The Step-Transaction Doctrine, QSPs, and Tax-Free Reorgs.

By Erin Moshier, CPA, MS, Dallas, TX, and Nick Gruidl, CPA, MBT, Minneapolis, MN

Editor: Rick Klahsen, CPA

Rev. Rul. 2008-25, issued in May 2008, further expands on existing rulings with respect to the application of the step-transaction doctrine within the context of qualified stock purchases and tax-free reorganizations. Though neither surprising nor unexpected, the ruling provides a succinct yet comprehensive analysis that sheds light on the combined application of the predecessor rulings.

Historical Interaction of Step Transaction, QSPs, and Sec. 368 Reorgs.

Prior to the enactment of Sec. 338, certain stock purchases followed by the liquidation of the target (T) were stepped together and treated as taxable asset sales followed by liquidation of the target under Kimbell-Diamond Milling Co., 14 T.C. 74 (1950), aff’d per curiam, 187 F.2d 718 (1951), cert. denied, 342 U.S. 827 (1951). This tax result likely represented an unfortunate surprise to many unsuspecting taxpayers.

Rev. Rul. 67-274 subsequently addressed application of the step-transaction doctrine in the context of a reorganization under Sec. 368. The ruling characterized an otherwise qualifying Sec. 368(a)(1)(B) reorganization, followed by a liquidation of the target, as a Sec. 368(a)(1)(C) reorganization. Unfortunately, the ruling was not required to address, and was therefore silent as to, the treatment of the transaction if stepping together the multiple steps had instead resulted in a failed Sec. 368(a) reorganization.

In 1982, Sec. 338 was enacted and provided guidelines for treating a qualified stock purchase (QSP) as an asset acquisition. The statute’s legislative history supports the conclusion that enactment of Sec. 338 killed the Kimbell-Diamond doctrine, stating that “[t]he bill is also intended to replace any nonstatutory treatment of a stock purchase as an asset purchase under the Kimbell-Diamond doctrine” (H.R. Conf. Rep’t No. 760, 97th Cong., 2d Sess. (1982)). Note the use of the term “stock purchase” rather than QSP in the legislative history.

Citing the legislative history of Sec. 338, the IRS held in Rev. Rul. 90-95 that the step-transaction doctrine would not apply to treat a QSP followed by an upstream merger as a taxable asset acquisition, even when the merger occurred under a plan in existence at the time of the acquisition. Rather, the ruling respects the QSP and the upstream merger (a qualifying Sec. 332 liquidation) as separate transactions.

Later, in Rev. Rul. 2001-46, the IRS addressed the ramifications of both (1) an upstream merger following an otherwise qualifying QSP and (2) an upstream merger following an otherwise tax-free Sec. 368(a)(2)(E) reorganization. Holding that the legislative history of Sec. 338 did not apply to the fact pattern in the ruling, the IRS applied the step-transaction doctrine to integrate the steps, which in both scenarios resulted in a tax-free reorganization under Sec. 368(a)(1)(A). Recently finalized regulations under Sec. 338(h)(10) loosened the grip of Rev. Rul. 2001-46, allowing taxpayers to turn off the step-transaction doctrine if, following a QSP and upstream merger or liquidation otherwise representing a Sec. 368(a)(1)(A) reorganization, a valid joint Sec. 338(h)(10) election is made (Regs. Sec. 1.338(h)(10)1(c)(2)). The transaction is then treated as a QSP followed by a liquidation or merger.

Rev. Rul. 2008-25

Happily for tax professionals, Rev. Rul. 2008-25 neatly ties together the three rulings mentioned above and answers the question left unanswered in Rev. Rul. 67-274. In Rev. Rul. 2008-25, T is acquired by the purchaser (P) in an otherwise qualifying Sec. 368(a)(2)(E) reverse triangular merger. However, as part of an integrated plan, T was liquidated into P. With the application of the step-transaction doctrine to the multiple steps, the transaction failed to qualify as either a reorganization under Sec. 368(a)(1)(C) by way of Rev. Rul. 67-274 (too much boot) or a merger under Rev. Rul. 200146 (a liquidation is not a merger). As a result, stepping the transaction together would result in a taxable asset acquisition under the Kimbell-Diamond doctrine and Rev. Rul. 69-6.

Citing the legislative history of Sec. 338 and the ruling history, Rev. Rul. 2008-25 held that the transaction is not stepped together to cause an acquisition but instead represents a QSP followed by a liquidation. As such, the new ruling retained the IRS historic ruling position, holding that the step-transaction doctrine is applied to characterize a series of transactions as a tax-free reorganization but is not applied to characterize a QSP and subsequent liquidation as a taxable asset acquisition. Interestingly, the ruling turns off the step-transaction doctrine to avoid taxable asset sale treatment, yet it seemingly applies the doctrine to the same series of transactions to hold that the first step does not qualify as a reorganization under Sec. 368(a).

Unanswered Issues

While unsurprising, Rev. Rul. 2008-25 provides useful clarification for taxpayers by confirming P’s ability to simply elect out of an otherwise tax-deferred transaction through liquidation of T as well as the ability to use primarily equity in a taxable asset acquisition by way of Sec.

338. However, interesting issues remain unanswered. For example, does the ruling apply in the context of a transaction that does not involve a QSP, and how would post-liquidation transfers affect the ruling?

Non-QSP Transactions

As with the other applicable rulings and the Sec. 338(h)(10) regulations, Rev. Rul. 2008-25 addresses only the application of the step-transaction doctrine to a QSP. Would the same result occur if T were acquired in a non-QSP?

Example 1: P acquired more than 20% of the value of T a number of years ago. As a result, the acquisition of the remaining T shares will not result in a QSP. Assume that applying the step-transaction doctrine to T’s planned liquidation into P would not result in a qualifying Sec. 368(a) reorganization. Without a QSP, is the taxpayer allowed to turn off the application of the step-transaction doctrine under Rev. Rul. 2008-25? That is not likely, so P and T are left to rely on the Sec. 338 legislative history, which perhaps supports that the Kimbell-Diamond doctrine is dead in stock purchases outside Sec. 338 as well.

Example 2: Under the fact pattern of Rev. Rul. 2008-25, the T shareholders obtained Sec. 368(c) control of P, and the transaction, barring the liquidation, represents a Sec. 351 transfer with boot. Does Rev. Rul. 2008-25 support a conclusion that the steps represent a good Sec. 351 transfer followed by a Sec. 332 liquidation, or is the Kimbell-Diamond doctrine alive and well, thereby requiring the transaction to be treated as an asset transaction?

Conclusion

Rev. Rul. 2008-25 is a helpful clarification for tax advisers structuring multistep transactions. However, it is also important to understand the parameters and potentially limited scope of the ruling before liquidating an entity following an acquisition.


EditorNotes

Rick Klahsen is managing director, Tax Services, with RSM McGladrey, Inc., in Minneapolis, MN.

Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.

For additional information about these items, contact Mr. Klahsen at (952) 921-7630 or rick.klahsen@rsmi.com.

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