What conditions must be met to qualify for a Tax Free Reorganization?
To qualify the following four conditions of Section 368 of the Internal Revenue Code must be met:
- Continuity of Ownership Interest. At least 50% of the consideration received from the sale is paid in the acquirer's stock.
- Continuity of Business Enterprise. The acquirer must continue the same historical business or use the assets acquired in the same line of business for at least two years.
- Valid Business Purpose. There must be a valid business purpose for the transaction beyond tax avoidance.
- Step-Transaction Rules. The transaction cannot be part of a larger plan that would make up a taxable acquisition if viewed in it's entirety.
Will there be any taxable gain with this?
If cash or other property is received as part of the sale it will be considered "boot" and will be taxable as such. Also, when the acquiring company's stock is sold then there will be a taxable gain on that transaction and the basis of the stock must be calculated upon sale. This is not a way to avoid tax but rather a way to defer it and retain the investment. As such, you must believe the acquiring company's stock will increase in value to make this a worthwhile transaction.
How does this transaction affect the purchaser?
The entity acquiring your company assumes a carryover basis in all assets and there is no gain or loss in the stock exchanged in the sale. Tax attributes of the acquired company such as net operating losses are carried over within limits.
Section 351 Mergers
In some circumstances when the Section 368 reorganizations are impractical, there is another Internal Revenue Code, Section 351, that allows for Tax Free Reorganizations. These are more flexible but also quite complex transactions that generally involve forming a new company that both companies contribute assets to and then receive stock in exchange.