Sec. 338(h)(10) Temp. Regs. and the Step-Transaction Doctrine

The application of the step-transaction doctrine generally wreaks havoc in most corporate reorganizations. The IRS has often used the doctrine as a weapon, but the July 2003 issuance of Temp. Regs. Sec. 1.338(h)(10)-1T now allows taxpayers to turn it on and off as needed.

According to Temp. Regs. Sec. 1.338(h)(10)-1T(c)(2), the temporary regulations apply when one step in a multi-step reorganization independently qualifies as a qualified stock purchase (QSP), as defined in Sec. 338(d)(3). The parties to a reorganization can either deactivate the doctrine and treat one step as a QSP for purposes of making a Sec. 338(h)(10) election, or activate the doctrine and treat the reorganization as a single statutory merger under Sec. 368(a).

Overview

Sec. 338 allows one corporation (P) buying the stock of another (T) to elect to treat the purchase as an asset acquisition. This election allows P to obtain a stepped-up basis in Ts assets under Sec. 1012. Without the election, P would take a stepped-up basis in Ts stock, but a historical-cost basis in Ts assets. Sec. 338 creates a tax fiction of deemed events; the stock purchase is treated as Ps acquisition of Ts assets, in which P obtains a stepped-up basis.

Sec. 338 is a remnant of an old case, Kimbell-Diamond Milling Co., 14 TC 74 (1950), cert. den. The Tax Court held that Ps acquisition of Ts stock, followed by a liquidation of T into P so that P would acquire Ts assets, had to be treated as a direct purchase of Ts stock. Congress codified the decision in then-Sec. 334(b)(2), which allowed P to obtain a basis step-up in Ts assets on Ps purchase of Ts stock and immediate liquidation of T into P. In 1982, Congress repealed then-Sec. 334(b)(2) and replaced it with Sec. 338. Unlike then-Sec. 334(b)(2), which required Ts liquidation into P for P to obtain a basis step-up, P obtains a basis step-up now by making a Sec. 338 election.

The repeal of the General Utilities doctrine has made a Sec. 338 election less useful, because of the double tax imposed on both T and its shareholders. However, a Sec.  338(h)(10) election imposes only one level of taxthe stock sale is ignored for Federal income tax purposes, and Ts shareholders or selling affiliate (usually a consolidated group) incurs tax on Ts deemed asset sale. Because Ts affiliates are liable for income tax, the Sec. 338(h)(10) election must be made jointly by Ps and Ts affiliates.

Sec. 338(d)(3) (referring to Sec. 1504(a)(2)) defines a QSP in terms of P acquiring 80% or more of Ts stock. A cash purchase of all of Ts stock is a QSP, but other acquisition structures may also apply, including some multi-step reorganizations (such as a reverse triangular merger in which T merges into Ps subsidiary (S), after which P owns 100% of T). The IRS has ruled that this may qualify as a QSP; see Rev. Rul. 90-95.

Multi-step reorganizations such as a reverse subsidiary merger are often one step in a Sec. 368(a) tax-free reorganization.

Example: P Corp. owns all of the stock of a new subsidiary, S Corp. Individual X owns all of the stock of T Corp. Under a plan of reorganization, T merges into S, with T surviving. X exchanges his T stock for 80% of Ps voting stock and 20% cash in a reverse merger. After the merger, T merges upstream into P in a statutory merger. What is the proper tax treatment of this transaction?

Doctrine does not apply: When each step is analyzed independently, the reverse merger qualifies as a QSP. Without a Sec. 338 election, Ts shareholders would recognize gain, P would take a stepped-up basis in Ts stock and a historical-cost basis in Ts assets. Alternatively, a reverse subsidiary merger may qualify as B reorganization.

Doctrine applies: The structure should qualify as an E reorganization. Because the reverse merger is not recognized in the collapsed structure, the parties cannot treat it as a QSP or make a Sec. 338(h)(10) election.

The Service held in Rev. Rul. 2001-46 that the step-transaction doctrine applies in a reverse subsidiary merger; consequently, the transaction qualifies as an A reorganization. The Service also held that a Sec. 338 election was not available.

Temp. Regs. Sec. 1.338(h)(10)-1T

In July 2003, Treasury issued Temp. Regs. Sec. 1.338(h)(10)-1T, effective for stock acquisitions occurring after July 8, 2003. The regulation allows taxpayers to make a Sec. 338(h)(10) election for multi-step reorganizations, provided one of the steps independently qualifies as a QSP. Hence, taxpayers can effectively turn off the step transaction doctrine, by making the election. However, if the election is not made, the doctrine will continue to apply, under Rev. Rul. 2001-46.

For example, a stock acquisition followed by an upstream merger without a Sec. 338(h)(10) election would be treated as a tax-free reorganization under Sec. 368(a); see Temp. Regs. Sec. 1.338(h)(10)-1T(e), Example 11.

A stock acquisition followed by an upstream merger and Sec. 338(h)(10) election would be treated as a QSP; Sec. 368(a) would not apply. Thus, the tax fiction of Sec. 338 applies; the stock acquisition would be treated as a deemed asset acquisition and P would take a stepped-up basis in Ts assets. In addition, turning off the step-transaction doctrine eliminates the parties rights to rely on the doctrine for other purposes and A reorganization treatment would no longer be available; see Temp. Regs. Sec. 1.338(h)(10)-1T(e), Example 12.

The new regulation also allows a Sec. 338(h)(10) election for a stock acquisition followed by a brother-sister merger; see Temp. Regs. Sec. 1.338(h)(10)-1T(e), Example 13.

Conclusion

New Temp. Regs. Sec. 1.338(h)(10)-1T allows a Sec. 338(h)(10) election in multi-step reorganizations by effectively turning off the step-transaction doctrine, provided that one of the steps independently qualifies as a QSP under Sec. 338.

From Anthony Vernaglia, CPA, MST, Gray, Gray & Gray, LLP, Westwood, MA