Overview of Common M&A Transactions and Tax Consequences for C Corporations (2024)

In a previous Tax Tip Tuesday article, we touched on some common factors to keep in mind when a private equity firm comes calling to discuss the potential sale of your business. Whether a buyer expresses an interest in the purchase of your business or if you are considering going through any type of reorganization of the company structure, it is important to be aware of the common tax treatment and pitfalls especially as it relates to your business’s entity structure. In this installment of our tax tips for mergers and acquisitions series, we will focus on the basic tax issues to be aware of when your business is structured as a C corporation and is undergoing a sale or reorganization.

C corporations are separate legal entities for tax purposes and are typically said to be taxed at two levels. First, the entity is taxed on income it earns at the corporate level. Second, the shareholder is generally taxed when it receives any consideration from the corporation. Due to the nature of C corporation taxation, C corporations may have specific concerns that arise during common merger and acquisition activity.

As reviewed in our previous article, a sale of an entity will ultimately either be sale of the company’s assets or a sale of the owner’s stock/equity interests. This distinction can have very important implications for both the seller and the buyer, so it is crucial to understand the different tax consequences, especially for transactions involving C corporations.

In an asset sale, the buyer purchases all the assets of the company. When this happens, the buyer receives what is commonly referred to as a “step-up” in tax basis to fair market value of the assets. This allows the buyer to have more basis available for depreciation deductions in the future and is one of the reasons buyers often prefer to buy assets of a company rather than stock/equity interests. For C corporations, however, this benefit to the buyer can come at a significant cost to the seller. As described above, C corporations are taxed both at the entity level and shareholder level. As a result, the C corporation will recognize gain on the sale of its assets and then the owners of the C corporation stock will also be taxed on any proceeds they receive from the sale.

In contrast, in a stock sale, the target company does not necessarily recognize any corporate-level gain. Any gain is only recognized on the shareholder level upon the shareholder’s sale of their equity interest. Thus, the C corporation double-taxation issue is mitigated. Therefore, sellers, especially of C corporations, will often prefer this type of transaction. However, buyers will not receive a step-up in basis of the C corporation assets. This generally means that the buyer will have less opportunity to generate valuable depreciation deductions, as the buyer will have a “carryover” basis in the assets the C corporation owns at the time of the equity sale.

Many aspects of deal structuring and negotiation involve trying to make both buyer and seller “whole” with respect to these competing interests. Thus, it is important for there to be an open, professional dialogue on the tax issues that arise during the deal structuring so that both parties can agree to terms, including tax consequences, that they are comfortable with.

In addition to the typical sale/purchase event with new owners, C corporations may also engage in reorganizations that are generally tax-free. There are various tax consequences to keep in mind with the reorganization of an existing business entity structure. These will be briefly outlined in the next section.

For C corporations, the Internal Revenue Code provides various avenues for tax-free reorganizations. These reorganizations are subject to a plethora of requirements and exceptions that have to be navigated very carefully and with proper professional guidance. In general, the common aspect that allows such reorganizations to qualify as “tax-free” is that the shareholders of the target corporation must receive stock in the new corporation. As a very general overview, here is an outline of some common tax-free reorganization types identified within IRC 368:

• Type A: This is a statutory merger whereby the assets and liabilities of the target corporation merge with the assets and liabilities of the acquiring corporation and whereby the target corporation shareholders receive stock of the new corporation.
• Type B: This involves the acquisition of a target corporation’s stock in exchange for the acquiring corporation’s stock if, immediately after the transaction, the acquiring corporation has control of the target corporation.
• Type C: This involves one corporation acquiring substantially all of the assets and liabilities of a target in exchange solely for voting stock of the acquiring corporation, followed by a liquidation of the target.
• Type D: This is defined as an acquisitive business reorganization in which a target transfers substantially all of its assets to an acquiring corporation (controlled directly by shareholders of the target) and distributes all of its properties. These transactions must meet other requirements under the Internal Revenue Code to qualify as tax-free, which are outside the scope of this article.
• Type E: This is a recapitalization that involves an adjustment of a corporation’s equity or debt financing.
• Type F: This type of reorganization is defined as a mere change in identity, form, or place of organization of a corporation. It must reflect only minor adjustments to the structure of the business.
• Type G: This involves the transfer of assets in a Chapter 11 bankruptcy or similar proceeding. These transactions must meet other requirements under the Internal Revenue Code to qualify as tax-free, which are outside the scope of this article.

If you are considering a reorganization for your business, it is crucial you engage professional legal, tax, and accounting advisors for guidance on the full requirements of the above reorganization types.

As can be seen above, there are many risks and opportunities to be on the lookout for when you begin considering the reorganization or sale of your business as a C corp. In future informative articles, we will outline key issues as they relate to other entity structures, such as S corps and partnerships. When considering a transaction or restructuring, for help navigating the complexities of this process.

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