AC507 Unit 9 Tax-Free Reorganization Case Study Example

Sixty Percent Stock, Forty Percent Cash: A Unit 9 Reorganization Case Study of a Software Merger

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Purdue University Global

AC507: Business Taxation and Strategies

Unit 9 Reorganization Case Study

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[Date]

The software company, the buyer, the founder, the employee and every figure are composite; the statutes, regulation, case and publication cited are real; this is coursework analysis, not tax advice.

Deal Summary

The buyer, a listed enterprise software company with an equity value of about $900 million, will acquire the target in a statutory merger under state law, with the target merging into a wholly owned subsidiary of the buyer. Target shareholders receive consideration worth $60 in buyer voting stock and $40 in cash for every $100 of target value. Most holders take the standard mix. A few, including some early employees, have elected all cash, and the buyer has agreed provided overall consideration stays at 60 percent stock.

The founder holds target shares with a basis of $400,000 and will receive $1,800,000 of buyer stock and $1,200,000 of cash. An early employee, Devin, holds 20,000 target shares acquired by exercising stock options three years ago, with a basis of $60,000, and will receive $500,000 in cash.

Qualification

A statutory merger can qualify as a reorganization if it meets the statute and the judicial requirements the regulations codify (Definitions relating to corporate reorganizations, 26 U.S.C. § 368, 2018). The merger of the target into the buyer's subsidiary, with buyer stock as consideration, is a forward triangular merger, which also requires that the subsidiary acquire substantially all of the target's properties and that the merger would have qualified had the target merged into the buyer itself.

Continuity of interest. The target's shareholders must keep a substantial equity stake through the buyer's stock. The regulations treat the requirement as met where stock makes up 40 percent of the consideration, using values fixed under a binding contract (Treas. Reg. § 1.368-1, 2024). At 60 percent stock, the deal clears that comfortably.

Continuity of business enterprise. The buyer will continue the target's software business and use its assets, which satisfies this requirement.

Business purpose. The merger has a clear commercial purpose: the buyer gains the target's products and customers.

The deal qualifies.

The Founder

The founder realizes a gain of $2,600,000: $3,000,000 received less $400,000 of basis. In a reorganization, a shareholder recognizes gain only up to the cash and other property received, called boot (Receipt of additional consideration, 26 U.S.C. § 356, 2018). He recognizes $1,200,000.

How that $1,200,000 is characterized turns on whether the exchange has the effect of a dividend. The Supreme Court held that the test is applied as if the shareholder had first received only buyer stock and the buyer had then redeemed the portion equal to the cash (Commissioner v. Clark, 1989). Measured that way, the founder's interest in the buyer falls from a tiny percentage to an even tinier one, a meaningful reduction, so the $1,200,000 is long-term capital gain.

His basis in the buyer stock is his old basis, $400,000, plus the gain recognized, $1,200,000, less the cash received, $1,200,000: $400,000. The remaining $1,400,000 of gain is deferred until he sells the buyer stock. His holding period carries over from his target shares.

The reorganization rules defer the founder's gain only to the extent he keeps investing through the buyer's stock, so the 40 percent he takes in cash is taxed now and the 60 percent he keeps in stock carries his old basis forward, preserving the untaxed gain for later.

The Early Employee

Devin receives only cash, so he has no continuing interest to protect; his exchange is fully taxable regardless of the deal's qualification. He realizes and recognizes $440,000, $500,000 less his $60,000 basis.

The character of his gain depends on his options. If they were incentive stock options and he has held the shares more than two years after the grant and more than one year after exercise, the gain is long-term capital gain. He exercised three years ago and the options were granted five years ago, so he meets both periods. If they were nonqualified options, the spread at exercise was already taxed as wages and included in his basis, and the remaining gain is capital gain as well. Either way, his $440,000 is long-term capital gain this year.

Devin should also confirm that no part of his cash is treated as compensation, which can happen when employees receive more than other holders per share; here all holders receive the same value per share, so it is not.

Corporate Consequences

The target recognizes no gain on transferring its assets in the reorganization, and the buyer recognizes none on issuing its own stock. The subsidiary takes the target's assets at their existing basis, which means the buyer gets no step-up and inherits the target's lower tax depreciation and amortization. The target's tax attributes, such as net operating losses, carry over subject to limits on loss use after an ownership change (Internal Revenue Service, 2025).

What If the Deal Had Failed to Qualify

If the stock portion had been too small, say 25 percent, the merger would be a taxable acquisition. The founder would recognize his entire $2,600,000 gain now, and the buyer would still receive the target's assets at their old basis unless the parties elected otherwise. The early employee would be in the same position as before, since he took only cash. This contrast shows that qualification matters only to holders who take stock: for them, it is the difference between paying tax on $1.2 million and on $2.6 million this year.

Reporting

The target will issue information reporting showing each holder's consideration, and the buyer must file a statement describing the reorganization with its return. The founder must attach a statement to his own return showing the basis of the target stock surrendered, the value of the buyer stock and cash received, and the gain recognized. Keeping these records matters, because the basis he carries into the buyer stock, $400,000, will decide his gain when he sells it, perhaps many years later.

He should also check his state's treatment, since a few states do not follow the federal reorganization rules for individuals.

Points for the Founder's Advisers

The founder could defer more gain by electing more stock, if the buyer allowed it, or less by taking cash for diversification. He should also consider that his deferred $1,400,000 would be eliminated for income tax purposes if he held the buyer stock until death, since his heirs would take a stepped-up basis. These are planning choices, but the case shows how much turns on the mix of consideration.

References

Commissioner v. Clark, 489 U.S. 726 (1989).

Definitions relating to corporate reorganizations, 26 U.S.C. § 368 (2018).

Internal Revenue Service. (2025). Corporations (Publication 542). U.S. Department of the Treasury.

Receipt of additional consideration, 26 U.S.C. § 356 (2018).

Treas. Reg. § 1.368-1 (2024).