IRC Section 338 allows corporations to elect to treat stock purchases as asset acquisitions for tax purposes. When a corporation makes an IRC Section 338 election, the buyer is treated as if it sold the underlying assets of the acquired corporation to itself. Thus, the buyer gets to step up the target corporation’s assets to reflect the price paid for the target’s stock. Since it owns the acquired company, the purchaser is economically responsible for the tax on the deemed asset sale reported by the acquired corporation; however, it also reaps the benefits of the stepped-up basis.

Because the tax savings resulting from the increase in basis will be spread over a number of years (e.g., as additional depreciation expense), it often does not make sense to make an IRC Section 338 election. In some situations, however, tax attributes (NOLs, capital loss carryovers, tax credit carryovers, etc.) are available to offset most or all of the corporate-level gains and tax liability that result from an IRC Section 338 election. Thus, the target corporation’s assets can be stepped up in basis without incurring any significant tax liability.

Two separate elections are available under IRC Section 338. Of the two types of elections, an IRC Section 338(g) election (hereafter referred to as a regular 338 election) is made only by the purchasing corporation, while an IRC Section 338(h)(10) election is made jointly by the target corporation’s shareholders and the purchasing corporation.

When the regular IRC Section 338 election is made, the deemed sale resulting from this transaction has the effect of potentially creating a tax liability that is the target corporation’s responsibility. Because the purchasing corporation is in control of the target corporation after the acquisition of its stock, this tax may become a liability of the buyer and possibly decrease the price the buyer is willing to pay. The seller of the target stock also recognizes gain or loss on the sale of that stock. Therefore, double taxation may occur.

The IRC Section 338(h)(1 0) election can be made when the target corporation is a member of a consolidated return group. It can also be made when the stock of the target is owned by another corporation and the target does not join in filing a consolidated tax return. Finally, the IRC Section 338(h)(1 0) election can be made when the stock of an S corporation is purchased by another corporation. The general effect of an IRC Section 338(h)(1 0) election is to treat the target corporation as if it sold its assets and then distributed the sales proceeds to its shareholders in complete liquidation. When the target is a C corporation, this avoids double taxation because, after the deemed sale, the target is deemed to be liquidated into its parent corporation tax-free, under IRC Section 332 (which deals with liquidations of subsidiaries).

The seller of the target stock ignores the sale of the stock for tax purposes. However, the IRC Section 338(h)(10) election can create a tax liability from the deemed sale transaction that is the responsibility of the selling consolidated return group or the selling S corporation shareholders rather than the target corporation.

The significant difference between the two elections is that a regular IRC Section 338 election can result in a tax cost on both the buyer and the seller of the target corporation’s shares (double taxation), while a IRC Section 338(h)(10) election may only impose a tax cost on the seller (a single level of taxation).

The buyer should be aware that the accounting treatment of an acquisition will not necessarily match the tax treatment. In an asset purchase, the allocation of the purchase price for tax purposes is governed by IRC Section 1060. Under IRC Section 1060, the purchase price must generally be allocated among the assets, other than goodwill and going-concern value, in accordance with their fair market values. The remainder is allocated to goodwill and going concern. This is known as the residual method. Under this method, individual assets are assigned to an asset class.

The purchase price is to be allocated among the following asset classes in priority order. For assets acquired after January 6, 2000, consideration is allocated among the following asset classes:

1. Cash and cash equivalents.
2. Actively traded securities.
3. Accounts receivable, mortgages, property, plant and equipment.
4. Stock in trade of the taxpayer or other property of the kind that would properly be included in the inventory of the taxpayer if on hand at the close of the tax year,   or property held by the taxpayer primarily for sale to customers in the ordinary course of trade or business.
5. All assets not in Classes I, II, III, or IV.
6. All Section 197 intangibles, except goodwill and going concern value.
7. Goodwill and going concern value.

Both the buyer and the seller in an asset acquisition, must complete Form 8594, Asset Acquisition Statement, and report the transaction’s details, including the allocation of purchase price to IRC Section 197 intangibles. An individual who owns 10 percent or more of the transferred entity, as determined under IRC Section 318 immediately before the transfer, must also report the existence of any covenants not-to-compete, employment contracts, lease agreements, royalties, or similar arrangements entered into between the individual and the transferee to the IRS. This reporting requirement applies unless the covenant, contract, lease, royalty, or similar arrangement was not entered into in connection with the transfer of the interest in the entity to the transferee.

Caution

Since, under IRC Section 197, goodwill and other intangibles such as customer lists and covenants not-to-compete may be amortized over a 15-year period for tax purposes, the IRS will carefully scrutinize asset allocations and may attempt to allocate as much purchase price as possible to such assets.