Asset acquisition: practical guidance on Sec. 338 election.
These Final Regulations have been in place for more than three years since they are to be applied to all qualified stock purchases or applicable asset acquisitions made after March 15, 2001.
A QSP is defined as a stock acquisition wherein the purchasing corporation acquires 80 percent or more of the total voting power and 80 percent or more of the total value of the stock of a target corporation by purchase within a 12-month period.
Sec. 332 provides for the liquidation of a controlled subsidiary corporation. This definition also is used for purposes of applying Sec. 338.
TYPES OF ELECTIONS
There are still two different types of elections which can be made pursuant to Sec. 338:
Election 1: Often referred to as the general election under Sec. 338(g), this election takes a traditional view of the tax consequences on the purchasing corporation, target corporation and the selling shareholders.
In essence, the selling stockholders continue to be taxed on the sale of their stock. The target corporation is viewed as having transferred all of its assets to an unrelated person in exchange for consideration which includes the assumption of liabilities thereby generating a realized gain or realized loss on the deemed sale of assets.
In accordance with the provisions of Sec. 338(g), the new target corporation is treated as a new corporate entity that is not related to the old target except for issues relating to retirement plans and similar provisions. [Regs 1.338-1(b)(2)].
Election 2: A more novel approach to the contemplated transaction is electing Sec. 338(h)(10), whereby the selling shareholders are permitted to join with the purchasing corporation in choosing to significantly alter the tax ramifications for the selling shareholders, the target company, and the purchasing corporation.
Although this election has received much attention as a planning tool during the past few years, tax practitioners should not automatically assume that it is the best choice in all situations. The following example will illustrate the care that must be taken to make an election that is most advantageous for clients.
Assume that Acquirer, a C corporation, purchased all of Target Corporation's common stock for $40 million in cash Sept. 30, 2003. Acquirer Corp. and Target Corp. agreed to make a timely election under Sec. 338(h)(10). The balance sheet of Target Corp. as of Sept. 30, 2003 reflected the following data:
Target Corp. has been an S corporation since its inception on June 6, 1981 and uses the cash method of accounting. The equipment cost $800,000 when purchased by Target Corp. and was depreciated using the standard MACRS statutory rates.
Target had no other assets or liabilities as of the date of the acquisition. Target's ordinary income for calendar year 2003 was $4 million, of which $3.5 million was recognized as of Sept. 30, 2003. Target's sole shareholder, Jones, had an adjusted basis in her stock of $1 million immediately before the acquisition.
Assume that any excess purchase price is attributable to goodwill. In addition, assume that Jones is in the 35 percent federal income tax bracket for ordinary income purposes and 15 percent federal income tax bracket for long-term capital gains purposes.
Does the election under 338(h)(10) yield the best results?
For our purposes, this analysis shall ignore the possible impact of the alternative minimum tax and state and local income taxes. However, it is always important to consider the tax ramifications at the state and local level of any contemplated transaction.
To the extent that a target incurs income taxes as a result of a 338 election, the Aggregate Adjusted Deemed Selling Price would be modified accordingly.
Since the parties agreed that a Sec. 338(h)(10) election is desirable, Acquirer and Target must jointly file Form 8023 on or before June 15, 2004 since it is the fifteenth day of the ninth month beginning after the month in which the acquisition date occurred pursuant to section 338(g)(1).
Sec. 338(h)(2) defines the "acquisition date" as the first day during the 12-month acquisition period on which the 80 percent stock purchase requirement is met. The parties must understand that 338(h)(10) election is irrevocable in accordance with 338 (g)(3).
In addition, Acquirer Corp. and Target Corp. must attach Form 8883 to their Form 1120 and 1120S, respectively, for the taxable year (2003) that includes the purchase date.
Since Target Corp. has been an S corp since its inception in 1981, there will be no negative tax ramifications for Target Corp. because all statutory requirements have been met. Sec. 1361(b)(1) and 1361(b)(2) delineate shareholder and corporate-related requirements, respectively.
Further, it is assumed that the Target Corp. is not subject to the built-in gains tax of Sec. 1374, the excess net passive income tax of Sec. 1375, nor the LIFO recapture tax of Sec. 1363(d). The sale of the Target company's stock does not cause a termination of its S status, but the S corp status will terminate on the acquisition date pursuant to 1362(d)(2) as a result of the acquisition of the Target Corp. stock by Acquirer, which is an ineligible shareholder.
It should be noted that the repeal of Sec. 1371(a)(2) clarified the availability of Sec. 338 to S corp acquirers. (See also TAM 9245004, which allowed an S corp acquirer to elect under Sec. 338 and liquidate its purchased subsidiary under Secs. 331 and 337. In such a circumstance, the S corp acquirer will typically elect to treat the target as a qualified S corp subsidiary to preserve pass-through status).
Target Corp. should first file Form 1120S for the short period covering Jan. 1, 2003-Sept. 30, 2003. In addition, Target Corp. must file Form 1120 for the short period covering Oct. 1, 2003-Dec. 31, 2003.
There are several tax issues affecting shareholder Jones.
First, the ordinary income of $3.5 million, which was generated by the S corp from Jan. 1, 2003-Sept. 30, 2003 passes through as ordinary income to the shareholder under traditional conduit theory principles. [Sec. 1362(e)(6)(d)].
A second source of taxable income to shareholder Jones relates to the tax consequences of the deemed sale by the Target Corp., which also flow through to Jones at the individual level. The deemed sale by Target Corp. would be viewed as follows (Reg. 1.338-4):
Amount of Cash Paid to Target: $40M
Plus: Accounts Payable of Target: $1.2M
Equals the Aggregate Deemed Sales Price (ADSP) or amount realized: $41.2M
Allocation of ADSP:
Attributable to Cash: -$500,000
Attributable to Accounts Receivable -$3M
Attributable to Equipment: -$600,000
Balance Attributable to Goodwill: $37.1M
The resulting tax consequences on shareholder Jones can be summarized in three components:
(A) Flow-thru of $3.5 million Ordinary Income from S corp covering period from Jan. 1, 2003-Sept. 30, 2003.
$3.5M X 35% rate = $1,225,000
(B) Ordinary Income from Target Corp. sale of Accounts Receivable
$3M X 35% rate = $1,050,000
(C) Capital gains tax applied to the net long-term capital gain of $32.5 million resulting from the capital gain of $37.1 million on the sale of goodwill, as calculated above, minus the capital loss of $4.6 million on the deemed liquidation of Target Corp.
The adjusted stock basis of Jones would be calculated as follows: Initial Basis $1 million plus share of Ordinary Income from Operations ($3.5 million) plus Ordinary Income from Sale of Accounts Receivable ($3 million) plus capital gain on sale of Goodwill ($37.1 million) equals Final Basis of $44.6 million.
The capital loss on the deemed liquidation would be computed by comparing the liquidation proceeds of $40 million with the Final Basis of $44.6 million, thereby generating a $4.6 million long-term capital loss. (Sec. 331 liquidation provision affecting shareholders and Secs. 1366 and 1367 S corp. provisions affecting calculation of stock basis of shareholder).
$32.5M X 15% (LTCG rate) = $4,875,000
Therefore, the total federal income tax liability imposed upon shareholder Jones would be $7,150,000, which is the sum of the three components noted above. (This analysis assumes that Target's cash basis accounts payable totaling $1.2 million would not be deductible on its final stub period tax return. But a deduction may be justifiable under TAM 9125001 and Commercial Security Bank v. Commr. 77 T.C. 145 (1981).
It is now essential to analyze the tax ramifications for shareholder Jones assuming that she did not make the Sec. 338(h)(10) election.
This analysis can be broken down into two components:
(A) Flow-through of $3.5 million Ordinary Income from S corp covering period from Jan. 1, 2003-Sept. 30, 2003.
$3.5M X 35% = $1,225,000
(B) Long-term capital gain tax on sale of stock which has an adjusted basis of $4.5 million (Initial Basis of $ 1 million plus Share of Ordinary Income of $3.5 million). The sale proceeds of $40 million minus the stock basis of $4.5 million would yield a long-term capital gain of $35.5 million.
$35.5M X 15% = $5,325,000
Therefore, if shareholder Jones does not make the 338(h)(10) election, the total federal income tax liability would be $6,550,000.
Based on the analysis and calculations, shareholder Jones would be wise in not making the election under Sec. 338(h)(10). She will save $600,000 in after-tax dollars by not joining in the election.
Since the election must be made jointly by the Acquirer Corp. and Target Corp. and must be signed by all Target Corp. shareholders, it appears that Jones should use this information as a negotiation tool to maximize her tax and non-tax advantages of the transaction.
Tax practitioners who represent the shareholders of the Target Corp. must be sure to always do a detailed analysis to ascertain the desirability of engaging in the Sec. 338(h)(10) election.
Adjusted Basis Fair Market Value Cash $500,000 $500,000 Equipment $600,000 $600,000 Accounts receivable -0- $3 million Accounts payable -0- $1.2 million
BY CHARLES A. BARRAGATO, CPA & MICHAEL J. ABATEMARCO, CPA
Charles A. Barragato, Ph.D., CPA, CFE and Michael J. Abatemarco, J.D., LL.M., CPA are professors at the C.W. Post School of Professional Accountancy. You can reach them at Charles.Barragato@liu.edu and Michael.Abatemarco@liu.edu.
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|Title Annotation:||PROFESSIONAL ISSUES|
|Author:||Abatemarco, Michael J.|
|Date:||Jan 1, 2005|
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