Do You Like Fiction? – Stock Purchase as an Asset Purchase

By: THOMAS W. GARTON & BEAU J. HURTIG

March 2011

Section 338(h)(10) of the Internal Revenue Code doesn’t sound like the title for a work of fiction, but a fiction is what it creates. When selling or buying a bank holding company or bank that operates as an S Corporation, understanding the uses and consequences of this Code Section is helpful.

Applicability of the 338(h)(10) Election

The 338(h)(10) election is useful in situations where individual shareholders sell their stock in a corporation that has previously made an S Election. The 338(h)(10) election is not applicable where an S Corporation holding company sells the stock of its wholly-owned Qualified S Corporation Subsidiary. Therefore, the stock of the top tier corporation, whether it be a bank holding company or a bank (with no holding company), that has previously made an S Election, must be the subject of the sale in order for Section 338(h)(10) to be available.

Fiction Resulting from the 338(h)(10) Election

When an election is made under Section 338(h)(10), the Buyer’s purchase of the stock of an S Corporation from the S Corporation shareholders will be subject to tax treatment that is not consistent with the commercial or corporate law treatment of the transaction. First, the S Corporation will be treated for tax purposes as if the Buyer purchased assets from the corporation (fiction number one). Second, that “deemed” sale is followed by the corporation’s “deemed” distribution of the sale proceeds to its shareholders as a distribution in liquidation of the S Corporation (fiction number two). The reality is that the corporation has sold nothing, and the corporation is not liquidated, but continues as an ongoing entity owned by the new shareholders; and the sale proceeds are actually paid directly to the selling shareholders, not passed through the corporation to the shareholders.

Benefits to Buyer of the 338(h)(10) Election

So why would a Buyer suggest, or a Seller permit, an election to come within these fictional transactional rules for income tax purposes?

Let’s look first at the Buyer’s side. From the Buyer’s point of view, the election is beneficial because it can generate future tax savings for the Buyer. A stock purchase does not allow a step up in the tax basis of the corporation’s assets. An asset purchase, whether in reality structured as such, or through the fiction of a Section 338(h)(10) election, will give the Buyer a full fair market value basis in the assets of the purchased corporation, thereby providing greater depreciation on depreciable assets, and lower gain on any eventual sale of the assets. In a rational world, the Buyer will pay a higher price to obtain these benefits. How much higher depends on the anticipated future tax savings. If the Buyer’s perceived value of those tax savings is less than the Seller’s additional tax costs arising from the 338(h)(10) election, the election would not be made. If future Buyer tax savings are greater than the Seller additional tax cost, there is a rational point at which the parties can agree on a price higher than the nonelection stock purchase, and both parties can benefit.

Tax Treatment for Seller If No Election Is Made

Without the election being made, the selling shareholders recognize gain on the sale of their stock as capital gain, subject to the favorable capital gain rates. The corporation itself is not a party to a taxable transaction because it has not sold anything. There is a single tax payable by the selling side of the deal, and that is imposed at the shareholder level.

The 338(h)(10) Election Often Results in No Additional Costs to Seller

If the election is made, however, the corporation recognizes gain on the deemed sale of its assets. As an S Corporation, the corporation does not pay tax on its gain (with an important exception discussed below), and the gain is passed through to the S Corporation shareholders to be reported on their individual returns consistent with the rules of Subchapter S. That passed-through gain gives the shareholders a corresponding increase in the tax basis of their stock. Then when the corporation makes its deemed liquidating distribution to the shareholders, the shareholders’ tax basis (increased by the amount of the passed-through gain) is generally sufficient to cover the amount of deemed liquidating distribution, so there is not a second tax to be paid on the sale. The results of the fiction are parallel to the results of the “real” form of the transaction, that is, a single tax is paid on the gain…with two potentially critical exceptions.

Exceptions Resulting in Additional Costs to Seller

The first exception is that the S Corporation does pay tax on the deemed sale of its assets if it holds assets subject to the “built in gains tax.” If the corporation made its S Election more than five years prior to the sale (for sales in 2011), there will be no built-in gain subject to that tax. However, if the S Corporation had a previous life as a C Corporation before making the S Election, and if that S Election was made less than five years prior to the sale, any appreciation in the assets sold by the corporation as measured at the date of the S Election will generate built-in gains tax payable by the corporation when those assets are sold. This is a second tax that adds additional cost to the Seller when the 338(h)(10) election is made. Therefore, if the corporation being sold made its S Election less than five years ago, the 338(h)(10) election will negatively impact Seller. (Note that the 2011 five-year time period will revert to ten years after 2011.)

The second exception arises because all of the assets that the S Corporation is deemed to have sold might not be capital assets. To the extent any of those assets deemed sold are ordinary income assets (inventory, unrealized receivables, depreciation recapture, etc.), the character of the gain passed through to the shareholders will be ordinary income, not capital gain. The 338(h)(10) election will have converted what would have been capital gain into ordinary income for the shareholders. This can add additional tax cost to the Sellers.

Negotiating the Purchase Agreement

So why would a Seller agree to make the 338(h)(10) election? In many cases, permitting such election does not result in negative tax consequences for Seller. Thus Seller may be able to gain leverage by granting the Buyer the favorable 338(h)(10) election without a downside. Where an exception applies resulting in negative consequences to Seller, the answer typically lies in the pricing. If an offer to purchase stock is acceptable to the selling shareholders at $1,000, the price that would be acceptable if the 338(h)(10) election were to be made would logically be greater in order to cover any additional tax costs. As an alternative to increased pricing, Seller may be able to gain other valuable accommodations from Buyer in negotiating the terms of the Purchase Agreement by permitting the 338(h)(10) election even where it negatively impacts Seller, such as shortening the indemnification period, capping the indemnification amount, and/or shortening the term of a noncompete agreement.

Takeaway

For a number of non-tax reasons, Bank purchasers favor stock acquisition transactions to asset purchases. Through the fictions accorded by a Section 338(h)(10) election, the Buyer of an S Corporation holding company or S Corporation bank can accomplish its commercial objectives of purchasing stock while enjoying the tax benefits of an asset purchase, and both the Buyer and the Seller can get a “better deal” through careful negotiations and pricing. The loser in this situation is the tax collector… and that is almost too good to be true.