In episode 26 of How Tax Works, Matt Foreman discusses how to ensure mergers and acquisitions are tax-free, why it’s not always best to squeeze into tax-free status, general requirements, and common issues.

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:00]:
Hello and welcome to the 26th episode of How Tax Works. I’m Matt Foreman. In this episode, I’ll discuss tax free acquisitive reorganizations under 368A1 of the internal Revenue Code, or as I like to call it, the ABCs of ABMC reorg. So I’m not going to talk about acquisitive deeds. That’s another day. And I’ll probably never do it because they’re so rare. How Tax Works is meant for informational and entertainment purposes only.

Matthew Foreman [00:00:34]:
This may be attorney advertising, and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions that we all make. Before I get started, a few things administratively new episodes every two weeks. Next episode, we’ll discuss how f reorgs can be used to fix problems after you made your S selection when you probably shouldn’t have. If you have any questions, comments, or constructive criticism, you can email me at my FRB email address, which you can find via your favorite search engine. Upcoming Webinars Speaking game notes are on the How Tax Works landing page of the FRB website. All right, what are we discussing? We’re Talking about the ABCs of A, B and C reorgs.

Matthew Foreman [00:01:20]:
So we’re talking about tax free reorgs. All right, and, and I should know, and this is really important and I’m going to talk about boot, I brought cash and things like that. And there may be tax due even if you do a good reorg. I’ll talk about that throughout. But make sure your clients know when they’re going to pay tax and how much. I’ve seen ones where people think, you know, I’ll get into it in a second with a reorgs. But you know, they’re having 50% cash and they’re like, oh, I don’t pay tax on the cash. And that’s just, you know, not true.

Matthew Foreman [00:01:48]:
It’s still a good A reorg. The rollover portion or, or the actual reorg portion where you get stock and the resulting entity that’s tax free. But when you get cash, you are paying tax. So that’s really important. So make sure your clients know when they’re going to pay how much. You know, it’s not always I one thing I always point out is it’s not always best to do a tax free reorg if they have 1202 qualified SOL business stock which I talk about a month or so ago at this point. Or if they have really high basis, you know under 1014 for example you may want to intentionally blow the reorg tax free reorg in order to recognize gain. You know because it’s not going to be that much in comparison to other factors.

Matthew Foreman [00:02:27]:
So people always say oh, tax free tax treatment. Maybe not. Maybe not. Right. Where do the letters come from? 368A1 and then A1 cap A A1 cap B A1 cap C. Those are your A, B and C reorganization with D E F. I think it goes to G is, is the number is the letter you’re going to get through. So whenever you talk about a reorgs 368A1 cap A.

Matthew Foreman [00:02:48]:
Right. These are the exception. The general rule is that everything is taxable. If you don’t follow these rules very closely. Follow, follow what the structures are very closely. You are going to have tax that’s going to be suboptimal for your client unless they know they’re doing it right. There are ones where I go it’s going to be 80% cash and 20% rollover that’ll be tax free. And I’m like maybe not kind of have to structure into it.

Matthew Foreman [00:03:11]:
Be a little interesting. So how they generally work. So before we start let’s talk about international section 367 turns off the 368 reorgs generally. Right. So country to country, whatever. So the US is very sensitive to inversions because it’s worldwide income. So watch out for switching countries whether to or from you know a country where we have a treaty, don’t have a treaty or just moving countries generally watch out for that. Going from an American parent to a foreign pair could be an inversion.

Matthew Foreman [00:03:40]:
So you’re going to run, run into that. 367 or I think it’s 1248 is the other code section. But don’t quote me on that because I didn’t double check it before I started. Secondly, before we start these are all corpse S corpse and C corpse can do the exact same things. Really important to note that not so much with, with C reorgs but that’s kind of a weird one anyway. But generally you know most tax reorgs when I do them, especially A, B and C they tend to evolve C corpse rather than other ones. It’s a way to keep deferring the. The built in gain and defer the fact that you know that you don’t have pass through treatment.

Matthew Foreman [00:04:12]:
Right. There’s two levels of tax form controls the tax. Generally speaking, the less for for C reorgs. But I’ll get into that later. Not really that relevant. So let’s, let’s start out. We’ll go in alphabetical order because it’s, it’s arbitrary and capricious. But why not? So A reorgs type A368A1 cap.

Matthew Foreman [00:04:29]:
A statutory merger or consolidation. Under state law, every single state has the ability to merge or consolidate multiple entities into one. Under state law, every single one and D.C. obviously. So that allows you to do it. Basically the buyer uses stock to acquire the target which no longer exists afterward. How much stock? This is a really important question. Minnesota tea is the case.

Matthew Foreman [00:04:53]:
I’m not going to give citations. You can Google Minnesota tea. You might come up with a tea company in Minnesota. I don’t know. You know, whatever. So how much stock? Right. A definite and material interest. I don’t know what that means.

Matthew Foreman [00:05:05]:
You don’t know what that means. And the people who’ve done this before are gonna say what do you mean, Matt? Like this is 40%. That’s what it should be. Right. And the answer is. Well, sort of. So Treasury Reg. 1.3681 E2 Romanet 5 example 1 says at least 40%.

Matthew Foreman [00:05:21]:
But there’s a case from before that treasury regulation called John A. NELSON that says 38% is okay. So my rule is if you want to be certain, make sure there’s 40. If you’re willing to have a, you know, little, little risk and you’re willing to litigate it if the IRS or a state were to change it. Cause states all follow these. Then, then that’s, then you’re fine. Then you can go below. I don’t recommend it.

Matthew Foreman [00:05:45]:
Just, just, just be 40. You know, don’t, don’t be greedy. This is, this is one of those situations where that’d be really not good. You know, look at the control, look at value. Look at the economic value. Control vote economic value. You got to be all them. At least 40% is going to be equity.

Matthew Foreman [00:06:01]:
So you can do 60% cash. That’s a lot of cash. Right. Or a boot earnouts can push if can push that below 40. I saw one once that was making up numbers. $50 cash, $50 stock. And then there was an earn out where they could make another $30 in cash. Well that’s $130 total, right? 50.

Matthew Foreman [00:06:19]:
50 plus the 30. So 80 out of 130. That’s, that’s going to push you over the 60% cash. So that can actually blow the a reorg as a result. So you have to make sure that if you’re going to have an earnout, you assume the maximum possible earnout exists. Most earnouts are not uncapped. They, they tend to be, you know, capped somehow. If you have an uncapped earnout, then you have to have some sort of safety leverage or you run the risk, right? Because what’s going to happen is the IRS is going to look at this after the earnout has already been paid.

Matthew Foreman [00:06:50]:
So, so they’re going to look at it and say, well, you knew, you knew what you were doing here. You know, nefarious, awful person, you know, Dr. Nefario or whatever. So the second thing is that you must continue the business enterprise. So the historic business or use the assets of the historic business must be used in the new new business or the business that continues, the business survives. So like, you know, if you were to have one company, you know, computer company A buys computer company B. You don’t have to necessarily keep operating computer company B as a separate entity, but computer company A needs to use the asset somehow, can be using the ip, can be using the manufacturing facilities, can, you know, whatever. That’s fine.

Matthew Foreman [00:07:29]:
If a target has two businesses and sells business X and then does an A reorg, both become taxable sales. So you really need to watch out for, for, you know what happens if you’re selling one and you’re gonna, you’re on a device device with reorg one, you’re selling one in cash or doing a tax free or things like that. Order matters, timing matters, things like that. It’s all about the passage of time. It’s all about business risk. So you can’t acquire a new business then immediately shut it down and dump the assets. You must at least try to operate or integrate or use the assets. People always ask me what do you mean by try? I always say, you know, don’t give the old college try so to speak.

Matthew Foreman [00:08:06]:
Make it a real attempt to operate it. So I think that’s really important. And then you need time between the sale and the A reorg. So if you do a sale then a tax free to get it, there must be time. What’s your real business risk? Couple years, right? You can de reorg then a reorg but it must be 100% stock or you can blow the deorg because right after any date de reorg. I talked about this too soon you have a taxable transaction, even if it’s other, you know, partially Tax free or whatever and any tax are going to pay. That’s going to be problematic. So there must be a business purpose.

Matthew Foreman [00:08:36]:
It cannot be for the avoidance of federal income taxes. What about state taxes? Yes, sure. What about federal. State taxes? Yeah, sure. It says federal income taxes. Really important people say, well, what if a trust owns it? You know, trusts pay income tax. So is the difference between estate taxes and income taxes can be excise taxes, whatever. There is a partner at a large, fairly prominent, I would say quite prominent law firm was partnered in the New York office who says where there is a business, there’s a purpose.

Matthew Foreman [00:09:04]:
So the business doesn’t have to be. The purpose doesn’t have to be all that screaming in your face. But it really cannot be for the avoidance of federal income taxes. There’s also a thing called the assumption of liabilities. Probably fine, could be an issue if there’s too much. But if you assume too many liabilities that can be considered boot could push down the consideration. You know, watch out for that. And then there’s what’s called a creeping A.

Matthew Foreman [00:09:27]:
So you acquire over time. Acquire, you know, maybe six months, you start buying a little, buying a little, buying a little. And then you acquire the rest, whether, you know, by cash. Acquire the rest with stock, whatever. That’s fine. You can do what’s called a creeping A. Doesn’t sound like the greatest, most inviting name. But here, here we are, right? All right, let’s.

Matthew Foreman [00:09:43]:
Let’s get a little music in. Let, let, let’s listen. Let’s jam out for a second. We’re going to come back, we’re gonna talk about forward and reverse a orgs. All right, we’re back. We’re talking about a reorg some more. We’re going to start with a forward or forward triangular reorg. If someone says, let’s just do a triangular reorg, I don’t know if they know what they’re talking about because there’s two different kinds of triangular reorganizations and they are in some ways the same, in some ways the exact opposite.

Matthew Foreman [00:10:15]:
So forward triangular reorg 3368 a 2 cap D. Also a 1A but a 2 cap D. And what happens is the buyer, the acquirer, forms a subsidy. I’m going to use the words buyer and acquire probably interchangeably during this reor. During this podcast episode. I somewhat apologize for that. But whatever. The buyer forms a subsidiary and the buyer subsidiary survives.

Matthew Foreman [00:10:37]:
Okay? So the target disappears. It’s really the same idea as the buyer surviving then dropping into new Corp through outer 351. You may lose assets that need, you know, to change title or contracts that need to assign. So that could be problematic with having the target disappear and the target’s liabilities are still isolated and subsidiary without, you know, ever holding them in parent. So with the parent. So that could be, for a liability perspective, could be very attractive. And then it’s held in, in the sub. A lot of times you have a parent that has nothing.

Matthew Foreman [00:11:07]:
It just holds a number of subsidiaries below it, right. You think about public companies, for example, and then there’s even private companies that have the structure that have that below. Whether it’s, you know, C Corps or. Or Q subs below. Same idea. Then there’s also what’s called a forward triangular reorg. Excuse me, a reverse triangular reorg. Get this right.

Matthew Foreman [00:11:25]:
This time, reverse is the same as a forward, except the difference is that the target survives, right? So this way you don’t need to sign contracts, you don’t need to do anything. The buyer’s merger sub disappears. Called the merger sub for a reason. It exists for the merger. Then boom, it’s gone. These entities tend to exist for like a week. Don’t do a whole lot, don’t file a return, you know, move along. Isolates liabilities and targets.

Matthew Foreman [00:11:50]:
But for this one, you have to use voting stock. For regular A, you can use voting and non voting stock. So kind of an interesting, interesting mix there that. It’s just disparate how things turn out. I’ve never totally understood why it’s not in 368A1. I always thought if they do, they actually redo the code, right? There’s 39, there’s 54, there’s 86. If I actually get around to really doing this reorder stuff, reorganize stuff. They should clean this up, go A1A, A1B, A1C and sort of rename what they are.

Matthew Foreman [00:12:20]:
You know, whether it’s A1A1 Romanette1 or something like that. Just as a way to sort of drop down and clean up the order for them. And also probably want to make it statutory. What percentage you need of things. The whole, like having it in cases and regs is really probably not the best way to do it, especially post blooper bright. Right. And anyway, so B reorg. B reorg is the most tricked.

Matthew Foreman [00:12:41]:
It’s an acquisitive. It’s stock for stock and it’s where you don’t have a state merger or consolidation. Okay, so boot bust the B. That’s something that’s going to keep coming up with B’s. Other than the nice how wonderful it sounds with the alliteration, it’s really important. You must use 100% stock to acquire the, the acquirer. After the transaction, the target shareholders must hold stock and the buyer same real end result is A. But there’s no boot allowed, no cash, nothing, nothing, nothing, nothing, nothing.

Matthew Foreman [00:13:10]:
And it cannot be a statutory merger. There’s rules whether if you have an A or a B, what you want to be, what you want it to be. Boy, this, this pun is just killing it. I’m not even trying. So I apologize for that. Depending on what you want to do, A is much more, much easier. So if you’re going for a B and somehow end up in A because it has happens to be a statutory merger, that’s fine. I’m not totally sure how you’d end up with a B without a statutory merger, but they do exist.

Matthew Foreman [00:13:35]:
I’ve run into them a few times. I’ve never looked into from a non tax perspective why there’s no statutory merger. The risk of sounding like I’m, I’m lazy or stupid, I don’t really care. What mattered is it needs to be right. You can use preferred shares, but the shares must be voting if, even if only fractional. But don’t be greedy. You know I, I saw one where someone’s like well we’re going to do, you know the class a shares are 1 vote per share and the class B are 0.000001. I don’t know if that would pass muster.

Matthew Foreman [00:14:02]:
There’s some real economic substance problems. And again tax free reorgs are the exception to the rule. Don’t try to wiggle your way around and get cute in the exception. Okay, don’t do that. Don’t try to get cute and wiggle around in the exception. Just drive it through it, get through. It’s fine. You know, you can pay cash or other non cash property for fractional shares.

Matthew Foreman [00:14:21]:
You can’t, you can’t buy out actual dissenters. So if the ratio they end up with like 13.5 shares, you can buy off the 0.5, but you can’t buy out someone who doesn’t want it to be there. You could theoretically, you know, in a public company have them just look, we’re going to buy it out. You’re going to get stock in a public company. You can do what you want, that’s fine. Can’t have a plan in place. So immediately after the reorganization, the acquirer must control at least 80% of the vote and value of the target. So that’s really important.

Matthew Foreman [00:14:47]:
People think, you know, oh, you have to acquire a hundred percent of the company. No. Of the target. No, that’s not the case. You only need 80 enough to consolidate and you must acquire enough, like I said, to consolidate. But I’m not going to go in detail on consolidation. I don’t think it’s necessary. I don’t think it’s helpful.

Matthew Foreman [00:15:03]:
It just. Consolidation is way beyond what this podcast. Definitely what it is right now and definitely, almost certainly what I want it to be. Consolidations, really interesting stuff, really complex, fun stuff to deal with because it’s really hard and it makes you think. But no, I’m not, I’m not doing it here. You must again, similarly to a, you must use the historic business or assets after the reorganization. And again, the business purpose cannot be for the avoidance of federal income tax. All right.

Matthew Foreman [00:15:31]:
There’s also triangular bees, same, you know, as, as the regular ones. But the buyer uses the parent stock to acquire the target. So the acquirer is a subsidiary, uses the parent stock. The premise, you could just do a B reorg, then contribute the assets to newly formed subsidiary under 351. You can do a creeping B, such as you have 12 up to 12 months. Treasury Reg. 1.3682 C. Talk about that.

Matthew Foreman [00:15:58]:
So that’s important. You don’t have to do it. So you’ll have situations where you’ve, you’re slowly buying or you own a little bit and then you acquire 85% of it with stock. Great. That’s fine. That 85% is fine. That’s a big reason why you only need to acquire 80 as part of the B reorg. So it can happen.

Matthew Foreman [00:16:17]:
All right, let’s. Let’s get one more music break in here. Then we’ll bring it on home with C reorgs. So sea reorgs. Right. 368A1C. The form controls, sort of. I’ve always referred to a C reorg as, as a hidden asset acquisition.

Matthew Foreman [00:16:43]:
What happens is the acquirer acquire substantially all of the properties of the target solely for acquirer voting stock. Okay, so what you’re doing is you’re not actually acquiring the company itself. You’re acquiring its assets. I will get into that in a second. And why, probably a couple minutes. And why. But it’s really important to remember this is not stock for stock. It’s actually assets for stock.

Matthew Foreman [00:17:08]:
So first off, what is substantially. All right, you’re acquiring Substantially all of the properties of the target. That means at least 90% of the net assets, assets less liabilities and at least 70% of the gross assets. So if you ignore liabilities, you’re acquiring at least 70%. That’s your 7090 rule. Whenever people talk about the substantially all requirements within the tax code and people are like, oh, like what does substantially all mean? The answer is it’s rarely defined. And if it is, it’s defined inconsistently such that there’s no one definition. I know a big problem in 1202 for example, is they say, oh, you must, you know, must do this substantially all the time.

Matthew Foreman [00:17:45]:
You must have, what’s it called, you know, been a C corp. Substantially all the time. What does that mean? I don’t know. Right. I tend to use 80, but 9070 is interesting in a different context. That’s why some people say you can go to as low as 70 for substantially all. I don’t know, maybe, maybe not, whatever, it doesn’t really matter. The second one is solely for voting stock.

Matthew Foreman [00:18:03]:
Solely only means 80% in this one. So solely is 80, substantial is 90 and 70. I don’t know what either one means. You can take on, you can take liabilities with you, but the assumption of liabilities can only be up to 80% of the stock that you take. So you know, that becomes problematic if you’re taking a lot of liabilities with you. A lot of times I found that C reorgs are done as part of a larger restructuring where the company is trying to raise capital or something like that to do other things or certain assets in it, et cetera. And then they’re going to shut it down again. You know, you must use the targets that the acquirer must use the targets assets after the reorg.

Matthew Foreman [00:18:41]:
So this is where it gets kind of funky. This is why, you know, people. Why do C reorgs even exist? It’s kind of weird. And the answer is it is basically a tax free asset sale. The idea is that you could merge the two companies, acquirer survives and then you, the target dissolves. Right. But for non tax reasons, you, you don’t want to do that. You want to keep some risk out, sell the assets, whatever.

Matthew Foreman [00:19:05]:
The target must liquidate within a reasonable amount of time. Don’t know what that means. If it’s, there’s a plan and you’re slowly going down the plan. I’ve seen this used where there was an environmental remediation risk. They held the cash in order to deal with that. It costs money to Clean it up, make sure it’s done. There’s accounting, there’s legal, there’s all that stuff that goes on. Okay.

Matthew Foreman [00:19:25]:
At the end of it, the target shareholders hold stock in the buyer, they liquidate the selling entity. The business purpose again cannot be for the avoidance of federal income tax. And there’s different kinds of, there’s of course other kinds of series orgs, as is tradition. Right. There’s a triangular C and a drop down C. Same idea. A drop down C, where is the assets are dropped down into a new coast. So basically you do a C reorg, then drop it down under 3 51.

Matthew Foreman [00:19:52]:
A triangular is you form a subsidiary, then the subsidiary uses the parent stock to acquire the assets. Pretty standard, really. Not that exciting. I, I’ve done that one. Those are the C’s that I’ve done. I’ve never done one where they really put the assets right into the parent company. I actually think it’s fairly rare, whatever. Fairly rare to actually do a regular A, B or C reorg.

Matthew Foreman [00:20:13]:
They’re almost always triangular or drop down or something like that. Just because once you’re at of that size, you really don’t want to upset the apple cart of like what’s going on with that entity. You want to isolate each business separately. So that’s really important. All right, A, B and C reorgs. We’re done here. That, that was the 20 and the 8020 rule. So this episode’s kind of end up being around 25 minutes.

Matthew Foreman [00:20:34]:
I don’t, you know, I take breaks in the middle and stuff like that, you know, 20, 25 minutes. But sometime later I’ll do the other 80% of what goes on in 368A because there’s a lot that can go on there. There’s a lot of issues that come up there and things like that. It’ll be like a, like a one, like a 20 or 30 minute episode per each one. But I think it’s really important for this one to, especially for, for these. Just to give you a little flavor for what’s going on. I am going to do a series of webinars in the fall, probably sometime between November and the end of the year where I’m going to talk about ABC reorgs in one, I’m going to talk about D and F reorgs in another and I’m probably going to do partnership divisions in a third. I may also talk about operating agreements in a webinar and what should be in an operating agreement from a tax perspective.

Matthew Foreman [00:21:18]:
But that that’s another day I’ll release that. I’ll talk about that more when that comes up. I still need to do that. You know, there’ll be cpe CE and CLE for that. So get some, get some good credits on that. All right, that was a 26 episode of how Tax Works. I hope you learned something that this was just for context. This, this is the last one of the first year.

Matthew Foreman [00:21:38]:
26 every other week, right? This is the end of year one. So I hope you enjoyed it. I’ll be back in two weeks with the new year, so to speak. 27th episode. I’m going to be talking about Eorg’s part du, right? I took Spanish, so I don’t know if I said it right. If I didn’t, that’s, that’s perfectly fine. I don’t really care. And now for the best song of all time.