Sec. 338(h)(10) Checklist

This article explains why S corporation shareholders might make a Sec. 338(h)(10) election (deemed asset sale) and presents a checklist for small and mid-size firms, to assist in accurately making that election. An example illustrates the election's tax consequences.

Kenneth N. Orbach, Ph.D., CPA
Professor of Accountancy
Florida Atlantic University
Boca Raton, FL

Stewart S. Karlinsky, Ph.D., CPA
Graduate Tax Director
San Jose State University
San Jose, CA

Greg W. Smith, CPA
Senior Tax Manager
Middle Market Advisory Services
PricewaterhouseCoopers LLP
Washington, DC

Samuel P. Starr, LL.M., CPA
Tax Partner
Washington National Tax Services
Pricewaterhouse Coopers LLP
Washington, DC

Marc A. Hyman, MST, CPA
Technical Manager
AICPA
Washington, DC

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. Dr. Orbach is the task force Chair; Samuel Starr is the task force's Chair Emeritus. Authors' note: All of the TRP members made useful comments incorporated into the final manuscript. The authors wish to specially thank Laura M. MacDonough, the TRP's Chair, for her many technical contributions and leadership. For more information about this article, contact Dr. Orbach at (561) 297-2779 or orbach@fau.edu, Dr. Karlinsky at karlinsky_s@cob.sjsu.edu or Mr. Smith at greg.w.smith@us.pwcglobal.com.

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.

    

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. (The checklist is in .pdf format; after downloading, it needs to be viewed in Adobe Acrobat.)

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 full 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), ADSP⁴ 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:

$100,0005

–           06

+  10,0007

$110,000  =   ADSP

AGUB⁸ is the amount for which New T is deemed to have purchased its assets from Old T:

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%:

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 liquidating 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.