Divesting an unwanted asset
INSIGHT ARTICLE |
Sometimes paying a tax can be a sound planning idea. Consider the following: Target is a domestic C corporation that manufactures widgets. Its widget business has a value of $65x. In addition, Target owns a parcel of undeveloped real estate with a value of $35x (tax basis of $20x).
Acquiring is also a domestic C corporation in the widget business. Acquiring has offered a plan of acquisition (POA) to Target. This POA envisions Target transferring 100 percent of its widget business to Acquiring solely in exchange for shares of Acquiring voting common stock. Acquiring has made two points clear: (1) it has no interest in acquiring the parcel of real estate, and (2) it does not want to engage in a merger with Target because of potential contingent liabilities of Target that would be assumed by Acquiring under local law if Target were to merge into Acquiring.
Target believes the offer by Acquiring is attractive but is unsure what to do about its parcel of real estate. One solution would be for Target to simply distribute the parcel to its shareholders and then transfer its widget business to Acquiring. There are at least two reasons this is not a sound plan. First, if Target distributes the real estate to its shareholders, a double tax will occur. Target will be taxed on the appreciation of $15x, and the full value of the real estate will be taxed to the shareholders, likely as a capital gain since the real estate should be viewed as boot under section 356 if distributed pursuant to the POA. Second, because Acquiring does not wish to engage in a merger, the POA will need to qualify as a "C" reorganization under section 368 if the transaction is to be tax-free. In a "C" reorganization, it is required that Acquiring acquire "substantially all" the assets of Target. Neither the Code nor the regulations define what is meant by "substantially all" of a target's assets, but it is clear that a pure divestiture of 35 percent of Target's assets would raise an issue.
Here is where paying a tax can be sound planning. Target should simply sell its parcel of real estate to a buyer. This, of course, would be taxable. However, Target could retain the after-tax proceeds, roughly $30x, and then transfer its widget business plus the $30x of cash to Acquiring solely for Acquiring voting common stock. By doing this, two positive things will happen: (1) the transfer of 95 percent of Target's assets in the transaction will certainly satisfy the "substantially all" requirement, and (2) only one level of tax (rather than two) will be paid on the real estate. This second benefit results because the shareholders of Target will not receive any boot. All the shareholders will receive is $95x of Acquiring voting common stock (Target will be transferring $95x worth of assets in the transaction), and receipt of that stock will be tax-free under section 354.
Thus, as can be seen, sometimes paying a tax can be a sound planning idea.