The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 7, February 1999, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

Tax professionals, investment bankers and business mavens all have their own lingua franca. Among tax lawyers and tax accountants, there are few phrases more romantic than the step transaction doctrine. Steeped in the lore of hoary tax cases, the step transaction doctrine is one of those frightening sounding, and yet strangely exciting, tax principles.

As we all know, this pervasive doctrine treats a series of separate steps as a single transaction. Accordingly, it assesses tax consequences from that perspective. In the distant past, another staple tax doctrine was known by the case name that made it famous, Kimbell-Diamond. Basically, under this doctrine a corporation's acquisition of the stock of another corporation, pursuant to a plan to liquidate the latter and acquire its assets, was treated as a purchase of the target's assets. As a result, the acquirer was able to bypass the rules of Section 334(b)(1) and obtain a cost basis in the target's assets.

Eventually, the Kimbell-Diamond doctrine was codified, initially in old Code Section 334(b)(2) (prior to the Tax Reform Act of 1986) and, currently, in Section 338. Under Section 338, a cost basis with respect to the assets of an acquired corporation is attainable if: (1) the acquisition of stock constitutes a "qualified stock purchase"; and (2) not later than the 15th day of the ninth month beginning after the month in which the acquisition date occurs, the acquirer executes a Section 338 election.

Electing Section 338

Section 338 is the principal means by which a stock acquisition can be "converted" for tax purposes into an asset acquisition which, in turn, affords a buyer a coveted cost basis for the target's assets. Of course, since the repeal of the General Utilities doctrine in 1986, many taxpayers will opt to maintain the target's historic asset basis. Nevertheless, where target has a Net Operating Loss that can offset the gain triggered by the repeal of the General Utilities doctrine, a cost basis for the target's assets will be both desirable and achievable.

Moreover, it is clear that a Section 338 election can be filed even if a subsidiary is liquidated into the purchaser immediately after the stock purchase is completed. A liquidation, immediately after the stock purchase does not impair a subsequently filed Section 338 election. Conversely, where the acquirer is newly-formed, and the acquirer is merged downstream into the target (or, alternatively, if the acquirer itself is liquidated), the efficacy of the Section 338 election will turn on the question of whether Newco is really the "purchaser" of the target's stock.

Step Transactions and Section 338

Under a somewhat different application of the step-transaction doctrine, the transitory existence of a newly-created entity in this kind of situation can be disregarded. If the newly created subsidiary is disregarded it will mean that a qualified stock purchase could not occur. To be disregarded, the newly created subsidiary must be both created and extinguished in the course of an integrated transaction. See, e.g., Revenue Rulings 67-448, 73-427 and 78-250.

Where asset purchase treatment is not desired, the IRS has provided a safe harbor regarding the effect of a prompt liquidation of the target. In Revenue Ruling 90-95, the Service ruled that a qualified stock purchase followed immediately by a preplanned liquidation would not be collapsed, into an asset acquisition (under Kimbell-Diamond principles). Instead, the purchase transaction and the liquidation will each be accorded independent significance.

In fact, the Service concluded that Section 338 was the exclusive means for converting a stock acquisition into an asset acquisition. With the enactment of Section 338, says the IRS, Congress intended to eliminate all non-statutory routes to this end.

How Far Does 90-95 Go?

Unfortunately, Revenue Ruling 90-95, by its terms, is limited to cases in which the stock acquisition constitutes a qualified stock purchase. What if the stock acquisition does not attain qualified stock purchase status? In other words, what if any one of the formal requisites to a Section 338 election are not met? The IRS apparently does not intend to perpetuate the Kimbell-Diamond theory in these instances.

On the other hand, perhaps Revenue Ruling 90-95 is more expansive. Is its ruling and theory expansive enough to encompass all Section 332 liquidations, not merely those that are preceded by a qualified stock purchase? Important consequences flow from how one (especially the IRS!) chooses to answer these questions.

Unclear Scope = Caution

If Revenue Ruling 90-95 is truly limited in its scope, and a preplanned liquidation is stepped together with a stock acquisition that does not constitute a qualified stock purchase, the target will be taxed on its gain arising out of the liquidation. This is almost certainly an undesirable result. Hopefully, however, our old friend the Kimbell-Diamond doctrine is broader than is implied by Revenue Ruling 90-95.

If it is, all Section 332 liquidations should be viewed as transactions independent of the prior stock acquisition. After all, it is difficult to imagine that Congress wanted Kimbell-Diamond to survive as the proverbial "trap for the unwary."

Still, Revenue Ruling 90-95 is sufficiently ambiguous to permit one to reach a contrary conclusion. That should urge tax planners and deal structurers to tread a little carefully in this still confused area. In cases where a cost basis is undesirable and the preceding stock acquisition is not a qualified stock purchase, taxpayers would be wise to insure that an ensuing liquidation is not stepped together with the stock acquisition. Unfortunately, it just isn't clear that the old Kimbell-Diamond doctrine is entirely dead.

Liquidating a Recently Acquired Subsidiary, Vol. 7, No. 7, M&A Tax Report (February 1999), p. 4.