Types of Acquisitions (#88)
/In this podcast episode, we discuss the different types of acquisition structures that can be used, and their relative advantages and disadvantages. Key points made are noted below.
The Requirements to Defer Taxes
When there’s an acquisition, a key part of the deal for the seller is avoiding taxes – or, actually, deferring taxes. According to the Internal Revenue Service, if you want to defer taxes, the deal has to fulfill three requirements.
First, the acquisition has to have a bona fide business purpose other than just deferring taxes.
Second, there has to be a continuity of interest, which means that the ownership interest of the seller has to carry over into the acquiring company, which basically means that the buyer has to pay with at least 50% of its own stock.
And finally, there has to be a continuity of business enterprise, which means that the buyer either has to continue the seller’s business, or use a significant proportion of the acquired assets in a business.
Buyer and Seller Motivations
The IRS has come up with four types of legal reorganization that incorporate these requirements, which means that the buyer and seller have a few alternatives for deferring taxes. These are called Type A, B, C, and D reorganizations. We’ll skip the Type D reorg, since it’s only for a limited number of situations. If you deal with many acquisitions, you’ll see references to these reorg types quite a bit, usually in the acquisition term sheet.
Now before we jump into the types of reorgs, let’s cover the positions of the buyer and seller regarding the type of acquisition. The buyer usually doesn’t recognize any gain or loss at the time of the acquisition, but it would prefer to increase the assets it acquires to their fair market values, assuming that the fair market values are higher than their book values. By doing so, the buyer can record a larger amount of asset depreciation, which reduces its future tax liability. However, the buyer can only do this if it does an asset acquisition, and one other scenario that I’ll get to shortly. Otherwise, it has to retain the acquired company’s tax basis.
Also, the buyer may want to retain the selling company’s legal entity, since there may be some contracts that would expire if the entity is liquidated. If the buyer just wants to acquire some technology or other assets of the selling company, then it may not care so much about retaining the entity.
The seller may be OK with paying taxes now, if it’s being paid in cash, or if it’s going to recognize a loss on the transaction – in which case it isn’t going to pay any taxes. Otherwise, the seller will want to use one of the IRS reorgs to delay its tax payments.
Types of Reorganizations
So, let’s get back to those reorgs. In a Type A reorganization, you transfer all of the seller’s assets and liabilities to the buyer in exchange for a payment that includes at least 50% of the buyer’s stock, and then you liquidate the selling entity. Under this scenario, the seller defers tax payments on that part of the payment that was made with the buyer’s stock.
The problem with a Type A reorg is that you liquidate the selling company, which means that any contracts associated with that company may be terminated. So on this one, the buyer may not be too happy about possibly losing some contracts, while the seller may be quite pleased with some limited tax deferral.
A Type B reorganization is the same as a Type A reorg, except that the seller has to take the buyer’s stock for all of the payment, and the selling entity can be retained. A Type B reorg tends to make buyers a lot happier, since they can keep the selling entity, but sellers may not be too happy about being paid only in stock.
A Type C reorg contains a little bit of both the Type A and B reorgs. The seller has to accept mostly the buyer’s stock – at least 80%. The buyer has to liquidate the selling entity, but it can mark up the assets to their fair market value.
In addition to these types of reorganization, it’s also possible to do either a triangular merger or a reverse triangular merger.
In a triangular merger, a subsidiary owned by the buyer merges with the seller, and the selling entity then liquidates. This is called a merger instead of an acquisition, so approval of the selling entity’s shareholders is not needed – only its board of directors.
To achieve a tax deferral with a triangular merger, the buy has to obtain at least 80% control over its own subsidiary, and acquire at least 90% of the fair market value of the buyer’s net assets.
In brief, a triangular merger involves a shorter approval process, but you still lose the selling entity. Usually, a better approach is the reverse triangular merger. In this case, a subsidiary owned by the buyer merges into the seller, and the subsidiary then liquidates. This also only requires board approval, and the buyer gets to retain the selling entity, which may be critical if it has a lot of valuable contracts attached to it. However, the seller has to make do with no more than a 20% cash payment – the rest of the payment has to be in the buyer’s stock.
So, there’s five types of acquisitions, besides just paying all cash for the selling company, in which case there is no tax deferral of any kind. In general, the buyer is writing the purchase agreement, and will insert the type of acquisition that will most benefit it – not the seller. So… the seller needs a really good tax attorney to comb through the purchase agreement and negotiate for whichever type of reorganization makes the most sense for the seller.
And one final point of clarification. If the buyer pays cash to the seller for any portion of a purchase price, then the buyer has to pay income taxes now on that cash payment. It’s only that portion of a payment made with the buyer’s stock that is eligible for tax deferral.