Taxable Acquisitions

• Pages: 235-273
• Author: Howard E. Abrams,Don A. Leatherman,Thomas J. Brennan

235

Chapter 9

TAXABLE ACQUISITIONS

Suppose that X Corp. holds non-cash assets with a $150,000

basis and $450,000 fair market value, along with $63,000 in cash,

and also has $100,000 of liabilities. X Corp. is wholly owned by S, an

individual, who has a $200,000 basis in the X stock. B wants to buy

the X Corp. stock or assets for cash and also assume the X liabilities.

Assume that the X assets constitute a trade or business. The

acquisition could be structured in one of the following ways:

• B could buy the non-cash assets from X Corp. in

exchange for cash and assumption of the liabilities,

and X Corp. could either reinvest the net proceeds or

liquidate.

• X Corp. could liquidate, with the assets distributed to

S and S succeeding to the liabilities, and B could buy

the former X Corp. assets from S and assume the

liabilities.

• B could buy the X stock from S and either liquidate X

Corp. or continue to hold X Corp. as a subsidiary.

1

Each of these transactions is taxable, although the tax

consequences vary. For example, if B buys the X assets from X Corp.

in exchange for cash and liability assumption, X Corp. will recognize

gain or loss on the sale of its assets. § 1001. B’s bases in the X assets

will be determined under § 1060.

2

If X then liquidates, S will

recognize gain or loss under § 331 and § 1001. Further, none of X’s

tax attributes (e.g., its net operating loss carryovers or earnings and

profits account) will survive the transaction.

If, instead, X Corp. liquidates and B then purchases the former

X assets from S and assumes the liabilities, both X Corp. and S will

recognize gain or loss on the liquidation. § 331(a); § 336(a). None of

1

B could also use an acquisition vehicle to acquire the X stock or assets. For

example, B could form a new entity (e.g., a corporation or limited liability company)

and X Corp. could merge into that entity in exchange for payment of cash to S. For

federal income tax purposes, the merger should be treated as if the following two steps

occurred: First, X Corp. transferred its assets to the entity in exchange for the cash

received by S and the assumption of its liabilities. Second, X Corp. liquidated,

distributing the cash to S. See Rev. Rul. 69–6, 1969–1 C.B. 104.

2

If X Corp. merges into a newly formed entity, the results depend on whether,

for federal income tax purposes, the entity is treated as a corporation or disregarded

entity. If it is disregarded, B will be treated as if it acquired the X assets directly, with

the results noted in the text. If the entity is treated as a corporation, that corporation

will be treated as acquiring the X assets and take a basis in the assets determined

under § 1060.

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TAXABLE ACQUISITIONS

Ch. 9

X’s tax attributes ( e.g., its net operating loss carryovers or earnings

and profits account) will survive the liquidation. S will take a fair

market value basis in the former X assets (§ 334(a)), and therefore

will recognize no gain or loss on his sale of those assets to B. B’s bases

in those assets will be determined under § 1060.

If B acquires or is treated as acquiring X stock for cash, S will

recognize gain or loss, measured by the difference between the cash

received and his X stock basis. § 1001. B will take a cost basis in the

X stock acquired. § 1012. Unless a § 338 election is made for the stock

purchase, X Corp. will recognize no gain or loss when its stock is

acquired and will retain its historic tax attributes (including historic

asset bases).

3

A § 338 election can be made only if B is a corporation and

acquires the X stock in a qualified stock purchase. If a § 338 election

is made for a stock purchase, that purchase is treated in certain ways

as an asset purchase. In this case, if the election is made, X Corp. will

be deemed to sell its assets, but S will be treated as also selling his X

stock.

4

Assuming that B and S are economically rational and

sophisticated with equal bargaining positions, they should price and

structure the X acquisition to maximize S’s after-tax consideration

and minimize B’s cost. They would consider the present and future

expenses relating to each structure, including tax costs. Would it not

then make sense to try to structure the transaction to avoid all tax

costs?

Tax costs may be avoided (or, more precisely, deferred) in their

entirety if the transaction is structured as a nontaxable

reorganization. (Those reorganizations are discussed in Chapter 10.)

For example, if B is a corporation, B may be able to acquire the stock

or assets of X Corp. without B, S, or X Corp. recognizing gain or loss.

Given nontaxable alternatives, why would taxpayers ever choose a

3

If X Corp. then liquidates, the tax consequences depend on whether or not B

is a corporation. If it is and the liquidation qualifies under § 332, neither X Corp. nor

B will recognize gain or loss, B will take a transferred basis in the X assets, B will

succeed to the liabilities of X, and important X attributes will flow to B. § 332(a);

§ 334(a); § 337(a); § 381. If the liquidation does not qualify under § 332, X Corp. and B

will recognize gain or loss on the liquidation, the X tax attributes will not survive, and

B will take fair market value bases in the X assets. § 331(a); § 334(a); § 337(a).

4

If S were a corporation, S could join with B to make an election under

§ 338(h)(10) or join with X Corp. to make an election under § 336(e). Under either

election, X Corp. would still be treated as selling its assets but S would be treated as

receiving the sales proceeds in liquidation of X Corp. § 338(h)(10); § 1.338(h)(10)–1(c);

id. at (d)(4); § 336(e); Regs. § 1.336–2(h). See also Regs. § 1.336–1(b)(6)(ii) (generally

providing that if a § 338 election can be made for a stock purchase, a § 336(e) election

cannot be made). If the liquidation qualified under § 332, as is typical, S would

recognize no gain or loss on its deemed receipt of deemed liquidation proceeds (i.e., the

sales proceeds) and would succeed to important X tax attributes. § 332(a); § 381.

Sec. 9.01

ASSET PURCHASES

237

taxable structure? There are several possible reasons. First, to

qualify for a nontaxable reorganization, a transaction must meet

stringent requirements. Often, those requirements cannot be met or

can be met only at an unacceptable cost. Second, a taxable

transaction may, in fact, be cheaper than a nontaxable one. In a

taxable transaction, gain or loss may be recognized, and if the

transaction produces loss, it may also produce a tax benefit (a tax

reduction or refund). That benefit may make the taxable (or, m ore

precisely, recognition) alternative the preferable choice.

9.01 Asset Purchases

Consider again the example that began this chapter. If B buys

the non-cash assets from X Corp. for $350,000 cash and $100,000 of

liability assumption, X Corp. recognizes a $300,000 gain on the sale.

5

If X Corp. is taxed at a 21-percent rate, the tax is $ 63,000, which X

Corp. pays with its available cash. When X Corp. liquidates, S is

taxed on $150,000 of gain under § 331 and § 1001. This is computed

as the excess of the $350,000 of cash received over S’s basis of

$200,000. If S is taxed at a 20-percent rate, S pays a $30,000 tax and

ends up with $320,000. B takes a cost basis in the assets of $450,000.

§ 1012.

6

The two steps of this transaction are illustrated in Figure 9-1.

The first step is the asset sale (left diagram), and the second step is

the liquidation (right diagram).

7

Similar treatment occurs if B is a

corporation and X Corp. merges into B Corp. (with B Corp. surviving)

with the X Corp. shareholder (S) receiving cash—a taxable merger.

8

5

For simplicity’s sake, X Corp’s gain is determined as if it held a single asset.

As is noted below, the total consideration would have to be allocated among the assets,

and gain or loss determined separately for each asset. The text also disregards selling

costs and buying costs to facilitate the sale, costs that reduce the amount realized and

increase asset basis See § 1.263(a)–5(g)(2)(i) (treating commissions, attorney’s fees,

and other transaction costs to facilitate a sale as buying costs that increase asset

basis); id. at (g)(2)(ii)(A) (treating commissions, attorney’s fees, and other transaction

costs to facilitate a sale as selling costs that reduce the amount realized).

6

Suppose that X Corp. had sold its assets to B on the installment method.

Upon liquidation X Corp. would have to recognize all deferred gain. § 453B(a).

Further, S generally would have to immediately take into account the fair market

value of the note in determining his gain or loss and would have a basis in the note

equal to its fair market value. However, if the installment obligation arose from a sale

or exchange of the X ass ets after the adoption of the plan of liquidation and the

liquidation was completed within 12 months, S could take his gain on the installment

note into account as the note was paid. § 453(h)(1)(A). See also id. at (h)(1)(B)

(providing that if the install ment obligation arose from the sale of inventory,

installment reporting is available to shareholders only if substantially all the

inventory was sold in bulk to a single purchaser); id. at (g) (providing that installment

reporting is not available for sales of depreciable property between related persons).

7

Note that the values in the figure are written in terms of thousands of

dollars. This convention is also used in subsequent figures in this chapter.

8

As one critical difference, in a typical taxable merger, B Corp., the acquiring

corporation, would acquire all X Corp. assets, including the $63,000 cash, and also