Mergers and acquisitions (M&A) broadly describes many different types of deals with all shapes and sizes. A merger can be forward, horizontal, vertical, reverse triangular, forward triangular, upstream, or downstream. It can also be acquisitive, meaning the target is combined with/into a buyer, or divisive, meaning the target’s assets are divided among two or more surviving corporations. These can be taxable at the corporate and/or shareholder level unless certain requirements are met.
To qualify as a tax-free reorganization, stock of the buyer (or an affiliate) generally must be used as a significant portion of the purchase price. This can vary from about 40% to 100% of the consideration, depending on the type of reorganization. In certain tax-free reorganizations, the stock must be voting stock. Four conditions are (1) continuity of ownership interest, (2) continuity of business enterprise, (3) valid business purpose and (4) the step transaction doctrine. The continuity of ownership interest requires at least 40% of the consideration in the transaction is made up of acquirer stock. Continuity of business enterprise condition either means continuing the target’s business or using the target’s assets in an existing business for at least 2 years following closing. Valid business purpose requires that the deal serve a purpose beyond just the avoidance of taxes. Lastly, the step transaction doctrine can be used to alter the tax status of a series of steps, if any individual step was taken just to avoid taxes. If these four conditions aren’t all met, then the transaction won’t qualify as a “reorganization” under Section 368 of the IRS Code.
If the merger satisfies the requirements of a tax-free reorganization, then the parties generally defer current US federal income tax and capital gains tax on their stock and asset transfers. Tax is generally deferred rather than eliminated, though, because the basis of the stock or assets received in a tax-free reorganization is a carryover basis.
Section 368(a) lists several types of tax-free reorganizations. This is relevant where the target’s owners agree to accept buyer’s stock as a main form of payment. Rollover stock is a component of deals that’s becoming more and more frequent, and even prevalent in some industries. Rollover stock aligns buyer and seller interests and encourages sellers to stay involved and invested in the ongoing success of the business, so it’s worth knowing when that deal point can result in a qualification for tax-free treatment. The various types of tax-free reorganizations set forth in Section 368(a) are listed out below:
Type A – Statutory Merger – 368(a)(1)(A)
Only one corporation can survive a statutory merger. Target’s assets and liabilities become those of the acquiring corporation, and the target corporation ceases to exist. Generally, this requires 2/3 approval from stockholders. There’s flexibility with consideration. Voting stock has to be at least 40% of consideration given. Must comply with state’s merger and consolidation laws, meaning the target company ceases to exist following the transaction. Target shareholders get continuity of interest in the new entity.
Buyer is stuck with all target liabilities. One way to mitigate this is to try to have the target sell off unwanted assets or divisions before a buyer gets the business. Within Type A, another approach is a forward triangular merger. This is an option where the purchaser creates a subsidiary that the target merges with/into. This approach gives the subsidiary (instead of the parent) all of the liabilities and contingencies that come with the target.
Dissenting shareholders and holdouts can demand their shares be appraised and purchased. Patents and contracts should carry over, but be careful with anti-assignment provisions.
Type B – 368(a)(1)(B)
100% voting stock as consideration, and acquirer must have at least 80% control of target immediately after the deal is done. This is an acquisition of stock of the target corporation in exchange solely for voting stock of the acquiring corporation.
Type C – Practical Merger – 368(a)(1)(C)
Voting stock has to be at least 80% of consideration given. Don’t need shareholder approval or to follow state laws. Must acquire substantially all of the target’s assets, meaning at least 70% of the fair market value (FMV) of gross assets and 90% of FMV of net assets, but only need to take liabilities specifically listed in agreement. Buying “substantially all” the assets of the target corporation in exchange for voting stock of the acquirer (plus a limited amount of boot is allowed).
Type D – Acquisitive or Divisive – 368(a)(1)(D) and 355
With Type D Acquisitive, the target gives substantially all assets in exchange for shares of buyer (not necessarily all voting stock). This is a liquidating distribution. Key is that the target or target shareholder controls the purchasing corporation following the deal. Control means at least 50% of combined voting power and 50% of value of all classes of stock. Type D Divisive includes spin-offs, split-offs, split-ups, flip-ups, and other varieties. Certain corporate divisions can qualify as tax-free divisive D reorganizations.
Type E, Type F, and Type G are all reorganizations through restructuring. Type E is recapitalization, Type F is changing the corporation’s name or state, and Type G is bankruptcy.
If you have any questions about tax-free reorganizations or other M&A deal structures, our team and external resources are here to help. The point of this primer is to show how deals are not one-size-fits-all, and you should have counsel to guide you.
Picture on the top is by Andrea Piacquadio and is in the public domain.
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