Tax Law Changes Create New Opportunities to Obtain a Tax Basis Step-up in the Assets of an Acquired Corporation

Growth through acquisitions is a key component of many organizations’ business strategy.

The ability for a buyer to obtain a tax basis equal to the fair market value of the target business’s underlying assets, and therefore, the ability to enjoy future depreciation and amortization tax deductions for the value paid for the assets can have a meaningful impact on the economics of a transaction to the buyer and the purchase price that a buyer is willing to pay. As a result, buyers generally prefer to purchase the assets of a business, which allows them to depreciate or amortize the acquired assets at the fair market value purchase price, rather than purchase the stock of a C corporation where the historical tax basis of the target’s assets carry over and continue to be depreciated or amortized at historical values.

However, if a buyer purchases the assets of a C corporation, and the corporation then distributes the proceeds from the sale to its shareholders in a liquidating distribution, the transaction is subject to two levels of tax. First, the corporation is taxed on any gain from the sale of the corporation’s assets. Second, the shareholders are taxed on the subsequent liquidation of the corporation as if they sold their stock for the liquidation proceeds. These mechanics result in the double taxation of the asset sale proceeds and therefore, historically these asset purchases were rare due to the prohibitive tax cost to the corporation and its shareholders.

Besides these tax consequences there are sometimes business reasons for doing a stock purchase rather than an asset purchase (e.g., difficulty assigning key contracts, licenses or permits). The question then becomes, how can a corporate buyer obtain a fair market value (or stepped-up) tax basis in the target’s assets when the target is a corporation and the transaction is for the acquisition of all of the corporation’s stock?

Sec. 338 Election

The Internal Revenue Code provides for a special election to treat, solely for tax purposes, the purchase by a corporation of all the corporate stock as if the target corporation sold all of its assets to a new corporation. This election is found under Sec. 338, and is commonly referred to as a Sec. 338 election.

Like many areas of the tax law, there are multiple facets to the Sec. 338 election. Historically, a Sec. 338 election was most often utilized in the form a Sec. 338(h)(10) election, which is only applicable to target corporations that are S corporations or C corporations that are subsidiaries in a consolidated group. The Sec. 338(h)(10) election is useful to obtain a tax basis step-up in the target’s assets without subjecting the sale to a full second level of tax. This result is accomplished through an increase in S corporation stock basis for the corporate gain on the deemed sale of assets, or a deemed liquidation of a C corporation subsidiary into its parent corporation immediately following the sale of its assets which is generally a tax-free Sec. 332 transaction.

In a C corporation acquisition, however, many practitioners have all but forgotten the regular Sec. 338 election that is not Sec. 338(h)(10), often referred to as a Sec. 338(g) election. The Sec. 338(g) election differs from the Sec. 338(h)(10) in that it creates tax at both the corporate and shareholder level (i.e., double taxation), just as if the transaction were for the purchase of the corporation’s assets, and not a purchase of stock. However, since the deemed asset sale occurs after the actual stock sale, only the purchaser pays the tax on the deemed sale and receives a basis step-up on those assets. While Sec. 338(g) elections are typically used in conjunction with foreign target corporations not subject to U.S. tax, the domestic Sec. 338(g) election is rarely used and limited to very unique fact patterns. One such situation is where the target has expiring net operating losses (not subject to Sec. 382 limitations) that could offset the entire corporate gain on the deemed asset sale, effectively eliminating the corporate-level income tax.

Impact of Tax Reform

The tax law changes passed in December 2017 could alter how acquirers consider domestic Sec. 338(g) elections. First, the lower corporate tax rate and elimination of the corporate alternative minimum tax immediately reduces or eliminates the potential cost of a domestic Sec. 338(g) election. Any time there is a tax cost to obtain a basis step-up in the corporation’s assets, the benefit of the step-up is typically measured in terms of the present value of future tax savings from the additional depreciation and amortization of the stepped-up asset basis, less the tax cost of obtaining the step-up. Therefore, while the reduced corporate tax rate lowers the potential upfront cost of a domestic Sec. 338(g) election, the impact swings both ways because it also lowers the present value of future tax savings.

Next, the changes to the bonus depreciation rules that permit immediate expensing for used property could provide significant benefits for capital intensive businesses with qualified property. Previously, the definition of qualified property under Sec. 168(k)(2)(A) required that the original use of the property commence with the taxpayer placing it in service. Now, so long as the property was not used by the same taxpayer prior to acquisition, it can qualify for the immediate expensing (until 2022) of the full amount allocable to those assets, not just of the step-up. This ability to take bonus depreciation on used property is changing how buyers look at the value of asset acquisitions. In situations where the target corporation is capital intensive and possesses considerable fixed assets eligible for immediate expensing, the fact pattern required to make a Sec. 338(g) election beneficial could be much broader than the narrow set of circumstances in which it made sense in the past.

Finally, with the reduced corporate tax cost of a Sec. 338(g) election, it is possible that under some circumstances buyers could view Sec. 338(g) as more advantageous compared to a Sec. 338(h)(10) election. The Sec. 338(g) election is a unilateral election made by the buyer only, and does not require consent of the seller. A Sec. 338(h)(10) election requires both the buyer and seller to jointly make the election, because its impact reaches directly to the sellers. Often, when negotiating the purchase of stock with a Sec. 338(h)(10) election there is a purchase price component for tax equalization payments to the selling shareholder(s) for any increase in net tax cost as a result of the deemed asset sale compared to a sale of stock. It is possible that a Sec. 338(g) election may be more advantageous compared to a Sec. 338(h)(10) election, even when a Sec. 338(h)(10) election is available, when considering the impact of tax equalization payments. Of course, it is also necessary to consider the tax cost of making the Sec. 338(g) election itself.

With the reduction in corporate tax rates, along with other aspects of tax law changes benefitting corporations, it is possible that there will be an increase in closely held businesses organized and taxed as C corporations, compared to the previously common pass-through entity structure (e.g., S corporations or partnerships). If so, the Sec. 338(g) election could become a more common tool for corporate buyers to use to obtain a tax basis step-up in the target corporation’s assets.