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Sec. 338 election for targets with built-in losses.

When a corporation makes a "qualified stock purchase" of a target corporation, the buyer has the option of making a Sec. 338(g) election. However, after the repeal of General Utilities, these elections are not typically beneficial since the resulting step-up in basis is purchased with the cost of an "asset sale" tax. Unless tax rates rise dramatically after the year of the election, the present value of the current tax will exceed the potential future benefit resulting from the stepped-up basis. However, a Sec. 338(h)(10) election remains attractive when the selling group has a net operating loss (NOL) carryover that will offset the income triggered on the deemed asset sale or when the seller's stock basis is close to the net inside basis of the target's assets.

The regular Sec. 338(g) election may be attractive when there are significant built-in losses in the target's assets. If the selling corporation files separate returns, or if a member of a consolidated return does not want to make a Sec. 338(h)(10) election, the buyer may be able to make a Sec. 338(g)(10) election and reap the benefit of these losses. An immediate benefit is available if the deemed sale of the target's assets creates an NOL or capital loss that can be used in a carryback year. In addition, a deferred benefit is available if the election causes basis to be shifted from nondepreciable property to depreciable property.

A Sec. 338(g) election generally causes the target to have a basis in its assets equal to the assets' fair market value (unless it is acquired in a bargain purchase). If nondepreciable assets (such as land or goodwill) have built-in losses prior to the election but there are other assets with built-in gains (such as machinery or buildings), a shift in basis will occur. Hence, a Sec. 338(g) election may allow the buyer to obtain a more beneficial allocation of basis for future depreciation deductions. On the other hand, the opposite result would occur if the built-in loss assets were depreciable assets and the built-in gain assets were nondepreciable. A careful review of the character of gains and losses must be made, since capital losses may only offset capital gains.

A Sec. 338 election in these circumstances makes economic sense for the same reason that making a Sec. 338 election with respect to a target with appreciated assets does not make sense. The present value of the immediate and deferred benefit is greater than the present value of the step-down in asset basis that results from the deemed sale.

Sec. 172(h) which in general disallows the carryback of NOLs following certain stock acquisitions, does not apply for two reasons. First, Sec. 172(h)(3)(B)(ii) excepts any qualified stock purchase to which a Sec. 338 election applies from the meaning of the term "major stock acquisition." Second, since none of the loss generated from the deemed sale of assets is attributable to allocable interest deductions, the loss is not covered by the term "corporate equity reduction interest loss."

The computation of the deemed sales price and the tax benefit available from the deemed sale may be complicated. Moreover, the deemed sale may generate capital losses for which no benefit is available either as a carryback or an offset to gains created by the Sec. 338(g) election, or the carryback of NOL may only free up credits that cannot be used. In any case, the upper limit on the available benefit is the recoverable tax from the carryback period,

From Mark L. Yecies, Esq., Washington, D.C.
COPYRIGHT 1993 American Institute of CPA's
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Author:Yecies, Mark L.
Publication:The Tax Adviser
Date:Jan 1, 1993
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