The use of "boot" in B-type reorganizations.

• Author: Knight, Ray A.

The Use of "Boot" in B-Type Reorganizations

A B-type reorganization allows one corporation to acquire another corporation tax free where it is advantageous to keep the acquired corporation alive. To qualify for a B-type reorganization, section 368(a)(1)(B) of the Internal Revenue Code requires the acquiring corporation to use only voting stock as consideration in the acquisition of control of the acquired corporation. Control for this purpose is 80 percent of voting stock and 80 percent of each other class of stock. Before 1954, the Code required that the acquiring corporation acquire 80 percent of the stock of the acquired corporation. This requirement made it impossible for a corporation already owning more than 20 percent of a corporation to acquire the remainder of the stock or merely enough to result in holding 80 percent of the acquired company's stock and have the transaction fall within the definition of a reorganization. The section was amended in 1954 to read:

The acquisition by one corporation, in exchange solely for all or part of its voting stock . . ., of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation (whether or not such acquiring corporation had control immediately before the acquisition).

Although the amended Code provision answered the questions surrounding "creeping reorganizations" in B-type reorganizations, many gray areas remained unanswered. The principal problems in B-type reorganizations stem from the "solely for voting stock" requirement. The ITT-Hartford merger in 1980 brought to the fore several questions concerning B-type reorganizations. This article analyzes the court cases and questions that sprang from this merger. In addition, the article analyzes (1) the issues concerning "poison pills" and Letter Ruling No. 8808081 in which the Internal Revenue Service held that "poison pill" stock rights were taxable boot in an otherwise tax-free reorganization, and (2) Revenue Ruling 90-11 in which the IRS discussed the federal income tax consequences of a corporation's adoption of a poison pill plan.

ITT-Hartford Merger

In April 1969, International Telephone and Telegraph (ITT) reached an agreement with the Hartford Fire Insurance Company (Hartford) for a takeover of the Connecticut insurance company. The plan met the requirements of a B-type reorganization. In a private letter ruling dated October 21, 1969, however, the IRS held that the plan would not qualify as a reorganization under 368(a)(1)(B) unless ITT disposed of the Hartford stock it had purchased for cash in the previous year. ITT did dispose of this stock by selling it to an Italian bank. The merger was never effected, however, because it was disapproved by the Connecticut Insurance Commissioner. Subsequently, ITT tried to exchange with the Hartford shareholders the same stock they would have received under the original merger plan. The insurance commissioner allowed this tender offer. ITT subsequently submitted an exchange offer to the Hartford shareholders and by June 8, 1970, more than 95 percent of the Hartford shares had been tendered, including those held by the Italian bank.

In March 1974, the IRS retroactively revoked the October 1969 letter ruling on the grounds that the nature of the obligations and rights of the parties to the sale had been misrepresented. The IRS asserted that the disposition had not been unconditional and, thus, had not removed the "tainted" shares acquired for cash from consideration as stock acquired as part of the plan of reorganization. Accordingly, the IRS concluded that the requirements of section 368(a)(1)(B) were not met.

The acquisition of the Hartford Insurance Company by International Telephone and Telegraph gave rise to litigation where the taxpayers-shareholders claimed the acquisition qualified as a tax-free, B-type reorganization. The IRS disagreed since it retroactively revoked its favorable private letter ruling. In Pierson v. Commissioner, 472 F. Supp. 957 (D. Del. 1979), and Reeves v. Commissioner, 71 T.C. 727 (1979), the taxpayers set forth two arguments. First, the taxpayers argued that the "reorganization" relevant to determining gain or loss on the exchange of stock was the plan approved by the insurance commissioner in 1970 in ITT-Hartford. Since there were no cash purchases in the 1970 exchange, the requirements of 368(a)(1)(B) would be met, allowing a tax-free stock for voting stock exchange. The second argument assumed, arguendo, that the ITT cash purchases of stock and the 1970 exchange offer were a single transaction. Nevertheless, the plaintiff argued that where at least 80 percent of the stock of the acquired corporation is exchanged for voting stock in the acquiring corporation, the literal requirements of section 368(a)(1)(B) are met. Therefore, the presence of non-stock consideration (or "boot") in the same transaction would not preclude its qualifying as a reorganization.

In both Pierson and Reeves, the trial court ruled in favor of the taxpayer based on the second argument. These two decisions appeared to make a B-type reorganization almost synonymous with a C-type reorganization, allowing boot consideration to be given as long as the controlling purchase was made with voting stock. These decisions were reversed, however, in Heverly v. Commissioner, 621 F.2d 1227 (3d Cir. 1980), and Chapman v. Commissioner, 618 F.2d 856 (1st Cir. 1980).

The Third Circuit and First Circuit, respectively, reasoned that in a stock-for-stock transaction in which control is achieved, the acquiring corporation may exchange no consideration other than voting stock to effect a tax-free, B-type reorganization. The appellate courts, however, remanded the cases for consideration of the taxpayers' first argument -- that ITT's exchange offer in 1970 was a separate plan of reorganization. Because of an out-of-court settlement, the trial court never reconsidered this issue, which raises several questions concerning the B-type reorganization.

Heverly and Chapman support the proposition that acquisitions that are part of a single transaction are to be considered together when testing for B-type reorganization requirements. No guidance is provided in the decisions, however, to determine when several purchases are to be examined as part of one single acquisition transaction. In addition, no mention is made of the tax consequences of prior stock purchases for consideration other than voting stock (i.e., "boot") that were not part of the acquisition involving only voting stock. The only guideline is that the prior purchases must be "old and cold," but no time period is specified for determining what constitutes "old and cold."

In both Reeves and Pierson, the acquiring corporation had obtained a controlling interest with a single purchase of stock. Thus, questions remain concerning creeping acquisitions, for no guidelines are given for grouping purchases into one acquisition plan for determining B-type reorganization status. The only requirement is that the purchases that are part of the plan of reorganization must be solely for voting stock. These questions are usually answered by the courts and IRS using the step-transaction doctrine.

The Step-Transaction Doctrine in B-Type

Reorganizations

Revenue Ruling 85-139, 1985-2 C.B. 123, provides that the solely-for-voting-stock requirement applies to the entire transaction in which stock of a corporation is acquired, not just to the acquisition of a block of stock constituting control. Revenue Ruling 70-65, 1970-1 C.B. 77, requires that all steps or purchases in a single plan be for voting stock of the acquiring corporation to qualify as a B-type reorganization. Revenue Ruling 75-123, 1975-1 C.B. 115, makes the solely-for-voting-stock requirement even stricter by requiring that the consideration given for whatever stock is acquired by the acquiring corporation be voting stock. Although this ruling appears to make the issue clear-cut, it is in conflict with Treas. Reg. [section] 1.368-2(c), which includes the following example sanctioning a B-type reorganization where prior cash purchases had been used to acquire stock of the acquired corporation:

[C]orporation A purchased 30 percent of the common stock of corporation W (the only class of stock...