Intercompany debt in a deemed asset sale election.

• Author: Anderson, Kevin D.

Most practitioners are familiar with the tax consequences of an election under Sec. 338(h)(10), which can reconcile the divergent positions of the seller and buyer

of a business because it allows the acquisition to be structured as a stock sale, yet enables the buyer to obtain a basis step-up in the acquired assets.

It is less known, however, that the regular tax consequences of making a Sec. 338(h)(10) election can be altered when debt of a parent corporation is contributed to capital immediately before a stock sale for which a Sec. 338(h)(10) election is made. This item discusses IRS guidance illustrating the impact of extinguishment of intercompany debt immediately preceding a Sec. 338(h)(10) election.

The Deemed Asset Sale Election

It is often preferable to structure the sale of a business as an asset sale rather than as a sale of stock because stock sales do not afford the purchaser a step-up in the basis of the acquired company's assets. The Code provides the parties to a transaction a valuable planning tool in Sec. 338(h)(10), which permits taxpayers to achieve the tax benefits of an asset sale while structuring the transaction in the form of a stock sale.

The seller and purchaser may jointly elect under Sec. 338(h)(10) to treat the stock sale as an asset sale if the target is (1) a member of a consolidated return group, (2) a nonconsolidated selling affiliate, or (3) an S corporation. The purchaser must acquire at least 80% of the target's stock in vote and value during a 12-month period.

An election under Sec. 338(h)(10) causes the target to be deemed to have sold its assets in a taxable transaction and then to have distributed the proceeds in a constructive liquidation, while still remaining a member of the selling consolidated group or still owned by the selling affiliate or S corporation shareholders. The sale of the target's stock will therefore be ignored for tax purposes, and the distribution of the sales proceeds will be treated as a complete liquidation of the target. The parties then allocate the purchase price for the stock, grossed up to 100% if less than 100% of the stock is sold, as well as the liabilities of the target, to the target's assets under the "residual method" the Code prescribes for an asset sale, with any residual purchase price allocated to "Class VII" assets (i.e., goodwill and going-concern value).

If the target was a member of a consolidated group, this deemed asset sale will be considered to have occurred while the target was still a member of the selling consolidated group; this allows for any gain on the deemed asset sale to be sheltered by operating losses of all members of the selling group, including the target. In most instances, the deemed asset sale is followed by a tax-free liquidation of the target into the selling parent under Secs. 332 and 337. Under Sec.332(a), a subsidiary must be solvent for the liquidation to qualify as a tax-free transaction. An important benefit from the application of Sec. 332 is that Sec.381 allows a carryover of favorable tax attributes, including net operating losses (NOLs) and tax credits.

Cancellation of an Insolvent Subsidiary's Debt

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