IRC Section 338(h)(10) Election Strategies for Tax Counsel Strategies - - PowerPoint PPT Presentation

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IRC Section 338(h)(10) Election Strategies for Tax Counsel Strategies for Tax Counsel

Leveraging the Election in Structuring Acquisitions, Dispositions and Asset and Stock Transfers

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUES DAY, DECEMBER 18, 2012

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Monty W Walker Principal Walker Business Advisory Services Wichita Falls Texas Monty W. Walker, Principal, Walker Business Advisory Services, Wichita Falls, Texas S hane Kiggen, Manager, Transaction Advisory S ervices - M&A, Ernst & Young, Washington, D.C.

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Strafford Section 338(h)(10) Webinar

Tuesday December 18, 2012

Shane Kiggen

Ernst & Young h ki @ shane.kiggen@ey.com 202.327.7289

Monty Walker

Walker Business Advisory Services mwalker@walkeradvisory.com 940.322.5086

Circular 230 disclaimer

• Any US tax advice contained herein was not

Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax l i i law provisions.

• These slides are for educational purposes only

d i d d d h ld b li d and are not intended, and should not be relied upon, as accounting advice.

6

Elections under Section 338 generally g y

• Section 338 provides two elective procedures – Section 338(g) and Section 338(h)(10) –

to treat a qualifying purchase and sale of stock of an eligible target as a purchase and to treat a qualifying purchase and sale of stock of an eligible target as a purchase and sale of the assets of the target (and, in some cases the target’s subsidiaries) for Federal income (and, in some cases, state) tax purposes

• The Federal income tax consequences of, and prerequisites to, making a Section 338(g)

q , p q , g (g) election differ markedly from the Federal income tax consequences of, and prerequisites to, making a Section 338(h)(10) election:

– A Section 338(g) election can be made with respect to a qualifying acquisition of any C corporation; a Section 338(h)(10) election can be made only with respect to a qualifying acquisition of an 80% corporate ( )( ) y p q y g q p subsidiary or an S corporation – A Section 338(g) election results in both corporate and shareholder level tax; a Section 338(h)(10) election results only in corporate level tax

• The two levels of tax that attend a Section 338(g) election render it uneconomic in all but a limited set of circumstances (e.g., where

(g) ( g , the seller is foreign or the target has net operating or built‐in losses sufficient to offset corporate‐level gain on the deemed asset sale)

– A Section 338(g) election is made unilaterally by the purchasing corporation, and the purchasing corporation bears the incremental tax burden from the gain on the deemed sale of the target's assets; a Section 338(h)(10) election is made jointly by the purchasing corporation and seller, and the seller bears the incremental tax burden from the gain on the deemed sale of the target's assets incremental tax burden from the gain on the deemed sale of the target s assets

7

Section 338(g) Transaction

Purchaser Seller Actual:

Purchaser Receives Stock Seller Receives Cash

Deemed Additional Transaction:

Target Target Target moves to Purchaser

Deemed Additional Transaction: New Old

New Target receives all of Old Target Assets

Target Target

Old Target receives Cash PLUS New Target assumes liabilities

8

Impact of Section 338(g) Election p (g)

New T Old T

New Target receives all of Old Target Assets

Target Target

Old Target receives Cash PLUS New Target assumes liabilities

• Target is treated as having sold its assets for Fair Market Value
• Target’s unused and remaining tax attributes disappear

’ Sh h ld d lli S k

• Target’s Shareholders treated as selling Target Stock
• Target’s Shareholders liable for tax on gain from stock sale
• Purchaser is liable for tax on gain from deemed asset sale

Purchaser is liable for tax on gain from deemed asset sale

9

Section 338(h)(10) Transaction

Purchaser Seller

Actual:

Purchaser Receives Stock

Target Target

Seller Receives Cash

Target moves to Purchaser P h S ll

Deemed:

Purchaser Seller New Target receives all of Old Target Assets Old target liquidates into Seller New Target Old Target g g Old Target receives Cash PLUS New Target assumes liabilities into Seller

10

g

Impact of Section 338(h)(10) Election p ( )( )

Purchaser

Seller

Old target

New Target Old Target

New Target receives all of Old Target Assets Old target liquidates into Seller

• Target’s shareholder’s stock sale is disregarded

g

Old Target receives Cash PLUS New Target assumes liabilities

• Target is treated as selling assets and ceasing to exist for federal tax

purposes

• Target’s shareholders are liable for tax on gain from deemed asset sale
• Purchaser generally receives step‐up in basis on Target’s assets
• Target’s unused tax attributes carry over to selling shareholder if member
• f consolidated filing group

11

Mechanics of the Section 338(h)(10) election ( )( )

• The Section 338(h)(10) election is a joint election by the purchasing corporation (P) and the selling

consolidated group (or selling affiliate or S corporation shareholders) (S) to treat a qualifying purchase and sale of stock of an eligible target (T) as a purchase and sale of the assets of T (and, in some cases T’s b idi i ) f d l i ( d i ) subsidiaries) for Federal income (and, in some cases, state) tax purposes

• If P and S join in making a Section 338(h)(10) election for T:

– T (Old T) is treated as transferring all of its assets to an unrelated person in a taxable transaction for an amount generally equal to the consideration received for the stock plus liabilities assumed generally equal to the consideration received for the stock plus liabilities assumed – Old T recognizes gain or loss on the deemed sale of its assets while a member of the S consolidated group – Following the deemed asset sale, but while Old T is still a member of the S consolidated group, Old T is treated as transferring all of its assets (i.e., the deemed sales proceeds) to S and as ceasing to exist

• This transfer is characterized for Federal income tax purposes as if the parties had actually engaged in the transactions

deemed to occur, taking into account other transactions that actually or were deemed to occur. The principal consequences of this characterization are that, usually, the shareholders will have the tax result attendant to a liquidation of the company

Th l ti l b t f P’ ti th t ti b i d if it t d ( t l t – The regulations are unclear, but from P’s perspective, the transaction may be viewed as if it created a new (at least 80% owned) subsidiary (New T), which purchased the assets of Old T in a taxable transaction for an amount generally equal to the consideration paid for the stock plus the assumption of T’s liabilities

• The principal consequence of this characterization is that, as in any other taxable purchase, New T will take basis in its

assets equal to the purchase price, and will generally not succeed to the tax attributes of Old T

12

Requirements of a Section 338(g) and 338(h)(10) El i Elections

• Purchaser must be a corporation
• Purchaser makes a Qualified Stock Purchase “QSP”

– Purchase ‐ An actual taxable purchase must occur – 80‐80 Test – Must acquire at least 80 % of the voting stock and at least 80% of the total shares of all other classes of stock except nonvoting 80% of the total shares of all other classes of stock except nonvoting preferred stock. – 12 Month Period – All applicable shares must be acquired within a 12 month period

• Purchaser must make Election by 15 day of the 9th month following the

QSP Purchase

– Election is made by filing IRS Form 8023 Both Purchaser and Seller must jointly file Election for a Section – Both Purchaser and Seller must jointly file Election for a Section 338(h)(10)

• In a Section 338(h)(10) Election, Target must be an eligible Section

338(h)(10) Target

13

Code Section 338(h)(10) target eligibility ( )( ) g g y

• Target is a member of a “Consolidated Group”

(This is a group that does a consolidated tax filing.); or

• Target is a member of an “Affiliated Group”

Target is a member of an Affiliated Group

(This is a group that has the ability to file a consolidated return.); or );

• Target is an S‐Corporation

Treasury Reg. Section 1.338(h)(10)‐1(c)

14

Examples of when a Section 338(g) may be f l useful

• The target corporation has unused net operating losses, capital losses or

tax credit carryovers that will offset the tax liability created as a result of tax credit carryovers that will offset the tax liability created as a result of the election.

• The target corporation has depreciable assets and has had a tax liability

within the last two or three years prior to the sale of the business. The within the last two or three years prior to the sale of the business. The deemed sale of the depreciable assets may create a net operating loss that can be carried back to obtain a tax refund from a prior year.

• The target corporation has non‐depreciable built‐in loss property and has

d bl b l b h l h depreciable built‐in gain property. Subsequent to the sale, these gains and losses have the effect of canceling each other out. Additionally, the depreciable property will have a stepped up basis, which will provide a larger depreciation deduction going forward.

• The selling stockholders recognize minimal gains or a loss on the sale of

the target corporation’s stock.

15

Examples of when a Section 338(g) may be f l useful

• Because the Section 338(g) election results in the imposition of corporate‐

d h h ld l l i ( ) i ll f l l i and shareholder‐level tax, a Section 338(g) is generally useful only in two instances:

• Where the target net operating losses (NOLs) or credits that can

shelter the Federal tax caused by this election y

• Where the target is a foreign corporation

16

Examples of when a 338(h)(10) may be useful Examples of when a 338(h)(10) may be useful

• The target corporation is a member of a consolidated return group that has tax

attributes to offset the gain and any resulting tax liability from the deemed sale of assets.

• The target corporation is a member of a consolidated return group and has tax

The target corporation is a member of a consolidated return group and has tax attributes beyond what is needed to absorb any gains resulting from the deemed sale of assets.

• The target corporation is an S Corporation.
• Target has large base of assets requiring title transfer

h h h d ff l f

• Target has Contracts which are difficult to transfer
• Target has Authorizations which are difficult to transfer
• Target has Government preference status such as HUB
• Purchaser desires maximum consistency for ongoing operations
• Purchase desires maximum transparency for ownership change
• Target has long history which Purchaser would benefit by preserving
• Target has excellent insurance rates, Workers Comp Rates, State Unemployment

Rates, etc… P h i k l f l

• Purchaser is a key employee or group of employees
• Etc…

17

Qualified Stock Purchase Defined Q

• A QSP is any transaction, or series of transactions, in which P "purchases,"

within the "12‐month acquisition period," stock constituting at least 80% of the vote and 80% of the value of T. Only a narrow class of non‐voting, non‐ participating preferred stock is excluded from consideration (Section 1504(a)(4))

The 12 month acquisition period is generally the 12 month period beginning with – The 12‐month acquisition period is generally the 12‐month period beginning with the date of the first purchase of the T stock counted in determining whether a QSP has occurred – The acquisition date is the date on which the QSP occurs. In other words, it is the fi d h P hi h i d 80% hi f T b h i hi h 12 first day that P achieves the required 80% ownership of T by purchase within the 12‐ month period – All stock purchases made by members of the P group are aggregated in determining whether a QSP has occurred – Note that in order for a transaction to constitute a QSP, a corporation must purchase the stock of T

18

Purchase Defined

• To count as part of a QSP, T stock must be acquired by purchase. A purchase is

any acquisition of stock with the following exceptions: y q g p

– Carryover basis acquisition: an acquisition where the basis to P is determined, in whole

• r in part, by reference to its basis in the hands of the transferor (carryover basis) is not

a purchase (e.g., T stock acquired in a transaction subject to Section 304) – Non‐recognition transaction: an exchange to which Sections 351, 354, 355, or 356 apply, or any other acquisition described in regulations in which the transferor does not recognize the full amount of realized gain or loss (e.g., T stock acquired in a Section 351 exchange or a B reorganization) exchange or a B reorganization) – Related‐party acquisition: an acquisition from a person whose stock ownership would be attributed to P under the attribution rules of Section 318(a) (other than the option attribution rule of Section 318(a)(4))

• However, a purchase, otherwise qualifying, will not be disqualified by the related‐party rules if

the acquisition is from a corporation, at least 50% of whose stock was purchased by P

19

The Related‐Party Acquisition Rule y q

• Reg. §1.338‐3(b)(3)(ii) generally provides that for purposes of the related‐ party

acquisition rule, P is treated as related to another person if the relationship q , p p exists

– In the case of a single transaction, immediately after the purchase of T stock In the case of a series of acquisitions otherwise constituting a qualified stock – In the case of a series of acquisitions otherwise constituting a qualified stock purchase within the meaning of Section 338(d)(3), immediately after the last acquisition in such series – In the case of a series of transactions effected pursuant to an integrated plan to f ff p g p dispose of T stock, immediately after the last transaction in such series

20

Going Public ‐ Section 338(h)(10)

Public Public Parent

Subsidiary stock NewCo stock + $

Parent Underwriter

$

IPO investors

NewCo stock $ NewCo stock 51% 49%

Subsidiary NewCo Subsidiary NewCo

Transaction steps:

– Parent forms NewCo with nominal capital – Parent enters into a binding contractual agreement with Underwriter whereby Parent agrees to sell 51% of the NewCo stock to Underwriter, for resale to the public, immediately after step (3) below y Subsidiary – Parent transfers all of the Subsidiary stock to NewCo in exchange for shares of NewCo stock and cash – pursuant to the agreement executed in step 2 above, Parent sells 51% of the NewCo stock to Underwriter, which, in turn, sells the NewCo stock to the public – Parent and NewCo join in making a Section 338(h)(10) election for Subsidiary – Parent and NewCo enter into a TRA whereby NewCo agrees to annually pay to Parent 85% of the tax benefits attributable to the depreciation and amortization deductions that would have been unavailable in the conventional IPO (i e a sale of 51% of the Subsidiary stock to Underwriter for amortization deductions that would have been unavailable in the conventional IPO (i.e., a sale of 51% of the Subsidiary stock to Underwriter, for resale to the public)

See Reg. Section 1.338‐3(b)(3)(iv), example 1

21

Staged Going Public ‐ Section 338(h)(10)

Public Public Parent

Subsidiary stock NewCo stock + $

Parent Underwriter

$

IPO investors

NewCo stock $ NewCo stock 21% 79%

Subsidiary NewCo Subsidiary NewCo Subsidiary Transaction steps:

• Parent forms NewCo enters into a binding contractual agreement with Underwriter whereby Parent agrees to sell 21% of the NewCo stock to Underwriter for resale to the public,

immediately after step (3) below

• Parent transfers all of the Subsidiary stock to NewCo in exchange for shares of NewCo stock and cash
• Pursuant to the agreement executed in step 2 above Parent sells 21% of the NewCo stock to Underwriter which in turn sells the NewCo stock to the public

y y

Pursuant to the agreement executed in step 2 above, Parent sells 21% of the NewCo stock to Underwriter, which, in turn, sells the NewCo stock to the public

• Parent and NewCo join in making a Section 338(h)(10) election for Subsidiary
• within 24 months of step (4), Parent undertakes one or more additional public offerings of NewCo stock to reduce its ownership below 50%. If the offerings do not occur as

planned, Parent, in accordance with a plan of disposition, reduces its ownership of NewCo to less than 50% through one or more alternative transactions

• Parent and NewCo enter into a TRA whereby NewCo agrees to annually pay to Parent 85% of the tax benefits attributable to the depreciation and amortization deductions that

would have been unavailable in the conventional IPO (i.e., a sale of 51% of the Subsidiary stock to Underwriter, for resale to the public)

• NewCo with nominal capital

See PLRs 200427011, 201228011

22

Section 197 Anti‐churning Rules g

• In general, the Section 197 anti‐churning rules preclude amortization of intangibles if:
• Acquired from a related party or from an unrelated party when the user of the intangible asset does

not substantially change

• The intangible was held by the taxpayer or the seller at any time from July 25, 1991 to

August 10, 1993

• The intangible was not the type of asset that would have been depreciable or amortizable under

pre‐Section 197 law

• Section 197(f)(9) defines relatedness by reference to Sections 267(b) and 707(b), but lowers

the ownership threshold from 50% to 20%. The persons are related if the relationship exists either immediately before or immediately after the acquisition of the intangible I th f i f l t d t ti ( i f t ti th t i

• In the case of a series of related transactions (or a series of transactions that comprise a

QSP), the time for testing the relationship between the buyer and the seller is “immediately before the earliest such transaction or immediately after the last such transaction.” Reg. §1.197‐2(h)(6)(ii)(B)

• If buyer is a newly formed corporation, the momentary relationship does not cause the anti‐

churning rules to apply

• However, if the buyer is an existing corporation, the anti‐churning rules apply since immediately

before the transaction, the seller is related to the buyer

23

QSP: Sell the Seller to satisfy related party acquisition rule

$ (4)

Public Public Parent

FMV=700 Wanted Subsidiary stock

Parent

(3) NewCo stock

Acquiring

Parent stock Wanted Unwanted FMV=100 =30 FMV=700 = 200

NewCo

Wanted Unwanted Subsidiary

NewCo

Transaction steps:

Subsidiary Subsidiary

Subsidiary

Wanted Subsidiary

• Parent forms a new corporation, NewCo, with nominal capital
• Parent transfers all of the Wanted subsidiary stock to NewCo in a transaction that does not qualify for non‐recognition treatment
• Parent distributes its entire interest in the NewCo stock to Public
• Public sells Parent to Acquiring for cash
• Parent and NewCo join in making a Section 338(h)(10) election for Wanted subsidiary
• Parent and NewCo join in making a Section 338(h)(10) election for Wanted subsidiary

See PLRs 201126003, 201145007, 201203004 24

Bifurcated acquisition of standalone Target with NOL g

A

$70

A

FMV=100 =70 $30 $30 (2)

A Acquiring

(3)

Target

=0 L

Acquiring

(1)

Target

FMV=70 =70 Target Stock

Target

Ls=0 NOL=30 PP&E

Target

Transaction steps:

• Target sells Property, Plant and Equipment to Acquiring for its value of $30. Acquiring will use the PP&E in its business and thus has

no plan or intention to transfer the PP&E to Target

• Target distributes the $30 proceeds to A in redemption of 30% of A’s Target stock

ll k f l f $

• A sells its remaining Target stock to Acquiring for its value of $70, recognizing no gain

25

The Consistency Rules of Section 338 y

• When Congress enacted Section 338 in 1982, it included “consistency rules”

designed to curb selectivity in the treatment of corporate acquisitions – that is, h i i i f i d h i i i f k ( “bif d the acquisition of certain T assets and the acquisition of T stock (a “bifurcated acquisition”)

• Currently, the regulations implementing the consistency rules prevent P from

b i i d b i f h d f T h

• btaining a stepped‐up basis for assets purchased from T where

– P subsequently acquires T in a QSP without a Section 338 election – The gain from the sale of T’s assets is essentially not taxed at the corporate level

• Where T is a domestic corporation, the consistency rules generally apply if T is a

subsidiary member of a consolidated group, and during the 12‐month period preceding the QSP, P acquires assets from T (or a lower‐tier affiliate of T) at a gain, and the gain is reflected in S’s basis in the T stock under Reg. §1.1502‐32, thereby reducing the S group’s gain from the sale of the T stock

26

Structuring Around the Consistency Rules g y

• A stock purchase with a Section 338(h)(10) election is treated as an asset

purchase So the consistency rules may apply if the P group acquires the

• purchase. So, the consistency rules may apply if the P group acquires the

stock of a higher‐tier corporation and does not make a Section 338 election

This is because the gain from the Section 338(h)(10) election will “tier up” and – This is because the gain from the Section 338(h)(10) election will tier up and generally will reduce the gain on the sale of the stock of the higher‐tier member

• The consistency rules apply only in the case of a QSP, which requires a

stock purchase by a corporation Where P wishes to structure a stock purchase by a corporation. Where P wishes to structure a bifurcated acquisition, the consistency rules can be avoided in certain circumstances by having a partnership first purchase selected T’s assets and then purchase T’s stock and then purchase T s stock

27

Bifurcated acquisition: Avoiding the consistency rules

Fund MGMT

rules

Buyer stock Fund MGMT

(1) (1)

FMV=100 =70

(3)

Seller

$30

Buyer LLC Target =70 =0 Ls 0 Buyer LLC

(2) $30 Transaction steps:

Ls=0

Business A assets

Buyer

• Fund and Buyer management form LLC, a limited liability company that is classified as a partnership for Federal income tax purposes, and

transfer to LLC all of the stock of Buyer

• LLC purchases from Target the assets of Business A for their value of $30
• Target distributes the proceeds from the sale of the Business A assets to Seller

See PLR 201213013 28

Bifurcated acquisition: Avoiding the consistency rules (continued) ( )

Fund MGMT Fund MGMT LLC

(5) Buyer Stock

Fund FMV=70 =70 Buyer Seller

(4) $70

Target LLC Target Target

Target Stock

Buyer Buyer

Transaction steps:

• The following day, LLC purchases all of the stock of Target for its value of $70
• LLC transfers all of the stock of Buyer to Target in a transaction qualifying as a reverse acquisition within the meaning of
• LLC transfers all of the stock of Buyer to Target in a transaction qualifying as a reverse acquisition within the meaning of
• Reg. §1.1502‐75(d)(3). Thus, the Buyer group continues with Target as the common parent of the Buyer group

29