While an IRC Section 338(h)(10) election to purchase an incorporated business can offer the buyer many advantages, there are some issues that may make it problematic for a seller.
When analyzing whether to take an election, an eligible buyer should first determine if the benefit of the step-up exceeds the tax cost of the assets being acquired. If it does, an election likely makes sense. Of course, the seller also needs to agree. According to the IRS, a Section 338(h)(10) election is “jointly made by the purchasing corporation and the common parent of the selling consolidated group (or the selling affiliate or S-corporation shareholder(s)).” If the target is an S-corporation, all of the target’s shareholders must make the election.
There are other reasons an election might not favor a seller. For one, a selling shareholder has a reasonable expectation to be made whole in the transaction, but tax law intricacies may make that impossible. For instance, the shareholder might be forced to reorganize ordinary income on the asset sale but record a capital loss on the reorganization.
Another reason an election might not favor a seller relates to built-in gains. This situation typically applies when an S corporation was previously a C corporation. Back in 2010 President Barack Obama signed the Small Business Jobs Act, which changed the requirements concerning BIG recognition for S corporations – making the tax applicable for tax years beginning in 2011. It didn’t alter the recognition period, but rather stated that “no tax is imposed on the net unrecognized built-in gain of an S corporation if the fifth year in the recognition period precedes the 2011 tax year.”
For the S corporation subject to the BIG tax of Sec. 1374 and still within the recognition period (the five calendar years from the first day of the first tax year for which the corporation was an S corporation) for any assets sold or deemed to be sold, the corporation is subject to a 35 percent tax on the unrecognized built-in gain.
Further, in certain situations, some of the selling S corporation’s shareholders could be negatively impacted by a Sec. 338(h)(10) election. This could occur if there exists an entity-level state tax that would not be applicable in the case of a straight stock sale.
The tax ramifications surrounding Sec. 338(h)(10) elections are complex and nuanced. And anecdotal evidence points to the fact that the IRS of late has launched a significant number of audits on companies using these elections when making acquisitions. The IRS wants not only to ensure the Sec. 338(h)(10) election is correctly reported and all appropriate forms are filed but they also want to know whether the allocation of the purchase price among the various assets is adequately supported.
Remember, even though the IRS deems the buyer and seller adverse and capable to make this determination of value, the agency still has the right to question an allocation and try to determine if evidence supports a different allocation.
Furthermore, companies are faced with a preference from their auditors to obtain a formal valuation for GAAP purposes. A third-party valuation is always helpful to determine value but can end up different than the parties expected for purposes of the tax allocation, which causes some potential complications. •
Carl J. Giardino is a managing director in the Tax Group at CBIZ Tofias, which has offices in Providence, Boston and nationwide.
