Homework Set 5—Acquisition of Subsidiaries, Formation of Joint Ventures

Sections 354, 358, 368

Case 1

Midway Auto, Inc. is a family-owned corporation formed 25 years ago to purchase and operate Toyota dealerships in the Midwest. The company has been approached by a larger distribution company in a neighboring state with an acquisition offer.

As of the last day of last month, Midway had the following balance sheets (tax and book, respectively):

Tax Basis_ / FMV___
Cash & liquid investments / $1,250,000 / $1,250,000
Inventories / 3,600,000 / 4,250,000
Land, buildings, etc. / 8,500,000 / 12,500,000
Total assets / $13,350,000 / $18,000,000
Liabilities / $8,000,000 / $8,000,000
Common stock / 1,000,000 / 1,000,000
Additional paid in capital / 1,500,000 / 1,500,000
Retained earnings / 2,850,000 / 7,500,000
Totals / $13,350,000 / $21,600,000

The FMV balance sheet above was compiled from figures provided by a professional valuation analyst.

The outstanding stock of Midway Auto is owned as follows:

# of Shares / Tax Basis_
Sybil Johnson / 30,000 / $4,000,000
Harold Johnson / 30,000 / $4,000,000
Billy Johnson / 20,000 / $3,000,000
Heather Johnson / 10,000 / $1,000,000
Total Shares / 90,000 / $12,000,000

Sybil, Harold, and Billy are siblings. Heather is Billy’s daughter.

Assume that the acquirer proposes a stock for stock exchange in which it would transfer two and one-half of its own shares to each shareholder of Midway in exchange for each of their shares in Midway. Thus, for example, Sybil would receive 75,000 shares of the acquirer in exchange for her 30,000 shares of Midway. At the date of the offer, the acquirer’s shares were trading for $66.66 per share. There are no fractional shares, so none of the Midway shareholders will receive cash.

  1. Based on the above offer, what is the apparent value assigned by the acquirer on Midway’s goodwill?
  1. How much gain or loss will the Midway shareholders recognize in connection with the proposed acquisition?
  1. What will be their tax bases in their newly acquired Acquirer shares?
  1. What will be the Acquirer’s tax basis in its newly acquired Midway shares?

Case 2

Assume in case 1 above that the acquirer had acquired the assets of Midway, rather than the outstanding shares of Midway stock. The transaction would be structured much like above, except that Acquirer would transfer 225,000 of its shares to Midway in exchange for all its assets and liabilities. Midway would then liquidate, distributing the Acquirer shares to its shareholders.

  1. Would this transaction qualify as a tax-free organization under §368? If so, which kind?
  1. What would be the Acquirer’s tax basis in the assets received from Midway?
  1. What would be the Midway shareholders’ tax bases in their Acquirer shares (received in the liquidation of Midway).
  1. From a tax perspective, which of these two plans is most beneficial for the Acquirer? Why?
  1. Is either plan more beneficial to the Midway shareholders than the other? Explain.

Case 3

Assume the Acquirer does not want to acquire Midway in a tax-free transaction. It offers to pay a premium to Midway in order to acquire Midway’s assets, subject to all known liabilities (i.e., those listed on Midway’s balance sheet). It offers to pay $18 million cash to Midway, plus assumption of the company’s liabilities, for all of Midway’s assets. Midway will pay all income taxes attributable to the sale, and then liquidate, distributing the remaining money to its shareholders in liquidation of their shares.

  1. How much cash will the Midway shareholders, as a group, receive upon liquidation of Midway?
  2. How much money will the shareholders have left, again in the aggregate, after payment of shareholder level taxes on their gains?
  3. What basis will Acquirer take in each asset acquired from Midway?
  4. Assume that Acquirer paid the premium for Midway’s assets in order to obtain additional tax benefits. Further assume that the premium was $3 million. Based on your answer to number 3 above, was this a good decision for Acquirer? (Note that a yes or no answer is insufficient here. You should calculate the present value of the additional tax benefits, using a 5% required rate of return, to support your answer. Assume a 35% flat tax rate).