An Introduction to Type B Tax-Free Corporate Reorganizations

In a Type B reorganization, a purchasing corporation or (“P”) acquires a controlling interest in target corporation (“T”) from the T shareholders solely in exchange for all or part of P’s voting stock. IRC Section 368(a)(1)(B). Two significant elements of the Type B reorganization should be understood. First, the purchasing corporation must have control over the target corporation immediately after the stock acquisition from the target shareholders. “Control,” for purposes of Section 368, generally requires ownership by the acquiring corporation of “at least 80 percent of the total combined voting power of all classes of stock entitled to vote” and “at least 80 percent of the total number of shares of all other classes of stock.” IRC Section 368(a)(1)(B). Second, the Type B reorganization provides explicit rules regarding the type of consideration that may be used to compensate target shareholders of their stock. The target shareholders must exchange T stock solely for all or part of the acquiring corporation’s voting stock or solely for all or part of the voting stock of the acquiring corporation’s parent. Thus, the only consideration that may be used in a Type B reorganization is voting stock of the acquiring corporation or parent. One minor exception to this rule is that the “solely for voting stock’ requirement…will not be violated where the cash paid by the acquiring corporation is in lieu of fractional share interests to which the shareholders are entitled, representing merely a mechanical rounding-off of the fractions in the exchange, and is not separately bargained for consideration.” The stock used in a Type B reorganization may be either common or preferred, as long as the stock is voting stock.

Given the strict “solely for voting stock” restriction applied to Type B reorganizations, acquiring corporations must be creative in dealing with minority or nonparticipating target corporation shareholders. Any cash or notes paid to any shareholders may cause the transaction to violate the requirements of Section 368(a)(1)(B). Sometimes shareholders who do not wish to participate in the acquisition transaction is a redemption of the nonparticipating shareholder’s interests by the target corporation. If the target corporation redeems stock from some of its shareholders prior to the reorganization using its own funds or borrowed funds, a subsequent Type B stock-for-stock exchange will still likely qualify.

A more difficult question arises if the target corporation’s shareholders guaranteed the target debts and the debts are later paid off by the acquiring corporation. In such a case, the relief from a guarantor obligation paid by the acquiring corporation may be considered additional consideration other than voting stock. As long as the acquiring corporation’s payment of the debt was not a condition for the exchange of stock, the payment of debt may be characterized as a separate transaction for purposes of qualifying for Type B reorganization treatment. Rev. Rul. 79-4, 1979-1 C.B. 150; Rev. Rul. 79-89, 1979-1 C.B. 152.

Tax Consequences of Type B Reorganizations

In most Type B reorganizations, the purchasing corporation (P) acquires 100% of the stock of the target corporation (T) from T’s shareholders entirely in exchange for P voting stock in a single transaction. Since the T shareholders exchanged stock in one corporation a party to a reorganization (T) solely for stock in another corporation a party to a reorganization (P), they will not report gain or loss on the exchange. IRC Section 354(a)(1). Under Section 358(a)(1) of the Internal Revenue Code, the T shareholders’ basis in P stock received in the exchange will be the same basis that they previously had in their T shares- a substituted basis. As a result of its acquisition of all of the T stock, P is the new owner of T, now a wholly owned P subsidiary. Under Section 1032(a), P has no gain or loss upon the receipt of T stock in exchange for its own stock. P’s basis in its new T shares will be the same basis the old T shareholders previously had in their T shares pursuant to Section 362(b).

A Type B share-for-share acquisition may potentially be a tax-free acquisition for U.S. tax purposes as long as there is no consideration other than the voting shares and the acquiring corporation has control of the target corporation immediately after the transaction.

It should be noted that although many Type B reorganizations involve a purchasing company acquiring all the stock of a target corporation, an acquiring corporation does not necessarily need to purchase all of its shares in the acquiring corporation at one time to qualify for a Type B reorganization.

Plan of Reorganization

A Type B reorganization must occur pursuant to a plan in order to qualify as a reorganization under Section 368. Treas. Reg. Section 1.368-1(c), 1.368-2(g). Prior to implementing a reorganization, a written plan should be entered into by all shareholders.

Conclusion

This article is intended to provide the reader with a basic understanding of basic tax-free corporate reorganization principles. It should be evident from this article that this is a complicated area of tax law that requires advance planning. If you are considering utilizing a tax-free corporate reorganization as a planning option, it is crucial that you consult with a qualified tax attorney to review your particular circumstances.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.