Tax-free M&A transactions are considered “reorganizations” and are similar to taxable deals except that in reorganizations the acquirer uses its stock as a significant portion of the consideration paid to the seller rather than cash or debt. Four conditions must be met to qualify a transaction for tax-free treatment under Internal Revenue Code (IRC) Section 368:
- Continuity of ownership interest – At least 50% of the consideration is acquirer stock (although transactions with as little as 40% stock consideration have qualified for tax-free treatment).
- Continuity of business enterprise – The acquirer must either continue the target’s historical business or use a significant portion of the target’s assets in an existing business for 2 years after the transaction.
- Valid business purpose – The transaction must serve a valid business purpose beyond tax avoidance.
- Step-transaction doctrine – The transaction cannot be part of a larger plan that, taken in its entirety, would constitute a taxable acquisition.