Double-tax trap in a sec. 338(h) (10) transaction.

• Author: Bailine, Rick

When a corporate buyer (Buyer) purchases the stock of a target corporation (Target) from a selling consolidated group, Sec. 338(h)(10) offers the opportunity for the Buyer to obtain a step-up in basis for the assets owned by Target. In addition, there is typically only a single level of tax in the transaction.

Assume Parent is the common parent of a consolidated group that includes Target. If Parent sells 100% of the stock of Target to Buyer, it is common practice for Parent and Buyer to jointly make a Sec. 338(h)(10) election, which results in a federal income tax fiction. To wit, Parent will not be taxed on the sale of the Target stock, and instead the transaction will be viewed as if Target sold all its assets to New Target (a fictional corporation deemed to be wholly owned by Buyer) in exchange for the price paid for Target's stock plus Target's liabilities.

After the deemed asset sale, Target is treated as if it liquidated into Parent and distributed the proceeds of the deemed asset sale. If Target is solvent, this deemed liquidation is tax free to Target and Parent under Sees. 332 and 336. Target is fully taxed on the fictional sale of its assets to New Target, and no further tax liability results because Target is deemed to have liquidated tax free into Parent under Sec. 332. As a result of the Sec. 338(h)(10) election, Buyer is viewed as owning New Target, and New Target has a cost basis in the assets it is deemed to have purchased from Target.

But is it possible that a second tax will result, one that Sec. 338(h)(10) normally does not evoke? Assume that two years before Parent sold the stock of Target to Buyer, the stock of Target had been owned by Sub, another subsidiary of Parent. Assume further that Sub distributed all the stock of Target to Parent at a time when the fair market value of Target's stock was $100 and Sub's tax basis in that stock (and Target's basis in its assets) was $40.

Absent the application of Sec. 355, a deferred intercompany gain of $60 would result to Sub when Sub distributed the Target stock to Parent. That is, Sub would have distributed an asset with a value greater than the tax basis, resulting in a gain to Sub (see Sec. 311(b)). Because the distribution would have occurred within a consolidated group, Sub's $60 gain would be deferred under Regs. Sec. 1.1502-13(c). Now, two years later when Parent sells Target to Buyer for $100 and Parent consents to make the election under Sec. 338(h)(10), Target would...