The direction of a merger: pitfalls and opportunities.

Regardless of whether a merger is structured as a taxable or tax-free transaction, merging in the wrong direction can be disastrous for Federal income tax purposes. Corporate counsel is often unaware of the significance of "who survives" in the merger; constant vigilance by tax advisers is therefore required. At the same time, knowledge is power; manipulating the direction of a merger can be an effective tax planning tool.

Taxable Squeeze-Out (Reverse Subsidiary) Merger for Cash

Since the repeal of the General Utilities doctrine, sales of appreciated assets by corporations generate a full tax at the corporate level. Thus, if a corporation transfers its assets for cash, there is a corporate tax and a shareholder tax when the selling corporation distributes the proceeds of the sale to its shareholders (via liquidation or otherwise). (If the seller is a controlled subsidiary, a distribution of the proceeds in liquidation may be tax-free to the recipient parent corporation under Sec. 332 and escape the normal shareholder-level tax.)

The corporate sale may be by contract or take the form of a state law merger. Such a merger, although it may be "a statutory merger" under applicable state law, will not qualify as an A reorganization because it is accomplished with cash (and/or debt) and therefore cannot satisfy the judicially imposed continuity-of-interest requirement. As a result, such transactions are rarely planned unless there is little or no appreciation in the assets to be sold (including intangibles), the selling corporation has losses to absorb the gain, or the selling corporation is a controlled subsidiary or S corporation (such that, effectively, only one level of tax will be imposed).

Although most taxpayers and their advisers are aware of these tax consequences, that knowledge may be tested when the transaction being planned is a so-called "squeeze-out" or reverse subsidiary merger. The term reverse is important, because it indicates that the target corporation, and not the new company formed to effectuate the squeeze-out, will be the survivor. In a typical squeeze-out merger, the acquiring corporation intends to buy stock instead of assets and wants to ensure that all of the target's shareholders will surrender their stock. To ensure that surrender, the acquirer sets up a new company and merges it into the target (owned by the selling shareholders), with the target surviving. The new company (which is created and disappears in the same transaction) is disregarded for tax purposes; the transaction is treated as one in which the target shareholders sold their stock, with dissenting or recalcitrant shareholders squeezed out (Rev. Rul. 90-95; Rev. Rul. 73-427). Because the transaction is treated as a stock sale, there is no sale by the corporation of its assets, and therefore, no corporate-level tax.

The problem comes when, either through inadvertence or deliberation (and generally without thought to the tax consequences), the direction of the merger is reversed and the new company is the survivor. In such a case, the transaction will be treated as a sale of assets by the target, followed by a liquidation of the target in which the cash proceeds of die sale are distributed to the target shareholders. In other words, the transaction will bear full taxation at both the corporate and shareholder levels; see Rev. Rul. 69-6. (Rev. Rul. 69-6 was published before the repeal of the General Utilities doctrine, and therefore refers to old Sec. 337 on how to avoid recognition of corporate-level tax. This is no longer possible.) Non-tax corporate attorneys, generally unaware of the importance of the direction of the merger, may in fact recommend that the target merge into a new company, for a number of (real or perceived) reasons (e.g., more expeditious state law filings or an implication that, if target shareholders are being squeezed out, the target should be disappearing). The only way to be certain that the merger is proceeding in the correct direction is to review the merger documents.

Tax-Free Mergers

Tax-free reorganizations are often accomplished using mergers. A host of statutory and judicial requirements are imposed on the target and acquiring corporations in a tax-free reorganization. If either the target or acquiring corporation fails to satisfy one or more of those requirements, reversing the direction of the merger (and thereby reversing the roles of the two corporations) can often be an easy fix.

Example 1--Continuity of interest. Acquiring (X) is owned by one person (A) and target (7) is owned by 15 people. The parties have decided to merge T into X for a package of consideration that will ostensibly be 50% X stock and 50% cash. To assure that the continuity-of-interest requirement is satisfied, the fair market value (FMV) of the X shares to be given to the T shareholders must be established. In other words, the FMV of the X stock to be issued in the merger must be 40-50% of the total consideration and not some unacceptably lower amount (eg., 20%).

Because there is no market for the X stock (it is currently owned solely by A) or the T stock (T is closely held), there is no objective standard for determining the relative value of the cash compared to the value of the total package of consideration (cash and X stock). To make matters worse, suppose that after the merger, the T shareholders as a group will own only 25% of X. If the entire remaining 75% will be owned by A, should a minority discount be applied in valuing the shares issued in the merger? Although these problems could be addressed by appraisals, these can be costly, time consuming and subject to scrutiny by the IRS or a court.

Reversing the direction of the merger (i.e., merging X into T) eliminates these problems. T can first distribute cash (or notes that will be repaid with X funds after the acquisition) to its old shareholders in partial redemption of their stock. Then, in the merger, T will issue solely its stock to A, in an amount constituting 75% of T's total stock outstanding. The cash distribution will be a redemption taxed as a capital exchange under the rationale of Zenz v. Quinlivan, 213 F2d 914 (6th Cir. 1954), and the merger will be tax-free with no continuity/valuation issue at all. T's name can be changed to X in an F reorganization immediately after the merger; see Rev. Rul. 96-29.

Example 2--NOLs: Individual B owns all of X and all of Y B would like to combine X and Y Y has a net operating loss (NOL), but is no longer active. B would like to use Y's NOL to shelter X's profits. If Y merged into X, the continuity-of-business-enterprise requirement would probably not be satisfied, due to Y's inactivity Alternatively, if B dropped the Y stock to X, so that Y became a wholly owned subsidiary of X (a Sec. 351 transfer that does not require business continuity), Y's NOLs would be subject to the separate return limitation year (SRLY) rules of the consolidated return regulations, at is unlikely that a second-step liquidation of Y into X could resolve the SRLY issue. Rev. Rul. 67-274 may apply to recast the stock transfer/liquidation into a reorganization with the continuity problems.)

Once again, a simple reversal of the direction of the merger will solve the problem. If X is merged into Y, continuity-of-business enterprise will not be a problem; that requirement applies only to the acquired corporation (X), and not to the acquiring corporation (Y) (see Rev. Rul. 81-25).

The reversal of direction in this scenario will not solve every possible problem, however. The parties win still need to contend with the business purpose doctrine applicable to all reorganizations. In general, however, an explicitly articulated and carefully documented legitimate business purpose (e.g., elimination of duplicate state filings, fees or insurance costs) should overcome this concern.

Tax-Free Merger and Sec. 357(c)

Example 3--Sec. 375(c): As in Example 2, B owns all of X and Y B would like to combine X and Y. Y has liabilities that exceed the tax basis of its assets, but X does not. A merger of Y into X, although a valid A reorganization, would also be a D reorganization. As a result, Sec. 357(c) would apply, such that the excess of liabilities assumed plus liabilities to which the transferred Y assets are subject over the basis of the Y assets transferred would be treated as gain to Y; see Rev. Rul. 75-161. (If X and Y are members of an affiliated group, Regs. Sec. 1.1502-80(d) provides that Sec. 357(c) will not apply.)

A simple reversal of direction, merging X into Y, will accomplish the desired result, while eliminating the Sec. 357(c) problem. Although a merger of X into Y will still be a D reorganization to which Sec. 357(c) applies, the transferor in the transaction (X) will not be transferring assets with liabilities in excess of basis. Following the merger, the name of the survivor (Y) could be, changed to X, if the parties so choose.