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).)
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 — 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).)