Sec. 338(h)(10) elections with S corps.
A Sec. 338(h)(10) election allows a buyer and seller to jointly elect to treat a stock sale as an asset sale for tax purposes. A Sec. 338 (h)(10) election is available when, within a 12-month period, 80% or more of the stock of an unrelated target is purchased by an acquirer. To be able to make a Sec. 338(h)(10) election, the selling corporation must be either part of an affiliated group, consolidated group or an S corporation. In the case of an S target, the election is made jointly by the S shareholders and the acquiring corporation. Once made, the election is irrevocable. To make the election, both the buying and selling parties must complete Form 8023, Election Under Section 338 for Corporations Making Qualified Stock Purchase. All parties must file this form with the District Director for the IRS district in which the main corporate offices of the purchasing corporation are located. Form 8023 is due by the 15th day of the ninth month beginning after the acquisition date.
When a Sec. 338(h)(10) election is made for an S target, the S corporation is treated as if it had sold all of its assets in a single transaction at the close of the acquisition date. The gain on the deemed sale of the assets is reported on the final S return and the S shareholders are responsible for the tax liability related to the deemed sale.
As previously stated, as a result of a Sec. 338(h)(10) election, the target S corporation recognizes gain as if its assets were sold. This poses a potential disadvantage for S shareholders that normally would be taxed at capital gains rates on a sale of stock, as they may be forced to recognize ordinary income as a result of the deemed asset sale.
Example: An S shareholder has outside basis in his stock of $100; the inside basis of the S assets are zero. The original cost of the fixed assets was $100 and they are fully depreciated. The shareholder is willing to sell his stock for $100. If the transaction were structured as a stock sale, the shareholder would have no gain or loss. If, instead, a Sec. 338(h)(10) election were made, the S corporation would realize $100 in ordinary gain from depreciation recapture on the deemed asset sale. The shareholder's basis in his stock would be increased to $200 from the flowthrough of the ordinary gain, and he would receive $100 in liquidation of the S corporation. The difference between the amount received in distribution and the shareholder's basis would create a capital loss of $100. On the shareholder's return for the year of the transaction, he would recognize the ordinary income; however, he might be limited on the deduction of the capital loss. Additionally, there will be a substantially higher tax rate on ordinary income. Often in this situation, a purchaser will attempt to reimburse a seller for the increased tax liability but, with the reduction of the capital gains rates (as a result of the Taxpayer Relief Act of 1997), this has become quite costly.
This situation can be remedied by a careful review of the purchase price allocation. If, in the example, an allocation of zero to the fixed assets could be supported with a $100 allocation to goodwill, a much different tax picture would result. The allocation to goodwill would create capital gain income for the S shareholders from the deemed asset sale, which would offset the capital loss created by the liquidation. Regs. Sec. 1.338(h)(10)-1(f) sets forth the procedures for allocating purchase price under a Sec. 338(h)(10) election. These procedures are similar to those provided under Sec. 1060 for allocating the purchase price in a taxable asset acquisition.
A serious disadvantage of a Sec. 338(h)(10) election for some S corporations relates to the application of the built-in gains (BIG) tax. S corporations that were formerly C corporations and elected S status after 1986 may be subject to the BIG tax. Essentially, the BIG tax is a 35% corporate-level tax on the BIG on assets sold within the first 10 years as an S corporation. The S shareholders are not subject to this penalty tax on the sale of their stock; however, the BIG tax is applicable when the stock sale is treated as an asset sale using a Sec. 338(h)(10) election.
Another disadvantage to the S target being a party to a Sec. 338(h)(10) election is the potential prohibition on using the installment method to report the gain when a note is received for some of the purchase price. Technical problems with the deemed nature of the asset sale would seem to preclude the use of the installment method of accounting for the gain. Under Regs. Sec. 15A.453-1 (b)(3), an installment payment includes receipt of an evidence of indebtedness of a person other than the person acquiring the property from the taxpayer. In a Sec. 338 (h) (10) transaction, the former target is deemed to be the taxpayer-seller and the new target is deemed to be the acquirer of the property. As a consequence of the deemed characterization of the transaction, it seems technically impossible for the new target to issue an installment note to the former target, because the former target fails to actually sell the property (it sells its stock) and the deemed new target does not exist until the day after the sale. While theoretically it appears that installment sale treatment is not available to the seller, the IRS has not ruled against using the installment method.
Most often, a buyer will demand that a Sec. 338(h)(10) election be used when a target has favorable contracts that cannot be transferred in an asset sale. (Examples are leases, union contracts and local business licenses.) Additionally, a Sec. 338(h)(10) election may be requested by a buyer when an S corporation is qualified to do business in several states and, if the transaction were structured as an asset sale, the acquirer would be required to reapply for qualification to do business in those states. With a Sec. 338(h) (10) election, a buyer escapes this requirement. Obviously, the greatest benefit to the buyer in a Sec. 338(h)(10) election is the step-up in bases of the assets being acquired and the ability to amortize any goodwill created in the transaction.
The major risk to a buyer in structuring an acquisition as a stock sale or a deemed asset sale using a Sec. 338(h)(10) election is being subject to a seller's recorded and unrecorded liabilities. To protect against this risk, the buyer will most likely require the seller to provide substantial representations and warranties on its prior business dealings.
There are numerous items to consider in structuring any acquisition. Tax ramifications, legal liability and the ability to effectively conduct the historical business of a target are three of the most important items to be considered. In the proper situation and with the proper consideration, a Sec. 338 (h)(10) election may provide an opportunity to structure the transaction most advantageously for a buyer and a seller.
FROM TRACY J. MONROE, CPA, MT, COHEN & COMPANY, CPAs, CLEVELAND, OH
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|Title Annotation:||IRC section 338(h)(10); S corporations|
|Author:||Monroe, Tracy J.|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 1999|
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