Seller Beware of State Tax Hit

Agreeing to use a tax code play to give the seller a cost basis in an acquisition may be look like the right play, but double the interplay of stat...
Robert WillensDecember 22, 2008

In January, 1997, K Corporation became a wholly-owned subsidiary of C Corporation. Some four months later, CCorp sold 100 percent of K’s capital stock to Newell Corporation. For federal income tax purposes, the stock sale was treated as a sale of assets under the Internal Revenue Code — specifically under Section 338(h)(10). A so-called (h)(10) election is made jointly by the buyer and seller, CCorp and Newell in this example.

As a result, K reported the gain from the sale as income on a pro forma federal income tax return that was filed as part of CCorp’s consolidated federal income tax return. For legal purposes the transaction was simply a sale by CCorp of the stock of its subsidiary to Newell. However, for federal income tax purposes, and in light of the election under Section 338(h)(10), the transaction was treated as if K had sold all of its assets to “NewK.”

NewK is a corporation formed by Newell for an amount equal to the price it paid for the K stock, plus K’s liabilities inherited by NewK while it was a member of C’s affiliated group. It was as if immediately after the Newell transaction was “deemed asset sale,” K distributed its assets to CCorp in a complete liquidation. (See Regulation Section 1.338(h)-10(d).)

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The effect of the “deemed sale” is that the target’s assets acquire a new basis equal to their fair market value — a cost basis. The tax benefit garnered in the maneuver is not without sacrifice, though. Indeed, the buyer secures a cost basis in the target’s assets, but does so at the unacceptably steep cost of two levels of tax. The sellers of the target’s stock (to the buyer) will recognize gain on the stock sale and the target itself will recognize gain on the deemed sale of assets that the Section 338 election sets in motion.

As a result, what is always desirable &#8212 but exceedingly difficult to attain — is for the acquirer to obtain a cost basis in the target’s assets at a “manageable” cost. That is, a cost of only a single level of tax. This goal can be achieved if the target is: (1) a subsidiary of another corporation (in which event the buyer and seller might jointly execute an election under Section 338(h)(10)); (2) a real estate investment trust (in these cases no entity level tax is incurred if the REIT distributes to its shareholders the proceeds derived from the sale of its assets); or (3) a non-corporate entity.

In this case, the buyer and seller jointly executed the (h)(10) election. But now the companies involved must figure out whether the election is hampered by state tax law. More specifically, whether the gain CCorp booked from the sale of K’s capital stock was properly included in K’s excise tax base under Tennessee law. A state court found that the gain could be included in K’s excise tax base — although Newell disagreed. (See Newell Window Finishing, Inc. v. Johnson, Tenn. Ct. App., No. M2007-02716-COA-R3-CV (2008).)

Legal Fiction?

The court said that the buyer and seller could make a Section 338 (h)(10) election if two criteria were met. That the target — Kappa — was a member of the “selling consolidated group” before the transaction, and that the target recognized a gain or loss with respect to the transaction as if it sold all of its assets in a single transaction. If those two hurdles were cleared, then no gain or loss would be recognized on stock sold or exchanged in the transaction by members of the selling consolidated group, namely CCorp and Kappa.

But Newell contended that Section 338(h)(10) creates the legal fiction that the transaction is a sale of K’s assets followed by an immediate liquidation of that corporation. As a result, Newell argued that the legal fiction was the only reason K reported a gain from the sale on the pro forma tax return. Further, Newell asserted that the legal fiction should not determine K’s Tennessee excise tax liability. Instead, asserted Newell, the gain from the sale of K’s capital stock should be included in CCorp’s excise tax base, not in K’s.

The state tax statutes provide that all profit-making corporations organized in Tennessee — or another state or country and doing business in Tennessee — without exception shall pay an excise tax. Moreover, the starting point for determining a company’s Tennessee excise tax base is federal taxable income. Here, the court observed that Newell received a “real tax benefit” as a result of the (h)(10) election. To be sure, Newell obtained a “cost basis” in K’s assets at the cost of only a single level of tax imposed on CCorp, rather than being hit twice. Having “freely chosen” to proceed under Section 338(h)(10), Newell is bound by that choice and all attendant consequences, asserted the court.

The Tennessee court “found guidance” in an opinion of the tax court of New Jersey — Gen. Bldg. Prods. Corp. v. New Jersey,14 N.J. Tax 232 (1994). New Jersey does not recognize consolidated groups or consolidated filings, similar to the way Tennessee imposes its excise tax on each separate corporation doing business in the state. In the New Jersey case, the buyer argued that the (h)(10) election is provided for use by consolidated groups, so it could not recognize the tax consequences of the Section (h)(10) election — including the deemed sale of the subsidiaries assets and the related gain reported.

But the New Jersey court rejected the buyer’s claim. It observed that New Jersey’s prohibition against consolidated tax returns does not immunize the subsidiary from state taxation of any gain as a result of its assets. The parties made the election under Section 338(h)(10) and are bound to accept the consequences which flow from the rule. Similarly, the Tennessee court concluded that the gain reported by K as a result of the deemed sale of its assets was properly included in its excise tax base.

Business Income

Newell tried another approach, insisting that even if the gain from the sale of K’s assets is properly recognized, such gain constitutes non-business earnings and, therefore, should not be included in K’s taxable base. Newell asserted that earnings are properly classified as business earnings only if they arise from the “regular conduct” of the taxpayer’s trade or business.

Once again, the court disagreed with Newell. The court pointed out that business earnings that arise from either the management, use, acquisition, or disposition of property that constitutes an “integral part” of the taxpayer’s trade or business. Therefore, the proper question is not whether the disposition was an integral part of the corporation’s regular business but rather, whether the disposed property was such an integral part. It was, ruled the court.

Accordingly, the court concluded that the gain realized by K as a result of the deemed sale of its assets — triggered by the execution of an election under Section 338(h)(10) — constituted business earnings properly included in K’s excise tax base.

So in pondering whether the Section 338(h)(10) makes sense in cases when the seller’s “outside basis” in its target stock is greater than the target’s “inside net asset basis, consider the following. That the buyer should increase the amount it is willing to pay for the stock to insure that the seller is not at a disadvantage, on an after tax basis, as a result of the election and state tax law consequences. As a result, a price premium for the seller may be in order, especially if the state “respects” the results of an election under Section 338(h)(10), and the tax affect (if any) of asset sale treatment (as opposed to stock sales treatment).

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for