There are two basic types of business combinations – taxable and nontaxable.
Taxable Business Combinations (Asset Purchase):
In a taxable business combination, new tax bases for acquired assets and assumed liabilities are generally determined on the basis of the fair market value. The acquirer “steps up” the acquiree’s historical tax bases in the assets acquired and liabilities assumed to fair market value. Under the U.S. federal income tax law (IRC Section 338), certain stock purchases can be treated as taxable business combinations if an election to treat the stock purchase as a taxable asset purchase is filed.
Both the seller and purchaser of a group of assets that makes up a trade or business generally must use Form 8594 to report the transaction and both must attach the form to their respective income tax returns. The taxpayers are not required to file Form 8594 when a group of assets that makes up a trade or business is exchanged for like-kind property in a transaction to which section 1031 applies and when a partnership interest is transferred. For stock purchases treated as asset purchases under Sections 338(g) or 338(h)(10), the purchaser and seller must first file Form 8023, to make the 338 election. Form 8883 is then filed by both the purchaser and the target to supply information relevant to the election.
There is no legal requirement that the target and acquiring company take consistent positions on their respective tax returns, and therefore each could in principle take a different position favorable to itself. However, if they do so, the IRS is likely to discover this fact and protect itself by challenging the positions taken by both parties. To avoid this result, acquisition agreements almost always provide that the parties will attempt to agree on an allocation of price among the assets within a relatively short time after the closing of the transaction.
Non-Taxable Business Combinations (Stock Purchase):
In a nontaxable business combination, the acquirer assumes the historical tax basis of the acquired assets and assumed liabilities. In this case, the acquirer retains the “historic” or “carryover” tax bases in the acquiree’s assets and liabilities. Generally, stock acquisitions are treated as nontaxable business combinations (unless a Section 338 election is made). Nontaxable business combinations generally result in significantly more temporary differences than do taxable business combinations because of the carryover of the tax bases of the assets acquired and liabilities assumed. To substantiate the relevant tax bases of the acquired assets and assumed liabilities, the acquirer should review the acquired entity’s tax filings and related books and records. This information should be evaluated within the acquisition’s measurement period.
The non-taxable corporate reorganization Internal Revenue Code provisions are concerned with the form, rather than the substance, of the transaction. Therefore, it is important to document that the correct procedures have been followed. Regulation Section 1.368-3 sets forth which records are to be kept and which information needs to be filed with tax returns for the year that such a transaction is completed. Each corporate party to a non-taxable reorganization must file a statement with its tax return for the year in which the reorganization occurred that contains the names and EINs of all parties, the date of the reorganization, the FMV of the assets and stock transferred, and the information concerning any related private letter rulings. All parties must also maintain permanent records to substantiate the transaction. While there are no statutory penalties for failure to comply with the reporting requirements, the IRS has argued that failure to comply with the requirements could indicate that a transaction was a sale and not a non-taxable reorganization.