S corporations and sec. 338(h)(10).

Regs. Sec. 1.338(h)(10)-1 uses "legislative" authority under Sec. 338(h)(10) to provide an interesting result for the corporate acquisition of an S corporation. Specifically, the purchasing corporation and the former S shareholders can join in an election under Sec. 338(h)(10) to tax the gain built into the acquired corporation's assets back to the selling shareholders. Under the general rules of Sec. 338(a), this gain would be taxed to the purchaser by virtue of obtaining a step-up in basis of the acquired assets.

Regs. Sec. 1.338(h)(10)-1 provides that a proper election is made using Form 8023, Corporate Qualified Stock Purchase Elections (Under Temporary Regulations Section 1.338), not later than the fifteenth day of the ninth month after the month of acquisition. The election must be a "simultaneous joint" election by the acquiring corporation and the S shareholders.

The election treats the acquired S corporation as if it had sold all of its assets at the close of the acquisition date, while it was still owned by the S shareholders. The S corporation is then treated as having distributed all assets remaining after the deemed sale in complete liquidation to its shareholders.

While the regulations require potentially complex allocations of a modified aggregate deemed sales price (MADSP), the thrust of the election is to treat the S corporation as if it had sold assets to the buyer and had then liquidated. Thus, any gain or loss on the assets is recognized at the corporate level and passes through to the shareholders. The passthrough of gain or loss results in increases or decreases to aggregate stock basis. The deemed liquidation that follows produces another measure of gain or loss, comparing the adjusted aggregate basis after the deemed sale to the assets distributed (i.e., the sales proceeds). Overall, the result is a single level of tax on the gain contained in the S corporation's assets.

Why would selling S shareholders agree to join in this election? Such agreement would come likely as part of the negotiations with the potential purchaser, trying to minimize the purchaser's cost while also maximizing after-tax cash to the selling S shareholders.

It is very possible that the total tax on the transaction will be less with a Sec. 338(h)(10) election. First, there is only one level of tax to deal with. Furthermore, depending on the amount of the gain and the individual tax situations of the S shareholders, capital gains rates (or alternative minimum tax rates) may produce a lower overall tax than if computed at C corporation rates.

If a tax adviser is involved in planning for a corporate acquisition of an S corporation, he should review the potential impact of a Sec. 338(h)(10) election.

The regulations also give an opportunity for amended returns to be filed for any qualifying acquisitions between jan. 14, 1992 and Jan. 19, 1994, inclusive, under authority of Regs. Sec. 1.338(i)-1(b). An acquired S corporation can use the provisions of Regs. Sec. 1.338(h)(10)-1 by including a statement to that effect in its amended return. Other amended returns would be required for other entities, including the former S shareholders, to report the transactions consistently with the Sec. 338(h)(10) election.