Tax Consequences of the Reverse Merger Structured as a Stock-For-Stock Exchange
Many of our corporate clients who desire to go public are drawn to the “reverse merger” because their goal of becoming a public company can be accomplished in a short period of time and without the burden of registration with the Securities and Exchange Commission. Most reverse merger transactions are structured as stock-for-stock exchanges because they are easy to execute, require less extensive paperwork, and usually qualify for tax-free treatment. A brief discussion of reverse mergers, stock-for-stock exchanges, and the tax consequences of the reverse merger transaction structured as a stock-for-stock exchange is set forth below.
What is a Reverse Merger?
A “reverse merger” or “reverse acquisition” is a method by which a private company becomes publicly traded without having to undertake an expensive, time consuming initial public offering. In a typical reverse merger, a private company is acquired by, or merges into, a non-operating publicly traded company. The public company’s stock is listed for trading on a stock exchange, most commonly the Over-the-Counter Bulletin Board, but could be the Pink Sheets or NASDAQ as well. The public company is most commonly called a “shell” corporation because all that exists of the original company is its publicly traded corporate shell structure. Shells come into existence when an operating company ceases doing business or when it spins off a subsidiary. Shells can be categorized as “pure” or “cash heavy.” A pure shell has neither assets nor liabilities, and a cash heavy shell has cash retained after selling its assets and settling its debts. By being acquired by, or merging into, such an entity, a private company becomes public.
In a reverse merger transaction, the public company acquires the private company from a legal standpoint while the private company acquires the public company from an accounting standpoint and the post-transaction public company uses the historical financial statements of the private company. The private company’s shareholders will usually change the name of the public company to match the private company name and install its own management and board of directors. The transaction is called a “reverse merger” or “reverse acquisition” because the former stockholders of the formerly private company hold a majority of the voting stock of the public company upon completion of the transaction. A reverse merger can be structured as a statutory merger, stock-for-stock exchange, or a stock-for-assets acquisition. Perhaps the easiest transaction to understand and implement is the stock-for-stock exchange, described in detail below.
Stock-for-Stock Exchange in the Context of a Reverse Merger
For a reverse merger structured as a stock-for-stock exchange, the public shell typically acquires 100% of the issued and outstanding voting securities of the private company from the private company’s shareholders in exchange for shares of the public shell’s common stock. Because the goal of the private company’s shareholders is to acquire a majority of the public shell’s issued and outstanding voting stock, usually up to 90% to 98%, prior to, or simultaneously with, the execution of the stock-for-stock exchange, the private company’s shareholders normally purchase a large percentage of the shell shares from the shell’s controlling shareholders and/or the controlling shell shareholders vote to authorize the issuance of a new large and highly dilutive block of shares to the private company shareholders.1 In addition to cash, the controlling shell shareholders may retain a small percentage of the new public company in exchange for their controlling stake in the public shell. Upon consummation of the stock-for-stock exchange (i) the private company is a wholly-owned subsidiary of the public company; (ii) the former shareholders of the private company own approximately 90% to 98% of the public company; and (iii) the shareholders of the public shell, including the former controlling shareholders, own approximately 2% to 10% of the new public company and may thereafter benefit by owning shares of a company with growth potential, as opposed to a defunct corporate shell.
Tax Consequences of the Reverse Merger Structured as a Stock-for-Stock Exchange
Generally, the reverse merger structured as a stock-for-stock exchange qualifies, for United States federal income tax purposes, as a tax free reorganization within the meaning of Section 368(a)(1)(B) of the Internal Revenue Code of 1986, as amended (the “Code”). This type of reorganization is also known as a “B” reorganization because of the section of the Code that defines it.
In a B reorganization, the acquirer must acquire target shareholders’ stock solely in exchange for voting stock of the acquirer. In addition, the acquirer must control the target immediately after the stock exchange. For this purpose, control is defined in section 368(c) of the Code as direct ownership of at least 80% of the voting power of all classes of target stock entitled to vote, and at least 80% of each class of nonvoting target stock.
The “solely for voting stock” requirement is unyielding on its face and is strictly applied by the courts and Internal Revenue Service. Any receipt of boot2 by target shareholders in exchange for their target stock, even a de minimis amount, will disqualify the B reorganization.3 However, the requirement that solely voting stock be used as acquisition consideration focuses only on the consideration issued, directly or indirectly, by the acquirer to the stockholders of the target.4
Reverse mergers structured as stock-for-stock exchanges almost always satisfy the strict requirements of the type B reorganization. First, the requirement that solely voting stock be used as acquisition consideration is satisfied because the only consideration issued by the public shell to the private company’s shareholders is common stock listed on some exchange. Cash paid for fractional shares in the acquirer as a rounding off mechanism will not violate the solely for voting stock requirement.5 In addition, cash may also be paid to dissenters, but only out of funds provided by the target.6 Second, the requirement that the acquirer must control 80% of the voting power of all classes of target stock entitled to vote is easily satisfied because the public shell typically acquires 100% of the voting securities of the private company. However, the parties to the exchange must not overlook the second part of the control requirement, that the acquirer must control 80% of each class of nonvoting target stock, if any. The transaction will not qualify as a tax-free B reorganization if the public shell fails to acquire at least 80% of the total number of shares of all other classes of stock.
Because they receive solely voting stock in the public shell, the shareholders of the private company recognize no gain or loss. The public shell’s basis in the stock of the private company is equal to the basis that the private company’s shareholders had in their stock (although, as a practical matter, this may be difficult to determine). And because this is a stock transaction, there is no change in the public shell itself so that its basis in its assets and most of its tax attributes carry over. Obviously, any cash received by the controlling shareholders of the public shell in exchange for stock in the public shell is subject to capital gains tax.
Conclusion
As discussed above, the reverse merger transaction structured as a stock-for-stock exchange is a simple and speedy way to go public. The shareholders of the private company acquire voting control of the public shell from its controlling shareholders, install their own management and board of directors, and continue operating their business as a wholly-owned subsidiary of the publicly traded company. Finally, as long as the public shell uses solely voting stock as acquisition consideration and acquires at least 80% of all classes of voting and nonvoting stock of the private company, the transaction will qualify as a tax-free B reorganization within the meaning of the Code.
This article is not a complete and thorough discussion of the Internal Revenue Code or the requirements, cases and rules applicable to B reorganizations. This article is intended only as a general discussion of these issues. It should not be regarded as legal advice.
Edward H. Weaver is an attorney with The Lebrecht Group, APLC, located in Irvine, California and Salt Lake City, Utah. He can be reached at (801) 983-4948 oreweaver@thelebrechtgroup.com .
Please visit our website at www.thelebrechtgroup.com for further information.
1 The value of the public shell depends upon numerous factors including, the exchange on which its stock is listed; the age of the corporation; the state of incorporation; the number of shareholders; the existence of assets or liabilities, and the trading history of the company.
2 Money or property other than stock or securities in a corporate party to the reorganization. See I.R.C. §356.
3 Helvering v. Southwest Consol. Corp., 315 U.S. 194, reh’g denied, 316 U.S. 710 (1942); Rev. Rul. 75-123, 1975-1 C.B. 115.
4 See Rev. Rul. 73-54, 1973-1 C.B. 187 (cash transferred by acquirer to the target or its shareholders to pay shareholder expenses, investment or estate planning fees, shareholders legal or accounting fees or shareholder transfer taxes, constitutes boot). Rev. Rul. 73-102, 1973-1 C.B. 186 (acquirer’s payment of dissenters’ fees constitutes boot); Rev. Rul. 70-108, 1970-1 C.B. 78 (target shareholders’ receipt of rights to acquire additional acquirer stock constitutes boot); Rev. Rul. 75-360, 1975-2 C.B. 110 (target dividends paid with acquirer cash or borrowed cash repaid by the acquirer constitutes boot).
