Mergers and acquisitions refer to the process where two companies join to become a single company or one company acquires the equity or assets of another company. Companies with capital availability often consider M&A a growth strategy.
However, certain mergers and acquisitions can result in significant federal and state tax liabilities for both the target and the acquirer. Tax planning is, therefore, a vital part of structuring an M&A deal. This article explains certain tax implications when structuring mergers and acquisitions.
If you have any questions, our experienced M&A lawyers have helped our clients navigate the tax consequences of dozens of transactions. We can help answer any questions you might have.
Primary Tax Considerations around M&A Deals
Mergers and acquisitions can qualify as either taxable or non-taxable. Taxable mergers are mergers where both companies assume tax liability. When two companies merge, they pay taxes on gains from the capital, stock, or assets acquired during the merger. Two common forms of taxable mergers are standard mergers and triangle mergers.
In a standard merger, the target company is absorbed into the acquiring company, and the surviving company continues offering both companies' services. An example of a standard merger was the Disney company's acquisition of Pixar.
In a triangle merger, by contrast, there is a standard merger at a subsidiary level, with the parent company taking financial responsibility. In other words, a small company owned by a parent company merges with another small company. The parent company assumes the tax liability in this type of merger.
In contrast to taxable mergers, the Internal Revenue Service has recognized that mergers that qualify as “reorganizations” are not subject to tax liability under IRC § 368. However, the IRS has stringent rules for whether a merger constitutes a tax-free reorganization. Therefore, your company must understand whether or not it qualifies under this statute.
How Is a Corporate Reorganization Treated for Federal Income Tax Purposes?
A corporate reorganization is not subject to federal income taxes if it meets certain conditions under the IRC. In a reorganization, the companies essentially “swap,” rather than sell, the assets and equity so that the resulting company is a new company.
Generally, a transaction qualifies as a non-taxable reorganization where the acquiring company pays the seller company with stock instead of cash or debt. The transaction must meet four conditions to be eligible for a tax-free reorganization:
- Continuity of Ownership Interest. This means at least 50% of the consideration for the transaction is paid with stock from the acquiring company.
- Continuity of Business Enterprise. The acquiring company must continue to run the target's business as it has historically been run, or it must use a significant part of the target company's assets in its existing business for two years after the M&A.
- Valid Business Purpose. The transaction cannot be solely used to avoid tax liability.
- Step-transaction Doctrine. The transaction cannot be part of a larger series of transactions that would be subject to tax liability if treated as a single transaction. The IRS uses the step-transaction doctrine to deny tax-free status where it determines that a series of transactions are primarily implemented to avoid tax liability.
What Target Companies Should Be Aware of In Corporate Reorganizations
If a transaction deal qualifies as a tax-free reorganization, the target company needs to be aware of the implications. The target company that is being acquired will not recognize either a loss or gain for tax purposes if:
(1) it receives only stock, securities, or both in a company that's part of the reorganization; and
(2) the target company distributes the stock, securities, or both to its shareholders.
If the target company receives other property during the reorganization, it must recognize a gain for tax purposes if the property is not distributed to the target company's shareholders. The assumption of liability of a target company is generally not treated as a gain for tax purposes.
In sum, the target company's shareholders are on the hook for tax liability where they receive consideration other than in the form of stock. This non-qualifying consideration is referred to as “boot.”
Further, the target company's shareholders' tax basis in the acquired company's stock is their old basis in the target stock. Any tax liability based on gains for shareholders is deferred until the shareholders sell the stock.
What Acquiring Companies Should Be Aware of In Corporate Reorganizations
Generally, an acquiring company during a reorganization is not required to report a tax gain or loss when it issues its stock in exchange for the property of the company it is acquiring. Also, the basis of the target company's assets will carry over to the acquiring company, increased by the gain recognized by the target company's shareholders.
Tax Implications on the Timing of an Acquisition
A merger becomes effective when the companies file the articles of merger. Many mergers are closed during the middle of a target company's tax year. An issue that often arises in M&A negotiations is who assumes the tax liabilities during the "straddle period.” The straddle period refers to any taxable period that begins on or before and ends after the closing date of the merger.
Common issues that come up are:
- Whether the merger causes the target company's tax year to end;
- Who is responsible for filing any straddle period returns;
- How any tax refunds are handled; and
- Which party handles any post-closing tax audits of pre-closing tax periods.
Generally, a target company is subject to audit and assessments on pre-closing tax liabilities long after the merger closing date. Indeed, pre-closing tax liabilities can be assessed to the target company up to four years after the closing date.
The parties can agree to shift the burden of pre-closing tax liabilities to the seller company through well-crafted tax provisions in a purchase and sale agreement. Because serious tax implications may arise during the pre-closing period, the acquiring company needs to conduct thorough due diligence regarding the target company's pre-closing tax status and liabilities.
To protect the acquiring company, a purchase and sale agreement will often include provisions for tax representations and warranties, tax covenants, tax indemnity and survival clauses, and tax-related definitions.
Common Structuring in Transactions to Reduce Tax Liability
For tax purposes, there are two types of purchases in M&As—stock purchases and asset purchases. With a stock, or ownership, purchase the buyer purchases the seller's ownership interest in the target company.
The 2018 Tax Cuts and Jobs Act (TCJA) implemented a 21% corporate federal income tax rate, which has made the purchase of stock in a C corporation a good option. The C corporation pays fewer taxes and therefore generates more after-tax income. Also, built-in gains from corporate assets that appreciate will be subject to a lower tax rate if sold later.
The TJCA also results in lower tax rates for individual tax liability where a stock purchase involves an S corporation (with pass-through tax liability), partnerships, and LLCs treated as a partnership for tax purposes. Note that the TJCA tax cuts on individual taxpayer liability are subject to expire in 2025.
Which M&A structure is better for reducing tax liability?
There is no 'one-size-fits-all' structure for every business. It is important to consult with an experienced M&A attorney to determine which structure is best for your company.
Some sellers prefer stock purchases for two non-tax reasons:
- To avoid post-sale liabilities; and
- Getting the full amount on the sale price if the seller provides financing to the buyer.
Sellers may also prefer stock purchases from a tax standpoint because gains on the sale are usually treated as long-term capital gains, which are taxed at a lower level than short-term capital gains.
Although stock purchases can result in reduced tax liability, some buyers prefer to conduct asset purchases instead. This is because, with an asset purchase, the acquiring company can acquire assets while avoiding unknown liabilities that buyers often face when buying ownership interests in a company. With stock purchases business-related liabilities usually transfer to the buyer.
Buyers also may prefer an asset purchase because, with asset purchases, the buyer gets a stepped-up basis on purchased assets for tax liability purposes. The buyer can claim lower gains for tax purposes when certain assets such as receivables and inventory are sold or converted to cash. The buyer can also take tax deductions based on depreciation for certain assets.
The TJCA expanded first-year depreciation deductions, thus making asset purchases attractive from a tax standpoint. By contrast, with stock purchases, there is no-stepped-up basis unless the buyer makes a Section 338 election, which means the buyer seeks to have a stock purchase treated as an asset purchase.
Purchase Price Allocation
Finally, when negotiating an M&A deal, the parties will need to determine how the purchase price is allocated for specific assets. Buyers usually want to allocate less to assets requiring amortization or depreciation over long periods (such as buildings and intangibles) and assets the buyer must permanently capitalize for tax purposes (such as land).
By contrast, sellers want to allocate more to assets that generate lower-taxed, long-term capital gains (such as intangibles, buildings, and land). Given these competing interests, one party may demand a higher purchase price in exchange for agreeing to the other party's allocation requests.
Determining how to structure your merger or acquisition can have serious tax consequences. You should always consult with an M&A lawyer with years of experience to understand how your structure will affect your tax liabilities for the fiscal year.
Contact our knowledgeable lawyers here at Newburn Law today for a free consultation.