Considerations for S Corporation Shareholders in Negotiating a 338(h)(10) Election
In the course of negotiations to acquire an S Corporation, the acquirer of such S Corporation (the “Purchaser”) will often want the commercial benefits of a stock purchase (e.g., maintain existing contracts and licenses) while also achieving the tax benefit of an asset purchase by receiving a step-up in the tax basis of the assets of the target. The seller of an S Corporation (the “Seller”) will typically prefer a sale of stock because any gains recognized on the stock sale generally will be treated as capital gains, whereas an asset sale may result in the Seller recognizing ordinary income in whole, or in part.[i]
A “qualified stock purchase” by a corporation (or an entity that has elected to be treated for tax purposes as a corporation) of shares of an S Corporation may be eligible for a joint election (a “338(h)(10) Election”) by the Seller and the Purchaser pursuant to Section 338(h)(10) of the U.S. Internal Revenue Code to treat the stock purchase for U.S. federal income tax purposes as an asset purchase.[ii] Eligibility for a 338(h)(10) Election requires: (x) a “qualified stock purchase” by a corporation of stock of an S Corporation and (y) a joint election by the Purchaser and all Sellers. Further, a “qualified stock purchase” generally requires the acquisition by the corporate purchaser of at least 80% of the target’s stock.
A request by the Purchaser for a 338(h)(10) Election raises a number of considerations for the selling shareholders of an S Corporation, as follows:
Gross Up of the Purchase Price. Sellers should consider conditioning their agreement to make a 338(h)(10) Election upon the Purchaser’s willingness to increase the purchase price so that Sellers are put in an economically equivalent position on an after-tax basis, taking into account both federal and state taxes, to a sale of stock.
State Tax Treatment. State tax implications of a 338(h)(10) Election may be different from the federal tax implications, and may vary from state to state. The states where selling shareholders are residents, as well as the states where the target corporation conducts business or owns property, should be identified, and the tax implications of a sale with and without a 338(h)(10) Election determined. Consider the following examples where tax treatment may vary:
Some states may not conform to the federal treatment of a 338(h)(10) Election as a deemed asset sale.
If (x) a selling shareholder is resident in a state with no income tax and (y) the target corporation operates in one or more states with an income tax, then the difference between the results of a sale with and without such election may be significant.
Representations and Deliverables. In a stock sale with a 338(h)(10) Election, the Purchaser will typically require representations that the target corporation’s subchapter S Election is valid. Such representations may be supported by an indemnity obligation, in addition to the general indemnification provisions. Selling shareholders should make sure that the facts support the validity of the corporation’s S Election and that the necessary documentation is identified and located to demonstrate these facts to the Purchaser.
Ultimately, whether a Seller is willing to entertain a Purchaser’s request for a 338(h)(10) Election should be based on a number of factors, including those outlined above. Before agreeing to a 338(h)(10) Election in any letter of intent or otherwise, a Seller should consult with his or her tax and legal advisors to determine the ramifications of that decision.
[i] For simplicity, this article assumes: (i) a transaction in which either a sale of stock or a deemed sale of assets would result in a gain to the seller or deemed seller, and (ii) that the target corporation’s S Election has been in effect since the formation of the corporation.
[ii] A 338(h)(10) Election can also be made with respect to certain purchases by a corporation of stock of a C Corporation from a “consolidated” or “affiliated” corporate group. The discussion herein is limited to a 338(h)(10) Election with respect to an S Corporation. In certain circumstances, when a 338(h)(10) Election is not available, such as when the Purchaser is not a corporation, an alternate election under Section 336(e) of the U.S. Internal Revenue Code may be available to achieve an analogous effect.
