As discussed previously in other articles, reorganizations can provide a way to restructure business entities or acquire others without experiencing high tax costs. In other words, reorganizations provide ways to accomplish business goals through tax free restructuring.
One common method used is a forward triangular merger, or as some people refer to it, an indirect merger under Section 368(a)(2)(D) of the Internal Revenue Code. This type of merger is particularly useful when a parent corporation is looking to purchase or acquire another entity, known as the target corporation, but is hesitant to inherit any liabilities or other negative aspects of the target. In a traditional A reorganization under Section 368(a)(1)(A), the target corporation merges directly into the acquiror, at which point the acquirer is responsible for all liabilities associated with the target. Therefore, the purchasing corporation may often structure the transaction as a forward triangular merger rather than a traditional A merger by using a subsidiary to protect against any liabilities, both known or unknown, that the target may have. The article below has been prepared by a Denver business attorney to provide additional information related to a forward triangular reorganization.
Forward triangular mergers are also popular where entities plan to use a significant amount of cash, or boot, in the deal. Unlike reverse triangular mergers, forward triangular mergers have greater flexibility in the amount of boot that may be used in the transaction since the 80% voting requirement does not apply under Section 368(a)(2)(D) for purposes of consideration.
For example, consider Corporation P who would like to acquire Corporation T. However, Corporation T has a huge liability on its books that Corporation P is hesitant to acquire. Corporation P will first set up another entity called Subsidiary. The Corporation T is the target corporation and will then merge into Subsidiary, rather than Corporation P, for consideration provided by Corporation P. The target corporation ceases to exist and thereby liquidates. At this point, the only surviving corporation in the merger is the subsidiary. Thus, the shareholders of Corporation T will ultimately receive the consideration provided by Corporation P. This structuring allows the liabilities of the target to remain isolated within a subsidiary while simultaneously allowing the purchasing corporation, to acquire the target, Corporation T. Note, even though this may be considered a tax free reorganization, there may still be tax consequences to the shareholders of the target corporation upon liquidation depending on the amount and type of consideration used in the transaction (See Internal Revenue Code Section 354).
There are three critical things to remember in a forward triangular reorganization. First, this transaction only qualifies for tax free treatment if it would have satisfied the requirements of a traditional A reorganization under Section 368(a)(1)(A) had the merger been done directly between the purchasing corporation and the target corporation. This requires evaluating the transaction as if the subsidiary were not used at all. If the target simply merged into the purchasing corporation and still satisfied the A reorg requirements, then this would satisfy Section 368(a)(2)(D)(ii). This requires a statutory merger, and even more importantly, continuity of interest requirements.
Second, in a Section 368(a)(2)(D) reorganization, no stock of the subsidiary entity may be used as part of the consideration in the transaction. Only stock of the purchasing corporation, Corporation P in the above example, may be used. However, other consideration from the subsidiary may be provided, such as cash. If stock of the subsidiary corporation is used, then it will fail the requirements of Section 368(a)(2)(D) and may result in a taxable transaction unless it satisfies another reorganization structure under Section 368.
Finally, according to the treasury regulations under 1.368-2, the purchasing corporation must acquire substantially all of the assets of the target through use of the subsidiary.
Forward triangular reorganizations optimize restructuring without facing tax consequences while also removing the transfer of a target’s liabilities to a parent corporation. Depending on the type and value of consideration available, a forward triangular reorganization may be the best restructuring tool for your merger.
You can contact The McGuire Law Firm to discuss your business or tax related issues with a Denver business attorney or tax attorney.