Quick Answer
In a merger, target shareholders exchange shares for the acquirer's shares (or cash, or both) at a set exchange ratio. A qualifying tax-free reorganization defers gain, substitutes the old cost basis, and tacks on the old holding period; cash or property ("boot") received alongside stock triggers gain recognition up to the boot amount, but losses are never recognized.
Spinoffs and mergers move in opposite directions: one company splitting apart versus two combining. Both follow a similar "defer now, recognize later" tax logic, but a merger adds a wrinkle spinoffs don't have: the shareholder actively exchanges old shares for new ones, which is what opens the door to boot and partial gain recognition.
How Do Mergers Work for Shareholders?
- In a merger or consolidation, shareholders of the acquired company exchange their shares for shares of the surviving company (or cash, or a combination)
- The exchange ratio determines how many shares of the acquiring company a target shareholder receives per share of target stock
Example: A 2:1 exchange ratio means you receive 2 shares of the acquiring company for every 1 share of the target company you held.
What Happens Tax-Wise in a Qualifying Reorganization?
When shares are exchanged in a tax-free reorganization, the following rules apply:
| Element | Treatment |
|---|---|
| Gain or loss | No gain or loss recognized at the time of exchange |
| Cost basis | Shareholder's basis in the new shares equals their basis in the old shares (substituted basis) |
| Holding period | The holding period of the old shares carries over (tacks on) to the new shares |
Exam Tip: Gotchas
- The holding period of old shares carries over to the new shares in a tax-free reorganization. This means long-term status is preserved.
What Happens When Cash Enters the Picture?
Boot is any non-stock consideration received in a reorganization (typically cash or other property).
Key rules when boot is received:
- Gain is recognized to the extent of the boot received (but never more than the total gain realized)
- Loss is NEVER recognized in a reorganization exchange, even when boot is received
- The shareholder's basis in the new shares is adjusted to account for the boot
Example:
- You exchange target shares with a $5,000 basis for acquiring company shares worth $8,000 plus $2,000 cash (boot)
- Gain realized: $10,000 total value - $5,000 basis = $5,000
- Gain recognized: $2,000 (limited to the boot received)
- You defer the remaining $3,000 gain through your adjusted basis in the new shares
Exam Tip: Gotchas
- In a tax-free merger with ONLY stock, no gain or loss is recognized and the old cost basis carries over. If the shareholder also receives cash (boot), gain is recognized up to the amount of boot, but loss is NEVER recognized in a reorganization.
What Disclosure Does a Merger Require?
- The reorganization rule treats the exchange of securities as a sale, so the securities issued must be registered, in connection with:
- Mergers
- Consolidations
- Reclassifications
- Asset transfers
- The shareholder vote on the restructuring is required by state corporate law or the company's own charter, not by the reorganization rule
- Together they mean shareholders get a registered offering document before they vote on a major corporate restructuring
Exam Tip: Gotchas
- The reorganization rule supplies the registration, not the vote. It applies to mergers, consolidations, reclassifications, and asset transfers. If an answer choice says the rule itself requires shareholder approval, that is the trap: the vote comes from state law or the charter.
How Do Spinoffs and Mergers Compare?
| Feature | Spinoff | Tax-Free Merger |
|---|---|---|
| Direction | Company splits apart | Companies combine |
| Shareholder action | Receives new shares passively | Exchanges old shares for new |
| Cost basis | Split by relative FMV | Substituted (old basis carries over) |
| Holding period | Tacks on | Tacks on |
| Gain/loss at time | None (tax-free spinoff treatment) | None if stock-only; gain to extent of boot |
| Loss recognition | N/A (no exchange) | Never recognized, even with boot |
What Should You Check on Exam Day?
- Gain is recognized only up to the amount of boot received; loss is never recognized in a reorganization, boot or not.
- Both the holding period and, for stock-only exchanges, the cost basis carry over from the old shares to the new.
- Mergers require a registered offering of the securities issued; the shareholder vote comes from state corporate law or the charter, not from the reorganization rule.