Careful vetting of relative tax benefits and costs has generally been key in a private equity firm’s decision as to whether to request a section 338(h)(10) election in the acquisition of a U.S. subsidiary from a U.S. tax group. But the decision rarely offers much room for creativity. The basic analysis (which may be complicated) is whether the benefit of the step-up to the buyer exceeds the tax cost to the seller. A recent private letter rule confirms that more innovative approaches can be used to maximize the tax benefits on exit. These may be particularly attractive in situations where a private equity firm is buying a target with two businesses and anticipates exiting the businesses separately.
By way of background, when buying the stock of a U.S. target corporation from a U.S. consolidated group, one of the first issues that needs to be addressed is whether a section 338(h)(10) election will be made to step up the tax basis of the target’s assets. Traditionally, there has been an all or nothing aspect to making a section 338(h)(10) election: the election is made to step up the tax basis in all of the target’s assets when the benefit of the step-up to the buyer exceeds the tax cost to the selling consolidated group. If the tax cost to the seller exceeds the tax benefit to the buyer, a section 338(h)(10) election is not made, and the target corporation’s tax basis in its assets carries over.
The recent private letter ruling issued by the IRS (PLR 201213013) allows for a more tailored transaction. The transaction blessed by the ruling (or a variant of that structure) is likely to prove useful in cases where the tax cost of a section 338(h)(10) election is prohibitive, but it is important to the buyer that the tax basis in certain assets be increased to their fair market value. This can occur, for example, where a private equity fund is buying the stock of a target corporation that holds more than one business, and the sponsor believes that the businesses held by the target may eventually be sold to separate buyers.
What is a Section 338(h)(10) Election? A section 338(h)(10) election refers to an election under section 338(h)(10) of the federal tax code. If various conditions are met, the election allows the parties in a sale of stock of a corporation to treat the transaction for federal income tax purposes as if it had been structured as an asset sale. In effect, the parties are treated (purely for applicable tax purposes) as though (1) the buying corporation established a new corporation (“New Target”), (2) New Target purchased the assets of the target corporation (“Old Target”) and assumed its liabilities and (3) Old Target liquidated in the hands of the seller. A section 338(h)(10) election is available only where the target corporation is a member of a U.S. consolidated tax group or is treated as an S corporation for federal income tax purposes.
In the consolidated group context, the gain (or loss) in the target’s assets arising from a section 338(h)(10) election passes up to the selling consolidated group, and the tax on that gain is payable by the selling consolidated group. The selling consolidated group is generally not taxed on the deemed liquidation of the target. Thus, if a section 338(h)(10) election is made, the selling consolidated group’s tax is based on the gain inherent in the target’s assets; if no section 338(h)(10) election is made, the group’s tax is based on the gain inherent in its target stock.
Suppose, for example, the selling consolidated group has $150 of tax basis in the stock of a target corporation, the target corporation has $100 of tax basis in its assets and the stock of the target is sold for $200 to a single buying corporation. If a section 338(h)(10) election is made, the selling consolidated group would have $100 of gain. If a section 338(h)(10) is not made, the group would have $50 of gain.
What is the benefit to the buyer of a Section 338(h)(10) Election? If a section 338(h)(10) election is made, the tax basis in the target’s assets will be reset to equal their fair market value. In cases where the assets (including goodwill) of the target have appreciated, a section 338(h)(10) election will typically result in a step-up (increase) in the overall tax basis of the target’s assets. A higher tax basis can provide a variety of tax benefits. First, if an asset is later sold by the target, the higher tax basis will reduce the tax gain on the sale. Second, if an asset is depreciable (or amortizable) for tax purposes, a higher tax basis will result in greater depreciation (or amortization) deductions for tax purposes.
Continuing with the example above, if a section 338(h)(10) election is made, the buying corporation would acquire a corporation with $200 of tax basis in its assets. If a section 388(h)(10) is not made, the buying corporation would acquire a corporation with $100 of tax basis in its assets.
When will a Section 338(h)(10) Election be made? As noted above, a section 338(h)(10) election is typically made when the benefit of the election to the buyer exceeds the tax cost of the election to the selling consolidated group. The benefit to the buyer is typically driven by how much built-in gain exists in the target’s assets and how quickly (through sales, depreciation or amortization) the buyer would realize the benefits of a step-up in that tax basis. The tax cost of a section 338(h)(10) election to the selling group is typically driven by the difference between the amount of gain inherent in the target’s assets and the amount of gain inherent in the stock of the target and whether the selling group can readily shelter the gain or can otherwise be compensated for bearing the tax on any additional gain.
A More Tailored Transaction
Suppose that a target corporation (valued at $200) operates two businesses of equal value (Business A and Business B). Suppose further that the selling consolidated group has $140 of tax basis in the stock of the target corporation (with $60 of gain inherent in the target stock), that the target’s tax basis in Business A is $50 (so there is $50 of inherent gain in Business A) and the target’s tax basis in Business B is $0 (so there is $100 of inherent gain in Business B). (This basic fact pattern can arise whenever the stock of the target corporation was originally purchased by the selling consolidated group with no section 338(h)(10) election).
If a buyer purchases the stock of the target and a section 338(h)(10) election were not made, the selling consolidated group would have $60 of tax gain and, after closing, the target would continue to have $50 of inherent gain in Business A and $100 of inherent gain in Business B. In order to eliminate this built-in gain, the buyer could request that a section 338(h)(10) election be made to step up the tax basis of each business to $100. However, this would increase the selling group’s gain from $60 to $150 and the selling group would demand a higher price to compensate it for the cost of the election (i.e., the tax on $90 of additional gain). On these facts, it seems likely that the tax benefit of a section 338(h)(10) election to the buyer would be less than the tax cost of the election to the selling group and, therefore, a section 338(h)(10) election would not be made.
Suppose, however, that (1) the buyer was an LLC taxed as a partnership (rather than a corporation), (2) the buying LLC brought Business A directly (or bought the stock of a subsidiary owning Business A) for $100 and (3) the next business day, the buying LLC bought the stock of the target corporation (owning just Business B) for $100. The selling consolidated group would have $50 gain on the sale of Business A. Under the consolidated return regulations, this gain generally would increase the selling group’s tax basis in the stock of the target. As a result, the selling group would have only $10 of gain upon the subsequent sale of the stock of the target. Thus, the selling consolidated group would have $60 of gain in total (the same amount it would have recognized on a straight sale of the target stock). However, the buying LLC would receive a tax step-up in the tax basis of Business A (or the stock of the subsidiary owning Business A).
The IRS blessed this transaction in PLR 201213013 (the actual facts of the ruling are more complicated and involved an add-on acquisition by an existing portfolio company). The private letter ruling holds that the selling group will be required to recognize the gain on the sale of Business A and that the buying LLC’s step-up in Business A will not be limited under the so-called asset consistency rules (see below). The IRS required a variety of representations of the taxpayers, including that Business A would be operated by the buyer as a distinct business separate from Business B.
One of the primary issues in these transactions is whether the step-up in tax basis of the assets being sold is disallowed under the so-called “asset consistency rules.” Those rules are designed to deny a step-up in the tax basis of an asset where the gain recognized by the selling group in the transaction that gives rise to the step up reduces the group’s gain on a sale of stock of the corporation that sold the asset. While this is exactly what happened in the private letter ruling, the asset consistency rules generally apply only if there is a purchase of the target stock by a corporation, which was not the case in the private letter ruling. The structure at issue in PLR 201213013 is not new but has not been used frequently. Moreover, in certain circumstances, it may be possible to achieve similar results with somewhat simpler structuring. The favorable treatment afforded in the ruling can be expected to increase the use of these structures, either with or without a private ruling, and to provide a significant tax benefit when a target corporation operates two or more businesses and the buyer expects to dispose of the businesses separately.