When determining the proper structure of an acquisition, the taxability of the transaction to the seller plays a key role. To avoid taxable gain recognition, the Internal Revenue Service (IRS) has stipulated that the following requirements be met:
- The transaction must have a bona fide business purpose other than tax avoidance.
- There must be a continuity of interest, where the ownership interests of the selling stockholders continue into the acquiring entity. This is achieved by having the buyer pay a substantial portion of the purchase price in its own stock. The IRS considers a “substantial portion” of the purchase price to be at least 50%. Some transactions are structured to pay sellers preferred stock rather than common stock, so that they still meet the requirements of the continuity of interest rule, but also give the sellers rights to additional payments, as would be the case with debt.
- There must be a continuity of business enterprise, where the buyer must either continue the seller’s historic business or use a significant proportion of the acquired assets in a business.
The IRS has incorporated these requirements into three types of legal reorganization, which are commonly described as Type A, B, or C reorganizations. The letter designations come from the paragraph letters in the Internal Revenue Code under which they are described.
A type “A” reorganization is governed by paragraph A of Section 368(a)(1) of the IRC, which simply states that a reorganization is “a statutory merger or consolidation.” To expand upon this limited definition, a statutory merger involves the transfer of all seller assets and liabilities to the buyer in exchange for the buyer’s stock, while a statutory consolidation involves the transfers of the assets of two companies into a new entity in exchange for the stock of the new entity. In both cases, the selling entities are then liquidated. The Type A reorganization is not commonly used when valuable contracts are associated with the selling entity, because they may be terminated at the option of the business partners when the selling entity is liquidated at the end of the reorganization. The Type A reorganization is primarily of benefit to the seller, who can obtain some cash, debt, or preferred stock as part of the purchase price, while still retaining tax deferred status on the purchase price that is paid with the buyer’s stock. It is less useful for the buyer, who runs the risk of losing contracts associated with the selling entity.
A type “B” reorganization is governed by paragraph B of Section 368(a)(1) of the IRC. The paragraph is as follows:
“The acquisition by one corporation, in exchange solely for all or a part of its voting stock (or in exchange solely for all or a part of the voting stock of a corporation which is in control of the acquiring corporation), of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation (whether or not such acquiring corporation had control immediately before the acquisition).”
In essence, the buyer exchanges nothing but its stock for the stock of the seller, resulting in the selling entity becoming a subsidiary of the buyer. The IRS has clarified the basic definition to state that only voting stock can be used in the transaction. For example, if the buyer issues any preferred or non-voting stock as part of the deal, then it no longer qualifies as a Type B reorganization. Also, the seller cannot give the selling entity’s stockholders the option of being paid with cash instead of stock. Thus, the Type B reorganization is most useful when the selling entity must be retained, usually because it has valuable contracts that would otherwise be terminated if the entity were to be liquidated.
The principal difference between the Type A and B reorganizations is that other consideration besides stock can be paid under a Type A, whereas the price paid under a Type B must be solely for stock. Also, the selling entity is dissolved in a Type A, but can be retained in a Type B reorganization.
A type “C” reorganization is governed by paragraph C of Section 368(a)(1) of the IRC. The paragraph is as follows:
“The acquisition by one corporation, in exchange solely for all or a part of its voting stock (or in exchange solely for all or a part of the voting stock of a corporation which is in control of the acquiring corporation), of substantially all of the properties of another corporation, but in determining whether the exchange is solely for stock the assumption by the acquiring corporation of a liability of the other shall be disregarded.”
In order to be a non-taxable transaction, paragraph C requires that the seller transfer essentially all of its assets in exchange for the buyer’s voting stock. Also, the stock paid for the transaction must be entirely the seller’s voting stock, and the selling entity must liquidate itself.
To qualify under the asset transfer requirement of the Type C reorganization, the seller must transfer to the buyer at least 90% of its net assets, including all of those assets considered critical to the ongoing operations of the business.
It is possible for the buyer to pay some cash as part of this transaction. However, at least 80% of the fair market value of the assets purchased must be solely for stock, so only the remaining asset value can be paid for with cash. The seller must pay income taxes on any portion of the purchase that is not paid for with the buyer’s stock.
Any dissenting shareholders may have the right to have their ownership positions appraised and then paid in cash. The extent of these cash payments will increase the total proportion of non-stock payment made, which can affect the non-taxable nature of the entire transaction. Thus, a significant proportion of dissenting shareholders can prevent the “C” reorganization from being used.
In summary, the Type C reorganization is most useful when the seller is willing to accept mostly stock in payment, while the buyer does not need the selling entity, which is liquidated. The buyer can also record the acquired assets at their fair market value, which is generally higher than the tax basis that would otherwise be inherited from the seller.