Legal Developers

How to Structure a Business Sale Without Tax Consequences

For business owners considering selling their company, avoiding U.S. federal income tax is a dream come true. Structuring a business sale as a tax-free reorganization under Section 368 of the Internal Revenue Code (“IRC”) permits such tax benefits. Unlike a taxable straight asset or stock sale under IRC Section 1001, resulting in capital (and potentially ordinary) gains, a properly executed tax-free reorganization allows the seller to defer gain, thereby preserving wealth and pushing off tax impacts. Of course, to obtain such favorable treatment the transaction must satisfy various stringent IRS requirements. Failure to meet such requirements can trigger unintended tax liabilities.

Key Types of Tax-Free Reorganizations

In general, tax-free reorganizations are governed by IRC Section 368, which sets forth several key types of reorganizations each with distinct legal and tax implications. The most commonly used structures for a business sale include the following:

• A Reorganizations, commonly referred to as statutory mergers. This type of reorganization involves merging one company, typically the target company, into the acquiring company under and pursuant to state law. Often the deal consideration in this instance will include a mix of stock in the surviving entity, as well as cash.
• B Reorganizations, also known as stock-for-stock deals. B reorganizations require that the acquiring corporation obtain at least 80% of the target company’s voting stock in exchange for its own voting stock, and that generally no cash or other property are exchanged in the deal. This structure is advantageous given the simplicity of the exchange, and it’s attractive for sellers that want to stay invested in, and involved with, the resulting entity.
• C Reorganizations, also known as stock-for-asset deals: In this form of reorganization, an acquiring company buys “substantially all” of the target entity’s assets in exchange for voting stock of the acquiring company. This is similar to a B Reorganization, but a key difference in this case is that the legal form of the target remains separate given the acquiring entity solely obtains assets of the target, rather than an equity interest. Immediately following the asset acquisition, the target liquidates post-transaction. This structure is desirable for business owners seeking to engage in the equivalent of an asset sale but without the immediate tax consequences that would typically accompany the same.

Other forms of tax-free reorganizations include D Reorganizations, often used for internal restructuring of large corporations, and F Reorganizations, most often used with respect to the acquisition of an S Corporation to control for historical tax liabilities and obtain favorable tax benefits, such as an inside basis step-up.

It’s important to note that certain doctrinal requirements accompany the above forms of reorganizations. Specifically, these transactions must meet the continuity of interest and the continuity of business enterprise requirements (known as the COI and COBI requirements) which require:

1. The surviving business to substantially continue with the operations of the merged target, and
2. That the shareholders of the target hold a meaningful ownership interest in the surviving company post-merger.

The IRS also requires that any tax-free reorganization have a valid business purpose, which is construed broadly. This requirement is primarily an anti-abuse rule insofar as there must be a business reason (operational or otherwise) for the merger beyond simply tax avoidance.

Why Undertake a Reorganization?

The primary advantage of structuring a business sale as a tax-free reorganization is the ability of the seller to defer tax costs until a later trigger event, such as selling the stock in the acquiring company obtained in the merger. Tax deferral also grants the selling party an opportunity to reinvest in the acquiring company without an immediate tax burden. It may also be the case that the growth proposition in the stock of the acquiring company held by the target shareholders post-merger is significant, affording the target seller a tax-free opportunity to obtain significant asset value appreciation. Additionally, tax-free reorganizations open the door to a host of new buyers, especially buyers that are unwilling or unable to entertain a large cash outlay in exchange for target stock or target assets.

It’s worthwhile to note that while Section 368 applies primarily to corporations, similar planning opportunities exist for partnerships and S corporations.

In particular, partnerships can utilize tax-free contribution and distribution rules under Section 721 and Section 731 of the IRC to restructure business ownership without triggering immediate taxable gain. S corporations may also qualify for certain tax-deferred reorganizations, though additional limitations exist due to shareholder and ownership restrictions under IRC Section 1361.

Takeaway

At the end of the day business owners must assess and explore all available exit strategies to determine which method will provide the most benefit to them in view of their particular needs, as well as the nature of the business. The reorganizations outlined above may be highly desirable for certain sellers and provide benefits that a typical arms-length sale couldn’t offer. Business owners should review these options with competent tax counsel as failure to satisfy all of the conditions attendant to the aforementioned reorganization options can result in the IRS treating the transaction as a taxable sale, potentially triggering significant tax liability for the selling party.

If you are contemplating a sale of your business in the near future, the tax attorneys in Obermayer’s business and finance department would be happy to discuss your goals and help you determine the optimal structure for a successful business sale.

The information contained in this publication should not be construed as legal advice, is not a substitute for legal counsel, and should not be relied on as such. For legal advice or answers to specific questions, please contact one of our attorneys.