Sec. 338(h) (10) Temp. Regs. and the step-transaction doctrine.

• Author: Koppel, Michael D.

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 T's assets under Sec. 1012. Without the election, P would take a stepped-up basis in T's stock, but a historical-cost basis in T's assets. Sec. 338 creates a "tax fiction" of deemed events; the stock purchase is treated as P's acquisition of T's 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 P's acquisition of T's stock, followed by a liquidation of T into P so that P would acquire T's assets, had to be treated as a direct purchase of T's stock. Congress codified the decision in then-See. 334(b)(2), which allowed P to obtain a basis step-up in T's assets on P's purchase of T's stock and immediate liquidation of T into P. In 1982, Congress repealed then-See. 334(b)(2) and replaced it with Sec. 338. Unlike then-See. 334(b)(2), which required T's 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 tax--the stock sale is ignored for Federal income tax purposes, and T's shareholders or selling affiliate (usually a consolidated group) incurs tax on T's deemed asset sale. Because T's affiliates are liable for income tax, the Sec. 338(h)(10) election must be made jointly by P's and T's affiliates.

Sec. 338(d)(3) (referring to Sec. 1504(a)(2))...