A lot of decisions need to be made when considering the right tax structure for the purchase of a company, but it all comes down to whether the buyer wants to purchase assets or buy stock and forgo the step-up tax basis advantage. The Section 338(h)(10) election gives the buyer the potential to have it both ways and still achieve that advantage, says Porte Brown’s Mark Gallegos.
The Internal Revenue Code allows buyers and sellers of the stock of an S corporation to make a Section 338(h)(10) election so that a qualified stock purchase will be treated as a deemed asset purchase for federal income tax purposes. A Section 338(h)(10) election is a joint election that requires agreement between and among all of the selling shareholders and the prospective buyer. As a result of this election, a stock sale for legal purposes will be treated as an asset sale for tax purposes, resulting in different tax consequences for both the buyer and seller that selling shareholders need to understand.
Importantly, a Section 338(h)(10) election will adjust the tax basis of the S corporation’s assets in the hands of the buyer to fair market value. The buyer may enjoy incremental tax benefits as a result, including amortization and depreciation of the assets’ purchase price for federal income tax purposes, along with resulting future tax deductions for the amount paid over the tax life of the acquired assets.
For tax purposes, the selling company is considered to have sold all its assets and is liquidated even though legally the selling company is still in existence.
Specifically, the following events are considered to have happened:
Where one corporation purchases the stock of another corporation (target), and the purchasing corporation makes a Section 338 election, the “new” target corporation that is then deemed to purchase all the assets of the old target must use the same employer identification number as the old target used.
The stock sale is treated as a taxable sale of all the target’s assets solely for US federal income tax purposes. Not for information reporting, payroll tax, sales and use tax, and other non-income tax purposes.
For legal purposes, the transaction is a stock sale. Therefore, the target’s liabilities are transferred, including any undisclosed or contingent liabilities. In contrast, in a direct asset purchase, the buyer is responsible only for liabilities that are expressly assumed or secured by the acquired assets.
If the target is an S corporation, its S status continues through the close of the acquisition date, including the deemed asset sale and the deemed liquidation—despite the general rule that S status terminates at the beginning of the day on which it acquires an ineligible corporate shareholder.
The target S corporation thus files a final S corporation return through the end of the acquisition date, which includes the deemed asset sale.
The gain on the S corporation’s assets is passed through to the S corporation’s shareholders. The liquidation of the S corporation target is a Section 331 taxable liquidation, but the gain on the S corporation’s assets isn’t taxed twice because the gain on the sale increases the shareholders’ basis in their S corporation stock. Generally, it’s one level of tax imposed on gains recognized by the old target on the deemed asset sale.
Joint election is required by buyer and seller(s), i.e., buyer corporation and common parent of a selling consolidated group/selling affiliate or S corporation shareholder(s).
The common parent of a consolidated group must provide a copy of the election statement to the target on or before the due date of the target’s tax return. If the seller and target are members of an affiliated group but don’t file a consolidated return, both seller and target should include the election statement on their respective returns. If the target is an S corporation, all of the target’s shareholders, including shareholders who don’t sell target stock, must join in the election.
Form 8023 must be filed by the buyer corporation with the Internal Revenue Service Center, where it files its annual return. A copy of Form 8023 should be attached to tax returns of old the target, new target, and buyer for the year that includes the acquisition date. Failure to do so will not invalidate the election. In addition, both the old target and new target must attach Form 8883 to the tax return reporting the effects of the deemed transaction.
Elections must be made no later than the 15th day of the ninth month beginning after the month in which the acquisition takes place. A 12-month automatic extension of time may be available. Once made, the election is irrevocable.
When deciding on the right tax structure for the purchase of a company, there are numerous decisions to be made that have many different implications. However, the decision comes down to whether the buyer wants to purchase assets or buy stock and forgo the step-up tax basis advantage. The Section 338(h)(10) election gives the buyer the potential to have it both ways and still achieve that advantage.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Mark Gallegos, CPA, MST, is a tax partner on Porte Brown’s accounting and consulting services team in the Elgin, Ill., office. He works on advising, speaking, and writing about international tax, mergers and acquisitions, and credits and incentives.
Please Note: This article was originally published on Bloomberg Tax on June 9, 2022.
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