The direction of a merger: pitfalls and opportunities.

• Author: Bailine, Richard W.

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...