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Sec. 338(h)(10) elections involving S corporation targets.

In early 1994, the Treasury issued regulations under Sec. 338(h)(10) that dramatically altered the mergers and acquisitions landscape for closely held businesses. These regulations expanded the beneficial treatment of Sec. 338(h)(10) from consolidated groups(1) to S corporations and affiliated groups(2) not filing consolidated returns.

This was once an area that had little impact on the smaller tax practitioner. However, the changes to the Sec. 338(h)(10) regulations make it incumbent on any professional assisting a client with the purchase or sale of a business to understand and, when applicable, make the election. The failure to recognize opportunities to use these new rules may cause taxpayers to forgo significant tax benefits.

Unfortunately, it is not entirely clear from the regulations how the S corporation rules and the Sec. 338(h)(10) election interrelate. No examples are provided involving S corporations and the descriptive language detailing the rules as they relate to S corporations is limited.

This article will examine the ramifications of a Sec. 338(h)(10) election involving an S corporation target. When the final regulations are silent or unclear about certain outcomes, the authors will provide what they believe to be the most reasonable alternatives. Additionally, several examples will illustrate the decision criteria that must be considered by the seller and the buyer in analyzing whether to make a Sec. 338(h)(10) election.

Sec. 338

In 1982, Congress enacted Sec. 338 to allow a purchasing corporation to treat the acquisition of a target corporation's stock as the acquisition of its assets. In a straight Sec. 338 election, this is accomplished by treating the target corporation (Old Target) as having sold its assets at the close of the acquisition date to a new corporation (New Target) that is deemed to acquire the assets as of the beginning of the next day. A straight Sec. 338 election does not affect the selling shareholder (i.e., gain is recognized on the stock sale as though the election had not occurred).

A Sec. 338 election is allowed only for transactions in which control of Old Target is acquired in a "qualified stock purchase" (QSP). Sec. 338(d)(3) defines a QSP as any transaction or series of transactions in which "control" (i.e., at least 80% of vote and value) of a target corporation is purchased by an acquiring corporation during a "12-month acquisition period." Thus, the purchaser must be a corporation and 80% of vote and value must be completely acquired within an actual time span of 12 months.

Under pre-Tax Reform Act of 1986 (TRA) law, the straight Sec. 338 election was quite beneficial because the target's appreciated assets received a step-up in basis at little or no current tax cost. However, due to the TRA's repeal of the General Utilities doctrine,(3) the deemed asset sale is now fully taxable. Accordingly, straight Sec. 338 elections are now rare. Only in certain limited situations does it make financial sense to generate current taxable income to obtain a higher basis in the target's assets.

Sec. 338(h)(10)

One significant post-TRA planning opportunity is the Sec. 338(h)(10) election.(4) The enactment of Sec. 338(h)(10) resolved the question that arose under original Sec. 338 as to whether gain generated by a Sec. 338 election made with respect to a target that was a subsidiary in a consolidated group was included in the consolidated return of the selling group or, rather, had to be reported on a separate return (as is generally the case under Sec. 338). Sec. 338(h)(10) treats the gain as part of the selling consolidated group's income.

Recognition of the gain by the selling consolidated group in a Sec. 338(h)(10) election is accomplished by treating Old Target as if it had sold all of its assets in a taxable "deemed asset sale" to New Target, followed by the liquidation of Old Target.

The fundamental difference between a Sec. 338 election and a Sec. 338(h)(10) election is generally the elimination of one level of tax. In a Sec. 338 transaction, the seller recognizes taxable income on the sale of stock, and Old Target separately recognizes gain on its deemed sale of assets, creating two levels of tax. In a Sec. 338(h)(10) transaction in which Old Target is a subsidiary in a consolidated group, Old Target is deemed to have sold its assets to New Target in a taxable transaction and then liquidated tax free into the selling shareholder(s) under Sec. 332.(5) Thus, the transaction creates only one level of tax--on the deemed asset sale. The Sec. 338(h)(10) acquisition technique is particularly beneficial when Old Target's consolidated group has significant net operating losses (NOLs) that are about to expire or Old Target has NOLs that are of little value to the purchasing corporation.(6) In such a case, even though the selling consolidated group must recognize taxable income on the deemed asset sale, the gain may be offset by the NOLs. Any unused NOL is carried forward by the selling consolidated group under Sec. 381, because the liquidation of Old Target is treated as a Sec. 332 liquidation into the selling consolidated group.

New Regs.

Historically, the Sec. 338(h)(10) election was somewhat limited by the requirement that the target be a member of a consolidated group. To expand Sec. 338(h)(10)'s availability, TRA Section 631(b)(3) also added flush language after Sec. 338(h)(10)(B)(ii) to allow the Treasury to publish regulations permitting deemed asset sale treatment to any affiliated group of corporations, whether or not the group files a consolidated return. TRA Section 631(a) also added Sec. 336(e) to provide that under regulations, principles similar to Sec. 338(h)(10) may be applied to taxable distributions of controlled corporation stock. Apparently, the Treasury relied on these two statutory delegations of authority to allow Sec. 338(h)(10) treatment to a target that (1) satisfies the requirements of Sec. 1504(a)(2) but is not included in a consolidated return, or (2) is an S corporation.(7) While the result is appropriate and reasonable given that similar results would obtain from a direct sale of assets, there appears to be no statutory support for the regulatory inclusion of S corporations as allowable targets in Sec. 338(h)(10) transactions. Neither the Sec. 338(h)(10) regulations nor their preamble offers any insight into the Treasury's rationale.

* Joint election requirement

While an election under Sec. 338(h)(10) is potentially desirable, it is also irrevocable.(8) Thus, once the election is made, the purchaser and the selling shareholder(9) are permanently bound to Sec. 338(h)(10) treatment.

Under Regs. Sec. 1.338(h)(10)-1(d)(2), a Sec. 338(h)(10) election is made jointly by the purchasing corporation and the S shareholder on Form 8023, Corporate Qualified Stock Purchase Elections. In July 1994, the IRS issued a new Form 8023-A, Corporate Qualified Stock Purchases, to make the election. The Treasury has not yet updated the regulations to provide for the change in the form, nor has any announcement been made on the substitution of the new form for the original. While guidance appears to be lacking, it is reasonable to assume that, even though Form 8023 does not expire until Oct. 31, 1995, and has not been withdrawn or declared obsolete, it has been revised and replaced by Form 8023-A.

Form 8023-A must be jointly filed by the purchasing corporation and the S shareholder with the Service Center where the target's Federal income tax return is filed, by the fifteenth day of the ninth month beginning after the month in which the acquisition occurs.(10) Thus, if the acquisition date is Jan. 20, 1995, the form would be due by Oct. 15, 1995. In addition, a copy of the filed Form 8023-A must be attached to the final income tax return for Old Target and the first return of New Target.

Form 8023-A institutes new filing requirements for any acquisition that is a QSP. Regardless of whether a Sec. 338 election is made for the target, the purchasing corporation must attach Form 8023-A to its Federal income tax return for the tax year that includes the acquisition date. In addition, while the instructions to the form are not totally clear, they appear to state that the form must also be filed separately with the Service Center where Old Target's final return will be filed.

Regs. Sec. 1.338(h)(10)-1(c)(2) provides that, since the target is an S corporation, the purchasing corporation cannot acquire any target stock before the acquisition date if a Sec. 338(h)(10) election is to be made. Any such purchase by a corporate buyer would terminate the target's S election, thus denying the target eligibility for Sec. 338(h)(10) treatment, absent a restructuring to create an affiliated group.

* Tax consequences to Old Target

If a joint election is made under Sec. 338(h)(10), Old Target recognizes gain or loss under Regs. Sec. 1.338(h)(10)-1(e)(1) as if, while still owned by the S shareholder, it sold all of its assets in a single transaction at the close of the acquisition date (but before the deemed liquidation). Gain or loss on each asset held by Old Target is determined by comparing the basis in the hands of Old Target to the allocated fair market value (FMV) of such asset.

Rules are provided to determine the sales price of each asset "sold" in the deemed asset sale. Specifically, the price at which each asset of Old Target is deemed to have been sold is calculated by (1) determining the modified aggregate deemed sale price (MADSP) and (2) allocating MADSP among the assets of Old Target.(11) For S corporations, MADSP is defined by Regs. Sec. 1.338(h)(10)-1(f)(2) as the sum of (1) the basis of the New Target stock in the hands of the purchaser, (2) New Target's liabilities and (3) other relevant items.

New Target's liabilities: The amount of New Target's liabilities taken into account in determining MADSP is determined under Regs. Sec. 1.338(h)(10)-1(f)(3) as if New Target had acquired Old Target's assets from an unrelated person and, as part of the transaction, had assumed or taken property subject to the liabilities.

Under Regs. Sec. 1.338(b)-1(f)(2)(i), for a liability to be considered in the MADSP calculation, it must be a bona fide liability of the target as of the day after the acquisition date that is properly includible in basis under principles of tax law that would apply if New Target had acquired Old Target's assets from an unrelated person and, as part of the transaction, had assumed or taken property subject to the obligation. For example, if, as of the day after the acquisition date, a contingent or speculative obligation of the target (e.g., estimated accrued worker's compensation claims) was properly excludible from basis, the obligation is not initially included in MADSP. Regs. Sec. 1.338(b)-1(f)(2)(ii) provides that if an obligation is initially excluded from MADSP, general tax law applies to determine the treatment of the obligation had the transaction been a direct purchase of assets.(12)

Income tax liability from deemed asset sale: If the target S corporation is subject to the built-in gains tax under Sec. 1374, a corporate tax liability will arise from the deemed sale. This tax is a legal liability of the corporation and will remain a liability of the target corporation after the transaction.

The definition of MADSP in Regs. Sec. 1.338(h)(10)-1(f) does not refer to assumed target tax liabilities as does the definition of aggregate deemed sales price (ADSP) in Regs. Sec. 1.338-3(d).(13) In defining ADSP, Regs. Sec. 1.338-3(d)(1)(ii) specifically includes in the liabilities of New Target tax liabilities resulting from the deemed sale. In defining MADSP, Regs. Sec. 1.338(h)(10)-1(f)(2)(ii)(B) includes no such reference to tax liabilities. In addition, in discussing liabilities in determining ADSP, Regs. Sec. 1.338-3(d)(3) directs the reader to Regs. Sec. 1.338(b)-1(f) and specifically refers to tax liabilities. The similar provision in Regs. Sec. 1.338(h)(10)-1(f)(3) makes no such reference to tax liabilities. Is there any significance to the failure of Regs. Sec. 1.338(h)(10)-1(f)(3) to mention tax liabilities?

The examples under Regs. Sec. 1.338(h)(10)-1(g) offer no answer. In the examples, all of which deal with the sale of a target corporation by a consolidated group, the selling shareholder pays the target's tax liability for the year of sale (which includes the tax from the deemed sale), thus skirting the issue.

However, the failure of Regs. Sec. 1.338(h)(10)-1(f)(3) to mention assumed tax liabilities probably is not significant. While a deemed sale transaction is difficult to reconcile with an actual transaction (due to the target's retention of the "selling" corporation's tax liability), that tax liability is a valid legal liability of the target on the day after the transaction. Absent specific regulatory language excluding the tax liability from the MADSP formula, it appears that the assumed tax liability is a valid liability for MADSP purposes.

Other relevant items: Regs. Sec. 1.338(h)(10)-1(f)(4) defines other relevant items to include reductions for (1) acquisition costs of the purchaser incurred in connection with the stock purchase that are capitalized in the basis of the New Target stock (e.g., brokerage commissions and any similar costs incurred by the purchaser to acquire the target stock) and (2) selling costs of the selling shareholders that reduce the amount realized on the sale of the target stock. These reductions convert the purchaser's acquired basis in the stock (which includes costs incurred) to the seller's deemed net sales price for the assets (which would not include the purchaser's costs and would be further reduced for the seller's costs).

Allocation of MADSP: Once MADSP is determined, it must be allocated among the assets of Old Target as provided in Temp. Regs. Sec. 1.338(b)-2T (without taking into account Temp. Regs. Sec. 1.338(b)-2T(c)(2)). In general, the rules operate as follows. All assets of the corporation are segregated into four classes: Class I (cash and cash equivalents), Class II (certificates of deposit, U.S. Government securities, readily marketable stocks or securities, foreign securities, etc.), Class III (all remaining assets of the corporation, other than goodwill or going concern value) and Class IV (goodwill and going concern value). MADSP is first allocated to Class I assets up to their FMV, then to Class II assets in proportion to and up to their FMV, and then to Class III in a similar manner. Any amount of MADSP in excess of the FMV of Classes I through III is allocated to Class IV.

Once MADSP has been allocated to the individual assets, they are deemed to be sold at that value. Gain or loss is recognized on each asset based on the difference between allocated MADSP and the individual asset's adjusted basis.

Regs. Sec. 1.338-1(e)(1) requires the gain or loss and tax liability resulting from the deemed asset sale to be included in Old Target's final return, which is defined by Regs. Sec. 1.338-1(c)(6) as the income tax return for the tax year ending at the close of the acquisition date. Regs. Sec. 1.338-1(e)(6)(i) provides that the final return is generally due on the fifteenth day of the third calendar month following the month in which the acquisition occurs.

Deemed liquidation of Old Target: For purposes of subtitle A of the Code, Old Target is treated under Regs. Sec. 1.338(h)(10)-1(e)(2)(ii) as if, while still owned by the Old Target shareholder, it distributed all of its remaining assets in complete liquidation under Sec. 331. Generally, Sec. 331 provides for the recognition of capital gain or loss as if the shareholder had disposed of his stock in a taxable disposition.

The regulations further provide that Secs. 1366 (relating to the passthrough of S items to a shareholder) and 1367 (relating to adjustments to the shareholder's basis of S stock) continue to apply to the transaction. In short, the gain recognized by the S corporation on the deemed asset sale will be passed through and taxed to the Old Target shareholder under Sec. 1366. Any gain passed through will increase the Old Target shareholder's stock basis under Sec. 1367 before measuring the gain on the deemed liquidation.

* Sale of target stock

No gain or loss is recognized under Regs. Sec. 1.338(h)(10)-1(e)(2)(iv) on the sale or exchange by the S shareholder of the target stock included in the QSP. Ordinarily, under Sec. 1362(d)(2), the purchase of S shares by a C corporation will terminate the S election as of the day before the day the shares are acquired. Absent a regulation to the contrary, the target would therefore not be an S corporation on the acquisition date and no Sec. 338(h)(10) election would be available. Accordingly, Regs. Sec. 1.338(h)(10)-1(e)(2)(iv) clarifies that, provided Old Target is an S corporation immediately before the acquisition date, the sale of its stock to the purchasing corporation does not result in a termination of the S election before the completion of the deemed asset sale and deemed liquidation.

* Tax consequences to New Target

As stated above, New Target is treated as though it had purchased assets as of the day after the acquisition date. Generally, New Target will take a basis (adjusted grossed-up basis (AGUB)) in the acquired assets equal to the basis of the stock acquired plus Old Target's liabilities and other relevant items.(14) AGUB for New Target's assets is determined and allocated among the assets deemed acquired as provided in Temp. Regs. Secs. 1.338(b)-2T and -3T. Generally, New Target's basis will be allocated to the individual assets in a manner consistent with that previously described for the allocation of MADSP.

Regs. Sec. 1.338(h)(10)-1(e)(5) also provides that, in contrast to a typical asset sale, New Target will be liable for the tax liabilities of Old Target, including those arising from the deemed sale transaction. Generally, in the case of an S corporation, such liabilities will be limited to the built-in gains tax, if applicable. While pointed more at the concept of continuing joint and several liability than at the determination of MADSP and AGUB, this regulation supports the conclusion previously stated concerning the inclusion of assumed tax liabilities in MADSP.

Examples

The following examples illustrate the principles of Regs. Sec. 1.338(h)(10)-1. In each example, Old Target is an S corporation. The selling shareholder is assumed to be subject to a 39.6% marginal tax rate for ordinary income and 28% for capital gains. No transaction costs are incurred on the sale.

Example 1: The stock of Old Target (Old T) has an FMV of $50,000 and a basis to the selling shareholder (S) of $10,000. Old T elected to be treated as an S corporation on incorporation and, therefore, is not subject to the built-in gains tax under Sec. 1374. Purchaser P, a C corporation, wishes to buy Old T from S. Old T's gross inside asset basis is $20,000. In addition, Old T has $3,000 in liabilities, so that its net book value is $17,000.(15) No depreciation has been claimed on any assets held. Any gain generated in a sale of assets would be treated as Sec. 1231 gain to Old T and, therefore, taxable to S at capital gains rates.

Before addressing the ramifications of a Sec. 338(h)(10) election, first consider the tax implications of a straight stock sale. S would recognize $40,000 gain ($50,000 sales price -- $10,000 basis). The gain would be capital and S would be subject to capital gains tax of $11,200 (28% of $40,000), resulting in net cash to S of $38,800. P would take a $50,000 basis in the stock of Old T, the purchase price. Old T would retain its $20,000 historical basis in its assets.

Assume that a valid Sec. 338(h)(10) election is made. The straight stock sale would be "reconstructed" as a deemed asset sale. The $50,000 paid by P to S for the Old T stock would be deemed to be transferred to Old T in exchange for its assets and the assumption of its liabilities. Accordingly, Old T's $3,000 of liabilities assumed by P are added to the sales price to arrive at a MADSP of $53,000, and Old T's adjusted asset basis of $20,000 is deducted, resulting in a total Sec. 1231 gain of $33,000. The Sec. 1231 gain is passed through to S, who pays tax at 28%, or $9,240. S increases the basis in the Old T shares from $10,000 to $43,000 ($10,000 + $33,000 deemed sale gain passed through).

Old T is then treated as having liquidated and distributed the $50,000 of proceeds to S in liquidation. S would pay capital gains tax of $1,960 on an additional $7,000 ($50,000 realized -- $43,000 basis). Total tax paid by S on the Sec. 338(h)(10) deemed sale is $11,200, exactly the tax that would have been paid under a straight stock sale.

Under the Sec. 338(h)(10) election, P is treated as having formed New Target (New T), which has purchased the assets of Old T. New T will take a basis (AGUB) in total assets of $53,000 ($50,000 purchase price + $3,000 of liabilities assumed) and will begin its tax life just as if it were a new corporation with purchased assets.

Example 2: The facts are the same as in Example 1, except that Old T's gross inside asset basis is $30,000, which has been reduced by accumulated depreciation of $10,000, for a net adjusted asset basis of $20,000. Accumulated depreciation subject to recapture as ordinary income is $3,000. Any remaining gain is taxable to S as Sec. 1231 gain.

A valid Sec. 338(h)(10) election is made. As in Example 1, the total gain on the deemed asset sale is $33,000. From this amount, $3,000 ordinary income depreciation recapture is subtracted, leaving a Sec. 1231 gain of $30,000. S recognizes the $3,000 of ordinary income passed through and is taxed at 39.6%, resulting in a tax of $1,188. The $30,000 Sec. 1231 gain is also passed through to S and taxed at 28%, or $8,400. S increases the basis in the Old T shares from $10,000 to $43,000 ($10,000 + $33,000 deemed sale gain passed through).

Old T is then treated as having liquidated and distributed the $50,000 of proceeds to S in liquidation. S would pay capital gains tax of $1,960 on an additional $7,000 ($50,000 realized -- $43,000 basis). Total tax paid by S on the sale under the Sec. 338(h)(10) election is $11,548, or $348 more than S would have paid under a straight stock sale. S has paid tax on the same total amount of gain in each case ($40,000). The $348 increase in tax relates to the 0.116 rate differential (0.396 -- 0.280) on the $3,000 ordinary income portion of the gain.

The results in this example to the buyer are the same as in Example 1. New T will take a basis (AGUB) in total assets of $53,000. However, this basis increase has come at the cost of an increased tax liability to S. Ordinarily, this increase in basis available to the buyer will cause the parties to agree to increase the purchase price to cover at least some of S's increased tax liability.

Example 3: The facts are the same as in Example 2, except that Old T was previously a C corporation and is subject to the Sec. 1374 built-in gains tax. Of the built-in gain inside Old T, $10,000 represents taxable built-in gain.

If no Sec. 338(h)(10) election is made, the results of this transaction will be the same as those outlined in Example 1. S will recognize capital gain on the sale of the stock, P will take a basis in the stock equal to the cash purchase price, and Old T will retain its historic tax basis in its assets. If, however, a joint election under Sec. 338(h)(10) is made, the results change significantly from those in Example 1.

Under the Sec. 338(h)(10) election, Old T is deemed to sell its assets for the MADSP. Before consideration of the built-in gains tax, MADSP and the gain on the deemed asset sale are tentatively determined as follows:
Basis of New T stock $ 50,000
New T's liabilities 3,000
Other relevant items 0
Tentative MADSP 53,000
Less: Adjusted basis of assets (20,000)
Tentative gain on sale $ 33,000




Under Sec. 1374, Old T must pay income tax at the highest rate under Sec. 11(b), currently 35%. Accordingly, without considering any of the many nuances to the built-in gains tax and under a variety of simplifying assumptions, Old T must pay built-in gains tax on the lesser of the built-in gain ($10,000) or the actual gain on the sale. As will be illustrated, the actual gain on the sale will be greater than $33,000, but certainly no less than the amount of the built-in gain. Accordingly, Old T must pay a built-in gains tax of $3,500 (0.35 x $10,000).

Once the amount of the built-in gains tax is known, a final determination of MADSP may be made. The built-in gains tax is a liability that carries over to and is assumed by New T. Accordingly, the built-in gains tax represents a New T liability in determining MADSP. The final MADSP and gain on the deemed sale are determined as follows:
Basis of New T stock $ 50,000
New T's liabilities
 (including built-in gains tax)(*) 6,500
Other relevant items 0
Tentative MADSP 56,500
Less: Adjusted basis of assets (20,000)
Tentative gain on sale 36,500
Less: Ordinary income recapture (3,000)
Sec. 1231 gain $ 33,500




(*)$3,000 + $3,500

The gain passed through, the tax thereon and the basis effects to S are determined as follows:
Ordinary income passed through $ 3,000
Less: Applicable built-in gains tax(a) (288)(b)
Ordinary income included in S's
 taxable income 2,712
Tax at ordinary income rates 1,074
Sec. 1231 gain passed through 33,500
Less: Applicable built-in gains tax(a) (3,212)(c)
Sec. 1231 gain included
 in S's taxable income 30,288
Tax at capital gains rates 8,481
Original stock basis 10,000
Plus: Ordinary income passed through 2,712
 Sec. 1231 gain passed through 30,288
Total basis before deemed liquidation 43,000
Deemed liquidation proceeds 50,000
Capital gain on liquidation 7,000
Tax at capital gains rates 1,960
Total tax paid by S $11,515
Effects on P:
Basis in shares of New T $50,000
New T's liabilities(d) 6,500
Other relevant items 0
Total AGUB $56,500




(a)See Sec. 1366(f)(2). Allocation of the built-in gains tax is made on a pro rata, item-by-item basis. For example purposes, the built-in gains tax is allocated pro rata based on total gain.

(b)$3,500 x $3,000/$33,500 + $3,000

(c)$3,500 x $33,500/$33,500 + $3,000

(d)$3,000 + $3,500

The IRS receives $15,015 ($11,515 paid by S + $3,500 of built-in gains tax paid by New T), as opposed to $11,200 if no Sec. 338(h)(10) election is made. The increase of $3,815 represents the tax on the built-in gain assumed by P and the increased tax to S from the rate differential on the ordinary income. P is compensated for the tax assumed by achieving a basis step-up from $20,000 to $56,500. Whether the tax cost associated with this step-up is justified depends on how rapidly P can achieve the tax savings associated with it.

Summary of examples: The three examples provide a basis for some overall conclusions concerning the anticipated results of a Sec. 338(h)(10) election for an S corporation target. The tax costs to the seller and buyer in each scenario are:
 Seller Buyer Total
Straight stock sale $11,200 None $11,200
Election under Sec. 338(h)(10)
 (assuming no ordinary income) 11,200 None 11,200
Election under Sec. 338(h)(10)
 (assuming ordinary income) 11,548 None 11,548
Election under Sec. 338(h)(10)
 (assuming ordinary income
 and built-in gains tax) 11,515 $3,500 15,015




As can be seen, assuming that S will pay the same rate of tax on asset gain as would be paid on stock gain, S should be indifferent as to whether a Sec. 338(h)(10) election is made. In addition, generally, the existence of ordinary income potential will increase the tax cost to S of a Sec. 338(h)(10) election vis-a-vis a straight stock sale. When the built-in gains tax is brought into the picture (and assuming the existence of ordinary income potential), S will generally pay more tax than if he had simply sold stock, but less tax than if there had been no corporate built-in gains tax liability. Of course, P will be forced to pay the increased total tax liability due to the built-in gains tax.

Effective Date

Under Regs. Sec. 1.338(i)-1, the final regulations are generally effective for targets with acquisition dates after Jan. 19, 1994.

Conclusion

The deemed asset sale election available under Sec. 338(h)(10) has historically represented a significant opportunity for tax savings on the part of corporations acquiring targets that were members of consolidated groups. With the promulgation of Regs. Sec. 1.338(h)(10)-1, tax practitioners now must be aware of the tax planning opportunities offered by a Sec. 338(h)(10) election involving an S corporation target. In considering the advisability of such an election, the interrelationship of the S corporation and Sec. 338(h)(10) rules must be carefully examined to determine if the benefits of such an election outweight the corresponding costs. Results will vary depending on the level of inside asset and outside stock basis as contrasted with the FMV of the target corporation's stock, the exposure to the built-in gains tax, and the ratio of ordinary income to capital or Sec. 1231 gain.

(1)The term "consolidated group" refers to a group as generally defined in Regs. Sec. 1.1502-1(h) (i.e., an affiliated group filing a consolidated return for the tax year in question).

(2)As defined in Sec. 1504(a).

(3)General Utilities and Operating Co., 296 US 200 (1935)(16 AFTR 1126, 36-1 USTC [paragraph]9012), condified in part by now-repealed Sec. 333 and pre-TRA Secs. 336 and 337.

(4)This provision was originally added as Sec. 338(h)(9) by a technical correction to the Tax Equity and Fiscal Responsibility Act of 1982.

(5)Regs. Sec. 1.1502-34 aggregates the consolidated group members' stock ownership in the target corporation for Sec. 332 purposes. Therefore, even though Old Target may not have a single shareholder that owns at least 80% of its stock, as long as the aggregated ownership of the members of the selling consolidated group at least equals 80%, the liquidation is covered by Sec. 332. The definition of "affiliation" for purposes of filing a consolidated return is the same as the definition of "ownership" for purposes of Sec. 332 eligibility.

(6)The NOLs may be of little value to the purchasing corporation because of numerous provisions that limit the ability to traffic in them (e.g., Sec. 382 and the separate return limitation year rules).

(7)This article's emphasis is on application of the Sec. 338(h)(10) election to an S corporation target and, unless otherwise stated, any reference to a target corporation refers to a target S corporation.

(8)Sec. 338(g)(3) and Regs. Sec. 1.338(h)(10)-1(d)(3).

(9)For the sake of simplicity, it is assumed that the target S corporation is 100% owned by a single shareholder. The discussion of any rule applicable to an S corporation target with a single shareholder is equally applicable if there are multiple shareholders.

(10)See Form 8023-A and Regs. Sec. 1.338(h)(10)-1(d)(2).

(11)Regs. Sec. 1.338(h)(10)-1(f)(1). The allocation is made in accordance with Temp. Regs. Sec. 1.338(b)-2T (without taking into account Temp. Regs. Sec. 1.338(b)-2T(c)(2)).

(12)See Temp. Regs. Sec. 1.338(b)-3T for the application of these principles of tax law to certain contingent liabilities that are initially excluded from MADSP.

(13)ADSP serves the same function in a straight Sec. 338 election as does MADSP in a Sec. 338(h)(10) election.

(14)Regs. Sec. 1.338(h)(10)-1(e)(5). This calculation is to be made in accordance with Regs. Sec. 1.338(b)-1(c).

(15)Assume that a transfer by inheritance accounts for the difference between the inside basis of Old T's net assets and outside basis of S's Old T stock.
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Author:Stewart, Dave N.
Publication:The Tax Adviser
Date:Feb 1, 1995
Words:5696
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Sec. 338(h)(10) elections with S corps.
Final regs. under secs. 338 and 1060 reflect significant changes.
Acquisitions by S corporations - -beware the QSub election.
S corporation elections guide.

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