Corporations & Shareholders
The Sec. 338 purchase-price allocation rules can yield unexpected results when applied to a multitiered group of corporations with subsidiaries. These results arise as a result of the “top-down” application of the purchase-price allocation methods of Regs. Sec. 1.338-6. This item illustrates the surprising problem that can arise and suggests a solution.
Sec. 338 Election Generally
While a complete discussion of the mechanics of Sec. 338 is beyond the scope of this item, a brief summary is necessary. Generally, in a stock purchase, the corporate target maintains its historic tax basis in its assets. However, if a Sec. 338 election is made in connection with a taxable stock purchase, the transaction is treated as a hypothetical asset purchase for tax purposes, and the buyer’s tax basis in the net assets of the target is revalued to reflect the purchase price. To make a Sec. 338 election, a number of statutory and regulatory limitations must be met, including:
- The buyer must be a corporation;
- The buyer must acquire at least 80% of the target within a 12-month period; and
- The target must be a corporation.
If a Sec. 338 election is made, the target is treated as if “Old Target” sold all of its assets in a single transaction to “New Target.” New Target’s total basis in the assets that it is deemed to purchase (adjusted grossed-up basis, or AGUB) is the sum of (1) the buyer’s grossed-up basis in the recently purchased Old Target’s stock; (2) the New Target’s liabilities; and (3) other relevant items. This amount is the total basis to be allocated among the assets acquired.
Under Regs. Sec. 1.338-6, AGUB generally must be allocated to the following seven classes of assets, starting with Class I; then to Class II, up to fair market value (FMV); and so on. Within any class, the AGUB is allocated to the underlying assets based on their respective FMVs. The following asset classes are listed in Regs. Sec. 1.338-6:
- Class I assets: These include cash and cash-like items such as savings and checking accounts.
- Class II assets: These include actively traded personal property such as U.S. government securities and publicly traded stock. Class II does not generally include stock of target affiliates.
- Class III assets: These include assets that the taxpayer marks to market at least yearly for federal income tax purposes and debt instruments, including accounts receivable.
- Class IV assets: These include the taxpayer’s stock in trade or other property of a kind that would properly be included in the taxpayer’s inventory if the assets are on hand at the close of the tax year.
- Class V assets: These include all assets other than Classes I, II, III, IV, VI, and VII assets. Thus, Class V assets include the stock of target affiliates.
- Class VI assets: These consist of all assets that are Sec. 197 intangibles, other than goodwill and going-concern value.
- Class VII assets: These consist of goodwill and going-concern value (whether or not the goodwill or going-concern value qualifies as a Sec. 197 intangible).
Under these rules, no amount of the purchase price can be allocated to Sec. 197 intangible assets unless the buyer pays consideration in excess of the aggregate FMV of all other assets (as described in Classes I–V).
The following example demonstrates the typical application of the AGUB allocation rules to a corporation making a Sec. 338(h)(10) election:
Example 1: Target (S) is a C corporation and a member of a consolidated group, with assets consisting of inventory with a pretransaction tax basis of $10 and value of $30. S also has $10 of liabilities. Buyer (B) acquires 100% of S’s outstanding stock for $20, and the parties make a Sec. 338(h)(10) election.
S’s AGUB is $30: the $20 purchase price, increased by the assumed liabilities of $10. The inventory with FMV of $30 is therefore allocated tax basis of $30 under Regs. Sec. 1.338-6. No intangible assets receive any basis. When the inventory is sold, no gain will be realized.
The problem that is the main concern here arises when the target company has subsidiaries, as in the following example:
Example 2: S is the parent of S1. S1 holds stock of S2 and S4. S3 is a wholly owned subsidiary of S2. S, S1, S2, S3, and S4 file a consolidated return. S3 owns $30 of inventory with $10 of tax basis, and S4 has liabilities of $10. S1 and S2 are merely holding companies. B acquires the stock of S1 from S for $20, and the parties make a Sec. 338(h)(10) election for each of the acquired companies. The difference in the facts from Example 1 is that the liabilities and inventory are no longer in the same legal entity, but the economic situation of the two examples is similar.
Under Regs. Sec. 1.338(h)(10)-1(d)(3)(ii), the deemed asset sale for S1 is considered to precede that of its subsidiary. In other words, the regulations mandate a “top-down” approach to the AGUB allocation. S1 will calculate its own AGUB, allocate it to its assets (including stock of S2 and S4), and then S2 and S4 will calculate their respective AGUB and allocations.
S1’s AGUB is $20—the $20 purchase price, since S1 has no liabilities of its own. The $20 AGUB must be allocated among the seven classes listed above. S1 owns no Class I–IV assets. S1 holds only Class V assets—the stock of subsidiaries S2 and S4. The $20 AGUB must be allocated within this class based on the relative values of the Class V assets. Since S2 has a value of $30 (because of the inventory) and S4 has a value of $0 (because it is insolvent), the $20 AGUB will be allocated to S2.
S2 is a holding company valued at $30, owning only a Class V asset (S3 stock). Therefore, S2’s AGUB of $20 is allocated to its stock in S3. S3 in turn has AGUB of $20, which it allocates to its inventory worth $30. S3’s inventory now has a built-in gain of $10 that will be recognized as soon as the inventory is sold.
No AGUB was allocated to the S4 stock, which itself holds $10 of debt. Therefore, S4 has AGUB of $10 ($0 purchase price, plus $10 of liabilities). S4 has no assets, so the AGUB is allocated to Class VII goodwill.
Even if the S4 goodwill is amortizable, the operation of the rules creates a problem because of the offsetting shortfall in inventory basis and “phantom” goodwill. The buyer group will have immediate taxable income upon selling its inventory, and at best it will receive offsetting Sec. 197 amortization deductions over the next 15 years.
When faced with this issue, the parties might agree to combine some of the legal entities before the transaction. For example, S4 could merge with S2 or S3 , thus placing the inventory and debt into the same AGUB allocation. Alternatively, S1 could contribute the stock of S2 to S4 to achieve a similar result. Note that each “solution” has its own tax issues, including consolidated return issues, Sec. 351 issues, and potential reorganization issues, so this solution should not be implemented without considering all these potential problems.
If, for example, S4 merged into S2 with S2 surviving, S2’s AGUB would be $30, all of which would be allocated to S3’s stock. S3’s AGUB would then be $30, because that inventory receives full basis equal to FMV. The “phantom goodwill” identified in the prior example is eliminated, and no surprises are awaiting in the first year’s tax return for the group.
Practitioners should make clients aware of the potential pitfalls present in the purchase-price allocation and recommend that parties consider these issues before closing the transaction.
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, D.C.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.