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Resurrecting transactions to qualify under secs. 338 and 338(h)(10).

Although it is readily apparent that a long-standing, significant stock interest in a target corporation precludes a subsequent Sec. 338 transaction, it is less well known that a Sec. 338(h)(10) transaction is also precluded, even if the stock interest was recently acquired. There is, however, a way to substantively negate the prior ownership and permit free use of Sec. 338, with or without a concomitant Sec. 338(h)(10) election.

Example: Corporate Buyer (B) acquired 25% of the only class of outstanding Target (T) common stock from corporate Seller (S) for cash three years ago. The other 75% of T stock continues to be owned by S. B acquired its stock in T as an investment, but now would like to obtain all of T's assets and business operations. From a tax point of view, S is amiable and is willing to sell its T stock or to cause T assets to be sold. From an economic point of view, however, the transaction must be structured as a stock acquisition, because T has valuable nonassignable licenses, leases and contracts.

If B were to purchase the remaining 75% of the T stock from S, a Sec. 338 election f or T would not be possible. A Sec. 338 election requires a "qualified stock purchase," which in general means an acquisition of 80% of the stock of T by "purchase" within a 12-month period (Sec. 338(d)(3)).

If B's acquisition of its 25% interest in T occurred three months ago, rather than three years ago, B could acquire the remaining 75% stock interest and make a Sec. 338 election. The combined two-step purchase within a 12-month period would satisfy the qualified stock purchase requirement.

This approach will, however, result in dual tax, once to S on the sale of its 75% stock interest in T, and once to T on the deemed sale of its assets pursuant to the Sec. 338 election. To avoid the dual tax associated with a straight Sec. 338 election, the parties would like to make a Sec. 338(h)(10) election. The effect of that election would be to cause the stock acquisition to be disregarded and the transaction treated as if there had been a deemed sale of T assets to New T (owned by B) (Regs. Sec. 1.338(h)(10)-1(e)(1)).

This seems to solve the dual tax problem, but the prior ownership interest may still be a concern. An election under Sec. 338(h)(10) is deemed to take place on the "acquisition date," i.e., the day that 80% of the stock is acquired. On that date, S and T must either file a consolidated return together or be affiliated (Regs. Sec. 1.338(h)(10)-i(c)(3) and 14)). In either case, on the acquisition date, S must own 80% of the vote and 80% of the value of the T stock. Thus, the acquisition by S of 80% of the stock of T in two transactions (each of which exceeds 20%) will preclude Sec. 338(h)(10) treatment. Consequently, B's acquisition of 25% of the stock of T prevents a Sec. 338(h)(10) election, even though the remaining stock of T was acquired within 12 months in a qualified stock purchase.

To cure this problem, what is needed is a meaningful elimination or reduction of B's existing stock interest in T so that B can then acquire, from S, T stock having 80% of the vote and value. The immediate and obvious answer - a redemption of B's T stock by T - is also the wrong answer; see Regs. Sec. 1.33821b)15)(iii) and (iv), Example 5. B is also precluded from "selling" its 25% stock interest to S (only to reacquire 80% of the T stock from S) or "selling" T stock to an agent, only to reacquire that stock as part of a later 80% purchase. (Although a "purge sale" to a third party within the meaning of Rev. Rul. 72-354 theoretically would provide authority for a reacquisition of the purged shares as part of an acquisition of the stock held by S, finding a genuine purchaser in a nonpublic context would be exceedingly difficult.)

There may still be a way to resolve these problems. If B were to exchange with T its 25% stock interest in T for a new class of nonvoting preferred T stock of equal value, the new preferred T stock would be excluded as stock under the definition in Sec. 1504(a)(4). As a result, the remaining T stock held by S would represent I 00 % of the vote and value of T. Thus, B would be able to acquire from S the requisite percentage of T stock to qualify the transaction as a qualified stock purchase and to permit elections under both Sec. 338 and 338(h)(10). Because the exchange of B's common stock for nonvoting preferred stock would be a tax-free recapitalization under Sec. 368(a)(1)(e), it would be tax free to B and T.

The recapitalization is a permanent realignment of T's capital structure, and would be respected as a separate economic event. The IRS has long permitted a corporate party to undertake a recapitalization as a prelude to achieving favorable tax treatment on an immediately succeeding event; see, e.g., Rev. Ruls. 56-117, 69-407 and 76-223. As long as the preferred stock remains outstanding (and could be disposed of without a disposition of the T common stock), it is immaterial that B may hold all of T's stock.

The fact that the sequence of the steps could have been reversed (B first acquiring the T common stock from S (not a qualified stock purchase) and then participating in a recapitalization exchanging its historic common stock for new preferred stock) is also immaterial. When two steps are undertaken in proper sequence, the Service usually refrains from reordering the steps to achieve an adverse taxpayer result; see Esmark, Inc., 90 TC 171 (1988), aff'd without published opinion, 886 F2d 1318 (7th Cir. 1989), and Rev. Ruls. 84-11, 78-330, 73-246 and 70-18.

Frequently, tax planners will abandon consideration of a stock purchase followed by Sec. 338/338(h)(10) elections on the grounds that no "qualified stock purchase" is possible. Sometimes that will be true, but sometimes the problem can be solved.
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Author:Bloom, Gilbert D.
Publication:The Tax Adviser
Date:Jun 1, 1995
Previous Article:Incorporations and reorganizations involving qualified small business stock.
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