Traps for the Unwary: Rollovers and the Sec. 338 Election

By Mark Hoffenberg, J.D., and Alexandra Yeadon, J.D., LL.M., Washington, DC

Editor: Mary Van Leuven, J.D., LL.M.

When one corporation acquires another, the target corporation shareholders often roll over their investment in the target corporation by receiving stock of the acquiring corporation as part of the purchase price. Drawing on a case in which the target corporation is a subchapter S corporation and the parties intend to make an election under Sec. 338(h)(10), this item focuses on how to structure the transaction when one or more of the S corporation shareholders wish to roll over their S corporation investment. If structured incorrectly, a rollover can render a Sec. 338(h)(10) election unavailable. Note that the S corporation transaction is presented for illustrative purposes; similar issues may arise in other variants of elections under Secs. 338(h)(10) and (g).

For the parties to make a Sec. 338(h)(10) election in the S corporation context, the acquiring corporation must acquire domestic S corporation stock in a qualified stock purchase (QSP). In general, a QSP occurs when a corporation acquires by purchase at least 80% of the target stock within a 12-month period. For this purpose, a purchase is generally any stock acquisition for which the seller recognizes gain or loss. Therefore, a purchase does not include any exchange transaction to which Secs. 351, 354, 355, or 356 apply or any carryover basis transaction.

Moreover, a purchase does not include a stock acquisition from a person related to the acquiring corporation (regardless of whether gain or loss is recognized). For this purpose, the acquiring corporation and the seller are related if stock owned by the seller would be attributed to the acquiring corporation under the Sec. 318 attribution rules (tested immediately after the acquisition of the target corporation’s stock or, in the case of a series of transactions, immediately after the last transaction). Keeping this background in mind, the tax consequences of a Sec. 338(h)(10) election base scenario are described, and then several ways in which an improperly structured rollover can preclude a valid Sec. 338(h)(10) election are illustrated.

Base Case: Sec. 338(h)(10) Election

The base scenario illustrates the general effect of a Sec. 338(h)(10) election.

Example 1: S, which has always been an S corporation, has two individual shareholders, A (who owns 70%) and B (who owns 30%). P, the purchasing corporation, pays cash to S’s shareholders for all the S stock. P and S’s shareholders jointly make a Sec. 338(h)(10) election. As a result, Regs. Secs. 1.338(h)(10)-1(d)(3) and (4) treat S as if it (1) sold all its assets to an unrelated corporation in exchange for the consideration from P and then (2) distributed that consideration to A and B in a transaction that should, in this context, constitute a complete liquidation.

The tax consequences of the deemed transactions are not discussed in detail here, but, in summary, assuming S does not have built-in gains subject to corporate-level tax under Sec. 1374, the Sec. 338(h)(10) election results in P owning a new subsidiary with a stepped-up basis in its assets and A and B paying a single level of tax on the sale (because any S gain on the deemed asset sale should flow through and be taxed to the shareholders under the normal subchapter S rules). A and B will not recognize gain or loss on the deemed liquidation of S because the gain on the deemed asset sale increases their basis in the S stock under Sec. 1367.

Rollovers and Traps for the Unwary

As illustrated below, adding a rollover to this transaction can, if structured incorrectly, prevent the acquisition from qualifying as a QSP and thus prevent the parties from making a valid Sec. 338(h)(10) election.

Trap 1—Related transactions: This example illustrates one potential problem in a rollover scenario.

Example 2: Assume the facts are the same as in Example 1 (the base scenario), but B rolls over his S stock in exchange in whole or in part for P stock. P pays A $70 cash for 70% of S and issues $20 cash and $10 of P stock to B for the remaining 30%.

Because the rollover is by a shareholder who owns more than 20% of S, the parties may inadvertently jeopardize the QSP’s status. For example, if B’s transfer of S stock in exchange for cash and P stock is characterized as part of a Sec. 351 exchange (as may be the case if P is newly formed and others contribute cash and/or property to P as part of the same plan), then P acquires only 70% of S’s stock by “purchase” (not the required 80%). Accordingly, there is no QSP and the parties cannot make a Sec. 338(h)(10) election.

An alternative for Trap 1: Consider a potential alternative designed to achieve the rollover without jeopardizing the QSP.

Example 3: P forms N, a new subsidiary that is a corporation for federal income tax purposes, and contributes $90 cash and $10 of P stock to N in a tax-free Sec. 351 exchange. N, rather than P, purchases the S stock in exchange for $70 cash to A and $20 cash and $10 of P stock to B.

The exchange with B should not constitute part of a Sec. 351 exchange with N because N is issuing P stock rather than its own stock (see Rev. Rul. 78-130 for an example of this concept). N’s acquisition of S should be a valid QSP so the parties can accordingly make a Sec. 338(h)(10) election.

Although other issues, such as the potential applicability of Sec. 269, should be considered, this planning technique should be effective as long as B does not acquire more than 49% of P’s stock. The consequence of exceeding this threshold is addressed below.

Trap 2—Acquisition by a partnership: The approach described above has become a relatively common way to achieve rollovers without disqualifying Sec. 338 elections. Some taxpayers have attempted to expand this approach to situations involving a partnership, rather than a corporation, as the ultimate purchaser. Unfortunately, this technique is not effective when a former S shareholder acquires an interest in the acquiring partnership. Before considering how the attribution rules affect the partnership scenario, return to Example 3 to see how the attribution rules could thwart the Sec. 338(h)(10) election.

Recall that P is a corporation and P’s subsidiary, N, acquires S. As noted previously, a purchase does not include a stock acquisition by a related person. The buyer is related to the seller if stock owned by the seller would be attributed to the buyer under the Sec. 318 attribution rules. In this case, the related-party rule will affect the transaction only if B acquired 50% or more of P’s stock.

When a shareholder owns 50% or more of a corporation’s stock, the Sec. 318(a)(3)(C) attribution rule deems the corporation to own any stock owned by that shareholder. Thus, if B acquired 50% of P, P would be deemed to own any stock that B owns. In turn, the same attribution rule deems N to own any stock that P owns (either actually or as a result of attribution), including stock owned by B. Thus, because N would be deemed to own any stock that B owns, N and B would be related parties and N’s acquisition of S stock from B would not qualify as a QSP. As long as B owns (directly or via the attribution rules) less than 50% of P’s stock, however, no attribution from B to P occurs under Sec. 318(a). Accordingly, the related-party rule will not prevent a QSP.

Now consider the alternative to Trap 1 involving a partnership.

Example 4: Return to Example 1 but assume that P is a partnership for federal tax purposes. P forms N (a corporation for federal tax purposes) and contributes $100 cash. N uses the cash to acquire 100% of the S stock and, as part of the integrated plan, B uses $1 of the cash he receives to acquire a small interest in the partnership.

At first glance this transaction appears to be a QSP of 100% of the S stock by N. However, the related-party exception to a purchase, coupled with a quirk in the attribution rules, prevents a QSP in this scenario.

The quirk in the case of partnership attribution is that there is no 50% threshold similar to that for corporations. Instead, Sec. 318(a)(3)(A) deems stock owned by a partner to be owned by the partnership regardless of the size of the partner’s interest in the partnership. Thus, when B acquires an interest in partnership P after N acquires the S stock, the attribution rules deem P to own any stock that B owns. Under the corporate attribution rule, N is deemed to own any stock owned by P, which includes any stock owned by B. Because of the operation of these rules, N is deemed to own any stock owned by B, thereby preventing N’s acquisition of S stock from B from qualifying as a QSP. Because B is a more-than-20% shareholder of S, N will not be able to complete a QSP of the requisite 80% of S, and no Sec. 338(h)(10) election will be available, regardless of the small size of B’s partnership interest. When a rollover with a Sec. 338 election is desired, therefore, it may often be the case that the rollover entity must be classified as a corporation for U.S. tax purposes.


Mary Van Leuven is a Senior Manager at Washington National Tax KPMG LLP in Washington, DC

The information contained in this Tax Clinic is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser. The views and opinions expressed are those of the authors and do not necessarily represent the views and opinions of KPMG LLP.

©2008 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.



If you would like additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or

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