As noted in an earlier post, some types of acquisitions can be tax free or tax deferred to the sellers. In order to determine whether the tax-free reorganization provisions are available, the type of currency being given to the sellers in exchange for their stock or assets must meet certain requirements. The “currency” could be in the form of buyer stock, cash, compensation, debt or contingent and deferred payments. Of that currency, some portion must be in the form of buyer equity. The amount of equity in the deal will drive the rest of the analysis.
A seller must retain a sufficient equity stake in the acquirer in order for a transaction to be treated as a tax-free reorganization. That “stake” is commonly referred to as the “continuity of interest” requirement and according to the IRS, there should be at least 50% continuity to meet the IRS safe harbor. By “at least 50% continuity,” we mean that at least 50 % of the value of the consideration to be received by the seller will be equity of the buyer. Fifty percent is considered safe. Case law goes as low as 25% but most tax lawyers will not accept such a low amount as sufficient continuity for the transaction to be tax-free.
Traditionally, the IRS will rule on a transaction if there is at least 50% continuity (e.g. 50% of the consideration is Buyer stock). Escrowed shares tend to count for continuity purposes and relatively recent developments in the law are more tax friendly towards transactions with less than 50% equity. Under current law, buyer stock is valued the day immediately before the signing of the definitive acquisition agreement. Fluctuations in value between the day of signing and the day of closing are less of a concern. Additionally, if there is other property that has a specified value (e.g. $100,000 worth of stock), that specified value will be used.
The percentage of equity in a tax-free merger is important because the shareholders in a tax-free merger realize gain only to the extent of boot. “Boot” includes non-stock property and securities. Selling shareholders will not recognize taxable gain or pay tax on the value of stock received in a transaction. They will take a low “exchange” basis in the buyer stock received in the merger and recognize a gain when they eventually sell the buyer stock, but they will not recognize that gain at the time of the merger.
In our next post, I will discuss the different types of tax free reorganizations.
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.