Question: I plan on merging my corporation with a public company and receiving cash and stock in return. Can I avoid paying income tax on the stock I receive?
Answer: Depending on a number of factors, the stock you receive in the acquiring corporation may not be taxable to you. Any cash you receive will be subject to income tax.
The Internal Revenue Code provides tax-free treatment for transactions that satisfy the complex corporate reorganization rules. Although there are various corporate reorganizations which are generally designated by letters A-G, the most common form of reorganization is an A-reorganization. A-reorganizations generally involve either a merger between two corporations or a consolidation of corporations into a new entity. In your case, your transaction would appear to take the form of a merger as your corporation will be merged with the acquiring public company. In return for the surrender of the stock of your corporation, you will receive stock of the public company along with cash consideration.
As an acquirer of stock, the acquiring corporation will be inheriting liabilities of your corporation, the target corporation. In order not to taint the business of the acquiring corporation, the acquiring party will often create a wholly-owned corporate subsidiary strictly for purposes of consummating the merger. In such case, the newly-created entity would merge with your corporation. If the acquiring corporation’s subsidiary is the surviving corporation, the merger will be treated as a forward triangular merger. Alternatively, if the acquiring corporation’s subsidiary is merged into your corporation, the merger will be treated as a reverse triangular merger.
There is no bright line test that delineates what portion of the consideration must consist of stock of the acquiring party to satisfy the tax-free reorganization rules of the Internal Revenue Code. Generally speaking, where more than one-half of the consideration consists of acquiring party stock, the transaction will assuming the other reorganization requirements are satisfied, qualify for tax-free treatment thereby permitting the avoidance of income tax on the stock portion of the consideration. Some cases and IRS rulings have upheld reorganization treatment, where somewhat less than one-half of the consideration received consists of acquiring company stock. Assuming your transaction satisfies this requirement, you will only be taxed on the cash portion of the consideration you receive; the receipt of stock will not be subject to tax.
It is noteworthy that your tax basis in the stock you acquire in the transaction will not be increased to the fair market value of the shares you acquire. Instead, your basis in the newly-acquired shares will be determined by reference to your basis in the shares you surrender. At such time as you sell the shares, you acquire in the transaction, the gain may effectively be taxed due to your carryover basis in the shares. If you hold the acquired shares until your death, your basis in the shares will be recomputed based on the fair market value of the shares at the time of death which means the unrecognized gain may never be taxed.
If a meaningful portion of the consideration from this transaction will be in the form of the acquiring party’s stock, you should make every effort to attempt to structure the transaction to fit within the corporate reorganization rules. There is no doubt a number of other requirements which must be satisfied to qualify for tax-free reorganization treatment under the Internal Revenue Code. Nevertheless, the opportunity to defer tax on at least a portion of the consideration you receive from the sale of your company makes exploring reorganization treatment a worthwhile endeavor.
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