United States

Third Circuit affirms shareholder taxable on $17.3M merger gain

Netting of gains and losses on separate blocks of stock is rejected

TAX ALERT  | 

The U.S. Court of Appeals for the Third Circuit affirmed a Tax Court’s decision that rejected a taxpayer’s claimed netting of gains and losses on the disposal of separate blocks of stock in a single transaction. The court’s decision in Tseytin v. Commissioner[1] holds the taxpayer to the form of his transaction and highlights the rules governing recognition of gain in corporate reorganizations under section 354 and section 356 (section 356 is applicable when the reorganization involves both stock and other property or boot). A previous RSM article (Tax Court rejected taxpayer’s claimed netting of gains and losses) discussed the 2015 Tax Court decision[2] affirmed by the Third Circuit.

Merger transaction partially taxable

The taxpayer in Tseytin was the majority shareholder of a corporation (Target) that operated franchise restaurants. Target was acquired in a merger in June of 2007. In the merger, the taxpayer received stock worth about $30.8M, plus about $23.1M of cash. His receipt of stock was not taxable because the merger was a reorganization qualifying under section 368(a)(1)(A) of the Tax Code. The cash, however, was taxable “boot” under section 356(a) to the extent it did not exceed gain realized by the taxpayer on the exchange.

The Tax Court had held the taxpayer’s recognized gain was about $17.3M. The taxpayer presented two arguments to the Third Circuit in support of his contention that this gain amount was too high.

Taxpayer held to the form of his transaction

The taxpayer held 75% of the shares of the target company with a tax basis of zero. He also bought the remaining 25% for $14M about three weeks before the merger. The taxpayer argued that he was not the owner of the 25% block of stock, but acted merely as an agent for the 25% shareholder in connection with the merger.

The Third Circuit dismissed this argument, citing its Danielson rule. Under that rule, a taxpayer is held to the form of its transaction unless one of a limited class of exceptions is met.[3] The taxpayer in this case did not meet any of these exceptions. The contracts signed by the parties statee in explicit terms that the taxpayer purchased the stock in question for his own account (i.e., not as an agent). The Third Circuit noted that the taxpayer’s hypothetical ability to have structured the deal in a different manner did not provide any benefit, holdng the taxpayer bound by the transction form he chose.

No netting of gains and losses; gain computed separately on each block of stock

The taxable gain to the taxpayer on the merger was not the full $23.1M cash he received, but was limited to the $17.3M of capital gain realized. The taxpayer argued that this gain amount should be further reduced by netting a loss realized with respect to one block of stock with the gain realized on another block. The Third Circuit, like the Tax Court, rejected this argument as contrary to section 356 of the Tax Code, which requires recognition of certain gains and does not allow netting.

Increasing deferral of gain where boot is received in a reorganization

The taxpayer in Tseytin may have been able to reduce his taxable gain if the merger documents specified which shares he was exchanging for cash and which for stock. Tax regulations issued in 2006 allow taxpayers to allocate consideration received to specific shares of stock exchanged, provided that the terms of the agreement express the shareholders’ preferences and those terms are economically reasonable. If the agreement governing the transaction does not provide an allocation, the regulations require a pro rata allocation of consideration in proportion to the value of each item exchanged. Below are two examples which highlighting advantageous use of these regulations used in tax planning.

Example 1 – Different classes of shares with different bases

A. No allocation in merger agreement:

Public Corporation (PC) will acquire Corporation XYZ (XYZ) in a merger qualifying as a coporate reorganization. In the merger shareholder 1 will exchange one common XYZ share and one preferred XYZ share, having tax basis of $5 and $10, respectively, for $10 of cash and one PC common share. The terms of the merger agreement do not specify to which shares the consideration is to be allocated. Pursuant to the default allocation rules, Shareholder 1 receives consideration consisting of $5 in cash and $5 in PC stock for each XYZ share exchanged. Shareholder 1 realizes $5 of gain on her XYZ common share ($10 less her $5 tax basis in that share) and will recognize all of this $5 gain because thre is $5 cash boot allocated to the XYZ common share. Shareholder 1 realizes and recognizes $0 of gain on her XYZ preferred share ($10 less her $10 tax basis in that share). Her’s total recognized gain is $5.

B. Specific allocation in merger agreement:

Assume the same facts as in A. above, except that the terms of the merger agreement specify that the $10 of cash is allocated to Shareholder 1’s preferred XYZ share and the one PC common share is allocated to her XYZ common share. Also assume that the allocation is economically reasonable. As in the example above, Shareholder 1 realizes $5 of gain on her share of XYZ common. However, , she will not recognize any of this $5 gain because only stock consideration (rather than boot) is allocated to the share of XYZ common. As in the example above, Shareholder 1 realizes and recognizes $0 of gain on her XYZ preferred share. Her’s total recognized gain is $0.

Example 2 – Single class of shares acquired at different dates and values

A. No allocation in merger agreement:

The founding shareholder or Corporation ABC (ABC), F, buys 100 shares of XYZ stock for $1 per share. A second shareholder, S, also buys 100 shares for $1 per share. A few years later, ABC’s stock has increased in value. On Date 1, F purchases from S all of S’s shares for $20 per share, or $2,000. F now owns 100 shares that have a $1 basis per share and 100 shares that have a $20 basis per share. A year later, F and PC agree that PC will acquire 100% of ABC’s stock in a qualifying corporate reorganization for $5,000 ($25 per share), consisting of $2,000 (or 40%) cash and 60%, or $3,000 (60%) PC common stock.

F realizes $24 ($25 - $1) of gain on each of his 100 shares having a $1 tax basis – a total of $2,400 on these shares ($24 x 100 shares). Of this gain amount amount, he will recognize $1,000, based on the default allocation rules. F realizes $5 ($25 - $20) of gain on each of his 100 shares having a $20 tax basis – a total of $500 on these shares ($5 x 100 shares). Of this amount, he will recognize all $500 based on the default rules. ecause F received boot to this extent for those shares. F will recognize gain of $1,500 in total ($1,000 + $500).

B. Specific allocation in merger agreement:

Assume the same facts as in A. above, except that the terms of the agreement specifically provide that F will receive $2,000 in cash (boot) for 80 of the shares in which F has a basis of $20 each. F will realize and recognize $400 of gain ($2,000 - ($20 per share x 80 shares or $1,600)) on these 80 shares. The agreement also provides that F will receive $3,000 in PC common stock for F’s other 120 shares (F hold 20 of these shares, with a $20 per share tax basis, and in he holds 100 of them, with a $1 per share tax basis. F will realize gain on these 120 shares of $2,500 ($3,000 - ($20 per share x 20 shares + $1 per share x 100 shares, or $500)). However, F will not recognize any gain on these 120 shares because he exchanged them for PC common stock in the reorganization. F’s total recognized gain is $400 ($400 + $0).

Conclusion

Taxpayers participating in corporate acquisitions and reorganizations often engage in tax planning. Two steps that can achieve tax savings in some cases are (1) aligning the transaction structure with the intended tax treatment and (2) providing specific allocations of consideration in transaction agreements. The taxpayer in Tseytin did not take these steps, and the resulting IRS’ tax assessment was upheld by both the Tax Court and the Third Circuit. Taxpayers undergoing corporate reorganizations should consult with their tax advisors experienced in handling merger and acquisition transactions.

[1] Tseytin v. Comm’r, (3d Cir. No. 16-1674, Aug. 18, 2017).  

[2] Tseytin v. Comm’r, T.C. Memo. 2015-247.

[3] See Comm’r v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967).

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