1 Section 338(h)(10) S Corporation Checklist (Rev. 9/05) PREFACE When the shareholders of an S corporation decide to dispose of their interests in the corporation in a taxable transaction, they have several alternative methods to effectuate the deal. From a tax perspective, a sale of all of the S corporation s outstanding stock will result in the same total amount of gain or loss being recognized by the S corporation s shareholders as a sale of all of the S corporation s assets followed by a complete liquidation of the S corporation. However, with an asset sale, some of the gain may be taxed at ordinary income tax rates, while with a stock sale the gain would generally be all capital gain. In addition, with an asset sale, the built-in gain tax or passive investment income tax may apply. 1 There may also be state and local tax differences between a stock sale and an asset sale followed by a complete liquidation. From the buyer s perspective, a stock acquisition results in a cost basis in the stock acquired, but not in a step-up (or down) in the basis of the acquired corporation s assets. The tax attributes (e.g., net operating loss carryovers and earnings and profits) of the acquired corporation remain with the corporation. If the buyer acquires assets, the buyer s bases in the assets are stepped-up (or down) to reflect the purchase price paid by the buyer for such assets. The buyer does not succeed to the acquired corporation s corporate tax attributes. In determining whether to structure the sale of an S corporation as stock sale or as an asset sale followed by a complete liquidation of the corporation, the additional cost of an asset sale from the seller s perspective (e.g., ordinary income taxed at a higher rate and built-in gain tax) is often compared to the benefit of the basis step-up received by the buyer. Non-tax issues also come into play. Examples include the need to: determine who has responsibility for disclosed and undisclosed liabilities; decide what happens to unwanted assets; and address the situation of dissident shareholders. In addition, an actual sale of some kinds of assets may not be possible (e.g., certain licenses that are not transferable). State transfer taxes can also weigh against an asset sale. If the target is an S corporation and a stock purchase is desired for non-tax reasons, but an asset purchase is desired for tax reasons, it is common for the target S corporation s shareholders and the acquiring corporation to agree to make an election under section 338(h)(10). Regulation section 1.338(h)(10)-1(c) permits corporations making a qualified stock purchase (QSP) of a target S corporation to make an election under section 338(h)(10) jointly with the S corporation shareholders. When this election is made, for tax purposes the sale of the stock by the selling shareholders is ignored. Instead, the S 1 However, for purposes of determining if the passive investment income tax applies, liquidating distributions are taken into account in determining if the corporation has earnings and profits at the close of the tax year; thus, generally the passive investment income tax will not apply in the year of liquidation.
2 corporation is deemed to sell its assets to the acquirer (in the form of new target) and to liquidate, generally under sections 331 and 336. Because the target s S status remains in effect throughout this deemed sales process, any gains or losses recognized on the deemed sale flow through to the shareholders (and adjust their stock bases for purposes of determining gain or loss on the deemed liquidation). The deemed asset sale may cause the built-in gain tax or the passive investment income tax to apply at the S corporation level (but see footnote 1). All shareholders of the target S corporation (selling and non-selling) must consent to the section 338(h)(10) election. It should be noted that an S corporation could also be the acquiring corporation. In that case, the acquiring corporation could make a qualified subchapter S subsidiary (QSub) election with respect to the target, provided it acquires 100 percent of the target stock in the QSP and the target is a domestic corporation and is not an ineligible corporation as defined in section 1361(b)(2). The QSub election would be effective after the effective date of the section 338(h)(10) deemed asset sale. See regulation sections (c)(1)(i) and (b)(4). This Section 338(h)(10) S Corporation Checklist is meant to make the experienced tax professional aware of certain federal income tax issues arising from a section 338(h)(10) transaction involving an S corporation target.
3 Validity of S Corporation Status 1. Is the target corporation an S corporation at the time of the qualified stock purchase? Note: Only certain target corporations can participate in a section 338(h)(10) election. Members of a consolidated group, affiliated corporations, and S corporations can participate in a section 338(h)(10) transaction. This checklist focuses on S corporation targets. In this regard, if stock of a purported S corporation is purchased in a qualified stock purchase (QSP), it is critical to ascertain that the target corporation has a valid S election in effect at the time of acquisition if a section 338(h)(10) election is intended. 2. Has the target S corporation maintained its S status continuously since its most recent election? 3. Determine continuous S status by examining the following documents: Form 2553, Election by a Small Business Corporation. Make sure all shareholders at the time of the corporation s current S election have signed the form. The consents of certain other shareholders may be required. See reg. section (b)(2). Have appropriate consents been reviewed? Did both spouses sign the election form if they live in a community property state?
4 With respect to the last question, are both spouses qualified shareholders? If a qualified subchapter S trust (QSST) was a shareholder on the date of the S election, did the current beneficiary (rather than the trustee(s)) sign the election form? Was a valid QSST election made by the current beneficiary? Under reg. section (b)(2)(iv) if an electing small business trust (ESBT) is a shareholder on the date of the S election, the trustee is required to consent to the S election. If the grantor portion of the ESBT (see reg. section 1.641(c)-1(b)(1)) consists of S stock, the deemed owner of the grantor portion also must consent to the S election. Has this rule been followed? Was a valid ESBT election made by the trustee? Examine the corporation s governing provisions and ask the target to provide a distribution schedule for each of its shareholders on a year-by-year basis. Do the governing provisions provide that each outstanding share of stock has identical rights to distribution and liquidation proceeds and were distributions made on a pro rata basis? If not, could the non-pro rata distributions result in a second class of stock? See reg. section (l) to determine whether a potential second class of stock exists. Note that payment of varying amounts to S corporation shareholders in a transaction for which a section 338(h)(10) election has been
5 made will not violate the one class of stock requirement, provided the varying amounts have been negotiated at arm s length with the purchaser. Have these things been done? Have you reviewed any shareholder agreements, buy-sell agreements or redemption agreements to determine whether these instruments have created a second class of stock? Have you reviewed the liabilities and equity sections of the balance sheet to make sure that no instruments, obligations or arrangements exist that could result in a second class of stock? See reg. section (l)(4). Have you reviewed any stock option plans to determine if call options are outstanding and whether a second class of stock exists? Have you reviewed all trust shareholder agreements to make sure the trusts are eligible S corporation shareholders? Have you reviewed past year tax returns, including schedules K-1, for possible disqualifying transactions, e.g., pre-1997 ownership of 80% or more of the stock of a domestic or foreign corporation? 4. Has there been an inadvertent termination (or an invalid election) of S status? If so, request a private letter ruling from the IRS seeking a waiver of the invalid election or termination. (See Rev. Proc , C.B. 998, for certain automatic waivers.) If applicable, has this been done?
6 Validity of QSub Election 5. If the target S corporation has a purported QSub, have you verified that the QSub election has been properly filed and that no event has terminated that election? 6. If the status of a subsidiary as a QSub is uncertain, have you considered making a protective section 338(h)(10) election with respect to the subsidiary? Qualified Stock Purchases 7. With respect to the anticipated acquisition, will the requirements for a QSP be met? Note: If the acquisition is not a QSP, a section 338 election cannot be made and cost basis in the target s assets will not be obtained. Has 80% or more (vote and value) of the target s stock been acquired? Note: If the acquisition takes place in multiple steps that could be characterized as a reorganization under the step-transaction doctrine, see temp. reg section 1.338(h)(10)- 1T(c)(2),(e)Examples (11)-(14). See also Rev. Rul , C.B. 67, and Rev. Rul , C.B Is the acquirer a C or S corporation? Has the acquiring corporation purchased the stock of the target S corporation?
7 Note: Section 338(d)(3) requires, among other things, that a QSP be effected through a purchase. In general, stock is purchased if the acquiring corporation acquires the stock from an unrelated person and receives a cost basis in the stock. See section 338(h)(3) and reg. section (b). 8. Has the equity interest of a shareholder of the target S corporation been completely terminated during the S corporation s final taxable year but prior to the QSP? If so, have the S corporation, the terminated shareholder, and other affected shareholders agreed to a section 1377(a)(2) closing of the books for income allocation purposes? If so, is the new management of the S corporation (New Target) contractually obligated to effectuate the section 1377(a)(2) election by attaching an appropriate statement to Old Target s timely filed original or amended final return? If a section 1377(a)(2) election has not been made with respect to a previous termination of a shareholder s interest, has such an election been considered?
8 Note: If a shareholder s entire interest in an S corporation is terminated during a taxable year, the corporation may elect under section 1377(a)(2) to close its books with respect to the affected shareholder(s) at the close of the day of such termination. All affected shareholders and the corporation must agree. Regulation section (b)(5) requires the election to be attached to a timely filed or amended return for the taxable year. If the S corporation is the target of a QSP for which a section 338(h)(10) election is made, the management of New Target files the tax return for the target corporation s taxable year that ends on the date of the QSP. Thus, the old shareholders of the S corporation may want to contractually require that New Target attach the election to the Form 1120S. Note that a similar issue arises in the case of a qualifying disposition under reg. section (g). 9. Will all target shareholders sell their stock to the acquiring corporation? If not, have the non-selling shareholders determined how they will pay tax on asset gains allocated to them, as well as gain or loss on the deemed liquidation, when the section 338(h)(10) election is made and the S corporation is deemed to have sold its assets and liquidated? Filing Requirements 10. Will New T file the final S corporation return of Old T? Notes:
9 New T is responsible for filing Old T s final Form 1120S. The Old T shareholders should negotiate with P, prior to the QSP, the content of the final Form 1120S. New T is liable for Old T s Federal income tax liabilities, including the tax liability for the deemed sale tax consequences, notwithstanding the deemed liquidation of Old T. Reg. sections 1.338(h)(10)-1(d)(2) and (b)(3)(i). Under section 6011(a) and reg. section (a) such person liable for the tax is responsible for the proper filing of returns. Although New T and Old T generally are treated as two separate corporations for purposes of subtitle A of the Code, New T generally is treated as a continuation of Old T for purposes other than subtitle A. Reg. section (a)(1), (b)(1), (b)(3). Procedure and administration is in subtitle F; thus, New T is a continuation of Old T for this purpose. 11. Will the final Form 1120S for the Old Target S corporation be filed by the 15 th day of the third month following the month of the QSP? 12. Will P and all target S corporation shareholders (even those who do not sell their stock) jointly make a section 338(h)(10) election on Form 8023, Elections Under Section 338 for Corporations Making Qualified Stock Purchases? Note: See Rev. Proc , C.B. 803, for automatic extension for making a section 338(h)(10) election).
10 Will the Form 8023 be filed by the 15 th day of the 9 th month following the month of the QSP? Note: Penalties for failure to file or pay tax are waived if the final return of the Old Target S is filed and the tax paid by the due date of the Form In that case, interest on any underpayment runs from the original due date of the final return to the date of payment. See reg. section (b). Note: Form 8023 is no longer required to be attached to either Old Target s, New Target s, or purchasing corporation s income tax returns. 13. Will Form 8023 be ready for signature at the closing of the acquisition? Note: From the buyer s perspective, the target shareholders should not be allowed to walk away from the closing table with cash in hand without having signed the Form If the parties have not yet decided to actually file the election form (due by the 15th day of the ninth month following the month of the QSP), the executed form can be held by either the buyer s or seller s attorney until such a decision is made. If the selling shareholders have already agreed to the section 338(h)(10) election, as a matter of convenience it makes sense for all selling shareholders to sign the election at closing. Note: With respect to a transaction subject to a section 338 election, the IRS requires that Form 8883, Asset Allocation Statement Under Section 338, be filed with the income tax returns of Old Target and New Target for the tax periods that
11 include the deemed sale and purchase. The Form requires information about the allocation of ADSP (aggregate deemed sale price) and AGUB (adjusted grossed-up basis). Installment Sales 14. Did the consideration received for the S stock include nonmarketable installment obligations that are not payable on demand? If yes: Did the target S corporation, with respect to the deemed asset sale, recognize the full gain or loss on S assets that are not subject to installment method treatment? Did the target S corporation properly account for depreciation recapture under section 453(i)? Did the target S corporation properly take into account a deemed payment on the installment obligation under the liabilities-in-excess-of-basis rule of reg. section 15A.453-1(b)(3)(i)? Note: When some or all of the target stock is sold for an installment obligation and a section 338(h)(10) election is made, reg. section 1.338(h)(10)-1(d)(8) makes the section 453 installment sale method of accounting available to the old target, provided the deemed asset sale would otherwise qualify for installment sale reporting. Section 453 generally applies to gain (not loss) from a sale of property where at least one of the payments will be received in a future year. Property disqualified from installment treatment includes inventories of personal
12 property, real property held for sale to customers in the ordinary course of the corporation s trade or business, and publicly traded stock or securities. If a sale or other disposition of the installment note occurs, gain or loss will generally be recognized. In general, the installment obligation may not be payable on demand or readily tradable for section 453 to apply. If a liquidation occurs within a 12-month period and section 331 applies, then the receipt of certain installment obligations by a shareholder is not deemed a liquidation payment. Instead, under section 453(h), payments made to the shareholder pursuant to the installment obligation are deemed payments for the shareholder s stock. All amounts distributed along with the installment obligation, such as cash and the fair market value of other property, are considered to have been received by the shareholder as the section 453 selling price for the stock in the liquidating corporation. See reg. section (a)(3) and (a)(5), Example 2. In addition, in such a 12-month liquidation of an S corporation, the liquidating S corporation does not recognize gain or loss on the distribution of the installment obligation, except for purposes of computing taxes under sections 1374 and Section 453B(h). 15. If the target S corporation is subject to section 1374 and the deemed sale is within the recognition period, did target properly take into account the recognized built-in gain (or more infrequently, loss) on the deemed distribution of the installment note in complete liquidation of the target S corporation? See section 453B(h). A similar rule applies if target is subject to
13 section Note: This gain or loss on the distribution of the installment obligation applies only for purposes of computing corporate level tax. 16. Does the face amount of the installment sale obligation exceed $5 million? If so, see section 453A. Note: For purposes of section 453A (relating to interest charged on taxes deferred when using the installment method), a $5 million threshold is applied and interest calculations are made at the shareholder level. See Notice 88-81, C.B. 397.
14 Miscellaneous 17. Is Old T subject to the section 1374 built-in gain (BIG) tax? Note: The BIG tax is a liability of Old T. However, under reg. section 1.338(h)(10)-1(d)(2) New T remains liable for the tax liabilities of Old T (including the tax liability for the deemed sale tax consequences) - in particular the BIG tax. See also reg. section (b)(3)(i). Because the BIG tax will be paid out of the assets of New T, the BIG tax should be included in the adjusted grossed-up basis (AGUB). Reg. section (e)(1). Similarly, it is included in the aggregate deemed sale price (ADSP). Reg. section (d). See also reg. sections (g), Example 1 and (g), Example 1 (Old T s tax liability resulting from T s deemed asset sale included in AGUB and ADSP). Under section 1366(f)(2) the amount of the BIG tax flows through as a loss to the Old T shareholders. 18. Have contingent liabilities arisen with respect to the QSP? Note: Regulation section (a) states that ADSP and AGUB are re-determined at such time as an increase or decrease would be required under general principles of tax law for the elements of ADSP or AGUB. See reg. sections (b)(2)(ii) and -5(b)(2)(ii). Under reg. section (c)(3) any changes in the deemed sale tax consequences of a section 338(h)(10) transaction caused by an increase or decrease in ADSP are accounted for in determining the taxable income of the S corporation (Old T) shareholders for the taxable year in which it is taken into account. See reg. section (d) for
15 the effect of a contingent payment on acquisition date assets that are disposed of, depreciated, amortized, or depleted by New T. 19. Have you considered assumed liabilities, including compensation liabilities? 20. Have you considered the proper treatment of transaction costs? Note: Transaction costs are not taken into account in allocating ADSP or AGUB to assets, except indirectly through their effect on the computation of ADSP and AGUB. Reg. section (a)(2)(ii). Note: The proper treatment (as nondeductible capital items, deductible expenses, or amortizable expenses) of acquiring corporation s and target S s expenditures to effect the section 338(h)(10) election is unclear. The law is developing and authorities sometimes conflict. 21. Have you properly taken into account estimated taxes with respect to the QSP? Note: The American Jobs Creation Act of 2004 clarified section 338(h)(13) to provide that if a transaction eligible for the section 388(h)(10) election occurs, estimated tax is determined based on the stock sale unless and until a proper section 338(h)(10) election is made by the parties. Once the proper section 338(h)(10) election is made, estimated tax is computed based on the deemed asset sale (computed from the date of sale), rather than based on the stock sale.
16 22. Did the acquiring corporation, due to unforeseen circumstances, transfer all the acquired stock of an S corporation target back to the S corporations shareholders, where as part of the original QSP the parties made a section 338(h)(10) election? If so, the target s shareholders do not need permission under section 1362(g) to make a new S election for the target. See PLR (8/13/2004). The Service reasoned that because a section 338(h)(10) election was made, the target s S election did not terminate under section 1362(d)(2)(A) (or under any other provision of section 1362(d)). Thus, by its terms section 1362(g) does not apply when the target s former shareholders reacquire the stock. See, also, PLR (10/29/2004). Rev. 9/05