Buying an S corporation? Use a 338(h)(10) election.

In subsidiary acquisitions, stock transactions can be treated as asset deals for tax purposes by using the Internal Revenue Code section 338(h)(10) election. A seller will agree to this election only if the tax on an asset deal does not differ materially from the tax-imposed on a stock sale or if the buyer agrees to increase the purchase price to reflect any difference. Typically, a buyer will agree to increase the purchase price only when the tax savings from the basis step-up at least equals the amount it pays to the seller.

The section 338(h)(10) election historically has been available to buyers of subsidiaries only. Now, a regulation (regulations section 1.338-l(h)(10)-1) generously makes it available to a larger group of targets. Section 338(h)(10) elections are permitted in acquisitions of S corporations even though, by definition, S corporations do not fulfill the statute's requirement that the target be a subsidiary. Thus, an S corporation acquisition can be set up as a stock purchase, but it can be treated as an asset purchase followed by a liquidation of the S corporation for-tax purposes.

Using a section 338(h)(10) election is a very attractive way to acquire an S corporation because of the e&se with which a stock purchase is consummated from a nontax point of view--acquiring an S corporation's assets creates complicated legal issues. A section 338(h)(10) election greatly reduces the transaction's complexity while providing a basis step-up.

Like the conventiona1 section 338(h)(10) election, an S corporation 338(h)(10) election has only a single level of tax because the gain on the asset sale passes through to the shareholders of the S corporation, who are then taxed on the gain. Fortunately, the shareholders obtain a basis increase in their stock equal to the pass-through: gain. This increased basis then serves to either reduce the gain or increase the loss recognized by shareholders on the hypothetical distribution of the S corporation's net assets in the liquidation phase of the transaction.

Observation: This development makes a section 338(h)(10) election a foregone conclusion in most acquisitions of S corporations. Advisers would be remiss if they did not point out the election's benefits when negotiating the acquisition of an S corporation on behalf of a client. --Robert Willens, CPA, managing director at Lehman Brothers, New York City.