Did IRS Misuse `Step’ Doctrine in Revenue Ruling 2008-25?

In Rev. Rul. 2008-25, ¹2008-21 I.R.B. 986. Mr. A owned 100% of the stock of T Corp. (T); T possessed assets with a gross value of $150x and had $50x in liabilities.

Unrelated P Corp. (P) forms X Corp. (X) for the express purpose of acquiring all the stock of T by causing X to merge with and into T (“the acquisition merger”). In the merger, P acquires the stock of T and Mr. A exchanges his T stock for $10x in cash and P voting stock with a value of $90x. Following the merger, and as part of an integrated plan, T liquidates into P.

If the acquisition merger and the liquidation were treated as separate from each other, the acquisition merger would be treated as a stock acquisition that qualifies as a reorganization within the meaning of §368(a)(1)(A) by reason of §368(a)(2)(E), and the liquidation would qualify under §332. In that event, Mr. A’s gain from the exchange would be recognized, but in an amount not in excess of the cash he received, and P would hold the T assets received in the liquidation at the same basis at which they were held by T. ²See §356(a)(1) and §334(b)(1).

However, in determining whether a transaction qualifies as a reorganization, the transaction, the ruling reminds us, must be evaluated “under relevant provisions of law,” including the step transaction doctrine. ³See Regs. §1.368-1(a). Accordingly, the acquisition merger and the liquidation may not be considered independently of each other for purposes of determining whether the transaction satisfies the statutory requirements of a reorganization described in §368(a)(1)(A) by reason of §368(a)(2)(E).

This transaction, the ruling concluded, does not qualify as a reorganization described in §368(a)(1)(A) by reason of §368(a)(2)(E) because, after the transaction, T (having been liquidated) does not hold substantially all of its properties and those of the merged corporation.

Can the transaction be classified as some other variety of reorganization? In determining whether the transaction is a reorganization, the approach reflected in Rev. Rul. 67-274
⁴1967-2 C.B. 141. is applied to ignore P’s acquisition of the T stock in the acquisition merger and to treat the transaction as a direct acquisition by P of T’s assets in exchange for a combination of P voting stock, cash, and the assumption by P of T’s liabilities.

However, such a direct acquisition does not qualify as a reorganization. P’s acquisition of T’s assets is not a reorganization within the meaning of §368(a)(1)(C) because the consideration exchanged is not solely voting stock and the requirements of §368(a)(2)(B), the so-called boot relaxation rule, are not satisfied: §368(a)(2)(B) would treat P as acquiring fully 40% of T’s assets for consideration other than P voting stock and the boot relaxation route to a “C” reorganization only applies in cases where not more than 20% of the gross value of all of the properties of the acquired corporation are acquired for consideration other than voting stock of the acquiring corporation (or the voting stock of a corporation in control of the acquiring corporation). ⁵See Regs. §1.368-2(d)(2)(ii).

Moreover, P’s acquisition of T’s assets is not a “two-party” “A” reorganization for the simple reason that T did not merge with and into P. Accordingly, the overall transaction does not constitute a reorganization.

Here, application of the approach reflected in Rev. Rul. 67-274 would result in treating the acquisition of T’s stock as a taxable purchase of T’s assets, with the result that P would secure a “cost basis” in such assets. Such treatment, however, would violate the policy underlying §338, that a cost basis in assets should not be obtained through the purchase of stock where no election under §338 is made. Accordingly, the acquisition of the stock is treated as a “qualified stock purchase” followed by a liquidation.

The transaction, therefore, is not a reorganization: The acquisition merger is a qualified stock purchase and the liquidation is a complete liquidation of a controlled subsidiary to which §332 applies.

Mr. A, for want of a reorganization, is taxed on the entire gain he realized on the exchange of his T stock for P stock and cash, and P holds the T assets at the same basis at which they were held by T.

What About `American Potash’?

There is support, however, for the proposition that the step transaction doctrine should not be the governing notion in evaluating a transaction of this nature and that, as a result, the acquisition merger should be viewed independently of the liquidation.

If that were the proper analytical approach, the acquisition merger would constitute a reorganization, with the result that Mr. A’s recognized gain would be limited to the amount of cash he received in such acquisition merger.

Thus, in American Potash & Chemical Corp. v. U.S., ⁶399 F.2d 194 (Ct. Cl. 1968). between September 1954 and November 1955, P Corp. (P) acquired all of the stock of W Corp. (W) in exchange for some 66,662 shares of its voting stock and $466.12 in cash for fractional shares. Between Sept. 28, 1954, and Nov. 3, 1954, P acquired (for its voting stock plus cash in lieu of fractional shares) 48% of W’s stock. On Nov. 30, 1955, P acquired, solely in exchange for its voting stock, the remaining 52% of W’s stock.

Thus, P did not acquire either 80% of the total combined voting power of all of T’s voting stock or 80% of the total number of shares of all other classes of T’s stock during any 12-month period between September 1954 and November 1955.

On June 30, 1956, W was completely liquidated. It was conceded that the acquisition of W’s stock and the liquidation of W were steps in an integrated transaction. At issue was the basis at which P would hold W’s assets. Was P entitled to a cost basis in such assets or would it hold the assets at the same basis at which they were held by W?

The IRS, arguing for a carryover basis, contended that a reorganization under §368(a)(1)(C) had occurred and, therefore, a carryover basis was required.

The Federal Court of Claims disagreed. In its view, the transaction did not meet the requirements of a reorganization under §368(a)(1)(B) because control of W was not obtained by a series of stock-for-stock exchanges within a 12-month period. Here, the entire transaction took place over 14 months and P never obtained control of W within any 12-month period. ⁷See Regs. §1.368-2(c); “… the acquisition of the stock of another corporation by the acquiring corporation solely for its voting stock … is permitted tax-free even though the acquiring corporation already owns some of the stock of the other corporation. Such an acquisition is permitted tax-free in a single transaction or in a series of transactions taking place over a relatively short period of time such as 12 months ….”

IRS argued that the entire transaction should be “tested” as a reorganization under §368(a)(1)(C) because P stated, from the outset, that it intended to obtain W’s assets. Thus, the issue confronting the court was whether it could transform a stock-for-stock exchange that did not qualify as a B reorganization into a C reorganization by finding that the subsequent liquidation had no tax significance. The court believed it was not able to do so.

The court could not find, it noted, any decision that has transformed a nonqualifying B reorganization into a valid C reorganization by concluding that a subsequent liquidation was without tax significance.

The IRS argued that the liquidation should be denied any significance because it was an “interim transitory step” in the overall scheme. Its argument was that the liquidation and the stock-for-stock exchange should be combined and that the only transaction that should be given tax significance is the one that did not occur, a transfer of stock for assets.

This, the court observed, is a misuse of the step transaction doctrine.

The court concluded that the nonqualifying B reorganization cannot be deemed a valid C reorganization by virtue of a subsequent liquidation. A C reorganization, the court concluded, requires an exchange of stock for assets that did not, in fact, occur. Nor was there a qualifying reorganization pursuant to which the court could find that the liquidation was undertaken.

The court conceded that where, subsequent to a valid B reorganization, the acquired corporation is liquidated, the assets received in the liquidation (if it is part of the same scheme) are considered assets received “in connection with a reorganization.” Rev. Rul. 67-274 would prefer to call this a C reorganization, rather than a B reorganization to which the liquidation is linked. However, Rev. Rul. 67-274 is inapplicable to a stock-for-stock exchange that is not a qualifying B reorganization.

The court went on to find that P was entitled, under Kimbell-Diamond principles, to a cost basis in W’s assets and that W’s shareholders should be taxed on the exchange of their W stock for P stock.

In Rev. Rul. 2008-25, the acquisition merger, standing alone, does qualify as a reorganization within the meaning of §368(a)(1)(A) by reason of §368(a)(2)(E). Thus, the infirmity the court confronted in American Potash & Chemical is not present. There, the court conceded that where, subsequent to a valid reorganization, the acquired corporation is liquidated, the assets received in the liquidation (if, as in Rev. Rul. 2008-25, the liquidation is part of the same scheme) are considered assets received “in connection with the reorganization.” In Rev. Rul. 2008-25, there was a valid reorganization (under §368(a)(1)(A) by reason of §368(a)(2)(E)) to which “the liquidation was linked.”

Thus, if the reasoning utilized by the court in American Potash & Chemical was employed to evaluate the transaction described in Rev. Rul. 2008-25, a somewhat different outcome would have ensued. The acquisition merger, a qualifying A reorganization, would have been accorded independent significance, with the result that Mr. A’s gain on the exchange of his T stock for P stock and cash would have been recognized but in an amount not in excess of the cash. In addition, P would have obtained a carryover (not a cost) basis in T’s assets.

It is now clear that the Kimbell-Diamond doctrine has no continuing vitality and that a cost basis in acquired assets can only arise, in cases where the acquisition of assets is preceded by an acquisition of the target’s stock, by means of an election under §338. Under this view of the transaction, an election under §338 was not available to P because the acquisition of T’s stock did not occur by means of a “purchase”; such acquisition, instead, was an exchange to which §354 applied. ⁸See
§338(h)(3)(A)(ii). (The predicate for an election under §338 is a qualified stock purchase; a transaction or series of transactions within a 12-month period, in which the amount of the target’s stock specified in §1504(a)(2) is acquired by means of “purchase.”) ⁹See §338(d)(3). ).

This analytical approach accomplishes IRS’s principal goal—to insure that P does not secure a cost basis with respect to T’s assets. Moreover, it enables Mr. A to limit his recognized gain to an amount not in excess of the cash obtained in the transaction. Most notably, this approach does not entail a misuse of the step transaction doctrine.

While the court in American Potash & Chemical ruled that a nonqualifying acquisition of stock cannot be transformed into a qualifying acquisition of assets by means of a preplanned liquidation, it should also follow that a qualifying stock acquisition should not be denied that status on step transaction grounds because the integrated transaction (taking the ensuing liquidation into account) does not constitute a qualifying acquisition of assets. Thus, it is submitted that the transaction evaluated in Rev. Rul. 2008-25 should not have been characterized as a taxable acquisition of Mr. A’s stock in T followed by a §332 liquidation. It should have been categorized, instead, as a tax-free (except to the extent of the cash) acquisition of Mr. A’s stock followed by such a §332 liquidation.

That view of the transaction would not engender a misuse of the step transaction doctrine because it would have the virtue of accounting for only those transactions that actually occurred and would withhold tax significance from the only transaction that did not take place—a transfer by T of its assets to P.