Sec. 368 Reorganization Taxation
Internal Revenue Code (IRC) Section 368 allows merger and acquisition transactions to qualify as a reorganization when an acquiring corporation gives a substantial amount of its own stock as consideration to the acquired (or “target”) corporation. Section 368 has several conditions which must be satisfied in order for a transaction to qualify as a “reorganization;” just as with partial exchanges in a Section 1031 transaction, target shareholders in a Section 368 transaction will be taxed when they receive “boot,” which means any consideration other than the acquiring corporation’s stock.
In this article, we will provide an overview of Section 368 and the several different types of reorganization transactions which can be performed. Then, we will identify and discuss the four conditions which must be checked off in order for the transaction to be considered valid.
A Reorganization General Overview
When business entities seek to merge, they can select between a variety of ways to structure their transaction. Depending on the circumstances, it may be desirable to utilize another applicable section of the code to an acquisitive transaction. Section 368 comes into play when the shareholders of the target corporation agree to accept acquirer stock as a main form of compensation. Section 368 transactions come in several variations, and the maximum amount of boot allowed depends on the variation. In every Section 368 transaction, at least 40 percent of the consideration must be in the form of acquirer stock, or else lose status as a reorganization.
The following are the different variations of 368 reorganizations: Type A reorganizations (stock-for-assets), Type B reorganizations (stock-for-stock) and Type C reorganizations (also stock-for-assets). Within Type A reorganizations, there are several additional variations: there are statutory mergers and consolidations, forward triangular mergers and reverse triangular mergers. Each of these variations has its own sophisticated mechanics. In future articles, we will explore the complexity of these mechanics in detail.
Four Conditions of a 368 Reorganization
To qualify for the tax-deferral treatment provided by Section 368, four different conditions must be met. These conditions are continuity of ownership interest, continuity of business enterprise, valid business purpose and the step transaction doctrine. The continuity of ownership interest condition is met by seeing that at least 40 percent of the consideration in the transaction is made up of acquirer stock. The continuity of business enterprise condition can be met by either continuing the target company’s business or using the target company’s assets in an existing business for at least 2 years following the transaction. The valid business purpose condition requires that the transaction serve a purpose beyond just the avoidance of taxes. And the step transaction doctrine can be used to alter the tax status of a series of steps, if any individual step was taken solely to avoid taxes; accordingly, parties in a 368 transaction must make sure that every action has an independent economic motive. If these four conditions aren’t all met, then the transaction won’t qualify as a “reorganization” within the meaning of Section 368.
As you can already tell, a section 368 transaction can get a bit tricky, with its many layers and permutations. Complexity like this is one of the main reasons why corporations need to consult with a qualified NYC tax attorney prior to initiating a transaction of this kind. The attorneys at Mackay, Caswell & Callahan would be pleased to assist you with your 368 issue or with any other tax issues you may have.
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