Sale of a Subsidiary

If the company to be sold is a subsidiary of another corporation with which it files a consolidated tax return, it is subject to some differences in tax treatment that may affect its decision to sell assets or stock. First, only one level of gain is taxed when the assets of a subsidiary are sold, even if the subsidiary is liquidated or the proceeds are distributed after the sale. Second, the parent company adjusts its basis in its subsidiary to reflect the subsidiary's earnings and losses, so that a large difference between the inside basis of the subsidiary's assets and the outside basis of the subsidiary's stock is less likely. Third, the sale of stock at a loss to the parent corporation would not be recognized for tax purposes by the parent corporation in certain circumstances, but the sale of assets at a loss would be deductible in a consolidated return. Fourth, a special rule allows the sale of stock of a subsidiary to be taxed as if it were an asset sale.

If the company to be sold is a subsidiary of another corporation, and they do not file a consolidated return, as long as the parent corporation owns at least 80% of the stock of the subsidiary by vote and value (excluding certain preferred stock), there will only be one level of gain on the sale of the assets, even if the subsidiary is liquidated and the special rule (which allows the sale of stock to be taxed as if it were an asset sale) also applies.

This election to treat a stock sale as an asset sale offers the advantages of both a stock sale and an asset sale. Legally, the transaction is a stock sale. However, if the selling corporation makes the election (known as a Section 338[h][10] election), the sale of the stock will be disregarded for tax purposes, and the transaction will be treated as if the subsidiary had sold its assets.

When the subsidiary's inside and outside bases are substantially the same, this election does not result in additional tax cost to the selling parent. At the same time, it often produces a better tax result for the purchaser since, by treating the transaction as if it were a sale of assets, the purchaser can allocate the purchase price to the assets that were acquired. Applied properly, this tax election can add value to the total transaction.

Tax-Free Reorganizations

Business owners sometimes do not want to sell out completely but see a strategic advantage to combining forces with another entity. The tax laws allow a number of different ways to restructure two separate organizations into one continuing entity without significant tax effects.

Although the tax rules that determine whether a specific transaction will be tax-free are quite complex and must be adhered to precisely, the essential element of all tax-free reorganizations is continuity -- continuity of ownership and continuity of the business. In order to meet the "continuity of interest" test the shareholders of the target company must receive equity in the acquiring company. The Internal Revenue Service (IRS) believes that the requisite continuity exists if at least one-half of the equity in the target company is acquired in exchange for stock of the acquiring company, though the courts have found continuity of interest to exist even at somewhat lower levels. If the continuity test is not met, the merger will not be tax-free, the corporation will have taxable gain on the sale of its assets, and the shareholders of the acquired corporation will have taxable gain to the extent that the value of stock and cash they receive exceeds their basis in their old stock.

A business combination must also fit into one of five basic structures in order to avoid current taxation. Although these structures are referred to as "tax-free" reorganizations, they would more properly be described as "tax-deferred." Since the parties pay no taxes at the time of the transaction, their basis in the stock or assets does not change. Thus, the inherent gain in the transaction carries over and will be taxable if the stock or assets are later sold in a taxable transaction. Statutory Mergers

The merger of two corporations (Click for information on Structuring the Sale) is the most flexible form of tax-free reorganization. There is wide latitude in the type of consideration that may be used, as long as the continuity of interest requirement is met.

To the extent that the shareholders of the target company receive stock of the surviving corporation, they do not recognize gain or loss on the transaction. However, any other consideration received (e.g., cash) is taxable as a dividend or, if the additional consideration is distributed disproportionately to only some of the shareholders, as a capital gain. The holders of debt securities in the target corporation can exchange those securities for debt securities in the surviving corporation tax-free to the extent that the principal amount does not exceed the principal amount of the debt securities surrendered.

The surviving corporation generally assumes a tax basis in the target corporation's assets equal to the basis that the target corporation had in the assets.

The same rules apply when the acquiring company forms a subsidiary to effectuate the transaction and the target company merges with and into the subsidiary, with subsidiary surviving. In order to qualify an (a)(2)(D) reorganization, the subsidiary must acquire substantially all the assets of the company. The IRS will view this requirement as met if at least 70 percent of the fair market value of the gross assets and 90 percent of the fair market value of the assets (net of liabilities) are acquired. In addition, as long as continuity of interest is met to the extent stock is issued, it must only be stock of the subsidiary's parent.

Acquisition of Stock for Stock

Perhaps the easiest form of reorganization to understand is the stock-for-stock reorganization. To qualify, the shareholders of one corporation must surrender their stock solely in exchange for the voting stock of the acquiring corporation (or the voting stock of its parent), immediately after the transaction the acquiring corporation must own at least 80 percent of the voting stock of the target company, and at least 80 percent of each and every class of nonvoting stock. This type of reorganization is also known as a "B" reorganization because it is defined in Section 368(a)(1)(B) of the Internal Revenue Code.

Although a B reorganization is conceptually easy to understand, it is often difficult to execute because it is relatively inflexible. Any consideration other than voting stock will disqualify the transaction as a B reorganization.

Because they receive solely voting stock in the acquiring corporation, the shareholders of the acquired corporation recognize no gain or loss. The acquiring corporation's basis in the stock of the acquired company is equal to the basis that the shareholders had in their stock (although, as a practical matter, this may be difficult to determine). And because this is a stock transaction, there is no change in the acquired company itself so that its basis in its assets and most of its tax attributes carry over.

Acquisitions of Assets for Stock

A third type of tax-free reorganization is known as a "C" reorganization, in which substantially all the assets of the target company are acquired solely for the voting stock of the acquiring corporation (or the voting stock its parent), which stock is then distributed to the shareholders of the target company. The acquiring corporation is generally also permitted to assume the liabilities of the target company.

In order to qualify as a C reorganization, the acquiring corporation must acquire substantially all the assets of the target company. The ability to leave a small amount of cash or other assets in the target company allows some flexibility to accommodate dissenting shareholders.

No taxable gain or loss is recognized by the shareholders of the target company when they receive stock of the acquiring corporation. However, if cash or other assets of the target corporation are distributed, taxable income will result.

Even though this is an asset sale, the acquiring corporation does not get a new basis in the acquired assets. The acquiring corporation generally takes the basis that the target company had in the acquired assets.

Reverse Triangular Mergers

One of the most common forms of acquisition is a reverse triangular merger, or an "E" reorganization, where the subsidiary of the acquiring corporation is merged into the target company, with the target corporation surviving. This has the advantage of preserving the legal existence of the target.

To qualify as a reverse triangular merger, the acquired company must continue to own "substantially all" its assets, and the assets of the acquired corporation, and the shareholders of the target company must exchange stock of the target company constituting 80 percent control for voting stock of the parent. Thus, a reverse triangular merger, like a B reorganization, uses voting stock as consideration. Other consideration, however, may be used to acquire some portion of the stock.

As in both the statutory mergers and the forward triangular merger, the shareholders of the target company have current taxable income only to the extent that they receive any nonstock consideration, and the basis of the target company's assets carries over.

As you can see from the above descriptions, the rules for tax-free reorganizations are complex and specific. Care must be used in meeting the requirements of the desired structure. Failing to qualify in all respects under one of the provisions can result in a transaction that is currently taxable.

Capital Gains vs. Ordinary Income

For individuals, capital gains are taxed at rates below the maximum rate for ordinary income. Conversely, an individual's deductions for capital losses are limited annually to $3,000 plus any capital gains.

With stock sales, any gains or losses will generally be capital gains or losses. In a sale of assets, much of the gain may be ordinary income. Ideally, the sale agreement will identify the assets purchased and the amount paid for each item. Most of these assets -- inventory, equipment, etc. -- will result in ordinary income. Some items, such as goodwill, most real property gains, and any appreciation over the original cost of equipment, will qualify as capital gains.

The identification and valuation of "intangible" assets can be significant negotiating items. Goodwill is an intangible that has capital gain treatment for the seller. The buyer can generally amortize purchased goodwill over 15 years.

It is sometimes advantageous to both the purchaser and the seller to allocate a reasonable portion of the total consideration being paid to a covenant not to compete. It is common to have the proceeds attributable to a covenant not to compete paid directly to the shareholders of a corporation, thereby avoiding a corporate level tax on that portion of the price even in an asset purchase. The covenant payments are taxable to the selling shareholders as ordinary income, the purchaser is generally entitled to amortize the covenant payments over 15 years.

A portion of the purchase price may also be assigned to such items as customer lists, favorable leases, backlogs, technology, etc. These items can be amortized over 15 years with a resulting tax deduction for the purchaser.

Since 1993, purchased intangible assets including goodwill and going concern value have generally been amortizable by the buyer over 15 years. Gain from the sale of these assets will usually be treated as capital gain by the sellers. However, for some assets the 15-year amortization period provided in the law sometimes causes a longer recovery period to the buyer than would have been available under prior law.

Net Operating Losses

Special considerations apply when a company has net operating loss carryforwards or carryforwards of tax credits. If the buyer purchases a company's stock, that company's tax attributes (including carryforwards) are retained. However, the tax code puts limitations on the amount of carryforwards a company may use after a change in ownership has occurred. Generally, the NOL and other carryforwards are totally disallowed if the business of the company is discontinued during the first two years following a change in ownership. Even if the business is continued, an annual limitation applies. Generally, the Section 382 limitation is calculated by multiplying the total value of the company by the tax-exempt long-term bond interest rate at the date of the ownership change. For example, if the acquired company had NOL carryforwards of $2 million, if the value of the company were $4 million, and if the appropriate bond interest rate were 8 percent, then the buyer would be allowed annually to use carryforwards of only $4 million 8 percent, or $320,000. In this example, it would take seven years to realize the total benefits of the NOL carryforwards acquired. In other instances, the limitation may turn out to be so restrictive that a portion of the carryforwards would never be used (the NOLs can only be carried forward 15 years from the date they are incurred).

The Section 382 limitation is triggered by a 50 percent or more change in the ownership of a corporation during a three-year period, not only as a result of taxable sales of stock by existing shareholders but also as a result of tax-free reorganizations and issuances of stock to new shareholders and in certain instances, the issuance of options. Thus, a company should monitor its ownership changes to avoid unintentionally triggering this limitation.

Be aware that the Section 382 limitation also limits the use of certain losses that are economically "built-in" at the time of the 50 percentage point ownership change.

In addition to these limitations, there are also further limitations on the use of net operating loss carryforwards and certain built-in losses. The NOLs and certain built-in losses of an acquired company can only be used to offset future income of that company, not taxable income of other businesses of the buyer that are included in the buyer's consolidated return. However, if the acquired company continues to have losses, the buyer may offset current losses against current profits of the rest of the businesses, as long as the buyer files a consolidated tax return.

Installment Reporting of Gain

If the seller finances some portion of the transaction, the installment sales method of income recognition may be available to defer the payment of taxes. Under this method, the seller will recognize gains on the sale only as the proceeds are received, not when the transaction takes place.

There are several restrictions on the availability of the installment sale method. First of all, gains from inventory, publicly traded securities, or depreciation recapture are not eligible for installment reporting. Also, to the extent that the amount of the installment receivable exceeds $5 million as of the end of the year of sale, interest is charged on the taxes deferred. Finally, if the seller uses the installment receivable as collateral for other borrowings, the debt proceeds are treated as if they were a payment of the receivable, thereby triggering a portion of the deferred gain.

S Corporations

Sellers can avoid double taxation of their gains by structuring transactions as stock sales rather than as asset sales. Another, but more difficult, way for the seller to avoid two layers of tax is to change the tax structure of the company to an S corporation.

With only a few exceptions, the S corporation is not a taxpaying entity. The income or loss of an S corporation is taxed directly to the shareholders in the same way that partnership income or loss is taxed directly to the partners. Therefore, no second layer of taxation occurs when an S corporation sells its assets. An S corporation can treat a sale of stock as an asset sale if a section IRC Section 338(h)(10) election (discussed above) is made.

To be eligible to make an S election, the corporation must meet many specific requirements, including having only one class of stock, having no more than 35 stockholders, all of whom are individual citizens or residents of the United States, having no subsidiary of which it owns 80 percent or more, etc. Be aware also that the tax code attempts to limit the use of the S corporation vehicle to avoid corporate taxation of gains that are economically "built in" at the time the election is first effective; if a sale of assets occurs within 10 years of the election, the built-in gain in those assets will still be subject to the corporate level tax. However, any appreciation in the company's assets that the taxpayer can demonstrate occurred after the S corporation election was made escapes the corporate level tax.

Excess Debt

Because of the tax benefits inherent in debt (i.e., interest is deductible, while dividends are not), restrictions on the deductibility of interest could substantially diminish the benefits of a transaction structured as a leveraged buyout.

The tax laws contain restrictions on the deduction of interest on obligations that purport to be debt obligations but are, in reality, equity. For example, Section 385 enumerates factors to be considered in determining whether an interest in a corporation is debt or equity, and Section 279 denies the deduction for interest incurred to acquire the stock or assets of another corporation if the indebtedness contains features, such as subordination or convertibility, which suggest that the indebtedness is really disguised equity. For this reason, carefully constructed capital structures that clearly demarcate debt from equity securities have been used to avoid such problems.

Concern over the highly leveraged acquisitions that have occurred in the last several years has caused Congress to place additional restrictions on the deductibility of interest expense. The Internal Revenue Code currently prevents the carryback of net operating losses that result from interest deductions from debt arising out of major stock acquisitions or from excess corporate distributions and redemptions. In addition, Congress authorized the Treasury to characterize obligations that have significant debt and equity characteristics as part debt and part equity, thereby allowing only a partial deduction for amounts paid under the instrument