Statutory Mergers: A Reorganization

Stock issued as part of the purchase price of a business can, if structured correctly, be considered a tax-free reorganization under Section 368(a)(1)(A). When qualified a tax-free reorg can be a great way to help relieve at least the short-term tax burden of the sellers. In most cases, the seller is only taxed on the cash received in the transaction, which is generally the combined federal and state long-term capital gains tax rates.

As always, there are trade-offs. The amount of tax paid in such a reorganization is generally dependent on factors apart from the cash received at the time of sale. The existing stock basis the shareholders had in the selling company as well as the reorganization gain experienced in the sale both play a role in the amount of tax paid when the transaction eventually closes.

In addition, a typical low carryover basis in the amount of stock received as compensation for the company’s sale can create a large tax liability later if the selling shareholder decides to sell the buyer’s stock before death. The reason for this is that the seller’s basis in the buyer’s stock is carried over to the new entity. There is no step-up in basis in the new stock. Therefore, any gain made in the eventual sale of the stock would be considered as pure profit, which is taxable at a higher rate. Furthermore, in many instances the sale the said stock later could be treated as “dividend” income which is often taxed at a higher rate than long-term capital gains. Both future considerations when thinking about selling. Of course, there are other options to help in tax liability remediation like asset exchanges and the like which would help to alleviate some of the eventual tax pain.

What Qualifies as an A Reorganization?

There are four requirements that must be satisfied before a statutory merger can be considered legal. We’ve listed them simply below:

  1. The seller must be dissolved by operation of law. That is, under state law the statutory merger or consolidation of the entities must be done and transferred to the buyer entity without the need for specific asset or liability transfer documentation. 
  2. Continuity of interest doctrine must be satisfied. That is, the stock issued to the seller shareholders must be equal to a defined percentage in the transaction. John A. Nelson Co. v. Helvering case law indicates that the lowest arguably defended was 40%. In most cases, the IRS has indicated 50% will do. It is important to understand that the nature of the consideration and not the percentage alone is what would deem such a merger to qualify for A reorganization.
  3. The merger must be for a particular business purpose. If that purpose is to strengthen the entities or provide a more favorable outcome that would not have been gained by the two entities remaining separate, then the rule would most likely be shown as satisfied.
  4. Continuity of the business must remain intact. That is, the buyer must maintain a significant portion of the selling company’s business and business assets for a similar purpose.

It is important to note as well that the seller or buyer is not limited on the ability to sell some of the seller stock to a party unrelated to the transaction immediately before the merger. Nor is the selling shareholder limited in their ability to sell any of the buyer stock immediately after the merger takes place, even if there was a prearrangement to do so.

Many sellers and buyers alike find that as long as they fit within the guise of the law, there are a number of very creative and helpful ways (like the 338 election previously mentioned) in which transactions can be structured so as to benefit both parties. In doing so, however, it is important to understand the limitations and laws regarding getting a deal done. This often involves speaking with the right consultants long before you experience your life-changing liquidity event.


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Nate Nead
Nate Nead is a licensed investment banker and Principal at Deal Capital Partners, LLC which includes InvestmentBank.com and Crowdfund.co. Nate works works with middle-market corporate clients looking to acquire, sell, divest or raise growth capital from qualified buyers and institutional investors. He is the chief evangelist of the company's growing digital investment banking platform. Reliance Worldwide Investments, LLC a member of FINRA and SIPC and registered with the SEC and MSRB. Nate resides in Seattle, Washington.
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