Corporate Acquisitions and Mergers
In the competitive business world, it is often advantageous for a corporation to buy another corporation so that it can acquire know-how, valuable management or employees, or a new or larger market. When buying another corporation, a corporation can purchase the other corporation's assets or stock, either as a taxable or tax-deferred transaction.
One way that a corporation can buy a business is simply to buy its assets, paying a specific price for each asset, or paying a lump sum price for all assets. In the process, legal titles are transferred from seller to buyer. The purchase contract should specify which liabilities of the target are being legally assumed by the acquiring corporation. Any liabilities not so assumed remain the target corporation's.
Another way of acquiring another corporation is through a merger, which is the absorption of one corporation into the other, according to state law. All assets and liabilities of the acquired corporation become that of the acquiring corporation, thereby eliminating the time and expense of titling over specific assets. Most states require that shareholders with either the majority or 2/3 of the voting stock of both the acquiring corporation and the target corporation approve the merger. If so approved, then the merger can continue in spite of dissenting shareholders. After the merger, the target corporation discontinues its legal existence.
Another means of buying a corporation is simply by buying the stock so that it is a controlled subsidiary. This may be done because the target corporation may have nontransferable property rights such as copyrights, franchises, licenses, and patents, or the target may have favorable leases or other contracts on which the buyer may not be able to get as good a deal by renegotiating. The buyer may also want to keep the management and employees of the target corporation or to retain a strong brand or highly recognizable name.
Buying the stock instead of merging the company also has the advantage that the parent corporation's legal liability for undisclosed or contingent liabilities of the target corporation is limited. If the buyer subsequently wants to operate the business directly, they can always liquidate the controlled subsidiary without any tax consequences under IRC §332 and 337.
Taxable and Nontaxable Acquisitions
The acquisition can be taxable or tax-deferred. If the acquiring corporation uses cash to buy either the assets or to merge the business or to purchase the stock, then that will be a taxable event to the shareholders of the target corporation, who must recognize either a gain or loss on the transaction.
However, if the acquiring corporation uses its stock to settle the transaction, then the transaction will be a nontaxable event, since a corporation can exchange the stock for any property without recognition of gain or loss. IRC §1032(a)
Both newly issued and treasury stock can be used to acquire the target. When the corporation does acquire another corporation, by whatever method, it also incurs professional and investment banking fees and other expenditures, which must be capitalized rather than deducted.
A major advantage of using stock rather than cash to purchase a corporation as a nontaxable transaction is that the shareholders of the target corporation may accept a lower price if the transaction does not force them to recognize gain.
When buying the target's assets, the buyer takes a cost basis in each asset. The cost of purchased inventory can be recovered when the inventory is sold or consumed, and the cost of operating assets can be depreciated or amortized.
If the buyer pays a lump sum price for the assets, it will want to allocate as much of the purchase price as possible to inventory or to depreciable or amortizable assets so as to maximize cost recovery.
However, any allocation of price to a specific asset cannot exceed its fair market value (FMV). Both buyer and seller must accept the price allocation, since it serves as the buyer's cost basis and the seller's proceeds from the sale. So if a buyer allocates $10,000 of the purchase price to a machine, then the seller must realize that amount on its sale. Any allocated purchase price that exceeds the aggregate FMV of the target's operating assets will be allocated to goodwill, amortizable over a 15-year period. IRC §1060
After a sale, the target corporation can maintain its existence and invest the sale proceeds in a new business, or it can liquidate by distributing the proceeds to its shareholders. Shareholders recognize a gain or loss equal to the difference between the distribution amount and their stock basis:
Gain or Loss = Liquidating Distribution – Stock Basis
Cash Mergers and Reverse Cash Mergers
When companies merge under a cash deal, which is often referred to as a cash merger, then the target corporation must recognize gain or loss under the assumption that all of the assets were sold for FMV. The acquired corporation must pay tax on the gain; likewise, for the shareholders of the target corporation, since they must pay tax on the difference between what they receive for their stock and their basis.
To prevent double taxation, the merger can be structured as a reverse cash merger, where the acquiring corporation forms a new subsidiary for the only purpose of merging it with the target corporation. The acquiring corporation contributes cash to the newly formed subsidiary which is then used to buy out the stock of the target corporation. Because the parent corporation pays cash to the subsidiary in exchange for the subsidiary stock, it is not a taxable event. Likewise, the subsidiary pays cash to the target corporation in exchange for the stock held by the target corporation, which is also a nontaxable event. Cash is also paid to the shareholders for their stock. However, the payment to the shareholders is a taxable event for the shareholders, since they must recognize the income, but there is no corporate tax paid because of the merger.
The main drawback of a reverse cash merger is that the cost basis of the acquired assets remains as it was, whereas in a straight merger, the buyer's tax basis receives a cost basis equal to the FMV.
When the corporation simply buys a controlling interest in the target stock, then it's only cost basis is in the stock itself. The target's tax basis in its own assets does not change. However, if the target becomes a member of an affiliated group or files a consolidated tax return, then the stock basis must be adjusted according to regulations.