Installment Reporting for Sales of S Corporation Stock with a 338(h)(10) Election
In January 5, 2000, the Treasury Department adopted Temporary Regulation §1.338(h)(10)-1T (the “temporary regulation”), which clarifies that the installment method of reporting under §453 may be used by taxpayers selling stock in transactions in which an election under §338(h)(10) is made (hereinafter a 338(h)(10) election).1 P rior to the adoption of the temporary regulation, it was unclear whether the installment method of reporting was available in such cases.
The installment method of reporting is generally very advantageous for taxpayers selling eligible property2 w ith deferred payment terms. S corporation stock is eligible property in most cases, and it is common to use deferred payment terms in sales of such stock. As a result, the clarity provided by the temporary regulation provides reliable tax planning opportunities in sales of S corporation stock where a 338(h)(10) election is available and where at least some of the proceeds are to be received by the selling shareholders in the taxable year following the year of the closing. Unfortunately, new §453(a)(2), enacted on December 17, 1999, prohibits the use of the installment method of reporting in conjunction with a 338(h)(10) election if the target corporation uses the accrual method of accounting. Therefore, the benefits of coupling a 338(h)(10) election with the installment method of reporting are only available when the target uses the cash method of accounting.
This article focuses on the use of the installment method of reporting in connection with a 338(h)(10) election for the sale of S corporation stock. Section I discusses eligibility requirements and tax consequences of a 338(h)(10) election in connection with the sale of S corporation stock. Section II discusses the uncertainty that existed prior to the adoption of the temporary regulation regarding the availability of the installment method of reporting for sales of S corporation stock in which a 338(h)(10) election was made. Section III describes the application of the temporary regulation. Lastly, section IV discusses the impact of new §453(a)(2) on S corporation stock sales in which a 338(h)(10) election is made. The temporary regulation also applies to certain C corporations; however, the specific issues relating to C corporations are beyond the scope of this article.
Overview of §338(h)(10)
Section 338(h)(10) is a unique provision of §338. Section 338 generally allows the purchaser of stock in certain stock transactions to treat the transaction as though the target corporation sold all of its assets for their fair market value immediately after the stock purchase.3 An election under §338, as opposed to a 338(h)(10) election, does not impact the tax treatment of the selling shareholders (i.e., they are treated as selling their stock).
comparison, if a 338(h)(10) election is made, the stock purchase is ignored and the transaction is treated as a sale of assets by the target corporation followed by a liquidation of the target corporation. A 338(h)(10) election is only available if the target is an S corporation or a member of an affiliated or consolidated group immediately prior to the stock purchase.4
With respect to a sale of S corporation stock in which a 338(h)(10) election is made, the S corporation reports gain or loss as if it had sold all of its assets. The gain or loss flows through to the S corporation’s shareholders in accordance with the normal rules of Subchapter S and causes an appropriate adjustment to each shareholder’s stock basis. The S corporation is then deemed to distribute the sale proceeds to its shareholders in complete liquidation. As a result of the basis adjustment, the deemed liquidation is generally tax-free to the S corporation shareholders. The purchaser is treated as having formed a new subsidiary corporation which purchases the target S corporation’s assets for fair market value. This provides the purchaser, through its newly formed subsidiary, with a stepped-up basis in the target’s assets in most instances.5 The ability to acquire stock and obtain the tax benefits of an asset acquisition under §338(h)(10) presents significant planning opportunities to tax advisors in S corporation stock transactions.
In order to make a 338(h)(10) election the purchaser must make a “qualified stock purchase” of the stock of an eligible target. In general, a “qualified stock purchase” of an S corporation’s stock occurs when 80 percent or more of the S corporation’s stock is acquired by a corporate purchaser in a single fully taxable transaction.6 A 338(h)(10) election for an S corporation stock sale must be made by the purchaser and all of the S corporation shareholders, including those who do not participate in the qualified stock purchase.7
Consequences to S Corporation Target Shareholders
If a 338(h)(10) election is made, no gain or loss is recognized by the selling S corporation shareholders on the sale of the stock.8 However, the target recognizes gain or loss as if it had sold all of its assets for an amount equal to the “aggregate deemed sales price” (as defined below, the “deemed price”) in a hypothetical sale to an unrelated purchaser.9 The target corporation is treated as both the seller and the unrelated purchaser in this deemed sale of its assets. The specific mechanics of these rules are described in detail in the following paragraphs. For purposes of the following analysis of the 338(h)(10) election, the target corporation, in its capacity as the seller in the deemed asset sale is referred to as “Old T,” and in its capacity as the purchaser, is referred to as “New T.”
The deemed sale of the target’s assets is treated as occurring when Old T is an S corporation whose shares are held by the selling shareholders and the nonselling shareholders, if any.10 The deemed price generally equals the sum of 1) the liabilities of Old T, and 2) the purchase price of the Old T stock which is sold divided by the percentage of Old T stock sold in the qualified stock purchase.11 For example, if the amount of Old T’s liabilities equals $2,000,000 and 80 percent of the Old T stock is sold for $8,000,000 in a qualified stock purchase, the deemed price would equal $12,000,000 (i.e., $2,000,000 plus $8,000,000 divided by 80 percent). Accordingly, in this example, Old T would be deemed to have sold all of its assets to New T for $12,000,000.
In determining the amount and character of gain or loss recognized as a result of the deemed asset sale, the deemed price is allocated to each of the assets of Old T in accordance with their respective fair market values pursuant to the residual method of allocation described in Treas. Reg. §1.338-6T.12 The amount and character of the gain or loss recognized by Old T on the deemed sale is passed through to all its shareholders (including those shareholders who do not sell their stock in the qualified stock purchase) pursuant to §1366, and each shareholder’s stock basis is adjusted accordingly.13
Immediately thereafter, Old T is deemed to distribute the deemed price to its shareholders in a liquidating distribution.14 The liquidating distribution generally does not result in additional taxation to the S corporation shareholders because each shareholder’s basis in its stock has been adjusted to reflect the gains or losses recognized on the deemed asset sale.15
Consequences to
New T and the Purchaser
New T is generally treated as a new corporation which is unrelated to Old T for purposes of the income tax provisions of the Code.16 In the deemed transaction, New T is treated as having purchased all of the assets of Old T in a fully taxable transaction. New T acquires the assets with an aggregate basis equal to the adjusted grossed-up basis of the assets. The grossed-up basis is similar to the deemed price and equals the sum of 1) the amount paid for the target corporation stock (determined without regard to capitalizable acquisition costs) divided by the percentage of target stock purchased in the qualified stock purchase; 2) the amount of the liabilities of the target; and 3) the amount of capitalizable acquisition costs incurred by the purchaser in connection with the qualified stock purchase.17 The grossed-up basis is allocated among the assets of New T in the same manner as the deemed price was allocated.18 The purchaser’s basis in the stock of New T is equal to the amount paid for the stock increased by the amount of capitalizable acquisition costs incurred by the purchaser in connection with the qualified stock purchase.19
Uncertainty Eliminated by the Temporary Regulation
Prior to the adoption of the temporary regulation, it was unclear whether the installment method of reporting was available for S corporation stock sales in which a 338(h)(10) election was made. The issue arose frequently in the S corporation context because many purchasers of closely held businesses20 are unable or unwilling to pay the full amount of the purchase price in cash at closing.21 If the installment method of reporting was unavailable in such transactions, the target’s shareholders would be required to recognize all of the gain inherent in the target’s assets even though the selling shareholders had yet to receive the full amount of the purchase price. Due to the uncertainty that existed prior to the temporary regulation, the parties to an S corporation stock sale in which a 338(h)(10) election was desired and in which a significant amount of the purchase price was to be paid in subsequent taxable years were often forced to either restructure the transaction as a direct asset purchase,22 forego the 338(h)(10) election, restructure the purchase price to provide for a greater amount of cash up front, or report the transaction on the installment method notwithstanding the tax risk the uncertainty presented to the target shareholders.
The uncertainty resulted from the interaction of the §338(h)(10) election rules and the installment reporting rules in §453. In general, to the extent §453 applies, the mere receipt of an installment obligation does not result in gain recognition.23 As the obligation is paid, basis is applied ratably to the payments, and the obligee recognizes income to the extent the payment exceeds such ratable portion of basis.24 There are two primary reasons why it was unclear whether the installment method of reporting could be used with a 338(h)(10) election. First, the language in §338(h)(10) is arguably inconsistent with the installment method of reporting. Section 338(h)(10)(A) provides that if a 338(h)(10) election is made, the target corporation “recognizes gain or loss with respect to the transaction as if it sold all of its assets in a single transaction” (emphasis added). This provision was subject to two divergent interpretations.25 The provision could be interpreted to mean that the target must recognize gain or loss as if it had sold all of its assets in a single transaction for the same consideration (as appropriately grossed-up) that is paid by the purchaser. This interpretation would allow use of the installment method of reporting. However, the provision could also be interpreted to mean that the target must recognize immediate gain as if it had sold all of its assets for cash in a single transaction. This interpretation would preclude use of the installment method of reporting.
Second, the technical mechanics of the deemed asset sale under §338(h)(10) were inconsistent with the requirements for the installment method of reporting. In order to use the installment method of reporting, the installment obligation must be an obligation of the purchaser.26 Under §338(h)(10), a New T (i.e., a new corporation) is the deemed purchaser of Old T’s assets27; however, the obligor on the note received by Old T in the deemed sale and distributed to its shareholders in liquidation is the stock purchaser.
Most tax experts believed that the installment method of reporting should be allowed with a 338(h)(10) election because such treatment is consistent with expressed policy of §338(h)(10) (i.e., to allow taxpayers to elect to treat certain stock sales as asset sales by the target followed by liquidation of the target) even though such a result was contrary to some of the technical rules of the applicable Code sections. In the case of an actual sale of an S corporation’s assets followed by the S corporation’s liquidation, the installment method of reporting is generally allowed.28 This criticism and broad support for clarification ultimately led to the Treasury Department’s adoption of the temporary regulation.
The Temporary Regulation
The temporary regulation expressly provides that the installment method of reporting is available in the context of S corporation stock sales in which a §338(h)(10) election is made and modifies certain rules regarding the hypothetical 338(h)(10) sale to cure the inconsistencies which had created the uncertainty.29 Under the temporary regulation, when selling shareholders receive installment obligations (e.g., a promissory note or other evidence of a deferred payment of the purchase price) from the purchaser, Old T is treated as receiving installment obligations of New T with the same terms as the purchaser’s obligation in the deemed asset sale from Old T to New T.30 Old T is then deemed to distribute in complete liquidation the New T installment obligations to the shareholders who received installment obligations from the purchaser in the stock sale.31
When Old T is deemed to receive the New T installment obligation in the hypothetical asset sale, Old T may report the gain attributable to the installment obligation using the installment method to the extent available for Old T’s assets.32 Upon distribution of the installment obligation in complete liquidation, no further gain is generally recognized by Old T.33 Selling shareholders who receive installment obligations would report gain attributable to the installment obligations as the deferred payments are received. This result is consistent with the tax treatment of an actual asset sale by an S corporation in which part or all of the consideration is in the form of an installment obligation, followed by a complete liquidation of the corporation in which the sales proceeds are distributed to the corporation’s shareholders.34
New Legislation
On December 17, 1999, Congress enacted §453(a)(2), which generally prohibits the use of the installment method of reporting by taxpayers who use the accrual method of accounting. This new legislation has been widely criticized by commentators, especially in the context of an actual or deemed (under §338(h)(10)) sale of all of the assets of an S corporation whose shareholders are cash method taxpayers.35
As previously discussed, in the case of a stock sale in which a 338(h)(10) election is made, the temporary regulation provides that Old T is deemed to receive New T installment obligations and then immediately distribute the obligations to the selling shareholders who receive installment obligations in the stock sale. If the target corporation is an accrual method taxpayer, §453(a)(2) now requires the corporation to immediately recognize all of the gain inherent in the installment obligations and to pass through such gain to its shareholders pursuant to §1366.36 This results in immediate gain recognition of all of the gain inherent in the installment obligations. Section 453(a)(2) requires this result even in cases where the shareholders of the target report their income on the cash method of accounting and even though Old T is deemed to hold the installment obligations for a mere instant in time.37
Conclusion
Prior to the adoption of the temporary regulation on January 5, 2000, it was unclear whether the installment method of reporting was available in stock sales with respect to which a 338(h)(10) election was made. The temporary regulation makes clear that such reporting is now available. Thus, the temporary regulation provides reliable tax planning opportunities where S corporation stock is sold in a qualified stock purchase for consideration which includes deferred payments. Unfortunately, these tax planning opportunities are limited by new §453(a)(2) to those cases in which the target reports income using the cash method of accounting. However, due to criticism of new §453(a)(2), future legislation may, and in the author’s view, should, expand this opportunity to sales by cash method taxpayers of stock in accrual method S corporations. q
1 T.D. 8858, 65 Fed. Reg. 1235 (January 7, 2000). All references and citations to sections in this article are to sections of the Internal Revenue Code of 1986, as amended, unless otherwise indicated.
2 Certain property is ineligible for the installment method of reporting. For instance, sales of inventory and marketable securities generally may not be reported on the installment method. §§453(b)(2) and 453(k)(2).
3 §338(a).
4 Treas. Reg. § 1.338(h)(10)-1T(c)(1).
5 However, if the basis of the target’s assets was greater than their fair market value, the §338(h)(10) election would “step-down” the basis of the target’s assets. In such a case, the election generally would not be advisable.
6 §338(d)(3). Accordingly, a purchase of 80 percent to 100 percent of an S corporation’s stock for cash by a corporate purchaser would constitute a “qualified stock purchase.” However, a transaction described in §351 or 354 would never constitute a “qualified stock purchase.”
7 Treas. Reg. §1.338(h)(10)-1T(c)(2).
8 Treas.Reg. §1.338(h)(10)-1T(d)(5)(iii).
9 Treas. Reg. §1.338(h)(10)-1T(d)(3)(i).
10 Id.
11 Treas. Reg. §1.338-4T. In cases where the selling shareholders incur selling costs in connection with the sale of the target stock, the deemed price would equal the excess of the sum of 1) the liabilities of the target corporation, and 2) the aggregate of each shareholder’s amount realized on the sale of the shareholder’s stock (as determined without regard to selling costs incurred by the selling shareholders in connection with the sale) divided by the percentage of target stock sold in the qualified stock purchase, over the amount of the selling costs.
12 Treas. Reg. §1.338-4T(a). In very general terms, this method allocates the deemed price in the following manner: first to cash, second to cash equivalents (e.g., certificates of deposit) and securities, third to accounts receivables, fourth to inventory, fifth to any remaining tangible property, sixth to intangibles other than goodwill or going concern value, and last to goodwill or going concern value. Treas. Reg. §1.338-6T(b).
13 Treas. Reg. §1.338(h)(10)-1T(d)(5)(i).
14 Treas. Reg. §1.338(h)(10)-1T(d)(4)(i).
15 However, if immediately prior to the stock sale, a shareholder’s basis in its stock (i.e., the outside basis) is less than the shareholder’s ratable portion of the aggregate basis of the corporation’s assets (i.e., the inside basis), the shareholder will recognize gain on the deemed liquidating distribution. In addition, to the extent that the built-in gains tax provisions of §1374 apply to the deemed asset sale, a corporate level tax would be imposed upon the deemed liquidating distribution. Section 1374 is beyond the scope of this article.
16 Treas. Reg. §1.338-1T(b)(1). However, New T is treated as a continuation of Old T for other provisions of the Code (e.g., the employment tax provisions) and for the income tax provisions specified in Treas. Reg. §1.338-1T(b)(2).
17 Treas. Reg. §1.338-5T.
18 Treas. Reg. §1.338-5T(a).
19 §1012.
20 Due to its pass-through nature, the S corporation is the preferred corporate form for most closely held businesses.
21 See New York City Bar Reports on Installment Method Reporting for Stock Sale Elections, 97 Tax Notes Today 108-38 (June 5, 1997) (New York City Bar Report).
22 If an S corporation target sells all of its assets for a purchase price which includes an installment obligation and then distributes the obligation in complete liquidation, installment reporting would generally be available with respect to installment obligation. See text accompanying note 29 infra.
23 §453(c).
24 Id.
25 See, e.g., New York City Bar Report and Ginsburg & Levin, Mergers, Acquisitions, and Buyouts, November 1999 at §§206.1.8 and 1108.3 (Ginsburg & Levin).
26 §453(f)(3).
27 §§338(a) and 338(h)(10).
28 §§453(h) and 453B(h). As noted above, the installment method of reporting would not be available to the extent the installment obligation is attributable to the sale of certain inventory items or marketable securities. See §§453(b)(2) and 453(k)(2). In addition, as discussed in Section IV of this article, the installment method of reporting is no longer available for installment obligations received by taxpayers who report their income using the accrual method of accounting.
29 See Treas. Reg. §1.338(h)(10)-1T(d)(8).
30 Treas. Reg. §1.338(h)(10)-1T(d)(8)(i).
31 Treas. Reg. §1.338(h)(10)-1T(d)(8)(ii). To the extent that the Deemed Price consists of amounts other than liabilities of Old T or installment obligations (i.e., generally either (i) the cash component of the purchase price or (ii) the grossing-up amount in cases where less than 100 percent of the stock is purchased), Old T is deemed to receive cash.Treas. Reg. §1.338(h)(10)-1T(d)(8)(i). The cash is then deemed to be distributed, in complete liquidation of Old T, to the selling shareholders who receive consideration in a form other than installment obligations and to the shareholders of target who do not sell their stock in the qualified stock purchase. Treas. Reg. §1.338(h)(10)-1T(d)(8)(ii). The shareholders of target who do not sell their stock are treated as purchasing New T shares for fair market value on the day after the qualified stock purchase. Treas. Reg. §1.338(h)(10)-1T(d)(5)(ii).
32 See Treas. Reg. §1.338(h)(10)-1T(e), Example 10. As previously discussed, to the extent the installment obligation is attributable to assets which are ineligible for the installment method of reporting (e.g., certain inventory), the installment method of reporting may not be used.
33 §453(h). A corporate level tax would apply to Old T upon the distribution of the installment obligation to the extent it is attributable to property which is subject to §1374.
34 See §§453(a), 453(h), and 453B(h).
35 See, e.g., John S. Harper, The Case Against Installment Method Repeal for Accrual Method S Corporations, 86 Tax Notes 557 (Jan. 24, 2000); Lee A. Sheppard, Installment Method Repealed For Whom?, 86 Tax Notes 8 (Jan. 3, 2000). In fact, Martin D. Ginsburg and Jack S. Levin write that they “would not be surprised by a Year 2000 legislative correction retroactively carving out an exception” in §453(a)(2) to provide that it is inapplicable to actual or deemed sales of all of the assets of an S corporation if the S corporation thereafter liquidates (or is deemed to liquidate). Ginsburg & Levin at § 206.1.8.
36 IRS Notice 2000-26 (April 10, 2000). After distribution of the installment obligation, the shareholders would not recognize any further gain upon payment of the obligations.
37 IRS Notice 2000-26 (April 10, 2000). The result would be the same under new §453(a)(2) if the accrual method target corporation had actually sold all of its assets for consideration which includes an installment obligation and then distributed the proceeds to its cash method shareholders in complete liquidation.
