Unwanted Assets in a Stock Sale

In any sale of a subsidiary's stock by a parent corporation, there may be subsidiary assets that the parent would like to retain, as well as assets that a purchaser may not want to acquire. Such assets could include contracts vital to the parent's business, machinery nearing the end of its useful life or other assets not essential to the subsidiary's business. In planning for such assets, three principal alternatives would permit a parent to retain certain assets not wanted by a purchaser while minimizing tax liabilities. The first two relate to the distribution of assets with built-in gain before a sale of a subsidiary's stock in which the subsidiary joins in the filing of a consolidated return with the parent. The third planning technique involves a sale of loss assets by the subsidiary to its parent, when the subsidiary is entitled to claim a loss.

First Strategy

Generally, when a corporation distributes an appreciated asset to a shareholder, the corporation recognizes gain under Sec. 311(b). However, for corporations filing a consolidated return, application of the investment adjustment rules of Regs. Sec. 1.1502-32 may produce a different result.

Example: P, a parent, has a $40 basis in the stock of a subsidiary, T. The stock has a fair market value (FMV) of $100. A sale of T's stock would result in a gain of $60 to P. If T owns an asset with a zero basis and a $40 FMV that a purchaser, A, does not want to acquire, T could distribute the asset to P prior to a sale of T stock without incurring any additional tax liability. Specifically, T would distribute the asset to P and recognize a $40 gain (under Sec. 311(b)), which would be deferred under Regs. Sec. 1.1502-13(c)(1). P would be treated as receiving a dividend equal to the asset's FMV ($40). This dividend would be included in P's income under Regs. Sec. 1.1502-13(f)(2)(ii), and P's basis in its T stock would be reduced to $60 ($100 – $40) on receipt of the distribution (Regs. Sec. 1.1502-32(b)(2)(iv)). The subsequent sale of T stock to A would trigger a deferred intercompany gain, with $40 of gain being recognized by T while T is a member of P's consolidated group and P's basis in its T stock would increase by the $40 gain recognized (Regs. Sec. 1.1502-13(d)).

As a result of these transactions, P's basis in its T stock would still be $40 ($40 beginning basis, less $40 dividend, plus $40 gain), but T's stock would be worth only $60 ($100 beginning basis less $40 from the unwanted asset); P's gain on the sale of T stock would be $20 ($60 – $40). This $20 gain (coupled with the $40 gain recognition from the unwanted asset) would result in the same amount of gain recognition to the P group that would result from a sale of the T stock without a distribution of the unwanted asset. Although the dividend may have state tax consequences, for Federal tax purposes, P now holds the unwanted asset at its FMV and may be able to claim depreciation deductions on the stepped-up amount or dispose of it at no gain. Further, depending on the relevant facts, consideration should be given to the possibility of leasing the asset to A (if A wants to use, but not own, the asset) or to another party.

 

Second Strategy

A subsidiary may be able to avoid recognition of gain or loss on the distribution of an unwanted asset by "bootstrapping" the distribution onto a deemed Sec. 332 liquidation and making a Sec. 338(h)(10) election; see Letter Rulings 8821047, 9137040 and 9303006.

In general, when a purchasing corporation makes a qualified stock purchase of a subsidiary's stock from a member of a consolidated group, it is treated as a deemed sale of the subsidiary's assets if a Sec. 338(h)(10) election is made. On a distribution of the unwanted asset, the selling consolidated group first must explicitly adopt a plan of complete liquidation for the subsidiary before the asset distribution. Next, the subsidiary distributes the unwanted asset to its parent under the plan of liquidation; the parent sells the subsidiary stock to a purchaser and the parties jointly make a Sec. 338(h)(10) election for the sale. As a result of the election, the subsidiary is deemed to sell all its assets to a "new subsidiary" owned by the purchaser in exchange for the consideration paid by the purchaser. The subsidiary completes its liquidation into the parent, which is generally tax-free under Sec. 332.

The new subsidiary takes an FMV basis in the subsidiary's assets; by contrast, under the first alternative, the purchaser has a carryover basis in the subsidiary's assets. The parent takes a carryover basis in the subsidiary's unwanted asset; by contrast, under the first alternative, the parent takes an FMV basis in the subsidiary's unwanted asset. Further, because of the Sec. 338(h)(10) election, there generally should not be a dividend distribution for state tax purposes (provided that Sec. 338(h)(10) applies under the applicable state tax law). Importantly, without a plan of complete liquidation, the parent will not be able to "bootstrap" successfully onto a deemed Sec. 332 liquidation. As a result, the subsidiary will inherit the gain or loss, although the gain will continue to be deferred under the consolidated return rules.

Third Strategy

The final strategy should be considered in a stock sale when the basis of the unwanted asset exceeds its FMV (i.e., a loss asset). This strategy is described in detail in Turner Broadcasting, 111 TC 315 (1998), in which the taxpayer acquired the stock of MGM in a reverse subsidiary merger, and MGM sold the stock of its wholly owned subsidiary, United Artists, back to the former MGM shareholders at a loss.

The court refused to reorder the steps of the transaction to treat MGM as distributing the United Artists stock to its shareholders, even though the merger and sales agreements were negotiated and entered into simultaneously. Instead, the loss was allowed and the court held that Sec. 311(a) did not apply. If MGM had distributed the loss asset before the sale, the loss would be disallowed under Sec. 311(a). Turner Broadcasting demonstrates how a subsidiary can claim a loss (possibly subject to Sec. 382 limits) from an unwanted loss asset when a purchaser acquires the subsidiary's stock, and the loss asset is subsequently sold back to the parent. The subsidiary reports this loss, not the parent.

In summary, with careful tax planning, an unwanted asset can be excluded from a stock sale transaction without incurring any additional tax liability. Further, such planning may lead to the realization of a tax benefit, such as increased basis in the unwanted asset or the ability to claim a loss on a depreciated asset.

From Lara C. Recknagel, J.D., LL.M., Washington, DC