Understanding the Tax Implications of Bank Mergers

If your institution is contemplating a merger, there are a variety of tax issues to consider.  Two key issues today are the dividend versus capital gains treatment of cash payments in a tax-free merger and the preservation of deferred tax assets. It’s also important to conduct thorough due diligence to uncover any tax liabilities you might inherit from the target bank.

Even in a “tax-free” merger, any portion of the purchase price paid in cash rather than stock (commonly referred to as “boot”) is taxable to the acquired bank’s shareholders. The question then becomes: Is boot taxed as a dividend or as a capital gain? The answer is important for several reasons:

Historically, capital gains have been taxed at a lower rate than dividends, although currently qualified dividends are taxed at the capital gains rate.

If the target bank’s stock is held by a C corporation, the C corporation will likely prefer dividend treatment. This allows it to take advantage of the dividends-received deduction (or, if the parties to the merger are part of a consolidated group, to treat the payment as a nontaxable intercompany dividend).

In some cases, dividend treatment may run afoul of regulatory dividend restrictions.

Determining whether boot is taxed as a dividend or a capital gain can be complicated. The first step is to recharacterize the transaction as if the acquiring bank purchased the target bank’s stock with its own stock and then immediately redeemed a portion of the stock in exchange for the boot. Generally speaking, this fictitious redemption is considered a sale or exchange (taxed as a capital gain) if it terminates or substantially reduces the shareholder’s interest in the corporation. Otherwise, it’s treated as a distribution.

A distribution isn’t automatically taxed as a dividend, though. It’s only treated as a dividend to the extent of the shareholder’s proportionate share of the corporation’s earnings and profits. Any distribution in excess of that amount is taxed as a capital gain.

Deferred tax assets

One potential benefit of a merger is preservation of the target’s deferred tax assets, such as net operating loss (NOL) carryovers, which otherwise might be lost. However, the use of the NOL could be potentially limited by Section 382 if there is a change in control greater than 50 percent. Also, in a loss situation, watch out for the Unified Loss Rule (ULR). Although the rule is complex, it’s important to consider it before a merger because it can result in the loss of valuable tax benefits.

Suppose, for example, that your bank wishes to acquire the stock of another bank that has substantial NOL carryovers. The target is part of a consolidated group owned by a common bank holding company (BHC), which will recognize a loss on the sale of the target’s stock. The ULR, which is designed to avoid “duplicate losses,” may wipe out the NOL benefits. One way to avoid this result is to negotiate with the BHC for a protective election that reduces its potential loss and preserves the target’s NOL carryovers.

Due diligence

Many bank mergers are “statutory mergers.”  These transactions are relatively simple because their terms are generally dictated by state or federal law. One of the terms, however, is that the acquiring bank automatically assumes all of the target bank’s liabilities, including tax liabilities. Thorough due diligence is critical to identify any potential liabilities for income, employment, or other taxes that your bank may inherit from the target and to adjust the purchase price accordingly.

Alternatively, consider a “purchase and assumption agreement.” These agreements are more complex, but they provide some flexibility to specify which liabilities you will assume.   

Editor’s Note: This article was provided by Brady Nitchman and Steve Schick, partners at Plante & Moran LLC, an accounting firm based in Chicago.