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