• Business Mergers & Acquisitions Law
  • Forms of Corporate Change Compared
    • Classical Mergers
  • Tax Considerations
    • Federal Tax Issues Regarding Corporate Change
    • State Tax Issues Regarding Corporate Change
  • Avoiding Liability
  • Due Diligence
  • Conclusion
  • Resources

Business mergers and acquisitions are a small part of the virtually limitless world of corporate change. As to mergers alone, the Department of Justice (DOJ) has established and published guidelines for defining markets, classifying mergers, analyzing market impact, and assessing proposed mergers. However, the DOJ itself is quick to warn that because the guidelines are applied to such a vast range of factual circumstances, each proposed corporate change is handled differently from the last. Corporate change always has economic and legal implications. While many forms of corporate change have tax implications, it is possible to structure a tax-free reorganization. The area of corporate change is so complex and detailed that every proposal is a new challenge that is best handled by a professional familiar with the ramifications of any decision that might be made.

Mergers and acquisitions are an important part of corporate change. Some terms for corporate change are erroneously used interchangeably, but the reality is that the subtle differences have grave legal implications. The following is a brief list of terms relevant to corporate change and the appropriate definition for each.

• Acquisition: An acquisition is the acquiring of control of one corporation by another. An acquisition may be by agreement or it may be the result of a hostile takeover. The acquisition may be in the form of cash, stock, or other assets.

• Consolidation: Consolidation occurs when two or more organizations are combined into one new legal entity. Typically, a consolidation is a friendly, cooperative deal in which the new entity takes the "best" of the former corporations. Presumably, with consolidation, each former corporation enters into the new venture on equal footing.

• Divestiture: Divestiture is the disposition of all or part of a business. A divestiture may take the form of a selloff (for cash) or a spinoff (for shares) and is often a tool used in creating a joint venture.

• Hostile takeover: A hostile takeover develops when the directors of the target corporation concede that the target company's sale is inevitable. Hostile takeovers are regulated by the federal Williams Act, state takeover statutes, and common law principles of target management duties.

• Initial public offering: An initial public offering is the sale of newly issued stock to the public for the purpose of raising capital for future corporate development. Often, the initial public offering is the first stage of the creation of a new publicly held corporation.

• Leveraged buyout: A leveraged buyout is the acquisition of a business through the use of borrowed funds, which are later repaid from the business' profits or sale of assets. Usually there is a complete restructuring of the corporation's balance sheet with the transfer of ownership. The so-called "leveraging" of the corporation's balance sheet is what distinguishes a leveraged buyout from a traditional acquisition.

• Liquidation: A liquidation is the conversion of assets into cash with the intent of paying off creditors and distributing the balance to corporate owners.

• Merger: A merger is the combination of two or more entities by direct acquisition of all assets by one corporation. Typically, a merger includes the exchange of stock, resulting in a surviving corporation. A merger is distinguished from a consolidation in that one of the corporations survives the others.

• Recapitalization: Recapitalization is the adjustment of a corporation's capital stock. For example, a corporation may exchange its stock for debt securities, resulting in a leverage against its capitalization.

• Reorganization: A corporate reorganization is the adjustment of the corporation's capital structure. Often reorganization is used in conjunction with Chapter 11 bankruptcy to allow the corporation to stay in business.

• Restructuring: A corporate restructuring is used to maximize corporate assets. Restructuring may occur in conjunction with divestiture, spinoff, recapitalization, or acquisition.

Classical Mergers

Generally speaking, a classical merger begins with an agreement between two corporations to merge together, resulting in the exchange of the transferor corporation's securities to the surviving corporation's control. Usually, after negotiations are completed, representatives from each corporation sign a preliminary agreement or letter of intent. If the merger is approved by the board and shareholders of each corporation, the articles of merger are filed with the Secretary of State. Upon acceptance of the filing, the surviving corporation has all the rights, privileges, franchises, and assets of the transferor corporation. Other than in exceptions such as the small-scale merger and the short-form merger, most classical mergers require approval by a two-thirds vote of the outstanding shares of each corporation as well as appraisal rights for the shareholders of each corporation. Upon completion of the merger, the transferor corporation loses its identity, which is fused into the surviving corporation.

The federal and state tax laws surrounding mergers and acquisitions and other corporate changes can be quite complex. This chapter cannot possibly provide or identify information regarding all the possible pitfalls and obligations one must consider. Instead, this section will attempt to outline the major areas of concern for the parties to consider when entering into a merger, acquisition, or other such corporate change.

Federal Tax Issues Regarding Corporate Change

Federal tax liability varies greatly depending upon the structure of the corporate change. In general, however, the seller is taxed consistent with the general principles of gain recognition and the buyer is treated on the basis of acquired assets.

Typically, a buyer wants to allocate as much of the purchase price as possible to assets that provide an immediate or early tax benefit. Allocations to inventory, therefore, are favored because the inventory is immediately sold and, in turn, increases the cost-of-goods benefit. The second objective for a buyer is to allocate the purchase price to equipment and other tangible personal property that can be quickly recovered through depreciation deductions. Next most favorable is the allocation of assets like leases, service contracts, and other assets that can be amortized over 15 years. The least desirable classification to the buyer for tax purposes is any benefit that will only occur as a capital gain when the property is resold. The general principles of allocation of sale price with respect to the seller, discussed below, apply equally to the buyer in the purchase of assets.

The sale of a business, for tax purposes to the seller, generally is treated like the sale of any other asset. The assets are treated as having been disposed of into a taxable transaction unless a provision of the tax law exempts the resulting gain from being taxed. The taxable gain or loss is the difference between the amount realized on the sale (usually the sale price) and the adjusted tax basis from the property transferred (usually the amount it cost to acquire the property).

If the sale of the business is a tax-free reorganization, usually a substantial part of the sale includes the stock of the acquiring corporation. In such a case, the seller is only taxed on that portion of the transaction that exceeds the amount of stock received.

Besides the typical taxable gain or loss or the tax-free reorganization, it is important for a seller to consider some of the following issues for tax liability purposes: tax liability for sale of subsidiary stock; apportionment or allocation of gain; basis in targeted assets; sale of the target corporation's assets; net operating loss carryovers; tax effects of transfers, sales, and leases; property taxes; sales taxes; use taxes; and possible exemptions that can be claimed. An attorney experienced in corporate change issues can help identify taxable aspects of a transaction.

State Tax Issues Regarding Corporate Change

California imposes a sales and use tax on most retail sales of tangible personal property. Because California retailers may not charge the tax to consumers as a tax, the purchase price on a given item typically takes the tax into account. Some tangible personal property, however, is not subject to California sales and use tax. For example, property purchased for resale is not subject to sales and use tax. However, in order to take advantage of the exemption, the seller must provide to the buyer a certificate of resale. Occasional sales made by a seller who does not "hold himself out as engaged in business" also are exempted. However, unlike many other states' laws, California does not include a business' assets within this exemption. In fact, California regulations specifically state that business assets are taxable. Therefore, the California occasional sale exemption is limited to sales of property for which the seller is required to hold a seller's permit. Sales and use taxes do not apply to transfers of property of a constituent corporation or new corporation undergoing a statutory merger.

California also imposes a tax on bulk sales. The buyer of one location of a business with multiple locations is liable for the taxes of the purchased location, even if it does not purchase the business or stock of goods of all locations. If the property subsequently is purchased by two or more persons, the new business owners may incur successor liability. A transferee of property also becomes liable for any unpaid franchise taxes, limited to the smaller of the transferor's liability or the value of the assets received.

In addition to sales and use, occasional sales, and bulk sales taxes, California imposes a property tax on all real property and personal property other than inventory, household goods, personal effects, and intangible property. Typically, the greatest tax consideration regarding property taxes is the reassessment of the value of property with each change of ownership. Because it is possible to create corporate reorganization without a change in ownership, such an alternative may be worth exploring. If, however, a change in ownership is unavoidable, it is important to factor a property tax increase into the economic analysis of the corporate change.

One of the most common methods for avoiding liability during a corporate change is to obtain regulatory approval. However, the time it takes to obtain regulatory approval can make or break a transaction. If it is necessary to obtain regulatory approval, the business should work with the regulators early. Being prepared and knowledgeable about a prospective transaction can go a long way toward ensuring a liability-free transaction. Furthermore, it is imperative to deal with the regulators openly and honestly. Here is a checklist of tactics that can help a corporation to be properly prepared:

• Research the target organization.

• Develop an acquisition structure designed to allow the purchaser to acquire the appropriate assets, but that avoids or minimizes complex regulatory approvals.

• Schedule meetings with regulators early. Educate those who must be involved with the transaction so that when their approval is needed, there is no "down time."

• Ask regulators early in the transaction what approval or filings are required.

• Present the transaction to the regulators with balance. Let them know why both sides will benefit from the transaction. Address anticipated concerns of the regulator before the regulator is forced to make an inquiry.

• Be prepared to be flexible and anticipate when negotiation with all parties and the regulators is required.

• Wherever possible, obtain pre-approval of the proposal from the regulators.

• Develop and adjust the detailed structure of the transaction.

• Submit filings in a timely manner.

• If possible, request an early decision from the regulators.

Be aware that different transactions require contact with various regulators. Some regulators that may need to be contacted regarding your transaction include:

Federal Authorities

Department of Justice

Federal Trade Commission

Securities and Exchange Commission

Health Care Financing Administration

Department of Defense

State Authorities

State securities regulators

Insurance Department

Department of Health Services

Professional licensing groups

Medical groups

HMO and insurance licensing authorities

Professional corporations

In addition to concerns regarding proper filing of a corporate change, each party to a corporate change has a fiduciary obligation in the form of due diligence. This fiduciary obligation is owed to corporate shareholders and others affected by the business dealings of the corporation. Basically, the law imposes on each corporate director a general obligation of good faith and fair dealing based upon a reasonably informed judgment. There are some basic questions that can go a long way toward determining whether the duty of each party has been fulfilled. For example:

• Each party should be able to show that a majority of the directors are not "interested parties" or that the board exercised due care in reaching its decision. In addition, the parties must show an intrinsic fairness to all parties to the transaction.

• If the transaction involves (a) sale of control; (b) takeover response; or (c) change in the fundamental nature of the corporation, the parties must show that they acted in a way to maximize the value and fairness of the transaction.

• Regardless of the nature of the transaction, the parties must be able to show that the transaction does not result in unreasonable harm to those who have an interest in the corporation, but are not directly involved with the decisions that led to the corporate change.

• A party must research the previous sales history of the other party to ensure that all tax liabilities are properly disclosed. At a minimum, the party should obtain all previous tax return filings, appraisal reports, payroll history, property schedules, and outstanding liabilities.

Stock or asset acquisitions, mergers, and other corporate change entails an intricate mixture of economics, business, and law. Each transaction requires a great deal of investigation and valuation. It is important to structure the transaction in the best interest of the parties as well as within the confines of the law. After the terms of a corporate change have been negotiated, the regulators enter the scene to ensure that the interests of all parties are properly balanced. It is strongly recommended that every corporate change proceed only with the assistance of an experienced professional.

The following federal authorities may need to be contacted for information concerning, or regulatory approval of, corporate change:

Department of Justice, 10th & Constitution Avenues N.W., Washington, DC 20530

(202) 514-2007; California Northern District, 450 Golden Gate Avenue 11th Floor, P.O. Box 36055, San Francisco, CA 94102, (415) 436-7200; Central District, 312 Spring Street North, Los Angeles, CA 90012, (213) 894-2434; Southern District, 880 Front Street # 6293, San Diego, CA 92101, (619) 557-5610.

Federal Trade Commission, 6th Street & Pennsylvania Avenue N.W., Washington, DC 20580, (202) 326-2222; Los Angeles Region, 11000 Wilshire Boulevard #13209, Los Angeles, CA 90024, (310) 235-7575; San Francisco Region, 901 Market Street #570, San Francisco, CA 94103, (415) 356-5270.

Securities and Exchange Commission, 450 5th Street N.W., Washington, DC 20549, (202) 942-8088; San Francisco District Office, 44 Montgomery Street #1100, San Francisco, CA 94104, (415) 705-2500.

Department of Defense, The Pentagon, Washington, DC 20301-1000, (703) 697-5131; P.O. Box 96081, Stockton, CA 95296-0001, (209) 982-2201.

These state authorities also may have information and regulatory requirements for corporate change:

Department of Corporations, 3700 Wilshire Boulevard # 600, Los Angeles, CA 90010, (213) 736-3481, (213) 736-3593 FAX.

Insurance Department, 300 Spring Street South, Los Angeles, CA 90013, (213) 897-8921.

Department of Health Services, Vital Statistics, Office of State Registrar, 304 S Street, P.O. Box 730241, Sacramento, CA 94244-0241, (916) 445-2684.