Tax-free* Acquisitions of
Freestanding C Corporations
Basic types:
IRC §368(a)(1)(A)—Statutory merger
IRC §368(a)(1)(B)—Stock-for-stock acquisition
IRC §368(a)(1)(C)—Stock-for-asset acquisition
Other:
Forward and reverse triangular mergers
* These transactions are not actually “tax-free”—they only
provide target shareholders with tax-deferral of the gain on the
acquisition. Also, each of these “tax-free” reorganization
structures requires shareholders to recognize a taxable gain to
the extent they receive cash or other forms of boot.
General Requirements for Taxfree Treatment Under IRC §368
• Continuity of interest must be maintained by
target shareholders in the assets of the target—
target shareholders must receive stock of the
acquirer.
• The principle of continuity of business interest
requires the assets of the target to be used in a
productive capacity post-acquisition. An acquirer
cannot liquidate the target’s assets after purchase.
• The acquirer must have a valid business purpose,
not just a desire to avoid taxes.
IRC §368 “A” Reorganization—
Statutory Merger
• The acquirer exchanges its stock (and possibly
some boot) for the assets and liabilities of the
target.
• The target corporation must distribute to its
shareholders in return for their target stock the
consideration received from the acquirer.
– This liquidating distribution is tax-free if target shareholders
receive stock of the acquirer; cash received is taxable even if the
transaction is tax-free.
– Gain recognized by target shareholders is the lesser of the gain
realized or the boot received.
– Gain realized is equal to the purchase price (value of consideration
received) less the selling shareholder’s tax basis in the stock.
– Losses realized are not recognized.
Requirements to Qualify for Tax-free
Treatment Under IRC §368(a)(1)(A)
• Reorganizations must qualify as statutory mergers
under applicable state law—the merger must be
approved by both the acquirer’s and the target’s
shareholders.
• “A” reorganizations usually require that at least
50%* of the total consideration received by target
shareholders in the acquisition is acquirer stock—
acquirers can use either voting or non-voting stock and
either common or preferred stock.
* 40% acquirer stock is sufficient in some transactions.
Tax Consequences of a §368 “A”
• Target shareholders take a substituted basis in the
acquiring firm stock received in the transaction:
Substituted basis = same basis as had in T stock + any
gain recognized – boot received
• The acquirer takes a carryover basis in the assets
of the target.
• The tax attributes of the target will carry over to
the acquirer, but they will be limited by IRC §382.
Given Information
for Examples
Given Information
Purchase Price
Target Shareholder Stock Basis
Net Tax Basis of Target's Assets*
Corporate Tax Rate
Capital Gains Tax Rate*
Discount Rate
$1,370.00
$200.00
$200.00
35%
20%
10%
Assume that any acquirer stock received by T's shareholders in the
transaction is held until death and that all shareholders receive an equal
portion of stock and boot.
*Historical cost equals $200, and there is no accumulated depreciation.
*T's shareholders have held the stock of T for more than 12 months.
Tax Implications of a §368 “A” Reorganization
Given Information
Purchase Price
Target Shareholder Stock Basis
Net Tax Basis of Target's Assets
Corporate Tax Rate
Capital Gains Tax Rate
Discount Rate
Purchase Price:
Cash
Stock
Target Corporation Tax Liability
$1,370.00
$200.00
$200.00
35%
20%
10%
Tax-free Acquisitions Taxable Acquisitions
Stock Sale w/o
a 338 Election
368 "A"*
$1,370.00
$1,370.00
548.00
1,370.00
822.00
0.00
0.00
0.00
548.00
109.60
1,370.00
234.00
Target Shareholder After-tax Wealth:
Cash
Stock
Total
$438.40
822.00
$1,260.40
$1,136.00
0.00
$1,136.00
Acquirer Net After-tax Cost:
Pre-tax Cost
Less: Incremental Tax Savings
Net After-tax Cost
$1,370.00
0.00
$1,370.00
$1,370.00
0.00
$1,370.00
Target Shareholder Gain Recognized
Target Shareholder Tax Liability
*Assumes that the mix of consideration is 60% stock and 40% cash.
Tax-free Merger Under IRC
§368(a)(1)(A)—Statutory Merger
Target:
Receives $1,370 of consideration
from acquirer and distributes all
of the consideration to
shareholders in liquidation.
$548 Cash
$822 Stock
Assets and
Liabilities of
Target
$548 Cash
$822 Stock
Acquirer:
Transfers $1,370 to target for its
assets and liabilities. Target is
merged into acquirer under state
law.
All of Target’s
Stock
Target Shareholders:
Basis in target stock = $200. Gain
realized is $1,170 ($1,370
received - $200 stock basis). Gain
recognized is $548 (lesser of gain
realized or boot received).
Acquirer Shareholders:
No direct tax effect.
Post-acquisition Structure:
Statutory Merger
Acquirer:
Holds the assets and liabilities of the target.
Has a carryover basis in the target’s assets.
Target Shareholders:
Now own acquirer stock
and have some boot.
Acquirer Shareholders:
Remain owners of the
acquirer.
Non-tax Issues Associated w/
the §368 “A” Structure
• The acquirer obtains all the liabilities (including contingent
and unrecorded liabilities) of the target.
• Some of the target’s assets may be non-transferable based
on laws and/or contracts.
• Qualifying as a statutory merger can involve significant
non-tax costs for both the acquirer and target, i.e.,
shareholders of both the acquirer and target have to
approve the transaction.
• The acquirer can use up to 60% cash in the transaction.
• Acquiring is not required to take all target’s assets.
Forward Triangular Merger
• Forward Triangular Merger--the acquirer establishes a subsidiary
through which it acquires the target (and its assets and liabilities) for
stock (voting and non-voting) of the acquiring firm.
– The surviving entity is the subsidiary of the acquirer, i.e., target’s
liabilities are isolated.
– The acquirer must acquire “substantially all”* of the target’s assets.
– Acquiring firm shareholders do not have to formally approve a
triangular merger (unless required by the corporate charter).
– Up to 50% of consideration may be in the form of cash.
* 90% of net fair market value of the target’s assets and 70% of gross fair
market value of those assets.
Tax-free Forward Triangular Type-“A” Merger
Acquirer:
Transfers $1,370 in consideration to
subsidiary for all of subsidiary’s stock.
$548 Cash
$822 acquirer stock
Target:
Receives $1,370 of consideration
from the acquirer and distributes
all of the consideration to shareholders in liquidation.
$548 Cash
$822 acquirer stock
“Substantially All”
of the target’s assets
and liabilities.
$548 Cash
$822 acquirer stock
All of target’s
stock
Target Shareholders:
Basis in target stock = $200.
Gain realized is $1,170 ($1,370 - $200). Gain
recognized is $548 (lesser of gain realized or
boot received).
Acquirer Shareholders:
No direct tax effect.
100% of
subsidiary’s stock
Acquirer Subsidiary:
Transfers $1,370 (cash and
acquirer stock) for all of the
assets and liabilities of the
target.
Post-acquisition Structure: Forward
Triangular Type-“A” Merger
Acquirer:
Subsidiary of the acquirer owns
substantially all of the assets of the target.
The acquirer has a basis in acquirer
subsidiary stock of $200.
Target Shareholders:
Own stock of the
acquirer and some
boot.
Acquirer Subsidiary:
Takes a carryover basis in the
target’s assets ($200).
Acquirer Shareholders:
Maintain ownership of
the acquirer.
IRC §368 “B” Reorganization—
Stock-for-Stock Acquisition
• The acquirer exchanges its voting stock directly
with that of target shareholders, obtaining
ownership of the target’s assets through ownership
of its stock.
• The target becomes a subsidiary of the acquirer
and, thus, maintains its legal identity while the
owners of the target’s stock change (much like a
reverse triangular merger under §368 “A”).
Requirements to Qualify for Tax-free
Treatment Under IRC §368(a)(1)(B)
• 100% of the consideration used in the
acquisition must be voting stock of the
acquirer.
• The deal’s tax-free treatment is disqualified
if any cash (except cash paid for fractional
shares) is used.
• The acquirer must obtain 80% control of the
target.
Tax Consequences of a §368 “B”
• Target shareholders take a substituted basis in the
acquiring firm stock received in the transaction:
Substituted basis = same basis as had in T stock + any
gain recognized – boot received
• The acquirer takes a carryover basis in the assets
of the target and in the stock of the target equal to
the target shareholder’s basis in the target’s stock
pre-acquisition.
• The tax attributes of the target will carry over to
the acquirer, but they will be limited by IRC §382.
Gain realized by T’s shareholders = value of the consideration
received - target shareholder’s basis in the target stock.
Gain recognized by T’s shareholders = lesser of gain realized
or boot received.
Tax Implications of a §368 “B” Reorganization
Given Information
Purchase Price
Target Shareholder Stock Basis
Net Tax Basis of Target's Assets
Corporate Tax Rate
Capital Gains Tax Rate
Discount Rate
Purchase Price:
Cash
Stock
Target Corporation Tax Liability
$1,370.00
$200.00
$200.00
35%
20%
10%
Tax-free Acquisitions Taxable Acquisitions
Stock Sale w/o
368 "A" 368 "B"*
a 338 Election
$1,370.00 $1,370.00
$1,370.00
548.00
0.00
1,370.00
822.00 1,370.00
0.00
0.00
0.00
0.00
548.00
109.60
0.00
0.00
1,370.00
234.00
Target Shareholder After-tax Wealth:
Cash
$438.40
$0.00
Stock
822.00 1,370.00
Total
$1,260.40 $1,370.00
$1,136.00
0.00
$1,136.00
Acquirer Net After-tax Cost:
Pre-tax Cost
Less: Incremental Tax Savings
Net After-tax Cost
$1,370.00
0.00
$1,370.00
Target Shareholder Gain Recognized
Target Shareholder Tax Liability
$1,370.00 $1,370.00
0.00
0.00
$1,370.00 $1,370.00
*Assumes that 100% of the consideration is voting common stock.
Tax-free Merger Under IRC §368(a)(1)(B)-Stock-for-Stock Acquisition
Target:
Owners of target’s stock change.
Tax basis in the target’s assets is
unchanged.
Acquirer:
Transfers $1,370 in acquirer stock directly
to target shareholders for all of the target’s
stock. Target becomes a wholly owned
subsidiary of the acquirer.
$1,370 of Acquirer Stock
100% of Target’s Stock
Acquirer:
Transfers $1,370 in acquirer stock directly
to target shareholders for all of the target’s
stock. Target becomes a wholly owned
subsidiary of the acquirer.
Acquirer Shareholders:
No direct tax effect.
Post-acquisition Structure:
Stock-for-Stock Acquisition
Acquirer:
Owns all of the stock of the target.
Target is a wholly owned subsidiary of
the acquirer. The acquirer’s basis in the
target stock is $200 (same as target
shareholder’s basis).
Target Shareholders:
Own stock of the
acquirer and some
boot.
Target (now a subsidiary of
the acquirer):
Asset basis carries over ($200).
Acquirer Shareholders:
Maintain ownership of
the acquirer.
Non-tax Issues Associated w/
the §368 “B” Structure
• The acquirer is liable for all of the target’s liabilities, but . .
• The acquirer’s liability is limited to its investment in the
target since the target is a subsidiary of the acquirer.
• Title to the target’s assets does not change since the target
retains its corporate identity. (This is a benefit if the target
has assets that are difficult to transfer.)
• Target’s intangibles, contracts, goodwill, preserved.
• Difficult to force out dissident shareholders of the target.
• Dilution may be a problem for acquiring firm’s
shareholders.
Reverse Triangular Merger
• Reverse Triangular Merger--the surviving entity
is the target corporation, which is a subsidiary of the
acquirer after the transaction.
• Target must retain substantially all of T’s assets*
• At least 80% of consideration must be in the form of
acquiring firm’s voting stock.
• Functionally similar to “B” reorganization except can
force out dissenters and use more cash.
* 90% of net fair market value of the target’s assets and 70% of gross fair
market value of those assets.
Reverse Triangular Merger
-TRANSACTION-
T
S/Hs
A
“A”
Voting
Stock
“A”
Voting
Stock
“A” Voting Stock
Acq. Sub.
Merged
T
• T S/Hs Transfer Control (80%) for “A” Voting Stock.
• T must hold Sub-all of Acquisition Sub and T’s Assets.
Reverse Triangular Merger
-RESULT-
A
T
Former
T
S/Hs
• Same result as a Type
B.
IRC §368 “C” Reorganization-Stock-for-Assets Acquisition
• The acquirer exchanges its voting stock
(and possibly some boot) for the target’s
assets.
• The target distributes the acquirer’s stock
and other consideration received in the
acquisition to its shareholders in liquidation.
Requirements to Qualify for Tax-free
Treatment Under IRC §368(a)(1)(C)
• The acquirer must purchase “substantially all”* of
the target’s assets but is not required to assume all
of the target’s liabilities.
• At least 80% of the total consideration used must
be voting stock of the acquiring firm.
• If the acquirer uses any boot in the transaction, the
liabilities of the target assumed by the acquirer
count as boot in the 80% test.
* 90% of net fair market value of the target’s assets and 70% of gross fair
market value of those assets.
Tax Consequences of a §368 “C”
• Target shareholders take a substituted basis in the
acquiring firm stock received in the transaction:
Substituted basis = same basis as had in T stock + any
gain recognized – boot received
• The acquirer takes a carryover basis in the assets
of the target.
• The tax attributes of the target will carry over to
the acquirer, but they will be limited by IRC §382.
Gain realized by T’s shareholders = value of the
consideration received - target shareholder’s basis in
the target stock.
Gain recognized by T’s shareholders = lesser of gain
realized or boot received.
Tax Implications of a §368 “C” Reorganization
Given Information
Purchase Price
Target Shareholder Stock Basis
Net Tax Basis of Target's Assets
Corporate Tax Rate
Capital Gains Tax Rate
Discount Rate
$1,370.00
$200.00
$200.00
35%
20%
10%
Tax-free Acquisitions
Purchase Price:
Cash
Stock
Target Corporation Tax Liability
368 "A"
368 "B"
368 "C"*
$1,370.00 $1,370.00 $1,370.00
548.00
0.00
274.00
822.00 1,370.00
1,096.00
Taxable Acquisitions
Stock Sale w/o
a 338 Election
$1,370.00
1,370.00
0.00
0.00
0.00
0.00
0.00
548.00
109.60
0.00
0.00
274.00
54.80
1,370.00
234.00
Target Shareholder After-tax Wealth:
Cash
Stock
Total
$438.40
$0.00
$219.20
822.00 1,370.00
1,096.00
$1,260.40 $1,370.00 $1,315.20
$1,136.00
0.00
$1,136.00
Acquirer Net After-tax Cost:
Pre-tax Cost
Less: Incremental Tax Savings
Net After-tax Cost
$1,370.00 $1,370.00 $1,370.00
0.00
0.00
0.00
$1,370.00 $1,370.00 $1,370.00
$1,370.00
0.00
$1,370.00
Target Shareholder Gain Recognized
Target Shareholder Tax Liability
*Assumes that the mix of consideration is 20% cash and 80% acquiring firm voting stock.
Tax-free Merger Under IRC §368(a)(1)(C)—
Stock-for-Asset Acquisition
Target:
Receives $1,370 of consideration
from acquirer and distributes all
of the consideration to
shareholders in liquidation.
$274 Cash
$1,096 Stock
All of Target’s
Stock
Target Shareholders:
Basis in target stock = $200. Gain
realized is $1,170 ($1,370
received - $200 stock basis). Gain
recognized is $274 (lesser of gain
realized or boot received).
$274 Cash
$1,096 Stock
“Substantially
All” of the
Assets and
Liabilities of
Target
Acquirer:
Transfers $1,370 in consideration
to target for its assets and
liabilities.
Acquirer Shareholders:
No direct tax effect.
Post-acquisition Structure:
Stock-for-Asset Acquisition
Acquirer:
Holds substantially all of the assets and
liabilities of the target. Has a carryover basis in
the target’s assets.
Target Shareholders:
Now own acquirer stock
and have some boot.
Acquirer Shareholders:
Remain owners of the
acquirer.
Non-tax Issues Associated w/
the §368 “C” Structure
• The acquirer is not required to assume all of the target’s
liabilities since the deal is done by contract instead of
under state merger laws.
• Consent of acquiring firm’s shareholders not required.
• Possible dilution of acquiring firm’s stock because at least
80% of consideration must be stock.
• Unwanted assets may be a problem.
• T’s shareholders must approve liquidation of T.
Limitations on Target Firm Tax Attributes
• Under IRC §382, any transaction after 1986
that results in a 50% change in ownership of
a corporation triggers a limitation on the
firm’s tax attributes.
• The annual limitation on the amount of the
firm’s tax attributes that can be used equals
the market value of the subject firm’s equity
at the date of the ownership change times
the long-term tax-exempt rate of return.
Note: Losses generated by a target firm postacquisition can be offset by profits of the acquirer.
More Rules on Target Firm Tax
Attributes
• The target firm’s NOLs can be used to
offset the corporate level gain on the actual
or deemed asset sale in taxable transactions
in which the tax basis of the target’s assets
are stepped-up.
• However, the valuable tax attributes of the
target that are not used to offset the gain on
the step-up are lost.
Example of Tax Implications of Tax-free
Acquisitions of Free-Standing C Corporations
Given Information
Value of Target's Stock (and Purchase Price)
Target Shareholder Stock Basis
Tax Basis of Target's Net Assets
Corporate Tax Rate
Capital Gains Tax Rate
Discount Rate
$1,370.00
$200.00
$200.00
35%
20%
10%
The target corporation and the acquiring firm are C corporations.
The target is owned by individual investors and has no liabilities.
The acquirer's stock does not pay dividends, and the acquirer does not
intend to pay dividends anytime in the future.
Comparison of Tax Implications of Tax-Free
Acquisitions of Free-Standing C Corporations
Tax-free Acquisitions
Taxable Acquisitions
Stock Sale w/o
368 "A"* 368 "B"* 368 "C"*
351*
a 338 Election
$1,370.00 $1,370.00 $1,370.00 $1,370.00
$1,370.00
548.00
0.00
274.00
822.00
1,370.00
822.00 1,370.00 1,096.00
548.00
0.00
Purchase Price:
Cash
Stock
Target Corporation Tax Liability
0.00
0.00
0.00
0.00
0.00
548.00
109.60
0.00
0.00
274.00
54.80
822.00
164.40
1,370.00
270.00
Target Shareholder After-tax Wealth:
Cash
Stock
Total
$438.40
$0.00
$219.20
$657.60
822.00 1,370.00 1,096.00
548.00
$1,260.40 $1,370.00 $1,315.20 $1,205.60
$1,100.00
0.00
$1,100.00
Acquirer Net After-tax Cost:
Pre-tax Cost
Less: Incremental Tax Savings
Net After-tax Cost
$1,370.00 $1,370.00 $1,370.00 $1,370.00
0.00
0.00
0.00
0.00
$1,370.00 $1,370.00 $1,370.00 $1,370.00
$1,370.00
0.00
$1,370.00
Pre-Tax Price to Leave Target
Shareholders Indifferent
$1,195.66 $1,100.00 $1,145.84 $1,250.00
$1,370.00
Target Shareholder Gain Recognized
Target Shareholder Tax Liability
60% stock & 40% cash
100% stock
80% stock & 20% cash
40% stock & 60% cash