IRC Section 338 Election
Hey all.
I am somewhat confused about the IRC 338 election. Here's what I know about it, but it'd still be great if anyone could fill in the holes for me. It's legally a stock sale that is treated like an asset sale for accounting / tax purposes. It's generally known that buyers prefer an asset acquisition (to pick and choose assets / liabs + get a step up for tax purposes. This means they can save on taxes b/c of higher D&A), whereas sellers prefer a stock sale, where they only get taxed once (cap gains) and are able to unload all their liabs. Okay. In Section 338 (h) (10), the buyer still acquires all assets + liabs of a company (ala stock acquisition), but the seller gets taxed twice (cap gain and asset appreciation). However, the buyer gets an asset step up for tax purposes. Hence, the buyer is able to pay more for such an acquisition as it saves the buyer $ on taxes.
Herein come the questions:
1) What is the difference between Section 338 (g) and Section 338(h)(10)? When the 338 benefits are mentioned, it's always the 338(h)(10) that gets the nod. Then why have 338 (g)? (also probably has to do with the fact that (g) is unilateral, whereas (h)(10) has to be agreed upon by both parties)
2) Why does the existence of NOLs at the target firm make it more advantageous for the buyer? I heard 2 explanations for it, but don't know which one's correct:
a) the nol balance gets written down completely, so more excess purch price can be allocated to asset write-ups
b) NOLs can offset the tax liability created by the 338 election. The tax liability (for the buyer) is supposedly arisen b/c he is now in control of the seller, who passes it onto the buyer.
3) 338 has the advantage of an Asset deal for the buyer in the sense that it provides for an asset step-up for tax purposes. So this implies that the Stock transaction does NOT have this advantage. Okay. But it does give the buyer the ability to still increase the BOOK value of the assets. This then creates a deferred tax liability - with higher depreciation on a new asset, you SAVE on the taxes in the short term, but that liability is still there, meaning that you have to pay those taxes back. But how does it work?? I mean, when DTL gets created b/c of accelerated depreciation, that makes sense - we accelerate the depreciation of our asset, and then seemingly pay less in tax in the short term, but since the depreciation is so fast, in 5-6 years our asset will depreciate fully, but we'll still owe the IRS the same amount as if it were straight-line - so we tap into our DTL. But how does it work for the asset step up in a stock deal? According to what schedule do we suddenly pay back all that tax that we save in the short term?
Sorry if these questions are too long, just trying to get to the bottom of it. Thanks in advance.
I'm not a tax expert, so make sure you actually speak to one before relying on any of this. That said, here's my understanding of the issues.
1) First, 338(g) applies to C corps, while 338(h)(10) applies to S corps and subsidiaries. As you note, 338(h)(10) must be agreed to by both parties, since the seller typically picks up the tax bill in exchange for a higher purchase price. 338(g) is made by the C corp itself, so it effectively pays higher taxes today in exchange for lower taxes in the future.
2) Your suggestions 2(a) and 2(b) don't make any sense. The benefit of NOLs, which can only be transfered to the buyer under a stock sale (e.g., after a 338(h)(10) election) is that the buyer can use the NOLs to offset income tax going forward. Just be aware that the buyer can only use NOLs up to an annual limit equal to the equity invested in the purchase times the Applicable Federal Rate (typically close to 30-year Treasury yields) at the time of purchase, so you may not be able to use the NOLs as fast as the seller would have been able to. This time value of money needs to be factored into the decision of whether to make the 338(h)(10) election or not.
3) You are confusing cash and book taxes. Book taxes have nothing to do with the actual amount of cash paid to the IRS. When you make a 338(h)(10) election, the seller pays more tax and the buyer pays less tax. The book value of assets is only relevant to the income statement, not to actual cash profits.
You're off-base on a few key items here, so make sure you speak with a tax expert to set you straight.
My reasons a) and b) from above actually come from a couple of books / websites. In fact, when you say "in 338(h)(10) the buyer can use the NOL" goes in direct contradiction with this line from BIWS interview guide that I used a few years ago when I recruited: "Even though the seller still gets taxed twice, buyers will often pay more in a 338(h)(10) deal because of the tax-savings potential. It's particularly helpful for sellers with high NOL balances (more tax-savings for the buyer because this NOL balance will be written down completely - and so more of the excess purchase price can be allocated to asset write-ups)". Any idea on what they mean by "written down"?
Got it. I just confused the whole concept of DTL. A DTL gets created when we expect to be understating our taxes for some time, and then it gets "tapped" into every year, so if our real (cash) taxes exceed our book taxes, that DTL gets depleted every year, which shows on on the operating section in the CF statement as a use of cash.
This is more to prepare myself so that I know what's going on in our transaction proposal. As you see I'm referencing interview prep books ;). In the actual execution, there's no question tax pros will have to be present.Thanks again!
I wasn't very clear on this in my first post. After making the election, the C corp will have a higher asset base going forwards, which means they will have increased tax depreciation, and thus lower income tax payable. However, at the time of making the 338(g) election, the C corp will recognize a taxable gain in the amount of the asset base step-up, and will pay tax on this gain right away. Thus, the C corp pays more tax today than in the future.
From the buyer's perspective, there are two primary benfits of making a 338(h)(10) election: 1) The buyer can utilize the seller's existing NOLs to offset future income taxes (up to certain limits); and 2) The buyer's "cost basis" in the purchase is higher, so when the company is sold later on, the original buyer (now the subsequent seller) will have a smaller gain and thus pay less capital gains tax.
From the seller's perpsective, there are two primary issues to consider when making a 338(h)(10) election: 1) The seller will recognize a larger gain upon completion of the transaction, and so will pay more capital gains tax; and 2) The buyer will likely be able to pay more for the company because of the benefits noted above.
Typically, the two most important inputs which determine whether a 338(h)(10) election is sensible to make are: 1) The amount of NOLs that the buyer will be able to use each year; and 2) The marginal tax rates of the buyer and seller (for instance, if the seller is a tax-exempt pension fund or sovereign wealth fund, then they are typically happy to make the election in order to receive a higher price).
I don't know what they mean by "writing down" the NOL balance, but I think they are confusing two issues. The ability of the buyer to use existing NOLs has nothing to do with the stepping-up the asset base, it is merely coincidental that under a 338(h)(10) election the buyer is able to use the existing NOLs (because the transaction is a stock deal) and has stepped-up the asset base (because the election means the transaction is treated as an asset deal).
You are correct in the first part, about how the DTL is typically reduced over time. As for the second part, reducing the DTL is not a use of cash; rather it is an adjustment to net income to reflect the actual amount of taxes paid (if cash taxes > book taxes, then net income over-states cash generation). Just keep in mind that the DTL is an accounting construct, and doesn't actually mean that a company has unpaid cash taxes.
This is more to prepare myself so that I know what's going on in our transaction proposal. As you see I'm referencing interview prep books ;). In the actual execution, there's no question tax pros will have to be present.Thanks again![/quote]
No worries. If your firm typically deals with the same few tax or accounting firms, you can probably reach out to one of them on a friendly basis and ask for a quick primer on these issues. They all have pre-prepared materials which they will usually send right over; they want you in their corner when it comes time to actually engage the advisor.
I am no tax lawyer either but I don't think the target's existing NOL's, to the extent they exist, transfer to the buyer in a 338(h)(10). 338h10 is a stock sale that is treated as an asset sale for tax purposes so the NOLs would remain with the seller. Asset sales can be cumbersome legally (docs, consents, etc.) which is I think one of the reasons why h10 exists. The buyer does, however, get to use any depreciation from coming from the assets which they would not be able to utilize had they had acquired stock (you can't amortize stock). This depreciation (losses) has value (think of it as a 0% loan from the government) which is why a buyer would pay more, not because the buyer is acquiring the target's NOLs.
In a standard stock acquisition, section 382 limits the target's NOLs if there is a large equity ownership change. I think, but am not certain, these limited NOLs do get transferred in the standard 338 case (338 (g) is just the instructions for the election, like you have to make it before the 15th day of the 9th month following the acquisition and that it is irrevocable)
let me know if i'm wrong but hope this helps
A 338(h)(10) election is only treated as an asset sale insofar as you are permitted to write-up the value of the acquired company. In all other respects it is still a stock sale, so the buyer obtains the seller's NOLs (the NOLs technically belong to the company being sold, and not to the seller).
You are correct about the limitation on the buyer's ability to use the seller's existing NOLs. See my comment #2 on Jan 3 for the basic calculation used to determine the size of the annual limitation. You are also correct about the deadline for making a 338 election (either 338(g) or 338(h)(10)).
google "nol written down completely under 338 h 10", the first pdf from breakintowallstreet
it seems NOL is completely lost under 338 h 10
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