Tax Planning for Carve-Out and Take-Private Transactions: Use of Selective Section 338 and/or 336 Elections

In carve-out transactions, especially in take-private transactions backed by private equity (PE), tax friction costs can often make or break a deal.  By the same token, creative tax planning ideas can enhance deal value and help to bridge valuation gaps in competitive situations. This note will highlight a vintage tax planning technique that we believe may be underutilized in the take-private context. In essence, this technique allows a company to use built-in losses from one subsidiary to offset the gain recognized with respect to another, achieving a stepped-up tax basis in the gain assets, as well as the larger future deductions that come with it, at potentially no incremental cash-tax cost and effectively converting otherwise trapped or unusable losses into real economic value.

Let’s assume a public corporation (PubCo), which has two distinct business lines held in separate corporate subsidiaries: Sub A, which holds Business A, and Sub B, which holds Business B. For non-tax reasons, let’s also assume that it makes perfect sense for Business A and Business B to be profitably operated separately, and that a take-private transaction in which Business A and Business B are separated could be very valuable, but for the tax cost of “breaking” the consolidated tax group. Finally, let’s assume that Business A is in a built-in gain position (i.e., low inside basis and a low basis in the stock of Sub A) and Business B is in a built-in loss position (i.e., high inside basis and a high basis in the stock of Sub B).

Using these basic facts, a few different transactions might be possible, with widely varying tax results. We won’t try to address all the permutations, but in our experience in the market, the planning for a transaction like this one would often start from the premise that the tax on the gain inherent in Business A must be avoided at all costs, resulting in tax analytical resources and diligence efforts that are solely focused, at an early stage, on separating out Business B. This focus could end up being a distraction from a more valuable planning option; namely, the possible use of the inherent loss in Business B to offset the inherent gain in Business A. How might that be accomplished?

Let’s further assume a PE-backed buyer that will acquire 100 percent of equity of PubCo for cash, followed by a sale of the equity of Sub B to an unrelated third-party buyer. If the buyer makes a Section 338(g) election with respect to PubCo (resulting in a deemed sale of the directly held assets of PubCo, here, solely the stock of Sub A and Sub B), long-standing IRS guidance indicates that it is generally possible to push down the effects of that election by making follow-on Section 338(g) elections with respect to corporate subsidiaries, and that those follow-on elections may be made for some but not all subsidiaries. See IRS AM 2007-006, citing Treas. Reg. Section 1.338-8(a)(1). Similar rules should apply with respect to a Section 336(e) election, if applicable to the particular transaction. See Treas. Reg. Section 1.336-1. Accordingly, follow-on Section 338(g) elections could be made for Sub A and Sub A’s corporate subsidiaries (as applicable), resulting in recognition of the entire inside gain in Business A and resulting in a step up to fair market value (FMV) of the inside tax basis of the Business A assets. Standing alone, this deemed sale would generate substantial taxable gain to PubCo because of the low inside basis in the Business A assets. However, due to the simultaneous recognition of the inherent loss in the stock of Sub B (or its assets if the 338(g) election is pushed down further), this gain may be completely offset.  (Note, care should be taken to assess potential character mismatches and state variations in tax treatment that could impact the potential offset.) The net result is a basis step-up in the Business A assets at potentially no incremental cash-tax cost to PubCo and the immediate utilization of PubCo’s Business B loss, which could otherwise have been deferred or limited following the change of control.

A Template for Future Transactions

Investors encountering similar fact patterns should consider whether this structure, or a variation of it, can unlock significant value. If you have any questions on this structure, please contact one of the Katten lawyers listed above.