Utilizing IRC Section 338 Elections Post-Tax Reform

IRC 338 | Canva - Young Lawyer Signing Paperwork at His Desk

Back in July 2019, California Governor Gavin Newsom signed California Assembly Bill (A.B.) 91 into law. With the new legislation, dubbed the “Loophole Closure and Small Business and Working Families Tax Relief Act of 2019,” came a number of changes to California personal income tax and corporate tax. The bill selectively conforms to certain federal provisions from the Tax Cuts and Jobs Act (TCJA) of 2017. One of the topics addressed in A.B. 91 is the Section 338 election.

With state-level changes effective in the new year, we look at what an Internal Revenue Code (IRC) Section 338 election entails and what the enactment of A.B. 91 means for businesses operating in California.

What is IRC Section 338?

The special Sec. 338 election allows a corporation to treat the purchase of corporate stock as if the target corporation sold all of its assets to a new corporation. This treatment of the purchase is solely for tax purposes.

Similar to many other areas of U.S. tax laws, there are multiple facets to a Sec. 338 election. Historically, taxpayers most often utilized 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 tax-free Sec. 332 transaction.

In a C corporation acquisition, however, there is another beneficial Sec. 338 election known 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. Typically, taxpayers make Sec. 338(g) elections in conjunction with foreign target corporations not subject to U.S. tax. Domestically, a 338(g) election is rare and often limited to very unique fact patterns.

What is a Section 338(h)(10) election?

The Sec. 338(h)(10) election applies to acquisitions of corporate subsidiaries or S corporations. Both the acquirer and the seller jointly make the election prior to completing the deal. In this case, the seller bears any incremental tax cost from the deemed asset sale.

A Section 338(h)(10) election is available only in certain types of transactions with certain types of buyers and targets. For a Sec. 338(h)(10) transaction, the buyer must be a corporation. It can be either a C or S corporation. The same goes for the target – it must be a corporation.

What is a Section 338(g) election?

This election applies to acquisitions of freestanding C corporations. It is a unilateral election, completed by the acquirer after purchasing stock from the target’s shareholders. Generally, the acquirer takes on the incremental tax burden from the gain on the deemed sale of the target’s assets.

A corporation becomes eligible to make an election under Sec. 338(g) upon acquiring greater than 80% of the total stock and voting power of the acquired target corporation.

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What are some general requirements for a Sec. 338 election?

In order to utilize a Sec. 338 election, the transaction must meet certain specifications. This includes:

  • The election is not available in a non-taxable stock deal.
  • The buyer must acquire control of the target in a qualified stock purchase, defined as purchase of at least 80% of the total voting power and value of the target’s stock within twelve consecutive months of the first purchase of such stock. Preferred stock does not count towards voting power or value. The “acquisition date” is the date on which the 80% threshold is met.
  • The buyer must be a C corporation.
  • Foreign targets are not eligible for a Sec. 338(h)(10) election, but are eligible for a Sec. 338(g) election.
  • Taxpayers must complete a Sec. 338 election by the fifteenth day of the ninth month after the month in which they breached the 80% control threshold.

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How did the TCJA impact Section 338 elections?

Domestic Transactions

Per the tax law changes outlined in the TCJA of 2017, there are a number of new considerations for how acquirers utilize Sec. 338(g) elections. For example, the lower corporate tax rate (35% to 21%) and elimination of the corporate alternative minimum tax immediately reduces or eliminates the potential cost of a domestic Sec. 338(g) election.

Next, there are potentially significant benefits for capital intensive businesses with qualified property due to the changes in bonus depreciation rules. Previously, the law limited the definition of qualified property to original use property placed in service. However, the law now qualifies property for bonus depreciation if the equipment is new to the user.

Therefore, as long as the taxpayer did not interact with the property prior to acquisition, it can qualify for immediate expensing of the full allocable amount, not just the step-up. As such, these changes affect the ways buyers may evaluate asset acquisitions. In situations with capital intensive target corporations with considerable fixed assets, the fact pattern required to make a Sec. 338(g) election beneficial may expand significantly.

With the reduced corporate rate, some circumstances may render a Sec. 338(g) election more advantageous than a Sec. 338(h)(10) election. For instance, the 338(g) election is unilateral, requiring action only from the buyer.

However, Sec. 338(h)(10) elections call for both the buyer and the seller to jointly make the election as its impact directly reaches the sellers. Often, when negotiating the stock purchase 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 stock sale.

Thus, Sec. 338(g) may be the more advantageous route when considering the impact of tax equalization payments. Note, though, that it is still necessary to consider the tax cost of making a Sec. 338(g) election itself.

Foreign Transactions

Prior to the TCJA, Sec. 338(g) elections were a long-time staple of cross-border acquisition planning. However, the situation may warrant a renewed analysis post-tax reform. More specifically, the implementation of a hybrid territorial international tax regime under Sec. 245A and Sec. 1248(j) mitigates the benefits of Sec. 338(g) elections. With the new hybrid regime, Sec. 245A effectively equalizes the tax treatment of foreign target corporation dividends and return-of-basis distributions and, as such, removes a significant motivating factor behind the Sec. 338(g) election.

Another area to consider are the Subpart F or GILTI inclusions. In some instance, sellers could have higher tax costs if the additional inclusions resulted in taxable income greater than the amount of gain on the sale of the stock, and the seller does not have capital gains to absorb the resulting capital loss.

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What changed for California under A.B. 91?

Within A.B. 91, there are some notable changes to the treatment of a Sec. 338 election. The new bill provides that if a taxpayer makes a Sec. 338 election for federal tax purposes to treat a qualified stock purchase of a target corporation as an asset purchase, the federal Sec. 338 election will be binding for California tax purposes. Likewise, failure to make a federal Sec. 338 election, then disallows a separate California Sec. 338 election.

The new California Sec. 338 election rules apply to a qualified stock purchase made on or after July 1, 2019, but do not apply to a qualified stock purchase that is subject to a binding contract entered into before the aforementioned date and that remains binding at all times after that date.

Previously, if the target corporation in a qualified stock purchase governed by a federal Sec. 338 election was not an S corporation, a separate California Sec. 338 election was allowed if it was not made for federal purposes, or an election out of a federal election was allowed for California bank and corporation tax purposes.

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How can Squar Milner help?

No matter what state your business operates in, you need a team that knows the ins and outs of the tax regulations that pertain to you. Squar Milner boasts a significant State and Local Tax (SALT) practice to help guide your business to maximum tax savings in your local jurisdiction.

In addition, we have an experienced Mergers & Acquisitions group dedicated to helping your business throughout the transaction lifecycle of your sale or acquisition. Between our SALT and M&A teams, we are fully prepared to help your business optimize the Sec. 338 election as deemed appropriate.

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Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.

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