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. So the stock swap tax implications are little to none at the time of the merger or acquisition, but there may later be some stock swap tax consequences. Although reorganizations are often considered tax-free, the shareholders will eventually pay tax when they dispose of the stock.
Cash and Stock Merger Tax Treatment
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.
An Exception and an Example
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.
For example, 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. So, 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.
Tax Changes for 2018
The biggest effect of the tax code enacted early in 2018 on stocks exchanged through a merger or acquisition is that corporate tax rates decline from 35 percent to 21 percent, and the corporate alternative minimum tax has been repealed. Effective tax rates, although usually lower than 35 percent, will likely be lower than 21 percent. Reduced tax rates may increase target company values. Companies may have more cash to spend on mergers and acquisitions. Information on IRS forms for 2018 corporate taxes can be found here.
Tax Rules for 2017
Corporate tax rates for 2017 tax returns will remain at the higher rates, as will the corporate alternative minimum tax. The rules for taxes on stocks exchanged through mergers and acquisitions changed little for 2017 from previous years.
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