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.
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 1.338-3(c)(1)(i)
and 1.1361-4(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.
YES
NO
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• 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
1.1362-6(b)(2). Have appropriate consents been reviewed?
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• Did both spouses sign the election form if they live in a
community property state?
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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.
3.
Has the target S corporation maintained its S status
continuously since its most recent election?
Determine continuous S status by examining the following
documents:
COMMENTS
YES
NO
• With respect to the last question, are both spouses qualified
shareholders?
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• 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?
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• Was a valid QSST election made by the current beneficiary?
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• Under reg. section 1.1362-6(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?
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• Was a valid ESBT election made by the trustee?
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• 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 1.1361-1(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
COMMENTS
YES
NO
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?
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• Have you reviewed any shareholder agreements, buy-sell
agreements or redemption agreements to determine whether
these instruments have created a second class of stock?
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• 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 1.1361-1(l)(4).
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• Have you reviewed any stock option plans to determine if
call options are outstanding and whether a second class of
stock exists?
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•
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. 2003-43, 2003-1 C.B. 998, for certain automatic
waivers.) If applicable, has this been done?
COMMENTS
YES
NO
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?
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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?
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Validity of QSub Election
5.
6.
Qualified Stock Purchases
7.
With respect to the anticipated
requirements for a QSP be met?
acquisition,
will
the
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. 90-95,
1990-2 C.B. 67, and Rev. Rul. 2001-46, 2001-2 C.B. 321.
•
Is the acquirer a C or S corporation?
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•
Has the acquiring corporation “purchased” the stock of the
target S corporation?
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COMMENTS
YES
NO
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?
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• 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?
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• 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?
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• 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?
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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 1.338-3(b).
8.
COMMENTS
YES
NO
Will all target shareholders sell their stock to the acquiring
corporation?
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• 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?
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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 1.1377-1(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 1.1368-1(g).
9.
Filing Requirements
10.
Will New T file the final S corporation return of Old T?
Notes:
COMMENTS
YES
NO
11. Will the final Form 1120S for the Old Target S corporation be
filed by the 15th day of the third month following the month of
the QSP?
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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?
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•
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 1.3381(b)(3)(i). Under section 6011(a) and reg. section 1.60111(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 1.338-1(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.
12.
Note: See Rev. Proc 2003-33, 2003-1 C.B. 803, for automatic
extension for making a section 338(h)(10) election).
COMMENTS
• Will the Form 8023 be filed by the 15th day of the 9th month
following the month of the QSP?
YES
NO
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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 8023. 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 1.338-10(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 8023. 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
COMMENTS
YES
NO
Did the consideration received for the S stock include nonmarketable installment obligations that are not payable on
demand? If yes:
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• 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?
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• Did the target S corporation properly account for
depreciation recapture under section 453(i)?
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• 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.4531(b)(3)(i)?
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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.
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
COMMENTS
YES
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 1.453-11(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 1375.
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
NO
COMMENTS
section 1375.
YES
NO
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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.
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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, 1988-2 C.B. 397.
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COMMENTS
YES
NO
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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 1.338-1(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 1.338-5(e)(1).
Similarly, it is included in the aggregate deemed sale price
(ADSP). Reg. section 1.338-4(d). See also reg. sections 1.3385(g), Example 1 and 1.338-4(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 1.338-7(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 1.3384(b)(2)(ii) and -5(b)(2)(ii). Under reg. section 1.338-7(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 1.338-7(d) for
COMMENTS
YES
NO
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the effect of a contingent payment on acquisition date assets
that are disposed of, depreciated, amortized, or depleted by
New T.
19.
20.
Have you considered
compensation liabilities?
assumed
liabilities,
including
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 1.3386(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.
COMMENTS
YES
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
200453007 (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 200506007 (10/29/2004).
Rev. 9/05
NO
COMMENTS