Avoiding LBO Tax Missteps

Make sure LBO Sec. 338 elections don't trigger step transaction rules.
Robert WillensJune 5, 2002

Leveraged buyout participants that acquire the stock of a target may be able to garner tax benefits by treating the target stock purchase as an asset allocation. This is done by executing a “regular” Sec. 338 election—or in cases where the target is a member of an affiliated group, a Sec. 338(h)(10) election. In each case, the election enables the acquirer to obtain a “cost” basis in the target’s assets, which in turn, improves the acquirer’s tax posture. How does the acquirer grab the improved tax treatment? Bascially, the acquirer’s depreciation and amortization deductions will be geared to the higher costs basis in the acquired assets.

But caveat acquirer: the election carries a cost—which is the tax on the gain associated with the “deemed sale” of assets that an election sets into motion.

In any case, the point is that either variety of election will enable the acquirer to gain access to the benefits of Sec. 197, the provision enacted in 1993 that requires the cost of most acquired intangible assets, including goodwill, to be amortized ratably over 15 years.

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What’s the catch? For an election to be possible, there must first be, with respect to target’s stock, a qualified stock purchase. This means that the LBO must feature a Newco that, within a 12-month period, acquires by statutory purchases at least 80 percent of the voting power and value of the target’s stock. In many LBOs, the sponsor insists that certain target shareholders—for instance, management—become shareholders of Newco. These shareholders, the “rollover” shareholders, are constrained to re-invest a portion of the proceeds (from the sale of their target stock) into a specified amount of Newco stock.

The Newco stock maneuver, however, can undercut the acquirer’s ability to effect a Sec. 338 election. As Professors Ginsburg and Levin point out in their formidable tome on buyouts, the two seemingly separate transactions may fall, for tax purposes, under the “step transaction” doctrine, and therefore must be treated as a single transaction. Again, the transaction works like this: the old target shareholder purchases the stock in Newco so that (1) the shareholder receives cash in exchange for his target stock, and (2)contributes cash to Newco in exchange for its stock.

If the operation is treated as a single transaction, the shareholder is treated as participating in the “Sec. 351 formation” of Newco. That is because the shareholder is contributing his target stock to Newco in exchange for Newco stock and a net amount of cash—which is the amount by which the proceeds from selling the target stock exceeds the amounts contributed to Newco for its stock.

This characterization of the transaction, if proper, will frequently eliminate the ability to effect a Sec. 338 election—an election that is permissible only if there is a qualified stock purchase, and the term “purchase” does not include an acquisition of stock pursuant to Sec. 351.

Accordingly, there can be no Sec. 338 election if an excess of 20 percent of target’s stock is acquired by Newco pursuant to Sec. 351. In these cases, the Professors recommend that, to eliminate the “Sec. 351 risk,” Newco issue convertible debentures to rollover shareholders in lieu of stock. To do that, Newco must use a technique in which a wholly-owned subsidiary of Newco (Newco1) functions as the shareholder. Or alternatively, Newco could employ the purchaser of the target’s stock, and the rollover shareholders could purchase stock in Newco. Either way, none of the target stock acquired by Newco1 should be treated as acquired in a Sec. 351 transaction because the rollover shareholders do not acquire any stock in Newco1.

Whether the step transaction doctrine properly applies—to treat the formally separate sale and purchase of stock as a single transaction—is problematic (Cf. Stevens Pass, Inc. v. Commissioner). What is clear, however, is that only the IRS can invoke the step transaction doctrine to recharacterize a transaction. For the most part, the taxpayer is bound by the form of the transaction.

For example, in Insilco, Inc. v Commissioner—a case involving an LBO in which a shareholder of the target was required to reinvest proceeds in Newco stock—the IRS chose not to recharacterize the sale and purchase of stock as a single transaction to which Sec. 351 would apply. As a result, the Newco, in that case, was permitted to make a Sec. 338 election because its acquisition of the target’s stock was a qualified stock purchase.

Later, the target shareholder found that it would be advantageous to have the sale and purchase viewed together as an exchange under Sec. 351, but its efforts in this regard were rebuffed. The court repeated the maxim that only the IRS has the power to invoke broad doctrines of tax law—such as the step transaction principle. What’s more, the taxpayer, regardless of whether the result is detrimental to its interests, is irretrievably, bound by the form in which the transaction is cast.

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