The starting point in any discussion of Internal Revenue Code Section 338 is the case of Kimbell-Diamond Milling Co. v. Commissioner, 14 T.C. 74 (1950), 187 F.2d 718 (5th Cir. 1951), cert. denied, 342 U.S. 827 (1951). The corporate taxpayer in Kimbell-Diamond sustained a fire casualty that destroyed its mill. In its search to replace the mill property, Kimbell-Diamond found Whaley, a target corporation with a comparable mill. Kimbell-Diamond purchased 100 percent of Whaley’s stock and shortly thereafter liquidated the target, thus acquiring direct ownership of the mill. The issue before the court was the proper basis of the mill for purposes of depreciation. Kimbell-Diamond argued that it had legitimately liquidated the target, Whaley, and that the mill should have the same basis in its hands that it had in the target Whaley’s hands. The Internal Revenue Service (“IRS”) argued that since Kimbell-Diamond intended an asset acquisition of the mill, the purchase of stock and the subsequent liquidation should be collapsed into one transaction and viewed as a purchase of assets under the step transaction doctrine. The court agreed that the transaction should be viewed as an asset acquisition, resulting in Kimbell-Diamond having a cost basis in the mill instead of a substituted basis from the target, Whaley. The IRS’s success in Kimbell-Diamond was temporary. Tax attorneys quickly discovered that corporate taxpayers could receive a cost basis in assets of an acquired subsidiary simply by establishing an intent to acquire assets Consequently, Internal Revenue Code Section 338 was enacted by Congress.
Qualifying Stock Purchases (QSPs)
Internal Revenue Code Section 338 applies to stock purchases of control sufficient to meet an 80 percent ownership test required for consolidated reporting purposes. This control need not be acquired in one transaction alone, it may be acquired during a one 12-month period. The purchasing corporation must make a timely Section 338 election and, once made, the election is irrevocable. To be timely, the election must be “not later than the 15th day of the 9th month beginning after the month in which the acquisition date occurs.” See IRC Section 338(h)(1). To be timely, the election must be “not later than the 15th day of the 9th month beginning after the month in which the acquisition date occurred See IRC Section 338(g)(1). The “acquisition date” is the “first day on which there is a qualified stock purchase,” in general, the day on which the purchasing corporation’s stock acquisitions during the 12-month period first meet the 80 percent tests. See IRC Section 338(h)(2).
Section 338 only applies to qualified stock purchases. The definition of “purchase” provided in Section 338(h)(3) of the Internal Revenue Code excludes certain stock acquisitions. For example, target stock in which the purchasing corporation takes a transferred or substituted basis from the transferor is not acquired by purchase. In addition, any stock acquired from a person whose stock would be attributed to P under the attribution rules on Internal Revenue Code is not acquired by purchase.
Deemed Sale and Repurchase of Assets by Target
If the purchasing corporation makes a Section 338 election following a QSP, the target corporation will be deemed to have engaged in two significant transactions. First, under Section 338(a)(1), the target is treated as if it “sold all of its assets at the close of the acquisition date at fair market value in a single transaction.” This sale triggers recognition of gain or loss to the target and is often described as the deemed sale by “old target” (old T). Second, under Internal Revenue Code Section 338(a)(2) the target is treated as a new corporation which purchased all of the assets on the following day. This deemed repurchase of the target corporation’s assets is the transaction that effectively provides the purchaser with a cost basis in the target’s assets and is often described as the deemed repurchase by “new target.” (new T).
Step-one of the two-step process extracts a heavy price for the cost basis ultimately permitted to the purchasing corporation in the target corporation’s assets. There is no step-up basis for the purchasing corporation unless the target corporation paid tax on the previously unrealized gain or loss in the target assets. Second, notice that the deemed repurchase in step two takes place on the day after the acquisition date and the target is treated as a new corporation. With few exceptions, “new target is treated as a new corporation that is unrelated to old target.” See Treas. Reg. Section 1.338-2(d)(1). Thus, the new target no longer has any earnings and profits, net operating losses or other relevant tax attributes. The exceptions provided for in the regulations include various employee benefits, pension, annuity, profit sharing, stock bonus or options plans. See Treas. Reg. Section 1.338-2(d)(2). The new target will continue to be liable for such obligations to its employees. In addition, target will continue to be liable for old target’s federal income tax liabilities. See Treas. Reg. Section 1.338-2(d)(4)(i), (ii). By creating this new target for the deemed repurchase in step two, Congress meant to eliminate trafficking in tax attributes that might otherwise occur. For example, purchasing corporations might otherwise shop around for target corporations with net operating losses. Another consequence of having the deemed sale by the old target on day one and the deemed repurchase on the following day, is isolation of the old target’s gain or loss from the Section 338(a)(1) deemed sale. Special rules included in Section 338 provide that “the target corporation shall not be treated as a member of an affiliated group with respect to the sale.” This provision is also designed to prohibit trafficking in losses.
Mechanics of the Section 338(a)(1) Deemed Sale
The statutory language in Internal Revenue Code Section 338(a)(1) provides that “the target shall be treated as having sold all of its assets at the close of the acquisition date at fair market value in a single transaction.” According to the regulations of Section 338, an aggregate deemed sales price (“ADSP”) is used. The primary component of the ADSP is the purchasing corporation’s price for the QSP. Rather than “cost” or “price,” the regulations refer to the “grossed-up basis of the purchasing corporation’s recently purchased target stock.” See Treas. Reg. Section 1.338-3(d)(1). Grossed-up basis essentially is a surrogate for the purchasing corporation’s cost, with some adjustments as necessary for purposes of a Section 338 transaction.
The regulations use the buyer’s cost for the T stock as a surrogate for the fair market value of T’s assets. In addition, liabilities of the new target are included in the ADSP “as if the old target had sold its assets to an unrelated person of liabilities.” See Treas. Reg. Section 1.338-3(d)(3). Gain or loss from a deemed asset sale is determined on an asset-by-asset basis. Thus, the old target must allocate the overall ADSP price among its assets. The allocation method used for this purpose will be the same allocation method used for determining the basis of each asset in the purchaser’s hands. This residual method is discussed in Treasury Regulation 1.338-3(b)(2).
Although the idea behind the deemed repurchase of assets by the new target is to provide a cost basis to the purchasing corporation in the target’s assets, the mechanics of the repurchase can be a bit puzzling. Below, please find an example of a deemed repurchase of assets of target stock.
Assume, for example, that the purchasing corporation (P) acquired 10 percent of the target corporation (T) many years ago for $1,000. This 10 percent of the T stock in P’s hands is non recently purchased or old and cold stock. In a qualified stock purchase, P acquires the remaining 90 percent for $900,000. As of the acquisition date, T owns with a basis of $50,000 and a fair market value of $1 million. Whether or not P makes a Section 338 election, the T shareholders will report gain or loss on the sale of their T shares under Sections 61(a)(30) and 1001 of the Internal Revenue Code. If P does not make a Section 338 election, T will simply be a new subsidiary of P, retaining its historic basis of $50,000 in its assets. Even if P liquidates T, neither P nor T will recognize gain or loss and the target assets will have a $50,000 transferred basis in P’s hands.
On the other hand, if P makes a Section 338 election, old T will be deemed to sell all of its assets on the acquisition date for fair market value. Old T will report a gain of $950,000 on this deemed sale. On the following day, new T will be deemed to repurchase the same asset. The purchase price will be the grossed-up basis in P’s recently purchased stock plus the basis of the multiply the basis of the 90 percent recently purchased ($900,000) by a fraction of the recently purchased ($900,000) by a fraction of 90%/90% or 1. Under Internal Revenue Code Section 338(b)(4), the numerator of the fraction is 100 percent less the 10 percent old and cold stock and the denominator is the 90 percent recently purchased stock.
Changing the facts slightly, assume that P purchases 90 percent in a QSP, but that the remaining 10 percent is owned by minority shareholders. If P makes a Section 338 election, old T still is deemed to sell all of its assets as of the acquisition date. Thus, old T will still report a $950,000 gain. Since P has no non recently purchased stock, the purchased price on the deemed repurchase by new T under Section 338(b)(1) is just the grossed-up basis of the 90 percent recently purchased stock. P now will multiply its $900,000 cost basis in the recently purchased shares by a fraction of 100%/90%. Under Section 338(b)(4), the numerator is 100 percent less the non recently purchased shares. In this case, there are no such shares. The denominator is the recently purchased stock, ere 90 percent. Note that the grossed-up basis then is $1 million, the fair market value of T’s assets as of the acquisition date. Since T reported full gain on the deemed sale of its assets, and since all of P’s shares were recently acquired as part of a QSP, Section 338 permits a full step-up on the basis of T’s assets. See Corporate Taxation, Cheryl D. Block, Aspen Law & Business (1998).
Deciding Whether or Not to Make the Section 338 Election
The step-up in basis provided by a Section 338 election often comes at a heavy price. In the above example, old T was required to report a taxable gain of $950,000. Even though responsibility for this gain technically belongs to T, as a practical matter, the price to P of the overall acquisition often will increase substantially if the purchaser plans to make a Section 338 election. Given the large “toll charge” in the form of a taxable gain to T, a Section 338 election will be unwise for many taxpayers. On the other hand, if T’s assets are depreciable or included unimproved property that P plans to sell reasonably quickly, a step-up in the basis of T’s appreciated assets may be attractive to P. To decide whether such an election is sensible, the taxable gain from the deemed sale by the target must be weighed against the value to the purchasing corporation of the basis step-up. For example, it may be that the discounted present value of additional depreciation allowances provided by the higher basis will exceed the taxable gain to the target under Internal Revenue Code Section 338(a)(1). For an effort to mathematically describe the assessments involved, see Mark Kotlarsky, Stepping-Up Basis: Purchase of Stock or Purchase of Assets, 39 Tax Notes 1011 (1988).
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.