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S corp. targets and sec. 338(h)(10) update.

The IRS recently released temporary regulations on determining the amount realized and the basis amount allocated to each asset transferred in a deemed or actual asset acquisition.

Temp Regs. Sec. 1.338(h)(10)-1T clarifies and modifies the tax treatment of S corporations and their shareholders when a Sec. 338(h)(10) election is made on the disposition of shareholders' S stock in a qualified stock purchase.

This item addresses the following issues:

* Availability of installment sales tax treatment to a cash-method S corporation and its shareholders under an installment sale of S stock coupled with a Sec. 338(h)(10) election;

* Sec. 338(h)(10) election requirements when S shareholders, who own 20% or less of the S stock, retain S stock; and

* Tax effects on S shareholders who retain their S stock under the tax "fiction" of a Sec. 338(h)(10) election.

Installment Sale Treatment under Sec. 338(h)(10) Election

Under prior law, the installment sale of S stock by its shareholders to a C corporation, coupled with a Sec. 338(h)(10) election, arguably resulted in an unintended, immediate triggering of the entire deferred gain on the S corporation's deemed asset sale.

Under prior law, the Sec. 338 "fiction" provided for a bifurcation of a target corporation into "old target" and "new target." Old target is deemed to have sold its assets to new target. The deemed sale of assets and deemed liquidation is that of old target. If this fiction is literally followed, installment sale treatment is not available; the installment note is from the actual purchaser of the stock, and not from the deemed purchaser of the assets. Therefore, the note is a third-party note and, under Sec. 453, would not be eligible for installment-sale treatment, because it is not the note of the actual purchaser.

Further, the current Sec. 338 regulations do not provide rules for old target to report its deemed sale gain under the installment method.

Conversely, Prop. Regs. Sec. 1.338(h)(10)-1 does provide for old target to report its deemed sale gain under the installment method, as long as the deemed asset sale would otherwise qualify for installment sale reporting. The proposed regulations solve the problem of the third-party note by outlining a new "fiction" of the installment sale method of reporting when a Sec. 338(h)(10) election is made.

Specifically, Prop. Regs. Sec. 1.338(h)(10)-1(d)(8) dictates that, solely for purposes of applying Secs. 453, 453A and 453B in a deemed asset sale, old target is treated as receiving new target installment obligations, the terms of which are identical (except as to the obligor) to installment obligations issued in exchange for recently purchased target stock. For the deemed liquidation, old target is treated as distributing the new target installment obligations it is treated as receiving in the deemed asset sale. The S shareholders are treated as receiving in the deemed liquidation the new target installment obligations that correspond to the original installment obligations they actually received individually in exchange for their recently purchased stock.

Example (10) of Prop. Regs. Sec. 1.338(h)(10)-1(e) provides a detailed working example of the application of this installment sale method "fiction" to the S corporation and its selling and nonselling shareholders when a Sec. 338(h)(10) election is made.

Nonselling S Shareholders

All shareholders must consent to a Sec. 338(h)(10) election. Under current law, it appears that S shareholders who own 20% or less of the S stock and who chose not to sell their stock are bound by the Sec. 338(h)(10) election of the other shareholders.

This often results in a current tax without the receipt of cash to S shareholders who wish to retain their S stock. The deemed asset sale (to the extent of the shareholder's pro rata gain allocation, if any) and the deemed liquidation (to the extent of the deemed liquidation proceeds in excess of outside shareholder stock basis) can both result in current taxable income. Because the shareholders who retain their S stock are not participants in the stock sale, cash (or other assets) is not received to help pay the resulting tax liability.

Prop. Regs. Sec. 1.338(h)(10)-1(c)(2) requires all S shareholders to consent to the Sec. 338(h)(10) election. This change is important; under the proposed regulations, any dissenting S shareholder (regardless of the percentage of S stock owned) may prevent the making of the Sec. 338(h)(10) election.

Tax effects on an S corporation of shareholder's retaining S stock. If any and all S shareholders that (1) cumulatively own less than 20% of the S stock and (2) do not sell their stock to an acquirer nevertheless join in the filing of a Sec. 338(h)(10) election, some potentially unduly harsh tax consequences may result. Prop. Regs. Sec. 1.338(h)(10)-1(d)(5) describes consequences of the Sec. 338(h)(10) election to S shareholders. Outlined in these proposed regulations is the treatment of three deemed transactions to S shareholders who retain their S stock that may result in unfavorable consequences.

First, S shareholders (whether or not they sell their stock) take their pro rata share of the deemed asset sale gain into account under Sec. 1366. S shareholders who retain their interests will either increase or decrease their basis in their S stock under Sec. 1367 to the extent of the deemed asset sale gain or loss. To the extent that the deemed sale results in a tax gain, S shareholders who retain their interests will not receive a cash distribution to cover their incremental tax liability from the deemed asset sale.

Second, the S shareholders (whether or not they sell their stock) are treated as if they received the assets comprising the aggregate deemed sale price (ADSP) from the S corporation. In most cases, the transfer will be treated as a distribution in complete liquidation to which Sec. 331 applies. To the extent that an S shareholder retaining S stock has less basis in the S stock than the deemed liquidation proceeds, the shareholder will recognize capital gain. The shareholder receives deemed liquidation proceeds and not actual cash or property proceeds; therefore, the shareholder will not have cash or other assets to cover the incremental tax liability resulting from the deemed liquidation.

Note: Under the proposed regulations and the proposed tax fiction of the Sec. 338(h)(10) transaction, the transfer of the ADSP from old target to the S shareholders is characterized for Federal income tax purposes in the same manner as if the parties had actually engaged in the transactions deemed to occur, taking into account other transactions that actually occurred or are deemed to occur. For example, the transfer may be treated as a distribution in pursuance of a reorganization plan, a distribution in complete cancellation or a redemption of all its stock, etc. In most cases, the transfer will be treated as a distribution in complete liquidation to which Sec. 336 applies.

Finally, the proposed regulations indicate that, under the proposed tax fiction, S shareholders retaining their S stock are treated as acquiring the S stock (reacquiring the S stock under the tax fiction) so retained on the day after the acquisition date for its fair market value. The holding period for the retained stock starts on the day after the acquisition date. Any stock value appreciation recognized by the retaining shareholders on the disposition of S stock for one year after the date of the transaction will result in unfavorable short-term capital gain tax rates.

Note: The description of the reacquired stock above as "S stock" should not be confused to mean that the stock retained by the shareholder(s), after the transaction, is still that of an S corporation (i.e., if the acquirer is a C corporation (an ineligible shareholder), the target corporation will no longer qualify as an S corporation). The description is merely used to consistently identify the target corporation's stock.

Example (10) of Prop. Regs. Sec. 1.338(h)(10)-1(e) provides a detailed working example of the application of the proposed regulations, and the tax consequences thereof, to the nonselling shareholders when a Sec. 338(h)(10) election is made.

While the above tax consequences may appear unduly harsh, Prop. Regs. Sec. 1.338(h)(10)-1 (as outlined above), unlike current law, will give any dissenting S shareholder the ability to prevent a Sec. 338(h)(10) election from being made.

FROM MICHAEL LUX, CPA, AND STEW SHERWOOD, CPA, WASHINGTON, DC
COPYRIGHT 2000 American Institute of CPA's
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Title Annotation:Internal Revenue Code
Author:Sherwood, Steve
Publication:The Tax Adviser
Geographic Code:1USA
Date:Mar 1, 2000
Words:1440
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