M&A Tax Stories
August 31, 2020
A company and its owners may avoid federal corporate income taxation on its gain from the sale of the assets of the business if the seller receives buyer voting stock from the buyer and liquidates. This tax structure is called a C reorganization. Internal Revenue Code, Sections 368(a)(1)(C) and 368(A)(2)(G). If all the rules are followed then the owner won’t recognize income tax until he or she sells the buyer stock.
The company in this deal sold its assets in 1926 at a gain to the buyer in exchange for cash and short-term notes (all payable within 3 ½ months). The then C reorganization provision permitted the selling company to receive stock (no voting stock requirement) or securities.
The selling company did not recognize the gain on its tax return, treating the transaction as a C reorganization. The IRS disagreed and assessed tax, claiming that the short-term notes were not securities within the meaning of the C reorganization provision.
The dispute ended un in the Board of Tax Appeals. The company lost there and also in its appeal to the federal 5th circuit Court of Appeals. The company took the case to the U.S. Supreme Court. The high court also ruled for the IRS. It did not rule on whether the short-term notes were “securities” within the meaning of the then C reorganization provision.
Instead, the high court held that the transaction failed as a C reorganization because the selling company did not end up with a proprietary interest in the buyer. The court held that a tax favored C reorganization (an asset sale for buyer stock or securities) expands “the meaning of a reorganization from a traditional ‘merger’ or ‘consolidation” so as to include some things which partake of the nature of a merger or consolidation but are beyond the ordinary and commonly accepted meaning of those words — so as to embrace circumstances difficult to delimit but which in strictness cannot be designated as either merger or consolidation.”
However, the high court said that receiving short-term buyer notes did not come withing this expanded definition of reorganization, merger and consolidation: “But the mere purchase for money of the assets of … (this seller) … by … (this buyer) … is beyond the evident purpose of the provision, and has no real semblance to a merger or consolidation. Certainly, we think that to be within the exemption … (the seller) … must acquire an interest in the affairs of … (the buyer) … more definite than that incident to ownership of … (the buyer’s) … short-term purchase-money notes.”
This case is referred to as Pinellas Ice & Cold Storage Co. v. Commissioner, 287 US 462 – Supreme Court 1933 https://scholar.google.com/scholar_case?case=14650039434741271904&q=Pinellas+Ice+%26+Cold+Storage+Co.+v.+Commissioner&hl=en&as_sdt=2006
So, what does this 1933 Supreme Court decision tells us today? It tells us that a seller’s asset sale may not qualify as a C reorganization even if the seller receives some buyer voting stock. The amount of stock must be enough to give the seller an interest in the affairs of the buyer. Later courts would give businesses more guidance on what interest in the buyer is required.
By John McCauley: I help people with M&A tax issues involving privately held companies.
Telephone: 714 273-6291
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