Perhaps you’re the owner of a medium-large corporation and you’re looking to buy a smaller corporation or even a unicorn. And by unicorn, I don’t mean the mythical beast, but rather the mythical startup.
Today we’ll talk about another kind of unicorn, one entirely different than an elusive $1 billion startup. The (unofficial) unicorn of the tax world might just be the magical 338(h)(10) election.
Section 338(h)(10) Election Scenario 1
You’ve found a great company whose acquisition you believe would advance your objectives. Its stock is valued at $1.5 million. But then upon discussion with the target company, and you discover that the company’s tax basis in its assets is only $500,000.
You’re faced with a new dilemma. As we explained in our article on Asset Sales vs. Stock Sales, the the target company’s tax basis in its assets in a stock sale does not change.
Plus, you cannot depreciate or amortize stock. Instead, if you are buying the assets of the company, your tax basis in such assets gets stepped up to fair market value, or $1.5 million.
Further, with the higher basis collocated to the assets, to the extent such assets are depreciable or amortizable, the company will receive higher depreciation and amortization deductions, resulting in lower taxable income.
Except, the target company that you want to acquire has a number of contracts that cannot be easily transferred and therefore retaining the retaining the target company’s legal identity is critical to preserve the integrity of the company’s non-transferrable contracts.
In this scenario, a buyer who might otherwise prefer buying a company’s assets must instead buy a company’s stock.
The buyer shouldn’t despair quite yet. The solution to this particular dilemma lies in Section 338(h)(10) of the Internal Revenue Code, or for the purposes of this article, the unicorn of tax-land.
The buyer and the seller jointly make a 338(h)(10) election. With this election, the buyer purchases the stock, which allows the target company to maintain non-transferrable assets (e.g. contracts) and remain a separate entity from a legal standpoint.
Difference Between Normal Stock Purchases 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. So in our scenario above, the buyer would receive $1.5 million in the basis of the assets.
This seems like a win-win situation for both sides; the target company remains a legal entity and preserves the integrity of its assets, while the buyer is able to receive a stepped-up cost basis on the stock it receives.
338(h)(10) Election Restrcitions
So why don’t the participants in every stock sale make a 338(h)(10) election? Mostly because the following restrictions are placed on who can be a buyer and seller in this type of transaction:
- The buyer must be a corporation. It can be an S-corporation or a C-corporation. See our article on Choice of Entity to learn about a few basic differences between these two. It cannot be a partnership, LLC, etc.
- The target company must also be a corporation. Further, it must be one of the following types of corporations:
- A corporate subsidiary in a consolidated group that owns at least 80% of the subsidiary’s stock;
- Similarly, a corporate subsidiary in a group that is eligible but chooses not to file a consolidated return; or,
- An S corporation.
For tax purposes, the target company is considered to have sold all of its assets and is liquidated even though legally the target company is still in existence.
Specifically, the following events are considered to have happened:
- The buyer creates a new corporation (new Target)
- New Target buys the assets of the target corporation (old Target)
- 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.
The stock sale is ignored and the deemed liquidation is tax-free to the selling shareholders.
Why Buyers Prefer 338(h)(10) Elections
Buyers tend to prefer 338(h)(10) elections more than sellers do, since it is the buyer that benefits from the step up in cost basis and the ability to depreciate and amortize.
However, this imbalance in tax benefits to the buyer can create leverage during negotiations for the seller. A savvy seller might use a 338(h)(10) to ask for a higher price or as a compromise to close a deal.
In this situation, a buyer would be well-advised to undergo a tax modelling exercise to ascertain the tax implications of a transaction with a 338(h)(10) election versus one without so that they can make an appropriate offer with a full understanding of the amount of tax at stake.