If a post-deal asset disposal is correctly structured, it has the potential to minimise or eliminate taxable gain.
In order to better understand this concept, let us use a simple example. Pursuant company P wants to acquire target corporation T by purchasing corporation S in a leveraged buyout (LBO) transaction for $100. T1 and T2 are the two divisions that make up the activities of T. The acquisition price of the T stock was funded in significant part by loans from financial institutions. S has a tax basis of $20 in its T shares, and T has a tax basis of zero in its T1 and T2 assets, according to the IRS. In order to pay off purchase debt, P must sell the T2 division to a third party as soon as possible after acquiring T. Despite the fact that the two divisions of T are roughly equal in value, P thinks that it will be able to sell the T2 division on its own for $60,000.
Proposition: If P purchases all of T for $100, it should be able to promptly sell all of T for $100 and realise no taxable gain as a result of the transaction. What should follow is that if P disposes of the T2 division, which represents one-half of the value of T, for $50, no profit should be recorded in that transaction as well.
For the most part, whether or not this statement is correct will depend on whether or not P has acquired the assets of T or the shares of T. After purchasing the assets of T for $100 or electing to defer the application of Section 338, P will have a cost basis in all of the T assets and will realise no gain if it sells any or all of those assets for a sum equal to the cost of the acquisition. Alternatively, if P acquires the shares of T but does not make a Section 338 election, T maintains its carryover basis in its assets, and P will be liable for tax on the $50 of built-in gain realised by T upon a disposition of the T2 division.
Although a buyer may have acquired a cost basis in T’s shares, the general rule is that T may not dispose of its assets without incurring a tax liability on the increase in the value of those assets. The most direct and certain method of avoiding a second tax on built-in gain within a target is to obtain a cost basis in the target’s assets through a direct asset acquisition, a forward cash merger, or a Section 338 transaction. Direct asset acquisitions, forward cash mergers, and Section 338 transactions are all examples of such transactions.