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Tax reform has changed the analysis regarding the desirability of a Section 338(h)(10)1 election in connection with the acquisition of an S corporation. This article reviews the Section 338(h)(10) election rules for S corporations and explains the advantages and disadvantages of the election for buyers and sellers, focusing on incremental costs and traps, and how tax reform has changed the economic analysis (possibly unfavorably) for making a Section 338(h)(10) election.
Introduction
S corporations remain the predominant business entity in the United States, despite the lack of access to capital markets that public C corporations provide and the tax flexibility that partnerships offer. According to the Internal Revenue Service 2017 Data Book,2 S corporations accounted for 44% of all business entity filings during 2017, a slight increase from 2016. Therefore, it is not surprising that S corporations are commonly targets for private equity funds and other strategic buyers seeking growth opportunities.
Because of a flow-through federal tax regime that generally avoids double taxation, S corporations offer buyers the possibility of a cost basis in the acquired assets (i.e., the tax assets of a business, including intangibles and goodwill, are stepped up/down to fair market value; for purposes of this article, we will assume a stepup). However, the step-up benefit may result in higher exit tax costs to sellers compared with a traditional straight stock sale. As such, sellers may request a "gross-up payment" for the incremental tax difference between a traditional stock sale and a deemed asset sale with a Section 338(h)(10) election, which provides a mechanism for a tax step-up in a stock sale.
This article discusses the mechanics of an S corporation and Section 338(h)(10) election, potential step-up costs to sellers of an S corporation in a taxable disposition, a mitigating strategy designed to minimize tax leakage for rollover sellers, and potential pitfalls when installment sale notes are used as consideration or disproportionate rollovers by sellers occur. As this article explains, following significant changes to existing tax law, the net present value incentives for making Section 338(h)(10) elections are reduced, while the gross-up payment for an election may make it cost prohibitive. Of course, this first requires that the corporation is a qualifying S corporation.
S Corporation Tax Regime
A corporation electing to be...