Tax Free Mergers
Shareholders (SH) of a corporation may have an option to enter into a non taxable reorganization with an acquirer (A). A tax free merger is a “reorganization” under the tax code. In such a deal, A would use its stock as a significant portion of the consideration paid to SH rather than cash or debt. This requires SH taking equity, and thus risk in an investment stake in A.
The buyer may prefer a merger. Tax is effectively deferred under such a merger, except for cash or boot taken in the transaction. In this case, A would be able to pay for a significant part of the acquisition price with its equity. The motivation for such a deal may be that A cannot offer consideration other than equity. A may have little cash, and may have trouble financing the acquisition with debt.
Here, A and SH could pursue a non-taxable exchange of stock under a Section 368 statutory merger transaction. Continuity and non-tax avoidance criteria must be met. A and SH can pursue a reorganization such that A will be required to continue with target (T) business for a minimum of 2 years.
Taxes are only deferred, not avoided. A will defer taxes on the asset acquisition of T. SH will defer taxes until it sells its stock in A. A will pay taxes on the amount of boot taken in the deal. A will assume the tax structure of the assets of T, and take all carryover bases in those assets. This could be an incentive or disincentive depending on the spread between the bases and the market values of those assets. If and when A sells those assets it will realize taxable gain inherent in those assets. Under Section 368, up to 60% of the aggregate deemed asset disposition price (ADADP) can be money or other property received by SH.
SH may, in such a deal, take on what could be an undue risk with equity in A, deferring taxes, and limit and defer cash flows for A. If acquirer is a large solid firm, with a market for its shares, the risk to SH would be much lower. If the stock received in the transaction is higher risk, that stock could become worthless in a worst case scenario.
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