Question

Acquirer pays 1,000 for all the shares of Target Corp on Jan 2 of the current year. Targets assets have a basis of 200.   

a) Under what cases would acquirer want to make an election under Section 338?   

b) When is the due date of the election?

Answer 1

The United States Congress enacted Section 338 in 1982 to allow taxpayers to treat certain qualified stock purchases as asset acquisitions for federal income tax purposes.

Section 338 provides two elections: the so-called “regular Section 338 election” under Section 338(g), and the other under Section 338(h)(10). These elections treat a stock acquisition as an asset acquisition for federal income tax purposes. A Section 338 election is useful when the buyer has a good business reason to acquire stock rather than assets (e.g. difficulty assigning licenses or permits), but the buyer still wants the tax benefits of an asset acquisition.

Section 338(h)(10)

A Section 338(h)(10) election is much more common than a Section 338(g) election because a Section 338(g) election results in two levels of tax, whereas a Section 338(h)(10) election results in one. In a regular Section 338 election, two levels of tax are imposed: one on the shareholders upon their sale of the target stock and the other on the deemed asset sale by the target corporation (“Old Target”).

In a Section 338(h)(10) election, typically only one level of tax is imposed on the deemed asset sale; the stock sale is ignored for tax purposes and the deemed liquidation is tax-free to the selling shareholders. In effect, the parties are treated (purely for applicable tax purposes) as though (1) the buying corporation established a new corporation (“New Target”), (2) New Target purchased the assets of the target corporation (“Old Target”) and assumed its liabilities and (3) Old Target liquidated in the hands of the seller.

Tax Implications

Due to the double imposition of tax, a regular Section 338 election often is unattractive and typically is made only when the target has significant tax attributes (e.g. net operating losses) to offset the gain recognition at the target level.

While regular Section 338 elections are rare, elections under Section 338(h)(10) are quite common. Section 338(h)(10) elections are available only for targets who are S Corporations or members of an affiliated group of corporations (whether or not they file a consolidated federal income tax return).

Defining an S Corporation

An S Corporation is a regular corporation that has 100 shareholders or less, which enables the company to enjoy the benefits of incorporation but be taxed as if it were a partnership.

S Corporations typically do not pay taxes and instead file an informational return Form 1120S showing net profit or loss which flows through to the shareholders. The shareholders then show the net profit or loss on their personal tax returns. All S Corporations start as a regular or professional corporation, and only by requesting the S Election to the Internal Revenue Service can it act as an S Corporation.

S Corporations and Section 338(h)(10)

If the target is an S corporation and a stock purchase is desired for non-tax reasons, but an asset purchase is desired for tax reasons, it is common for the target S corporation’s shareholders and the acquiring corporation to agree to make an election under Section 338(h)(10).

As mentioned above, S Corporations don’t pay income taxes. Instead, the company’s income or losses are distributed through its shareholders, who in turn report income or losses on their individual income tax returns. This fact can potentially complicate the sale of an S Corporation.

However, Regulation Section 1.338(h)(10)-1(c) permits corporations making a qualified stock purchase (QSP) of a target S corporation to make an election under Section 338(h)(10) jointly with the S corporation shareholders. All shareholders of the target S corporation (selling and non-selling) must consent to the Section 338(h)(10) election. When this election is made, for tax purposes the sale of the stock by the selling shareholders is ignored.

Further, the regulation enables a stock sale of an S Corporation to be taxed as if the transaction were an asset sale. Asset sales offer several advantages. For one, the buyer can take a “stepped-up” tax basis, which means it can significantly raise the stated value of the seller’s assets. Greater asset value, in turn, enables a buyer to claim more depreciation on its to-be-acquired assets and, therefore, take a larger, current tax deduction.

P makes a section 338 election for T on or before June 15 of Year 2, which causes T's taxable year to end as of the close of September 20 of Year 1. An income tax return for T's taxable period ending on September 20 of Year 1 was due onDecember 15 of Year 1.