This document provides an overview and summary of key considerations related to buying and selling a business and the associated practical tax consequences. It discusses various types of tax-free reorganizations under Section 368 including Type A, B, C, and D reorganizations. It also covers taxable transactions such as stock sales and asset sales. Additionally, it summarizes continuity of interest requirements, net value rules, Section 382 limitations on losses after ownership changes, and strategies involving partnerships, S corporations, and foreign corporations.

1. BUYING AND SELLING A BUSINESS Practical Tax Consequences Roger Royse Royse Law Firm, PC 2600 El Camino Real, Suite 110 Palo Alto, CA 94306 rroyse@rroyselaw.com www.rroyselaw.com www.rogerroyse.com Skype: roger.royse IRS Circular 230 Disclosure: To ensure compliance with the requirements imposed by the IRS, we inform you that any tax advice contained in this communication, including any attachment to this communication, is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to any other person any transaction or matter addressed herein.

2. OVERVIEW OF TRANSACTIONS Tax Free Reorganizations: Type A – Merger Type B – Stock for Stock Type C – Stock for Assets Type D – Spin Off, Split Off, Split Up, and Type D Acquisitive Reorganizations Taxable Transactions: Stock Sale Asset Sale Foreign Corporations S Corporation Strategies Partnership Techniques 2

3. TAXABLE VS. TAX FREE Type of Acquisition Currency Stock Securities/Debt Deferred payments, earnouts Compensatory Nature of the Buyers and Seller Foreign Parties Tax Attributes of Parties Shareholder Level Considerations Tax Sensitivity of Shareholders Appetite for Complexity & Risk 3

4. CONTINUITY OF INTEREST 4 IRS – 50% Safe Harbor, Rev. Proc. 77-37 John A. Nelson – 38% Stock Miller v. CIR – 25% Stock Kass v. CIR – 16% Stock is Insufficient Value – 2007 Regulations address changes in value between the date of signing and close; if fixed consideration, (1) stock consideration is valued as of last business day before the first day the contract is binding and (2) if a portion of the fixed consideration is other property identified by value, then the specified value is used for that portion (see Reg. 1.368-1T(e)(2)). Consideration is “fixed” if contract states exact number of shares and other cash or property to be exchanged Post transaction sales and redemptions

6. Type B – Stock for Stock

7. Type C – Stock for Assets

8. Type D – Spin Off, Split Off, Split Up, and Type D Acquisitive Reorganizations

9. Ruling Guidelines

10. Rev. Rul. 77-37

11. Rev. Proc. 86-42

12. Rev. Rul. 73-54 (terms)

13. Rev. Proc. 89-50

14. Rev. Proc. 96-30 (Type D Checklist)5

16. Requires strict compliance with statute

17. Target can be foreign; Reg. 1.368-2(b)(1)(ii)

18. No “substantially all” requirement

19. No “solely for voting stock” requirement6

21. No Boot in a B

22. Reorganization Expenses – distinguish between Target expenses and Target Shareholder expenses (Rev. Rul. 73-54)

23. Creeping B – old and cold stock purchased for cash should not be integrated with stock exchangeAcquisition of stock of Target, by Acquiror in exchange for Acquiror voting stock Acquiror needs control of Target immediately after the acquisition Control = 80% by vote and 80% of each class

25. “Substantially All” – at least 90% of FMV of Net Assets and at least 70% of FMV of Gross Assets

26. Target must liquidate in the reorganization

27. 20% Boot Exception – Acquiror can pay boot (non-stock) for Target assets, up to 20% of total consideration; liabilities assumed are not considered boot unless other boot exists

28. Reorganization Expenses – Aquiror may assume expenses (Rev. Rul. 73-54)

29. Assumption of stock options not boot

30. Bridge loans by Acquiror are boot

32. TRI-ANGULAR OR SUBSIDIARY MERGERS 11 1. Forward Subsidiary Merger T P S 2. Reverse Subsidiary Merger T P S Key: T = Target P = Acquiror S = Merger Sub

34. P takes “drop down” basis in stock of Merger Sub (same as asset basis)T Shareholders P Stock T P 80% Merger Sub Survives S Section 368(a)(2)(D) Forward Triangular Merger A statutory merger of Target into Merger Sub (at least 80% owned by P) Substantially all of Target’s assets acquired by Merger Sub Would have been a good Type A merger if Target had merged into P Key: T = Target P = Acquiror S = Merger Sub

36. No gain to P and Merger Sub under Sections 1032 and 361

37. No gain to Target shareholders except to the extent of boot

38. P’s basis in Target stock generally is the asset basis, but P can choose to take Target shareholders basis in stock (if it is also a B)

39. If transaction is also a 351, P can use Target shareholders’ basis plus gainT Shareholders P Stock T P 80% Merger Target Survives S Section 368(a)(2)(E) Reverse Triangular Merger Merger of Merger Sub into Target where (i) Target shareholders surrender control (80% of voting and nonvoting classes of stock) for P voting stock and (ii) Target holds substantially all the assets of Target and Merger Sub Key: T = Target P = Acquiror S = Merger Sub

40. TAXABLE STOCK PURCHASES 14 Cash Reverse Triangular Merger Treated as Stock Sale T Shareholders Cash T P Merger Target Survives S Shareholders have gain or loss P takes cost basis in Target shares Key: T = Target P = Acquiror S = Merger Sub

41. CASH FORWARD MERGER 15 T Shareholders Asset sale followed by liquidation of Target Target has gain on sale Target shareholders have gain on liquidation (unless 332 applies) P takes cost basis in Target assets T P Merger P Survives Variation with Merger Sub: T Shareholders T P Merger Sub Survives S Key: T = Target P = Acquiror S = Merger Sub

42. NET VALUE RULES 16 2005 Proposed Regulation 1.368-1(b)(1): Exchange of no net value (liabilities exceed value) does not qualify as a reorganization Example: P owns all of the stock of both S and T. T has assets with FMV of $100 and liabilities of $160, all of which are owed to B. T transfers all of its assets to S in exchange for the assumption of T’s liabilities, and T dissolves. The obligation to B is outstanding immediately after the transfer. P receives nothing in exchange for its T stock. Under paragraph (f)(2)(i) of the Reg, T does not surrender net value because the FMV of the property transferred by T ($100) does not exceed the sum of the amount of liabilities of T assumed by S in connection with the exchange ($160). Therefore, under paragraph (f) of the Reg., there is no exchange of net value. See Prop. Reg. 1.368-1(f)(5) Example 3. Alabama Asphalt

44. Section 382

45. When there has been an ownership change of a corporation with loss carry forwards, use of Net Operating Losses (NOLs) against future income is limited to the product of the value of the Target and the long term interest rate

47. (2) issuer is required to redeem

48. (3) issuer has right to redeem and is more likely than not to exercise that right; or

49. (4) dividend rate varies based on interest rate, or commodity price or other index

50. Redemption right exercisable within 20 years and not subject to contingency that renders likelihood remote

51. Excludes stock compensation that may be repurchased on separation from service

52. Conversion feature not enough to participate in growth

55. Clark – hypothetical post-reorganization redemption reduced shareholder’s interest from 1.32% to .92% - substantially disproportionate under Section 302(b)(2)

56. Section 302(b)(1) – redemption that results in meaningful reduction in voting power is redemption and not essentially equivalent to a dividend

57. Section 302(b)(2) – greater than 20% reduction is substantially disproportionate

59. Target shareholders usually treated as owner of escrowed P shares unless otherwise agreed

60. especially true if Target shareholders have right to vote and receive dividends

61. not clear who is owner if Target shareholders do not have right to vote or receive dividends

62. Earn-Out Stock:

63. Target shareholders not considered owners until P shares are issued

64. Not treated as boot

65. Imputed Interest

66. Rev. Proc. 84-42 Ruling Guidelines – use of escrow or contingent stock

67. (1) stock must be distributed within 5 years, subject to escrow or contingency

68. (2) valid business purpose

69. (3) maximum number of shares cannot exceed 50%

70. (4) trigger event not controlled by Target shareholders and not based on tax liability

71. (5) Formula is objective and readily ascertainable

72. (6) Restrictions on assignment and substitution

74. Double Merger 23 REV. RUL. 2001-46 Step 2: A-type forward merger Step 1: Reverse triangular merger T Shareholders T Shareholders P Stock+cash Acquiror Target Acquiror Merger Sub Survives 80% Merger Target Survives Merger Sub Merger Sub Target+Sub Tax Benefit: A taxable reverse merger has just one tax on the shareholders, while a taxable forward merger has two taxes (one on shareholders and one on corporation). Intended that entire transaction be a tax-free A-type merger (where 20% boot limitation does not exist). Pairing the two reduces the risk of incurring the corporate level tax in the event the entire transaction is not treated as an A-type merger.

75. Double Merger – Wholly Owned LLC 24 REV. RUL. 2001-46 Step 2: A-type forward merger Step 1: Reverse triangular merger T Shareholders T Shareholders P Stock+cash Acquiror Target Acquiror Merger LLC Survives 80% Merger Target Survives LLC Merger Sub Target+Sub Tax Benefit: A taxable reverse merger has just one tax on the shareholders, while a taxable forward merger has two taxes (one on shareholders and one on corporation). Intended that entire transaction be a tax-free A-type merger (where 20% boot limitation does not exist). Pairing the two reduces the risk of incurring the corporate level tax in the event the entire transaction is not treated as an A-type merger.

78. taxation of boot

79. debt + non-qualified voting stock

80. assumption of liabilitiesPEG Target Cash out some and rollover T Shareholders Cash T Shareholders PEG Cash Cash Target PEG T Shares Cash Assets Cash NewCo NewCo Target Assets

81. LLC TECHNIQUES Step 1 Step 2 T Shareholders Former T Shareholders $ Target Corp. Acquiror LLC Target Merger LLC Survives LLC Target 27

82. FOREIGN CORPORATIONS 28 Section 367(a) – outbound transactions Foreign corporation not treated as a corporation except as provided in regulations Generally, gain recognized unless: No more than 50% of stock of foreign Acquiror received by US transferors, No more than 50% of stock of foreign Acquiror owned after the transfer by US persons that are officers or directors or 5% Target shareholders, Gain Recognition Agreement ("GRA") is entered into by 5% US transferee shareholders 36 month active trade or business test met, No intent to substantially dispose of or discontinue such trade or business, FMV of the assets of transferee must be at least equal to the FMV of the US target, and Tax reporting Section 367(b) – inbound and foreign to foreign transfers US Acquiror and foreign Target Target can be treated as a corporation May be income to Target’s US shareholders to extent of Target’s accumulated E&P

83. FOREIGN CORPORATIONS 29 Anti-Inversion Rules – tax outbound reorganization and/or tax foreign Acquiror as a U.S. taxpayer; Code Section 7874 If ownership of former U.S. Target shareholders in foreign Acquiror is 80% or more; foreign Acquiror is treated as a U.S. company If ownership continuity is between 60-80%; foreign Acquiror is NOT treated as a U.S. company, but U.S. tax attributes cannot be used to offset gains 20% excise tax on stock-based compensation upon certain corporate inversion transactions 7874 exception available for companies with “substantial business activities” in the foreign jurisdiction; facts and circumstances test compares activities of company in foreign jurisdiction with activities of company globally Controlled Foreign Corporations (“CFCs”) A foreign entity is classified as a CFC if it has “United States Shareholders” who collectively own more than 50% of the voting power or value of the company. For the purposes of the CFC rules, a “United States Shareholder” is defined as US persons holding at least a 10% interest in the foreign corporation.

84. 1248 AMOUNT ON SALE OF CONTROLLED FOREIGN CORPORATION 30 Section 1248 Seller of Controlled Foreign Corporation (CFC) must treat as dividend gain to extent of E&P 1248 inclusion carries foreign tax credits 1248 amount determined at year end and pro rated based on day count, so post closing events can have an effect on the 1248 amount

85. JOINT VENTURE STRUCTURES 31 Foreign Company US Company Cash Assets & Liabilities Section 367 Issues Disguised Sale LLC US & Foreign Assets

86. INSTALLMENT METHOD 32 Gain on each payment = gross profit ratio times payment Gross profit ratio = ratio of total gain to purchase price Pre-transaction planning opportunities to utilize basis Section 453A – interest charge to the extent taxpayer holds more than $5 million face amount of Section 453 obligations Section 453 Limits Not available for publicly held stock or securities, or inventory Not available for sales for demand notes or readily tradable notes Not available for instruments secured by cash or cash equivalents Obligor must be purchaser (cannot use parent debt) Section 453 applies unless taxpayer affirmatively elects out Section 453(h) – Target shareholders who receive Acquiror debt in liquidation of Target allowed to use installment reporting

87. CONTINGENT PAYMENTS AND EARN-OUTS 33 Distinguish Equity vs. Debt 3 Issues (1) allocation between interest and sales proceeds; (2) timing of realization of sales proceeds; and (3) timing of basis recovery Interest 1.1275-4(b) Contingent payment debt for cash or publicly traded property – use non-contingent bond method; projected non-contingent and contingent payments 1.1275-4(c) Contingent debt instrument issued for non-publicly traded property – bifurcate into non-contingent debt instrument and contingent debt instrument; contingent payment treated as principal based on present value, excess is interest Buyer’s basis is non-contingent portion plus contingent payments treated as principal

88. CONTINGENT PAYMENTS AND GAIN RECOGNITION 34 Reg. 15A.453-1(c) If capped by maximum amounts, assume maximum for purposes of gross profit percentage (accelerates gain, backloads basis) If no cap, but term, basis recovered ratably over term If neither time nor amount is capped, basis recovered ratably over 15 years Election out of Section 453 – FMV of contingent obligation is amount realized Open transaction treatment – rare and extraordinary situations only

90. Section 338(h)(10) – Sale and liquidation deemed to occur pre-close; joint election; S corporation or sale out of a consolidated group

91. Adjusted Grossed-Up Basis – New Asset basis is basis in recently purchased stock (last 12 months) grossed up to reflect minority shareholder’s basis + liabilities of Target (including taxes in 338(g))

94. Sections 1060 and 338 classes based on FMV

95. Class I – cash and equivalents

96. Class II – actively traded personal property under 1092

97. Class III – debt instruments and marked to market

98. Class IV – inventory

99. Class V – assets other than those in I-IV or VI

100. Class VI – goodwill and going concern

101. Agreement Allocations – Danielson Rule

102. Parties bound by agreement unless IRS determines that the allocation is NOT appropriate

103. SFAS 141R – Purchase Price Allocations

104. Assets booked at FMV as of closing date (not signing date)

105. Bargain purchase results in accounting gain

106. Earn Outs – estimated and recorded

107. Deferred tax assets for excess tax deductible goodwill over book value

109. (1) the exchange of fully vested stock for unvested stock of an acquiring corporation in a tax-free reorganization, and

110. (2) the exchange of fully vested stock for unvested stock of an acquiring corporation in a taxable exchange

112. OPTIONS – CASH OUT 40 Cancel options for cash payment NSO Ordinary income – compensation – withholding or 1099 Deduction to Target or Acquiror? TAM 9024002 – employer deducts based on method of accounting; not clear if cash out at close is pre-acquisition Target deduction or post-close Acquiror deduction in absence of scripting the timing Under the cash method, the deduction generally arises when the employer has “paid” the property to the employee. See Regs. §1.461-1(a)(1). Under the accrual method, the deduction arises when the employer's obligation to make the property transfer becomes fixed, the property's value is determinable and economic performance occurs. See Regs. §§1.461-1(a)(2) and -4(d)(2)(iii)(B) ISO FICA Exercise and disqualifying disposition treated differently

114. A deferral of compensation occurs whenever the service provider (employee) has a legally binding right during a taxable year to compensation that will be paid to such person in a later year. Treasury Regulation Section 1.409A-1(b)

115. Consequences of violating 409A

116. Amounts which were to be deferred are subject to immediate taxation

117. Additional 20% penalty on such amounts

118. Interest penalty

119. CA state tax penalty

120. Bonus or Carve Out Plans

121. Participation in Earn Outs (Reg. 1.409A-3(i)(5)(iv))

123. “Excess Parachute Payment” means the amount by which the Parachute Payment exceeds the Base Amount

124. “Parachute Payment” means a payment, the present value of which, exceeds three times the Base Amount

125. “Base Amount” means the average annual compensation for past 5 years

126. Must be paid to a disqualified individual (meaning employee, officer, shareholder, or highly compensated individual)

127. As compensation, AND

128. Contingent on a change in control (50% change ownership or effective control, or ownership change in a substantial portion of the company’s assets)

129. Reduce Excess for reasonable compensation

130. Exclude reasonable compensation for future services

131. Exception for small business corporation and non publicly traded corporation that has 75% uninterested shareholder approval

134. California 1.5% tax on S corporations

135. All Target shareholders must consent on Form 8023

136. Deemed 338 election for subsidiaries

137. 1374 – BIG Tax

138. Minority shareholders in rollover

139. Hidden tax in liquidation or deemed liquidation in installment sale.T (S Corp) P Reverse subsidiary cash merger S Key: T = Target P = Acquiror S = Merger Sub

140. S CORP 338(h)(10) ELECTION AND 453B(h) BASIS ALLOCATION ISSUE 45 Shareholders $1 million basis $1 million cash $4 million 453 Note Target Acquiror Stock Sale Reg. 1.338(h)(10) – 1(e) Example 10 Cash - $1 million / $1 million A/B Assets - $4 million / zero A/B Gain to Shareholders in year of sale: $1 million x 80% = $800,000; A/B of Shareholder = $1.8 million No 331 liquidation: $1 million cash decreases A/B by $1 million to $800,000; $800,000 A/B in Note = $3.2 million gain 331 liquidation – apportion basis: $1.8 million basis apportioned $360,000 to cash and $1,440,000 to Note; Gain in cash of $640,000 and gain in note of $2,560,000 for a total of $3.2 million gain (GP % on liquidation is 64%) Defer cash portion and include in installment obligation: gain on liquidation equal to zero; Shareholder A/B in note of $1 million; profit % is 80%

141. S CORP NO 338(h)(10) ELECTION – DISAPPEARING BASIS 46 T Shareholders Cash Liquidate Target into Merger Sub or check the box Q-Sub T (S Corp) P S Merger Carryover Basis Key: T = Target P = Acquiror S = Merger Sub

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