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A Closer Look at Taxable Corporate Mergers and Acquisitions

A Closer Look at Taxable Corporate Mergers and Acquisitions

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. The tax lawyer generally would not refer to these day-to-day corporate purchases of stock or assets as corporate acquisitions. A “corporate acquisition” generally refers to an acquisition of control by one corporation over another. (For purposes of this article, “control” refers to the 80 percent control requirement under Internal Revenue Code Section 1504).  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 (T) stock from the target’s shareholders, then becomes a parent to its newly acquired subsidiary (T). The parent may continue to operate T as a complete liquidation. In the case of a stock purchase followed immediately 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 corporation acquisition must first decide whether the transaction is to proceed as a taxable acquisition or a tax-free reorganization. A taxable acquisition is when a selling corporation is taxable upon the sale of its assets or that the selling shareholders are taxable upon the sale of its assets or that the selling shareholders are taxable upon the sale of their stock. Any particular transaction will be classified as a tax-free reorganization only if it fits within one of the precise meanings of the term “reorganization” as defined in Internal Revenue Code section 368.

Stock vs. Assets

The second basic decision required of the parties to a corporate acquisition is whether the purchaser will acquire stock or assets. Both buyer and seller 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 upon the extent to which the 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 its shareholders.  

After a simple sale of all of its assets for cash, the target company presumably will distribute the cash to its shareholders in a liquidation distribution taxable to the shareholders. Thus, an asset acquisition often involves a rather 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 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.

The Corporate Transaction

In a typical taxable asset acquisition, the selling or target corporation (T) transfers all or substantially all of its assets to the purchasing corporation (P) or a P subsidiary (S) in exchange for cash and/or notes. As part of the taxable acquisition, the purchasing corporation often will assume some or all of the selling corporation’s liabilities. Generally, the target corporation will liquidate shortly after the exchange, distributing cash and notes to its shareholders. Sometimes, however, T may be kept alive for various reasons. Another form of taxable asset acquisition is the target into P or P subsidiary (Merger of the target into a P subsidiary is called a ‘forward triangular merger’) for cash, notes, or other considerations that would not qualify for tax-free reorganization, sometimes referred to as a “cash merger.”  In this type of transaction the consideration is transferred directly by P to the T shareholders and there is no need for T to formally liquidate. For tax purposes, this transaction is treated as a taxable asset transfer by T followed by T’s complete liquidation.

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 Internal Revenue Code Section 61(a)(3) and Internal Revenue Code Section 1001. T must include in its amount realized from the sale any liabilities assumed by the purchaser, and the amount of liability to which any property transferred was subject. In addition, if the purchasing corporation assumes liabilities for accrued, but as yet unpaid operating expenses of a 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 any unsold assets. In most cases, a liquidation of the target will quickly follow the sale. Unless the target is making a liquidated distribution to a corporate parent, the subsequent liquidation distribution will be a taxable event to the distributing corporation. See Corporate Taxation, Cheryl D. Block, Aspen Law & Business (1998).

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. Consequently, a taxable asset acquisition usually results in an 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.

Taxable Acquisitions

In a typical stock sale, the selling shareholders transfer some or all of their target corporation (T) 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. P 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 target shareholders will report gain or loss from sale of their T shares to P. If the T shareholders receive P notes in exchange for their T shares, they may be entitled to report gain under the installment method pursuant to Internal Revenue Code Section 453. The target corporation itself bears no immediate tax consequence. T remains intact as a subsidiary of P. Each of T’s assets retains the same basis it had prior to the stock acquisition. If T liquidates it will recognize no gain or loss on the liquidated distribution. The Internal Revenue Code and its regulations address the extent to which the target corporation may continue to use any pre-existing net operating losses after the stock ownership change.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.