Section 338

What Is Section 338?

Section 338 of the Internal Revenue Code is the law that defines and allows taxpayers to treat certain stocks as asset acquisitions.  

The case of Kimbell-Diamond Milling Co. v. Commissioner, 14 T.C. 74 (1950) serves as the foundation for any discussion of Internal Revenue Code Section 338.

In 1942, Kimbell–Diamond Milling Co. (Kimbell-Diamond), a grain product firm, experienced a fire that destroyed its mill.

It came upon Whaley Mill and Elevator Company (Whaley), a target business with a similar mill, while looking for a replacement for the mill property, in part using money received through an insurance payout.

Whaley's shares were fully acquired by Kimbell-Diamond, which then swiftly liquidated the target to take direct possession of the mill.

The reason Kimbell-Diamond went to court is that the IRS disagreed with the firm on what the depreciable basis for the mill was. 

According to Kimbell-Diamond, who claimed it had lawfully liquidated Whaley, the mill should have the same legal basis for depreciation as it did while held by Whaley. 

The Internal Revenue Service (IRS) asserted that the purchase of stock and the subsequent liquidation should be combined into one transaction and considered a purchase of assets under the step transaction theory.

This is because Kimbell-Diamond planned to acquire the mill as an asset.

As a result, Kimbell-Diamond has a cost basis in the mill rather than a substituted basis from the target, Whaley, as the court decided that the transaction should be considered an asset acquisition.

Whaley’s substituted basis allowed Kimbell-Diamond to claim a basis in the acquired assets that was the same as Whaley’s had been while it was active - $300,000.

However, the IRS commissioner claimed it should be only $110,000 ($1,461,451 now), or Kimbell-Diamond’s cost of assets.

Why does the basis matter?

• The basis represents how much was invested in an asset or its cost.
• The revenue you generate from the asset, and the basis, determine how much that +asset made you and, by extension, how much is taxed.

The Kimbell-Diamond victory for the IRS was only momentary.Tax lawyers rapidly recognized that by merely demonstrating a desire to purchase assets, corporate taxpayers might obtain a cost basis in support of an acquired subsidiary, so it may add on or decrease the cost.

As a result, Congress passed Section 338 of the Internal Revenue Code.

Anatomy of section 338

The United States Congress adopted the section in 1982. It allows taxpayers to classify some qualified stock purchases as asset acquisitions for federal income tax purposes.

What is a qualified stock purchase? The IRS gives the following definition in its instructions for Form 8023, which is used to make elections under section 338:

A QSP is the purchase of at least 80% of the total voting power and value of the stock of a corporation by another corporation during a 12-month acquisition period. 

Preferred stock (as described in section 1504(a)(4)) is not included in computing voting power or value. See section 338(h)(3) for the definition of "purchase."

Section 338 regards the purchase of stock as the purchase of an asset, which can be done throughout multiple transactions in the acquisition period.

Section 338(a) states the IRS’ approach, per the aforementioned step transaction theory.

This section also provides two election options or methods of treating the transactions. The firm has until the 15th of the ninth month after the month in which the acquisition date occurs to decide which election it wants to use.

The acquisition date is generally the stock acquisitions over the last twelve months that meet the 80% voting power requirement.

Note that some stock acquisitions are not included under Section 338(h)(3) definition of "buy."

The first possible election, the "normal section 338 election," is provided by section 338(g), and the other is provided by Section 338(h) (10).

This election is helpful when the buyer desires the tax advantages of an asset acquisition but has a solid business reason to buy stock instead of assets (e.g., not, wanting to tie up more money in fixed assets).

Two tax levels are levied in a standard section 338 election: one on the shareholders upon selling target shares and the other on the target corporation's presumed asset sale.

Because section 338(g) election results in two levels of tax, a section 338(h)(10) election, which only taxes the sale, is much more popular.

Section 338(a)

This section determines how qualified stock purchases are treated.

The essential parts are:

• 338(a)(1)
• 338(a)(2)

"The target shall be treated as having sold all of its assets at the closing of the acquisition date at fair market value in a single transaction," states Internal Revenue Code Section 338(a)(1).

Second, the target is treated as a new entity that acquired all assets on the following day under Internal Revenue Code Section 338(a)(2).

See the relevant parts of these two sections below:

Deemed transaction, 338(a)(1)

“Elections are available under section 338 when a purchasing corporation acquires the stock of another corporation (the target) in a qualified stock purchase.

Under section 338(g), one type of election is available to the purchasing corporation. Another type of election, under section 338(h)(10), is, in more limited circumstances, available jointly to the purchasing corporation and the sellers of the stock.

However, if, as a result of the deemed purchase of the old target's assets under a section 336(e) election, there would be both a qualified stock purchase and a qualified stock disposition of the stock of a subsidiary of a target, a section 336(e) election may be made concerning the purchase.

Although the target is a single corporation under corporate law, if a section 338 election is made, then two separate corporations, the old target and the new target, generally are considered to exist for purposes of subtitle A of the Internal Revenue Code. 

The old target is treated as transferring all of its assets to an unrelated person in exchange for consideration, including the discharge of its liabilities.

The new target is treated as acquiring all its assets from an unrelated person in exchange for consideration that includes the assumption of those liabilities. 

(Such transaction is referred to as the deemed asset sale and the income tax consequences as the deemed sale tax consequences.) 

If a section 338(h)(10) election is made, the old target is deemed to liquidate following the deemed asset sale.”

Application of other rules of law, 338(a)(2)

“Other rules of law apply to determine the tax consequences to the parties as if they had engaged in the transactions deemed to occur under section 338 and the regulations thereunder except to the extent otherwise provided in those regulations. Other rules of law may characterize the transaction as something other than or in addition to a sale and purchase of assets; however, the transaction between old and new targets must be taxable.”

Note that this reference is taken from 26 CFR § 1.338-1 - General principles; status of old the target and new target. | CFR | US Law | LII / Legal Information Institute (cornell.edu) 

Section 338(a) Mechanism

The mechanisms behind every section are complex and different.

It is crucial to understand them because it provides us with an insight into the law and guidelines:

• Under section 338(a), the company whose shares are bought is first treated as if it sold all its assets on the acquisition date at market value and then as a new firm that bought all those assets the next day or as if it liquidated. 
• The first sale is sometimes called a "deemed sale''. It causes acknowledgment of gain or loss to the target. 
• This second transaction, if it occurs, creates the new cost basis and acts as if the bought-out firm closed and a “new” firm opened in its place. 

In most cases, it is seen as an entity unrelated to the “old” firm and should not be treated as a member of a certain group.

For the first transaction, It is necessary to use an aggregate deemed sales price (or "ADSP").The cost of the qualified stock purchase to the purchasing corporation is the main factor in the ADSP. 

The regulations use the phrase "grossed-up basis of the purchasing corporation's recently purchased target stock".

Treasury regulation section 1.338-3(d) (1). Grossed-up basis, with the necessary modifications for a section 338 transaction, essentially serves as a substitute for the acquiring corporation's cost.

The fair market value of the target’s assets is replaced by the buyer's cost for the company's stock. 

In addition, the ADSP includes the liabilities of the new target as if the bought-out firm had sold its assets to “an unrelated person of liabilities” because the firm must be treated as a new firm in every sense.

The profit or loss from asset sales is determined on a case-by-case basis, so the firm under 338(a)(1) allocates the ADSP price among all assets.

The method used here is the same as the allocation method used to find the basis of each item owned by the buyer. Treasury Regulation 1.338-3(b)(2) has more information on the residual approach.

Although the goal of the “new” firm's presumed repurchase of assets is to give the buyer a cost basis for the targeted firm’s assets, the repurchase procedures can be a little confusing.

You can find a thorough example in the next section: 

How does Section 338(a)(1) Work?

Assume, for instance, that the acquirer, Buyer Co. paid $2,000 years ago to purchase 10% of the target corporation, Acquired Inc.

This 10% of Acquired Inc stock that Buyer Co currently holds does not count towards a 338 election. Buyer Co purchases the remaining 90% in a qualifying stock for $1,800,000.

As of the acquisition date, towns with a basis of $50,000 and a fair market value of $1 million. The T shareholders must declare gain or loss on the sale of their T shares by Internal Revenue Code Sections 61(a)(30) and 1001 whether or not P makes a Section 338 election.

T will be a new subsidiary of P and keep its historical base of $50,000 in its assets if P does not make a section 338 election. Even if P liquidates T, neither P nor T will record a gain or loss, and the transferred basis for the target assets in P's possession is $50,000.

On the other hand, old T will be judged to have sold all its assets at fair market value on the purchase date if P makes a Section 338 election. On this considered sale, Old T will report a gain of $950,000.

The identical asset will be considered to have been repurchased the next day by fresh T.

The gross-up basis in P's most recent stock purchase plus the base of the 90 percent most recent buy ($900,000) multiplied by a fraction of 90 percent divided by 90 percent, or 1, will determine the purchase price.

The denominator is the 90% newly acquired stock, and the numerator is 100 percent less than the 10% old and cold stock, as required by Internal Revenue Code section 338(b)(4).

Assume, with a modest change in the facts, that P buys 90% of a Q.S.P. and that minority shareholders own the remaining 10%. Old T is still considered to have sold all of its assets as of the acquisition date, even if P makes a Section 338 election.

So, old T will continue to declare a $950,000 profit. The bought price on the considered repurchase by new T under Section 338(b)(1) is only the grossed-up basis of the 90% recently purchased stock because P owns no store that was not recently purchased.

P will now multiply its $900,000 cost base in the most recent share purchases by a percentage of 90% or 100%. The numerator is one hundred percent less than the non-recently acquired shares following Section 338(b)(4).

There are no such shares in this instance. The freshly bought stock, which makes up the denominator, is 90 percent. The fair market value of T's assets as of the acquisition date is represented by the grossed-up basis, which was $1 million at that time.

Since all of P's shares were recently purchased as part of a Q.S.P. and T reported total gain on the deemed sale of its assets, it allows a full step-up based on T's assets. 

Section 338(g)

A 338(g) election does not affect taxes paid by the acquired firm’s shareholders because the deemed asset sale occurs after the transaction is completed and they’ve already sold their stock.

Because only the acquirer is affected by the election, a 338(g) election can be made unilaterally.

As a result of a 338(g) election, there are two levels of taxation:

1. First, to the selling shareholders on the actual stock sale, and
2. Then to the target entity which recognizes a taxable gain on the deemed asset sale

Elections under section 338(g) are uncommon because the current tax cost of the deemed asset sale usually exceeds the present value of tax savings. 
A 338(g) election is generally only advantageous when the target has significant net operating loss or tax credit carryovers that the acquirer can use to offset any taxable gain caused by the deemed asset sale.

These tax benefits are only available for immediate use and will be lost if the target is liquidated.

Section 338(h)

Elections under section 338(h)(10) must be made by both the buyer and the seller, who must also be corporations (see section 338(a)).

This necessitates agreement between the corporate parties since, unlike section 338(g), where the purchaser bears the tax burden, the seller pays the tax from the asset transaction.

A qualified stock purchase is also necessary per 338(h)(10). Section 1504(a)(2) mandates the acquisition of 80% of the target entity's vote and worth. The 12-month acquisition period is not restricted to a calendar year for 338(h)(10).

The transaction is essentially considered an asset sale followed by liquidation if a 338(h)(10) election has been correctly made, with the selling party bearing the tax liability.

The corporation purchasing the acquired firm is technically considered as creating a new target entity.

This new corporation exists to acquire the original entity's assets. This enables the acquisition of an asset or firm while keeping the purchase a stock sale from a legal standpoint.

In other words, the sale is an asset sale for tax purposes and not by law.

It should be noted that:

• While the sale of assets results in a gain for the selling corporation,
• The sale of shares does not result in a subsequent tax, removing the second level of taxable income.

This is the difference between the section 338 h and section 338g election.

The buyer may profit from treating the sale as a stock acquisition by keeping specific contracts, permits, licenses, and other business assets that could be lost from an asset purchase agreement.

The stock sale is disregarded for tax purposes in Section 338(h)(10) election, and the deemed liquidation is tax-free to the selling shareholders.

Typically, only one level of tax is applied to the deemed asset sale. Accordingly, the parties are treated as though:

1. The buying corporation formed a new corporation. 
2. This new target acquired the target corporation's assets and took on its liabilities.
3. The target firm was liquidated in the seller's hands.

What is an S Corporation?

An S Corporation is a conventional corporation with 100 or fewer shareholders that allows the business to benefit from incorporation but is taxed similarly to a partnership.

Typically, S Corporations do not pay taxes; instead, they submit a Form 1120S informative return, which details the net profit or loss distributed to the shareholders. Then, the shareholders use their tax returns to disclose the net profit or loss.

All S Corporations begin as ordinary or professional corporations and can only become an S corporation by requesting the S election from the IRS. They do so by filing IRS Form 2553.

Section 338(h)(10) and S Corporations 

The shareholders of the target S company and the acquiring corporation must agree to vote under Section 338(h) if a stock acquisition is sought for non-tax reasons. However, the asset purchase is intended for tax reasons.

S Corporations don't pay income taxes. Instead, the corporation distributes its profits and losses to its shareholders, who record them on their income tax returns. This fact can make it more challenging to sell an S Corporation because of the tax filing system.

Under Section 1.338(h)(10)-1(c), corporations making qualified stock purchases of S corporations can file Section 338(h)(10) together with the S corporation’s shareholders.

The election must be approved by both selling and non-selling shareholders of the target S corporation. When the stock sale is disregarded for tax reasons.

Furthermore, the legislation authorizes an S Corporation stock sale to be taxed as though it were an asset sale, which comes with several benefits. 

The "stepped-up" tax basis allows the buyer to dramatically increase the declared worth of the seller's assets, among other benefits.

A bidder can obtain a larger current tax deduction by claiming more depreciation on the assets it intends to acquire, thanks to the higher asset value.

Benefits of Filing Section 338(h)(10)

The Internal Revenue Code's Section 338 election offers a means to characterize stock transactions as asset acquisitions for tax purposes.

In other words, the selling corporation will face the transaction-related tax under Internal Revenue Code 338(h)(10), but there will only be one level of taxation.

The basis for this single layer of taxation is the entity's internal gain on the assets it owns; different interest rate rates may not always ensure the gain.

However, there is no tax on the sale of the shares that follow. Both buyers and sellers can profit from resolving some of the problems resulting from stock trades thanks to the tax code's prescribed section election.

A) Why does it appeal to buyers?

Often at an accelerated rate, the buyer also receives a tax basis on the assets they have purchased equal to the purchase price.

Furthermore, because the transaction is seen as if it involves the purchase of assets, the buyer is eligible to register goodwill and benefit from amortization costs over the following 15 years. All of these elements result in considerable tax advantages for the buyer.

Buyers can also avoid the change of control problems arising in typical asset purchases and benefit from treating it as an asset purchase for tax purposes.  

All contracts and licenses that would generally need to go through the assignment process in an asset acquisition are transferred uninterrupted as with a regular stock transaction because a 338(h)(10) transaction is still a stock sale for legal purposes.

B) Why does it appeal to sellers?

Let us see the reasons why it appeals to sellers. It has been discussed below

This is merely a result of the tax benefits received by the buyer rather than the seller as a result of the concession provided. Not to mention that buyers can:

• Bypass the aforementioned assignment process, and
• Keep ownership of certain intangible assets. 

As a result, the 338(h)(10) election is frequently an attempt by a seller to reach a compromise to close the purchase. However, sellers may commonly request a higher purchase price during the negotiation process in response to a 338(h)(10) election as extra compensation to offset the tax burden they will face.

A 338(h)(10) election might not be used if the expense (to the seller) surpasses the benefit (to the buyer).

Disadvantages of Section 338(h)(10) election

There are many disadvantages of section 338(h)(10).

Here is an example of it:

1. The seller must be an S-Corporation or a U.S. corporate subsidiary.
2. The buyer and seller must work together to make the decision; it cannot be made solely by one party (i.e., all stockholders).
3. If treated as an asset sale for tax purposes, a 338(h)(10) election remains a stock sale for legal purposes. As a result, the buyer's exposure to known or unknown liabilities in the acquisition remains even with favorable tax treatment. 
4. The buyer, who must be a corporation executing a qualified stock purchase, must acquire at least 80% of the seller's stock over the course of a year.

So why don't the participants in each stock sale choose under Section 338(h)(10)? 

Primarily because the following limitations are imposed on who may participate in this kind of transaction as both a buyer and seller:

• The purchaser must be a corporation.
• It could be either a C or an S corporation.
• It can't be an LLC, partnership, etc.
• Additionally, the target business must be a corporation.

Additionally, it needs to be a corporation of one of the following kinds:

1. A business subsidiary in a consolidated group whose stockholders own at least 80% of the subsidiary; 
2. A corporate subsidiary in a group that is qualified but elects not to submit a consolidated return.
3. And lastly, an S company.

Pros and Cons of Section 388(g)

A taxable stock acquisition can be treated as a deemed asset sale under Section 338. Consequently, the fair market value of one or more purchased assets is adjusted on the day of purchase, which benefits the buyer in terms of certain tax considerations.

There are certain benefits and drawbacks to making a. Section 338(g) election when a U.S. buyer purchases a share in a foreign firm in the context of an international acquisition.

Section 901 can make section 338(g) election for foreign target entities more difficult. It significantly lowers the number of foreign tax credits a U.S. business acquirer can claim.

The reduction makes up for the foreign target corporation's higher corporate taxes. The Section 338(g) choice may increase depreciation and amortization deductions in a manner permissible from a U.S. tax perspective but not for foreign tax purposes.

The foreign tax credit for taxes paid on the foreign target's income, which allows the US-based acquirer not to pay taxes on that income, is essentially disallowed under Section 901(m).

The section 338(g) election may be more advantageous for the foreign target's effective foreign tax rate than not making the election, even with the effect of section 901(m).

Other advantages of section 338(g) election can include a restriction on the U.S. acquirer's subpart F income in the year of the purchase.

The foreign target's taxable year is closed due to the election, eliminating the U.S. acquirer's pre-acquisition Subpart F income.

Other effects of the choice include a reduction in the earnings and profits of the foreign target due to the depreciation and amortization deductions permitted for U.S. tax purposes. 

If those deductions are correctly allocated and apportioned to such income following U.S. federal tax laws, subpart F income may also be reduced.

The effect of Section 901(m) and the variations in the foreign target's effective foreign tax rate with and without a Section 338(g) election must be quantified. A U.S. seller of a foreign firm should consider any additional potential drawbacks of this section election.

Deciding the Section 338 Election

This section’s election's step-up in base frequently comes at a high cost. For example, old T was forced to report a $950,000 taxable gain in the scenario above.

Although T is technically responsible for this gain, if the buyer intends to make a section election, the total acquisition price will frequently increase significantly for P.

Many taxpayers would be foolish to make a Section election given the significant "toll charge" as a taxable gain to T.

On the other hand, a step-up based on T's appreciated assets may appeal to P if T's assets were depreciable or included unimproved property that P intended to sell reasonably quickly.

The value of the basis step-up to the purchasing corporation must be compared to the taxable gain from the target's deemed sale to determine whether such an election makes sense.

For instance, the taxable income to the target under Internal Revenue Code Section 338(a)(1) may be outweighed by the higher base's discounted present value of more significant depreciation allowances.

Impacts on Taxes

A regular election is rarely desirable due to the twofold imposition of tax. Usually, it is only made when the target has vital tax attributes (such as net operating losses) to offset the gain recognized by the target.

Elections made according to section 338(h)(10) are more frequent than prescribed section elections.

Recall that elections under section 338(h)(10) are only available to targets that are S corporations or entities that are a part of a related group of corporations.

The Tax Viewpoint for 338(h)(10): Section 338 reclassifies the stock sale as an asset sale, giving the assets a stepped-up basis, which benefits the buyer regarding taxes. The seller also benefits because there has only been one level of tax on the sale of assets.

Depreciation deductions are increased and could eventually reduce ordinary income to minimize tax paid. Furthermore, the presumed asset sale may make up for any losses the selling party suffers, depending on the nature of the gain.

In general, this section’s transactions give buyers and sellers a way to arrange a deal that will maximize the advantages of both stock sales and deemed asset sales while minimizing the tax obligations of each party. 

Researched and authored by Deeksha Pachauri | LinkedIn

Reviewed and Edited by Raghav Dharmarajan

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