Sec. 338(h) (10) checklist.

• Author: Orbach, Kenneth N.
• Position: Deemed asset sales by S Corporations

When S corporation shareholders decide to dispose of their investments in the corporation in a taxable transaction, they have several methods from which to choose. From a tax perspective, a sale of all of the S stock will result in the S shareholders recognizing the same total gain or loss as they would if the S corporation sold all of its assets and then liquidated. However, with an asset sale, some of the gain may be taxed at ordinary income rates; a stock sale generally will generate capital gain or loss. In addition, with an asset sale, the built-in gain (BIG) tax or passive investment income (PII) tax may apply. There may also be state and local tax differences between a stock sale and an asset sale followed by a complete liquidation.

Stock or Asset Sale?

Tax Issues

A stock acquisition will result in a cost basis to the buyer of the stock acquired, but not in a step-up (or -down) in the basis of the acquired corporation's assets. The acquired corporation's tax attributes (e.g., net operating loss carryovers and earnings and profits (E&P)) remain with the corporation. If the buyer acquires assets, its asset bases are stepped up (or down) to reflect the purchase price paid. The buyer does not succeed to the acquired corporation's tax attributes.

In deciding whether to structure an S corporation sale as a stock sale or as an asset sale followed by a corporate liquidation, the buyer and seller consider their relative costs and benefits. For example, the additional cost of an asset sale from the seller's perspective (e.g., ordinary income taxed at a higher rate and BIG tax) is often compared to the benefit of the basis step-up the buyer receives.

Nontax Issues

S corporation sales also trigger nontax issues, such as determining responsibility for disclosed and undisclosed liabilities, deciding on unwanted assets and addressing dissident shareholders' concerns. In addition, an actual sale of some kinds of assets may not be possible (e.g., certain nontransferable licenses). State transfer taxes can also weigh against an asset sale.

Sec. 338(h)(10) Election

If the target is an S corporation and a stock purchase is desired for nontax reasons, but an asset purchase sought for tax reasons, it is common for the target S shareholders and the acquiring corporation to agree to make a Sec. 338(h)(10) election. Regs. Sec. 1.338(h)(10)-1 (c) permits corporations making a qualified stock purchase (QSP) of a target S corporation to make a Sec. 338(h)(10) election jointly with the S shareholders. If this election is made, the stock sale is ignored for income tax purposes; instead, the S corporation is deemed to have sold its assets to the acquirer (in the form of a new target) and to have liquidated (generally under Secs. 331 and 336). Because the target's S status remains in effect throughout the deemed-sale process, any gains or losses recognized on the deemed sale flow through to the shareholders (and adjust their stock bases for determining gain or loss on the deemed liquidation). The deemed asset sale may cause the BIG or PII tax to apply at the S level. (1) All target shareholders (selling and non-selling) must consent to the Sec. 338(h) (10) election.

An S corporation may be the acquiring corporation. If so, it could make a qualified subchapter S subsidiary (QSub) election as to the target, provided it acquires 100% of the target's stock in the QSP and the target is a domestic corporation (other than an ineligible corporation as defined in Sec. 1361(b)(2)). The QSub election would be effective after the effective date of the Sec. 338(h)(10) deemed asset sale. (2)

The goal of the following checklist is to make an experienced tax adviser aware of many of the Federal income tax issues arising from a Sec. 338(h)(10) transaction involving an S target.

Example: (3) T, an S corporation, has three shareholders, A, B and C, who own 40%, 40% and 20% of T, respectively. A and B each has a $10,000 adjusted basis in T stock; C's adjusted basis is $5,000. T's sole asset is real estate with a $35,000 adjusted basis, $110,000 value and encumbered by a $10,000 debt. T does not hold the real estate primarily for sale to customers in the ordinary course of its trade or business.

On March 1, 2002, A sold all of his stock to P Corp. for $40,000 cash; B sold all of his stock to P for a $25,000 note (with adequate stated interest) and $15,000 cash. C does not sell his stock. Because P acquired 80% of the T stock, P has made a QSP. The note issued to B is not payable on demand or readily tradable and is due in flail in 2008. A and B have no selling expenses; P incurs no acquisition costs.

Assume Secs. 453A (interest on the deferred tax liability), 1374 (BIG tax), and 1375 (PII tax) do not apply and that A, B, C and P join in making a Sec, 338(h)(10) election. (Although C did not sell his T stock, Regs. Sec. 1.338(h)(10)-1(c)(2) requires his consent to the election because (as illustrated below) he will be affected by it.)

According to Regs. Sec. 1.338-4(c)(1)(i), ADSP (4) is computed as if A and B (the selling shareholders) were required to use Old T's accounting methods and the installment method were not available:

($100,000 (5) - 0 (6) + 10,000 (7) $110,000 = ADSP AGUB (8) is the amount for which New T is deemed to have purchased its assets from Old T:

$100,000 (9) + 0 (10) + 10,000 (11) $110,000 (12) = ADSP For purposes of the Sec. 453 installment-sale rules, the components of the $110,000 ADSP are a $25,000 note (deemed issued by New T), $10,000 in liabilities to which the T assets are subject and $75,000 in cash. (13) Absent a Sec. 453(d) election, Old T reports the gain under the installment method; the gross profit ratio is 75%:

$110,000 (selling price) - $35,000 (adjusted basis) $110,000 (selling price) - $10,000 (smaller of adjusted basis or liabilities) Thus, Old T must recognize a $56,250 gain ($75,000 x 0.75) in 2002, allocated 40% to A ($22,500), 40% to B ($22,500) and 20% to C ($11,250). Immediately before Old T's deemed liquidation, the shareholders' outside bases were as follows:

A: $32,500 ($10,000 + $22,500)

B: $32,500 ($10,000 + $22,500)

C: $16,250 ($5,000 + $11,250)

Old T is deemed to distribute $75,000 in cash and the $25,000 note in the deemed liquidation resulting from the Sec. 338(h)(10) election. A is treated as receiving $40,000 cash in the deemed liquidation; B is treated as receiving $15,000 cash, plus the $25,000 note (because B actually received the note in exchange for his stock); and C is treated as receiving $20,000 cash. A recognizes $7,500 capital gain ($40,000 - $32,500 outside basis) on the deemed liquidation distribution.

As for B, under Sec. 453(h), the distribution of the note is not a payment for B's stock (unless B makes a Sec. 453(d) election). Further, the distribution of the note is not a taxable event to Old T because of Sec. 453B(h). B's gross profit ratio on the Sec. 453(h) deemed installment sale of his stock is 18.75% ([$40,000 (selling price) - $32,500 (outside basis)]/$40,000 selling price). Thus, B must recognize $2,812.50 (18.75% x $15,000) capital gain on his deemed receipt of $15,000 in the deemed liquidation. B will recognize an additional $4,687.50 gain (18.75% x $25,000) when he receives payment on the note.

C recognizes $3,750 capital gain ($20,000 - $16,250 outside basis) on the deemed distribution. Because C did not actually sell any of his T stock, he is treated as acquiring his T stock for $20,000 on the day after the QSP, under Regs. Sec. 1.338(h)(10)-1(d)(5)(ii). T's holding period for the stock begins on that date.

Conclusion

The checklist and example should aid practitioners advising on Sec. 338(h) (10) elections for S corporation targets.

EXECUTIVE SUMMARY

* When S corporation shareholders decide to dispose of their stock in a taxable transaction, they have several methods from which to choose.

* S corporation sales trigger both tax and nontax issues.

* All target shareholders must consent to a Sec. 338(h)(10) election.

Editor's note: The authors are members of the AICPA Tax Division's S Corporation Taxation Technical Resource Panel's (TRP's) Sec. 338 (h)(10) Project Task Force.

Item Yes Validity of S status 1. Is the target an S corporation at the time of the QSP? -- Only certain target corporations can participate in a Sec. 338(h)(10) election (i.e., members of a consolidated group, affiliated corporations and S corpora- tions). This checklist focuses on S tar- gets. If stock of a purported S corpora- tion is purchased in a QSP, it is critical to ascertain that the target has a valid S election in effect at the time of acquisi- tion if a Sec. 338(h)(10) election is intended. 2. Has the target maintained S status con- tinuously since its most recent election? -- 3. Determine continuous S status by examining the following documents: [] Form 2553, Election by a Small Busi- ness Corporation. Make sure all share- holders at the time of the corporation's current S election have signed the form. Certain other shareholders' con- sents may be required; see Regs. Sec. 1.1362-6(b)(2). Have appropriate con- sents been reviewed? -- [] Did both spouses sign the election form if they live in a community prop- erty state? -- [] Are both spouses qualified shareholders? -- [] If a qualified subchapter S trust (QSST) was a shareholder on the date of the S election, did the current beneficiary (rather than the trustee(s)) sign the election form? -- [] Did the current beneficiary make a valid QSST election? -- [] Under Notice 97-12, 1997-1 CB 385, if an electing small business trust (ESBT) was a shareholder on the date of the S election, the trustee was required to consent to the S election. Did the trustee consent? -- [] Did the trustee make a valid ESBT election? -- [] Examine the corporation's "governing provisions" and ask the target to provide a distribution schedule for each of its shareholders on a year-by-year basis. Do the governing provisions state that each...