Selling a corporation can have significant tax consequences for both the buyer and seller. However, it is not impossible to satisfy both parties to the transaction with a §338(h)(10) election. Generally, sellers of corporate entities prefer to engage in a stock sale rather than an asset sale while buyers prefer to engage in an asset sell. This articles has been prepared by a Denver business attorney and tax attorney to discuss section 338(h)(10) of the Internal Revenue Code.
From the seller’s point of view, a stock sale is beneficial because it can result in capital gains treatment. This means that the gains from the sale of stock are taxed at a lower rate than ordinary income tax rates. If the transaction is structured as an asset sale, then the seller is likely to have a portion of purchase price taxed at ordinary income rates on things such as depreciation recapture, inventory, etc. Therefore, asset sales generally result in higher tax consequences simply based on the character of the gains and/or losses.
On the other hand, buyers prefer an asset purchase over a stock purchase so that they are able to increase their basis for depreciation purposes. If a purchaser simply pays for the stock of a target company, they receive a cost basis under §1012 for the value of the stock itself. The underlying assets held by the selling corporation retain the exact same basis as they had before, which does not create a benefit for the purchaser in terms of depreciation.
For instance, consider a corporation that holds a machine that costs $500. In year one and year two, the corporation depreciates the machine $100 per year, so that the adjusted basis under §1012 is now $300. This also assume that the seller holds the stock with a basis of $500, the total fair market value of the entity is $1,000, and there are no liabilities.
If the corporation engages in a stock sale, the purchaser will pay $1,000 for the stock since that is the fair market value. The buyer’s basis in the stock will be $1,000, under §1012. However, the machine retains the $300 basis. There is no adjustment to this underlying asset. The seller enjoys capital gains treatment on $500 of gain from the sale of the stock which is the difference between the amount realized of $1,000 and the adjusted basis of $500 (§1001). Even though the buyer purchased the stock for $1,000, he may only use the machine’s basis of $300 for depreciation purposes. There is no step up in basis allowed for underlying assets absent the §338 elections.
On the other hand, if the transaction had been structured as an asset sale, the buyer would have purchased the machine and all other assets of the corporation for $1,000. Within certain limits, buyers are permitted to allocate higher portions of the purchase price to assets that are depreciable than they would in a stock sale. If the buyer allocates $500 of the $1000 purchase price to the machine, then he is already better off for deprecation purposes. In the stock sale, the buyer was limited to the $300 basis in the machine but with the asset sale, he is able to start his depreciation calculations with a higher basis, providing more of a tax benefit in the future. However, the seller will now have to recognize $200 of gain taxed at ordinary income rates rather than capital gains rates due to the depreciation recapture. This results in a higher tax liability to the seller than a stock sale would.
Note, there are some limitations to asset purchases that make stock purchases more favorable. These include limitations built in by contracts and other legal obligations. There could also be other liability issues that prevent sellers from engaging in an asset sale.
For these reasons, section 338 may provide an attractive alternative to satisfy both the buyer and seller in a business sale. Please discuss any specific business or tax matters directly with your business attorney or tax attorney.
To speak with Denver business attorney or tax attorney please contact The McGuire Law Firm at 720-833-7705.