Final Regs. under Secs. 338 and 1060 Reflect Significant Changes

Final regulations issued earlier this year for deemed and actual asset acquisitions under Secs. 338 and 1060 apply to any qualified stock purchase (QSP) or asset acquisition (constituting a trade or business) occurring after March 15, 2001. While the final rules are similar in organization and substance to proposed regulations issued in August 1999 and temporary regulations issued in January 2000, significant changes were made in several areas, largely in response to comments received from taxpayers and practitioners.

History

The purpose of the proposed regulations was to simplify application of prior regulations and provide taxpayers with guidance on uncertainties created by the earlier regulations. Some of the more important items in the proposed regulations included:

• Installment-sale clarification;
• Increase in asset classes from five to seven;
• Specific-transaction cost allocation;
• De-linking adjusted deemed sales price (ADSP) and adjusted grossed-up basis (AGUB);
• Disallowing gross-up of selling and acquisition costs;
• New anti-abuse provision;
• Contingent liabilities conform to general principles of tax law; and
• Shareholder consent for S targets increased to 100%.

The January 2000 temporary regulations were substantially the same as the proposed regulations and were issued in temporary form because of the lack of comment the IRS received on the earlier proposed regulations. These regulations were effective for any QSP or asset acquisition occurring after Jan. 5, 2000.

Changes in Final Regs.

Anti-abuse rule. The temporary regulations included a new anti-abuse rule allowing the Service to reallocate values assigned to target assets when the target corporation transferred an asset (within two years of the QSP) that also was acquired by the purchaser in the QSP and continued to be "held or used to more than an insignificant extent" with one or more of the activities of the new target.

The final regulations change the standard for invoking the anti-abuse rule to "held or used primarily" with one or more of the activities of the new target. The change is intended to allow taxpayers to transfer assets in the ordinary course of business without triggering the anti-abuse rule in a later QSP. The anti-abuse rule is intended to apply only to transactions that manipulate operation of the general residual method of asset allocation.

Stock in lower-tier subsidiaries. The temporary regulations classified the stock of a lower-tier subsidiary as a class II asset (certificates of deposit, U.S. government securities, readily marketable stock or securities and foreign currency). The final regulations change the classification of stock of a lower-tier subsidiary to a class V asset (general asset category), unless the stock is publicly traded preferred stock described in Sec. 1504(a)(4).

Class III assets. The temporary regulations created two new asset classes for purposes of the residual method of basis allocation, a new class III for accounts receivable, mortgages and credit card receivables and a new class IV solely for inventory. The final regulations add "assets that the taxpayer marks to market at least annually and other debt instruments" to the class III asset category.

First-year purchase-price adjustments. The temporary regulations provided a rule that allowed changes in purchase price that occurred before the end of the new target's first tax year to be treated as if they had been made at the beginning of the day immediately after the acquisition date. The final regulations remove this rule, stating that the new target's fiscal year could extend beyond the old target's return due date (including extensions) in a Sec. 338(h)(10) transaction, thereby creating an inconsistency in reporting between the buyer and seller.

S corporations. The temporary regulations changed the consent requirement in a Sec. 338 transaction for S targets from 80% or more of the S shareholders to 100%. The final regulations recognize that this change has yet to be reflected in the instructions to Form 8023, Elections Under Section 338 for Corporations Making Qualified Stock Purchases. Therefore, according to the IRS, it will not invalidate Sec. 338 elections completed in accordance with that form's instructions until the form and instructions are updated.

Different S shareholders may receive different amounts of gross proceeds (on a per-share basis) in a QSP to reflect minority positions, control premiums, etc. Some practitioners concluded this could create a second class of S stock, which could jeopardize the Sec. 338 election eligibility requirements. Under the final regulations, varying amounts paid to S shareholders will not constitute a second class of stock, provided that the varying amounts are negotiated at arm's-length with the purchaser.

Reporting requirements. Under previous regulations, the Sec. 338 election was made on one Form 8023 by both the purchasing and target corporations; the basis allocation between the various asset classes was also completed on Form 8023. There was also no requirement to amend Form 8023 or report subsequent purchase-price adjustments made on a QSP.

Form 8594, Asset Acquisition Statement, now must be completed by both the purchasing and target corporations and attached to their respective returns when an election is made under Sec. 338. Purchases of controlled foreign corporations with Sec. 338(g) elections require Forms 8594 to be attached to the purchaser/target's (or their U.S. shareholders') Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. Subsequent purchase-price adjustments (i.e., increases and decreases to the AGUB or ADSP) require supplemental Forms 8594 to be filed by both purchaser and target in the year such adjustments occur. One example to such a purchase-price adjustment would be a contingent liability that subsequently becomes fixed.

Summary

Issuance of proposed, temporary and final regulations under Secs. 338 and 1060 during the previous 18 months has given corporate taxpayers clearer guidance when participating in a QSP or an asset acquisition constituting a trade or business. The final regulations are primarily a restatement of the proposed and temporary regulations, but with some notable modifications in application. The final regulations significantly change the reporting requirements for corporate taxpayers involved in Secs. 338 and 1060 transactions, and add new reporting requirements when subsequent purchase-price adjustments are made to prior-year Secs. 338 and 1060 transactions.

From Greg W. Smith, CPA, Washington, DC