Mergers and Acquisitions: Taxable Acquisitions & Tax-Deferred Reorganizations

This article will provide a brief overview of certain taxable acquisitions and transactions and the ramifications in M&A transactions, including those certain tax-deferred reorganizations under §368 of the Internal Revenue Code (“IRC”).  Often, due to the fact that the taxes are deferred under IRC §368, these M&A transactions are referred to as “tax-free.”

Taxable Acquisitions and Transactions in the Mergers and Acquisitions Context

Stock Purchase for Cash

Generally, if the acquiring company purchases the target company, and the shareholders receive cash as consideration for their shares of stock, the shareholders will be required to recognize a gain (or loss) of the sale of such shares.  For the company acquiring the shares, the tax basis after the purchase will generally be equal to the purchase price plus acquisition costs.

Asset Purchase for Cash

When the purchasing company buys all (or substantially all) of the target company’s assets via a cash transaction, the cash consideration received by the target company will generally be taxable at the corporate level.  If the target company then liquidates and distributes the cash from the transaction to the shareholders, such consideration receive by the shareholders will also be taxable (unless the corporation is an S-Corporation for which the income of the corporation passes through to the shareholders).

 

Tax-Deferred Reorganizations

Each of the different types of reorganizations discussed below are also subject to additional regulations such as a showing of a continuity of interest, continuity of business enterprise, and continuity of business purpose.

Statutory Merger / IRC §368(a)(1)(A) (the “A” Reorganization)

This reorganization is structures as a merger or consolidation.  An “A” reorganization is generally the most flexible of the tax-free reorganizations, as the bidding company can pay the target company’s shareholders up to approximately 50% of the purchase price in cash, property, or debt securities (for the remainder of this article, the cash, property, or debt securities provided to the shareholders of the target will be referred to as “boot”).  The boot the shareholders receive in the A reorganization does not qualify to be tax-deferred, and as such, is taxable to the shareholder.

However, the remainder of the purchase price paid to the target company’s shareholders can be paid using any class of the bidding company’s stock.  This means that the bidding company can use voting or nonvoting shares as consideration to target company’s shareholders.

After the reorganization is completed, the target company’s shareholders will pay taxes on the boot they received (approximately 50% of the purchase price), and the remaining 50% of the purchase price paid to the shareholder in the form of stock is tax-deferred / “tax-free.”

Stock for Stock Exchange / IRC §368(a)(1)(B) (the “B” Reorganization)

The “B” reorganization requires that the acquiring company acquire the target company’s shares directly from target company’s shareholders.  The acquiring company must acquire the target company’s shares solely in exchange for the voting stock of the acquiring company, and immediately after the transaction, the acquiring company must have “control” of the target company.  “Control,” for the purpose of reorganizations pursuant to IRC §368(a)(1)(B), is defined in IRC §368(c) as, “the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation” (emphasis added).

As previously stated, generally the only consideration allowed under this transaction is the voting (common) stock of the acquiring company.  However, an exception to this rule is that if the acquiring company has voting preferred stock, and such voting preferred stock affords the shareholders significant participation in the management of the acquiring company, such voting preferred stock can be used in the exchange as consideration.

Asset Acquisition in Exchange for Stock / IRC §368(a)(1)(C) (the “C” Reorganization)

This reorganization occurs when the acquiring company acquires all (or substantially all) of the target company’s assets in exchange solely for voting stock in the acquiring company.  The purchase price paid by the acquiring company to the target company under a “C” reorganization must be structured as at least 80% of the consideration being the acquiring company’s voting stock, and the remainder of the purchase price can be boot.  However, there is a qualification to the boot payment, being that the boot (non-qualifying consideration) plus the value of the target company’s liabilities to be assumed by the acquiring company cannot constitute more than 20% of the total consideration paid by the acquiring company.  Generally, immediately after the reorganization is complete, the target company is required to liquidate and distribute the consideration to the target company’s shareholders, and eventually dissolve once the winding up of all corporate fairs is complete.

Under a “C” reorganization, the shareholders of the target company will not have a taxable gain or loss as it relates to the consideration received in the form of the voting stock of the acquiring company, but the consideration in the form of boot will be taxable.  Generally, the acquiring company does not recognize a taxable gain or loss in the transaction, and generally, the tax basis in the acquired assets is equal to the assets tax basis when held by the target company.

For further clarification, IRS rulings have held that “substantially all,” means the acquiring company must acquire from the target company at least 90% of the fair market value of its net assets and 70% of the fair market value of its gross assets, as measured immediately prior to the transaction.

Forward Triangular Merger / IRC §368(a)(2)(D) (the “D” Reorganization)

A forward triangular merger occurs when the target company is merged with a subsidiary of the acquiring company, and the subsidiary is the surviving entity in the merger.  To qualify as a “D” reorganization, the forward triangular merger must operate so that the subsidiary acquires “substantially all” (as defined above) of the target company’s assets, similar to the “C” reorganization.  However, the acquiring company is not required to use voting stock to fund the purchase price; rather, the acquiring company can use any consideration authorized by the applicable merger statute, such as cash.  The tax consequences for the “D” reorganization are generally identical to those of an “A” reorganization.

Reverse Triangular Merger / IRC §368(a)(2)(E) (the “E” Reorganization)

A reverse triangular merger occurs when the target company is merged with a subsidiary of the acquiring company, and the target company is the surviving entity in the merger.  In order to qualify as an “E” reorganization, the target company must: (i) continue to own “substantially all” (as defined above) of its assets immediately after the transaction; and (2) the acquiring company must structure the consideration paid to the target company in such a way that there is an exchange of the acquiring company’s voting stock for a “controlling” (as defined above) amount of the target company’s stock.  The remaining consideration remaining after the exchange can consist of boot.  In other words, because the acquiring company is only required to acquire 80% of the target company’s stock, and the remaining 20% of target’s stock can be paid for with boot, it is more flexible than a stock-for-stock exchange under a “B” reorganization.  The tax effects of an “E” reorganization are generally identical to those of an “A” reorganization.