IRS clarifies application of the step-transaction doctrine.

• Author: Thornton, David A.

On May 8, 2008, the IRS issued Rev. Rul. 2008-25 to clarify the application of the step-transaction doctrine to situations in which an acquiring corporation (P) acquires a target corporation (T) by means of a reverse subsidiary merger followed immediately by a liquidation of T. This ruling addresses a particular fact pattern not considered in prior IRS guidance. In keeping with previously established standards for applying the step-transaction doctrine to postacquisition liquidations of T, the Service concluded that if the application of the step-transaction doctrine failed to result in a tax-free reorganization under Sec. 368(a), then the transaction would be viewed as a qualified stock purchase of T followed by a tax-flee liquidation of T under Sec. 332.

Background

Sec. 338 offers acquiring corporation P a unique election to treat a qualified purchase (i.e., a taxable purchase of at least 80% of the vote and value) of the stock of target corporation T as if P had purchased T's assets rather than T's stock. The ramifications of this election are significant in that the deemed asset purchase gives P a stepped-up basis in the acquired T assets and amortizable Sec. 197 intangibles.

However, this benefit may come at a significant cost. Under Sec. 338(g), the election is made exclusively by P and results in a corporate-level taxable gain to the newly acquired T from the deemed sale of its assets. However, since P is now T's owner, P (or the P group) will bear the tax burden on this gain. As a result, an election under Sec. 338(g) is uncommon except where T has tax attributes (such as a net operating loss or tax credit carryforwards) that can be used to offset this taxable gain.

Sec. 338(h)(10) offers e a similar election, but only if T is a subsidiary in an affiliated group of corporations or an S corporation. If made, the Sec. 338(h)(10) election treats a qualified stock purchase as a taxable asset purchase to P and a taxable asset sate to T.

Thus, if T is a corporate subsidiary of a selling affiliated group, there may be little if any additional taxable gain to the selling group from the deemed asset sale if the selling parent's basis in T stock is proximate in value to the tax basis of T's assets. For this reason, Sec. 338(h)(10) elections are more common than the Sec. 338(g) elections described above. Unlike the Sec. 338(g) election, both P and T must consent to a Sec. 338(h)(10) election.

Historically, the IRS has wrestled with the application of the step-transaction doctrine in a situation in which P acquires the outstanding T stock in a qualified stock...