In our last post, I described some general issues relating to tax free reorganizations. This posts decsribes the types of tax free mergers and reorganizations and the requirements for each, especially as I see them in my law practice in Silicon Valley, San Francisco, Los Angeles and Palo Alto Califoirnia.
Type A-Statutory Merger. Mergers require compliance with a state merger statute. For this reason, they are often referred to as “statutory mergers.” The typical merger occurs when two companies combine but only one survives. Domestic companies can now merge under Code Section 368 with foreign companies, subject to certain requirements described below.
There is no “substantially all” requirement in a merger. A “substantially all” requirement would have prevented the target from making distributions prior to the merger. There is also no “voting stock” requirement in a merger, which means that an acquirer can exchange non-voting stock for target company stock in a tax-free merger, in addition to cash and other property subject to continuity requirements.
There must be a business purpose for the reorganization; a tax motivation alone will not suffice. As a practical matter, the business purpose requirement has not been much of a hurdle. However, the “economic substance” doctrine (which has been codified into law) may subsume this requirement entirely. See below.
Plan of Reorganization. The acquirer must have a written plan of reorganization which should describe the transaction. This is the one requirement that should always be met.
COBE. The acquirer should intend to continue the acquired business after the transaction. Under the regulations, this means that the transferee must either continue the target’s historic business or use a substantial portion of the target’s assets in a business.
No Net Value. The relatively recent recession has spawned a newer requirement in the areas of tax-free reorganizations. The “no net value” rule requires an exchange of net value. Specifically, the deal must have equity, in other words, no net value would be exchanged at the owner level if debt exceeds the value of assets. Such a transaction would simply be a sale in exchange for debt, and would no longer be tax free (but see below).
Type B-Stock for Stock. Despite appearing to be the easiest type of reorganization, a Type B reorganization is rarely the right approach. The problem with a Type B is that no boot is allowed. Theoretically, if there is even one dollar of non-stock consideration, the transaction is treated as a taxable sale. Although Type B reorganizations are not done very often, it is sometimes a way of converting a non-taxable sale to a taxable one, which could be desirable depending on the parties’ preferences.
Type C-Stock For Assets. In a Type C reorganization, the acquirer transfers stock and cash to the target in exchange for substantially all of its assets and then the target liquidates. A Type C reorganization may be preferred to a Type A reorganization for two reasons. First, an acquirer might not want all of the assets of the target. A Type C reorganization allows the acquirer to be selective when purchasing the target’s assets while allowing the seller to obtain tax-free treatment.
The other instance when a Type C reorganization might be preferable to a Type A is when there are regulatory issues that would prohibit a statutory merger. This situation is rare but can occur in regulated industries such as banking.
A Type C reorganization implicates other issues that lawyers should be aware of. A type C reorganization is relatively restrictive since there has to be a transfer of at least 90% of the fair market value of the target’s net assets, and 70% of the target’s gross assets. An odd “hair trigger” boot relaxation rule provides that liabilities are not included in this net asset determination unless there is cash or other property passing from acquirer to the target, in which case it is all considered.
Type D Divisive Reorganizations. A divisive Type D Reorganization typically involves the transfer of assets to a corporation, the stock of which is then distributed to shareholders of the distributing company. A “spin off” is like a non-taxable dividend in that the stock of the transferee is distributed to shareholders pro rata. A “split off” is like a non-taxable redemption in that the transferee is distributed in exchange for some of the shareholders’ stock in the distributing company. Finally, a “split up” is similar to a non-taxable liquidation in that the distributing company’s businesses are dropped into companies that are distributed in complete liquidation of the distributing company.
Type D Non-Divisive Reorganizations. An acquisitive Type D Reorganization occurs when the shareholders of the transferor own 50% or more of the acquirer. Typically, an acquisitive D occurs when a corporation transfers assets to a controlled or related corporation in exchange for stock. The transaction might otherwise be a Type C reorganization except for the 90%/70% rule. However, 50% common ownership of the transferor and acquirer would allow this reorganization to be a Type D Reorganization.
Liquidation/Reincorporation Doctrine. Closely related to the concept of a forced Type D Acquisitive Reorganization is the judicially created concept of ignoring a liquidation that is followed by an incorporation. A company’s shareholders might want to engage in such a scheme in order to trigger losses built into their stock while maintaining the benefit of the corporate form. Under step transaction principles however, if the liquidation followed by a reincorporation were collapsed into one transaction, the transaction would be recharacterized either as a non-event (i.e. the result is the same as the starting point) or a Type D Reorganization. The success of the plan basically depends on there being no plan, and it is thus a risky strategy.
Triangular Mergers. Triangular or subsidiary mergers allow an acquirer to acquire a company in a tax-free reorganization without leaving liabilities at the subsidiary level, similar to a stock purchase in the taxable context. In a triangular merger, the acquirer will acquire the target in exchange for acquirer stock by merging it with or into a subsidiary, usually formed just for that purpose. When the smoke clears, the acquirer will own the stock of the subsidiary, which in turn will own the business of the target.
Forward and Reverse Triangular Mergers. In a forward subsidiary merger, the target merges with and into the merger subsidiary. The subsidiary survives and the separate existence of the target ceases. A good forward triangular merger requires the same five factors that are normally required for a merger – continuity of proprietary interest, continuity of business enterprise, business purpose, net value, etc.
In a reverse merger, the target survives and the separate existence of the merger subsidiary ceases. In both cases, the merger consideration is stock of the parent/acquirer (if it were stock of the merger subsidiary, it would simply be a merger, not a triangular merger).
In a reverse merger, the assets and business of the target stay with the target, and only ownership changes. In a forward merger, the business of the target is inherited by the subsidiary by operation of law. Sometimes that transfer by operation of law triggers anti-assignment clauses in contracts that would not be triggered by a reverse merger. In addition, the merger subsidiary will obtain a separate taxpayer identification number, requiring a new payroll. For those and other non-tax reasons, targets and sellers of targets typically prefer a reverse merger to a forward merger.
Often times in a reverse triangular merger, companies will have shareholder debt. This occurs when shareholders loan money to the company but do not document the loans, do not charge interest, etc. This debt sometimes does not get repaid and sometimes is instead converted into stock of the borrower. The tax risk is that debt would be treated by the IRS as a class of non-redeemable preferred stock. If that’s true, and that “deemed stock” is not exchanged for stock or securities of the acquirer, the transaction will fail to qualify as a reverse triangular merger because 80% of ALL classes of stock will not have been acquired for stock or securities.
The tax consequences and risks set the stage for an odd dynamic when considering whether to do a deal as a reverse or a forward merger. The continuity requirements of a reverse merger are more stringent, as discussed below, requiring that 80% of all classes of stock of the target be acquired for stock or securities of the acquirer. A forward triangular merger, however, is only subject to the general continuity requirement, so that an acquisition of 50% of the target stock for stock or securities of the acquirer would suffice, and it is not necessary that 50% of every class of stock of the target be acquired for acquirer stock or securities. Thus, it would seem that a forward merger is the safer bet, since it is easier to comply with the requirements.
The consequences of failing to qualify as a merger reverse the tax incentives. A “busted” forward merger is treated as an asset sale followed by a liquidation, which results in two levels of tax – one on the deemed sale of the target’s assets and again on the deemed sale of the target’s stock in liquidation. A busted reverse merger, however, is treated as a stock sale with only one level of tax at the shareholder level.
Thus, the seller has a Sophie’s choice – either take a heightened risk that the transaction will fail the tax-free reorganization provisions but with a potential of one level of tax (as a reverse merger), or take a lower risk of failure with a higher potential penalty (two levels of tax) as a forward merger.
This is a tough choice, since valuation issues can make the tax-free conclusion less than doubt-free. In addition, there may be concerns over what will be considered a class of stock for this purpose, so a reverse merger is rarely risk free.
Next post – a solution to this problem.
For more information on mergers and acsuisitions, and the tax aspects of purchases and sales of businesses, see RoyseLaw Mergers and Acquisitions, RoyseLaw Tax, Recent M&A Transactions, and blog posts at Royse University M&A, and Royse University Tax. Additional materials on mergers and acquisitions can be found at our blog posts at Franchise Tax Board Audits Sale of S Corp in 338(h)(10) Transaction, Corporate Reporting of Transactions Affecting Basis, M&A Trends and Qualified Small Business Stock. See M&A slides at SlideShare.