Transactions subsequent to a "B" reorganization.

Inconjunction with a "B" reorganization, the acquiring corporation or the target corporation's shareholders may undertake a transaction or a step that is considered part of the overall plan of reorganization. Listed below are 20 such transactions that may occur for business or economic reasons and the tax effect of each transaction on the qualification of the "B" reorganization.

In each instance, assume that the subsequent transaction (whether it takes place six days or six months after the "B" reorganization) is "part of the plan." No attempt is made to determine what is "part of a plan" or even what standard (end-result test, binding commitment test or independent significance test) should be applied in making that determination. Rather, the subsequent step is analyzed as if it took place contemporaneously with the reorganization and would be treated by the IRS as part of the overall plan. Similarly, assume that the shareholders of the target or the acquiring corporation, acting unilaterally, can cause their step (event) to be treated as part of the overall plan of reorganization.

The list below assumes that only one of the enumerated events take' place. In other words, each event is mutually exclusive of any other event; one should not extract the proposition that two events are innocuous because each event analyzed separately is innocuous.

In each situation, the acquiring corporation (AC) has just acquired, solely for its voting stock, all of the outstanding stock of the target corporation (T), a previously unrelated C corporation. Every shareholder of T is an individual. S is an existing wholly owned subsidiary of AC and S1 is a wholly owned subsidiary of S. All corporations and shareholders are U.S. persons. AC may or may not file a consolidated return. The comments below relate solely to the continuing validity of the "B" reorganization.

Subsequent Events Undertaken at the Behest of the Acquiring Corporation

1. T merges into AC: A "B" reorganization followed by an upstream merger (pursuant to state or Federal law) of T into the acquiring parent corporation (AC) is treated as a direct merger of T into AC. As a result, the transaction is not a "B" reorganization, but instead is a qualifying "A" merger. A transaction that would meet the qualifications of a "B" reorganization would automatically meet the qualifications of an "A" reorganization.

2. T liquidates into AC: The liquidation of T (other than via a state or Federal merger statute) prevents any part of the transaction from qualifying as a "B" reorganization. A transaction in which AC acquires T's stock only to give up that stock and control of T via liquidation has no substance. If, however, T's liquidation into AC qualifies as a "C" reorganization, the entire transaction will qualify as a tax-free reorganization; see Rev. Ruls. 67-274 and 76-123. The additional impediment to qualification as a "C" reorganization is the "substantially all" test, which may not be satisfied if T made a significant distribution of assets to its historical shareholders (via dividend, redemption or spin-off) prior to the acquisition by AC. Although some practitioners believe that two tax-free steps ("B" and a Sec. 332 liquidation) should not be recast into a failed "C" reorganization, there is no precedent to prove or disprove this hypothesis.

3. T merges into S: The entire transaction will be treated as a merger of T into S. AC's ownership of the T stock is transitory and ignored. As a result, the transaction is tested as a triangular merger under Sec. 368(a)(1)(A) and (2)(D). Application of Sec. 368(a)(2)(D) brings the "substantially all" requirement into play, with the same potential consequences described in #2.

4. T transfers all of its assets to S and dissolves: The transaction will be treated as a triangular "C" reorganization (see Rev. Rul. 78-130), and thus will need to satisfy the "substantially all" test.

5. S merges into T: Because T's corporate integrity has not been infringed and AC continues to own all of T after the merger, the merger has no adverse effect on the "B" reorganization.

6. AC transfers all of the stock of T to S: The drop-down of stock is expressly authorized by Sec. 368(a)(2)(C) and will have no adverse effect on the "B" reorganization.

7. AC transfers all of the T stock to S; S then transfers all of the T stock to S1: Although Sec. 368(a)(2)(C) expressly authorizes only a single drop-down, double (and even further) transfers to lower-tier controlled subsidiaries have historically been permitted by the Service; see Rev. Rul. 64-73 and Letter Ruling 9536032.

8. AC transfers all of the T stock to S; T then merges into S1: This transaction could be viewed as one in which T merged directly into S1 in exchange for AC stock. This view could result in a taxable transaction, because AC is the grandparent (as opposed to parent) of S1, and use of grandparent stock in a reorganization is not explicitly authorized by the Code. Nevertheless, the IRS has taken a pragmatic approach to this problem (e.g., Letter Rulings 9151036, 9532029 and 9620013), and allowed the use of grandparent stock.

9. AC transfers all of the T stock to S; AC then transfers all of the S stock to a newly created wholly owned subsidiary of AC (NEWCO): Although the net effect of all of these steps is that S acquired the T stock in exchange for stock of S's grandparent (AC), Prop. Regs. Sec. 1.368-1(f)(2) permits this type of transfer and the "B" reorganization is not adversely affected.

10. T has three businesses of equal size and discontinues two of them: Continuity of business enterprise is satisfied even if two of three businesses are discontinued; see Regs. Sec. 1.368-1(b)(5), Example (1).

11. T has three businesses of equal size and sells the assets of two of them to an unrelated third party for cash: If two out of three businesses can be discontinued, two out of three businesses can be sold without adversely affecting the "B" reorganization.

12. T has three businesses of equal size and transfers two of them to a controlled (80% or more owned) or noncontrolled (less than 80% owned) corporation in exchange for a stock interest: If two out of three businesses can be discontinued, two out of three businesses can be transferred to a controlled or noncontrolled subsidiary without adversely affecting the "B" reorganization.

13. AC disposes of 21% (or more) of the stock of T to a third party: The loss of control by AC in T voids the "B" reorganization.

14. AC distributes 21% (or more) of the stock of T to AC's shareholder, corporation P: Because there are no attribution rules in determining Sec. 368(c) control, the loss of control by AC in T voids the "B" reorganization.

15. Third-party investor (e.g., underwriter, IPO shareholder, acquired corporation in a merger) transfers assets to T for newly issued T stock representing 21% of T: The loss of control by AC in T voids the "B" reorganization.

Subsequent Events Undertaken at the Behest of the Target Shareholders

16. T shareholders dispose of 100% of their AC stock received in the reorganization to a third party: The "solely for voting stock" requirement in a "B" reorganization is limited to what the acquiring corporation can give in the reorganization. Dispositions by the T shareholders to third parties do not adversely affect the solely-for-voting-stock-requirement and do not adversely affect continuity of shareholder interest; see Prop. Regs. Sec. 1.368-1(e).

17. One T shareholder has one share of newly received AC voting stock redeemed by AC for cash, or sells one share of newly received AC voting stock to S or S1 for cash: The redemption will void the "B" reorganization, because the "solely for voting stock" requirement is not satisfied. The result will be the same if one share of newly received stock is sold to S or S1 for cash; see Rev. Rul. 85-139.

18. All of the T shareholders pledge their AC stock to a third party and receive cash: A pledge is not a "disposition" and therefore should not vitiate continuity of shareholder interest. Although there is no direct precedent, most practitioners also believe that a "short sale" will not adversely affect a "B" reorganization.

19. All of the T shareholders transfer their AC stock to a holding company or a trust for the benefit of a family member: Although technically, the attribution rules do not apply in measuring a disposition for continuity of interest purposes, it is "more likely than not" that such a transfer will not adversely affect the "B" reorganization; see Rev. Rul. 84-30, Letter Ruling 8911067 and Olson, 49 TC 84 (1967), acq.

20. One or more T shareholders exchanges (transfers or sells) services, a covenant not to compete, land, T warrants, T options, T debentures and/or a related corporation to AC for cash: The "solely for voting stock" requirement precludes cash consideration for T stock in the "B" reorganization. In general, the receipt by the T shareholders of cash for a nonstock interest will not invalidate the "B" reorganization. It is imperative, however, that the cash given by AC be equal to (or less than) the value of the nonstock considered transferred by the T shareholders. Any excess could be deemed to have been paid for the T stock and could violate the "solely for voting stock" requirement. Furthermore, any T debt must be true debt and not equity.

From Gilbert D. Bloom, CPA, J.D., LL.M., Washington, D.C.