Understand Section 338(h)(10) of the federal tax code.

 

In simple terms, a 338(h)(10) is a tax election for a qualified stock purchase (QSP), which recharacterizes a stock purchase as an asset purchase for federal tax purposes. It remains a stock purchase for all other legal purposes, such as contracts and licensing 

 

Difference between Normal stock purchase and 338(h)(10) elections.

The key difference between normal stock purchases and 338(h)(10) elections is that the latter allows the buyer in a stock purchase to be treated as if it bought the target company’s assets, solely for tax purposes. The basis received is at fair market values.  For example, the buyer would receive $1.5 million in the basis of the assets even though the tax value was $ 500,000 only.

 

Conditions for 338(h)(10) election.

·         Seller must be either a U.S. corporate subsidiary of a parent company or an S-Corporation (pass through entity).  

 

·         The buyer and seller (all stockholders) must jointly make the election – it cannot be unilaterally made by one side    

 

·         Buyer must be a corporation making a QSP (qualified stock purchase) – at least 80 percent of the seller’s stock needs to be acquired by the buyer

 

Final Outcome.

1. The buyer creates a new corporation (new Target)
2. New Target buys the assets of the target corporation (old Target)
3. Old Target liquidates in the hands of the seller.  Generally, there is only one level of tax imposed which is on the deemed asset sale.
4. The stock sale is ignored, and the deemed liquidation is tax-free to the selling shareholders.

 

Advantage for Buyer

·         Allows amortization or depreciation and allows full claim of investment as expense in the tax books.

·         the target company remains a legal entity and preserves the integrity of its assets, while the buyer can receive a stepped-up cost basis on the stock it receives. 

·         Buyer can claim 100% depreciation in the first year on the old book value of assets (in our example $ 5,00,000 in year one and on balance $1 Mn in 15 years by way of amortization of goodwill).

 

Dis-advantage to the Buyer

·         For legal purposes, a 338(h)(10) election remains a stock sale despite being deemed an asset sale for tax purposes. Thus, while there are favorable tax benefits, it does not eliminate the buyer’s exposure to known or unknown liabilities included in the acquisition.

 

 

Dis-advantage to the Seller

• The seller must pay tax on 100% of the gain built into the target, even if selling less than 100% of the target.
• The sale will be considered as normal ordinary business income and not capital gains which leads to higher rate of income tax.
• Further, there will be additional state tax based on the location of the S Corp

 

Case study.

Facts

·         There is a S Corporation with $500,000 tax value assets. This includes, Fixed assets of $ 200,000 and other current assets of $ 300,000

·         T Company want to acquire S Corporation for $1.5 Mn being the fair market value, hence value of goodwill will be $ 1 Mn

·         Hence in the books of S Corporation there will be a business gain of $1 Mn on which tax to be paid (21 %).  $210,000 and state tax of approx. 8% $ 80,000

·         Balance $710,000 will be distributed to S Corporation shareholders as liquidation and same will be not taxable in the hands of shareholder.

·         T Corporation now gain control over S Corporation with their assets and business contracts.

·         T Corporation in the first-year claim 100% depreciation on $200,000 of fixed assets.

·         Further T Corporation will claim amortization on goodwill for 15 years on value of $ 1 Mn.