Common Use for a Forward Triangular Merger

One standard method used is a forward triangular merger, or as some people refer to it, an indirect merger under Section 368(a)(2)(D) of the Internal Revenue Code. This type of merger is beneficial when a parent corporation is looking to purchase or acquire another entity, known as the target corporation, but is hesitant to inherit any liabilities or other negative aspects of the target. 

In a traditional A reorganization under Section 368(a)(1)(A), the target corporation merges directly with the acquirer. At this point, the acquirer is responsible for all liabilities associated with the target. Therefore, the purchasing corporation may often structure the transaction as a forward triangular merger rather than a traditional A merger by using a subsidiary to protect against any known or unknown liabilities the target may have. A Denver business attorney has prepared the article below to provide additional information on a forward triangular reorganization.

Where Forward Triangular Mergers are Prevalent

Forward triangular mergers are also prevalent where entities plan to use a significant amount of cash, or boot, in the deal.

Unlike reverse triangular mergers, forward triangular mergers have greater flexibility in the amount of boot that may be used in the transaction since the 80% voting requirement does not apply under Section 368(a)(2)(D) for purposes of consideration.

For example, consider Corporation P, which would like to acquire Corporation T. However, Corporation T has a massive liability on its books that Corporation P is hesitant to accept. Corporation P will first set up another entity called a subsidiary. The Corporation T is the target corporation and will then merge into a subsidiary, rather than Corporation P, for consideration provided by Corporation P. The target corporation ceases to exist and thereby liquidates. At this point, the only surviving corporation in the merger is the subsidiary. Thus, the shareholders of Corporation T will ultimately receive the consideration provided by Corporation P. This structuring allows the target’s liabilities to remain isolated within a subsidiary while simultaneously allowing the purchasing corporation to acquire the target, Corporation T. 

Note that even though this may be considered a tax-free reorganization, there may still be tax consequences to the target corporation’s shareholders upon liquidation, depending on the amount and type of consideration used in the transaction (See Internal Revenue Code Section 354).

Three Critical Things to Remember in a Forward Triangular Reorganization

 First, this transaction only qualifies for tax-free treatment if it would have satisfied the requirements of a traditional A reorganization under Section 368(a)(1)(A) had the merger been done directly between the purchasing corporation and the target corporation. This requires evaluating the transaction as if the subsidiary were not used. If the target merged into the purchasing corporation and still satisfied the A reorg requirements, then this would help Section 368(a)(2)(D)(ii). This requires a statutory merger and, even more importantly, continuity of interest requirements.

Second, in Section 368(a)(2)(D) reorganization, no stock of the wholly-owned subsidiary entity may be used as part of the consideration in the transaction. The only stock acquisition of the purchasing corporation, Corporation P in the above example, may be used. However, other reviews from the subsidiary may be provided, such as cash. Suppose the stock of the wholly-owned subsidiary corporation is used. In that case, it will fail the requirements of Section 368(a)(2)(D) and may result in a taxable transaction unless it satisfies another reorganization structure under Section 368.

Finally, according to the treasury regulations under 1.368-2, the purchasing corporation must substantially acquire all of the target’s assets by using the subsidiary.

Forward triangular reorganizations optimize restructuring without facing tax consequences while removing the transfer of a target’s liabilities to a parent corporation. Depending on the type and value of consideration available, a forward triangular reorganization may be the best restructuring tool for your merger.

Key Takeaways

• A forward triangular merger is a form of reorganization that provides a means to avoid the potential tax consequences of acquiring a company with substantial liabilities. It accomplishes this by merging the target with a subsidiary of the acquiring corporation. The target corporation ceases to exist and is liquidated. The sole remaining corporation is the subsidiary.
• The IRS considers a forward triangular merger to be a reorganization because it satisfies the definition of a reorganization found in Section 368(a).
• However, the IRS does not allow a forward triangular merger to qualify as a tax-free reorganizational event unless the following conditions are met:
  • The acquiring company must pay fair market value for the target company’s assets.
  • The target company continues to operate after the acquisition.
  • The acquired company ceases to exist and is liquidated.

You can contact The McGuire Law Firm to discuss your business or tax-related issues with a Denver business attorney or tax attorney. 

Are you considering establishing a corporation? Perhaps you have considered contributing property as consideration for your interest while another member would like to contribute cash. You may even find yourself in a situation where a third person would like to donate his services in exchange for an interest in the corporation. Each of these situations can have significant tax consequences, so you must plan to maximize the benefit of the formation. This article was drafted by a Denver Business Attorney and Denver tax attorney to provide information related to the contribution of a property when you form a corporation.

Features of IRC Section §351 

One of the most attractive features of forming a corporation is in §351 of the tax code. This provision allows persons to contribute property to a corporation without recognizing gain if done correctly. 

Alternatively, §351 may stop some members from recognizing a loss, which may be a negative factor. As a general rule, the exchange of stock for property creates a §1001 event taxable. However, Congress wanted to make a way where taxpayers could still contribute property to a corporation without getting hit with a huge tax liability. This resulted in §351, but this code section does create requirements for it to apply.

Requirements in IRC Section §351 

Many requirements must be met, and the whole transaction may trigger immediate tax consequences if the conditions are not met. Remember that simply contributing property to a corporation does not eliminate the gain nor create a step-up basis, similar to §1014. Instead, the tax consequences will linger in the background until any realized gains or losses must be recognized in the future. 

Section §351 of the Internal Revenue Code applies only to the contribution of property, which does not include services. However, there are exceptions, but you must be careful when creating a corporation with someone who plans to provide any services in their interest. The contribution of services may completely ruin a §351 transaction, depending on the value.

Requirements in IRC Section §368(c)

Under Section §368(c) of the Internal Revenue Code, members must also acquire control of the corporation’s formation. This section requires that the members contributing to the property possess 80% of the voting power and 80% of shares of all other classes of stock issued by the corporation.

Non-Recognition and IRC Section §351

Additionally, the non-recognition portion of Internal Revenue Code Section §351 applies only to situations where the members receive solely stock for their interest. However, in cases where members receive boot, or something other than stock, in exchange for their contribution, they may recognize gain or loss. Receiving something different than stock does not always ruin the §351 transaction entirely, but it may trigger profit or loss, which could defeat the entire purpose of the transaction.

Liabilities and IRC Section §351

Liabilities also create issues with IRC Section §351 transactions where the corporation assumes the debt. It is not uncommon to have machines or other equipment carrying a note or obligation to consider one’s interest. As mentioned above, the courts did not want to discourage taxpayers from transferring property to a corporation simply because a liability encumbered it. Instead, the whole purpose of §351 was to encourage entity formations.

As a general rule, if liabilities are incurred on a property for legitimate business purposes, these will not trigger gain or loss upon formation. Instead, the penalties will be accounted for on the member’s basis in the corporation. However, there is an exception where the liabilities exceed the basis of the property. Under §357(c), there will be gain recognition, but only to the extent that the liabilities exceed the basis.

Forming a corporation can have many benefits, but you must consider all the contributions made before determining the overall tax consequences to the newly formed corporation and its shareholders. 

In Summary

Consider speaking with a Denver business attorney and Denver tax attorney regarding the business and tax implications of forming a corporation and contributing property to the corporation. Planning the contributions in the beginning can help avoid significant tax liability in the future.

You can contact The McGuire Law Firm to speak with a Denver Business Attorney or Denver Tax attorney. Call us at 720-833-7705 or John@jmtaxlaw.com