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LBO: Taxable Stock Purchase

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


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LBOs and other restructurings generally involve taxable exchanges-cash or cash and notes to the sellers in exchange for their shares or to the Target in exchange for its assets. Buyouts involving public compares are often cash tenders where share-for-share exchanges may be more vulnerable to derailment, in the person of an eleventh-hour cash overbid, or unruly market conditions, because they can take longer to consummate.

Starting from the simple and moving to the complex, a cash purchase by the Host of shares from the Target's shareholders is taxable to the shareholders, the tax measured by their individual gain. The basis of the Target's assets, the so-called "inside basis," is unaffected. The Target's tax attributes remain undisturbed except for NOLs and built-in losses (which may be subject to limitation, for example, under § 382). The Target has no interest, ordinarily, in paying another tax in order to achieve a step-up in the basis of its assets so it does not make the § 338 election, which would create a deemed sale of assets. If the Host pays in cash and notes, or only notes, the selling shareholders will ordinarily be able to obtain installment sale treatment on the deferred payments unless, as discussed below, [1] the stock is publicly traded or the notes are liquid. The basis of the Target's stock in the Host's hands is what the Host pays (i.e., generally fair market value).

If there are more than a handful of Target shareholders, the Host often prefers to acquire the Target's stock (whether in a taxable or tax-postponed transaction) in a reverse subsidiary merger, entailing the creation of an acquisition or transient subsidiary which then merges into the Target. The Target's shares are canceled, and its shareholders receive whatever the plan of merger has in store for them-cash, notes, and/or equity in the Host. For tax purposes, the general rule is that the transitory subsidiary is disregarded and the economic substance of the transaction controls. Thus, if the cash or notes come from the treasury of the Host, the transaction is treated as a purchase by the Host of the Target's stock. [2] If the cash or notes come from the Target, the transaction will be deemed a redemption. [3] On occasion, the Host may elect a forward triangular merger, in which the target merges into the Host's subsidiary in exchange for cash, notes, and/or Host stock. This is viewed as if the Target had sold its assets to the Host or its subsidiary and then liquidated. [4]


[1] A seller recognizing gain on the installment method pays tax on a proportionate share of his "gross profit" each time he receives a payment. § 453(c). However, limitations on the use of the method apply (for example, the method is generally not available to dealers) and limitations on the benefits of the method may apply (such as under so-called interest and pledge rules).

[2] Rev. Rul. 73-427, 1973-2 C.B. 301; Rev. Rul. 79-273, 1979-2 C.B. 125.

[3] Rev. Rul. 78-250, 1978-1 C.B. 83; Rev. Rul. 79-273, 1979-2 C.B. 125.

[4] Rev. Rul. 69-6, 1969-1 C.B. 104. This transaction gives rise to the application of § 1060 and the related reporting requirements. As an asset transaction, it would also involve two levels of tax – one at the corporate level, on the asset sale, and the other at the shareholder level, on the deemed liquidation.

Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com

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