Stock Acquired Through a Consolidation or Transfer
Spinoffs involve splitting a company apart. Mergers and consolidations go the other direction: combining companies together. The tax treatment follows a similar "defer now, recognize later" logic.
How 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.
Tax-Free Reorganizations
When shares are exchanged in a tax-free reorganization (Type A, B, or C reorganization under Internal Revenue Code (IRC) Section 368), 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 |
Types of Tax-Free Reorganizations
| Type | Description | Consideration |
|---|---|---|
| Type A | Statutory merger or consolidation | Stock, cash, or other property (most flexible) |
| Type B | Stock-for-stock acquisition | Must be solely voting stock (no boot allowed) |
| Type C | Stock-for-assets acquisition | Primarily voting stock; boot limited to 20% of target asset fair market value (FMV) |
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.
- Type B reorganizations do NOT allow boot at all. Only voting stock can be used as consideration.
Boot: 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.
Securities and Exchange Commission (SEC) Rule 145
- SEC Rule 145 requires shareholder approval and registration of securities issued in connection with:
- Mergers
- Consolidations
- Reclassifications
- Asset transfers
- This ensures shareholders have proper disclosure and voting rights before a major corporate restructuring
Exam Tip: Gotchas
- SEC Rule 145 requires both shareholder approval AND registration of securities in mergers. It applies to mergers, consolidations, reclassifications, and asset transfers.
Comparing Spinoffs and Mergers
| 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 (IRC 355) | None if stock-only; gain to extent of boot |
| Loss recognition | N/A (no exchange) | Never recognized, even with boot |