1. Acquisitions of Subsidiaries of Freestanding Companies
Tax-free Subsidiary Sales
Taxable Subsidiary Sales
Taxable asset sale
Taxable stock sale
Taxable stock sale with an IRC §338(h)(10) election

2. Tax-free Subsidiary Sales
The divesting parent exchanges the stock or assets of the subsidiary for the stock of the acquiring firm.
No gain is recognized.
The sold subsidiary’s NOLs remain with the subsidiary but are limited by §382.
The acquirer takes a carryover basis in the subsidiary’s assets and stock.
The divesting parent takes a substituted basis in the acquiring stock received equal to its basis in the sold subsidiary’s stock.

3. Undesirable Aspects of Tax-free Subsidiary Sales
The seller has not truly divested its holding in the sold subsidiary.
The seller will hold a relatively illiquid block of the acquirer.
The acquirer and the seller may both hold financial positions with a built-in gain after consummation of the transaction.*
If the FMV of the subsidiary is greater than the seller’s tax basis in the subsidiary’s stock.

4. Given Information for Examples and Cases

5. Example: Tax-Free Subsidiary Stock Sale Under IRC §368(a)(1)(B)
Divesting Parent Shareholders:
No direct tax effect.
Acquirer Shareholders:
No direct tax effect.
Divesting Parent:
Receives $10,000 of acquirer
stock in return for the divested
subsidiary’s stock. Realizes a
gain of $8,000. No gain is
recognized. Takes a substituted
basis in the acquirer stock
received ($2,000).
Acquirer:
Purchases the stock of the target
(subsidiary) for $10,000 of its
stock. Takes a carryover basis
in the stock of the acquired
subsidiary ($2,000). Acquired
subsidiary becomes a subsidiary
of the acquirer and its asset
basis carries over.
$10,000 of
acquirer stock
All of the
subsidiary’s stock
Sold Subsidiary:
The owners of the subsidiary corporation change.
The tax attributes of the subsidiary are limited but
stay with the subsidiary. The tax basis of the
subsidiary’s assets carryover ($2,000).

6. Example: Post-Acquisition Ownership Structure
Acquirer:
Owns 100% of the sold subsidiary’s stock.
Has a basis in the target’s stock of $2,000
and a basis in the target’s assets of $2,000.
Sold Subsidiary:
Now a wholly owned
subsidiary of the acquirer.
Net asset basis is $2,000.

7. Taxable Subsidiary Sales
Taxable Asset Sale--the acquirer purchases the assets of the subsidiary (target) corporation (usually for cash) from the divesting parent.
Taxable Stock Sale--the acquirer purchases the stock of the target corporation from the parent for cash.
Taxable Stock Sale w/ an IRC §338(h)(10) election--completed as a stock sale but taxed like an asset sale.

8. Taxable Asset Sales
A gain or loss is recognized and computed as price less basis in subsidiary’s net assets.
The portion of the gain that arises from recaptured depreciation is ordinary income; the difference between the purchase price and the historical cost of the assets is a capital gain.
The sold subsidiary’s NOLs remain w/ the divesting parent, can offset a gain on sale, and are not limited by §382.
Continued

9. Taxable Asset Sales. . .Continued
Generally, the divesting parent corporation liquidates the sold subsidiary; no gain or loss is recognized on the liquidation under IRC §332.
The acquirer steps-up to a basis in the subsidiary’s assets equal to the purchase price paid.
There are tax benefits from additional depreciation and amortization deductions.

10. Taxable Subsidiary Asset Sale
Divesting Parent Shareholders:
No direct tax effect.
Divesting Parent:
Receives $7,200 from the sold subsidiary in
liquidation. There is no tax associated with
the liquidation under IRC § 332.
Acquirer Shareholders:
No direct tax effect.
$7,200
All of the subsidiary’s stock
Acquirer:
Purchases the assets of
the target (subsidiary)
for $10,000 cash. Takes
a basis in the target’s
assets equal to the price
paid ($10,000).
Sold Subsidiary:
Subsidiary receives $10,000 for all of its
assets. Recognizes a gain of $8,000 and
incurs a tax liability of $2,800. After-tax, it
has $7,200 that is distributed to the parent
corporation in liquidation.
$10,000 cash
All of the
target’s assets

11. Tax Implications of a Taxable Asset Sale
$10,000.00
$8,000.00
$10,000.00
2,800.00
$7,200.00
$10,000.00
1,720.48
$8,279.52
n/a
$10,000.00
8,000.00

12. Taxable Subsidiary Stock Sale w/o a §338(h)(10) Election
A capital gain is recognized and computed as price less basis in subsidiary’s stock.
The sold subsidiary’s NOLs remain with the subsidiary but are limited by §382.
The acquirer takes a carryover basis in the subsidiary’s assets.
The acquirer takes a basis in the target’s (subsidiary’s) stock equal to the purchase price.

13. Taxable Subsidiary Stock Sale w/o a §338(h)(10) election
Divesting Parent Shareholders:
No direct tax effect.
Acquirer Shareholders:
No direct tax effect.
Divesting Parent:
Receives $10,000 cash in return
for the divested subsidiary’s
stock. Recognizes a capital gain
on the stock sale of $8,000 and
incurs a tax liability of $2800.
After-tax, divesting parent has
$7,200.
Acquirer:
Purchases the stock of the target
(subsidiary) for $10,000 cash.
Takes a carryover basis in the
target’s assets ($2,000).
Acquired subsidiary becomes a
subsidiary of the acquirer.
$10,000 cash
All of the
subsidiary’s stock
Sold Subsidiary:
The owners of the subsidiary corporation change.
The tax attributes of the subsidiary are limited but
stay with the subsidiary. The tax basis of the
subsidiary’s assets carryover ($2,000).

14. Post-Acquisition Ownership Structure
Acquirer:
Owns 100% of the sold subsidiary’s stock.
Has a basis in the target’s stock of $10,000
and a basis in the target’s assets of $2,000.
Sold Subsidiary:
Now a wholly owned
subsidiary of the acquirer.
Net asset basis is $2,000.

15. Tax Implications of a Taxable Stock Sale w/o a §338(h)(10) Election
Sec. 338(h)(10) Election
$10,000.00
$8,000.00
$10,000.00
2,800.00
$7,200.00
$10,000.00
0.00
$10,000.00
$10,000.00
2,000.00
0.00

16. Taxable Stock Sale w/ a §338(h)(10) Election
§338(h)(10) allows for the potentially favorable tax treatment of an asset sale without incurring the non-tax costs of an asset sale.
A subsidiary stock sale can be taxed as an asset sale under §338(h)(10) only if both the acquirer and the divesting parent jointly make the election.

17. Taxable Stock Sale w/ a §338(h)(10) Election
A gain is recognized and computed as price less basis in the subsidiary’s net assets.
The portion of the gain that arises from recaptured depreciation is ordinary income; the difference between the purchase price and the historical cost of the assets is a capital gain.
The sold subsidiary’s NOLs remain w/ the divesting parent, can offset a gain on sale, and are not limited by §382.
Continued

18. Taxable Stock Sale w/ a §338(h)(10) Election. . . Continued
The acquirer steps-up to a basis in the subsidiary’s assets equal to the purchase price paid.
The acquirer takes a basis in the target’s (subsidiary’s) stock equal to the purchase price.
There are tax benefits from additional depreciation and amortization deductions.

19. Taxable Subsidiary Stock Sale w/ a §338(h)(10) election
Divesting Parent Shareholders:
No direct tax effect.
Acquirer Shareholders:
No direct tax effect.
Divesting Parent:
Receives $10,000 cash in return
for the divested subsidiary’s
stock. Recognizes a gain of
$8,000 (purchase price less
subsidiary’s net asset basis).
Divesting parent pays tax of
$2,800. After-tax, divesting
parent has $7,200.
Acquirer:
Purchases the stock of the
target (subsidiary) for
$10,000 cash. Takes a
stepped-up basis in the
target’s assets ($10,000
basis; $8,000 step-up)
as a result of the deemed
asset sale under §338(h)(10).
Acquired subsidiary
becomes a subsidiary of the
acquirer.
$10,000 cash
All of the
subsidiary’s stock
Sold Subsidiary:
The owners of the subsidiary corporation change. The tax
attributes of the subsidiary remain with the divested parent.
The tax basis of the subsidiary’s assets carryover ($2,000).

20. Post-Acquisition Ownership Structure
Acquirer:
Owns 100% of the sold subsidiary’s stock.
Has a basis in the target’s stock of $10,000
and a basis in the target’s assets of $10,000.
Sold Subsidiary:
Now a wholly owned
subsidiary of the acquirer.
Net asset basis is $10,000.

21. Tax Implication of a Taxable Stock Sale w/ a §338(h)(10) Election
Sec. 338(h)(10) Election
$10,000.00
$8,000.00
$10,000.00
2,800.00
$7,200.00
$10,000.00
1,720.48
$8,279.52
$10,000.00
10,000.00
8,000.00

22. Review of Various Subsidiary Sale Tax Structures

23. Tax Implications of Various Taxable Subsidiary Sale Structures

24. Indifference Price Equation
The seller is indifferent if:
PRICE338h10 - tc(PRICE338h10 - ASSET) =
PRICENO338h10 - tc(PRICENO338h10 -STOCK)
where
PRICE338h10 is the price when an election is made
PRICENO338h10 is the price if the election is not made
ASSET is the seller’s basis in the net asset
STOCK is the seller’s basis in the sold subsidiary’s stock
tc is the corporate tax rate

25. Minimum Price Equation
The minimum price demanded by the seller to make the §338(h)(10) election is:
PRICE338h10 =
PRICENO338h10 + [tc/(1 - tc)](STOCK - ASSET)
where
PRICE338h10 is the price when an election is made
PRICENO338h10 is the price if the election is not made
ASSET is the seller’s basis in the net asset
STOCK is the seller’s basis in the sold subsidiary’s stock
tc is the corporate tax rate

26. Maximum Price Equation
The maximum price that the acquiring firm will pay in a §338(h)(10) transaction is:
ACQPRICE338h10 = PRICENO338h10 + tc*
PVANN*[(ACQUPRICE338h10 - ASSET)/N]
where
ACQPRICE338h10 is the maximum purchase price the acquiring firm is willing to pay in a §338(h)(10) transaction
PRICENO338h10 is the price if the election is not made
ASSET is the seller’s basis in the net asset
tc is the corporate tax rate
N is the average useful life of the acquired subsidiary’s assets
PVANN is the present value of an annuity

27. A §338(h)(10) election will be made in a subsidiary sale when
ACQPRICE338h10 - PRICE338h10 > 0
or, put another way, when
[tc/(1/FACTOR) - tc][PRICENO338h10 - ASSET] - [tc/(1 - tc)][STOCK - ASSET] > 0
where
FACTOR is PVANN/N
The other variables are as previously defined

28. Factors Determining a Parent’s Basis in a Subsidiary’s Stock and Net Assets
The parent’s tax basis in the stock and net assets will be equal if the subsidiary was internally generated.
When the sold subsidiary was previously acquired by the divesting parent, the parent’s tax basis in the subsidiary’s stock and assets is determined by the tax structure used to acquire the target.

29. Subsidiary Sales vs. Sales of Freestanding C Corporations
With subsidiary sales, the seller is a corporation--not an individual shareholder or a group of various sorts of shareholders
Subsidiary sales often result in a step-up in the tax basis of the target’s assets; in acquisitions of freestanding C corporations, the target’s assets usually carry over.

30. Conditions When a §338(h)(10) Election is Optimal
When the target subsidiary’s stock basis = asset basis and purchase price > net asset basis.
Also, when the tax basis of the target’s assets > the tax basis of the target’s stock.

31. Conditions When a §338(h)(10) Election is Sub-optimal
When the divesting parent’s tax basis in the sold subsidiary’s stock substantially exceeds the net tax basis of the subsidiary’s assets.
This situation is likely to arise if the divested subsidiary was previously acquired in a taxable stock acquisition.