Increased Opportunities for Sec. 338(h)(10) Elections

President Barack Obama signed the Small Business Jobs Act of 20101 on September 27, 2010. Section 2014(b) of the act changes the S corporation built-in gains (BIG) tax for tax years (and only for tax years) beginning in 2011. The act does not change the BIG recognition period from 10 years. Instead, Sec. 1374(d)(7)(B)(ii) merely states that no tax is imposed on the net unrecognized built-in gain of an S corporation if the fifth year in the recognition period precedes the 2011 tax year.

According to the committee report, the five-year period refers to the five calendar years from the first day of the first tax year for which the corporation was an S corporation.2 For example, for corporations electing S status effective January 1, 2006, or earlier, no Sec. 1374 BIG tax will be assessed on gains from the sales of assets that contain unrecognized built-in gain at the election date. (This assumes that the S corporation in question did not receive assets from another C or S corporation through merger or other tax-free transaction after the election date.)

Most potential buyers of businesses operated by S corporations want to purchase the assets of the corporation (rather than S corporation stock) for a number of reasons. The buyer that purchases assets receives a tax basis in the assets equal to the purchase price. If the buyer purchases the stock of the S corporation, the tax basis of the underlying assets is unchanged. S corporations do not have an equivalent provision to subchapter K’s Sec. 754 election, which allows a purchasing partner’s basis in the interest to be stepped up or down based on the fair market value (FMV) of assets inside the partnership. In addition, the purchaser of stock indirectly acquires all the liabilities of the S corporation, known and unknown.

The selling shareholders, however, want to sell the stock of the S corporation. First, gain on the sale of stock will generate long-term capital gain at favorable tax rates, assuming the holding period requirements are met. Second, for the S corporation subject to the BIG tax of Sec. 1374 and still within the recognition period (based on S election or acquisition of C assets date) for any assets sold or deemed to be sold, the corporation is subject to a 35% tax on the unrecognized built-in gain of the corporation.

Other dynamics come into play. The corporation may hold contracts with vendors, customers, and employees that will require renegotiation unless the corporation remains in existence. Also, state taxes may make an asset sale more costly (e.g., some states subject the sale of tangible personal property to sales tax, even in a bulk sale of the business). Due to these tax and nontax issues, from the seller’s perspective the sale of stock is a requirement.

The BIG “no tax” provision referred to above provides another opportunity to the S corporation. A buyer might not be willing to reimburse the selling shareholders for the cost of the Sec. 1374 tax but may be willing to “sweeten the deal” for other costs incurred by the seller.

Whether structured as an asset sale or a stock sale, the total net gain to be recognized by the shareholders is unchanged, but the character of the gain will change.

Example 1: P owns 100% of R, Inc., an S corporation that until January 1, 2006, was a C corporation. P’s tax basis in the R stock is $100,000. The underlying net assets of the corporation have an aggregate tax basis of $250,000 and FMV of $1 million. Assume that the sale of the assets generates $750,000 of gain, of which $300,000 is Sec. 1245 gain. J, Inc., offers to purchase the business. If P sells his stock for $1 million, he will have a $900,000 capital gain ($1 million FMV less $100,000 tax basis). After paying federal income tax of $135,000 (15% of $900,000), P will be left with $865,000. If J purchases the R assets, Sec. 1245 gain of $300,000 flows through to P, together with the Sec. 1231 or capital gain of $450,000, increasing P’s tax basis in stock from $100,000 to $850,000. P liquidates the corporation, receiving the $1 million cash proceeds offset by his increased tax basis of $850,000, to generate capital gain of $150,000.3

As the example illustrates, P’s total gain from the asset sale of $900,000 ($300,000 + $450,000 + $150,000) equals his gain from the stock sale. However, the asset sale changes $300,000 of the capital gain to ordinary income. (Assume P has no nonrecaptured net Sec. 1231(c)(1) loss.) If P is in the 35% bracket, the sale of the underlying assets generates $60,000 of additional federal tax liability ($300,000 multiplied by the difference between the highest ordinary income tax rate of 35% and the 15% capital gain rate).

Example 2: J wants a fresh start on the tax basis of the assets, but R’s business is dependent upon contracts with vendors and customers that are beneficial to the business; neither buyer nor seller wants to reopen the negotiations on the contracts. P insists on the sale of stock because he wants to avoid the Sec. 1374 BIG tax and the Sec. 1245 ordinary income from the sale of the underlying assets. P recognizes the difficulties of renegotiating the contracts but believes this can be accomplished.

P’s tax adviser informs him that for a sale in 2011 the Sec. 1374 BIG tax is moot, due to the provisions of the Small Business Jobs Act. She also suggests to P that J may be willing to pay more for the R stock if J can benefit from additional tax basis in underlying assets. She advises P that rather than risking reopening the contracts from the sale of the business, a Sec. 338(h)(10) election may be available to achieve his targeted after-tax proceeds if J is willing to increase the purchase price in order to obtain a higher basis in the underlying assets. J may demand an indemnity agreement to protect it from undisclosed and unknown liabilities.

The adviser works out the numbers and determines that a sale price of $1,070,588 for the underlying assets will provide the same after-tax proceeds to P [$60,000 tax difference ÷ (1 – the capital gains tax rate) = $70,588]. Because R remains intact, contract renegotiation with vendors and customers is not necessary. If P and J can come to an agreement, J will receive an additional $820,588 of tax basis in the underlying assets. Presumably, $300,000 of the tax basis is allocated to equipment-type assets (which generated the $300,000 of Sec. 1245 gain) and $520,588 to intangible assets amortizable under Sec. 197 over 15 years (or other assets using principles provided under Regs. Sec. 1.338-6(b)).

Results of a Sec. 338(h)(10) Election

The regulations provide that a Sec. 338(h)(10) election may be made for a target if the purchaser (which must be a corporation) acquires the target in a qualified stock purchase from S corporation shareholders.4

The S corporation (Old Target) is treated as if it had transferred all its assets to a new S corporation (New Target) and then liquidated by distributing the proceeds to the S corporation shareholders. The gain on the deemed sale under Sec. 338(h)(10) is reported on the target’s final S corporation return and is therefore taken into account under Secs. 1366 and 1367 to determine the target shareholder’s basis in the target stock5 and the resulting gain or loss on the deemed distribution of proceeds in a transaction that may be characterized as a reorganization, a redemption, or a liquidation.6

New Target is deemed to purchase Old Target’s assets the day following the acquisition date.7 New Target remains liable for the tax liabilities of Old Target.8 The Sec. 338(h)(10) election must be made jointly by the purchasing corporation and the target shareholders.9 S corporation stock retained by the seller in the transaction is treated as if the shareholder acquired the stock on the day after the acquisition date for FMV.10

If the seller sold stock, the seller would clearly have a capital gain (or loss) on the sale. If the election is made, the assets are treated as being sold at FMV; any depreciation recapture changes the character of what would have been capital gain from the stock sale into ordinary income. In addition, any Sec. 1231 gain may be recharacterized as ordinary to the extent the seller has “unrecaptured Sec. 1231 losses” described in Sec. 1231(c)(1) (the five-year taint that appears in Part I of Form 4797, Sales of Business Property). Since the sale is of stock, state sales tax on the sale of equipment-type assets should not apply.

The Sec. 338(h)(10) election gives the buyer the better (not the best) of two worlds between asset and stock purchase. If the deal is contingent on the seller’s selling stock (because the seller does not want to deal with the liquidation of its corporation, for example) but the buyer wants a step-up in basis in the assets to their FMV, the Sec. 338(h)(10) election allows this to occur. For tax purposes, the target corporation is deemed to liquidate following the deemed asset sale.11 However, the legal existence of the corporation continues. The buyer may want to immediately liquidate the target corporation (tax free under Sec. 332) or perhaps continue the S corporation as a QSub (if the buyer is itself an S corporation). Or the buyer might keep the corporation in existence as a subsidiary member of a consolidated group (albeit as a C corporation). Regardless of the ultimate treatment of the target, the parties should agree as part of the sale/purchase document who will be responsible for filing the pre-sale income tax return of the acquired (target) corporation.

Typically, purchasers of stock are concerned about assuming corporate liabilities, known and unknown. The Sec. 338(h)(10) election does not alleviate this concern. Legally, the transaction remains a stock sale, even though it is treated as an asset sale for tax purposes. An indemnity agreement is only as good as the results of any necessary future litigation, and only if the person indemnifying has assets to pay. Consequently, purchasers should seek advice from an attorney about how to limit exposure to the unknown liabilities being assumed.

A Sec. 338(h)(10) election is made on Form 8023, Elections Under Section 338 for Corporations Making Qualified Stock Purchases, in accordance with the instructions for that form. The election is due by the fifteenth day of the ninth month starting after the month in which the acquisition occurs. The election is irrevocable.12

A Sec. 338(h)(10) election may produce major benefits for the buyer. Through such an election, the buyer may acquire a corporation and be able to attribute basis to each acquired asset at its then FMV. Such basis generally results in cost recovery and/or amortization deductions that are higher and/or over longer periods than if a carryover basis had been applied to each asset. The benefit to the buyer will decrease, however, if the target corporation is subject to the BIG tax on any of its gains. (A sale of stock in the S corporation would not subject the individual assets to a BIG tax, but a deemed sale of the assets would trigger the tax.)

The installment method is available to the shareholders of the S corporation in the same manner that it would have been available if an asset sale had been made.13 Upon an asset sale, depreciation recapture is recognized in the year of sale. Likewise, if a Sec. 338(h)(10) election is made, the deemed asset sale will accelerate the recognition of gain to the extent of gains not qualifying for installment sale treatment. Under a stock sale, there would have been no depreciation recapture.

Stock purchases treated as asset purchases under Sec. 338 are not applicable asset acquisitions, including stock purchases for which a Sec. 338(h)(10) election is made.14 Thus, the information reporting rules on asset acquisitions are not applicable, and the parties do not have to follow the proscribed Sec. 1060 rules. Form 8883, Asset Allocation Statement Under Section 338, must be filed by the S corporation target with its Form 1120S, U.S. Income Tax Return for an S Corporation, to supply information relevant to the Sec. 338(h)(10) election.

Conclusion

There are several points to remember in a Sec. 338(h)(10) election. The acquirer receives tax basis equal to the FMV of the assets. The parties should verify that the target corporation (the seller) will not incur a BIG tax with respect to the S corporation election and determine whether sales tax will be incurred on the sale of individual assets. The seller recognizes the same amount of gain whether the transaction is structured as an asset sale or a stock sale, but the character of some or all of the gain may change from capital to ordinary (or a higher-rate capital gain in Sec. 1(h)).

The final S corporation return must be filed within 2½ months after the month of acquisition, but, by agreement, the acquirer may file. Advice from an attorney should be sought regarding the legal ramifications of purchasing stock versus assets, including with regard to undisclosed or unknown liabilities, and the S corporation installment sale upon liquidation rules generally apply.

Footnotes

¹ Small Business Jobs Act of 2010, P.L. 110-240.

² Joint Committee on Taxation, Technical Explanation of the Tax Provisions in Senate Amendment 4594 to H.R. 5297, the “Small Business Jobs Act of 2010” (JCX-47-10) (September 16, 2010).

³ The potential BIG tax under Sec. 1374 is not applicable under the specific example due to the Small Business Jobs Act, discussed above.

⁴ Regs. Sec. 1.338(h)(10)-1(c).

⁵ Regs. Sec. 1.338(h)(10)-1(d)(5)(i).

⁶ Regs. Sec. 1.338(h)(10)-1(d)(4)(i).

⁷ Regs. Sec. 1.338(h)(10)-1(d)(5)(ii).

⁸ Regs. Sec. 1.338(h)(10)-1(d)(2).

⁹ Regs. Sec. 1.338(h)(10)-1(c)(3).

¹⁰ Regs. Sec. 1.338(h)(10)-1(d)(5)(ii).

¹¹ Regs. Sec. 1.338(h)(10)-1.

¹² Regs. Sec. 1.338(h)(10)-1(c)(4).

¹³ See Regs. Secs. 1.338(h)(10)-1(d)(8) and (9).

¹⁴ H.R. Conf. Rep’t No. 101-964, 101st Cong., 2d Sess. at 1095–96, regarding the Omnibus Budget Reconciliation Act of 1990, P.L. 101-508.

EditorNotes

Christopher Hesse is a principal in the tax resource group of LarsonAllen LLP in Minneapolis, MN. For more information about this article, contact Mr. Hesse at chesse@larsonallen.com.