For owners of a company, the decision to purchase another company can be exciting, but also daunting, given the multitude of forms and agreements to complete, fancy lingo to learn, pricey attorney fees to pay, and a plethora of other considerations. But when it comes time to pull the trigger on purchasing a company, there are really only two ways to do it. You can either purchase the company’s assets or purchase the company’s stock.
In most business transactions, the purchaser typically prefers to purchase the company’s assets, while sellers usually want to sell stock. The top reason to buy assets is immediate tax benefits for the purchaser, like depreciation of the underlying assets, affording a faster return on investment. On the other hand, a stock sale offers benefits to the seller in the form of preferred tax rates, but the purchaser’s return on investment will not come until a subsequent sale of those acquired shares down the road, because stock is neither depreciable nor amortizable.
In certain situations, a company may have no choice but to structure the deal as a purchase of only a company’s stock. This usually happens when the disruption to the business would be too great to justify changing the legal entity (for regulatory or other reasons). In these circumstances, buyers often try to structure the transaction in such a way to enjoy the benefits of business continuity available in a stock purchase transaction, but still reap some of the benefits of the asset purchase. That is where a Section 338(h)(10) election can be helpful.
What is a 338(h)(10) election, and why is it beneficial?
The 338(h)(10) election was originally enacted to allow companies that make certain stock acquisition transactions to treat the acquisition as a stock acquisition for legal purposes and as an asset acquisition for tax purposes, hence immediate tax benefits, as previously mentioned. When the election is made, the sale of stock is ignored for tax purposes, and the transaction is recast by the selling shareholders as an asset sell, followed by liquidating distributions to the shareholders.
For example, let’s say you purchase a company for $5,000,000, and the tax basis of the assets in the company is $2,000,000. When structured as an asset purchase, the purchase price of $5,000,000 will be allocated among the hard assets based on their respective fair market values, and then any excess amount would be allocated to an intangible asset, like goodwill. The purchaser could then immediately start depreciating and amortizing the full $5,000,000 purchase price. This so-called step-up in tax basis is what essentially makes asset acquisitions so much more appealing than stock acquisitions. Making a 338(h)(10) election allows the purchaser to receive this immediate tax benefit.
Who can make a 338(h)(10) election, and how?
A 338(h)(10) election must be made jointly by seller and buyer and is only available in limited transactions with certain types of buyers and sellers. The buyer must be a corporation or an S corporation. Therefore, partnerships are not eligible for the election. The seller must also be a corporation, but there are a few more restrictions for the seller side. The seller must be one of the following three types of corporations: an S corporation; a corporation that is a subsidiary in a consolidated group, meaning the stock is owned at least 80% by other members of the group; or a corporation that is a subsidiary in a group that is eligible to file a consolidated return, but chooses not to file one. Essentially, when the sell occurs, the selling corporation is deemed to liquidate and cease existence.
An election under Section 338(h)(10) must be made no later than the 15th day of the 9th month beginning after the month in which the qualifying purchase occurs. The election is made when both companies file Form 8023 with the Internal Revenue Service.
The calculations behind correctly recording a 338(h)(10) election can be very complicated, but the election can be a powerful tool when negotiating the acquisition or sale of a business. If you have any questions about the various tax benefits and consequences behind the election, or would like assistance in any matter involving tax strategy, business advisory, or transactional advisory, contact one of our PYA executives below at (800) 270-9629.
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