences.
Courts have held that 40% of the consideration paid by the acquiring corporation must constitute stock of the acquiring corporation. Unlike other reorganizations in Section 368 of the tax code, the 40% requirement may be satisfied using either voting stock or nonvoting stock.
For example, assume there is Corporation A which plans to acquire Corporation B for $150,000. At least $60,000 of the consideration must be stock of Corporation A, and the remaining $90,000 may be something else, such as cash or property. Corporation B will receive the $150,000 from Corporation A and will then liquidate. The consideration provided by Corporation A will be distributed to the shareholders in what is considered a tax-free transaction to both Corporation A and B. Typically, while the corporate entities may enjoy tax deferral, there may still be taxable gains to shareholders depending on the consideration provided in the transaction. Depending on whether the $90,000 of consideration is stock or other property, there may be tax consequences to the shareholders of Corporation B under §354 of the tax code.
Keep in mind that tax-free is a loose term when discussing reorganizations. Only certain types of consideration result in tax-free treatment and to certain parties. You should always consult with your business attorney and/or tax attorney when considering a tax-free reorganization.
You can speak with a Denver tax attorney or business attorney by contacting The McGuire Law firm at 720-833-7705.