Generally there are two methods of purchasing a corporation, buying the stock directly, or buying all the assets of the corporation. When buying the stock directly, the selling owner recognizes capital gain on the sale, and the buyer steps directly into the shoes of the seller with minimal administrative burden. However, any premium paid by the purchaser is tied up in their stock basis and cannot be depreciated. When the assets are purchased separately from the stock, the seller often realizes a mixture of ordinary gain and capital gain, and the continuation of the business itself isn’t as seamless. However, in an asset acquisition the purchaser obtains an increased basis in the business’s assets for their premium paid which they can depreciate or amortize to offset future income.
IRC 338(h)(10) is an internal revenue code section which outlines a hybrid election for buying a corporation. The details of the election itself are convoluted, but, in short, it allows a corporation to be deemed to sell all of its assets and liabilities when the business’s owner actually sold their stock. This allows the post-sale corporation to depreciate the increased assets rather than have the purchase price tied up in non-depreciable stock basis, while still allowing the purchaser to seamlessly step into the shoes of the seller. This can also significantly shift the tax burdens and benefits between buyer and seller.
In order to qualify for this treatment the purchased company must usually be an S corporation (with a few exceptions for certain C corporations). Likewise, the purchaser must also be a corporation (S or C), and a new corporation is often created for just this purpose.
Just as in a direct asset sale, the seller’s corporation must recognize gain on the deemed sale of assets inside the corporation. This can cause a portion of the gain to be treated as ordinary gain, resulting in higher tax rates. Immediately following the transaction, the purchased company now has a much higher basis for the company assets, allowing the purchaser to depreciate and amortize much of their purchase price to offset future taxable income.
With the wrong asset structure, this can be a difficult sized pill for a seller to swallow. However, if the seller has the right mix of assets, the election can also significantly increase the value of the business at minimal tax cost. This often serves as a negotiating point between the buyer and seller.
If you are considering acquiring or selling a corporation, and would like to know if engaging in a 338(h)(10) election could be of use, please feel free to contact us for a consultation.
Written by Damien Falato, CPA, MST, CGMA, Tax Director, & Rebecca DeWolfe CPA