A company can expand its market share, provide new services or enter new markets through a merger with or acquisition of another company. Reorganizations allow businesses to minimize the tax impact of a merger or acquisition by exchanging stock in the acquiring company for the stock or assets of the acquired company. Although reorganizations are often considered tax-free, the shareholders will eventually pay tax when they dispose of the stock.
Three types of reorganizations qualify for tax-free treatment of exchanged stocks. The first, type “A,” provides fairly flexible terms, allowing the acquiring company to exchange stock and other assets for the target company's assets. Type “B” reorganizations occur when the acquiring company provides voting stock in exchange for the voting stock of the acquired company. In a type “C” reorganization, the acquiring company provides voting stock in exchange for the assets of the acquired company.
If the merger or acquisition qualifies as a type “A,” “B,” or “C” reorganization, the shareholders don’t recognize any gain on the exchange of shares. Instead, the basis of their old shares transfers over to their new shares. Basis, the cost to acquire the shares, is recovered tax-free as a return of investment. Because type “A” reorganizations can involve assets other than stock alone, shareholders might have to adjust their basis.
Sometimes the value of assets being exchanged doesn’t match up. When that happens, the acquiring company can offer cash or other taxable consideration, which is called “boot.” Providing boot is only allowed in type “A” reorganizations, and includes consideration such as certain types of preferred stock or cash. The recipients must report the value of the boot as taxable income, and decrease their basis in the new shares by the value of boot received. Additionally, if the recipient realizes a gain on an exchange involving boot, that gain counts as taxable capital gains income and increases the recipient’s basis in the new shares.
Say Alpha Company purchases Beta Company through a type “A” reorganization, giving one share of Alpha voting stock worth $50 and $25 dollars in cash for each Beta share. Beta Company’s shareholder will recognize as gain the lesser of the gain realized or the boot received. For example, if the shareholder had a basis of $10 in Beta, she would realize a gain of $65 but report only $25, the value of the boot, as taxable income. In this case, the shareholder’s basis in Alpha stock would be $10 dollars, reduced to $0 from the receipt of boot and increased to $25 for the reported gain. On the other hand, if her basis in Beta were $60, her gain would only be $15 and she would report $15 because it is less than the value of the boot. Her adjusted basis would be $50, because she would decrease it by $25 for the value of the boot and increase it by $15 for the taxed gain.
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