Selling a Company Tax-Free

During negotiations, the purchase price of the deal is established along with a general idea of which assets are to be exchanged. The major objective of structuring a transaction is the ability to transfer the expected value of the deal to the seller while operating within constraints suitable to the buyer. The type of structure depends on the law, the tax code and the creativity of the professionals involved in the deal. There are a number of different ways to structure a transaction so that benefits to the buyer and seller can be maximized. This article provides an introduction to a variety of tax-free strategies that, when used properly, will maximize the value to both buyer and seller.

Generally, stockholders who sell or exchange their stock, and corporations that sell or exchange their assets, must recognize gains and losses for tax purposes. But the Internal Revenue Code (IRC) contains various rules that provide for tax-free treatment. IRC Sections 354-368 provide the basic rules for tax-free reorganizations. IRC Section 368 specifically identifies various types of corporate reorganizations that can qualify for tax-free treatment.

By way of background, a business may be transferred either by the corporation selling the assets of the business or by the owners of the corporation selling their shares. In the typical stock sale, the selling stockholders accept cash and notes for their stock and recognize a gain or loss at closing. The buyer receives a basis in the stock equal to the purchase price, and the tax basis of the assets and liabilities, within the acquired corporation, including any tax assets, such as net operating loss carry forwards, capital loss carry forwards and tax credit carry forwards, are unaffected. But use of these tax assets may be limited after an ownership change.

By way of contrast, selling stockholders can dispose of their stock in a tax-free reorganization by exchanging their shares for those of the acquiring corporation (i.e., instead of accepting cash and notes). The selling stockholders generally recognize no gain or loss, and obtain a basis in the acquiring corporation's stock equal to their basis in the selling corporation's shares. The tax basis of the acquired corporation's assets and liabilities are unaffected, and the acquiring corporation inherits the tax attributes of the acquired corporation. Similar to the taxable sale, the use of any tax attributes may be limited.

Such a tax-free reorganization is essentially a mere rearranging of the corporate ownership structure. But be aware that there must be a valid business reason for such a reorganization. For example, an individual may sell shares of his company in exchange for shares in a much larger company to remain involved with management or ownership of a much larger business entity.

Tax-free reorganizations generally are divided into three categories:

1) Mergers, consolidations and stock exchanges that lead to the acquisition or combination of corporations. In acquisition reorganization, the acquiring corporation ultimately ends up in control of the target corporation's assets or stock. These types of reorganizations typically are known as Type A, B and C reorganizations.

2) Divisive reorganizations that are otherwise known as spin-offs, split-offs and split-ups. The purpose is to divest a corporate business segment or divide the ownership of a corporation. These typically are known as Type D reorganizations, but a Type D reorganization also can be acquisitive.

3) Restructuring reorganizations that involve the change of form, place of organization or identity. These typically are referred to as Type E, F and G reorganizations and involve both the corporation and its stockholders.

A tax-free reorganization is advantageous if you are selling out to a corporate buyer whose stock is a good investment. Remember, you'll be exchanging a non-diversified investment over which you had control (your own company) for a non-diversified investment over which you may have little or no control. The IRC typically restricts how soon the acquired may sell the stock obtained in the transaction - typically for two years. What risk do you bear during those two years? That's your call.

Jeffrey J. Presogna, CPA CVA, is a Vercor partner and consults on the purchase and sale of midsize private companies. You can reach him at Jeff@vercoradvisor.com.