Revenue Ruling 79-26: Taxing Cash in Corporate Mergers

Official interpretations of tax law by the Internal Revenue Service (IRS) provide guidance for shareholders who receive cash for their shares as part of a corporate merger. The purpose of these principles is to establish a clear test for determining the U.S. federal income tax consequences of this cash payment. The guidance clarifies whether the cash should be treated as proceeds from a sale of stock or as a distribution of corporate profits, similar to a dividend. This distinction is important because the tax outcome for the shareholder can be significantly different depending on the classification.

The Transaction Scenario in Focus

A common business acquisition structure is the reverse triangular merger. In this scenario, an acquiring corporation, “P,” wishes to purchase a target corporation, “T.” To facilitate this, P first creates a new, wholly-owned subsidiary, “S,” which is a transitory entity formed for the purpose of the merger.

The core of the transaction is the merger of the subsidiary S into the target corporation T. Under the merger agreement, S ceases to exist, and T becomes the surviving legal entity. As a result of this merger, T becomes a wholly-owned subsidiary of the acquiring corporation, P.

From the perspective of T’s original shareholders, the merger triggers a mandatory exchange of their stock. In this type of transaction, these shareholders do not receive stock in the acquiring company but are “cashed out,” exchanging all of their T stock for a specified amount of cash. Concurrently, P exchanges its stock in the now-defunct subsidiary S for all of the stock of the surviving target corporation T.

The end result is that P now owns T, and the former shareholders of T no longer have any ownership in the business. The focus of tax analysis is to look past the corporate mechanics and determine the substance of this transaction for tax purposes from the viewpoint of the selling shareholders.

Determining the Tax Treatment

A central question for tax purposes is whether the cash received by the target corporation’s (T) shareholders represents proceeds from a sale of their stock to the acquiring corporation (P) or if it should be viewed as a redemption. IRS guidance establishes that the answer hinges on identifying the source of the cash used to pay the shareholders. This “source of funds” test is the analytical core of this analysis.

There are two primary possibilities. In the first, the cash paid to T’s shareholders is supplied by the acquiring corporation, P. P might transfer the necessary funds to its subsidiary (S) just before the merger, which then uses that cash to pay T’s shareholders. In this instance, the IRS views the transaction as if P purchased the T stock directly from the shareholders.

The second possibility is that the cash comes from the target corporation, T, using its own cash reserves or by taking on new debt. Because T is the surviving corporation and ultimately responsible for this new debt, the IRS considers the funds to have originated from T. When T is the source of the funds, the transaction is treated as a redemption of stock by T from its own shareholders.

If the transaction is classified as a redemption, the tax treatment is governed by Internal Revenue Code Section 302. This section provides tests to determine if a redemption should be taxed as a sale or as a corporate distribution equivalent to a dividend.

To achieve sale or exchange treatment under Section 302, the redemption must meet specific criteria, such as a “complete termination” of the shareholder’s interest or a “substantially disproportionate” redemption. If the redemption qualifies, it is taxed as a sale. If it fails, the entire cash amount is treated as a dividend to the extent of T’s accumulated earnings and profits (E&P).

Tax Consequences and Reporting

The tax outcome for a shareholder depends on whether the transaction is classified as a sale or as a dividend-like redemption. If treated as a sale, the shareholder calculates a capital gain or loss by subtracting their adjusted basis in the T stock from the cash received. The adjusted basis is typically what the shareholder originally paid for the stock, plus any commissions.

The resulting gain or loss is either short-term or long-term. If the stock was held for one year or less, the gain or loss is short-term and taxed at the shareholder’s ordinary income tax rate. If held for more than one year, the gain is long-term and taxed at lower preferential rates.

This capital gain or loss is reported on Form 8949, Sales and Other Dispositions of Capital Assets, and the totals are then carried to Schedule D of the shareholder’s Form 1040. Information for this reporting often comes from Form 1099-B, issued by the paying agent or broker.

If the transaction is a redemption that fails the Section 302 tests, the entire amount of cash received is treated as a dividend, up to the amount of the target corporation’s available earnings and profits (E&P). This dividend income is reported on Schedule B of Form 1040 and is typically taxed at qualified dividend rates.

A significant consequence of dividend treatment is the handling of the shareholder’s stock basis. Since the basis was not used to offset any sale proceeds, it is not lost. Instead, the basis of the redeemed shares is added to the basis of any other stock the shareholder might own in the same corporation.

Information Required for Analysis

To correctly determine the tax treatment of cash received in a merger, a shareholder must gather specific documents. This includes the plan of merger, shareholder circulars, or other communications from the corporations that describe the structure of the deal.

A shareholder needs to identify the source of the funds used in the buyout. The merger agreement or related public filings may state whether the acquiring or target corporation is providing the cash. Without this detail, it is impossible to apply the primary test to distinguish between a sale and a redemption.

Personal ownership records are also necessary. A shareholder must know their adjusted basis in their shares to calculate the potential capital gain or loss if the transaction is treated as a sale. These records include purchase confirmations and brokerage statements.

If the transaction is potentially a redemption, the amount of the target’s earnings and profits (E&P) is needed to determine how much of a failed redemption would be taxed as a dividend. Shareholders should also collect all tax forms received, such as a Form 1099-B or a Form 1099-DIV, as these indicate how the paying agent has classified the payment.