Expanding a Corporate Business With a Tax-Free Merger

If a corporate business is seeking to quickly expand, it may be considering one of these options:

1. Gaining control over another corporation's business (the target) indirectly via a merger transaction that would result in your corporation being in charge.

With a merger, the corporation generally issues stock to the target company's shareholders, which means they wind up owning part of the merged company. A merger can often be structured as a tax-free transaction for the seller, as well as the buyer.

2. Alternatively, the corporation may directly buy the target's stock or assets in a taxable transaction. With a taxable direct purchase deal, the corporation simply pays cash and/or issues debt in exchange for the target corporation's stock or assets. The target or its shareholders may owe income taxes but the buyer will not.

Here are some key factors to keep in mind when evaluating a corporate acquisition by merger (as opposed to a taxable stock or asset purchase).

Tax-Free Merger Pluses

From a company's perspective as a buyer, the beauty of a tax-free merger is that it doesn't require cash. Instead the corporation issues stock to the seller to finance the acquisition.

From the seller's perspective, the beauty of a tax-free merger is that it doesn't trigger an immediate income tax hit. Instead, the tax consequences are postponed until the stock received in the transaction is sold. That may be years later. Under current federal income tax rules, the maximum federal rate on an individual seller's long-term gain from a stock sale is only 15 percent. (If the seller is the target company's corporate parent, there's no preferential federal tax rate for the stock sale gain.)

While tax-free treatment is great, the merger must be carefully structured to gain the desired result. The applicable tax rules are complicated. Professional advice is critical to avoid mistakes.

Non-tax considerations are also important. It may be much easier from a legal perspective to take over control of the target company's assets with a merger rather than having to formally transfer title to a large number of acquired assets that would be necessary with an asset purchase transaction. (With a merger, the controlling corporation can generally take over effective ownership of the target's assets without filing any legal paperwork.)

Last but not least, a merger may allow you to gain control over valuable non-transferable assets owned by the target corporation, such as leases and licenses, that could not be acquired with an asset purchase.

Now for the Minuses of Mergers

Unlike a taxable asset purchase, a tax-free merger doesn't allow the buyer to "step up" (increase) the tax basis of the target's appreciated assets to reflect the purchase price. This means if your company is the buyer, it won't benefit from bigger post-purchase tax write-offs for depreciation, amortization, cost of goods sold and so forth. However, this is not a negative factor if:

• The target corporation's assets are not significantly appreciated.
• Your company doesn't need bigger tax write-offs.

With a merger, any target corporation liabilities (known or unknown) generally become the buyer's responsibility for all practical purposes — because the buyer effectively takes over legal ownership of the target corporation, including its imperfections. The seller or sellers are generally taken off the hook once the deal is done. To avoid unpleasant surprises about liabilities, a buyer may want to hire a professional firm to conduct a detailed due diligence investigation of the target.

With a merger, the target corporation's shareholder (or shareholders) will retain a piece of the business through their ownership of stock in the post-merger corporation. In other words, they buyer will have to put up with one or more new shareholders. If this is a big concern, the buyer should consider making a taxable stock or asset purchase instead. These transactions allow buyers to avoid having to take on additional shareholders.

Upshot: If your corporation is considering expanding by merging with a target corporation, there are important tax and non-tax factors to evaluate. Before finalizing any deal, get professional tax and valuation advice. A due diligence study can help avoid being harmed by unanticipated target corporation liabilities.