S corp. targets and sec. 338(h) (10) update.

• Author: Lux, Michael
• Position: Internal Revenue Code

The IRS recently released temporary regulations on determining the amount realized and the basis amount allocated to each asset transferred in a deemed or actual asset acquisition.

Temp Regs. Sec. 1.338(h)(10)-1T clarifies and modifies the tax treatment of S corporations and their shareholders when a Sec. 338(h)(10) election is made on the disposition of shareholders' S stock in a qualified stock purchase.

This item addresses the following issues:

* Availability of installment sales tax treatment to a cash-method S corporation and its shareholders under an installment sale of S stock coupled with a Sec. 338(h)(10) election;

* Sec. 338(h)(10) election requirements when S shareholders, who own 20% or less of the S stock, retain S stock; and

* Tax effects on S shareholders who retain their S stock under the tax "fiction" of a Sec. 338(h)(10) election.

Installment Sale Treatment under Sec. 338(h)(10) Election

Under prior law, the installment sale of S stock by its shareholders to a C corporation, coupled with a Sec. 338(h)(10) election, arguably resulted in an unintended, immediate triggering of the entire deferred gain on the S corporation's deemed asset sale.

Under prior law, the Sec. 338 "fiction" provided for a bifurcation of a target corporation into "old target" and "new target." Old target is deemed to have sold its assets to new target. The deemed sale of assets and deemed liquidation is that of old target. If this fiction is literally followed, installment sale treatment is not available; the installment note is from the actual purchaser of the stock, and not from the deemed purchaser of the assets. Therefore, the note is a third-party note and, under Sec. 453, would not be eligible for installment-sale treatment, because it is not the note of the actual purchaser.

Further, the current Sec. 338 regulations do not provide rules for old target to report its deemed sale gain under the installment method.

Conversely, Prop. Regs. Sec. 1.338(h)(10)-1 does provide for old target to report its deemed sale gain under the installment method, as long as the deemed asset sale would otherwise qualify for installment sale reporting. The proposed regulations solve the problem of the third-party note by outlining a new "fiction" of the installment sale method of reporting when a Sec. 338(h)(10) election is made.

Specifically, Prop. Regs. Sec. 1.338(h)(10)-1(d)(8) dictates that, solely for purposes of applying Secs. 453, 453A and 453B in a deemed asset...