A Brief Overview of Taxable Corporate Mergers and Acquisitions

By Anthony Diosdi

Corporations sometimes purchase stock in other corporations to hold for investment or purchase assets from other corporations to hold for investment or to use for business operations.In common tax parlance, “corporate acquisition” generally refers to an acquisition of control by one corporation over another. One corporation may acquire control over another through two different transaction types. First, a simple asset acquisition from the target corporation itself offers the purchaser direct control over the selling corporation’s assets. Second, a stock acquisition from the target corporation’s shareholders provides the purchaser with indirect control over the selling corporation’s assets through its ownership of the target corporation’s stock.

In a stock purchase, the purchasing corporation (P) acquires a controlling interest in the target corporation’s (T) stock from the target’s shareholder, thus becoming a parent to its newly acquired subsidiary (S). The parent may continue to operate T as a separate entity or may cause T to distribute its assets in a complete liquidation. In the case of a stock purchase followed by a liquidation of T, the purchasing corporation acquires control over T’s assets upon the liquidation distribution. 

Taxable Acquisition vs. Tax-Free Reorganization

The parties to a corporate acquisition must first decide whether the transaction is to proceed as a taxable acquisition or a tax-free reorganization. The label “taxable acquisition” is used to describe that the selling corporation is taxable upon the sale of its assets or that the selling shareholders are classified as a tax-free reorganization only if it fits within one of the precise meanings of the term “reorganization” as defined in Section 368(a). By definition, a corporate acquisition transaction that fails to fit within such a statutory nonrecognition provision is a taxable acquisition.

Under the statutory nonrecognition provisions applicable to corporate organizations and reorganizations, classification of an acquisition transaction as tax-free depends largely upon the consideration used by the purchasing corporation in the exchange. Generally speaking, where the consideration paid by the purchasing corporation provides the target corporation or its shareholders with a substantial continuing proprietary interest in the reorganized corporate entity, the transaction is likely to meet one of the “reorganization” definitions.

The first difference in tax consequences between taxable acquisitions and tax-free acquisitive reorganizations is that the seller typically recognizes gain or loss in a taxable acquisition, but is eligible for nonrecognition treatment in the case of a tax-free reorganization. In a tax-free asset acquisition, the target corporation is entitled to nonrecognition upon the exchange of its assets for eligible consideration, usually purchasing corporation stock. In a tax-free stock acquisition, the target shareholders will not recognize gain or loss upon the transfer of T shares for eligible consideration from the purchasing corporation, also usually P stock. See IRC Section 354.

The second distinction in tax consequence between taxable acquisition and tax-free reorganizations involves an important set of corollary basis rules. The purchasing corporation in a taxable asset acquisition is a “cost basis acquisition.” In contrast, the purchasing corporation in a tax-free asset acquisition is not entitled to a “cost basis,” but instead takes the target corporation’s assets with the same basis that the target corporation had. See IRC Section 362. In a taxable stock acquisition, the purchasing corporation is entitled to a Section 1012 cost basis only in the T shares purchased.

The purchasing corporation will not get a “cost basis” in T’s assets unless it makes a proper election pursuant to Section 338 (Section 338 is discussed below). In contrast, the purchaser in a tax-free stock reorganization is not entitled to a cost basis in the acquired stock, but instead takes the stock with the same basis in the acquired stock, but instead takes the stock with the same basis that it had in the shareholder’s hands. In addition, the target corporation’s assets will retain the same basis that they had immediately before the acquisition, again deferring recognition of gain or loss with respect to target’s assets. 

Given the dramatic differences in tax consequences, proper classification of a corporate acquisition transaction as either a taxable acquisition or a tax-free acquisitive reorganization is critically important to the parties to the transaction.

Stock vs. Assets

The second decision required to a corporate acquisition is whether the purchaser will acquire stock or assets. Both tax and nontax factors will influence this decision. With regard to nontax factors, the purchasers choice between stock or assets may be limited because the corporation is unwilling to negotiate a transfer of assets, the shareholders are unwilling to negotiate a transfer of stock, or some other stock, or some outside restrictions prevent the sale or transfer of the assets or stock. In addition, the choice of a stock or asset acquisition may be heavily influenced by the purchasing corporation’s desire to minimize its exposure to any outstanding target corporation’s creditors. 

Both buyer and seller also will have several tax factors to consider in deciding between a taxable stock or asset sale. The taxable sale of assets results in an immediate taxable gain to the selling corporation and a cost basis in the assets to the purchasing corporation. The purchasing corporation’s desire to acquire assets will depend on which assets are depreciable or otherwise would benefit from a cost basis. The selling corporation’s willingness to sell assets will depend on the extent of the gain or loss reflected in the assets and the possibility of using any offsetting losses to reduce gains. The selling corporation also must consider the tax consequences to the shareholders. After a sale of all of its assets for cash, the target company will likely distribute the cash to its shareholders in a liquidation distribution taxable to the shareholders. Thus, an asset acquisition often involves an immediate double tax- the corporation recognizes gain or loss on the sale of its assets for cash and the shareholders recognize gain or loss on the receipt of the cash proceeds upon the liquidation of their stock holdings. In contrast, a stock sale by the shareholders generally results in the immediate recognition  of only the shareholder level tax – the shareholders recognize gain or loss upon the sale of their stock while the target corporation’s assets remain with the target and retain their historic basis. 

Taxable Asset Acquisition

A taxable asset acquisition occurs when a P, which may be a corporation or an individual acquires the assets of a target corporation T in exchange for cash, notes, other property, or a mix of such consideration, and the acquisition does not qualify as a tax–free reorganization under Section 368 of the Internal Revenue Code. T normally liquidates following the sale of its assets and distributes the sales proceeds to its shareholders, but the shareholders may choose to keep T in existence and have it reinvest the proceeds.

Tax Consequences to the Target Corporation

In a taxable asset acquisition, the selling target corporation T will recognize a taxable gain or loss immediately upon the sale of assets under Sections 61(a)(3) and 1001. The amount and character of gain or loss on the sale of assets must be determined on an individual, asset-by-asset basis. In the event of a sale of a going business for a lump-sum price, it will be necessary to allocate a portion of the purchase price to each asset sold. Since some of the assets sold will result in capital gain or loss while others will result in ordinary income, the particular method used for allocating the purchase price will be important to the seller. Internal Revenue Code Section 1060 requires the use of the “residual allocation method” (discussed below) to measure the seller’s gain or loss on the assets sold. 

Consistent with these rules, T must include in the amount realized from the sale any liabilities assumed by the purchaser, and the amount of liability to which any property transferred was subject. See Treas. Reg. Section 1.1060-1T(c)(2). In addition, if the purchasing corporation assumes liabilities for accrued, but as yet unpaid operating expenses of a cash basis target corporation, the liabilities assumed should be included in T’s amount realized from the sale. Once T has included the assumption of operating expense liabilities as proceeds from the sale, T should be entitled to deduct these assumed operating expenses.

After a sale of all or substantially all of the target’s assets, the target corporation is simply a “shell” holding the consideration received from the purchasing corporation along with unsold assets. In most cases, a liquidation of the target will quickly follow the sale. Unless the target is making a liquidating distribution to a corporate parent, the subsequent liquidation distribution will be a taxable event to the distributing target. 

Tax Consequences to the Target Shareholders

When the target corporation distributes cash and other assets to its shareholders in liquidation following T’s taxable asset sale, the shareholders generally will report gain or loss upon the liquidating distribution pursuant to Section 331. Consequently, a taxable asset acquisition usually results in immediate double tax- the selling target is taxed upon receipt of consideration for the assets sold and the target shareholders subsequently are taxed when the target distributes this consideration to its shareholders. If T sells assets in exchange for P installment notes and subsequently distributes the P notes in complete liquidation, the note distribution will trigger T’s recognition of any gain previously deferred through installment reporting.

Tax Consequences to the Purchasing Corporation

The purchasing corporation in a taxable asset acquisition is entitled to a Section 1012 cost basis in assets purchased from the target. Since the target corporation is fully reporting gain or loss on the asset transfer and since the purchasing corporation is paying full consideration for each asset, there is no reason to deny the purchaser the same cost basis generally available under section 1012 for any purchase of assets. The overall price paid by the purchaser must be allocated among all the assets purchased in order to determine the cost basis of each particular asset in the purchaser’s hands. Some of the acquired assets may be depreciable or amortizable and others may not.

Allocation of the Purchase Price

Where appreciated capital assets are involved, the seller generally prefers as much as possible allocated to capital gain as opposed to ordinary income assets. On the other hand, the buyer generally prefers as much as possible allocated to assets that are depreciable or amortizable or or intended for resale.

In addition to the Section 197 rules on amortization of purchased intangibles, Section 1060 was added to the Internal Revenue Code which adapts “special allocation rules for certain asset acquisitions.” The Section 1060 special allocation rules apply to “applicable asset acquisitions,” defined to include transfers “of assets which constitute a trade or business” and “with respect to which the transferee’s [buyer’s] basis in such assets is determined wholly be reference to the consideration paid for such assets.” See IRC Section 1060(c). In other words, the rules are limited to taxable asset acquisition of a group of assets that together constitute a trade or business. The regulations here first cross-reference to the “active trade or business” requirement of Section 355(b), but continue to provide that even if the group of assets would not constitute a “trade or business” under Section 355, “it will constitute a trade or business for purposes of this section if its character is such that goodwill or going concern value coud under any circumstances attach to such group. See Treas. Reg. Section 1.1060-1T(b)(2). The classic example of a transaction covered by the Section 1060 allocation rules is a direct acquisition of all or substantially all of the target’s assets for cash or notes.

The Residual Method

A sale of corporate assets for a lump sum is treated for tax purposes as a sale of each individual asset of the business. The parties must allocate purchase price among the assets sold. Under Section 1060 of the Internal Revenue Code, which applies to taxable asset acquisitions, this allocation of total “consideration” paid is made by what is known as the “residual method.” “Consideration” paid includes liabilities assumed by the buyer or to which the acquired property is subject.

In allocating the purchase price under the residual method, the “consideration” paid is first reduced by cash and cash equivalents (known as “Class I assets”) transferred by the seller. See Treas. Reg. Section 1.1060-1T(d)(1). The remaining consideration is allocated first to certificates of deposit, U.S. Government and other marketable securities (Class II assets”) in proportion to their gross fair market values, next to all other tangible and intangible assets except Section 197 intangibles (“Class III assets”) and then to Section 197 intangibles, excluding goodwill and going concern value (“Class IV assets”) to the extent of their fair market value. Any remaining consideration is allocated to goodwill and going concern value (“Class V assets”). See Treas. Reg. Section 1.1060-1T(d)(2).

Taxable Stock Acquisition

In a typical stock sale, the selling shareholders transfer some or all of their target corporation (T) stock to the purchasing corporation (P) or a P subsidiary (S) in exchange for cash and/or notes. Assuming the purchase of a controlling interest, the purchasing corporation now becomes a parent to its newly acquired subsidiary.  May simply retain T as a distinct subsidiary. Since T remains intact as a corporate entity and remains liable to its creditors, P need not formally assume T’s liabilities. As an alternative, the purchasing corporation may completely liquidate T in an upstream merger. Upon such merger, P will become responsible for T’s liabilities.

Tax Consequences to the Selling Corporation and Its Shareholders

The selling shareholders will report gain or loss from sale of their T shares to P pursuant to Section 61(a)(3) and 1001. If the T shareholders receive P notes in exchange for their T shares, they will be entitled to report gain under the installment method in Section 453(a) and 453(b). The target corporation itself bears no immediate tax consequence. T simply remains intact, albeit now as a P subsidiary. Each T asset simply retains the same basis that it had prior to the stock acquisition. If T liquidates, it will recognize no gain or loss on the liquidating distribution pursuant to Section 337.

Tax Consequences to the Purchasing Corporation

The selling target shareholders will report gain or loss from sale of their T shares to P pursuant to Section 61(a)(3) and 1001. If the T shareholders receive P notes in exchange for their T shares, they will be entitled to report gain  under the installment method in Section 453. The target corporation itself bears no immediate tax consequence. T simply remains intact as a subsidiary of P. Each T asset simply retains the same basis that it had prior to the stock acquisition. If T liquidates, it will recognize no gain or loss on the liquidating distribution pursuant to Section 337. A complex set of statutory and regulatory provisions addresses the extent to which the target corporation may continue to use any pre-existing net operating losses or NOLs after the stock acquisition.

Tax Consequences to the Purchasing Corporation

In a taxable stock acquisition, the purchasing corporation is entitled to a Section 1012 cost basis in the T shares purchased. Since the shareholders fully reported gain or loss on the sale of stock and the purchasing corporation paid full consideration for the shares, there is no reason to deny such a cost basis in the stock. Absent an election under Section 338, however, the target corporation retains its assets with no change in asset basis. If the purchasing corporation distributes T’s assets in liquidation, P will not be required to recognize gain or loss pursuant to Section 332, and the parent will receive the assets with the same basis as the subsidiary had. Thus, even after liquidation, the T assets will retain their historic basis.

Stock Acquisitions Treated as Acquisitions Under Section 338

Section 338 permits a buyer of stock to elect unilaterally to recharacterize a taxable stock acquisition as a deemed asset acquisition. The main advantage to the buyer is the step up on the basis of the assets deemed acquired to the fair market value on the date of purchase. Section 338 applies only to an electing corporate purchaser of at least 80% of T’s stock within a 12 month period. It treats T as having sold all of its assets in a single transaction for their fair market value to a hypothetical “new” T, which takes an aggregate basis in those assets in an amount generally equal to what P paid for T’s stock. The Section 338 election is available only when P makes a “qualified stock purchase” of the stock of T.

A “qualified stock purchase” is a transaction or series of transactions in which P acquires by purchase 80% of the total voting power and value of T during a 12 month “acquisition period.” See IRC Section 338(d)(3). (Nonvoting stock is typically excluded from the 80% test). A “purchase” is generally an acquisition from an unrelated person in a transaction where P takes a cost rather than a transferred basis in the acquired stock. The first day that the “qualified stock purchase” requirement is satisfied is known as the “acquisition date.” See IRC Section 338(h)(2). P must acquire 80% of T during the 12 month “acquisition period.”

The goal of a Section 338 election is to: 1) ensure that the target and its shareholders bear the same tax burden on the sale of the target’s stock that they would have incurred on a sale of its assets followed by a complete liquidation; 2) provide the buyer with a cost basis in the assets of the target; and 3) terminate the tax attributes of the target and start new, regardless if the target was liquidated.

If P makes a valid Section 338 election, T is treated as having sold all of its assets at the close of the acquisition date for their “fair market value” in a single transaction and is treated as a new corporation which purchased all of its assets as of the beginning of the day after the acquisition date. In the hypothetical asset sale following a Section 338 election, T is treated under the regulations of Section 338 as selling its assets for their “aggregate deemed sale price” or (“ADSP”), which is the sum of the grossed-up basis of P’s recently purchased stock (including acquisition costs) plus new T’s liabilities, including any tax liabilities resulting from the deemed sale. See Treas. Reg. Section 1.338-3(d)(1).

If P makes a Section 338 election, new T’s aggregate adjusted gross-up basis or (“AGUB”) is allocated among those assets under regulations promulgated under Section 338(b)(5) of the Internal Revenue Code. AGUB is similar but not identical to ADSP. The principal difference is attributable to the fact that the AGUB calculation does not “gross up” the basis of P’s non recently purchased stock. P, however, may elect to recognize the gain on its non recently purchased stock as if it had sold that stock for the average price paid by P for the recently purchased T stock.

In effect, the parties are treated (purely for applicable tax purposes) as though 1) the buying corporation established a new corporation (“New T”), 2) New T purchased the assets of the old T (“Old T”) and assumed its liabilities and 3) Old T liquidated in the hands of the seller.

Acquisition of Stock of a Subsidiary

The Section 338 discussion above assumes that T was not a subsidiary of another corporation. Section 338(h)(1) applies in cases where T is owned by another corporation. If the election allows the parties in a sale of stock of a corporation to treat the transaction for tax purposes as if it had been structured as an asset sale. For example, if T is a subsidiary of another corporation or S and P would like to acquire T, S can avoid recognition gain on its T stock if T sells its assets directly to P and then distributes the sales proceeds to S in a tax-free liquidation or if T first liquidates, distributes its assets to S and then S sells the assets to P. A parent and its subsidiary-target can achieve the same result on a sale of T stock to P by making a joint election with P under Sections 338 and 338(h)(1)) to treat T as if it sold all of its assets for fair market value to “new T” and then distributed the sales proceeds to S in a tax-free liquidation. T is treated as a member of S’s “consolidated group” with respect to the sale, and S does not recognize gain or loss on the sale of its stock.

Conclusion

The foregoing discussion is intended to provide the reader with a basic understanding of the principles governing the taxation of corporation mergers and acquisitions. It should be evident from this article, however, that this is a relatively complex subject. As a result, it is crucial that corporate investors review his or her particular circumstances with a qualified tax attorney when planning a corporate acquisition transaction.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.