Section 368

What Is Section 368? 

Section 368 in the Internal Revenue Code (IRC) refers to the tax treatment of certain corporate reorganizations. Specifically, when an acquiring corporation offers a significant portion of its own equities as compensation to the target corporation it aims to acquire, such transactions may potentially qualify as a "reorganization" under IRC Section 368.

Similar to the concept of partial exchanges within Section 1031 of the tax code, shareholders of the target corporation involved in a Section 368 transaction become subject to taxation when they receive consideration other than the acquiring corporation's stock.

To qualify as a reorganization, a transaction must satisfy several criteria and conditions. When two business entities want to merge, they have various options for structuring the deal. Depending on the situation, it may be advantageous to apply alternative sections of the tax code to govern the acquisition transaction.

IRC Section 368 comes into play when the shareholders of the target corporation agree to accept shares of the acquiring corporation as the primary form of compensation for their ownership interests.

Within Section 368, there exist several transaction types, and each has a different maximum amount of money that can be used. However, it's essential to note that a Section 368 transaction cannot achieve reorganization unless the shares of the acquiring corporation constitute a minimum of 40% of the overall consideration involved in the transaction.

Subsections of Section 368

Section 368(A)(1) of the 1986 Internal Revenue Code (IRC) outlines the taxation framework for corporate reorganizations in the United States. However, to qualify for favorable treatment, reorganization transactions must comply with specific legal requirements. Moreover, case law has established additional precedents beyond the documented requirements.

For federal income tax purposes, various transactions may qualify as tax-free reorganizations. Nevertheless, to be considered a tax-free reorganization, a transaction must meet the legal requirements of one of the tax-free reorganization types.

These three jurisdictional requirements, namely continuity of interest, continuity of business enterprise, and a valid business purpose, apply to all tax-free reorganizations and are generally required.

IRC Section 368 defines the various tax-free reorganization types (a). Following are a few of them:

These reorganization types can be categorized into five distinct categories. Sections A, B, and C are classified under acquisitive reorganizations, which require a divisional structure.

The remaining four types of reorganizations, subsections D through G, belong to separate categories and will be further discussed below.

An Acquisitive Reorganizations

The first three acquisitions listed above are considered acquisitive reorganizations because they each involved the purchase of a subsidiary.

According to IRC Section 368(a)(1)(A), a tax-free acquisition is relatively straightforward. A divisional corporation is consumed into a parent company in a merger-type reorganization following any relevant state legislation or merger statute.

In contrast, a consolidation combines two businesses that are on equal footing. These two businesses might merge in terms of corporate structure to form a new corporation.

A forward triangular merger is a different kind of merger that is described in IRC Section 368(a)(2)(D). Instead of being purchased directly from the parent company in this reorganization, a target corporation is acquired by a parent company's subsidiary.

IRC Section 368(a)(2)(E) describes a reverse triangular merger in which the target corporation absorbs a subsidiary of the parent having acquired the company.

A stock-for-stock exchange, as defined in Section 368(a)(1) Subsection B, outcomes in such a parenthetical B reorganization.

In this kind of deal, the entire target company's stock is exchanged for a portion of the shares of the acquiring parent company. As a result, the acquiring company becomes the legal owner of the target company instead of the target company's shareholders.

In return, target company shareholders gain minority ownership in the acquiring business. 

A stock-for-asset exchange, also famously called a parenthetical C reorganization, is defined in Section 368(a)(1), Subsection C.

A Divisive Reorganization

A divisive reorganization, compared to an acquisitive one, involves selling off a portion of a group's assets or breaking up a corporation into relatively small subsidiaries. As a result, a tax-free reorganization occurs, analogous to the opposite of an acquisition. 

IRC Section 368(a)(1)(D) states that a parent company's asset division may qualify as a valid and legally binding reorganization if the holders of each divided portion accepted control right away after the transfer and were shareholders of the previous parent company.

Section 354 also describes a supporting framework for tax-free receipt of replacement shares in this reorganization.

When a company changes the ratio of debt to equity within the company, it undergoes a recapitalization. This might result from unfavorable economic conditions that force the company to restructure but not to the point where a merger or deconsolidation is necessary. 

Upstream and downstream recapitalization are the two different types of recapitalization. Common shareholders scale up into preferred shareholders due to an upstream recapitalization. 

A downstream recapitalization reduces the ownership of existing shareholders while eliminating debt by converting debt holders into shareholders.

Reorganization for federal tax purposes could be caused by a move or a change in organizational structure.

An old entity and a shell business entity in a new location may be merged to achieve this movement, or the desired organizational structure may be retained. 

This type of reshaping, which includes a mere transformation in individuality, form, or place, is referred to as a reorganization for tax reasons in Section F.

The classification of reorganization in the case of insolvency or bankruptcy law is described in the final subsection. For example, equity stake sales in corporations going out of business could be reorganizations and trigger income tax recognition.

More details can be found here.

Understanding section 368 

When shares of a company that controls the acquiring corporation are traded for shares in a reorganization that meets the requirements with subsection (1), (B), or (1)(C) (a). The controlling corporation is included in the definition of a party to a reorganization.

The term party to a reorganization includes the corporation controlling the corporation to which the acquired assets are transferred when a reorganization qualifies under paragraph (1)(A), (1)(B), (1)(C), or (1)(G) of subsection (a) due to paragraph (2)(C) of subsection (a).

Regulations in a reverse subsidiary merger permit a wide range of post-reorganization transactions of having survived Target's assets or stock as long as the conditions for maintaining the continuity of the business enterprise are met.

Particularly, Target's assets may be given to shareholders if doing so does not result in Target being deemed liquidated for federal income tax purposes.

To the extent that Target's assets or stock are moved within the competent group, and Target is not terminated due to the restructuring, all or a portion of Target's assets, store, or both may be transferred to Target's subsidiaries.

The remaining option is to transfer Target's stock to a partnership in which the eligible group members own an interest equal to section 368. (c) control.

Types of Section 368 Reorganizations

Section 368 categorizes reorganizations into different types, including:

• Type A (stock-for-assets)
• Type B (stock-for-stock)
• Type C (stock-for-assets)

Each type comes with its own set of requirements and conditions, often involving mergers, consolidations, and acquisitions.

Type A (stock-for-assets)

Type A reorganizations, often referred to as "stock-for-assets," involve a strategic exchange where target shareholders transfer their equity for acquirer shares, under specific conditions outlined in tax law. Here are some specificities related to Type A:

1. Transfer their shares for acquirer shares.
2. Up to 60% boot allowed in a statutory merger (continuity of interest requirement applies).
3. Must pay boot immediately while deferring tax on payments made in acquirer stock.

Stock Consideration:

• Voting and non-voting common or eligible preferred stock of the acquirer may be used.
• The target is compelled to sell, and the acquirer assumes control of the target's entire asset and liability portfolio.

Voting and Appraisal Rights:

• In most states, both acquirer and target shareholders must vote in favor of the merger plan.
• Dissenting shareholders can independently appraise their shares and buy them for cash.

Statutory Consolidation:

• Involves dissolution of multiple corporate entities.
• They contribute all assets and liabilities to the newly merged corporation to complete the transaction.

Merger of Equals:

• Mergers of equals fit well with this structure.
• Duplicate voting and appraisal privileges apply to target and acquirer shareholders.

Forward Triangular Merger:

• The target is merged into a conglomerate of the acquiring corporation.
• It abandons the subsidiary as the sole survivor.

Assets and Contracts:

• Non-transferable assets and contracts, including patents or licenses, may be lost due to target elimination.

Tax-Free Treatment Requirement:

• For tax-free treatment, the buyer must purchase substantially all of the target's assets.
• Defined as at least 70% to 90% of the future value of the target's gross and net assets.

Consideration and Continuity:

• Consideration must satisfy the continuity of interest requirement.
• Flexible type of securities for payment in acquirer stock (payment in subsidiary stock is disallowed).

Approval Flexibility and Liability Isolation:

• Unlike a statutory merger, acquirer shareholders don't need to approve the same merger unless it's significant or more shares need authorization.
• The acquiring company is shielded from target's liabilities as they are isolated in a distinct legal entity (the subsidiary).

Reverse Triangular Acquisition:

• A subsidiary of the acquiring firm merges into the target.
• Eliminates minority shareholders, leaving the target as the surviving organization and a subsidiary of the acquirer.

Protection and Flexibility:

• Similar to a forward triangular merger, it protects the acquirer from target's liabilities while preserving non-transferable assets and contracts.

Common Structure:

• The reverse triangular merger is frequently employed.

Equity Consideration and Voting:

• Less flexibility in equity consideration (voting must encompass at least 80% of the price paid in acquirer's preferred or outstanding stock).
• Comparable requirements to forward triangular mergers, including the "substantially all" and shareholder approval requirements.

Type B (stock-for-stock)

In a Type B reorganization, the acquirer engages in a strategic exchange, defined by the acquisition of 80% ownership in terms of both voting rights and the value of the target company's stock. Key features of Type B reorganizations include:

• Boot Exclusion: Unlike some other reorganization types, Type B transactions typically do not involve boot, except for minor sums exchanged for fractional shares.
• Liability Protection: The acquirer benefits from protection against the target's liabilities as the target continues to operate as a subsidiary of the acquirer. This shields the acquirer from assuming the target's obligations.
• Gradual Acquisition: Buyers have the flexibility to gradually acquire the required 80% ownership of the target's stock. This approach, often referred to as a "creeping" acquisition, allows for a more strategic and phased takeover. 
• Minority Shareholders: Notably, Type B reorganizations may still allow minority shareholders to retain ownership in the target. The structure does not mandate the acquisition of 100% of the target's shares, providing some flexibility. 
• Comparison with Reverse Triangular Mergers: Type B reorganizations share similarities with reverse triangular mergers. However, Type B reorganizations may involve boot to eliminate minority shareholders, and they require the buyer to acquire "substantially all" of the target's assets.

This structure can be advantageous, especially when target shareholders have specific considerations, such as potential capital gains upon a stock offering for cash. It also appeals to buyers seeking to avoid a substantial upfront payment for the acquisition or looking to insulate themselves from the target's liabilities.

These characteristics make Type B reorganizations a strategic choice in certain merger and acquisition scenarios.

Type C (also stock-for-assets)

In a C reorganization, the acquirer trades nearly all of the target's assets for its voting common or preferred stock.

The target liquidates its assets and distributes any remaining funds and assets to its shareholders. Accordingly, funds or other securities (other than voting common or preferred stock) may not be considered for 20% of the Fair Value of the target's pre-transaction assets. 

• If cash or other non-qualifying consideration is paid, any liabilities taken on by the acquirer count toward the 20% boot limit.
• The buyer can be picky about which of the target's assets it will assume, just like in taxable asset acquisitions.
• Rejecting certain liabilities provides more protection to the acquirer than containing those liabilities in a subsidiary.
• Unless it is limited by a subsidiary, the acquiring company is exposed to any presumed liabilities.

Additionally, the "C" restructuring can be mechanically challenging, expensive, and time-consuming, similar to taxable asset acquisitions. So "C" reorganizations are uncommon.

Four Conditions of the Section 368

Four requirements must be satisfied to qualify for Section 368's tax-deferral treatment. These requirements include the step transaction doctrine, the validity of the business reasons, the ownership stake, and the continuity of the business organization: 

1. At least 40% of the consideration must be acquirer stock during the transaction satisfies the requirement for continuity of ownership interest.
2. The target's business or assets must be used for a valid business purpose for at least two years after the transaction to satisfy the requirement for business continuity.
3. The transaction must serve a purpose other than tax avoidance to satisfy the valid business purpose condition.
4. Each step in the transaction must have an independent economic purpose.

The transaction will only count as a reorganization well within the definition of 368 if all of these four requirements are satisfied.

A transaction can be challenging due to its numerous layers and variations. One of the primary reasons businesses should speak with an experienced tax attorney before beginning a transaction of such a nature is its complexity.

Researched & Authored by Laiba Kamran Shamsi | Linkedin

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