Navigating Corporate Acquisitions: The Crucial Role of IRC Sections 338(h)(10) and 336(e)

When embarking on the journey of purchasing a business, many assume the options are limited to buying assets or stock. But what if you could legally purchase stock while treating it as if you'd acquired the business's assets for tax purposes? This dual advantage is precisely what Section 338(h)(10) and Section 336(e) of the Internal Revenue Code (IRC) offer. These elections allow buyers to "step up" the tax basis of the acquired company’s assets, leading to enhanced depreciation and tax deductions, potentially saving millions over time.

Understanding Sections 338(h)(10) and 336(e)

IRC Section 338(h)(10)

Section 338(h)(10) allows a purchasing corporation to treat the acquisition of at least 80% of a target corporation’s stock within a 12-month period as a deemed asset purchase. This election must be jointly made by the buyer and the seller, making it appear as if the target sold its assets and then liquidated. The buyer gains a step-up in the basis of these assets to their fair market value, optimizing depreciation deductions. However, this also means the seller recognizes gain or loss on the deemed asset sale, which could result in higher tax liabilities.

IRC Section 336(e)

Section 336(e) provides a similar mechanism but is more expansive. It applies to situations involving a qualified stock disposition, defined as the sale, exchange, or distribution of at least 80% of a corporation’s stock within a year. Unlike Section 338(h)(10), the buyer under Section 336(e) is not restricted to being a corporation. Individuals and partnerships can also qualify. The election is made unilaterally by the seller and the target corporation, facilitating transactions with variety in buyer types or involving multiple purchasers.

Advantages and Challenges from the Buyer’s Perspective

Both sections offer the primary advantage of asset basis step-up, resulting in increased depreciation deductions and potential tax savings. However, the joint election requirement in Section 338(h)(10) might complicate negotiations due to the need for seller consent. Conversely, the unilateral nature of Section 336(e) provides buyers more flexibility in structuring acquisitions. Yet, this may result in less certainty for buyers over the election, impacting negotiation dynamics.

Despite being treated as an asset sale for tax purposes, the transaction's legal form remains a stock sale, which means the buyer may still inherit certain liabilities from the target.

Purchase Price Allocation and Tax Implications

In both Section 338(h)(10) and 336(e) elections, the purchase price is allocated among the target’s assets based on fair market value using the residual method. This affects the buyer’s depreciation and amortization deductions, with assets classified into specific classes with varied recovery periods. For the seller, the perceived asset sale results in gain or loss recognition.

Filing Requirements and Short-Period Returns

Section 338(h)(10) requires joint filing of Form 8023 by the ninth month following acquisition, alongside the filing of a short-period return for the target. For Section 336(e) elections, a written agreement is necessary by the target’s tax return due date. Like Section 338(h)(10), a short-period return for the target is necessary, reflecting the deemed asset sale.

California State Tax Treatment

California conforms to federal tax laws regarding these elections, but with specific property and sales tax considerations. A change in ownership, as stipulated under California Revenue & Taxation Code § 64, may trigger property tax reassessment if it leads to a transfer of control. However, sales tax does not generally apply to the sale of an entire business.

Comparative Analysis: Section 338(h)(10) vs. Section 336(e)

While both elections allow the asset basis step-up for substantial depreciation benefits, differences exist:

Election Maker: 338(h)(10): Requires buyer and seller cooperation. 336(e): Made unilaterally by the seller.
Buyer Eligibility: 338(h)(10): Buyer must be a corporation. 336(e): Open to individuals, partnerships, or corporations.
Transaction Types: 338(h)(10): Pertains to corporate acquisitions. 336(e): Covers broader stock dispositions.

Ensuring Reporting Compliance

Buyers should engage in rigorous due diligence, ensuring prior tax liabilities are understood, especially those related to C corporation history. Valuations must be accurate to resist IRS scrutiny, and proper documentation must support the elections. Compliance is enhanced through collaboration with tax professionals, ensuring all filings are timely and correct.

Conclusion

Choosing between Sections 338(h)(10) and 336(e) hinges on the buyer's corporate status, negotiation power, and the implications of state taxes. Each has its requirements, but both offer significant tax advantages through asset basis step-up. By carefully handling these elections, buyers can optimize tax outcomes and ensure a smoother post-acquisition transition.

Navigating Corporate Acquisitions: The Crucial Role of IRC Sections 338(h)(10) and 336(e)

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