Installment reporting for sales of S Corporation stock with a s. 338(h) (10) election.

• Author: Polsky, Gregg D.

On January 5, 2000, the Treasury Department adopted Temporary Regulation [sections] 1.338(h)(10)-1T (the "temporary regulation"), which clarifies that the installment method of reporting under [sections] 453 may be used by taxpayers selling stock in transactions in which an election under [sections] 338(h)(10) is made (hereinafter a 338(h)(10) election).[1] Prior to the adoption of the temporary regulation, it was unclear whether the installment method of reporting was available in such cases.

The installment method of reporting is generally very advantageous for taxpayers selling eligible property[2] with deferred payment terms. S corporation stock is eligible property in most cases, and it is common to use deferred payment terms in sales of such stock. As a result, the clarity provided by the temporary regulation provides reliable tax planning opportunities in sales of S corporation stock where a 338(h)(10) election is available and where at least some of the proceeds are to be received by the selling shareholders in the taxable year following the year of the closing. Unfortunately, new [sections] 453(a)(2), enacted on December 17, 1999, prohibits the use of the installment method of reporting in conjunction with a 338(h)(10) election if the target corporation uses the accrual method of accounting. Therefore, the benefits of coupling a 338(h)(10) election with the installment method of reporting are only available when the target uses the cash method of accounting.

This article focuses on the use of the installment method of reporting in connection with a 338(h)(10) election for the sale of S corporation stock. Section I discusses eligibility requirements and tax consequences of a 338(h)(10) election in connection with the sale of S corporation stock. Section II discusses the uncertainty that existed prior to the adoption of the temporary regulation regarding the availability of the installment method of reporting for sales of S corporation stock in which a 338(h)(10) election was made. Section III describes the application of the temporary regulation. Lastly, section IV discusses the impact of new [sections] 453(a)(2) on S corporation stock sales in which a 338(h)(10) election is made. The temporary regulation also applies to certain C corporations; however, the specific issues relating to C corporations are beyond the scope of this article.

Overview of [sections] 338(h)(10)

Section 338(h)(10) is a unique provision of [sections] 338. Section 338 generally allows the purchaser of stock in certain stock transactions to treat the transaction as though the target corporation sold all of its assets for their fair market value immediately after the stock purchase.[3] An election under [sections] 338, as opposed to a 338(h)(10) election, does not impact the tax treatment of the selling shareholders (i.e., they are treated as selling their stock).

By comparison, if a 338(h)(10) election is made, the stock purchase is ignored and the transaction is treated as a sale of assets by the target corporation followed by a liquidation of the target corporation. A 338(h)(10) election is only available if the target is an S corporation or a member of an affiliated or consolidated group immediately prior to the stock purchase.[4]

With respect to a sale of S corporation stock in which a 338(h)(10) election is made, the S corporation reports gain or loss as if it had sold all of its assets. The gain or loss flows through to the S corporation's shareholders in accordance with the normal rules of Subchapter S and causes an appropriate adjustment to each shareholder's stock basis. The S corporation is then deemed to distribute the sale proceeds to its shareholders in complete liquidation. As a result of the basis adjustment, the deemed liquidation is generally tax-free to the S corporation shareholders. The purchaser is treated as having formed a new subsidiary corporation which purchases the target S corporation's assets for fair market value. This provides the purchaser, through its newly formed subsidiary, with a stepped-up basis in the target's assets in most instances.[5] The ability to acquire stock and obtain the tax benefits of an asset acquisition under [sections] 338(h)(10) presents significant planning opportunities to tax advisors in S corporation stock transactions.

In order to make a 338(h)(10) election the purchaser must make a "qualified stock purchase" of the stock of an eligible target. In general, a "qualified stock purchase" of an S corporation's stock occurs when 80 percent or more of the S corporation's stock is acquired by a corporate purchaser in a single fully taxable transaction.[6] A 338(h)(10) election for an S corporation stock sale must be made by the purchaser and all of the S corporation shareholders, including those who do not participate in the qualified stock purchase.[7]

Consequences to S Corporation Target Shareholders

If a 338(h)(10) election is made, no gain or loss is recognized by the selling S corporation shareholders on the sale of the stock.[8] However, the target recognizes gain or loss as if it had sold all of its assets for an amount equal to the "aggregate deemed sales price" (as defined below, the "deemed price") in a hypothetical sale to an unrelated...