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Tax-Deferred Reorganizations

—RMZ

Tax considerations are one of the most important drivers of a deal’s structure.  Likewise, tax considerations drive both the form of consideration that can be used in a deal and the price that each side is willing to pay or receive.  Buyers and sellers are each interested in using a deal structure that minimizes their respective tax liabilities.

From the seller’s perspective, it is often desirable to use a deal structure that defers some or all of the tax liabilities of the sale until a later period rather than recognize an immediate gain on the sale of stock or assets.  One common mechanism to defer tax liabilities is to use a deal structure that qualifies as a “reorganization” under Section 368(a)(1) of the Internal Revenue Code.  While Section 368(a)(1) provides for a number of different structures that allow for the deferral of taxes, there are a number of tests that must be satisfied in each structure, including the “continuity of interest” test, the “continuity of business enterprise” test and “business purpose” test.  These tests collectively require that the target corporation’s stockholders receive a minimum amount of stock as a percentage of the total consideration, that some portion of the target corporation’s pre-acquisition business be continued post-acquisition, and that the sale must not be a part of a “step transaction” that results in the overall transaction being taxable (which the buyer typically prefers since it would allow for a stepped-up basis and greater depreciation).

Below is a brief overview of Type A, B, and C reorganizations under I.R.C. Section 368(a)(1).  This overview is by no means intended to be a comprehensive treatment of each structure, but rather, is intended to merely highlight some of the important requirements of each.

A “Type A” reorganization is a statutory merger between an acquirer (“Acquirer”) and a target (“Target”) in which Acquirer issues stock and/or other assets (“boot”) to Target in exchange for all of Target’s assets and liabilities.  A Type A reorganization allows for flexibility in the form of consideration: Acquirer can use up to 60% boot (that is, at least 40% of the consideration must be Acquirer stock).  In addition, Acquirer can use non-voting stock.  This structure allows Target’s shareholders to receive cash or other property (which is taxed) and Acquirer stock (which is tax-deferred).  Post-acquisition, Acquirer is owned by both Acquirer shareholders and Target’s former shareholders, with Acquirer owning all of Target’s assets.  Because this structure requires a statutory merger, Target is no longer a continuing entity.

It is also worthy to note that there are 2 variants of the Type A reorganization that are commonly used: a forward triangular merger and a reverse triangular merger.  In both forward and reverse triangular mergers, Acquirer merges a subsidiary with Target instead of Acquirer itself, allowing Acquirer to vertically isolate risk (since Acquirer’s assets and liabilities are not comingled with Target’s assets and liabilities).  In a forward triangular merger, Acquirer’s subsidiary survives the merger with Target, whereas in a reverse triangular merger, Target survives the merger and becomes a subsidiary of the Acquirer.  The latter structure is often used when critical assets of Target are not transferable (e.g., certain permits or licenses).  These variants often impose additional restrictions.  For example, in a reverse triangular merger, the amount of boot that can be used is limited to 20% of the total consideration rather than 60% in the traditional Type A reorganization.

A “Type B” reorganization is a stock-for-stock exchange in which Acquirer transfers Acquirer stock to Target’s shareholders in exchange for control of Target.  Typically, Acquirer must own at least 80% of Target’s stock post-acquisition.  An important consideration here is that, unlike a Type A reorganization, in order to keep its tax-deferred status no cash or other assets can be issued to Target’s shareholders.  Post-acquisition, Target is a subsidiary of Acquirer and Acquirer is owned by both Acquirer shareholders and Target’s former shareholders.

A “Type C” reorganization is a stock-for-assets exchange in which Acquirer exchanges its voting common or preferred stock for substantially all of Target’s assets.  Certain requirements here are stricter than a Type A reorganization: Acquirer must use voting stock and the amount of boot used as consideration is limited to 20% of the total consideration.  Post-acquisition, Target must liquidate and distribute the Acquirer stock and any remaining assets to Target’s shareholders.

Roberts McGivney Zagotta LLC works with its clients and their accountants to structure deals that reflect desirable tax consequences.  Consult with one of our attorneys to discuss the deal structure that is right for your circumstances.

The information in this article is for informational purposes only and does not constitute formal, legal or tax advice.