Mergers and acquisitions can be accomplished using a variety of structures that involve the acquisition by one party, the acquirer, of one or more business entities or lines of business of another party, the acquiree or target. Planning for a merger or acquisition requires consideration by each party of alternative structures for the transaction that will maximize the benefit to the party and its equity holders while retaining the attractiveness of the deal for possible merger or acquisition partners. 

Typical reasons for choosing one or another structure focus on the tax consequences of the transaction, the preservation of tax or accounting advantages, the ability to selectively acquire a portion of the business, assets and liabilities of the target and the avoidance of the necessity to secure consents from third parties that have existing contractual or business relationships with one of the parties to the transaction. 

The three principal structural alternatives for a merger or acquisition transaction are the statutory merger, acquisition of assets and acquisition of stock or other form of equity of the target.

Statutory Merger 

A statutory merger is completed in accordance with the state laws that govern the organization of the parties to the transaction. Whether the parties are corporations, limited liability companies, partnerships, cooperatives or other entity forms, most state laws are now flexible enough to allow two different entity types to combine by merger of one into the other or by merger of one with a subsidiary of the other. 

A two-party or “simple” merger occurs when the acquired company merges with the acquiring company, typically with the shareholders of the acquired company receiving stock or other securities of the acquiring company, cash or a combination of securities and cash. A “triangular” merger occurs when the acquiring company forms a subsidiary for the purposes of the transaction and the acquired company is merged with the subsidiary rather than into the acquiring company, but the shareholders of the acquired company still receive cash and/or securities of the acquiring parent. Schematically, the three parties and their relationships in the transaction form a triangle. 

When the target merges into the acquirer or into a subsidiary of the acquirer, the merger is generally called a “forward” merger. Often, however, it is advantageous to structure the transaction as a “reverse” merger, where the acquiring company (at least from an economic standpoint) or subsidiary merge into the target. A reverse triangular merger occurs when the subsidiary of the acquiring parent merges into the acquired company, the opposite of the forward triangular merger. The shareholders of the acquired company still receive securities and/or cash from the acquiring parent and the parent’s shares in its subsidiary are converted into shares of the acquired company, making the acquired company a subsidiary of the parent. 

In the forward triangular merger, the subsidiary formed for the transaction is the surviving company following the transaction and the acquired company is merged out of existence, with all of its assets and liabilities passing to the subsidiary. In the reverse triangular merger, the acquired company is the surviving company and the separate existence of the subsidiary disappears. In that case, the acquired company continues to hold its own assets and liabilities but it continues existence as a subsidiary of the acquirer. 

Acquisition of Assets 

In an acquisition of assets, the acquiring company purchases some or all of the business and assets of the target and may assume specified liabilities of the target. The acquirer generally acquires only those liabilities of the target that it specifically agrees to assume, subject to “successor liability” doctrines imposed by law and court decisions such as liability for preexisting environmental issues. Following an acquisition of assets, the target may sell any remaining assets, satisfy its remaining liabilities and distribute the cash or securities received in the acquisition to its equity holders. Or, it may continue business with the lines of business and assets not sold in the acquisition.   

Acquisition of Stock, Other Equity Interests 

If the transaction is structured as an acquisition of equity interests, the transaction is conducted with the owners of the target rather than the target itself. The consideration provided by the acquirer can be cash or securities, or a combination of cash and securities, but cash is the most common form of consideration in stock acquisitions. In the case of a closely held target, the acquirer might successfully negotiate the simultaneous purchase of all of the outstanding equity. Where the equity of the target is more broadly held, the transaction might be conducted as a friendly or hostile “tender-offer,” in which the acquirer offers to purchase the equity of willing sellers, usually subject to a controlling percentage of the equity being tendered for sale. If a minority interest remains after an initial equity purchase, the acquirer will often conduct a second-stage “squeeze-out” or “freeze-out” merger, subject to state law, by which it would eliminate the minority interest for cash. 

Advantages, Disadvantages of Acquisition Forms 

Other than tax considerations associated with the different forms in which a merger or acquisition can be accomplished, there are a number of reasons why one form may be preferred for a given transaction. An acquirer often prefers an acquisition of assets because it can pick and choose what assets it wishes to acquire and avoid assuming some or all of the liabilities of the target. Avoiding liabilities is particularly important if there may be unknown or contingent liabilities that could have an adverse effect on the acquirer after closing. In the case of a merger or purchase of stock, the acquirer or its subsidiary will have all of the target’s assets and liabilities after the transaction. The advantage of a merger or stock purchase is the assurance that all of the assets of the target will be acquired, even if not clearly identified. 

A merger or sale of all or substantially all of the assets of a target will normally require the approval of the target’s equity holders, by majority vote or higher percentage specified by statute or the target’s organizational documents. A simple merger will also usually require a vote by the equity holders of the acquirer. A triangular merger may avoid a vote by the acquirer’s equity holders unless the transaction is sufficiently material that organizational documents, applicable stock exchange rules or the necessity to authorize additional securities to be issued in the transaction make such a vote necessary. A direct purchase of stock of the target will not require a formal vote of the target’s equity holders, but may not result in the acquisition of sufficient target stock to successfully complete the transaction. 

In an acquisition of assets, most governmental permits and any agreements with prohibitions on assignment will require the parties to obtain new permits and consents so the acquirer can continue the target’s business. Diligence review of all permits and contracts is essential to determine what new permits or consents are necessary. Consents are normally obtained prior to closing; permits sometimes cannot be obtained until after closing. In the case of a forward merger, whether simple or triangular, even though the applicable law normally provides that the surviving company in the merger succeeds to ownership of all assets and contractual rights, there may be permits and some contracts that treat a merger as a prohibited transfer; in that case, new permits and consents may still be required. In a reverse merger, however, since there is no change in the assets or liabilities of the acquired company, in most cases its permits, contractual relationships and the like will not be affected. In that case, unless there is a change of control prohibition or language that specifically addresses the situation, typically no new permit applications or consents would be required.

Tax Consequences of the Transaction

The tax consequences to the parties to a merger or acquisition and to their equity holders are major and often deciding factors in determining the structure and attractiveness of any transaction. The tax consequences will depend primarily on four principal variables: (i) the organizational form of the parties, which might be quite different; (ii) the structure of the transaction, which can be quite complex; (iii) the consideration to be exchanged in the transaction; and (iv) the pre-existing tax circumstances of each of the parties and their equity holders. 

For entities taxed as corporations, Section 368 of the Internal Revenue Code, allows a transaction to be accomplished without an immediate recognition of gain or loss by equity holders in certain carefully defined circumstances, all of which involve the continuation of an equity interest in the resulting enterprise. Often called “tax-free reorganizations,” these transactions actually defer tax on any gain at the time of the transaction, typically allowing capital gains treatment of tax on the gain when the equity is ultimately sold. If the equity holders receive cash, or if the transaction fails to meet the specific requirements for tax-deferred treatment, tax on any gain to the date of closing may be due, whether or not the transaction results in any cash distribution to the equity holders.   

Because Section 368 does not apply to entities taxed as partnerships, including limited partnerships and limited liability companies, transactions involving such entities may have taxable or tax deferred consequences to their equity holders based on other rules and analyses. Forward mergers, reverse triangular mergers and asset purchases are subject to different analytical processes and the form of consideration, such as securities, cash or a combination of securities and cash will dictate different results.  

The ultimate tax impact on equity holders will in large part be determined by the tax basis of their investment in the parties to the transaction. In the case of limited liability companies or partnerships, a transaction may also result in the recapture of losses previously recognized for tax purposes by the equity holders, the impact of which may differ among the holders.
An acquirer will also be interested in specific tax aspects of the transaction, such as the ability to step-up the tax basis of assets in an asset purchase and the possibility of preserving net operating loss carry-forwards of the target.

Author: Dean R. Edstrom
Partner Attorney, Lindquist & Vennum PLLP
(612) 371-3955
dedstrom@lindquist.com