1. Section 338(h)(10) Election.
    1. In General.
      1. Under the pre-1986 version of § 338, a corporation that sold the target's stock (the seller) was granted an election (a § 338(h)(10) election) to treat the stock sale as a sale of the target's assets in certain circumstances. This election was permitted only if there was a deemed sale of the target's assets under § 338 and if the stock sale was made by members of an affiliated group of corporations (of which the target was also a member) that filed a consolidated return. If the election were made, the sellers would recognize no gain or loss on the sale of the stock, but the gain or loss recognized on the constructive sale of the target's assets would be included in the selling group's consolidated return. An amendment to § 338(h)(10) that was made by TRA 1986 retains that provision and authorized the Treasury to extend the same treatment to certain other sellers.
      1. The amendment made by TRA 1986 authorizes the Treasury to promulgate regulations granting a § 338(h)(10) election to a sale of a target's stock by an affiliated group of which the target is a member regardless of whether the group files a consolidated return. An affiliated group of corporations is a group that meets the requirements of § 1504(a) without regard to the exception set forth in § 1504(b) (§ 338(h)(5)). In general, an affiliated group under § 1504(a) is a chain of two or more corporations with a common parent. For a corporation to be a member of an affiliated group, the corporation (other than the common parent of the group) must have outstanding stock owned by other members of the group that represent at least 80% of the voting power of such corporation's voting stock and have an aggregate value equal to at least 80% of the value of the corporation's outstanding stock. In determining whether the 80% of value requirement is satisfied, nonvoting, nonparticipating, nonconvertible preferred stock is ignored unless it provides redemption or liquidation rights that exceed its issue price plus a reasonable redemption or liquidation premium (§ 1504(a)(4)).
    1. Final Regulations.
      1. In the final regulations that were published in January, 1994, the § 338(h)(10) election was extended to certain affiliated corporations that do not file a consolidated return. In addition, the 1994 regulations allow the election to be made for the sale of stock of an S corporation. Accordingly, a § 338(h)(10) election can be made for a target only if the target is: a) a member of a selling consolidated group, b) a member of the selling affiliated group filing separate returns, or c) an S corporation (Reg. § 1.338(h)(10)-1(a), (d)).
        1. A selling consolidated group is a selling group that files a consolidated return for the period that includes T's acquisition date; T therefore will be a member of the consolidated group on the acquisition date (Reg. § 1.338(h)(10)-1(c)(3)).
        2. A selling affiliate is a domestic corporation from whom the purchasing corporation purchased sufficient T stock on the acquisition date to satisfy the stock holding requirements of § 1504(a)(2) and which is not a member of a selling consolidated group (Reg. § 1.338(h)(10)-1(c)(4)).
      1. A § 338(h)(10) election can be made only if a qualified stock purchase is made by P Co. (the purchasing corporation) from either a selling consolidated group, or a selling affiliate, or the shareholders of an S corporation. In the case of an affiliated group that does not file a consolidated return, the election is available only as to sales of T stock that are made by the selling affiliate; consequently, it appears that if more then one member of the affiliated group sold T stock to P Co., no more than one of its selling corporations (the selling affiliate) can benefit from the election.
      1. A § 338(h)(10) election applies to T only if a § 338 election is applicable to T. However, if a valid § 338(h)(10) election is made for T, that election is treated as simultaneously also making a § 338 election for T (Reg. § 1.338(h)(10)-1(d)(3)).
      1. A § 338(h)(10) election must be made jointly by the purchasing corporation and either the selling consolidated group, the selling affiliate, or the shareholders of the S corporation, as the case may be. The election must be made no later than the 15th day of the ninth month beginning after the month in which the acquisition date occurs (Reg. § 1.338(h)(10)-1(d)(2)).
      1. When a valid § 338(h)(10) election has been made for a target, old T is treated as having sold all of its assets in one transaction at the close of the acquisition date. Immediately after the deemed sale of its assets, T is deemed to have distributed all of the proceeds pursuant to a complete liquidation. The liquidation and distribution are deemed to have taken place while old T is still owned by the selling consolidated group or by the selling affiliate (or by its shareholders if T is an S corporation) (Reg. § 1.338(h)(10)-1(e)).
      1. If the § 338(h)(10) election is valid, no gain or loss is recognized by the selling consolidated group, the selling affiliate, or by the shareholders of a target that is an S corporation, for the sale of the target's stock that is part of a qualified stock purchase (Reg. § 1.338(h)(10)-1(e)(2)(iv)). Instead, those sellers will recognize gain or loss from T's deemed sale of its assets. Any sale of T's stock by some other seller (i.e., a shareholder who is not a member of a consolidated selling group and who is not a selling affiliate or a shareholder of an S corporation) will produce gain or loss to that seller. Such other shareholders are sometimes referred to as minority shareholders.
      1. Where T's constructive liquidating distribution is made to a selling consolidated group or to a selling affiliate, the liquidation will qualify for § 332 nonrecognition treatment; and, pursuant to the provisions of § 381, the selling consolidated group or the selling affiliate will inherit all or a part of T's tax attributes (such as its earnings and profits, its net operating loss, and capital loss carryovers). If T's constructive liquidating distribution is made to shareholders of an S corporation, it appears that the shareholders will recognize gain or loss; but, even if that is so, each shareholder's basis in his stock will first be increased by his share of old T's gain on the sale of its assets (§ 1367).
      1. If T's stock was sold by a selling consolidated group, the group must file a consolidated return for the period that includes the acquisition date (Reg. § 1.338(h)(10)-1(e)(6)); and so, the consolidated group will report in its consolidated return the gain or loss incurred by T on the deemed sale of its assets and will therefore incur the tax liability for that deemed sale. If, instead, T was an S corporation, its gain or loss from the deemed sale of its assets will pass through to its shareholders. If T's deemed liquidating distribution is made to a selling affiliate, it appears that the tax incurred by T on the deemed sale of its assets will be borne by the selling affiliate as a constructive transferee of T's assets. In any event, Reg. § 1.338(h)(10)-1(e)(1) provides that, when old T's stock which was purchased from a selling affiliate or from shareholders of an S corporation, the principles of several other regulatory provisions, including Reg. § 1.338(h)(10)-1(e)(6), apply to the return for old T's deemed sale. Reg. § 1.338(h)(10)-1(e)(6) requires a selling consolidated group to file a consolidated return for the period that includes the acquisition date. Applying that principle to a sale by a selling affiliate, the tax liability incurred because of the gain or loss recognized by old T on the deemed sale of its assets becomes a liability of the selling affiliate.
      1. Notwithstanding, when § 338(h)(10) applies, the sellers of old T's stock are primarily liable for the tax liability incurred on the deemed sale of old T's assets, new T also is liable for the tax liabilities that old T had (including the tax liability for the deemed sale of old T's assets) (Reg. § 1.338(h)(10)-1(e)(1)). Consequently, the purchasing corporation has a secondary vulnerability to bear the tax liability for the deemed sale of old T's assets.
      1. The basis that a selling consolidated group, selling affiliate, or shareholders of an S corporation have in T stock that they retain (i.e., do not sell to P Co.) is equal to the stock's fair market value as determined by a formula described later (see Reg. § 1.338(h)(10)-1(e)(2)(iii)).
      1. Minority shareholders (i.e., those who are not members of the selling consolidated group and who are not a selling affiliate or a shareholder of a target that is an S corporation) do not receive any special tax treatment from a § 338(h)(10) election. If they retain their stock in the target, they will recognize no gain or loss and their basis in their shares will remain the same as it was before the qualified stock purchase took place. If they sell to the purchaser any of their shares of the target's stock, they will recognize gain or loss on that sale (Reg. § 1.338(h)(10)-1(e)(3)).
      1. On the constructive sale of its assets, old T is treated as having received an amount determined under a formula. When a § 338 election is made (but a § 338(h)(10) election is not made), the selling price of the target's assets is determined by using a formula that is set forth in the regulations. The amount deemed to have been received by old T for its assets is referred to as the aggregate deemed sales price or by its acronym, ADSP. When a § 338(h)(10) election is made, the purchase price of the constructively sold assets is determined by a formula that is based on the ADSP formula with some modifications. The formula employed is a modified version of the ADSP formula and it is referred to as the MADSP formula (Reg. § 1.338(h)(10)-1(f)). In general, the MADSP is the sum of "G" plus "L" plus "X" where: "G" is the grossed-up basis of P Co.'s recently purchased target stock; "L" refers to the liabilities of new T at the beginning of the day after the acquisition date, but it appears that it does not include tax liabilities arising out of the constructive sale of old T's assets; and "X" refers to certain necessary adjustments (generally caused by events occurring after the acquisition date). The difference between the MADSP formula and the ADSP formula is that the latter takes into account the tax liability incurred as a consequence of the constructive sale and the former does not. When there is a § 338(h)(10) election, there is no reason to include the tax liability incurred on the constructive sale of T's assets in the purchase price since the § 338(h)(10) election places the incidence of that tax on the selling group. In a § 338 election in which a § 338(h)(10) election is not made, the incidence of that tax falls on the purchaser and so is properly included in the price paid for the assets.
      1. The MADSP is utilized both as the aggregate selling price constructively received for old T's assets and as the aggregate basis that new T acquired in those assets. The MADSP price, which serves as the selling price of all of old T's assets, and the basis of new T's assets, is allocated among those assets as set forth in § 1060. In general, this allocation operates by dividing assets into four broad categories and providing a priority of allocation among those categories (Reg. § 1.338(h)(10)-1(f)(1)(ii)).
      1. If any shares of old T's stock are retained by members of the consolidated group (or by the selling affiliate or by any of the shareholders of an S corporation), the basis of those retained shares will become their fair market value as determined according to the following formula. The fair market value of the retained shares equals the product of multiplying the percentage of T's outstanding stock represented by the retained shares times the difference between the grossed-up basis of P Co.'s recently purchased T stock and certain capitalized expenses P Co. incurred in acquiring the recently purchased T stock (Reg. § 1.338(h)(10)-1(e)(2)(iii)). In most cases, the formula will construct the fair market value of the retained shares as an amount equal to the product of multiplying the percentage of T's outstanding stock that is represented by the retained shares times the difference between the MADSP amount for T and the amount of new T's liabilities immediately after the acquisition date (Reg. § 1.338(h)(10)-1(g)(2), Ex. (2)(b)(iv)).
      1. If, at the acquisition date, the purchasing corporation owned shares of stock of T that were acquired prior to the twelve-month acquisition period (such shares are referred to as non-recently purchased stock), P Co. is required to recognize gain (but not loss) on the amount of appreciation (if any) of those shares at the acquisition date; and P Co.'s basis in those shares will equal their fair market value at the acquisition date. P Co. was treated as having made an election under § 338(b) to step up the basis of its non-recently purchased stock by treating them as having been sold on the acquisition date for their fair market value (Reg. § 1.338(h)(10)-1(e)(4)). Under § 338(b), the selling price of those shares (i.e., their fair market value) is determined according to a formula rather than by appraisal (Reg. § 1.338(h)(10)-1(e)(4)). Accordingly, the constructive selling price of those shares, which establishes the amount of P Co.'s gain on constructive sale and which also establishes P Co.'s basis in those shares, is determined under Reg. § 1.338(b)-1(e)(3).
      1. The § 338(h)(10) election only applies when a § 338 election also applies. TRA 1986 established an election that is similar to § 338(h)(10) for certain sales or distributions of stock of a subsidiary. When a corporation sells, exchanges or distributes all of its stock in a subsidiary, § 336(e) provides an election to treat that transaction as a disposition of all the assets of the subsidiary, and no gain or loss will be recognized on the sale, exchange, or disposition of the subsidiary's stock. This provision applies only if the parent corporation owns stock of the subsidiary representing at least 80% of the voting power of the subsidiary's voting stock and having a value equal to at least 80% of the value of all of the subsidiary's outstanding stock (in determining whether the latter 80% requirement is met, nonvoting, nonparticipating, nonconvertible preferred stock which has limited redemption and liquidation rights is ignored). A number of questions as to the manner in which an election under § 336(e) is to be made and the effect of making that election should be answered by the regulations when they are promulgated. For example, will the gain or loss from the constructive sale of the subsidiary's assets be recognized by the parent and will the basis of the subsidiary's assets be changed to reflect this constructive sale? Since the sale of the subsidiary's stock would qualify for a § 338(h)(10) election (the parent will qualify as a selling affiliate), perhaps a § 336(e) election will be treated the same as a § 338(h)(10) election is treated.
    1. Examples and Summary.
      1. Examples. The following examples illustrate the principles of Reg. § 1.338(h)(10)-1. In each example Old Target is an S corporation. The selling shareholder is assumed to be subject to a 39.6% marginal tax rate for ordinary income and 28% for capital gains. No transaction costs are incurred on the sale.
        Example 21: The stock of Old Target (Old T) has an FMV of $50,000 and a basis to the selling shareholder (S) of $10,000. Old T elected to be treated as an S corporation on incorporation and is not subject to the built-in gains tax of § 1374. Purchaser P, a C corporation, wishes to buy Old T from S. Old T's gross inside asset basis is $20,000. In addition, Old T has $3,000 in liabilities, so that its net book value is $17,000. No depreciation has been claimed on any assets held. Any gain generated in a sale of assets would be treated as § 1231 gain to Old T and, therefore, taxable to S at capital gains rates.
        Before addressing the § 338(h)(10) election, first consider the tax consequences of a straight stock sale. S would recognize $40,000 gain ($50,000 sales price minus $10,000 basis). The gain would be capital and S would be subject to capital gains tax of $11,200 (28% of $40,000), resulting in net cash to S of $38,800. P would take a $50,000 basis in the stock of Old T, the purchase price, and Old T would retain its $20,000 historical basis in its assets.
        Assume that a valid § 338(h)(10) election is made. The straight stock sale would be reconstructed as a deemed asset sale. The $50,000 paid by P to S for the Old T stock would be deemed to be transferred to Old T in exchange for it assets and the assumption of its liabilities. Accordingly, Old T's $3,000 liability assumed by P is added to the sales price to arrive at a MADSP of $53,000, and Old T's adjusted asset basis of $20,000 is deducted, resulting in a § 1231 gain of $33,000. The § 1231 gain is passed through to S, who pays tax at 28% or $9,240. S increases the basis in the Old T shares from $10,000 to $43,000 ($10,000 plus $33,000 deemed sale gain passed through).
        Old T is then treated as having liquidated and distributed the $50,000 of proceeds to S in liquidation. S would pay capital gains tax of $1,960 on an additional $7,000 ($50,000 realized minus $43,000 basis). Total tax paid by S on the § 338(h)(10) deemed sale is $11,200, exactly the tax that would have been paid under a straight stock sale.
        Under the § 338(h)(10) election, P is treated as having formed new target (New T), which has purchased the assets of Old T. New T will take a basis (AGUB) in total assets of $53,000 ($50,000 purchase price plus $3,000 of liabilities assumed) and will begin its tax life just as if it were a new corporation with purchased assets.
        Example 22: The facts are the same as in Example 21, except that Old T's gross inside asset basis is $30,000, which has been reduced by accumulated depreciation of $10,000, for a net adjusted asset basis of $20,000. Accumulated depreciation subject to recapture as ordinary income is $3,000. Any remaining gain is taxable to S as § 1231 gain.
        A valid § 338(h)(10) election is made. As in Example 21, the total gain on the deemed asset sale is $33,000. From this amount, $3,000 ordinary income depreciation is subtracted, leaving a § 1231 gain of $30,000. S recognizes the $3,000 ordinary income passed through and is taxed at 39.6%, resulting in a tax of $1,188. The $30,000 § 1231 gain is also passed through to S and taxed at 28%, or $8,400. S increases the basis in the Old T shares from $10,000 to $43,000 ($10,000 plus $33,000 deemed sale gain passed through).
        Old T is then treated as having liquidated and distributed the $50,000 of proceeds to S in liquidation. S would pay capital gains tax of $1,960 on an additional $7,000 ($50,000 realized minus $43,000 basis). Total tax paid by S on the sale under the § 338(h)(10) election is $11,548, or $348 more than S would have paid under a straight stock sale. S has paid tax on the same total amount of gain in each case ($40,000). The $348 increase in tax relates to the 0.116 rate differential (39.6% minus 28%) on the $3,000 ordinary income portion of the gain.
        The result in this example to the buyer is the same as in Example 21. New T will take a basis in total assets of $53,000. However, this basis increase has come at the cost of an increased tax liability to S. Ordinarily this increase in basis available to the buyer will cause the parties to agree to increase the purchase price to cover at least some of S's increased tax liability.
        Example 23: The facts are the same as in Example 22, except that Old T was previously a C corporation and is subject to the § 1374 built-in gains tax. Of the built-in gain inside Old T, $10,000 represents taxable gain.
        If no § 338(h)(10) election is made, the results of this transaction will be the same as those outlined in Example 21. S will recognize capital gain on the sale of the stock, P will take a basis in the stock equal to the cash purchase price, and Old T will retain its historic tax basis in its assets. If, however, a joint election under § 338 (h)(10) is made, the results change significantly from those in
        Example 21.
        Under the § 338(h)(10) election, Old T is deemed to sell its assets for the MADSP. Before consideration of the built-in gains tax, MADSP and the gain on the deemed assets sale are tentatively determined as follows:

Basis of New T Stock

$50,000

New T's Liabilities

3,000

Other Relevant Items

0

Tentative MADSP

$53,000

Less Adjusted Basis of Assets

( 20,000)

Tentative Gain on Sale

$33,000

        Under § 1374, Old T must pay income tax at the highest rate under § 11(b), currently 35%. Accordingly, Old T must pay built-in gains tax on the lesser of the built-in gain ($10,000) or the actual gain on the sale. As will be illustrated, the actual gain on the sale will be greater than $33,000, but currently no less than the amount of the built-in gain. Accordingly, Old T must pay a built-in gains tax of $3,500 (35% x $10,000).
        Once the amount of the built-in gains tax is known, a final determination of MADSP may be made. The built-in gains tax is a liability that carries over and is assumed by New T. (It is assumed that the tax liability that results under § 1374 remains a liability of the target corporation after the transaction, although the regulations under Reg. § 1.338(h)(10)-1(b)(3) fails to address this issue.) Accordingly, the built-in gains tax represents a New T liability in determining MADSP. The final MADSP and gain on the deemed sale are determined as follows:

Basis of New T Stock

$50,000

New T's Liabilities

(including built-in gains tax)

$6,500

Other Relevant Items

$0

Tentative MADSP

$56,500

Less Adjusted Basis of Assets

( 20,000)

Tentative Gain on Sale

$36,500

Less ordinary income recaptured

( 3,000)

§ 1231 gain

$33,500

        The gaim passed through, the tax thereon and the basis effects to S are determined as follows:

Ordinary income passed through

$ 3,000

Less applicable built-in gains tax

( 288) *

Ordinary Income

Included in S's taxable income

$ 2,712

Tax at ordinary Income Rates

$ 1,074

§ 1231 gain passed through

$ 33,500

Less applicable built-in gains tax

( 3,212)

§ 1231 gain

Inlcuded in S's taxable income

30,288

Tax at capital gains rates

$ 8,481

Original stock basis

$10,000

Plus ordinary income passed through

2,712

Plus § 1231 gain passed through

30,288

Total basis before deemed liquidation

$43,000

Deemed liquidation proceeds

$50,000

Capital gain on liquidation

$ 7,000

Tax at capital gains rates

$ 1,960

Total Tax Paid by S

$11,515

* $3,500 x

3,000

$33,500 + $3,000

        Effects on P:

Basis in shares of New T

$50,000

New T's Liabilities

6,500

Other Relevant Items

0

Total AGUB

$56,500

        The IRS receives $15,015 ($11,515 paid by S plus $3,500 built-in gains tax paid by New T) as opposed to $11,200 if no § 338(h)(10) election is made. The increase of $3,815 represents the tax on the built-in gain assumed by P and the increased tax to S from the rate differential on the ordinary income. P is compensated for the tax assumed by achieving a step-up from $20,000 to $56,500. Whether the tax cost associated with this step up is justified depends on how rapidly P can achieve the tax savings associated with it.
      1. Summary of Examples.
        1. The three examples provide a basis for overall conclusions concerning the anticipated results of a § 338(h)(10) election for an S corporation target. The tax costs to the seller and buyer in each of the situations are:

Seller

Buyer

Totals

Straight Stock Sale

$ 11,200

0

$ 11,200

Election under § 338(h)(10) (Assuming no ordinary income)

$ 11,200

0

$ 11,200

Election Under § 338(h)(10) (Assuming ordinary income)

$ 11,548

0

$ 11,548

Election Under § 338(h)(10) (Assuming ordinary income and built-in gains tax)

$ 11,515

$ 3,500

$ 15,015

        1. As is illustrated, assuming that S will pay the same rate of tax on asset gain as would be paid on stock gain, S should be indifferent as to whether a § 338(h)(10) election is made. In addition the existence of ordinary income potential will increase the tax cost to S of a § 338(h)(10) election as opposed to a straight stock sale. When the built-in gains tax is added (and assuming the existence of ordinary income potential), S will generally pay more tax than if it simply had sold stock, but less tax than if there had been no corporate built-in gains tax liability. P might be forced to pay the increased total tax liability due to the built-in gains tax.