Solving a problem with sec. 338 purchase-price allocations.

• Author: Daniel, Russ

The Sec. 338 purchase-price allocation rules can yield unexpected results when applied to a multitiered group of corporations with subsidiaries. These results arise as a result of the "top-down" application of the purchase-price allocation methods of Regs. Sec. 1.338-6. This item illustrates the surprising problem that can arise and suggests a solution.

Sec. 338 Election Generally

While a complete discussion of the mechanics of Sec. 338 is beyond the scope of this item, a brief summary is necessary. Generally, in a stock purchase, the corporate target maintains its historic tax basis in its assets. However, if a Sec. 338 election is made in connection with a taxable stock purchase, the transaction is treated as a hypothetical asset purchase for tax purposes, and the buyer's tax basis in the net assets of the target is revalued to reflect the purchase price. To make a Sec. 338 election, a number of statutory and regulatory limitations must be met, including:

* The buyer must be a corporation;

* The buyer must acquire at least 80% of the target within a 12-month period; and

* The target must be a corporation.

If a Sec. 338 election is made, the target is treated as if "Old Target" sold all of its assets in a single transaction to "New Target." New Target's total basis in the assets that it is deemed to purchase (adjusted grossed-up basis, or AGUB) is the sum of (1) the buyer's grossed-up basis in the recently purchased Old Target's stock; (2) the New Target's liabilities; and (3) other relevant items. This amount is the total basis to be allocated among the assets acquired.

Under Regs. Sec. 1.338-6, AGUB generally must be allocated to the following seven classes of assets, starting with Class 1; then to Class H, up to fair market value FMVs; and so on. Within any class, the AGUB is allocated to the underlying assets based on their respective FMVs. The following asset classes are listed in Regs. Sec. 1.338-6:

* Class I assets: These include cash and cash-like items such as savings and checking accounts.

* Class II assets: These include actively traded personal property such as U.S. government securities and publicly traded stock. Class II does not generally include stock of target affiliates.

* Class III assets: These include assets that the taxpayer marks to market at least yearly for federal income tax purposes and debt instruments, including accounts receivable.

* Class IV assets: These include the taxpayer's stock in trade or other...