IRS Clarifies Application of the Step-Transaction Doctrine

Editor: Frank J. O’Connell Jr., CPA, Esq.

On May 8, 2008, the IRS issued Rev. Rul. 2008-25 to clarify the application of the step-transaction doctrine to situations in which an acquiring corporation (P) acquires a target corporation (T) by means of a reverse subsidiary merger followed immediately by a liquidation of T. This ruling addresses a particular fact pattern not considered in prior IRS guidance. In keeping with previously established standards for applying the step-transaction doctrine to postacquisition liquidations of T, the Service concluded that if the application of the step-transaction doctrine failed to result in a tax-free reorganization under Sec. 368(a), then the transaction would be viewed as a qualified stock purchase of T followed by a tax-free liquidation of T under Sec. 332.

Background

Sec. 338 offers acquiring corporation P a unique election to treat a qualified purchase (i.e., a taxable purchase of at least 80% of the vote and value) of the stock of target corporation T as if P had purchased T’s assets rather than T’s stock. The ramifications of this election are significant in that the deemed asset purchase gives P a stepped-up basis in the acquired T assets and amortizable Sec. 197 intangibles.

However, this benefit may come at a significant cost. Under Sec. 338(g), the election is made exclusively by P and results in a corporate-level taxable gain to the newly acquired T from the deemed sale of its assets. However, since P is now T’s owner, P (or the P group) will bear the tax burden on this gain. As a result, an election under Sec. 338(g) is uncommon except where T has tax attributes (such as a net operating loss or tax credit carryforwards) that can be used to offset this taxable gain.

Sec. 338(h)(10) offers P a similar election, but only if T is a subsidiary in an affiliated group of corporations or an S corporation. If made, the Sec. 338(h)(10) election treats a qualified stock purchase as a taxable asset purchase to P and a taxable asset sale to T.

Thus, if T is a corporate subsidiary of a selling affiliated group, there may be little if any additional taxable gain to the selling group from the deemed asset sale if the selling parent’s basis in T stock is proximate in value to the tax basis of T’s assets. For this reason, Sec. 338(h)(10) elections are more common than the Sec. 338(g) elections described above. Unlike the Sec. 338(g) election, both P and T must consent to a Sec. 338(h)(10) election.

Historically, the IRS has wrestled with the application of the step-transaction doctrine in a situation in which P acquires the outstanding T stock in a qualified stock purchase and then immediately liquidates T. Before the issuance of Sec. 338, this series of transactions would be automatically stepped together under the Kimbell-Diamond doctrine and treated as if P had purchased T’s assets in a taxable asset acquisition, with T recognizing a taxable gain on the sale of its assets and P receiving a stepped-up basis in these assets (see Kimbell-Diamond Milling Co., 14 T.C. 74 (1950), aff’d, 187 F.2d 718 (5th Cir. 1951)). However, upon the enactment of Sec. 338, Congress explicitly stated that the election under Sec. 338 was to be the exclusive avenue for deemed asset sale treatment, and the Service would no longer seek to step these transactions together in the manner described above.

Rev. Rul. 90-95

Additional complications surrounding the immediate liquidation of a subsidiary following a qualified stock purchase arose within the context of reverse subsidiary mergers. In a reverse subsidiary merger, P creates a transitory subsidiary, P1, and causes P1 to merge with and into T, with T surviving the transaction. Given that P1’s existence is purely transitory and its only purpose is to facilitate the acquisition structure, P1 is ignored for tax purposes and the transaction is viewed as a direct acquisition of T’s stock by P. If the consideration paid to T’s shareholders consists of cash, other property, or an amount of P stock that is not sufficient to meet the continuity of interest requirements for a tax-free reorganization, then the transaction will constitute a qualified stock purchase of T, assuming P acquires at least 80% of T’s stock in the transaction.

Rev. Rul. 90-95 was issued to clarify this treatment within the context of two reverse subsidiary merger examples. Both examples involve P acquiring all of T’s stock by means of a reverse subsidiary merger with cash being the only consideration paid to T’s shareholders. In one example, T’s existence continues after the acquisition, and in the other example T is immediately liquidated into P. The ruling holds that both situations constitute a qualified stock purchase of T under which a Sec. 338 election could be made to treat the acquisition as a taxable purchase of T’s assets. The ruling further clarifies that, when T is immediately liquidated after its acquisition by P, the transaction will be treated as a qualified stock purchase followed by a Sec. 332 liquidation of T.

Therefore, unless a Sec. 338 election is made with respect to the stock acquisition, no gain will be recognized by T in the transaction, and P will receive a carryover basis in T’s assets upon its liquidation into P. In reaching this conclusion, the IRS reinforced the mandate that a Sec. 338 election, and not the step-transaction doctrine, is the exclusive avenue for a deemed asset sale where a qualified stock purchase is involved.

Rev. Rul. 2001-46

There is extensive precedent for the application of the step-transaction doctrine to integrate the related steps of an overall acquisition plan so that the end result can be tested for qualification as a tax-free reorganization under Sec. 368(a). One of the primary rulings in this area is Rev. Rul. 67-274. This ruling involved a situation in which P acquired all the outstanding T stock solely in exchange for P stock and then immediately liquidated T into P. The ruling concludes that the step-transaction doctrine must be applied to the immediate postacquisition liquidation of T, and the resulting integrated transaction must be viewed as an acquisition of T’s assets in exchange for P stock (which qualified as a tax-free reorganization under Sec. 368(a)(1)(C)).

While Rev. Rul. 90-95 addressed the nonapplication of the step-transaction doctrine within the context of a taxable reverse subsidiary merger, questions surrounding the application of this doctrine continued for reverse subsidiary mergers that would qualify as tax-free reorganizations under Sec. 368(a) if the step-transaction doctrine was applied. If a tax-free reorganization results from the integrated transaction, the nonrecognition provisions of Sec. 361 are mandatory and would generally preclude P from making a Sec. 338 election. In 2001, the Service issued Rev. Rul. 2001-46 to address this situation.

Rev. Rul. 2001-46 illustrates the application of the step-transaction doctrine through two examples. In both examples, P acquires T’s stock using a reverse subsidiary merger and T is then immediately liquidated into P via a merger of T into P (a key point that is later distinguished in Rev. Rul. 2008-25). In the first example, the consideration paid by P to the T shareholders consists of 70% P stock and 30% cash; in the second example, the consideration consists entirely of P stock.

In the first example, P’s acquisition of T via a reverse subsidiary merger would not qualify independently as a tax-free reorganization because the 70% stock consideration falls short of the 80% requirement for this particular structure under Sec. 368(a)(2)(E). Thus, viewed independently, this transaction would constitute a qualified stock purchase and would give P the opportunity to make a Sec. 338 election.

However, the ruling concludes that, because the step transaction must be applied within the context of testing a series of interrelated transactions for qualification as a tax-free reorganization, the transaction must be viewed as a direct merger of T into P. As a result, the transaction qualifies as a tax-free reorganization under Sec. 368(a)(1)(A) because, when viewed in this light, the 70% stock consideration is more than sufficient to meet the continuity of interest requirements for a standard A reorganization. This same conclusion is reached in the second example.

The application of the step-transaction doctrine to achieve tax-free reorganization status for these transactions would seemingly preclude P’s making a Sec. 338 election for either transaction. However, the IRS left open the possibility of allowing taxpayers to make a Sec. 338(h)(10) election if P’s acquisition of T’s stock, when viewed independently of the postacquisition merger of T, would constitute a qualified stock purchase.

Based upon the examples provided in Rev. Rul. 2001-46, this would give P the opportunity to make a Sec. 338(h)(10) election under the first example because P’s initial acquisition of T’s stock would not qualify as a tax-free reorganization. However, the election would not be available in the second example because the initial acquisition would constitute a tax-free reorganization under Sec. 368(a)(2)(E).  

In 2003, the Service issued Regs. Sec. 1.338(h)(10)-1(c)(2), formally acknowledging P’s ability to make a Sec. 338(h)(10) election under these circumstances. A Sec. 338(g) election is not permitted under these circumstances.

Rev. Rul. 2008-25

Rev. Rul. 2008-25 was issued on May 8, 2008, to provide further clarification of the application of the step-transaction doctrine to P’s acquisition of T’s stock followed by an immediate liquidation of T into P. However, the fact pattern provided in this ruling differs from that presented in Rev. Rul. 2001-46 in that P’s postacquisition liquidation of T does not qualify as a merger under state law. This nuance affects the application of the step-transaction doctrine because it disqualifies the integrated transaction from qualifying as a tax-free reorganization under Sec. 368(a)(1)(A).

The fact pattern presented in the ruling involves P acquiring all of T’s stock via a reverse subsidiary merger. The consideration delivered to T’s shareholders consists of 90% P stock and 10% cash. Immediately following P’s acquisition of T, P causes T to liquidate into P in a transaction that does not constitute a merger under applicable state law. While P’s acquisition of the T stock, viewed independently, would qualify as a tax-free reorganization under Sec. 368(a)(2)(E), the immediate liquidation of T into P must also be considered as part of the overall transaction for the purposes of testing the integrated transaction for qualification as a tax-free reorganization.

According to the revenue ruling, P’s acquisition of all T’s assets and liabilities does not qualify for any of the possible tax-free reorganization structures presented in Sec. 368(a). The integrated transaction cannot qualify as a type A reorganization because P did not acquire T’s assets and liabilities in a transaction qualifying as a merger under applicable state law, and the immediate liquidation of T causes the transaction to fail to meet the “substantially all” requirements of Sec. 368(a)(2)(E). The transaction cannot qualify as a B or C reorganization due to the assumption of T’s liabilities and the use of cash consideration. It also cannot qualify as a D reorganization because the control requirements for such a reorganization are not satisfied.

Conclusion

The ruling concludes that because the particular fact pattern presented does not result in a tax-free reorganization under the step-transaction doctrine, the transaction must constitute a qualified stock purchase of T followed by a tax-free liquidation of T under Sec. 332. Absent this conclusion, the application of the step-transaction doctrine would result in a deemed purchase of T’s assets. This would be in direct violation of the mandate set forth by Congress and reinforced in Rev. Rul. 90-95 that a Sec. 338 election, and not the step-transaction doctrine, is to be the exclusive avenue for achieving a deemed asset sale. Thus, a Sec. 338 election would be available to P with respect to P’s acquisition of T’s stock under the circumstances presented in the ruling.

EditorNotes:

Frank J. O’Connell Jr. is a partner in Crowe Chizek in Oak Brook, IL.

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

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or foconnell@crowechizek.com.