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B&N agrees to give the bookseller founders a tax break to seal a strategic deal that brings the college book store division into the corporate fold.
Robert Willens, CFO.com | US
August 17, 2009
Barnes & Noble Inc. is getting back into the college bookseller business. Last week, the company announced its intentions to purchase the stock of Barnes & Noble College Booksellers Inc. (B&N College) from its sole shareholders, Leonard and Louise Riggio, the founder and chairman of B&N, and his wife, respectively. The couple owns approximately 32 percent of the stock of B&N.
B&N College is an 'S' corporation, meaning that it is an "electing small business corporation." Because the Riggios do not own as much as 50 percent (by value) of the stock of B&N, the acquisition by the corporation of B&N College's stock from the Riggios is not a transaction described in Section 304(a)(1). That's the tax code section that applies when one corporation acquires stock of another company in return for property from persons in control of each corporation.
Moreover, the B&N College stock is not acquired by B&N from a person (the Riggios) the ownership of whose stock would be attributed to the acquirer (B&N).1 Therefore, the acquisition of the stock should constitute a "purchase."
What's more, the acquisition of the stock likely will constitute a "qualified stock purchase," which is defined as a transaction or series of transactions in which stock of one corporation, that meets certain requirements of the tax code, is acquired by another company through a purchase that takes place during the 12 month acquisition period.2 Specifically, the stock being acquired must meet the requirements of Section 1504(a)(2) of the code, which says that the shares must make up at least 80 percent of the stock by both voting power and value.
As a result, the parties are positioned to execute an election under Section 338(h)(10) of the tax code, which may be made for a target if the acquiring corporation acquires stock from the 'S' corporation shareholders in a qualified stock purchase.3 (Remember, the acquired stock must meet Section 1504(a)(2) requirements.)
If such an election is made, the acquiring corporation will obtain a "cost basis" in the target's assets, rather than being relegated to a carryover basis, with the result that the buyer's tax deductions (for depreciation and amortization) for periods following the acquisition will be maximized.
In this case, however, the acquisition agreement expressly provides that neither entity shall make a Section 338 election with respect to the transaction.
Sometimes the making of an election penalizes the selling shareholders. Where an election is made, the 'S' corporation is deemed to sell its assets to the buyer for an amount equal to the price paid for its stock, plus the liabilities of the 'S' corporation inherited by the buyer. The gain from the deemed asset sale is "passed through" to the selling shareholders whose basis in the 'S' corporation's stock is increased by the amount of gain. The 'S' corporation, immediately after the asset sale, is treated as distributing the sales proceeds in a liquidation to which Section 331 applies.
If the stock is sold and no Section 338(h)(10) election is made, the selling shareholders treat their stock sale gain as a capital gain. On the other hand, if the election is made, the gain from the deemed sale of the 'S' corporation's assets is passed through to the shareholders and a portion of the gain is considered ordinary income, taxed to the shareholders at top, marginal rates.
Here, B&N College uses the LIFO (last-in, first-out) method of valuing inventory. Accordingly, the gain from the sale of inventory — which would be ordinary in nature — could be substantial. This may explain why no Section 338(h)(10) election is being made here.
Although the acquiring corporation would surely benefit from the election, the selling shareholders would be penalized (the election would have the perverse effect of "converting" capital gain income into ordinary income) and, presumably, the penalties outweighed the benefits with the result that the parties have decided to forego the "basis step-up" that an election under Section 338(h)(10) affords.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.