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Deferring Gain on the Receipt of Boot in a Reorganization


5/9/16

Synopsis

Taxpayers involved in a reorganization under IRC §368 (other than “B” reorganizations) often receive a mix of consideration consisting of stock in the acquisition company and cash boot (or other non-stock consideration). If the taxpayer realizes gain in the transaction, and receives boot as part of the overall consideration, the taxpayer is generally required to recognize gain to the extent of the boot received.

Issue

The regulations under IRC §356 and §358 provide an opportunity for taxpayers to reduce or eliminate this gain. The regulations allow a taxpayer to allocate the consideration received to specific classes or blocks of stock, provided the terms of the agreement provide for such an allocation and such terms are economically reasonable; see, Reg. §§1.356-1(b) and 1.358-2(a)(2)(ii). In the absence of a specific allocation in the  agreement,  the regulations stipulate that the consideration received is allocated pro-rata  to the stock surrendered on the basis of the fair market value of the stock surrendered; see, Reg. §§1.356-1(b) and 1.358-2(a)(2)(ii).

The tax benefit of specifically allocating the consideration received is particularly evident in cases where  the target shareholders have different bases in the stock surrendered. This can arise in cases where the shareholder has recently acquired shares in a taxable acquisition, or the shareholder has recently inherited shares, or the shareholder holds different classes of stock.

Example: General rule, pro-rata allocation

Mr. T holds 20 shares of Class A stock in Corporation X. The Class A stock has a tax basis of $1/share. Mr. T also holds 20 shares of Class B stock. The Class B stock has a tax basis of $6/share. Corporation Y will acquire Corporation X in an “A” reorganization for stock and cash. On the date of the merger, Class A stock has a fair market value of $10/share and Class B stock has a fair market value of $10/share. Under the plan of reorganization, Mr. T surrenders all of his Corporation X shares for 40 shares of Corporation Y stock and $200 cash. On the date of the exchange, each share of Corporation Y stock has a fair market value of $5/share. The terms of the reorganization plan do not specify that Corporation Y stock or cash is allocated to particular shares or classes of Corporation X stock.

Under the default rule in the regulations, Mr. T receives 20 shares of Corporation Y stock and $100 cash in exchange for his Class A stock; and Mr. T receives 20 shares of Corporation Y stock and $100 cash in exchange for his Class B stock. As a result, Mr. T will realize gain of $180 on his Class A shares, and he will recognize gain on the Class A shares of $100. Mr. T will realize gain of $80 on his Class B shares, and he will recognize gain on the Class B shares of $80.

Example: Allocation of consideration per exchange agreement

Assume in the above example the plan of reorganization specified that the Class A shares will be exchanged for shares of Corporation Y, and the Class B shares will be exchanged for cash; and these  terms  are economically  reasonable. In such a case, Mr. T realizes gain of $180 on his Class A shares, none of which is recognized. Mr. T realizes gain of $80 on his Class B shares, all of which is recognized. Hence, with the simple step of including in the plan of reorganization an allocation of consideration, Mr. T would be able to defer $100 of gain.

The failure to make an allocation of  consideration in a reorganization  was an important element in a recent Tax Court decision; see, Tseytin v. Com’r,  T.C. Memo 2015-247 (Dec. 28, 2015). In this case, the majority shareholder (75%)  bought out the minority shareholder (25%) for $14 million. The majority shareholder’s basis in his original shares was zero. After the purchase, the company was acquired in an “A” reorganization for $53.9 million. The consideration  consisted of stock worth  $30.8 million and cash of $23.1 million. In the absence of an allocation in the agreement, the taxpayer was forced to allocate the stock and cash received proportionally to the two blocks of stock he held, based on relative  fair market values. Consequently, the taxpayer allocated `$5.775 million cash to his high basis shares,  and $17.325 million cash to his zero basis s hares. As a result, the taxpayer recognized gain on the exchange of his zero basis stock  in the amount of  $17.325 million. (Note that the taxpayer realized a loss on the exchange of his  high basis block of stock. This loss was not deductible.)

If the taxpayer in Tseytin was advised to take advantage of the allocation rules provided in the regulations, he could have included terms in the plan of reorganization regarding allocation of consideration, and he could have allocated substantially more cash to his high basis shares. Any additional cash allocated to his high basis shares would reduce his gain dollar-for-dollar.

What Does CohnReznick Think?
When representing target corporations in a reorganization it is important to recognize  any  stock basis differences in the shareholder group, and to be aware of the ability to include provisions in the plan of reorganization regarding allocation of consideration. Note that the taxpayer in Tseytin could easily fit within our client base.

Contact

For more information, please contact Laurence Karst, Director, at laurence.karst@cohnreznick.com or 646-762-3020.

Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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