Acquisition Planning for a Tax Basis Step-Up
It is well established that a properly structured transaction may result in significant benefits for the acquirer of an interest in a trade or business, and that such benefits may additionally serve to benefit a target’s seller.1 One significant tax benefit that results from certain acquisitions is a tax basis step-up. Although an acquisition of corporate stock generally does not result in a tax basis step-up, an asset purchase can result in a tax basis step-up. Tax law provides the purchaser with a variety of methods to obtain a tax basis step-up in the target’s underlying assets. This article discusses various tax forms that enable a purchaser to obtain a tax basis step-up. If one method of obtaining a tax basis step-up is precluded by the facts of a deal, another method may nonetheless be available. Thus, familiarity with the acquisition forms that enable a tax basis step-up is an essential aspect of acquisition planning. The article assumes that the purchaser is buying a target’s interests directly from seller in a cross-purchase (rather than, say, acquiring such interests directly from the target pursuant to an equity issuance).
The Benefits of a Tax Basis Step-Up
Where available, the tax basis step-up is a significant benefit sought by tax savvy acquirers. Generally, with respect to the tax basis of the target’s underlying assets, a purchase results in one of two situations: a) The tax basis is carried over from before the target’s acquisition; or b) the tax basis in the target’s underlying assets is adjusted to reflect the purchase price (when the purchase price exceeds the historical tax basis, this results in a tax basis step-up — this fact pattern is assumed for the course of the discussion). Depreciation and amortization deductions are only available to the extent of an asset’s adjusted tax basis,2 and any step-up in an asset’s tax basis results in additional depreciation or amortization deductions going forward. Furthermore, the subsequent sale of an asset that has been stepped-up will result in less taxable gain.3
Indeed, a purchaser may realize significant economic benefit as a result of a tax basis step-up, and a seller may in turn have additional leverage in negotiating the purchase price or other terms of a transaction. Given this, tax planning for an acquisition should be sensitive to whether such transaction will result in a tax basis step-up, as well as alternative techniques available in order to obtain such step-up.
Stock Acquisitions and Asset Acquisitions
While a purchaser is generally incentivized to engage in an asset acquisition in order to avoid acquiring unwanted liabilities of a target, as well as to obtain a tax basis step-up,4 a seller is typically incentivized to engage in a stock sale. From a liability perspective, a stock sale results in the seller being able to have “clean hands” with respect to the target, as generally all of the liabilities within a target would be transferred to the purchaser.5 Additionally, if a target is taxed as a C corporation, the sale of the target’s assets results in taxable gain at the corporate level, and potentially again upon the distribution of sale proceeds to the corporation’s shareholders as a dividend6 (whereas the sale of a target stock would result in only one layer of taxation). As a result, the purchaser and seller often have adverse interests when choosing between a stock and asset purchase. Fortunately, tax law provides for alternative planning techniques that result in a stepped-up tax basis for the purchaser, with decreased disincentives to the seller. As the below discussion indicates, the tax law is nuanced; as such, counsel is well-advised to pay close attention to the various forms available to obtain a tax basis step-up.
Acquisition of Interests in a Single-Member LLC
Absent an election to the contrary, a single-member limited liability company (LLC) is disregarded for federal income tax purposes.7 Accordingly, the purchase of all of the interests in a disregarded single-member LLC is treated as the purchase of the LLC’s underlying assets. Therefore, if the target is a single member LLC, the purchaser’s acquisition of all of the target’s interests will result in the purchaser obtaining cost-basis in the target’s assets.
The purchase of less than all of the outstanding membership interests of a single-member LLC is addressed in Situation 1 of Revenue Ruling 99-5.8 In this fact pattern, a purchaser buys membership interests in an LLC directly from its single member in exchange for cash consideration. The purchase is treated as if the single member sold a proportionate interest in each of the underlying assets held by the LLC, which are, immediately thereafter, contributed by each of the purchaser and seller to the LLC in exchange for interests in the LLC. As a result, a tax basis step-up results with respect to those assets treated as acquired directly by the purchaser.
Acquisition of Interests in an Entity Taxed as a Partnership
The purchase of all of the outstanding interests in an entity taxed as a partnership is addressed in Situation 2 of Revenue Ruling 99-6.9 The Revenue Ruling provides that when all of the outstanding interests in a partnership are sold to a single purchaser, the partnership is deemed to distribute its assets to each of the sellers in liquidation, and the purchaser is deemed to acquire, directly from the sellers, all of the former partnership’s assets. Thus, should the purchase price exceed the basis in the assets of the target, the purchaser will obtain a step-up in the target’s assets.
The acquisition of some, but not all, of the interests in an entity taxed as a partnership is treated differently. A foundational principle of partnership tax provides that a partnership may, in certain instances, be treated as an aggregate of separate partners’ interests (under what is known as the aggregate approach), or as a single entity (under what is known as the entity approach).10 With respect to the purchase of interests in a partnership, generally, the partnership is treated as an entity, and, thus, the underlying basis of the respective assets of the partnership is not stepped up to reflect its purchase price.11 On the other hand, if a partnership has a §754 election in place, an acquisition of interests in such partnership results in an adjustment in the basis of the underlying assets of the partnership, thus, resulting in the acquiring partner’s proportionate interests in the partnership’s assets being stepped-up to reflect the acquired interest’s purchase price.12
Provided that a §754 election is in place,13 the purchaser’s basis in the partnership’s underlying property will be stepped up as if such assets were sold for fair market value.14 Note that the adjustment affects only the purchaser, who will have a special basis for partnership property, as compared to the common basis of the partnership’s property.15 Accordingly, for tax purposes, the benefits generally inure to the purchaser exclusively, while the administrative costs of tracking the special basis in such partnership property is, absent an agreement otherwise, paid by the partnership itself. Because of this disparity in benefits and costs, the seller (or the partnership) may consider monetizing a portion of the value in the §754 election to the purchaser.16
The impact of §754 (and the related §743(b) adjustment) is primarily to the timing and character of income to the purchaser, but generally, will not impact the cumulative taxable income amount. This is because, were the purchaser’s initial basis determined pursuant to §743(a), subsequent income allocated to the purchaser would increase the purchaser’s basis in the partnership, and thus, upon eventual termination of the purchaser’s interests in the partnership, the purchaser should be eligible for a loss equal to the difference between his outside and inside basis.17
Acquisition of Shares in a Corporation
Absent additional transaction planning, the acquisition of shares in a corporation only results in a stepped-up basis in the underlying assets if either an election under §338 or an election under §336(e) is made.
Corporate Purchaser Required
• Section 338(g) Election — Generally, a §338(g) election is only advisable to a purchaser if a target has significant net operating losses or if a target is a foreign corporation. The election requires what the statute refers to as a “qualified stock purchase” — in short, the acquisition of 80 percent by voting power and value of a C corporation’s stock in a 12-month period.18 A §338(g) election is only available if the acquiring entity is taxed as a corporation.19 An election under §338(g) is treated as a deemed sale of assets by the target corporation to a new target corporation, along with the actual sale of the corporate stock by the shareholders of the corporation.20
Section 338(g) does not directly impact the tax liabilities of the seller, as the deemed asset sale is treated as if it occurred subsequent to the sale of stock by the seller (thus resulting in potential gain recognition on the sale of stock to the seller and on the deemed asset sale to the target, whose tax liabilities are inherited by the purchaser).21 Therefore, generally, the §338(g) election is only desirable to the purchaser if the tax cost of the deemed asset sale is less than the present value of the step-up.22 Examples of instances in which the tax cost of such a transaction may be mitigated include when the target has significant net-operating losses (which otherwise would not survive such election23), or with respect to the acquisition of a foreign target corporation.24 Note that neither net operating losses of the seller, nor of the purchaser (to the extent either are otherwise available) are available to offset gain to the target.25
• Section 338(h)(10) Election —A §338(h)(10) election is a common election made to step-up the interests in an eligible target which is taxed as either a C corporation or S corporation. A §338(h)(10) election is treated as a deemed sale of the assets of the underlying corporation, followed by a deemed liquidation of the corporation.26 As with an election under §338(g), an election under §338(h)(10) requires that at least 80 percent by vote and value of target be acquired.27 Additionally, as with respect to a transaction subject to a §338(g) election, an election under §338(h)(10) requires a corporate acquirer.28 Unlike with respect to an election under §338(g), an election under §338(h)(10) requires that the target be domestic and either an S corporation or a C corporation whose interests are held at least 80 percent by vote and value by another corporation.29
Note that, whereas the §338(g) election is made unilaterally (by the purchaser), the §338(h)(10) election requires consent of both the purchaser and seller.30 This is because, unlike a transaction with an election made pursuant to §338(g), one made under §338(h)(10) results in any tax liabilities of the deemed asset sale being incurred by the target prior to its disposition by seller.31 With respect to the sale of stock in an S corporation, all shareholders of the target must consent; selling shareholders not disposing of their shares in the target should be aware that they may nonetheless be allocated gain as a result of the deemed asset sale of all of the target’s underlying assets.32 Such tax costs may be avoided by engaging in alternative transaction structuring.
Corporate Purchaser Not Required for §336(e) Election
The §336(e)33 regulations issued in 2013 do not require that a purchaser be taxed as a C corporation or S corporation. Purchases subject to an election under §336(e) are treated as if the assets held by the old target are sold to an unrelated person, the old target is liquidated, and assets are acquired from the unrelated person by a new target.34
An election under §336(e) has similar requirements to an election under §338.35 Whereas §338 requires that only a single purchasing corporation acquire the stock of a target, §336(e) permits the aggregation of all stock of a target transferred to different acquirers.36 As with a §338 election, a §336(e) election requires that the transaction occur over no more than a 12-month period, which begins on the date of the first sale, exchange, or distribution of stock included in a qualified stock disposition.37 An election under §336(e) requires that both the seller and the target be domestic corporations.38
The tax costs of a transaction pursuant to §336(a) are borne by the old target (while held by the seller).39 Nonetheless, the election under §336(e) is made jointly by the sellers and target.40 The purchaser does not make the §336(e) election, and the preamble to the §336(e) Regulations notes that “purchasers should be able to protect their interests in any purchase contract.”41 Thus, it is advised that representations and warranties with respect to whether a §336(e) election has been made be included within purchase documents with respect to property potentially eligible for a §336(e) election.42
A purchaser and seller are constrained by the facts of the deal, and other concerns motivate transaction structuring aside for the purchaser’s desire to obtain a tax basis step-up. Moreover, the transaction forms discussed above implicate additional tax considerations outside the scope of this article. That said, flexibility in approach may enable a tax basis step-up to occur without conflicting with other deal objectives. At times, a creative combination of the discussed transaction methods may best enable a purchaser and seller to maximize transaction value.
1 Unless otherwise noted, “§” or “section” references are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder.
2 I.R.C. §167(c); I.R.C. §197(a).
3 To illustrate the foregoing: Assume a purchaser acquires stock in a target for $1,000 in cash and the value of the target’s underlying assets is entirely allocable to self-created amortizable intangibles, with $0 of basis prior to acquisition. No amortization deductions would be available absent a step-up. A $1,000 stepped-up tax basis in the intangibles would yield amortization deductions to target for 15 years (equaling 1/15 of $1,000 per year). If the intangibles were instead sold by the target, target would have $1,000 in taxable income absent a step-up in their basis. If the intangibles were sold with a stepped-up basis, the target would recognize no taxable income upon such sale (as the basis of $1,000 would equal the selling price).
4 For other reasons, a purchaser may prefer a stock acquisition; for example, such transaction eliminates the need to otherwise assign the target’s underlying contracts.
5 Note that the transfer of all of the target’s liabilities would be achievable if target were a limited liability company rather than a corporation. This is useful to consider for planning purposes.
6 I.R.C. §301(c).
7 Treas. Reg. §301.7701-3(b)(1)(ii).
8 Rev. Rul. 99-5, 1999-1 CB 434.
9 Rev. Rul. 99-6, 1999-1 CB 432.
10 See Rev. Rul. 89-85, 1989-2 CB 218 (“Subchapter K of the Code is a blend of the ‘aggregate’ and ‘entity’ treatment for partners and partnerships.”).
11 I.R.C. §743(a).
12 I.R.C. §743(b).
13 A §754 election is made by attaching a written statement with the partnership return for the taxable year during which the distribution or transfer occurs. Treas. Reg. §1.754-1. The election may only be subsequently revoked upon approval of the IRS. Treas. Reg. §1.754-1(c).
14 More precisely, a purchaser’s basis in a target will reflect the sum of cash (increased by tax losses, and decreased by taxable income) that purchaser would be deemed to receive upon a hypothetical disposition by the partnership of all of the partnership’s assets, in a taxable transaction for the fair market value of the partnership’s assets. Treas. Reg. §1.743-1(d).
15 Treas. Reg. §1.743-1.
16 See P. McDonald, Tax Food for Thought — Anticipating Common Issues Arising from Secondary Transfers of Private Equity Fund Interests, Business Entities (May/June 2015) (recommending that a “potential transferee…consider offering to reimburse the accounting and administrative costs incurred with respect to a Section 754 election and the attendant basis adjustments”).
17 See McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners §24.01, fn. 8 (Thomson Reuters, Tax & Accounting, 4th ed. 2007 & Supp. 2016-3) (“This offset occurs because the increase or decrease in the transferee’s share of partnership income causes an equal increase or decrease in the basis of his partnership interest, which subsequently affects the gain or loss realized upon disposition of the interest or carries over to the basis of the distributed assets.”).
18 I.R.C. §338(d)(3).
19 S corporations and C corporations may make the election. Treas. Reg. §1.338-3(b)(1).
20 I.R.C. §743(a).
21 I.R.C. §338(a). In calculating the deemed sale price (referred to as the aggregate deemed sales price or ADSP), in order to determine the tax consequences to the old target, the regulations require that the grossed-up amount realized by the old target, plus its liabilities, be summed. Treas. Reg. §1.338-4(b)(1).
22 The new target corporation’s basis (referred to as the adjusted grossed up basis or AGUB) is determined pursuant to Treas. Reg. §1.338-5(a), and may or may not equal the ADSP.
23 Treas. Reg. §1.338-10(a)(2)(iii).
24 Primarily, an election with respect to a foreign target yields foreign tax credit benefits with respect to the elimination of earnings and profits of the foreign corporation. Note that §901(m) may serve to reduce the impact of foreign tax credits going forward. The impact of this provision should be separately considered as well with respect to the acquisition of a foreign target corporation. See Yoder, Section 338(g) Election for a Foreign Target Continues to Provide Benefits to Buyer After New §901(m), 40 Tax Mgmt. Int’l J. 347 (June 2011).
25 Treas. Reg. §1.338-10(a)(5).
26 Treas. Reg. §1.338(h)(10)-1(d). As the transaction steps may include a deemed §332 liquidation, if the seller holds the target as part of a consolidated group, the seller may retain the tax attributes (including net operating losses) of the liquidated corporation.
27 Treas. Reg. §1.338(h)(10)-1(c)(1).
28 Treas. Reg. §1.338-3(b)(1).
29 Treas. Reg. §1.338(h)(10)-1(b).
30 Treas. Reg. §1.338(h)(10)-1(c)(3)
31 Treas. Reg. §1.338(h)(10)-1(d)(4)(i). As with an election under §338(g), a §338(h)(10) election is treated as if sold for the ADSP. Treas. Reg. §1.338(h)(10)-1(d)(3). The new target has a tax basis in its underlying assets (AGUB) as provided pursuant to Treas. Reg. §1.338-5. Treas. Reg. §§1.338(h)(10)-1(d)(2).
32 Treas. Reg. §1.338(h)(10)-1(d)(5)(i).
33 TD 9619 (May 10, 2013). Section 336(e) was enacted as part of the Tax Reform Act of 1986, authorizing the Treasury Department to enact regulations to treat certain sales, exchanges, or distributions of stock of a corporation as a disposition of the assets of such corporation. Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085. Only on May 23, 2013, were such regulations finalized.
34 Treas. Reg. §1.336-2(b).
35 Moreover, the regulations provide that “to the extent not inconsistent with section 336(e) or these regulations, the principles of section 338 and the regulations under section 338 apply for purposes of [the regulations under §336(e)].” Treas. Reg. §1.336-1(a).
36 Treas. Reg. §1.336-1(b)(6). Distributions of stock that are eligible for §336(e) treatment may be aggregated as well. Treas. Reg. §1.336-1(b)(6)(i).
37 Treas. Reg. §1.336-1(b)(6).
38 Treas. Reg. §1.336-1(b)(1).
39 Treas. Reg. §1.336-2(b)(1)(i)(B)(1).
40 Treas. Reg. §1.336-2(h). The preamble to the §336(e) regulations explain that by “requiring both seller and target to file the election statement on their respective returns, the IRS and Treasury Department believe that the final regulations significantly reduce the potential for unwanted results or unfair surprise.” TD 9619 (May 10, 2013).
41 TD 9619 (May 10, 2013).
42 See Chudy & Reddy, Stock Purchases Treated as Asset Acquisitions — Section 338 (788-3d T.M.) (recommending same and noting that: “It may be an unwelcome surprise (or unexpected boon) to discover that sellers and target made a §336(e) election for target without any notice to the purchaser.”).
Steven D. Shapiro is an attorney at the law firm of Barnett, Bolt, Kirkwood, Long & Koche in Tampa. He received his B.A. from the University of Miami and his J.D. from Georgetown University Law Center.
This column is submitted on behalf of the Tax Law Section, William Roy Lane, Jr., chair, and Christine Concepcion, Michael Miller, and Benjamin Jablow, editors.