Tax issues will always be a factor in the buying and selling of business interests.  The Internal Revenue Code contains a voluminous compilation of laws that affect just about every aspect of structuring a transaction.  The basic theme of this month’s message to buyers and sellers of business interests is to be aware of the high level of tax planning that should be an integral part of structuring your transaction.  In a related article, I discuss various tax strategies with regard to structuring a transaction as a tax-free reorganization.  This article will focus on the taxable treatment of certain stock transactions and summarize certain key points regarding Internal Revenue Code (IRC) Section 338.  Because of the complexity of these rules, this article is intended to introduce the reader to the very basic concepts inherent the application of the tax law applicable to this section.

During the negotiation phase of a deal, the decision of whether the transaction will be a “stock purchase” or an “asset purchase” can have a material effect to both buyer and seller.  What would happen if we could structure a deal as a “stock purchase,” but have it really be an “asset purchase” for tax purposes.  Believe it or not, the Internal Revenue Code contains a set of laws that will accomplish this task.  The set of laws I am referring to are known as IRC Section 338.

A taxable purchase of a corporation’s stock has no effect on the basis of the assets that are owned by the target corporation.  However, when IRC Section 338 is elected, the tax basis of the assets in the target corporation is stepped up to reflect the purchase price of the stock.  This is great news for the buyer, right?  The downside to this step up in basis is that the buyer pays the tax on the transaction.  This is bad news for the buyer, right?  The answer to this dilemma is that under the right circumstances the IRC Section 338 election may work for both the buyer and the seller.  When the target corporation owns certain tax attributes such as net operation loss carry forwards and tax credit carry forwards, these tax attributes can be used to offset the tax liability created by the IRC Section 338 election.  However, be aware that these tax attributes have various limitations.

There are two separate elections available under IRC Section 338.  The basic election under IRC Section 338 has the effect of making a stock purchase look like an asset purchase while creating a potential tax liability that is the responsibility of the target corporation.  Because the purchasing corporation will now be in control of the target corporation after the acquisition of the stock, the potential tax liability is now the responsibility of the buyer corporation.  An election under IRC Section 338(h)(10) can also be made when certain conditions exist within the structure of the entities involved in a transaction.  The IRC Section 338(h)(10) has essentially the same characteristics as the IRC Section 338 election. 

The IRC Section 338 election may be useful if the following conditions exist at the time of sale:

• The target corporation has unused net operating losses, capital losses or tax credit carryovers that will offset the tax liability created as a result of the election.
• The target corporation has depreciated assets and has had a tax liability within the last two or three years prior to the sale of the business.  The deemed sale of the depreciated assets may create a net operating loss that can be carried back to obtain a tax refund from a prior year.
• The target corporation has non-depreciable built-in loss property and has depreciable built-in gain property.  Subsequent to the sale, these gains and losses have the effect of canceling each other out.  Additionally, the depreciable property will have a stepped up basis, which will provide a larger depreciation deduction going forward.
• The selling stockholders recognize minimal gains or a loss on the sale of the target corporation’s stock.

The IRC Section 338(h)(10) election may be useful if the following conditions exist at the time of sale: 

• The target corporation is a member of a consolidated return group that has tax attributes to offset the gain and any resulting tax liability from the deemed sale of assets. 
• The target corporation has tax attributes beyond what is needed to absorb any gains resulting from the deemed sale of assets. 
• The target corporation is an S Corporation.
• The corporation selling the shares of the target corporation would recognize gain from the sale of those shares.

The disadvantage of either IRC Section 338 election is that the sale of the target corporation stock is still treated as a stock purchase for legal purposes.  This means that the target corporation’s liabilities still remain, which would include any unknown liabilities.