Asset acquisition: practical guidance on Sec. 338 election

California CPA, Jan-Feb, 2005 by Charles A. Barragato, Michael J. Abatemarco

The final regulations under Internal Revenue Code Sec. 338 certainly provide much desired clarity and guidance to tax practitioners. The main goal of these regulations was to change several accounting rules relating to deemed and actual asset acquisitions to enable them to be treated more in line with general principles under the tax law.

These Final Regulations have been in place for more than three years since they are to be applied to all qualified stock purchases or applicable asset acquisitions made after March 15, 2001.

A QSP is defined as a stock acquisition wherein the purchasing corporation acquires 80 percent or more of the total voting power and 80 percent or more of the total value of the stock of a target corporation by purchase within a 12-month period.

Sec. 332 provides for the liquidation of a controlled subsidiary corporation. This definition also is used for purposes of applying Sec. 338.

TYPES OF ELECTIONS

There are still two different types of elections which can be made pursuant to Sec. 338:

Election 1: Often referred to as the general election under Sec. 338(g), this election takes a traditional view of the tax consequences on the purchasing corporation, target corporation and the selling shareholders.

In essence, the selling stockholders continue to be taxed on the sale of their stock. The target corporation is viewed as having transferred all of its assets to an unrelated person in exchange for consideration which includes the assumption of liabilities thereby generating a realized gain or realized loss on the deemed sale of assets.

In accordance with the provisions of Sec. 338(g), the new target corporation is treated as a new corporate entity that is not related to the old target except for issues relating to retirement plans and similar provisions. [Regs 1.338-1(b)(2)].

Election 2: A more novel approach to the contemplated transaction is electing Sec. 338(h)(10), whereby the selling shareholders are permitted to join with the purchasing corporation in choosing to significantly alter the tax ramifications for the selling shareholders, the target company, and the purchasing corporation.

Although this election has received much attention as a planning tool during the past few years, tax practitioners should not automatically assume that it is the best choice in all situations. The following example will illustrate the care that must be taken to make an election that is most advantageous for clients.

EXAMPLE

Assume that Acquirer, a C corporation, purchased all of Target Corporation's common stock for $40 million in cash Sept. 30, 2003. Acquirer Corp. and Target Corp. agreed to make a timely election under Sec. 338(h)(10). The balance sheet of Target Corp. as of Sept. 30, 2003 reflected the following data:

Target Corp. has been an S corporation since its inception on June 6, 1981 and uses the cash method of accounting. The equipment cost $800,000 when purchased by Target Corp. and was depreciated using the standard MACRS statutory rates.

Target had no other assets or liabilities as of the date of the acquisition. Target's ordinary income for calendar year 2003 was $4 million, of which $3.5 million was recognized as of Sept. 30, 2003. Target's sole shareholder, Jones, had an adjusted basis in her stock of $1 million immediately before the acquisition.

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Assume that any excess purchase price is attributable to goodwill. In addition, assume that Jones is in the 35 percent federal income tax bracket for ordinary income purposes and 15 percent federal income tax bracket for long-term capital gains purposes.

Does the election under 338(h)(10) yield the best results?

ANALYSIS

For our purposes, this analysis shall ignore the possible impact of the alternative minimum tax and state and local income taxes. However, it is always important to consider the tax ramifications at the state and local level of any contemplated transaction.

To the extent that a target incurs income taxes as a result of a 338 election, the Aggregate Adjusted Deemed Selling Price would be modified accordingly.

Since the parties agreed that a Sec. 338(h)(10) election is desirable, Acquirer and Target must jointly file Form 8023 on or before June 15, 2004 since it is the fifteenth day of the ninth month beginning after the month in which the acquisition date occurred pursuant to section 338(g)(1).

Sec. 338(h)(2) defines the "acquisition date" as the first day during the 12-month acquisition period on which the 80 percent stock purchase requirement is met. The parties must understand that 338(h)(10) election is irrevocable in accordance with 338 (g)(3).

In addition, Acquirer Corp. and Target Corp. must attach Form 8883 to their Form 1120 and 1120S, respectively, for the taxable year (2003) that includes the purchase date.

Since Target Corp. has been an S corp since its inception in 1981, there will be no negative tax ramifications for Target Corp. because all statutory requirements have been met. Sec. 1361(b)(1) and 1361(b)(2) delineate shareholder and corporate-related requirements, respectively.