Corporate inversions are all the rage these days as U.S. businesses merge with foreign firms and then restructure the combined businesses as foreign-based corporations. That yields tax benefits and may boost their after-tax profits, but it can also leave their stockholders with unwanted capital gains and big tax bills.
As Howard Gleckman explained in TaxVox back in June, a corporate inversion leaves the U.S. business in place with a foreign firm as the new owner. That restructuring, combined with income shifts it makes possible, can cut or even eliminate the taxes the U.S. business owes the American government. No workers or production activities have to move; only legal ownership leaves for foreign shores.
But not everyone saves on taxes. As Laura Saunders discussed in the Wall Street Journal (pay wall) a couple of weeks back, an inversion that cuts the corporation’s tax bill can increase income taxes for the firm’s stockholders. An inversion, in effect, is the sale of a U.S. firm to a foreign company. Stockholders in the U.S. firm are deemed to have sold their shares in the U.S. firm in exchange for shares in the new foreign-based entity. They get no cash, just a stake in the new company.
Unfortunately for those investors, those shares often do poorly. A new study by Reuters found that the stocks of more than a third of the 52 inversions accomplished over the last three decades underperformed the S&P 500. Of course, many firms do well: another third beat the market average.
In any case, an inversion’s “sale” of U.S. shares is a taxable transaction as far as the IRS and states are concerned. If the sales value of the stock exceeds its basis, the stockowner owes tax on the capital gain. Those gains will likely be largest for long-time stockholders who purchased shares at low prices. Recent buyers of the firm’s stock tend to have smaller gains and hence smaller tax bills.
People who own shares through qualified retirement plans such as 401K plans or who benefit from accruals in defined benefit retirement plans are off the hook, as are tax-exempt investors such as universities and other charitable organizations. And low- and moderate-income shareholders won’t owe additional federal taxes since investors in the 15 percent bracket or below pay no federal income tax on capital gains. They may owe tax on their gains to their states, though, depending on where they live.
High-income taxpayers could face a big hit, however. The top rate on gains is now 20 percent, which jumps to about 25 percent when the limitation on itemized deductions (about 1.2 percentage points) and the Affordable Care Act’s net investment income tax (3.8 percentage points) kick in. In 2014, the limitation on deductions hits when income tops $254,200 ($305,050 for joint filers, both values indexed for inflation) and the investment tax affects people with income over $200,000 ($250,000 for couples, neither value indexed). Tack on state income taxes and high-income stockholders could owe nearly a third of their gains to the taxman.
Of course, stockholders also get a new, higher basis for their stock in the foreign corporation, which will reduce the tax they pay if they sell their shares later. Unless they plan to keep their holdings until they die (when their heirs will inherit their stock with stepped-up basis), paying tax now mostly shifts the timing of their tax bills. They just have to come up with cash to pay Uncle Sam.
Some affected stockholders will be able to offset their gains with capital losses on other investments or use other means to reduce their tax bite. Some will have enough cash to cover the additional tax. But some will be forced to liquidate assets—possibly the foreign firm’s stock they got from the inversion—to pay their higher taxes. A corporate inversion may be great for a firm’s executives, but when it comes to shareholders, it’s not always such a wonderful deal.