Structuring minority interest acquisitions with a step-up in basis: sec. 1239 and beyond.

• Author: Gruidl, Nick

In many private-equity M&A transactions, the private-equity firm invests in a noncontrolling interest in the target entity (T). Where the private-equity investment funds payments to pretransaction shareholders, the shareholders generally realize gain upon receipt of these payments. In addition, if structured properly, the transaction often provides a step-up in asset basis to either T or the private-equity firm that provides tax benefits in the form of future tax deductions. However, the failure to properly structure a transaction can result in ordinary income, as opposed to capital gain, to the pretransaction T shareholders due to the related-party traps of Secs. 1239 and 707. The recent decision in Fish, T.C. Memo. 2013-270, is a reminder of these traps and the importance of properly structuring a minority investment.

Background

Sec. 1239(a) provides that "in the case of a sale or exchange of property, directly or indirectly, between related persons, any gain recognized to the transferor shall be treated as ordinary income if such property is, in the hands of the transferee, of a character that is subject to the allowance for depreciation provided in section 167." Under Sec. 197(f)(7), any amortizable Sec. 197 intangible is subject to the allowance under Sec. 167. Furthermore, according to Regs. Sec. 1.197-2(g)(8), "an amortizable section 197 intangible is section 1245 property and section 1239 applies to any gain recognized upon its sale or exchange between related persons (as defined in section 1239(b))." Therefore, Sec. 1239 applies to the sale of intangibles, whether or not amortizable in the hands of the transferor before the sale (e.g., self-created intangibles and goodwill).

Sec. 1239(b)(1) defines a related party as a person and all entities controlled by that person. The Sec. 1239(c)(1) definition of controlled entities looks to a greater-than-50%-value test for corporations and a greater-than-50%-capital-or-profits-interest test for partnerships and includes any entity related to the person under Sec. 267(b)(3), (10), (11), or (12). In addition, Sec. 1239(c)(2) applies the Sec. 267(c) constructive-ownership rules. Similarly, for partnerships, Sec. 707(b) (2) treats gains recognized on the sale of property that would otherwise be considered capital under Sec. 1221 as ordinary if the sale occurs between related partnerships or a partnership and a related person. Like Sec. 1239, Sec. 707(b) applies a greater-than-50 % -capital-or-profits-interest test.

Fish

The facts surrounding the transaction in Fish mirror those of many noncontrolling acquisitions of an S corporation. Due to the single level of taxation on S corporations, a private-equity firm or strategic acquirer is...