LBO: Section 351 as a Surrogate for Section 368

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

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Section 351 postpones gain or loss on the contribution of appreciated property to a corporation[1] in exchange for stock,[2] assuming certain rules are followed. Section 351 is usually thought of in connection with the organization of unseasoned start ups. However, in fact the issuer can be newly organized or preexisting when the stock issuance occurs; it can be any size, have an unlimited number of shareholders pre- and post-financing and divide its shares into as many classes of stock as the situation warrants. In contrast to the S Corporation privilege, the principle of avoiding tax is not dependent on the resultant corporation being uncomplicated.

The principal requirement of § 351 is that, "immediately after" the financing, the investors who contribute property and/or cash in exchange for stock are in control;[3] that is, they own at least 80% of the issuer's combined voting power (all classes of voting stock) and 80% of the total number of all classes of nonvoting stock. If such is the case (and the property is not subject to liabilities in excess of its basis),[4] no gain will be recognized on appreciated property so transferred, either by the transferors or the recipient corporation. And, according to the usual rules governing tax-postponed transactions, the tax basis of that property in the hands of the corporation will be carried over from the basis of the contributor.[5] Prior to the 1989 amendments to the Code, the transferors could receive not only stock but "securities" tax free, meaning long-term debt instruments.[6] In that respect, § 351 is now aligned with its sisters (§§ 368 and 355) in that debt securities are boot.

Note some of the things § 351 does not do. It does not solve the "cheap stock" problem, when a founder, employee, consultant, and others are receiving stock in Newco in exchange for past or future services and want to avoid tax.[7] In fact, if one of the stock buyers is paying in services (past or future)[8] and getting back more than 20% of the issuer's voting power, the entire transaction will be disqualified, much to the distress of the individual(s) in the buying syndicate putting up appreciated property. The same problem arises if the service provider takes back the only shares of a class of nonvoting stock (or more than 20% of such shares).[9] The problem can be remedied by the service provider also contributing property to the corporation, so long as the value of the property contributed is more than nominal.[10]

[1]-The "Receptacle" or "Mixing Bowl" Concept

Section 351 can function alongside the § 368 tax postponed reorganizations if preexisting shareholders of the Target are to receive stock in Newco. In a § 368 reorganization, old stock is exchanged for new stock (or stock and boot) in a merger or its equivalent, tax is postponed, basis of the assets in the hands of the purchaser is a "substitute" or carryover basis, and the boot is taxable. To reach somewhat the same result using § 351 of the Code, Newco is used as a receptacle, a medium of exchange. The shareholders of the Target deposit their stock in Newco and receive back some Newco preferred stock[11] or Newco preferred stock plus debt securities. The acquiring company buys its stock in Newco for cash in an amount sufficient (coupled with cash expected to be developed from operations) to retire the notes and/or redeem the preferred. The selling shareholders pay tax on their gain only to the extent of the boot (i.e., the debt securities, if any) and/or if and as they sell (or are redeemed out of) their Newco preferred stock. If they hold the stock[12] until death, tax on the postponed gain will be forever forestalled under § 1014(a), at least for decendants dying in 2011 or 2012.[13]

Now that "boot" in a § 351 transaction includes debt securities and nonqualified preferred stock, much of the steam has gone out of § 351 transactions as an alternative to § 368. There is, however, one particularly useful role for § 351 in restructurings.

[2]-National Starch/Unilever

Section 351 retains some usefulness as a receptacle in connection with a common fact pattern: a group of Target shareholders, usually the managers, desire to "roll over" their interests in the Target into Newco without paying tax. The transaction is scheduled, like most LBOs, to be taxable as a cash acquisition, so the § 368 avenues are not open.

The paradigm transaction, National Starch/Unilever, was the subject of a 1978 IRS letter ruling[14] which blessed a tax postponed "rollover" for the selling shareholder who wished to acquire stock in Newco while his brethren were cashed out in a taxable reorganization. The structure entailed the following: The shareholder wishing to "roll over" transferred his stock to Newco in a § 351 exchange, receiving back preferred stock mandatory redeemable at death. The Target put enough cash in Newco in the course of the § 351 reorganization so that Newco could buy out the Target selling shareholders. Newco organized a transient subsidiary, capitalizing it with the necessary cash, and the subsidiary merged into the Target, the Target shareholders receiving the cash. The grand result was that the shareholder of the Target wishing to stay in the deal owned 14% of Newco in the form of a nonvoting preferred stock, having paid no tax on the exchange; the other Target shareholders had cash and Newco owned 100% of the Target, all courtesy of § 351. The shareholder who hung in expected to be redeemed out for cash, but without paying tax because of the presumed step-up in basis on his death. In a subsequent Revenue Ruling,[15] the IRS reversed the National Starch position and then, in 1984, reversed itself again and returned to the original position.[16]

The principal utility of the National Starch rollover is of course, in management buyouts when the management looks to rollover part of its equity interest in the Target company. There are now a number of special rules when this occurs, however. For example, in 1997, the Code was amended to add § 351(g)(2) to introduce the concept of "nonqualified preferred stock", essentially defined as preferred stock which does "participate significantly in corporate growth" and which is likely to be retired within twenty years of its issue date (or bears a dividend rate that varies with respect to certain indices). This makes it look like a debt instrument, of course, and the issue about preferred stock as debt also arises in the debt versus equity calculation. Convertible preferred may not curiously qualify as a preferred which participates in corporate growth but certainly participating convertible preferred will so qualify.

Also, § 197(f)(9) imposes an anti-churning rule on certain acquisitions of intangible assets held or used by a "related person" on or before July 25, 1991. The effect of this provision is to deny the ability to amortize a step-up in the basis of the intangible assets if owners of the Target (or "related persons") have a continuing interest of 20% or more in Newco.

[1] § 351(a).

[2] "Stock" eligible for § 351 treatment can be voting or nonvoting, common, or certain types of preferred, but warrants are not considered stock. Treas. Reg. § 1.351-1(a)(1). Furthermore, "non-qualified preferred" stock, as defined in § 351(g) (including preferred stock with certain redemption rights or indexed dividend features), is generally treated as boot for purposes of section 351 as well as for purposes of the reorganization provisions.

[3] The definition of "control" is borrowed from § 368(c).

[4] See § 357(c)(1) (providing that the excess of liabilities assumed over basis will be recognized, with gain limited, however to the total gain on the transaction).

[5] § 362(a). If a going business is being incorporated under § 351, there may be special tax problems. For example, receivables may provoke tax if the transferor was a cash basis taxpayer i.e., an individual and the receivables were created for services. An elaborate checklist that must be followed in requesting a § 351 ruling, includes a representation regarding "unreported income" such as accounts receivable or commissions due. In effect, the representation must state that the transferor did not accumulate receivables or make an extraordinary payment of payables in anticipation of the transaction and that the transferee will report the items which, but for the transfer, would have resulted in income to the transferor as ordinary income. There is, however, no blanket prohibition against the transfer of receivables.

[6] The effect of deleting "securities" from the category of non-recognition consideration is, inter alia, to scotch the usefulness of transactions in which the Target shareholders received preferred stock and long-term debt tax tax-free in exchange for Target stock and then "cashed in" the debt by pledging it in a tax-free transaction. The approach "proved too good to last" and was curtailed, along with related maneuvers such as "bump and strip," designed to postpone, if not eliminate, tax. The introduction of the concept of nonqualified preferred stock similarly eliminated planning techniques involving certain types of preferred.

[7] Treas. Reg. § 1.351-1(a)(1)(i). Receipt of such stock is taxable to the recipient.

[8] § 351(d)(1).

[9] A question can arise (if, for example, intellectual property is in issue) as to when an item is "property" for purposes of § 351 and when it is "services," occasioning tax to the donor and perhaps to other contributors of property relying on § 351 to shield their gain. For example, a secret process may be "property" if it has an owner and can be sold, and it is a reflection of past services -- capitalized labor. The information should be clearly protectable (i.e., at least a trade secret) and in fact adequate safeguards taken to guard the secret, "original, unique, and novel" (though not necessarily patentable) and not "developed especially [sic]" for the transferee.

[10] See Treas. Reg. § 1.351-1(a)(2), Ex. 3. For ruling purposes, the property received is not insignificant if its value equals at least 10% of the value of the stock received. Rev. Proc. 77-37, 1977-2 C.B. 658.

[11] The "selling" shareholders must not receive more than 50% (by value or vote) of Newco's shares, or the risk is triggered that the transaction will be treated as a taxable redemption under § 304. §§ 304(a)(1), (b)(3).

[12] No step-up in basis will be available for the notes received. See § 1014(c).

[13] The Tax Relief Act of 2010. It does not appear that § 351 is useful in achieving a stepped-up basis in the acquired assets. See CCH Tax Transactions, § 902.032.

[14] P.L.R. 7839060 (June 23, 1978).

[15] Rev. Rul. 80-284,1980-2 C.B. 117.

[16] Rev. Rul. 84-71, 1984-1 C.B. 106.

Joseph W. Bartlett, Special Counsel,

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