Shareholder Tax Consequences of an 82-25 Merger

A cash-option merger is a corporate acquisition where shareholders of the acquired company can choose to receive stock in the acquiring company, cash, or a combination of both. The structure of the deal is guided by the Internal Revenue Code, which determines if it can qualify as a tax-deferred reorganization. For shareholders of the company being acquired, this guidance is important because it directly impacts whether they owe taxes immediately on the exchange of their shares.

Understanding the Cash-Option Merger Structure

A cash-option merger often involves three primary entities: the acquiring parent corporation (P), a new subsidiary created by the parent (S), and the target corporation being acquired (T). The structure is a forward triangular merger, a sequence of events used to combine the companies while shielding the parent corporation from the target’s liabilities.

The process begins when P forms S, a shell corporation, to facilitate the acquisition. Following its formation, T merges directly into S, with S as the surviving entity holding all of T’s assets and liabilities. T ceases to exist as a separate corporation.

In exchange for their ownership in T, the former shareholders receive consideration from P. This consideration is flexible, allowing shareholders to receive P stock, cash, or a mix of both, based on the merger agreement. The result is that the former business of T is now operated by S, a wholly-owned subsidiary of P, and T shareholders who took stock are now P shareholders.

The Continuity of Interest Requirement

A merger must meet the Continuity of Interest (COI) doctrine to receive tax-deferred treatment. This rule requires that a substantial part of the value of the proprietary interests in the target corporation (T) be preserved through an ongoing equity interest in the acquiring corporation (P). This ensures the transaction is viewed as a continuation of business operations rather than just a sale.

To satisfy the COI requirement, at least 40% of the total value of T’s stock must be exchanged for P stock. If T was valued at $100 million, at least $40 million worth of P stock must be distributed to the former T shareholders in aggregate.

The COI test is applied to the transaction as a whole, and the tax consequences are determined on a shareholder-by-shareholder basis. This means that as long as the overall 40% threshold is met, the transaction can qualify as a tax-deferred reorganization. For instance, if 50% of T’s shareholders receive only P stock and the other 50% receive only cash, the transaction qualifies. The shareholders who received only P stock can benefit from tax-deferred treatment, even while their fellow shareholders are fully cashed out in a taxable sale.

Tax Consequences for Target Shareholders

The tax outcome for a target company (T) shareholder depends on the consideration they receive for their T shares. The Internal Revenue Code dictates different treatments for shareholders receiving stock, cash, or a combination.

Shareholders Receiving Only P Stock

For shareholders who exchange their T shares exclusively for stock in the acquiring parent corporation (P), the transaction is generally tax-deferred. No immediate gain or loss is recognized. The tax basis of the old T stock carries over to the new P stock received. For example, if a shareholder’s basis in T stock was $1,000, their basis in the new P stock is also $1,000. The holding period of the T stock also tacks on to the new P stock.

Shareholders Receiving Only Cash

When a shareholder exchanges their T shares solely for cash, the transaction is treated as a taxable sale. The shareholder must recognize a capital gain or loss, calculated by subtracting their adjusted tax basis in the T stock from the cash received. If a shareholder receives $1,500 in cash for T stock with a $1,000 basis, they would recognize a $500 capital gain.

Shareholders Receiving a Mix of P Stock and Cash

For shareholders receiving a combination of P stock and cash, the cash portion is “boot” and can trigger a taxable gain. Gain is recognized, but only up to the amount of boot received. The recognized gain is the lesser of the total realized gain (the fair market value of P stock plus cash, minus T stock basis) or the amount of cash received.

For instance, a shareholder with a $1,000 basis in T stock receives P stock worth $800 and $700 in cash. Their total realized gain is $500. Since the cash boot ($700) is greater than the realized gain ($500), the shareholder recognizes a taxable gain of $500.

The basis in the new P stock is calculated by taking the old T stock basis, adding the gain recognized, and subtracting the cash received. In the previous example, the new basis would be $1,000 + $500 – $700 = $800. This ensures the deferred portion of the gain is accounted for upon a future sale.

Required Information for Tax Reporting

To accurately report a merger, a shareholder must gather specific information. The most fundamental details are the shareholder’s adjusted cost basis and holding period for the target (T) shares exchanged. The holding period determines whether a gain is short-term or long-term.

The shareholder also needs figures from the transaction itself, including the exact amount of cash received and the fair market value (FMV) of the acquiring parent (P) shares received. The effective date of the merger is also necessary, as it establishes the tax year for reporting. Having this data allows the shareholder to correctly calculate the realized gain, recognized gain, and the basis of the new shares. Corporations involved in a merger are required to provide shareholders with official statements containing this information.

Shareholder Tax Filing and Reporting

The transaction must be reported on the shareholder’s federal income tax return using Form 8949, Sales and Other Dispositions of Capital Assets. The details from this form are then summarized on Schedule D, Capital Gains and Losses.

A shareholder who received only cash reports the transaction on Form 8949 as they would any other stock sale. They list the cash received as the proceeds and their original cost basis in the target (T) shares to calculate the capital gain or loss.

For shareholders who received both stock and cash, the reporting on Form 8949 is more detailed. The proceeds are reported as the sum of the cash received and the fair market value of the P stock received. The cost basis is the original basis in the T shares. The recognized gain, which was previously calculated as the lesser of the boot received or the total realized gain, is then entered, ensuring that only the appropriate portion of the gain is taxed in the current year.

If the exchange was entirely for acquiring parent (P) stock and was fully tax-deferred, the shareholder must still report it. A statement should be attached to the tax return that identifies the parties to the reorganization, the date, and the number and basis of the old and new shares. This provides transparency to the IRS.