Section 338 of the tax code can help resolve some of the issues created in stock sales in a way that benefits both buyers and sellers. Section 338 of the Internal Revenue Code provides a way to treat stock purchases as asset acquisitions for tax purposes only. In other words, under Internal Revenue Code §338(h)(10), the selling corporation will bear the tax associated with the transaction, but there will only be one level. This single layer of tax is based on the inherent gain in the assets held by the entity, but there is no tax on the subsequent stock sale. This article has been prepared by a Denver business attorney and tax attorney to discuss certain issues in greater detail.
Section 338(h)(10) elections require that both the purchaser and the seller be corporations and both parties must agree to make the election (see §338(a)). Unlike section 338(g) where the purchaser bears the tax burden, here the seller pays the tax from the asset sale so this requires agreement between both of the corporate parties.
Additionally, 338(h)(10) requires a qualified stock purchase. Section 338(d) defines a qualified stock purchase as one where the transaction occurs within a 12- month acquisition period and also satisfies the elements of §1504(a). Section 1504(a)(2) requires purchasing 80% of the vote and value of the target entity. For purposes of §338(h)(10), the 12- month acquisition period is not limited to a calendar year.
If a 338(h)(10) election has been properly made, then the transaction is essentially treated as an asset sale followed by a liquidation, with the tax liability flowing to the selling party. Mechanically, the purchasing corporation is deemed to create a new target entity. This new entity’s sole purpose is to purchase the assets of the original entity. This allows an asset purchase to occur while simultaneously maintaining the stock sale characteristics for legal purposes. In other words, the asset sale is only taken into consideration for tax purposes, not other legal aspects. Note, the asset sale does trigger gain to the selling corporation, but there is no subsequent tax from the stock sale, thus eliminating a second level of tax. Treating the sale as a stock purchase may have many benefits to the purchaser such as maintaining certain contracts, permits, licenses and other corporate attributes that could be lost from an asset purchase agreement.
From a tax perspective, the purchasing party is satisfied because now the transaction has been treated as an asset sale which provides a step up in basis for the assets. This increases depreciation deductions which may be used to offset ordinary income in the future. The seller is satisfied because there has only been one level of tax from the sale of the assets. Additionally, if the selling party has any losses, then depending on the character of the gain, these may be offset by the deemed asset sale.
Overall, §338 transactions provide a way for both buyers and sellers to structure a transaction to maximize the benefits of both stock sales and asset sales, while reducing tax liabilities to each party. You should discuss the elements and implication of a section 338 transaction with your business attorney or tax attorney.
You can schedule a free consultation with a Denver business attorney or tax attorney by contacting The McGuire Law Firm at 720-833-7705.