Wednesday, April 30, 2008

Tax Risk - The tax and other implications of forming a parent company

Question posted:

I have clients who own several corporations and an LLC. They want to form a parent corporation of all their other companies. How does one reverse the existing companies into the new parent company?

Would the clients assign their stock holdings to the parent corporation, so that the newly created parent corporation owns all the stock or do the individuals have to sell their shares to the parent company?

If they have to sell the stock to the new corporation, does it have to be at fair market value or can it be a nominal amount?

Are there any tax implications?

Comments follow posted by various persons, which IS NOT legal advice, but mere general information to be verified by a professional:

1. First, get a written tax opinion on all the tax aspects of such transaction.

Generally, you can contribute property to a corporation on a tax-free basis if you meet certain hurdles. IRS §351 is the provision for corporations.

A Subchapter S corporation in the mix may complicate things. One issue as to selling stock v. Making contributions is whether you want to avoid a gain or recognize a loss.

I would defer to the CPA as to issues regarding consolidated tax returns and consolidated financial statements and related party transactions for tax purposes.

Other considerations would be whether they should roll these entities up into one corporation or LLC. The reduction in accounting and tax preparation fees and franchise taxes may be substantial.

2. The clients can contribute their stock in the existing corporations (and their membership in the LLC if that is to be included) to the new corp in exchange for the new corp issuing to them stock of the new corp. The new corporation will be the parent by virtue of now owning all the stock of the existing corps (and membership interests if the LLC is included). To transfer the stock in the existing corporations, all they need to do is endorse the certificates over to the new corp and deliver them.

The exchange would normally be tax free under IRC §351, but there is an exception to tax-free treatment in the case of forming an "investment company." The definition of "investment company" used to be limited to holding readily marketable securities, but because of congress's concern about Wall Street exploiting "loopholes" by creating swap funds, the definition was changed to include any stock. Therefore, someone will have to study §351(e) and any regulations carefully to determine whether the exchange will be a taxable event.

If any of the existing corps are S corps, they may lose their S corp status by being owned by a corporation. An S corp can elect to treat a wholly owned subsidiary as part of the S corporation for tax purposes, but then the transaction is probably treated as a taxable liquidation of the subsidiary.

3. The first question for the client is, "Why? What are you trying to accomplish?" Depending on the answer, it may or may not be a worthwhile idea. Unless there are specific advantages (e.g., must have business A operating in state X in separate domestic entity to qualify for state contracts or whatever), I don't think there's generally any compelling reason for this kind of reorganization to be done for privately-owned businesses). If they're looking to consolidate the value of different enterprises into one entity to attract outside investors or in anticipation of going public, it could make sense, but only in the context of realistic plans and expectations of being able to go in such a direction.


Foreigners coming in to form parent/subsidiary companies:

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