Merger, Consolidation, Reorganization, Redemption, Liquidation

Advisors typically think of mergers, consolidations, reorganizations, redemptions, and liquidations in the corporate context since there is a particular body of corporate tax law dealing with these transactions. In fact, partnerships, limited liability companies, and trusts may also merge, consolidate, reorganize, redeem, or liquidate. Sole proprietorships can do none of these things.

Fear of taxation should not hinder a realignment of business assets into a different business structure (change of form rather than a change of substance) provided there is continuity of interest, continuity of business enterprise, and a business purpose (other than tax avoidance). There are standards to be met, however, to ensure that the change is indeed only one of form. A series of separate (step) transactions will be collapsed and viewed as a single transaction if they are interdependent and directed to a common objective. The route to a tax-deferred business transformation is not easy.

Mergers involve the combination of two or more business enterprises in accordance with state law with one of the existing businesses surviving and the others generally going out of business. Which entity "survives" a merger depends on many things including brand recognition, management quality, desires, and objectives, public perception, and regulatory or licensing issues. To accomplish these objectives, mergers frequently involve three or more entities and are referred to as "triangular" or "reverse triangular" mergers.

A consolidation is much the same as a simple statutory merger, except that neither the acquiring nor the target corporation survives. Rather, shareholders of both corporations exchange their stock for stock in a new corporation. Both of the "old" entities dissolve.

Other "acquisitive" corporate reorganizations include an exchange of stock for stock, an exchange of stock for assets, and an exchange of assets for stock. "Divisive" corporate reorganizations include a spin-off, a split-off, and a split-up. Each type of reorganization achieves different objectives and has different limitations under the tax law. Certain reorganizations are neither acquisitive nor divisive. They include a recapitalization, a mere change in identity, form or place of incorporation, and reorganizations in bankruptcy. While this list uses terminology specific to corporate tax law, partnerships and limited liability organizations engage in the same types of restructuring to achieve essentially the same objectives, but under different sections of state and federal tax law.

Divisive reorganizations typically involve splitting one corporation into multiple entities. Depending on the desired structure following the reorganization, these transactions may take the form of a split-up, a split-off, or a spin-off. Each of these has its own requirements in order to accomplish the desired tax-deferred nature objective. Again, there must be a substantial non-tax business purpose for the transaction.

Redemptions are essentially the sale of a business interest back to the entity itself. Thus, a corporation, partnership, or limited liability company can be said to "redeem" all or a portion of an owner's interest. How that redemption is taxed depends on the type of entity, the relationship between the redeemed owner and remaining owners, and whether the redemption is full or partial termination of the owner's interest. Special favorable rules apply to redemptions of corporate stock in order to pay death taxes.

Complete liquidations envision termination of a business and the distribution of all of its assets to its owners in exchange for all of their stock. Partial liquidations generally involve the termination of a specific portion of a business and the distribution of some of its assets to owners in exchange for some of their stock. How the liquidations are taxed depends on the type of business entity (regular "C" corporation, S corporation, partnership, limited liability company, or trust).

From both a legal and tax standpoint, mergers, consolidations, reorganizations, redemptions, and liquidations are complex and very "form" oriented. These transactions require considerable planning by legal counsel and tax advisors. We have worked as tax advisors to help our clients accomplish transactions of this nature without running afoul of tax traps along the way.

©2008 Ronnie C. McClure, PhD, CPA