New Regs. Alter Tax Consequences of Sec. 338(h)(10) Elections

Earlier this year, the IRS issued temporary regulations under Sec. 338, effective for transactions after Jan. 5, 2000. The prior regulations largely were restatements of the temporary regulations, developed and repeatedly amended over several years. As a result of the haphazard manner in the promulgation of these regulations, they were difficult to follow, lacked clear guidance on purchase price allocations and were inconsistent in their use of general tax accounting principles versus those used outside the purview of Sec. 338.

The new regulations modify the rules that determine a seller’s amount realized when making a Sec. 338(h)(10) election. In addition, the repeal of the installment sale method for accrual-basis taxpayers also affects the tax consequences of such elections.

Amount Realized and Basis—Prior Regs.

Under prior Regs. Sec. 1.338(h)(10)-1(f), the modified aggregate deemed sales price (MADSP) was the price at which an old target was deemed to sells its assets if it made a Sec. 338(h)(10) election. The MADSP is the sum of the following items:

1. The grossed-up basis of the purchasing corporation’s recently purchased stock;

2. The new target’s liabilities as of the beginning of the day after the acquisition date (i.e., the old target’s liabilities deemed transferred to the new target); and

3. Other relevant items (i.e., reduction for purchaser’s costs included in the first item and seller’s expenses).

The amounts in the first and third items do not directly depend on any overall accounting method. The grossed-up basis of the purchasing corporation’s recently purchased stock depends directly on the purchaser’s basis of the newly acquired stock. Other relevant items simply include the purchaser’s acquisition costs (included in the basis of the newly acquired target stock) and the seller’s expenses incurred in connection with the sale of the target’s stock. The liabilities considered in determining MADSP are the same liabilities that the new target considers in determining the basis of assets acquired in the deemed purchase.

Under Regs. Sec. 1.338(h)(10)-1(e)(5), the basis of new target’s assets is known as the adjusted grossed-up basis (AGUB), determined under Regs. Sec. 1.338(b)-1(c). The AGUB is the sum of the exact same three items that comprise the MADSP. However, AGUB is not reduced by the purchaser’s acquisition costs, nor the seller’s expenses incurred in connection with the sale of the target’s stock.

Under Regs. Sec. 1.338(b)-1(f), liabilities are those taken into account had the new target acquired the old target’s assets from an unrelated person and, as part of the transaction, assumed liabilities or taken property subject to the liabilities. Thus, contingent liabilities were initially excluded from the AGUB, and, therefore, from the MADSP. The new target takes these liabilities into account only when they become fixed and determinable.

Amount Realized and Basis—New Regs.

Under the new temporary regulations, the components of the MADSP and AGUB generally are consistent with the prior regulations. The MADSP is now the aggregate deemed sales price (ADSP), which is consistent with the Sec. 338(g) election. However, the major change in the new temporary regulations is that contingent liabilities initially excluded from the ADSP and the AGUB are taken into account under general principles of tax law, which may or may not be when the contingent liabilities become fixed and determinable.

Application of General Tax Accounting Principles

Under the prior regulations, a link existed between the MADSP and AGUB, both in their computation and timing. The link between the computation of the MADSP and AGUB was consistent with the rules associated with actual asset sales under Sec. 1060; however, the timing link between MADSP and AGUB did not necessarily exist.

In an actual asset sale under Sec. 1060, the seller’s consideration is the amount realized under Sec. 1001(b) and the buyer’s basis is its costs under Sec. 1012. The amount realized and the cost include the amount of fixed and determinable liabilities the buyer assumes. In addition, assuming some of these liabilities generate deductions for the seller in the income tax return that includes the sale, as well as basis in the assets the buyer receives. The seller can take a deduction even if it does not meet the economic performance rules before the transaction’s effective date; the buyer’s assumption of a fixed and determinable liability satisfies the economic performance rules under Regs. Sec. 1.461-4(d)(5).

While fixed and determinable liabilities that a buyer assumes become part of the amount the seller realizes and the basis the buyer receives, the treatment of liabilities not fixed and determinable (i.e., contingent liabilities) differs between the buyer and the seller. A determination that a contingent liability is not the seller’s responsibility (i.e., it relates to events occurring subsequent to the acquisition) should not affect the determination of the amount the seller realizes or the basis the buyer receives. However, a determination that a contingent liability that the buyer assumed is the seller’s responsibility requires the seller to consider it in determining its amount realized as of the acquisition date.

The buyer, on the other hand, generally does not receive basis until there is payment of the contingent liabilities or they become fixed and determinable. Thus, under general principles of tax law, there is a mismatch in the timing of the seller’s amount realized and the buyer’s basis; see Albany Car Wheel Co., Inc., 333 F2d 653 (2d Cir. 1964). This mismatch represents the inconsistency between the prior regulations under Sec. 338 and general tax principles applicable to asset acquisitions under Sec. 1060.

Repeal of the Installment-Sale Method

Historically, a seller would report an asset sale using the installment method. Regulations under the installment method provide rules that deal specifically with contingent payment installment sales. These rules generally use a “closed transaction” approach and force the seller to account for the contingent liability or adjust basis to determine the gain it realizes as of the transaction’s effective date.

For some time it was unclear whether installment-sale reporting under Sec. 453 applied to Sec. 338(h)(10) transactions, because the “actual” buyer and not the new target (or the “deemed” buyer) issued the installment obligations under a Sec. 338(h)(10) election. New Temp. Regs. Sec. 1.338(h)(10)-1T(d)(8) clarified this issue, providing that the old target receives an obligation from the new target, the terms of which are identical to the obligation that the actual buyer issued. Because of this, installment-sale reporting would generally be allowed in a Sec. 338(h)(10) transaction.

While new regulations clarify the availability of installment-sale reporting for Sec. 338(h)(10) transactions, Congress created new issues with its recent amendment to Sec. 453. For transactions after Dec. 16, 1999, the installment method is no longer available for accrual-method taxpayers. If the seller cannot use the installment method, the issue becomes whether it must value the contingent liability for inclusion in the amount realized on the sale’s effective transaction date, or, alternatively, can take an “open transaction” position and delay accounting for the contingent liability until the date it becomes fixed and determinable.

The U.S. Supreme Court initially recognized the open-transaction method in Burnet v. Logan, 283 US 404 (1931). Under the open-transaction method, if there is no way to value a contingent liability on the transaction’s effective date, no gain is realized until the receipt of proceeds in excess of basis. However, for transactions in which the open-transaction method results in losses, the results are less certain. In some circumstances, a taxpayer may recognize a loss in the year of sale; otherwise, the taxpayer can defer it until determination of the final contingent liability.

The IRS has historically disapproved of the use of the open-transaction method. The installment-sale regulations provide that, if the taxpayer does not use the installment method, the Service views the transaction as a closed transaction, and only in rare and extraordinary situations will the IRS allow the open-transaction approach. The Service issued these regulations prior to the amendment of Sec. 453 (disallowing the installment-sale treatment for accrual-method taxpayers). They address taxpayers that specifically elect out of the installment method. The new regulations deny accrual-method taxpayers the use of installment-sale reporting (versus the ability to elect out). Therefore, taxpayers should determine whether the open-transaction method is a viable position when making a Sec. 338(h)(10) election.

From Greg A. Stump, CPA, Elkhart, IN