Sec. 338(h) (10) elections involving S corporation targets.

• Author: Low, Dixon D.

In early 1994, the Treasury issued regulations under Sec. 338(h)(10) that dramatically altered the mergers and acquisitions landscape for closely held businesses. These regulations expanded the beneficial treatment of Sec. 338(h)(10) from consolidated groups(1) to S corporations and affiliated groups(2) not filing consolidated returns.

This was once an area that had little impact on the smaller tax practitioner. However, the changes to the Sec. 338(h)(10) regulations make it incumbent on any professional assisting a client with the purchase or sale of a business to understand and, when applicable, make the election. The failure to recognize opportunities to use these new rules may cause taxpayers to forgo significant tax benefits.

Unfortunately, it is not entirely clear from the regulations how the S corporation rules and the Sec. 338(h)(10) election interrelate. No examples are provided involving S corporations and the descriptive language detailing the rules as they relate to S corporations is limited.

This article will examine the ramifications of a Sec. 338(h)(10) election involving an S corporation target. When the final regulations are silent or unclear about certain outcomes, the authors will provide what they believe to be the most reasonable alternatives. Additionally, several examples will illustrate the decision criteria that must be considered by the seller and the buyer in analyzing whether to make a Sec. 338(h)(10) election.

Sec. 338

In 1982, Congress enacted Sec. 338 to allow a purchasing corporation to treat the acquisition of a target corporation's stock as the acquisition of its assets. In a straight Sec. 338 election, this is accomplished by treating the target corporation (Old Target) as having sold its assets at the close of the acquisition date to a new corporation (New Target) that is deemed to acquire the assets as of the beginning of the next day. A straight Sec. 338 election does not affect the selling shareholder (i.e., gain is recognized on the stock sale as though the election had not occurred).

A Sec. 338 election is allowed only for transactions in which control of Old Target is acquired in a "qualified stock purchase" (QSP). Sec. 338(d)(3) defines a QSP as any transaction or series of transactions in which "control" (i.e., at least 80% of vote and value) of a target corporation is purchased by an acquiring corporation during a "12-month acquisition period." Thus, the purchaser must be a corporation and 80% of vote and value must be completely acquired within an actual time span of 12 months.

Under pre-Tax Reform Act of 1986 (TRA) law, the straight Sec. 338 election was quite beneficial because the target's appreciated assets received a step-up in basis at little or no current tax cost. However, due to the TRA's repeal of the General Utilities doctrine,(3) the deemed asset sale is now fully taxable. Accordingly, straight Sec. 338 elections are now rare. Only in certain limited situations does it make financial sense to generate current taxable income to obtain a higher basis in the target's assets.

Sec. 338(h)(10)

One significant post-TRA planning opportunity is the Sec. 338(h)(10) election.(4) The enactment of Sec. 338(h)(10) resolved the question that arose under original Sec. 338 as to whether gain generated by a Sec. 338 election made with respect to a target that was a subsidiary in a consolidated group was included in the consolidated return of the selling group or, rather, had to be reported on a separate return (as is generally the case under Sec. 338). Sec. 338(h)(10) treats the gain as part of the selling consolidated group's income.

Recognition of the gain by the selling consolidated group in a Sec. 338(h)(10) election is accomplished by treating Old Target as if it had sold all of its assets in a taxable "deemed asset sale" to New Target, followed by the liquidation of Old Target.

The fundamental difference between a Sec. 338 election and a Sec. 338(h)(10) election is generally the elimination of one level of tax. In a Sec. 338 transaction, the seller recognizes taxable income on the sale of stock, and Old Target separately recognizes gain on its deemed sale of assets, creating two levels of tax. In a Sec. 338(h)(10) transaction in which Old Target is a subsidiary in a consolidated group, Old Target is deemed to have sold its assets to New Target in a taxable transaction and then liquidated tax free into the selling shareholder(s) under Sec. 332.(5) Thus, the transaction creates only one level of tax--on the deemed asset sale. The Sec. 338(h)(10) acquisition technique is particularly beneficial when Old Target's consolidated group has significant net operating losses (NOLs) that are about to expire or Old Target has NOLs that are of little value to the purchasing corporation.(6) In such a case, even though the selling consolidated group must recognize taxable income on the deemed asset sale, the gain may be offset by the NOLs. Any unused NOL is carried forward by the selling consolidated group under Sec. 381, because the liquidation of Old Target is treated as a Sec. 332 liquidation into the selling consolidated group.

New Regs.

Historically, the Sec. 338(h)(10) election was somewhat limited by the requirement that the target be a member of a consolidated group. To expand Sec. 338(h)(10)'s availability, TRA Section 631(b)(3) also added flush language after Sec. 338(h)(10)(B)(ii) to allow the Treasury to publish regulations permitting deemed asset sale treatment to any affiliated group of corporations, whether or not the group files a consolidated return. TRA Section 631(a) also added Sec. 336(e) to provide that under regulations, principles similar to Sec. 338(h)(10) may be applied to taxable distributions of controlled corporation stock. Apparently, the Treasury relied on these two statutory delegations of authority to allow Sec. 338(h)(10) treatment to a target that (1) satisfies the requirements of Sec. 1504(a)(2) but is not included in a consolidated return, or (2) is an S corporation.(7) While the result is appropriate and reasonable given that similar results would obtain from a direct sale of assets, there appears to be no statutory support for the regulatory inclusion of S corporations as allowable targets in Sec. 338(h)(10) transactions. Neither the Sec. 338(h)(10) regulations nor their preamble offers any insight into the Treasury's rationale.

* Joint election requirement

While an election under Sec. 338(h)(10) is potentially desirable, it is also irrevocable.(8) Thus, once the election is made, the purchaser and the selling shareholder(9) are permanently bound to Sec. 338(h)(10) treatment.

Under Regs. Sec. 1.338(h)(10)-1(d)(2), a Sec. 338(h)(10) election is made jointly...