The recent phenomenon of corporate inversions — a tactic wherein U.S.-based companies merge with foreign companies to take advantage of lower corporate taxes — means advisers and attorneys need to be vigilant about potential higher taxes for shareholders and employees of these companies.
What's become a sweet deal for the corporation is less of a good deal for shareholders at the companies involved in these transactions. Higher taxes are ahead for those who don't hold the companies' shares in a qualified account. Further, additional tax paperwork may be coming up, particularly for employees of companies going through these deals who also hold stock in those firms.
U.S.-based corporations are taking a closer look at so-called tax inversion deals, where companies based stateside purchase foreign companies who are based in jurisdictions with
more favorable corporate tax rates.
On paper, it appears that the smaller foreign companies are the ones buying the larger U.S.-based firms. After the transaction, the company is then domiciled in a foreign land and receives the benefits of those lower tax rates. For example, here in the U.S., corporate tax rates are at 35%. In comparison, Ireland —home to Covidien and Warner Chilcott, both recent acquisition targets by U.S. firms — has a rate of 12.5%.
“There is usually a capital gains realization when these companies invert or reincorporate abroad, so all the current shareholders have to pay capital gains that year, and they are issued new stock in the new company,” said Will McBride, chief economist at the Tax Foundation.
“Very simply, if they hold a foreign interest, there's an inversion and now you're holding some interest in the parent company as an employee, you have these potential filing requirements,” said Charles F. Schultz, partner at McGladrey LLP.
An employee of a company undergoing an inversion and who owns stock in that company may be required to file Form 8938 if the stock holding exceeds certain values. Singles or married-filing-separately will have to file if the value of their foreign stock interest is greater than $50,000 on the last day of the tax year or greater than $75,000 at any time during the tax year, Mr. Schultz noted.
Married-filing-jointly, employees will have to file Form 8938 if their holdings are greater than $100,000 on the last day of the tax year or $150,000 at any time during the tax year.
For individuals who hold shares and keep them outside of a qualified account — an IRA or a 401(k) — the tax hit is a steep one. Thanks to the American Taxpayer Relief Act of 2012, capital gains taxes can pack a punch of 20%, plus a 3.8% net investment income tax for taxpayers with a modified adjusted-gross income over $200,000 for singles and $250,000 for married-filing-jointly.
Shareholders who've held onto their stock for a long time will likely get hit the hardest.
“Say you have your shares and your basis is zero, but now the shares are worth $2.5 million,” said Peter G. Lennington, an attorney at an eponymous firm in St. Paul, Minn. “Through no fault of your own you pay capital gains on the entire thing. But you didn't want to sell; you wanted to keep your shares.”
Indeed, some of Mr. Lennington's clients include people who have worked with Medtronic PLC and have held shares in the company over the long-term. That firm is going through an inversion deal with Irish healthcare products firm Covidien. Those clients are calling with fears that they'll face higher taxes, he said.
There are also implications for beneficiaries of those shareholders if the investors intended to keep their shares and pass them onto the next generation.
Those investors were likely planning to hold the stocks until death so that their beneficiaries would get a step-up in basis, which would permit the appreciation during the investor's lifetime to avoid taxation, said Ed Slott, creator of the IRA Leadership Program. Those clients neither anticipated nor wanted to sell their shares in the first place.
“These inversions wreck that strategy, forcing the capital gain to be taxed that would've otherwise been tax free to beneficiaries,” Mr. Slott said.
For advisers with clients who are shareholders in these companies — and who happen to be employees of those firms — this might be a good time to consider diversifying those investments.
“If you have [that company stock] in both a retirement account and outside of a tax-deferred retirement account, you have too many eggs in one basket,” said Mr. Slott.
For shareholders going forward, the inversion deals suggest some interesting times are ahead when it comes to taxes. “I'm going to have clients with these stocks, and they'll come in next year and ask 'What the hell is this?' when they get their 1099s,” Mr. Slott added.
