Are you thinking of selling your business, but want to defer paying tax on the sale? There are a several ways to structure the sale to minimize the tax consequences. One effective way of achieving this goal is to structure the sale as a tax-free reorganization.
There are certain limitations to receiving tax-free treatment on the sale of your business. Tax-free reorganizations only apply to C-Corporations and S-Corporations, and the seller must predominantly receive stock, rather than cash. The amount of cash you can receive is determined by which reorganization structure you implement. You will pay tax related to the cash you receive, but assuming the deal meets the criteria of a tax-free reorganization, the tax related to the stock consideration can be deferred. The Internal Revenue Code describes five different types of tax-free reorganizations for you to consider when selling your business.
An “A” reorganization is a merger or consolidation of two corporations in which one of the combining corporations is required to go out of existence after the merger. Unlike most reorganizations, an “A” reorganization allows the seller to receive up to 60% of the consideration in the sale as cash.
A “B” Reorganization is a tax-free stock acquisition. The shareholders of the target corporation (the “target”) sell stock directly to the acquiring corporation (the “buyer”) in exchange for voting stock, and the target continues operations as a subsidiary of the buyer. It is important to keep in mind that no cash is permitted in a “B” Reorganization. Any amount of cash received causes the entire transaction to be taxable. The buyer may prefer this structure if it does not want to part with a substantial amount of cash to fund the acquisition or seeks to shield itself from the target’s liabilities.
A “C” Reorganization involves a tax-free asset acquisition in which the target transfers assets to the buyer in exchange for the buyer’s voting stock. The target liquidates following the reorganization. However, unlike a Type “A” reorganization, only up to 20% of the total consideration can be cash. One benefit of this type of reorganization is that it does not require the same level of shareholder approval as other reorganizations.
A “D” Reorganization, also known as a forward triangular merger, involves merging the target into a subsidiary of the buyer. As a shareholder of the target, you are required to receive stock in the buyer. The flexibility to receive cash as part of the reorganization is the same as in an “A” Reorganization; up to 60% of consideration received can be cash. You may want to consider a forward triangular merger if you wish to receive cash in the transaction and you anticipate that the buyer does not want to directly assume liabilities of your corporation.
An “E” Reorganization has a similar structure to the “D” reorganization. Also known as a reverse triangular merger, an “E” Reorganization involves merging a subsidiary corporation of the buyer into the target. The target shareholders must give up at least 80% of their stock in the target in exchange for voting stock of the buyer. This allows the shareholders to receive 20% of the total consideration in cash.
Although they may sound more advantageous, tax-free reorganizations are not always the best option for some businesses. You should also understand that a tax-free reorganization is not completely tax-free, but it allows you to defer any current gain on the sale related to stock consideration to a later tax year. Therefore, it is important to discuss the benefits and pitfalls of reorganizing your business with a tax professional. If you have questions about this topic, or would like help with any other tax matter, please do not hesitate to contact your L&B professional at (858) 558-9200.