A Little Respect for Stock Purchases under Sec. 338

Is the ''form'' of Sec. 338(h)(10) always respected in stock and asset purchases?
Robert WillensMarch 19, 2003

Sometimes fact is fiction–especially regarding elective recognition of a gain or loss by a target company under Sec. 338(h)(10). Indeed, if certain elections are executed, related to a qualified stock purchase, a series of tax “fictions” unfurl.

Under Sec. 338(h)(10) of the federal Tax Code, parties involved in a qualified stock purchase can execute a joint election when the acquired corporation is a member of an affiliated group, or an ‘S’ corporation. That is, of course, if the transaction, or series of transactions, takes place within a 12-month period in which a corporation “purchases” at least 80 percent of the voting power and value of the stock of another corporation.

If that’s the case, the stock sale gain or loss is entirely ignored and the target is treated as selling its assets to a “new target,”—which is deemed created by the acquirer—for the price that was paid for the target’s stock, together with the target’s liabilities that are inherited by the new target. This “deemed sale” occurs at a time when the target is still a member of the selling corporation’s group (or owned by the ‘S’ corporation’s shareholders).

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Immediately after the deemed sale, the target is then treated as having liquidated into its parent (in a tax-free transaction, under Sections 332 and 337, liquidation). In the case of an ‘S’ corporation, the liquidation is governed by Sec. 331.* Thus, the target shareholders are not viewed as selling their stock—although, legally, a stock sale is clearly what has transpired.

The target shareholders are viewed, instead, as exchanging their stock, for the target’s assets, deemed distributed in complete liquidation of such target. The beneficial result: a “cost basis” for the buyer in the target’s assets at the cost of only a single level of tax, imposed on the selling shareholders.

Does this fictionalized view of the transaction—the deemed sale of assets followed by deemed liquidation—apply for other relevant tax purposes? Sometimes.

For example, in Rev. Rul. 89-98, the selling parent had an Excess Loss Account (ELA) with respect to its stock in the target. That means the stock was sold and a joint election under Sec. 338(h)(10) was effected. The ruling concludes that the “asset purchase model” applies for purposes of the consolidated return rules.

Accordingly, the sale of stock was ignored for purposes of determining whether the ELA was properly included in income. Indeed, since a deemed Sec. 332 liquidation is not, for this purpose, a “disposition” of stock, the ELA was eliminated on the liquidation and did have to be taken into account by the selling parent. On the other hand, for purposes of the collection provisions of Subtitle F, the “stock purchase model” prevails.

Therefore, for this purpose, the new target is regarded, merely, as a “continuation” of the old target, and the new target remains directly liable for taxes of the selling consolidated group that are attributable to years during which the old target was a member of the selling group. (Reg. Sec. 1.1502-6.) This is true, moreover, despite the fact that an actual asset sale and liquidation would clearly exempt from the buyer from this “dash 6” liability.

Business income?

An interesting resolution of this dichotomy can be found in a recent court case decided in Pennsylvania, Canteen Corp. v. Pennsylvania, involving a target’s liability for state taxes.

The issue was whether the gain from a sale (of a target’s assets) deemed to occur under Sec. 338(h)(10), was taxable for Pennsylvania purposes, as “business income” or “non-business income.” The latter designation was desirable because the rates imposed on non-business income were decidedly lower.

The court concluded that the gain was properly regarded as non-business income. It found that the assets were not disposed of as an “integral part” of the taxpayer’s regular trade or business. This was so because under Sec. 338(h)(10)—which the court ruled had to be consistently applied—the proceeds derived from the sale of assets were not reinvested. Rather, under Sec. 338(h)(10)’s fictionalized view of the transaction, the proceeds were distributed (in liquidation) to the seller’s shareholder.

The court ruled that the liquidation (of assets) and (ensuing) distribution could not be recognized to yield a fictitious gain, subject to Pennsylvania taxes. But the court then avoided the precedents which had treated an asset sale gain (that was followed by a distribution as opposed to a reinvestment) of the sales proceeds as non-business income.

This was true, moreover, even though, as the dissenting opinion aptly pointed out, the transaction, in reality, did not involve a cessation of the target’s business. It was continued, without diminution, by the buyer of the target’s stock. Thus, at least in Pennsylvania, and for many other ancillary tax purposes, the form of a Sec. 338(h)(10) election is respected and, as the Canteen case demonstrates, recognition of such form will frequently yield favorable tax results.

Although the liquidation is governed by Sec. 331, no double taxation should result because the basis of selling a shareholder’s stock is adjusted, upward, to reflect the corporate level gain recognized on the deemed sale of assets.

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