Intercompany Debt in a Deemed Asset Sale Election

Editor: Kevin D. Anderson, CPA, J.D.

Corporations & Shareholders

Most practitioners are familiar with the tax consequences of an election under Sec. 338(h)(10), which can reconcile the divergent positions of the seller and buyer of a business because it allows the acquisition to be structured as a stock sale, yet enables the buyer to obtain a basis step-up in the acquired assets.

It is less known, however, that the regular tax consequences of making a Sec. 338(h)(10) election can be altered when debt of a parent corporation is contributed to capital immediately before a stock sale for which a Sec. 338(h)(10) election is made. This item discusses IRS guidance illustrating the impact of extinguishment of intercompany debt immediately preceding a Sec. 338(h)(10) election.

The Deemed Asset Sale Election

It is often preferable to structure the sale of a business as an asset sale rather than as a sale of stock because stock sales do not afford the purchaser a step-up in the basis of the acquired company’s assets. The Code provides the parties to a transaction a valuable planning tool in Sec. 338(h)(10), which permits taxpayers to achieve the tax benefits of an asset sale while structuring the transaction in the form of a stock sale.

The seller and purchaser may jointly elect under Sec. 338(h)(10) to treat the stock sale as an asset sale if the target is (1) a member of a consolidated return group, (2) a nonconsolidated selling affiliate, or (3) an S corporation. The purchaser must acquire at least 80% of the target’s stock in vote and value during a 12-month period.

An election under Sec. 338(h)(10) causes the target to be deemed to have sold its assets in a taxable transaction and then to have distributed the proceeds in a constructive liquidation, while still remaining a member of the selling consolidated group or still owned by the selling affiliate or S corporation shareholders. The sale of the target’s stock will therefore be ignored for tax purposes, and the distribution of the sales proceeds will be treated as a complete liquidation of the target. The parties then allocate the purchase price for the stock, grossed up to 100% if less than 100% of the stock is sold, as well as the liabilities of the target, to the target’s assets under the “residual method” the Code prescribes for an asset sale, with any residual purchase price allocated to “Class VII” assets (i.e., goodwill and going-concern value).

If the target was a member of a consolidated group, this deemed asset sale will be considered to have occurred while the target was still a member of the selling consolidated group; this allows for any gain on the deemed asset sale to be sheltered by operating losses of all members of the selling group, including the target. In most instances, the deemed asset sale is followed by a tax-free liquidation of the target into the selling parent under Secs. 332 and 337. Under Sec. 332(a), a subsidiary must be solvent for the liquidation to qualify as a tax-free transaction. An important benefit from the application of Sec. 332 is that Sec. 381 allows a carryover of favorable tax attributes, including net operating losses (NOLs) and tax credits.

Cancellation of an Insolvent Subsidiary’s Debt

In Chief Counsel Advice (CCA) 200818005, a corporation canceled debt of its insolvent subsidiary at the request of the unrelated purchaser. The cancellation preceded the stock sale, and the buyer and the seller agreed to join in a Sec. 338(h)(10) election.

The IRS recognized that the debt forgiveness had economic substance, as it was done at the request of an unrelated purchaser. Nevertheless, the IRS applied Rev. Rul. 68-602 to disregard the parent-subsidiary debt cancellation in determining whether the subsidiary was solvent, since the forgiveness occurred immediately before the deemed liquidation.

In Rev. Rul. 68-602, a wholly owned subsidiary had NOLs that its parent corporation wished to avail itself of. The subsidiary was indebted to the parent in an amount that exceeded the value of the subsidiary’s assets. The parent liquidated the subsidiary in an attempt to take advantage of Sec. 332 and receive the corresponding carryover of tax attributes with respect to the subsidiary’s assets under Sec. 381. To make the subsidiary solvent, the parent canceled the debt of the subsidiary before the liquidation.

The ruling held that the distribution of the subsidiary’s assets to the parent in complete liquidation of the subsidiary was not covered by Sec. 332 because no part of the transfer was attributable to the stock interest of the parent. Moreover, it held that a parent’s cancellation of its subsidiary’s indebtedness immediately before the subsidiary’s liquidation should be disregarded in determining whether Sec. 332 applies to the liquidation. Since the cancellation of indebtedness was disregarded, the subsidiary did not meet the requirements of Sec. 332 because it was considered insolvent.

The CCA concluded that a cancellation of indebtedness by the parent corporation immediately before the sale of the insolvent subsidiary’s stock, causing the subsidiary to become solvent, does not allow for the claim that a deemed tax-free liquidation under Sec. 332 occurs as a result of a Sec. 338(h)(10) election. The cancellation of debt was disregarded, and the liquidation of the insolvent subsidiary was not treated as a tax-free liquidation under Secs. 332 and 337.

Worthless Stock Deduction

However, the sale of a subsidiary with a corresponding Sec. 338(h)(10) election may trigger a deduction for worthlessness of stock. Under Secs. 165(a) and (g)(3), a taxpayer is allowed to claim an ordinary loss equal to its tax basis when an eligible security becomes worthless during a tax year and the loss sustained was not compensated by insurance or otherwise. Sec. 165(g)(2) includes a share of stock in a corporation in the definition of “security” for which a deduction may be allowable. Regs. Secs. 1.165-1(b) and (d) provide that, to be deductible, the loss must be (1) evidenced by a closed and completed transaction, (2) fixed by identifiable events, and (3) actually sustained during the tax year. One further requirement for ordinary loss treatment is that more than 90% of the subsidiary’s aggregate gross receipts for all tax years during which it has been in existence must be from active sources.

In determining whether stock is worthless for purposes of Sec. 165(g), its current liquidating value provides only an indication. The ultimate value of stock, and therefore its worthlessness, depends also on what value it may acquire in the future through the foreseeable operations of the business. Case law has held that stock may not be considered worthless, even when it has no liquidating value, if there is a reasonable hope and expectation that it will become valuable at some future time (see Morton, 38 B.T.A. 1270 (1938), aff’d, 112 F.2d 320 (7th Cir. 1940)). Such hope may be destroyed by events such as bankruptcy, cessation from doing business, or liquidation of the corporation. The taxpayer must therefore show both balance sheet insolvency (i.e., excess of a corporation’s liabilities over the fair market value of its assets) and a complete lack of future potential value.

The test for the worthlessness of a subsidiary under the consolidated return rules is when substantially all of the subsidiary’s assets are treated as disposed of, abandoned, or destroyed for federal income tax purposes (Regs. Sec. 1.1502-19(c)(1)(iii)(A)). Under Regs. Sec. 1.1502-80(c), a worthless stock deduction under Sec. 165 is deferred until the subsidiary is considered worthless within the meaning of Regs. Sec. 1.1502-19(c)(1)(iii)(A) or until the subsidiary ceases to be a member of the consolidated return group. A sale of a subsidiary out of a consolidated return group satisfies these requirements, as does a liquidation of the subsidiary if it does not qualify under Sec. 332.

In the context of a parent-subsidiary debt forgiveness immediately preceding a stock sale coupled with a Sec. 338(h)(10) election, the determination of worthlessness assumes that the intercompany debt was never forgiven. The above-mentioned factors would then be considered to determine solvency, including the value of all the tangible and intangible assets relative to all of the outstanding debt (e.g., intercompany as well as all other liabilities). A clear indication of a possible insolvency issue is an intercompany debt balance immediately preceding the forgiveness that exceeds the price ultimately paid by the unrelated buyer for the stock.

Election Followed by Bankruptcy

Under Regs. Sec. 1.338-1(a)(2), other rules of law apply to determine the tax consequences to the parties of a Sec. 338(h)(10) election as if an actual liquidation had occurred. For purposes of a worthless stock deduction, the deemed liquidation resulting from a Sec. 338(h)(10) election should therefore have the same tax consequences as an actual liquidation. The IRS confirmed this approach in Letter Ruling 201011003.

In this letter ruling, a parent member of a consolidated group sold its entire interest in a wholly owned LLC, which had previously elected to be classified as a corporation for federal income tax purposes, to an unrelated corporate purchaser. At the time of the sale, the subsidiary was solvent as a result of a capital contribution from the parent to extinguish the intercompany debt balance. On the next day, both parties made a Sec. 338(h)(10) election. As a condition to and immediately following the overall transaction, the selling parent and the purchaser agreed to cause the target to file a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. The expectation was that the bankruptcy would be completed in a successful and expedited fashion and that all of the equity would retain its value during the bankruptcy case.

Applying the principles of Rev. Rul. 68-602, the IRS treated the subsidiary as insolvent for purposes of qualifying as a tax-free liquidation the deemed liquidation that resulted from the Sec. 338(h)(10) election. The IRS concluded that the requirements of Sec. 165(g) and Regs. Sec. 1.1502-80(c) were satisfied and that the parent could claim a worthless stock deduction upon the subsidiary’s deemed liquidation. The deemed liquidation was treated like an actual liquidation and, therefore, seen as an identifiable event that could sustain a worthless stock deduction.

Actual Sale and Liquidation

In Letter Ruling 201103026, a parent treated certain accounts of its consolidated subsidiary as indebtedness for purposes of valuing the subsidiary’s outstanding stock. The subsidiary was indebted to the parent for amounts it borrowed. The loan was evidenced by an interest-bearing note executed between the parent and the subsidiary.

The parent decided to sell all the subsidiary’s assets, followed by a state law conversion of the subsidiary to a single-member LLC, or a disregarded entity, for federal tax purposes, and to ultimately terminate the subsidiary’s existence. The tax effects of these two transactions, an asset sale followed by a liquidation, parallel the tax effects of a stock sale coupled with a Sec. 338(h)(10) election. Following the initial sale of almost all of the subsidiary’s assets, its activities were limited to disposing of its remaining assets and winding up its business. The subsidiary’s net assets were insufficient to cover preferred stock claims.

Thus, the IRS ruled that the requirements for a worthless securities deduction under Sec. 165(g)(3) were met for the common stock. Regs. Sec. 1.1502-80(c) was taken into account, and, since all of the assets were being disposed of, the IRS allowed a worthless security deduction for the subsidiary’s common stock. The IRS specifically stated that this determination was made regardless of whether the intercompany account or a portion thereof was treated as debt or equity for tax purposes.

The ruling was consistent with the decision in Spaulding Bakeries, Inc., 27 T.C. 684 (1957), aff’d, 252 F.2d 693 (2d Cir. 1958), where a parent owned both nonvoting preferred stock and voting common stock of its subsidiary, and, at the time of the subsidiary’s liquidation, the value of the subsidiary’s assets was less than the par value (liquidating value) of the preferred stock. Accordingly, the liquidation distribution was only in respect of the nonvoting preferred stock and was therefore not a distribution in complete cancellation of all of the subsidiary’s stock as required by law. Therefore, the nonrecognition rule for subsidiary liquidations did not apply. The same result was reached in H.K. Porter Co., 87 T.C. 689 (1986), where the preferred stock had voting rights.

Debt or Equity?

In certain situations, taxpayers may attempt to argue that the intercompany obligations should have properly been classified as equity and not debt, so that the subsidiary would be considered solvent. However, this is a somewhat risky proposition. The IRS does not issue advance rulings on whether an instrument should be treated as debt or equity, since it considers the determination to be factual. (For a discussion of the debt-equity analysis, see Chiang, Di, and Hanke, “Debt or Equity Financing? Analyzing Relevant Factors,” 41 The Tax Adviser 412 (June 2010).)

Some of the factors that go into the determination include the formality of the obligation, the names given to any instrument evidencing the debt, the presence or absence of a fixed rate of interest and interest payments, the source of repayments, the debt-to-equity ratio of the subsidiary or current level of capitalization, expectations of repayment, conversion options, and other factors.

Claiming the Worthless Stock Deduction

A deduction for worthlessness of a subsidiary’s stock generates an ordinary loss equal to the selling parent’s tax basis in the subsidiary. The tax basis in the subsidiary is adjusted under the normal consolidated tax return basis adjustment rules for income through the date of sale as well as gains or losses on the deemed asset sale that precedes the deemed liquidation. The selling parent must then evaluate the deductibility of the loss under the unified loss rules (Regs. Sec. 1.1502-36).

The “toll charge” for the potential Sec. 165(g)(3) ordinary loss deduction is that the subsidiary’s deemed liquidation is not considered tax free under Secs. 332 and 337. Consequently, Sec. 381 is inapplicable, and any tax attributes, including NOLs and tax credits, that are not used to shelter gain in the deemed asset sale are permanently lost to the selling parent. The value of the subsidiary’s tax attributes should be compared with the value of the ordinary Sec. 165(g)(3) deduction to truly understand the benefit or detriment of obtaining a worthless stock deduction when making a Sec. 338(h)(10) election.

EditorNotes

Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.

For additional information about these items, contact Mr. Anderson at 301-634-0222 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.