David Hasen’s recent article on Code § 338 – which governs taxable acquisitions – displays the kind of dizzyingly intricate logical reasoning that attracts many curious law students to tax law. Marshalling legislative history, Congressional intent, and administrative rulings, Hasen makes a compelling case for how § 338 should be applied, and also shows that current regulations under § 338(h)(10) exceed the statute’s boundaries. In doing so, the article offers the sort of elegant doctrinal analysis that lawyers and law students dream of, but rarely get to craft in practice.
Because the article discusses Code § 338, it must start with the Kimball-Diamond (K-D) case, which Hasen dutifully recounts. To refresh the reader’s memory, in K-D the taxpayer bought all the stock of Whaley and then liquidated the resulting subsidiary under a predetermined plan. Because K-D always intended to hold Whaley’s assets directly, the court applied the step-transaction doctrine to collapse the two steps together into one asset purchase. As a result, K-D took the lower cost basis in the assets.
Although a win for the IRS, the K-D doctrine wrought havoc on the government’s ability to police taxable sales because it was based on the ever-elusive concept of taxpayer intent. Congress responded to the resulting taxpayer gaming by enacting § 338, which allows taxpayers to elect for certain stock purchases to be treated as asset purchases. (I believe such a policy tactic is known as the Path of Least Resistance.)
As Hasen explains, by allowing an election, § 338 “turns off” the step-transaction doctrine in certain cases. The question is, which cases? Some commentators have observed that § 338 turns off step-transaction analysis when the purchasing corporation makes a qualifying stock purchase (QSP)—that is, a stock purchase eligible for the § 338 election. Hasen disagrees with this characterization. Rather, he cogently argues and painstakingly supports the position that § 338 turns off the step-transaction doctrine for a broader set of cases: those where, before § 338 existed, the purchaser would have taken cost basis in the assets under K-D’s step-transaction analysis.
Hasen’s framework dictates the following two-step analysis. 1) First, one must ask whether the K-D doctrine would provide the purchaser with cost basis in target’s assets. 2) If yes, then the K-D doctrine does not apply and the steps of the purchase are analyzed separately. The stock purchase will be treated as an asset purchase only under the rules provided in § 338, that is, if there’s a QSP and taxpayer election. If the answer under Step 1 is no – for instance, because the purchaser would receive carryover basis in the target’s assets, as in a tax-free reorg – then § 338 does not override the K-D doctrine and the step-transaction doctrine still applies.
Hasen’s second argument follows on the scaffolding he builds in the first half. Pursuant to regulations promulgated under § 338(h)(10) (the part of the statute applying to purchases of subsidiaries), the taxpayer can elect § 338(h)(10) if a stock purchase is a QSP, regardless of whether it is also a step in a reorg. (Reg. § 1.338(h)(10)-1(c)(2)) Notice, this rule clearly violates Hasen’s framework. Section 338 is only meant to turn off the step-transaction doctrine where a stepped-together purchase would have provided the purchaser with cost basis in the assets. But here, Treasury allows taxpayers to turn off step-transaction analysis even where they would have received carryover basis in the assets.
Moreover, determining whether a purchase is a QSP under § 338 requires first checking the results under the step-transaction doctrine (Step 1 above), and only then turning off step-transaction analysis under certain circumstances. But, under the (h)(10) rule, Treasury allows for analysis of the transaction’s steps separately before determining whether they should be looked at separately. As he puts it, the rule “effectively permit[s] section 338 to apply to the question [of] whether it applies.” Hasen fails to find authority or precedent for such an expansive rule. The Treasury seems to have created it out of whole cloth.
Hasen’s multitiered argument involves many discreet pieces, and while one could perhaps take issue with particular assertions, cumulatively it is somewhat unassailable. In the end, however, taxpayer-friendly rules like those under § 338(h)(10) are rarely challenged, even during the rule’s notice-and-comment period. (See research here and here documenting the lack of public-interest involvement in the tax rule-making process.) Once promulgated, the rules are protected by strict taxpayer-standing requirements. Thus, while Hasen’s point is a good one and elegantly made, we will have to wait for change to come from within the Treasury or Congress, which doesn’t seem likely any time soon. If/when the time does come for policymakers to reconsider the § 338(h)(10) rule, I hope they read this article first.