Business Law 2

The Receipt of Cash in a Tax-free Reorganization
Robert R. Tufts

Robert R. Tufts is a Partner at Tufts Stephenson & Kasper, LLP in San Francisco. He is a Consulting Editor to Sales and Mergers of California Business (2002) Published by CEB. His e-mail address is rtufts@tsklaw.com

Introduction
Typically, in a tax-free reorganization, as defined in Section 368 of the Internal Revenue Code, an acquiring corporation will issue its stock to the selling corporation or its shareholders, without tax applying to the receipt of the stock by either. IRC §§354 and 361. The most commonly used transactions are a merger under §368(a)(1)(A), or a Type "A" Reorganization; a stock for stock exchange under §368(a)(1)(B), or a Type "B" Reorganization; a stock for assets exchange (followed by the selling corporation’s liquidation) under §368(a)(1)(C), or a Type "C" Reorganization; or a reverse merger under §368(a)(2)(E). In the latter, a transitory subsidiary of the acquiring corporation merges into the selling corporation, the subsidiary’s stock originally owned by the acquiring corporation, becomes the outstanding stock of the selling corporation and the selling corporation’s shareholders receive the acquiring corporation’s stock in cancellation of their own stock. Various uses of a subsidiary of the acquiring corporation in a Type A, B or C Reorganization are permitted under §368(a)(1)(B) and (C), §368(a)(2)(C) and (D) and §368(b). To assure tax-free treatment, compliance with the differing statutory and administrative requirements imposed upon the various types of acquisition transactions is vital. Several such requirements are not relevant to this discussion and are not reviewed.

Partial Payment in Cash and Related Issues
In some instances, the selling shareholders may want to receive property considerations (or "boot") other than the acquiring corporation’s stock, and usually the property desired is cash. (For the purpose of this article, "boot" property refers to cash). In this event, the attorney needs to resolve the following tax issues:

(1) To what extent may cash be issued, yet retain the tax-free treatment of the receipt of the stock involved?

(2) Assuming such tax-free treatment of the stock consideration, how will the cash portion received be taxed?

Extent of Permissible Cash
The amount of permissible cash consideration in conjunction with the issuance of stock to be issued and paid by the acquiring corporation depends upon the type of reorganization.

Permissible expenses
At the outset, certain payments and benefits provided by the acquiring corporation will not be treated as cash, or other "boot," and will not affect the tax-free status of the stock issued. Thus, the acquiring corporation’s payments for reorganization expenses, as legal fees, investment banking fees, transfer agent costs and proxy fees (Rev Rul 73-54, 1973-1 Cum Bull 187), costs of stock registration under the securities laws (Rev Rul 67-275, 1967-2 Cum Bull 142), and rounding off fractional shares (Rev Rul 66-365, 1966-2 Cum Bull 116), are not treated as cash or "boot" payments.

Type "A" Reorganization
The Type "A" Reorganization (merger) has no statutory prescriptions respecting the amount of cash that may be issued without violating the tax-free requirements for the stock receipt. A limitation, however, is imposed by the judicially and administratively created "continuity of interest" doctrine, which, in general terms, requires that the acquired shareholders continue a minimum equity interest in the acquiring corporation, following the acquisition, in all reorganizations. For purposes of receiving an advance ruling, the IRS requires that at least 50 percent of the consideration consist of stock. Rev Proc 77-37, 1977-2 Cum Bull 1568; Rev Proc §6-42, 1986-2 Cum Bull 722. The case law, however, has held that stock consideration as low as 38 percent (John A. Nelson Co. v Helvering (1935) 296 US 374) or 25 percent (Miller v Comm’r (6th Cir, 1936) 84 F2d 415) qualifies for tax-free treatment. It is understood that various tax attorneys have issued opinions conditioned upon a minimum 40 percent stock consideration, but each practitioner should seek an appropriate level of comfort.

Note that the Type "A" Reorganization does not specify the nature of the consideration, but the "continuity of interest" doctrine does impose a stock equity issuance requirement. The stock, however, may be preferred or common, or voting or nonvoting, although, if the stock is classified as "nonqualified preferred stock," it will not be treated as stock, unless it is exchanged for nonqualified preferred stock or for debt securities. IRC §§354(a)(2)(C)(i) and 351(g)(2).

Type "B" Reorganization
The Type "B" Reorganization (stock for stock exchange) requires that the consideration consist solely of the voting stock of the acquiring corporation (or of its parent corporation). Thus, no cash may be paid.

Type "C" Reorganization
In a Type C Reorganization (stock for assets exchange), cash may be issued to a maximum of 20 percent of the fair market value of the selling corporation’s assets, but that amount is reduced by the liabilities of the selling corporation assumed by the acquiring corporation. IRC §386(a)(2)(B). With that exception, the consideration must consist only of the voting stock of the acquiring corporation (or of its parent corporation). IRC §368(a)(1)(C). In many instances, the liabilities assumed exceed the 20 percent amount, resulting in no cash being permitted. Moreover, the vagaries attendant with fair market value and liabilities determinations should raise various caution signals before reliance is made upon the 20 percent test.

Reverse merger
The reverse merger transaction, under IRC §368(a)(2)(E), requires that voting stock of the parent (acquiring) corporation is exchanged for control (80 percent) of the stock of the acquired corporation. Thus, up to 20 percent of the stock of the acquired corporation may be exchanged for cash.

Summary
The following chart summarizes use of permissible amount of cash (as a percentage of the total consideration) that will retain tax-free treatment of stock consideration received:

Tax Treatment of Cash Received
Once the tax-free nature of the stock received is confirmed, the tax treatment of the cash received must be determined. As to any recipient corporation, in a Type A or C Reorganization, cash payments will not be taxable to it, if the total cash is distributed to its shareholders. IRC §361(b). In addition, whether the cash received by the shareholders, either from their corporation or directly in the transaction, is treated as a capital gain or as ordinary income (as a dividend) must be determined under IRC §356. While most recipient individual shareholders would prefer capital gains treatment, corporate recipient shareholders may prefer dividend treatment to benefit from the IRC §243 dividend deduction.

Comm’r v Clark (1989)
In Comm’r v Clark (1989) 489 US 726, 103 L Ed 2d 753, 109 S Ct 1455, the Supreme Court, by its interpretation of IRC §356(a)(2), applied the IRC §302 dividend tests to determine the capital gain/dividend treatment. The Court found the cash received in the tax-free triangular merger was capital gain and reached its conclusion by applying the §302 tests as if the acquiring corporation had made a redemption of that portion of the stock represented by the cash payment.

When is cash treated as capital gain?
Under Clark, in general, cash received by a shareholder will be treated as capital gain, if any one of the following tests (with pertinent attribution rules applied) is met:

• Under IRC §302(b)(2) (substantially disproportionate redemption), capital gain treatment applies if the recipient’s actual stock percentage in the acquiring corporation is less than 80 percent of that percentage the recipient would have received if stock were issued instead of cash. As a simple example, assume that there is one selling shareholder-recipient and that the acquiring corporation has 100 shares outstanding after the acquisition. If the recipient would have received 20 shares were there no cash, resulting in the acquiring corporation having 105 shares outstanding, but actually received 15 shares (the other 5 shares replaced by cash), then capital gain applies, as 20 of 105 shares (representing the stock numbers without the cash) is 19.05 percent and 15 of 100 shares (the numbers with the cash) is 15 percent, which 15 percent is less than 80 percent of 19.05 percent (or 15.24 percent). This test is measured by voting stock percentages, certain constructive ownership rules for related and affiliated parties are applied, and the test is not available if, after the transaction, the recipient owns 50 percent or more of the stock.

• Under IRC §302(b)(1) (redemption not essentially equivalent to dividends), the cash received by a shareholder will be treated as a capital gain if the deemed redemption is not essentially equivalent to a dividend. This test is much less certain than the mathematical one described above and must be measured under all of the facts and circumstances. In U.S. v Davis (1970) 397 US 301, 25 L Ed 323, 90 S Ct 1041, the Supreme Court held that the standard was whether a meaningful redemption occurred. A significant reduction in voting power should qualify, and, for holdings involving minuscule percentages, particularly in public corporations, capital gain should apply. See, Fireoved v. U.S. (3d Cir 1972) 462 F2d 1281; Rev Rul 76-385, 1976-2 Cum Bull 92; Rev Rul 75-502, 1975-2 Cum Bull 111.

• Under IRC §356(a)(2), boot may be taxable as a dividend only to the extent that it represents a shareholder’s ratable share of earnings and profits, which includes either accumulated or current earnings and profits. Does this measurement relate to the acquiring or the acquired corporation’s financial statements? Although the Clark case addressed only the IRC §302(b)(2) test and not earnings and profits, its use of the acquiring corporation’s stock structure may imply that the acquiring corporation’s status (after the acquisition) is an appropriate consideration. In any event, to the extent that the pertinent earnings and profits are nonexistent or too small for concern, dividend treatment may not be a problem.

Closing Comment
For many years, the author has deemed it ludicrous that the amount of cash (or other "boot") allowed in a tax-free stock transaction is predicated by the type of the transaction, when all of the relevant transactions result in the identical substantive net end effect. Such varying treatment has resulted from the historic hodge-podge development of §368 of the Internal Revenue Code, and various attempts to modernize and coordinate that Section have failed. Legislative reform would be welcomed.

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