Busting a "B": why and how, Letter Ruling 9508009.

There may be situations, under the proper circumstances and for the proper motivation, in which it is better that a reorganization fail to qualify as tax-free. The easiest way to do this is merely to issue an amount of cash sufficient to destroy continuity of shareholder interest. But suppose the acquiring corporation is short of cash or for some other reason does not want to use that amount of cash to defeat the reorganization. The acquiring corporation can nevertheless defeat reorganization treatment by structuring the transaction as a "B" reorganization (i.e., acquire all of the stock of the target corporation in exchange for acquiring stock) and by adding a modicum of cash. The "solely for stock" requirement in a "B" reorganization affords no leeway and the stock-for-stock exchange will result in a taxable stock swap.

Who would want to do a near "B"? In Letter Ruling 9508009, the parties apparently had a motive. Pursuant to an exchange agreement, Acquiring acquired all of the shares of Target in exchange for newly issued Acquiring voting common stock. Under the terms of the exchange agreement, Acquiring then paid cash to some of the Target shareholders as reimbursement for their expenses (investment, estate planning, legal and accounting advice) in connection with the stock acquisition. Under Rev. Rul. 73-54, such payments will scuttle a "B" reorganization, especially when the cash payments are made directly to the Target shareholders. In Letter Ruling 9508009, the IRS determined that the stock exchange did not qualify as a reorganization within the meaning of Sec. 368(a) (1) (B). As a result, Acquiring's stock purchase was a qualified stock purchase within the meaning of Sec. 338(d) (3) and (h) (3).

Letter Ruling 9508009 may be the first letter ruling to find a reorganization lacking solely because of Acquiring's payment of Target shareholder expenses; cf. Letter Ruling 8829064 (transfer in exchange solely for voting stock accompanied by Acquiring's payment of Target expenses treated as a valid Sec. 351 transfer). That is noteworthy, but the letter ruling also contains an interesting unspoken determination. The facts indicate that immediately prior to the stock swap, certain Target option holders exercised their options and acquired Target stock. The former option holders (now shareholders of Target) then sold their newly issued Target stock to Acquiring for cash. Although one could conclude that cash given to the erstwhile option holders who became shareholders is sufficient to defeat the "B" reorganization, the Service concluded that only the payment of Target shareholder expenses caused that defeat. Apparently, the IRS reasoned that the option holders' transitory ownership of the Target stock was best viewed as if the option holders sold options to Acquiring for cash. Viewed in that way, the sale would not defeat the "B" reorganization; see Rev. Rul. 69-91. This treatment of the options seems wrong, however, in light of GCMs 36040 and 36041, in which the Service determined that convertible debentures exercised immediately before a "B" reorganization (so that the new shareholders in Target participated in the reorganization and received Acquiring stock) count for continuity of interest purposes. If such recently acquired shares count for continuity purposes, it follows that cash paid to former option/share holders should invalidate a reorganization.

Finally, a word about motivations. Acquiring corporations might readily seek a taxable transaction in order to achieve a basis step-up, but why would a seller consent to a busted "B"? In other words, why would a seller agree to receive solely stock and nevertheless pay tax? There are at least three situations in which the seller might agree to do so. First, the seller may have a realized loss in the target shares. Second, the seller may demand and receive compensation (extra Acquiring stock) for Acquiring's favorable result. Third, the seller may not be a U.S. person, and therefore may not incur U.S. income taxes on the stock exchange. This was at least partially the case in Letter Ruling 9508009.

Letter Ruling 9508009 is a timely reminder that taxpayers occasionally want to avoid reorganization treatment. It also reaffirms that a "B" can be avoided by paying Target shareholder expenses. Finally, the ruling suggests that a pre-reorganization transaction (exercise of options and sale of shares) that might have worried advisers trying to achieve a tax-free reorganization might not be a cause for concern.

FROM GILBERT D. BLOOM, CPA, J.D., LL.M., WASHINGTON, D.C.