Tax free acquisitions

A tax-free acquisition is the purchase of a target company in which the recognition of a gain can be deferred. The deferral of gain recognition is of considerable importance, since it delays the payment of income taxes.

A proposed transaction must incorporate all three of the following concepts into an IRS-approved acquisition structure before gain deferral will be allowed:

  • Bona fide purpose. The proposed transaction must have a genuine business purpose other than the deferral or complete avoidance of taxes.
  • Continuity of business enterprise. The acquirer must continue to operate the acquired entity, or at least use a large proportion of the acquired assets in a business.
  • Continuity of interest. The shareholders of an acquired business must receive a sufficient amount of stock in the acquiring entity (generally considered to be at least 50% of the purchase price) to have a continuing financial interest in it.

The IRS acquisition models that can be used to defer income taxes are called Type A, B, C, or D reorganizations (we will refer to them as acquisition types, rather than reorganization types). The IRS requirements for these acquisition structures are described next.

The Type "A" Reorganization

A Type “A” acquisition has the following characteristics:

  • At least 50% of the payment must be in the stock of the acquirer
  • The selling entity is liquidated
  • The acquirer acquires all assets and liabilities of the seller
  • It must meet the bona fide purpose rule
  • It must meet the continuity of business enterprise rule
  • It must meet the continuity of interest rule
  • It must be approved by the boards of directors of both entities, plus the shareholders of the selling entity

This transaction type is among the more flexible alternatives available, since it allows for a mix of payment types. It also allows selling shareholders to defer the recognition of income taxes related to those shares exchanged for acquirer stock. However, shareholders must recognize income on all non-equity payments made to them. Also, because the acquired entity is liquidated, this terminates any acquiree contracts that had not yet expired, which could cause problems for the acquirer.

The Type "B" Reorganization

A Type “B” acquisition has the following characteristics:

  • Cash cannot exceed 20% of the total consideration
  • At least 80% of the acquiree’s stock must be acquired with the acquirer’s voting stock
  • The acquirer must buy at least 80% of the acquiree’s outstanding stock
  • Acquiree shareholders cannot be given the option of being paid in cash instead of stock, if the result could potentially be that less than 80% of the acquiree’s stock is acquired with the acquirer’s voting stock; even having this option available disallows the use of the Type “B” acquisition
  • The selling entity becomes a subsidiary of the acquirer
  • It must meet the bona fide purpose rule
  • It must meet the continuity of business enterprise rule
  • It must meet the continuity of interest rule
  • It must be approved by the boards of directors of both entities, plus the shareholders of the selling entity

The Type “B” acquisition is most useful when the seller needs to keep operating the seller’s business and its contracts. However, it forces the seller to accept nearly all acquirer stock in payment for the acquisition.

The Type "C" Reorganization

A Type “C” acquisition is the transfer of the assets of the seller to the acquirer in exchange for the voting stock of the acquirer. This acquisition has the following characteristics:

  • The acquirer must buy at least 80% of the fair market value of the acquiree’s assets
  • The acquirer can use cash only if it uses its voting stock to buy at least 80% of the fair market value of the acquiree’s assets
  • The selling entity must be liquidated
  • It must meet the bona fide purpose rule
  • It must meet the continuity of business enterprise rule
  • It must meet the continuity of interest rule
  • The acquirer may not have to gain the approval of its shareholders for the transaction, since this is an asset purchase. The acquired entity must gain the approval of its shareholders for the transaction.

The Type “C” acquisition is most useful when the acquirer wants to treat the transaction as an asset purchase, and the seller wants to be paid primarily in stock in order to defer the recognition of income taxes.

The Type "D" Reorganization

A Type “D” acquisition is designed primarily to subdivide a business into smaller components, which are then spun off to shareholders. The following are variations on the type “D” concept:

  • Spin-off. A company is divided into at least two entities, and existing shareholders receive shares in the new entities.
  • Split-off. A company is split into different entities, with some shareholders only retaining their shares in the original entity, while others turn in their shares in exchange for shares in the new entity.
  • Split-up. A company creates several new entities, transfers its assets and liabilities to them, and liquidates itself. Shareholder interests transfer to the new entities.

All of the variations noted here are designed for the internal restructuring of a business, rather than the acquisition of an outside entity.

Related Courses

Business Combinations and Consolidations 
Mergers and Acquisitions