Double-Tax Trap in a Sec. 338(h)(10) Transaction

Editors: Mindy Tyson Cozewith, CPA, M. Tax., and Sean Fox, MPA

Corporations & Shareholders

When a corporate buyer (Buyer) purchases the stock of a target corporation (Target) from a selling consolidated group, Sec. 338(h)(10) offers the opportunity for the Buyer to obtain a step-up in basis for the assets owned by Target. In addition, there is typically only a single level of tax in the transaction.

Assume Parent is the common parent of a consolidated group that includes Target. If Parent sells 100% of the stock of Target to Buyer, it is common practice for Parent and Buyer to jointly make a Sec. 338(h)(10) election, which results in a federal income tax fiction. To wit, Parent will not be taxed on the sale of the Target stock, and instead the transaction will be viewed as if Target sold all its assets to New Target (a fictional corporation deemed to be wholly owned by Buyer) in exchange for the price paid for Target’s stock plus Target’s liabilities.

After the deemed asset sale, Target is treated as if it liquidated into Parent and distributed the proceeds of the deemed asset sale. If Target is solvent, this deemed liquidation is tax free to Target and Parent under Secs. 332 and 336. Target is fully taxed on the fictional sale of its assets to New Target, and no further tax liability results because Target is deemed to have liquidated tax free into Parent under Sec. 332. As a result of the Sec. 338(h)(10) election, Buyer is viewed as owning New Target, and New Target has a cost basis in the assets it is deemed to have purchased from Target.

But is it possible that a second tax will result, one that Sec. 338(h)(10) normally does not evoke? Assume that two years before Parent sold the stock of Target to Buyer, the stock of Target had been owned by Sub, another subsidiary of Parent. Assume further that Sub distributed all the stock of Target to Parent at a time when the fair market value of Target’s stock was $100 and Sub’s tax basis in that stock (and Target’s basis in its assets) was $40.

Absent the application of Sec. 355, a deferred intercompany gain of $60 would result to Sub when Sub distributed the Target stock to Parent. That is, Sub would have distributed an asset with a value greater than the tax basis, resulting in a gain to Sub (see Sec. 311(b)). Because the distribution would have occurred within a consolidated group, Sub’s $60 gain would be deferred under Regs. Sec. 1.1502-13(c). Now, two years later when Parent sells Target to Buyer for $100 and Parent consents to make the election under Sec. 338(h)(10), Target would be deemed to liquidate, meaning the stock of Target (the item to which the deferred gain relates) would no longer exist as an asset within the Parent consolidated group. When an asset with a deferred gain leaves the consolidated group, typically that deferred gain is triggered into income. This raises the following question: Does Target’s deemed liquidation result in an event that would trigger the $60 deferred gain to Sub under Regs. Sec. 1.1502-13(d)(1)(ii)(A)?

The answer is “yes”: Target’s deemed liquidation would cause the $60 of deferred gain to be recognized by Sub (see Regs. Sec. 1.1502-13(f)(5)(i)). In addition, Target would recognize $60 of gain on the deemed sale of its assets in the Sec. 338(h)(10) transaction ($100 sales price less $40 basis of the assets). As a result, the Parent consolidated group would now be subject to double taxation: on the recognition of the $60 deferred intercompany gain as well as on the recognition of the $60 gain on the deemed sale of Target’s assets. Thus, even though Sec. 338(h)(10) excuses Parent from the recognition of gain on the actual sale of the Target stock, it does not prevent the triggering of the deferred gain related to the prior distribution of the Target stock.

Fortunately, relief exists for this potential double tax. Parent may elect under Regs. Sec. 1.1502-13(f)(5)(ii) to treat the deemed liquidation of Target not as a tax-free liquidation under Sec. 332, but rather as a taxable liquidation under Sec. 331. Under the consolidated return investment adjustment rules in Regs. Sec. 1.1502-32, Parent’s basis in the stock of Target would increase by the $60 gain that resulted from the deemed sale by Target of its assets in the Sec. 338(h)(10) transaction. Parent’s basis in the Target stock before the deemed sale of assets would have been $100, the fair market value of that stock when Sub distributed it to Parent two years ago. The result is that Parent’s total tax basis in the stock of Target would be $160.

If Parent makes the election to treat the liquidation of Target as a taxable event under Sec. 331, then the deemed taxable liquidation will result in a loss to Parent of $60. Under Regs. Sec. 1.1502-13(f)(5)(i), the intercompany gain triggered to Sub and the loss on the liquidation of Target may be netted, leaving only the $60 gain to Target on the deemed sale of its assets to be recognized.

To avoid double taxation, it is essential that the election be made in accordance with Regs. Sec. 1.1502-13(f)(5)(ii)(E) in the year of the liquidating event, that is, the year of the sale of Target. Also worthy of note is that it is likely that the fair market value of Target may change between the time of the intercompany distribution and the time of the liquidation of Target via the Sec. 338(h)(10) transaction, which may result in an incremental tax liability or benefit.

Regs. Sec. 1.1502-13(f)(5)(ii)(C)(2) generally limits the amount of the allowable loss on the Sec. 331 liquidation to the lesser of (1) the amount of Sub’s net intercompany gain on Target’s shares or (2) the net amount of any loss that would have been taken into account if Sec. 331 actually applied to the deemed liquidation. While the regulations under Regs. Secs. 1.1502-13 and 1.1502-36 are not as clear on this point as might be preferred, the IRS National Office has verbally agreed that a loss realized via the Regs. Sec. 1.1502-13(f)(5)(ii) election to treat the deemed liquidation of Target as a liquidation under Sec. 331 will not be subject to the unified loss rule of Regs. Sec. 1.1502-36 to the extent the loss offsets a deferred gain triggered with respect to the Target stock. (See also Dubroff, et al., Federal Income Taxation of Corporations Filing Consolidated Returns, §32.07[2] (Matthew Bender 2010).)

EditorNotes

Mindy Tyson Cozewith is a director, Washington National Tax in Atlanta, and Sean Fox is a director, Washington National Tax in Washington, DC, for McGladrey & Pullen LLP.

For additional information about these items, contact Ms. Cozewith at (404) 751-9089 or mindy.cozewith@mcgladrey.com.

Unless otherwise noted, contributors are members of or associated with McGladrey & Pullen LLP.