CORPORATE REORGANIZATIONS: "B" reorganization: Acquisition by one corporation of stock of another corporation--application for tax ruling

by Stephen E. Pigott

The second type of reorganization defined in the Internal Revenue Code, a "B" reorganization, is a transaction in which one corporation acquires the controlling stock interest in another. The Code definition of a "B" reorganization is "the acquisition by one corporation, in exchange solely for all or a part of its voting stock (or in exchange solely for all or a part of the voting stock of a corporation which is in control of the acquiring corporation), 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)."

"B" reorganization:

The "B" definition applies to the acquisition by a holding company of stock of another corporation from the latter's shareholders. Typically, the shareholders of X Corp. turn over 80% or more of their X stock to Y Corp. (or to a corporation controlled by Y Corp.) in return for part or all of Y's voting stock. Y Corp. (or the corporation controlled by Y Corp.) is then the holding company, and X Corp. is the operating subsidiary.

The term "control" means the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation. This must be literally satisfied. Mere voting control is not sufficient unless the specified percentages of voting and nonvoting stock are acquired. Moreover, there must be direct ownership of such stock.

Voting stock:

The definition of a "B" reorganization requires that the acquisition of the stock by a corporation be in exchange solely for all or a part of its "voting stock." This requirement, introduced in the 1954 Act, essentially replaced the prior judicial test which merely required "continuity of interest" of the X shareholders in relation to Y Corp. An acquisition does not qualify where the acquiring corporation's previously sole shareholder is given the exclusive right for five years to vote the shares exchanged for stock of the acquired corporation; shareholders of the acquired corporation do not receive "voting stock" in these circumstances. Nor will it be deemed an exchange for voting stock if the "voting stock" is subject to a voting trust or some other restriction whereby the right to vote the stock is in another party.

"Solely" for voting stock:

The requirement that the acquisition of the stock be "solely" for voting stock raises a problem where Y Corp., in a single transaction, acquires the necessary 80% control of X Corp. in exchange for its own voting stock, and acquires additional X Corp. stock for cash (or for nonvoting preferred stock or bonds). Under the 1939 Code, such a transaction was held to violate the statutory requirement. The same result would seem to follow currently. Although the Regulations do not expressly cover the point, they indicate that any cash purchases in a series of transactions covering a short period of time (e.g., 12 months) would vitiate the acquisitions for voting stock within that period. Since the acquired corporation's convertible debentures are not "stock," their acquisition for cash coupled with and conditioned upon the acquisition of the entire stock interest in exchange for voting stock does not disqualify a reorganization. Similarly, the acquisition of a corporation's stock and debentures for the acquiring corporation's stock and new debentures qualifies if the issued debentures do not constitute additional consideration for the acquired corporation's stock, even though some of the surrendered debentures are held by shareholders of the old company.

Fractional shares:

The "solely" for voting stock requirement also poses the troublesome problem of fractional shares. The Service has long sanctioned the device of permitting such an interest to be bought or sold by the shareholders without adversely affecting the reorganization itself. An appellate court even allowed the reorganization where cash in lieu of fractional shares was paid directly by the acquiring corporation under the reorganization plan. The small amount of cash was not an independent part of the consideration, so the "sole" consideration was the voting stock. The Service then ruled that the statute is satisfied where cash paid by the acquiring corporation represents a mechanical rounding-off of fractional shares to which the shareholders of the acquiring corporation are entitled. It has also ruled that the "solely" requirement is not violated where the acquiror agrees to substitute its stock for that of the acquired corporation for purposes of unexercised stock warrants and employee stock options.

"C" reorganizations:

In a "C" reorganization the remainder of the properties in excess of 80% may be acquired for cash or other property (see comment on Form 16.13). The "solely for voting stock" requirement may be jeopardized if the acquiring corporation grants an option to the transferor corporation whereby the acquiring corporation may be required to purchase part of its own stock. But the reorganization is not destroyed by such an option granted independently by the shareholders. It is important to note that if the reorganization itself is disqualified because the acquisition is not "solely" for voting stock, then the shareholder's gain is fully recognized, even if that gain exceeds the amount of cash and other property received by the shareholder. Where an acquisition of stock and debentures is made for the stock of the acquiring corporation, the Revenue Service's position is that the transaction is a nontaxable stock-for-stock exchange plus a taxable exchange of stock for debentures. An acquisition does not qualify where 60% of the stock of the acquired corporation is obtained in a transaction where all the parent corporation's assets are transferred to the acquiring corporation for voting stock plus the assumption of liabilities and the remaining 40% is acquired from individual shareholders in stock-for-stock exchanges, because the assumption of liabilities constitutes additional consideration. Thus, the 40% shareholders must recognize gain or loss where both transactions are part of the overall plan. The corporate asset acquisition qualifies as a "C" reorganization, however. A prior purchase of stock for cash will not violate the "solely for voting stock" requirement where the stock is unconditionally sold to an unrelated party before the reorganization exchange.

The so-called "creeping" control problem arose under the provisions of the 1939 Code in the case where Y Corp., already owning some X stock, acquired additional X stock in an exchange solely for its own voting stock. If the required percentage of stock was owned after the later acquisition, it appeared that such acquisition qualified as a "B" reorganization. The 1954 Code liberalized the rule by providing that the acquisition of control in exchange solely for voting stock qualifies as a "B" reorganization "whether or not such acquiring corporation had control immediately before the acquisition."

Redemption:

If an integral part of the plan requires Y Corp. to redeem part of the stock issued for the X stock, the cash redemption price would seem to violate the "solely for voting stock" requirement. But, an acquisition has been accepted as being solely for stock despite a cash redemption of part of the stock shortly after the reorganization, where the corporation had no commitment for such redemption.

The Code provisions governing the recognition of gain or loss to the shareholders of X Corp. upon the exchange require that the shareholders receive, in exchange for their X stock, stock in a "party to the reorganization." The definition of a "party to the reorganization" has been expanded (in line with the provision permitting the stock of X Corp. to be acquired by a subsidiary of Y Corp.) to include a corporation controlling the corporation to which the acquired stock is transferred. Thus, the acquisition of the stock of X Corp. by S Corp., a "controlled" subsidiary of Y Corp. will qualify if the X shareholders receive Y Corp. stock in exchange. Moreover, an otherwise qualifying "B" reorganization is not disqualified if Y Corp. subsequently transfers the X Corp. stock to S Corp. In both these instances, Y Corp. is also a "party to the reorganization." A transaction qualified although the acquiring corporation creates a separate wholly owned subsidiary which merges into the acquired corporation as a means of eliminating its dissenting shareholders. Similarly, where a subsidiary is formed solely to acquire the assets of another corporation in exchange for the parent's stock, the immediate liquidation of the subsidiary into the parent following the exchange qualifies as a "C" reorganization.

Basis:

When Y Corp. acquires the stock of X Corp. in a "B" reorganization, the stock retains the same basis that it had in the hands of the X Corp. shareholders. Thus, Y Corp. must depend upon the records of the individual shareholders of X Corp. to establish its own basis. In the absence of such records, some difficult practical problems can arise in any subsequent taxable disposition by Y Corp. of all or part of the stock of X Corp.

The form below is an agreement and plan of a "B" reorganization under which one corporation acquires from a group of individuals all of the issued and outstanding stock of another corporation in exchange solely for the former's own, newly issued voting stock, in accordance with an exchange ratio set out in the agreement. It should be noted that the corporation whose stock is being acquired is made a party to the agreement so that it can accept certain restrictions on its activities during the period prior to the closing.

The reorganization is conditioned upon the receipt of a favorable tax ruling or, if that is not possible before the date fixed for closing, an opinion from counsel stating that the reorganization qualifies as tax-free. An example of the application for such ruling is made part of this form. For additional examples of applications for tax rulings and discussion, see Forms 16.07, 16.13, and "The Tax Background."

It will be noted that this form utilizes the traditional "stock-stockholder" terminology as distinguished from the "share-shareholder" terminology. The "stock-stockholder" terminology is the language of the Delaware statute. The "share-shareholder" terminology is the current fashion. As indicated in the comment on Form 16.01, the draftsman will have no trouble in adapting the form he desires to employ to the appropriate terminology.

FORM

(1) Agreement and plan of reorganization

AGREEMENT AND PLANS OF REORGANIZATION, dated as of ______[date], among The Sussex Corporation, a Delaware corporation, hereinafter called Sussex; The Marlboro Corporation, a Delaware corporation, hereinafter called Marlboro; and John Irvine, Robert Edwards, Frederick Blaine, Mark Jones, William Smith, Philip McKay, John Rhodes, Lewis Arnold, Richard Toole, and Robert Niven, hereinafter called the Stockholders.

1. Plan of reorganization. The Stockholders are the owners of all of the issued and outstanding stock of Marlboro, which consists of 5,000 shares of common stock of the par value of 25 cents per share. It is the intention of the parties hereto that all of the issued and outstanding capital stock of Marlboro shall be acquired by Sussex in exchange solely for its voting stock.

2. Exchange of shares. Sussex and the Stockholders agree that all of the 5,000 shares of Marlboro shall be exchanged with Sussex for 25,000 shares of the common stock of Sussex. The following numbers of Sussex shares will, on the closing date, as hereinafter defined, be delivered to the individual Stockholders in exchange for their Marlboro shares as hereinafter set forth:

Stockholder / No of Shares
of Marlboro / No. of Sussex
Shares To
Be Issued /
John Irvine / 1,500 / 7,500
Robert Edwards / 700 / 3,500
Frederick Blaine / 700 / 3,500
Mark Jones / 500 / 2,500
William Smith / 500 / 2,500
Philip McKay / 300 / 1,500
John Rhodes / 300 / 1,500
Lewis Arnold / 200 / 1,000
Richard Toole / 200 / 1,000
Robert Niven / 100 / 500
______/ ______
5,000 / 25,000

Such shares shall be issued in certificates of such denominations, amounts, and names as may be requested by the respective Stockholders. The Stockholders represent and warrant that they will hold such shares of common stock of Sussex for investment.

3. Delivery of shares. On the closing date, the Stockholders will deliver certificates for the shares of Marlboro duly endorsed with signatures guaranteed and with documentary stamps affixed at the Stockholders' expense so as to make Sussex the sole owner thereof, free and clear of all claims and encumbrances; and on such closing date delivery of the Sussex shares, on which documentary stamp taxes will have been paid by Sussex, will be made to the Stockholders as above set forth. Delivery will be made at such place in or about Los Angeles, California, as may be determined by the parties. Time is of the essence.

4. Representations of stockholders. The Stockholders represent and warrant as follows:

(a) As of the closing date they will be the sole owners of the shares appearing of record in their names; such shares will be free from claims, liens, or other encumbrances; and, subject to the escrow of such shares established pursuant to permits heretofore issued to Marlboro by the Commissioner of Corporations of the State of California with respect to the issuance thereof in escrow, they will have the unqualified right to transfer such shares.