Using Sec. 338 to Avoid Anti-churning Rules

By Michelle Estrada, CPA, Boston

Editor: Annette B. Smith, CPA

Corporations & Shareholders

When assets are sold in a taxable transaction, the buyer must be aware of limitations placed on amortizing certain acquired intangibles under the anti-churning rules in Sec. 197(f)(9). A recent letter ruling highlights the ability to use a Sec. 338 election to create the effect of an asset sale while avoiding the anti-churning rules.

Letter Ruling

In Letter Ruling 201203004, Distributing owned Sub 1 , which owned Sub 7 and other Sub 1 Subsidiaries . Sub 7 owned Sub 7 Subsidiaries . Sub1 , Sub 1 Subsidiaries , Sub 7 , and Sub 7 Subsidiaries had built-in losses. The following steps were taken pursuant to a plan:

  • Distributing entered into a binding agreement to sell all the nonvoting preferred stock of newly formed Corp 1 to certain insiders and investors.
  • Distributing transferred Sub 1 to Corp 1 in exchange for Corp 1 common stock and nonvoting preferred stock (the contribution).
  • Distributing transferred all the Corp 1 common stock to Controlled and distributed Controlled to the public in a Sec. 355 spinoff.
  • Distributing sold all the Corp 1 preferred stock to the insiders and investors pursuant to the binding obligation.
  • Distributing and Corp 1 made Sec. 338(h)(10) elections with respect to Sub 1, Sub 1 Subsidiaries, Sub 7, and Sub 7 Subsidiaries.

The IRS ruled that the contribution followed by the prearranged sale of the preferred stock was a taxable sale of the Sub 1 stock under Sec. 1001. The letter ruling also concluded that assuming a Sec. 338(h)(10) election is made with respect to Sub 1 , Sub 1 Subsidiaries , Sub 7 , and Sub 7 Subsidiaries , any goodwill, going-concern value, and other Sec. 197 intangibles (for which amortization would not have been allowable but for Sec. 197) of Sub 1 , Sub 1 Subsidiaries , Sub 7 , and Sub 7 Subsidiaries are not subject to the anti-churning rules of Sec. 197(f)(9).

Qualified Stock Purchase

A Sec. 338 election is permitted only if there is a qualified stock purchase (QSP). A QSP is a transaction, or series of transactions within a 12-month period, in which a corporation purchases at least 80% of the voting power and value of the stock of another corporation (Sec. 338(d)(3)).

Stock is not considered purchased if it is acquired in a Sec. 351 or Sec. 354 transaction (Sec. 338(h)(3)(A)(ii)). In the letter ruling, the contribution was not a Sec. 351 transaction because immediately after the contribution, taking into account the binding obligation, Distributing did not own any Corp 1 preferred stock and thus was not in control of Corp 1 (Sec. 368(c)). The contribution was not a B reorganization, because Corp 1 issued nonvoting stock (Sec. 368(a)(1)(B)).

Stock also is not considered purchased if it is acquired from a related person. A seller generally is related to the purchaser if stock owned by the seller would be attributed to the purchaser under Sec. 318(a) (Sec. 338(h)(3)(A)(iii)). The key to determining relatedness is the time for testing:

  • In the case of a single transaction, test immediately after the purchase of target stock;
  • In the case of a series of acquisitions otherwise constituting a QSP, test immediately after the last acquisition in the series; and
  • In the case of a series of transactions effected pursuant to an integrated plan to dispose of target stock, test immediately after the last transaction in the series (Regs. Sec. 1.338-3(b)(3)).

When Corp 1 acquired Sub 1, Distributing’s ownership of Sub 1 would have been attributed to Corp 1 under Sec. 318(a) because Distributing owned more than 50% of Corp 1. However, as part of the same plan, Distributing severed its relationship with Corp 1. Immediately after the spinoff, Distributing and Controlled each were publicly traded, Controlled owned the Corp 1 common stock, and the insiders and investors owned the Corp 1 preferred stock. Consequently, Corp 1 purchased the Sub 1 stock.

anti-churning Rules

A Sec. 338 election in effect converts a stock purchase into an asset purchase. A fictional “old target” is deemed to sell all its assets subject to its liabilities to a fictional “new target.” This deemed asset sale raises anti-churning concerns.

The anti-churning rules in Sec. 197(f)(9), which were enacted on Aug. 10, 1993, are designed to prevent the amortization of intangibles if they were unamortizable under prior law, unless the ultimate user of the intangibles changes. In general, goodwill or going-concern value acquired after that date is not amortizable if:

  • The taxpayer or a related person held or used the intangible during the transition period (July 25, 1991, to Aug. 10, 1993);
  • The taxpayer acquired the intangible from a person that held the intangible at any time during the transition period and, as part of the transaction, the user of the intangible does not change; or
  • As part of the same plan as the acquisition, the taxpayer grants the right to use the intangible to a person (or person related to that person) that held or used the intangible during the transition period.

For this purpose, two persons are related if, among other relationships, one bears a relationship to the other that is specified in Sec. 267(b), substituting 20% for 50% for the ownership thresholds (Regs. Sec. 1.197-2(h)(6)(i)(A)). This includes two corporations in a parent-subsidiary controlled group connected by more than 20% voting power or value (Secs. 267(b)(3) and 267(f)). Relatedness is tested under Sec. 197(f)(9) and Regs. Sec. 1.197-2(h)(6)(ii):

  • In the case of a single transaction, immediately before or after the transaction in which the intangible is acquired; and
  • In the case of a series of related transactions (or a series of transactions that comprise a QSP), immediately before the earliest transaction or immediately after the last transaction.
Planning Using a Sec. 338 Election

Why did the IRS rule that the anti-churning rules would not apply to the deemed asset sale if old target and new target are the same legal entity? When a Sec. 338 election is made for an acquisition after Aug. 10, 1993, the Sec. 197 related-person rules are bypassed and new target is deemed not to be the person that held or used the assets during any period in which the assets were held or used by the old target (Regs. Sec. 1.197-2(h)(8)). In the letter ruling, the taxpayer structured the transaction into a QSP with a Sec. 338 election in order to recognize losses and to be able to amortize the remaining basis in the assets. If a Sec. 338 election had not been made, Distributing would have recognized only the loss in the stock of Sub 1 , if any, and Corp 1 would have had no new amortizable asset basis after it was spun off by Distributing .

What’s the Catch?

The anti-churning rules still may apply to a deemed asset sale if new target is related to old target within the meaning of Regs. Sec. 1.197-2(h)(6). For example, if (1) individual A owns 25% of the stock of each of P and T , (2) P makes a QSP of T from shareholders A and B in July 2000, and (3) P makes a Sec. 338 election, old target and new target would be members of a controlled group under Sec. 267(b)(3) (as modified to reflect 20% ownership). Therefore, any nonamortizable Sec. 197(f)(9) intangible held by old target would not be an amortizable Sec. 197 intangible in the hands of new target (Regs. Sec. 1.197-2(k), Example (23)). Contrast this example with the letter ruling in which affiliation between old target and new target for Sec. 197 purposes was severed with the spinoff, with the result that new target was not related to old target after the series of related transactions.


Annette Smith is a partner with PwC, Washington National Tax Services, in Washington, D.C.

For additional information about these items, contact Ms. Smith at 202-414-1048 or

Unless otherwise noted, contributors are members of or associated with PwC.

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