In the past, we’ve covered complex business transactions which may obtain optimal tax treatment by utilizing particular sections of the tax code. We’ve discussed the numerous variations of tax-deferred reorganizations under Section 368, for instance, as well as the tax-deferred exchange of property under Section 1031. Both of these sections can generate huge benefits for businesses and individuals; reorganizations can defer substantial gain from the sale of corporate stock and assets, and exchanges can defer recognition of capital gain taxes from the sale of real estate. Section 338 is yet another tool which, when used properly, can help taxpayers achieve more favorable tax treatment by having stock purchases treated as asset acquisitions
Why Have Stock Purchases Treated As Asset Acquisitions
Section 338 allows corporations to have their stock purchases treated as asset acquisitions for federal income tax purposes when they are acquiring both stock and assets from specific types of corporate entities. Treating stock as assets can generate substantial tax benefits for corporations, particularly when double taxation (of both the stock and assets) is avoided by means of Subsection 338(h)(10). In this post, we will introduce some of the key principles of Section 338, and then we will briefly cover the distinguishing features of S Corporations. We will then go over the basic mechanics of Section 338 and give a sense of how these transactions are structured.
Basic Section 338 Principles
As mentioned, Section 338 enables the stock portion of a stock and asset acquisition to be treated as an asset acquisition for federal tax purposes. There are two types of 338 transactions: regular 338(g) transactions, and 338(h)(10) transactions. In a regular 338(g) transaction, there is double taxation: the shareholders are taxed on the sale of their stock, and then the target corporation is taxed on the sale of its assets. Regular 338(g) transactions are less common than 338(h)(10) transactions because of the double taxation involved with the former.
Section 338(h)(10) transactions can confer substantial benefits to the parties involved because only the asset portion of the transaction is subject to tax.
Defining S Corporations
Section 338 may only be used when the target corporation is either an S corporation, a member of a consolidated group, or a non-consolidated selling affiliate. An S corporation is a corporation which has no more than 100 shareholders and has the same pass-through tax treatment as a partnership or other pass-through entity. S corporations file a specific form – Form 1120S – when they complete their tax return; this form reports the net gain or loss which has flowed through to the individual shareholders. Corporations must make a special election to receive status as an S corporation so that they can reap the advantages of pass-through treatment.
Again, Section 338 cannot be invoked in transactions which do not involve one of these three types of entities as the target corporation.
General Mechanics of Section 338(h)(10)
To conduct a Section 338(h)(10) transaction, both parties to the deal must provide their express consent that Section 338 will apply. The election must be jointly made, it cannot be unilateral; otherwise the transaction won’t qualify under 338. Once an agreement is made, the stock sale of the target corporation will be ignored for tax purposes and the asset portion of the transaction will be taxed as it normally would as an asset acquisition. The target corporation will therefore only be subject to tax on the sale of its assets, but both the stock and the assets will both be treated as asset acquisitions for tax purposes. This means that both the stock and assets will receive the “stepped up basis” treatment when sold to the acquiring corporation. The acquiring corporation can therefore take advantage of increased depreciation deductions and maximize its access to capital.
While the benefits of these more common 338(h)(10) can be plentiful iunder the right circumstances, there are situations in which this variation may not be desirable. For instance, if the basis of the target corporation’s assets is lower than the basis of its own stock, then the target corporation may be disadvantaged due to the fact that additional taxation may be incurred as a result of this discrepancy. However, depending on the specific facts, the acquiring corporation may decide to simply compensate the target corporation for the additional taxation in order to complete the deal. Other factors may also come into play to influence whether either a regular 338(g) or 338(h)(10) transaction is the best strategy; accordingly, anyone considering a 338 transaction really should consult with a qualified professional before deciding on which variation they should pursue. In the future, we will come back and look at one or more specific examples of Section 338 transactions to get a clearer sense of how these deals are structured to have stock purchases treated as asset acquisitions.
Benefit From Having Stock Purchases Treated as Asset Acquisitions
As we can see, the principles and mechanics of Section 338 are no less complicated than those underlying the other tax code sections we’ve previously covered. Given their complexity, a great deal of work is necessarily involved in structuring these transactions and ensuring that all applicable rules are followed. This work is not without its potential rewards, however: in many cases, a Section 338 transaction can help corporations avoid considerable amounts of tax on the sale of stock. The professionals at Mackay, Caswell & Callahan, P.C. devote considerable time and energy to mastering the rules and regulations of transactions such as qualified stock purchases under Section 338 so that you don’t have to shoulder this burden. If you’re contemplating using Section 338 and want to have stock purchases treated as asset acquisitions, or if you have another tax matter altogether, contact one of our top New York City tax attorneys today and we will promptly review your situation.