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Reviving the Reverse Morris Trust for Mergers
Reverse Morris Trust transactions gain popularity on the IRS's declaration that Revenue Ruling 70-225 is obsolete and the relaxation of the 'D' reorganization requirement.
Robert Willens, Lehman Brothers, CFO.com
July 03, 2002

Before the 1997 alteration of the law, the ground rules for structuring a Morris Trust transaction with respect to an acquisition were well understood—albeit somewhat illogical.

In most cases, the trust used to work like this: First, assume that the target corporation engaged in two different businesses. From the acquirer's perspective, one is a wanted business, and the other an unwanted business.

Next, the target company would "drop" the unwanted business into a Newco, and distribute the latter's stock to its shareholders. The acquirer would then obtain the target—which contained only the wanted business—in a merger or in a stock swap qualifying as a 'B' reorganization. See Rev. Rul. 70-434.

Note that the business combination had to take the form of a two-party merger—qualifying as an 'A' reorganization—or as a stock swap—qualifying as a 'B' reorganization. The ability to consummate a triangular, or "three party," reorganization—of either the forward or reverse variety—was circumscribed because the triangular reorganization provisions each contain a "substantially all" of the assets requirement.

Furthermore, because the plan called for a preliminary extraction of the unwanted business from the target, the target would, as a result, be unable to convey the requisite quantum of its assets to the acquirer in the case of an attempted forward triangular merger. Similarly, the target would not be able to hold substantially all of its assets in the case of an attempted reverse triangular merger.

The transaction was tax-free in its entirety. Indeed, the target's transfer of the unwanted business to Newco was tax-free, as was its distribution of Newco's stock to its shareholders. Why? Because the transaction qualified as a 'D' reorganization. Recall that the unwanted business was transferred to a corporation and the shareholders of the transferor (the target) were in control of the unwanted business immediately after the transfer.

The fact that the shareholders, as part of the plan, surrendered control of the target (in the merger or stock swap) was not relevant because the post-distribution control requirement only applied to the corporation (Newco) to which the assets were transferred. See Rev. Rul. 68-603

Conversely, if the identical economic result was sought through a different format (popularly known as a reverse Morris Trust transaction), the tax results would be markedly different.

So, when Rev. Rul. 70-225 is applied, the target dropped the wanted company (not the unwanted one) into Newco, and as part of a prearranged plan, distributed Newco's stock to its shareholders. Then, the acquirer obtained the Newco stock (from it's own shareholders) solely in exchange for voting stock.

Important here is that the IRS ruled that the transaction did not qualify as a 'D' reorganization because of the prompt and prearranged loss of control of the corporation to which the assets were transferred. Control here meaning the ownership of at least 80 percent of the total combined voting power of all classes of stock entitled to vote and 80 percent or more of the total number of shares of each class, if any, of nonvoting stock—See Sec. 368(c).

In other words, the transaction was treated as if the target had directly transferred the wanted business to the acquirer in exchange for stock—in a fully taxable exchange—and as if, immediately thereafter, the target had distributed the acquirer stock (constructively received) to its shareholders in a distribution to which Sec. 301 applied. Such distribution, assuming there was sufficient earnings and profits, was taxable as a dividend.

Thus, the same economic transaction, improvidently structured, yielded two levels of taxation: The target was taxed on the appreciation (in excess of its basis) inherent in the wanted business; and the target's shareholders were taxed, at dividend rates, on the value of wanted business.