VIII REORGANIZATIONS Exempt reorganizations: mergers, consolidations, holding companies, subsidiaries, recapitalizations, charter modifications, transfers to corporation. Recognition of gain or loss. Basic value in corporate organizations and reorganizations. Reorganization of sole proprietorship. Partnership reorganizations. The Supreme Court on reorganizations. Illustrations of reorganizations. ON pages 90 to 93, the general rules applying to reorganizations and to the changes in costs and other values assignable to new securities received in reorganization proceedings were outlined. A restatement of these points seems desirable, particularly with the idea of examining the taxable character of both organizations and reorganizations of business enterprise. Reorganizations, as the word is employed in the revenue act and in the regulations, include the following: (a) Mergers. A merger is the transfer of the assets of one corporation to another, through the outright purchase of all the assets. Prior to the purchase, the buying corporation may or may not have owned the capital stock or any portion of the capital stock of the selling corporation. A merger is sometimes referred to as the absorption of one corporation by another. The selling company is usually dissolved, although its dissolution is not a necessary feature of the exemption from tax which accompanies many mergers. (Sec. 203 (c)); the law states, however, that "substantially all" the properties must be transferred. (b) Consolidations. In a consolidation, two or more corporations combine their properties and form a single new corporation. The transfer of assets may have been preceded or not by an affiliation between the two or more selling cor porations. As in (a), all or "substantially all" the properties must be transferred to the new corporation if the transaction is to be called a reorganization. (c) Creation of a certain type of holding company. According to the law, the acquisition by one corporation of a majority or more of the voting stock and a majority or more of the non-voting stock of another corporation is a statutory reorganization. The requirement of a majority or more of non-voting stock is necessary if continued control is to exist, because (1) Many non-voting stocks become voting stocks when dividends are missed, properties are sold, and other conditions arise; it thus becomes difficult to define what "voting" stock really means. (2) Non-voting stock is easily changed into voting stock by amending the charter of the corporation. (3) Certain states, through their courts, have declared the non-voting provisions of stock issues invalid. The term "holding company" as used at the head of the preceding paragraph does not appear in the law; it is used in accounting and financial practice to signify a corporation which owns more than 50% of the voting stock of at least one other corporation, called a subsidiary. The existence of this relationship warrants, in most cases, the preparation of a "consolidated balance sheet" on which the holdings of outside stockholders in subsidiary companies are designated "minority interests," a quasi-liability. The object of a consolidated balance sheet is to give expression to present control; the tax law, by requiring a majority ownership of each class of stock, seeks to eliminate those cases where present control is not accompanied by the assurance of continued control. (d) Transfer of assets to a certain type of subsidiary or affiliated corporation. The statutory definition of reorganizations includes the transfer of all or a part of the assets of one corporation to another, the second corporation being either an established business or a corporation newly formed for the purpose. The condition attached is that "immediately after" the transfer there must be at least an 80% ownership of the voting stock and an 80%, or greater, ownership of the other classes of stock. The law provides that this ownership may vest in the first corporation, its stockholders, or both. Again, the distinction between financial practice and the tax law should be noted. If more than 50% of the voting stock remains in the possession of the first corporation, the corporation is a holding company and the second corporation is a subsidiary; if less than 50% or none of the voting stock is owned by the first corporation, but the statutory control is effected through a common holding of the stocks of both corporations, the corporations are said to be affiliated. It will be observed from (a) and (b) that "substantially all" the property of a corporation must be transferred in a consolidation or merger to come within the statutory definition of reorganization; but that in an "unscrambling" process any portion of the assets may be transferred. In (a) and (b) a new group of stockholders may be established who may or may not be in "control;" in (d) control must not change. The difference between (c) and (d) lies in the exchange of stock for stock in (c) and in the exchange of assets for stock in (d). In (c) the stock is necessarily purchased from the stockholders of the subsidiary, while in (d) the stock is issued directly to the controlling company by the subsidiary in payment for the assets purchased. However, in (c) only a bare majority control in the subsidiary need be acquired by the holding company; in (d) at least an 80% control must be retained by the parent company, or its stockholders, or both. No sound reason exists for the continuance of the 80% "control." Fifty per cent is all that is necessary to secure and maintain effective control. (e) Recapitalization. The law exempts recapitalizations without defining them. A recapitalization usually means the calling in of old securities and the issuance of new. But suppose a corporation issues bonds in exchange for a part of its stock or in addition to an even exchange of stock. In either case it would seem that if all stockholders were treated alike, a true recapitalization had been effected.1 (f) Charter modifications. A corporation may change its "identity, form or place of organization" and thus effect a reorganization as defined by the law (Sec. 203 (h); Art. 1574, 1577). (g) Related to the reorganization provisions is the "organization" provision whereby one or more persons transfer property to a corporation and immediately thereafter are in control (the 80% control previously described) of the corporation. If they contribute property owned jointly, they must be compensated in proportion to their original interests (Sec. 203 (b) (4). RECOGNITION OF GAIN OR LOSS No gain or loss arises from reorganizations in which there takes place 1. An exchange of securities (including bonds as well as stock) for securities (Sec. 203 (b) (2); Art. 1572, 1576); 2. An exchange by a corporation of property for securities (Sec. 203 (b) (3)); 3. A transfer of securities to stockholders without surrender of their stock (Sec. 203 (c)); Nor from an organization or transfer of property to a corporation where— 4. Property is transferred to a corporation under the conditions recited in the preceding paragraph (Sec. 203 (b) (4)). 1 See I. T. 2258 for a transter of bonds to stock. The receipt of cash, or "other property," or both, in addition to the receipt of securities, where the receipt alone of securities would have made the exchange tax-free, gives a taxable status to the transaction. The gain is then recognized, measured by the excess of the fair market value of what is received over the basic value of the property or securities surrendered; so much of the gain is subject to tax as is not in excess of the cash plus the fair market value of the "other property" received (Sec. 203 (d) (1); Art. 1573, 1575). No loss can be deducted where cash or other property is received. It is obvious that the rules governing gains taxable in part cannot be applied to losses. Cash and other property received are credits, therefore, against the old cost. (Sec. 203 (f); Art. 1573). The 1921 act provided that cash received in connection with a reorganization should be credited against basic value. However, the Treasury Department, immediately after the passage of the 1921 act, ruled that no cash might pass to the stockholder if the reorganization was to remain non-taxable. But this was contrary to Section 202 (e), which originally provided for the crediting of any cash or property other than securities to the cost of the old holdings; and apparently has not been held to by the Department itself.1 Congress saw fit (in the act of March 4, 1923) to uphold the rule of the Department, for in reorganizations after January I, 1923, the law, as altered, regarded the receipt of cash or other property in addition to securities as destroying their tax-free status. Should cash, for example, pass to the stockholder in addition to stock, the fair value of the latter would be added to the former, the result being the selling price; but the taxable income would be held, according to the statute, not to exceed the cash received. If any part of the cash or "other property" payment by a corporation to its stockholders-in cases 1 and 4-proceeds directly or indirectly from earned surplus, a dividend 1 See, for example, I. T. 1861. |