PLC - Stock Acquisitions_ Tax Overview

12/31/12 PLC - Stock Acquisitions: Tax Ov erv iew

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Stock Acquisitions: Tax Overview

Resource type: Practice Note: Overview

Status: Maintained

Jurisdiction: USA

An overview of the tax considerations involved when buying or selling the stock of a corporation.

PLC Corporate & Securities

Contents

Stock Acquisitions versus Asset Acquisitions

Sellers Generally Prefer to Sell Stock

Buyers Generally Prefer to Buy Assets

In an Economic Downturn, Buyers May Prefer to Buy Stock

Structure of a Taxable Stock Acquisition

Tax Consequences to a Target Company Stockholder

The Amount Realized by a Target Company Stockholder

The Gain or Loss Recognized by a Target Company Stockholder

The Timing of Gain Recognition and the Form of Consideration

Gain Recognition May be Deferred in Stock Sales with Escrows and Earn-outs

Tax Consequences to the Target Company

Limitations on the Use of Tax Attributes After the Stock Acquisition

Tax Consequences to the Buyer

Pre-Closing Income Taxes of the Target Company

Sales, Use and Other Transfer Taxes under State Law

FIRPTA Withholding

Stock Acquisitions Treated as Asset Acquisitions

Section 338(h)(10) Election

Section 338(g) Election

Proposed Section 336(e) Election

This Note focuses on the tax aspects of a stock acquisition. For a discussion of other considerations

involved when buying or selling the stock of a corporation, see Practice Note, Stock Acquisitions:

Overview (www.practicallaw.com/4-380-7696).

Unless otherwise indicated, this Note addresses only US federal income tax considerations and assumes

that:

The stock acquisition is for all of the outstanding stock of the target company.

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The stock acquisition is structured as a taxable transaction.

The stock acquisition is not structured as a merger.

The purchase price is paid in full at closing.

The buyer is a private US corporation that is a C-corporation (www.practicallaw.com/1-383-9868).

The target company is a solvent, private US corporation that is a C-corporation.

The target company has only US stockholders.

The target company is not a member of a consolidated group (either before or after the stock

acquisition) for tax purposes.

The buyer and target company are not related parties.

For a discussion of the tax issues in a stock acquisition when the target company is taxed as a pass-

through entity, see Practice Note, Taxation of Pass-through Entities (www.practicallaw.com/2-503-9591). For

a discussion of common tax issues that arise for buyers and sellers in acquisitions of financially distressed

targets, see Practice Note, Tax Traps in an Acquisition of a Financially Distressed

Target (www.practicallaw.com/2-503-3971).

Stock Acquisitions versus Asset Acquisitions

In a stock acquisition, the buyer acquires all of the outstanding stock of the target company. By doing so,

the buyer acquires all the assets, rights and liabilities (including unknown or undisclosed liabilities) of the

target company as a matter of law. This is fundamentally different from an asset acquisition where the buyer

only acquires the assets and liabilities it identifies and agrees to acquire and assume. The buyer and seller

must consider both tax and nontax factors when deciding between a stock and stock acquisition. As a

general matter, sellers prefer to sell stock and buyers prefer to buy assets.

Sellers Generally Prefer to Sell Stock

For nontax factors, sellers generally prefer to sell stock because the buyer assumes all liabilities of the

target company as a matter of law in a stock acquisition (whereas sellers are left with known and unknown

liabilities of the target company not assumed by the buyer in an asset acquisition). In addition, asset

acquisitions are more complicated and time consuming than stock acquisitions. For further discussion of

nontax factors, see Practice Notes, Asset Acquisitions: Overview (www.practicallaw.com/6-380-7695),

Stock Acquisitions: Overview (www.practicallaw.com/4-380-7696) and Private Acquisition

Structures (www.practicallaw.com/6-380-9171).

The tax treatment of a stock acquisition generally is more favorable for sellers because it often results in a

single level of taxation (at the stockholder level) as opposed to potential double taxation (at the entity and

stockholder level) in an asset acquisition (see Tax Consequences to a Target Company Stockholder, Tax











Consequences to the Target Company and Practice Note, Asset Acquisitions: Tax

Overview (www.practicallaw.com/6-383-6235)).

Buyers Generally Prefer to Buy Assets

For nontax factors, buyers generally prefer to buy assets because the ability to pick and choose specific

assets and liabilities provides the buyer with flexibility. The buyer does not waste money on unwanted

assets and there is less risk of it assuming unknown or undisclosed liabilities. For further discussion of

nontax factors, see Practice Notes, Asset Acquisitions: Overview (www.practicallaw.com/6-380-7695) and

Private Acquisition Structures (www.practicallaw.com/6-380-9171).

In an asset acquisition, the buyer receives a cost basis (www.practicallaw.com/4-382-3366) in the

acquired assets. This means the buyer acquires a basis (www.practicallaw.com/5-382-3262) in the

acquired assets equal to the purchase price paid plus assumed liabilities and certain other items. In a stock

acquisition, the target company's basis in its assets generally remains unchanged (see Tax Consequences

to the Target Company).

For tax purposes, a buyer generally prefers to receive a cost basis in the acquired assets. A cost basis

often is higher than the basis that the target company had in those assets (referred to as a stepped-up

basis (www.practicallaw.com/6-382-3841)). Basis is used, among other things, to calculate depreciation

and amortization deductions, as well as income, gain or loss on the sale or other disposition of the assets.

A stepped-up basis benefits the buyer by enabling it to take greater depreciation and amortization

deductions on such assets and by reducing the amount of taxable income or gain (or increasing the amount

of loss) on a later sale or other disposition of the assets.

For a further discussion of the tax considerations involved when buying the assets of a target company, see

Practice Note, Asset Acquisitions: Tax Overview (www.practicallaw.com/6-383-6235).

In an Economic Downturn, Buyers May Prefer to Buy Stock

For tax purposes, the buyer's basis in the acquired assets cannot exceed the fair market value of the

acquired assets. Therefore, if the buyer is purchasing assets from a target company whose asset values

have gone down (in other words, the target company’s basis in its assets exceeds their fair market

value), the asset purchase results in a "step-down" in the basis of the acquired assets. This may happen

more often in an economic downturn. A buyer generally prefers to structure a transaction as a stock

acquisition if there would be a step-down in the basis of the acquired assets (see Practice Note, Asset

Acquisitions: Tax Overview (www.practicallaw.com/6-383-6235)).

Structure of a Taxable Stock Acquisition

A taxable stock acquisition can be structured as:

A direct acquisition of all of the outstanding stock of the target company.

A merger treated as a stock acquisition for tax purposes.













The buyer generally acquires the target company's stock (either by direct acquisition or merger) with cash

or notes (or some combination of the two), but other consideration such as the buyer's or its affiliate's stock

can also be used.

In a direct acquisition of the target company's stock, the buyer acquires all of the outstanding stock of the

target company directly from the target company stockholders. After the transaction, the target company

either maintains its corporate existence and becomes a subsidiary of the buyer or liquidates into the buyer

(this liquidation is often structured as an upstream merger for corporate purposes). For more information,

see Practice Note, Stock Acquisitions: Overview (www.practicallaw.com/4-380-7696).

Alternatively, a taxable stock acquisition can be structured as a merger. Reverse triangular mergers and

reverse mergers generally are treated as stock acquisitions for tax purposes. A reverse triangular merger is

a state law merger of a buyer's newly formed or existing subsidiary (a merger

subsidiary (www.practicallaw.com/9-382-3627)) with and into the target company. After the merger, the

target company survives and becomes the buyer's subsidiary. A transaction can also be structured as a

reverse merger (www.practicallaw.com/4-503-5441) but this is not commonly used. Forward

mergers (www.practicallaw.com/8-382-3406) and forward triangular

mergers (www.practicallaw.com/9-382-3496) generally are treated as asset acquisitions for tax purposes.

For a further discussion of acquisitions that are structured as mergers, see Practice Notes, Private

Acquisition Structures (www.practicallaw.com/6-380-9171), Private Mergers:

Overview (www.practicallaw.com/0-380-9145), Public Mergers: Overview (www.practicallaw.com/4-382-2164),

and Mergers: Tax Overview (www.practicallaw.com/0-383-6747).

Tax Consequences to a Target Company Stockholder

A target company stockholder generally recognizes a taxable gain or loss on the sale of its stock equal to

the difference between the "amount realized" on the sale and the target company stockholder's basis in its

stock. For tax years beginning on or after January 1, 2013, a 3.8% medicare tax may apply to gains earned

by certain individuals, trusts and estates (see IRC § 1411).

The Amount Realized by a Target Company Stockholder

The amount realized on the stock sale includes more than the cash consideration received by a target

company stockholder. It includes among other things:

The fair market value of any stock (or other property) received by a target company stockholder.

The amount of any buyer or third party notes received by a target company stockholder.

The Amount Realized Includes the Fair Market Value of any Property

In calculating a target company stockholder's amount realized when stock (or other property) is used as

consideration, the property generally is treated like a cash payment equal to the fair market value of the

property. For example, if a buyer bought target company's stock from a target company stockholder with a

cash payment of $100,000 and stock with a fair market value of $50,000, the amount realized by the target

company stockholder on the stock sale is $150,000.












If Stock is Used as Consideration, the Stock Acquisition may Qualify as a Tax-Free Transaction

If stock of the buyer or its affiliate is used as consideration, it may be possible to structure a stock

acquisition as a tax-free reorganization (www.practicallaw.com/3-382-3871). Private company stock

acquisitions generally are structured as taxable transactions for business reasons, unless the buyer or

its affiliate is a public company. One business reason is that there generally is no market for the stock

of a private company so sellers are often not willing to accept it as consideration. In addition, sellers that

would recognize a loss in a stock acquisition prefer to structure the transaction as a taxable transaction.

This is because sellers are unable to recognize a loss in a tax-free transaction. For more information

about tax-free reorganizations, see Practice Notes, Tax-Free Reorganizations: Acquisitive

Reorganizations (www.practicallaw.com/0-386-4212) and What's Market: Tax-free

Transactions (www.practicallaw.com/5-386-1032).

The Amount Realized Includes the Amount of any Buyer or Third Party Notes

If the consideration includes buyer or third party notes, the target company's amount realized on the stock

sale includes the amount of any buyer or third party note. For example, if a buyer bought target company's

stock from a target company stockholder with a cash payment of $100,000 and a $50,000 buyer note, the

amount realized by the target company stockholder on the stock sale is $150,000. If buyer notes are used

as consideration, a target company stockholder may be able to defer certain gain recognition until the buyer

notes are paid (or disposed of) under Section 453 of the Internal Revenue

Code (www.practicallaw.com/2-382-3555) (IRC) (see The Timing Of Gain Recognition and the Form Of

Consideration).

The Gain or Loss Recognized by a Target Company Stockholder

If the shares were held as capital assets for more than one year, a target company stockholder recognizes

a long-term capital gain (www.practicallaw.com/2-382-3305) or capital loss (www.practicallaw.com/8-

382-3307). Long-term capital gain of an individual generally is taxed at a preferential rate (currently a

maximum tax rate of 15%, see IRC § 1(h)(1)). Corporate capital gains are not taxed at a preferential rate.

This means that the tax rates applicable to ordinary income (www.practicallaw.com/0-382-3660) and

capital gain of a corporation are currently the same (see IRC §§ 11 and 1201). For tax years beginning on or

after January 1, 2013, a 3.8% medicare tax may apply to gains earned by certain individuals, trusts and

estates (see IRC § 1411).

The Timing of Gain Recognition and the Form of Consideration

If the purchase price is paid in cash or stock (or some combination of the two) at closing, a target company

stockholder generally recognizes the full amount of any gain or loss immediately.

If the consideration includes buyer notes, the target company stockholder's amount realized on the stock

sale includes the amount of any buyer notes. In this case, the target company stockholder may be able to

use the installment method to defer the recognition of a certain amount of gain until the note is paid (or

disposed of) if all of the following:

At least one payment is received in a tax year after the year of sale (in other words, the sale provides

for deferred payments and meets the definition of an "installment sale" in IRC Section 453(b)).











The notes are issued by the buyer (generally not a third party) and are not payable on demand or

readily tradeable (see IRC § 453(f)(4-5)).

The target company stock is not traded on an established securities market (see IRC § 453(k)).

Under the installment method, the total recognized gain from the sale generally is prorated and reported by

a target company stockholder over several years as payments are received. The installment method does

not apply when a loss is recognized on the sale; the full amount of any loss is recognized immediately.

For example, assume on January 1, 2010, a target company stockholder sold stock for both a:

$40,000 cash payment.

$60,000 buyer note which bears adequate interest and is payable in two equal installments on January

1, 2011 and 2012 (so both payments on the notes occur after the year of sale).

If the target company stockholder has a $50,000 basis in its stock, the target company stockholder's total

gain recognized on the sale is $50,000 (amount realized of $100,000 minus basis of $50,000). Assuming

that the sale qualifies for the installment method, the target company stockholder is taxed on the stock sale

as follows:

Year one. 40% of the gain ($20,000) (because the target company stockholder received $40,000, or

40% of the total amount realized in year one) plus any interest received on the buyer note is

recognized.

Year two. 30% of the gain ($15,000) (because the target company stockholder received $30,000, or

30% of the total amount realized in year two) plus interest received on the buyer note is recognized.

Year three. 30% of the gain ($15,000) (because the target company stockholder received $30,000, or

30% of the total amount realized in year three) plus interest received on the buyer note is recognized.

If the buyer note does not provide for adequate interest, interest generally is imputed to the target company

stockholder (see IRC §§ 483 and 1274).

The benefit of the installment method is decreased in large stock sales because IRC Section 453A

generally imposes an annual interest charge on the target company stockholder's deferred tax liability in

any year that the aggregate face amount of installment notes (arising from all sales by the target company

stockholder with a sales price exceeding $150,000) exceeds $5 million.

The pledge of a buyer note (arising from a sale with a sales price exceeding $150,000) as security for a

borrowing by the target company stockholder generally accelerates the recognition of the gain that was

deferred by the installment method (see IRC § 453A(d)). For example, assume the same facts as above,

except that the target company stockholder pledges the $60,000 buyer note as security for a $30,000

borrowing. The target company stockholder immediately recognizes 50% ($30,000 divided by $60,000) of

the gain that was deferred by the installment method.

If a transaction meets the requirements for an installment sale, the installment method must be used unless

the taxpayer formally elects not to have it apply (see IRC § 453(d)). If there are multiple sellers, the

installment method can be used by a target company stockholder even if some of the stockholders elect not



to use the installment method.

If a target company stockholder elects not to use the installment method, the full amount of gain is

recognized in the year of the sale even though some payments of purchase price are deferred and paid after

the year of sale. A target company stockholder with expiring net operating

losses (www.practicallaw.com/8-382-3642) (NOLs) (or other tax attributes) may want to elect not to use

the installment method (for more information on NOLs and other tax attributes, see Limitations on the Use

of Tax Attributes After the Stock Acquisition).

Gain Recognition May be Deferred in Stock Sales with Escrows and Earn-outs

The installment method may also be available to a target company stockholder if a portion of the

purchase price is held in escrow (or there is an earn-out) and all or a portion of the escrow (or earn-out)

is released (or paid) to the target company stockholder in a tax year after the sale. For more information

on escrows and earn-outs, see Practices Notes, Earn-outs (www.practicallaw.com/0-500-1650),

Accounting for Transaction Costs and Earn-outs in M&A (www.practicallaw.com/4-504-4662) and Stock

Purchase Agreement Commentary (www.practicallaw.com/6-381-0589).


The stock sale generally does not have any immediate tax consequences for the target company. The

target company does not recognize gain or loss as a result of the sale and the target company's basis in its

assets remains unchanged unless an election is made to treat the stock acquisition as an asset acquisition

for tax purposes (see Stock Acquisitions Treated as Asset Acquisitions). However, the use of pre-

acquisition tax attributes (such as NOLs) of the target company may be limited after the sale (see

Limitations on the Use of Tax Attributes After the Stock Acquisition).

After the sale, the target company either maintains its corporate existence and becomes a subsidiary of the

buyer or liquidates into the buyer. If the target company liquidates into the buyer, the liquidation generally is

not taxable to either the target company or the buyer (see IRC §§ 332 and 337). This is because the buyer

is a 100% corporate stockholder of the target company after the sale.

Limitations on the Use of Tax Attributes After the Stock Acquisition

Before an acquisition, the target company may have valuable tax attributes that can be used to offset its

taxable income and a buyer may want to obtain access to those pre-acquisition tax attributes. One

example of a valuable tax attribute is NOLs. A taxpayer has a NOL when its allowable deductions exceed

its gross income in a specific taxable year (see IRC § 172).

The buyer in a stock acquisition generally obtains access (indirectly through stock ownership of the target

company) to the pre-acquisition tax attributes (such as NOLs) of the target company. These tax attributes

generally are used by the target company to offset its future taxable income, subject to limitations in the

IRC.

The buyer in a taxable asset acquisition generally does not obtain access to a target company's tax

attributes. Instead, the target company retains its tax attributes and may use its NOLs and other tax

attributes to both:










Reduce or eliminate the entity level gain recognized on the asset sale.

Offset any future taxable income of the target company.

After a stock acquisition, several Sections of the IRC may limit the use of pre-acquisition tax attributes of

the target company (see IRC §§ 172, 269, 381, 382 and 384 and the treasury

regulations (www.practicallaw.com/0-382-3882) relating to consolidated groups). IRC Section 382

generally limits the post-acquisition use of pre-acquisition NOLs (and certain built-in losses) of the target

company if there is a more than 50% ownership change in the target company's stock ownership over a

three-year period (such as, a buyer's purchase of more than 50% of the stock of the target company). After

a 50% ownership change, the target company can often use its pre-acquisition NOLs (and certain built-in

losses), but that use is limited annually to an amount equal to the value of the target company's stock at

the time of the acquisition multiplied by a statutory interest rate (see IRC § 382(b)(1)).

For example, assume that a buyer purchases 100% of the stock of the target corporation. At the time of the

sale, the target company had a value of $100,000 and a $50,000 NOL. There has been a 50% ownership

change, so the target company's post-acquisition use of its $50,000 NOL is annually limited by IRC Section

382. If, for example, the applicable statutory rate is 6%, the Section 382 annual limitation is $6,000 (6% of

$100,000), which means that the target company's post-acquisition use of its pre-acquisition NOL is limited

to $6,000 per year (for each year that it carries over).

If the target company has $80,000 of taxable income in its first taxable year after the stock sale:

The target company would only be allowed to use $6,000 of its $50,000 NOL in that year, so it would

have taxable income of $74,000 ($80,000 minus $6,000).

The remaining $44,000 of NOL generally carries forward (until it expires) and can be used to offset future

taxable income subject to the Section 382 limitation.

If the NOL expires five years after the stock sale, the target company will lose $20,000 of NOLs

($50,000 minus $6,000 multiplied by five).

In the absence of a 50% ownership change, the target company could have used the full $50,000 NOL in

that year to offset its taxable income, so it would have taxable income of $30,000 ($80,000 minus $50,000).

If the target company liquidates tax-free into the buyer after the stock acquisition, the target company's tax

attributes generally carry over and can be directly used by the buyer (see IRC §§ 381 and 332), subject to

certain limitations in the IRC. For example, any Section 382 limitation that applied to the target company

because of the buyer's stock acquisition also applies to the buyer's use of any remaining pre-acquisition

NOLs (and certain built-in losses) of the target company. For example, assuming the same facts as above,

except that the target company liquidated tax-free into the buyer after the stock acquisition (see IRC §§ 332

and 337), the buyer's use of the target company's pre-acquisition NOL is annually limited to $6,000.


The buyer receives a cost basis in the target company's stock. This means that the buyer acquires a basis

in the acquired stock equal to the purchase price paid plus certain other items. The buyer generally receives




a full cost basis at the time of the sale even if purchase price payments are deferred and the target

company stockholders use the installment method (see The Timing of Gain Recognition and the Form of

Consideration).

The target company's basis in its assets remains unchanged unless an election is made to treat the stock

acquisition as an asset acquisition for tax purposes (see Stock Acquisitions Treated as Asset

Acquisitions).

After the sale, the target company either maintains its corporate existence and becomes a subsidiary of the

buyer or liquidates into the buyer. If the target company liquidates into the buyer, the liquidation generally is

not taxable to either the target company or the buyer (see IRC §§ 332 and 337). This is because the buyer

is a 100% corporate stockholder of the target company after the sale. The buyer takes a carryover

basis (www.practicallaw.com/2-382-3310) in the assets of the target company after a tax-free liquidation.

The buyer (indirectly through stock ownership of the target company or directly after a tax-free liquidation)

also obtains access to pre-acquisition tax attributes (such as NOLs) of the target company, which generally

can be used to offset future taxable income, subject to limitations in the IRC (see Limitations on the Use of

Tax Attributes After the Stock Acquisition).

Pre-Closing Income Taxes of the Target Company

In a stock acquisition of all of the outstanding stock of the target company, the buyer acquires all the

assets, rights and liabilities (including pre-closing income tax liabilities) of the target company as a matter

of law. However, the stock purchase agreement generally requires the seller (of a private company) to

indemnify the buyer for pre-closing taxes and for certain third party taxes (such as tax liabilities of a

consolidated group).

Sales, Use and Other Transfer Taxes under State Law

Unlike an asset acquisition, stock acquisitions generally are not subject to sales, use or other transfer

taxes. However, a few states impose a stock transfer tax, and a few states impose a real estate transfer tax

on the sale of a controlling interest in a real property entity. It is advisable to consult with a state law tax

specialist when structuring an acquisition.

FIRPTA Withholding

A buyer generally is required to withhold a 10% tax with respect to acquisitions of US real property

(such as stock of a "United States real property holding corporation") from a foreign seller. This is

referred to as FIRPTA (Foreign Investment in Real Property Tax Act) withholding (see IRC § 897). This

10% tax is applied to the amount realized by the foreign seller. If the buyer does not withhold the 10%

tax, it may be responsible for the payment of the tax as well as tax penalties and interest. For this

reason, a buyer generally requires a seller to provide a certificate of nonforeign status at or prior to

closing to ensure that no FIRPTA withholding is required by the buyer.

Stock Acquisitions Treated as Asset Acquisitions







In certain circumstances, an election can be made to treat a stock acquisition as an asset acquisition for

tax purposes:

This usually is accomplished by the buyer and seller making a joint Section 338(h)(10)

election (www.practicallaw.com/9-382-3203).

The buyer can also make an election under IRC Section 338(g) (a Section 338(g) election) but this

election is less common because it often results in adverse tax consequences for the seller.

After proposed treasury regulations are finalized, a seller will be able to make an election under IRC

Section 336(e) (see Box, Proposed Section 336(e) Election).

The buyer generally prefers to make an election to treat a stock acquisition as an asset acquisition for tax

purposes if the buyer receives a stepped-up basis in the target company's assets (but this may not always

be the case, see Box, In an Economic Downturn, Buyers May Prefer to Buy Stock ).

To make a Section 338(h)(10) election, there generally must be all of the following:

A taxable purchase of at least 80% of a US target corporation (that is a C-corporation) within a 12-

month period.

A corporate buyer.

A US corporate seller that owns at least 80% of the US target corporation.

In some instances, a Section 338 (h)(10) election can also be made if the target corporation is an S-

corporation (www.practicallaw.com/2-382-3782) (see Treasury Regulations § 1.338(h)(10)-1(c)).

To make a Section 338(g) election, there must be both:

A taxable purchase of at least 80% of a US or foreign target corporation within a 12-month period.

A corporate buyer.

Unless otherwise indicated, the following discussion of Section 338(h)(10) elections and Section 338(g)

elections assumes that a US corporate seller owns 100% of the stock of a US target company (which is a

C-corporation for tax purposes).

Section 338(h)(10) Election

If a Section 338(h)(10) election is made, the stock sale is ignored for tax purposes. Instead, the target

company generally is treated as making a deemed taxable sale of its assets and then liquidating tax-free

into the seller.

Because the buyer and seller must jointly make a Section 338(h)(10) election, the tax consequences to

each party must be considered.


The tax treatment to the target company is generally the same as an actual sale of its assets followed by a







tax-free liquidation into the seller:

The target company generally recognizes taxable income, gain or loss on the deemed sale of its

assets.

The target company can use its NOLs and other tax attributes to reduce or eliminate the entity level

gain recognized on the deemed asset sale.

The amount and character (ordinary or capital) of the income, gain or loss from the deemed asset sale

is determined asset by asset.

The parties must agree to an allocation of the purchase price among the assets for tax purposes.

If buyer notes are used as consideration, the installment method may be available to defer the

recognition of a certain amount of gain on the deemed asset sale (see Treasury Regulations § 1.338(h)

(10)-1(d)(8)).

The target company does not recognize taxable gain or loss on a liquidating

distribution (www.practicallaw.com/1-382-3589) to the seller because the seller is a 100% corporate

stockholder of the target company (see IRC § 337).

For more information on the tax treatment of asset sales, see Practice Note, Asset Acquisitions: Tax

Overview (www.practicallaw.com/6-383-6235).

Tax Consequences to the Seller

The stock sale is ignored for tax purposes. Instead, the seller is treated as receiving a tax-free liquidating

distribution of the sale proceeds (see IRC § 332) and generally inherits the target company's pre-acquisition

tax attributes (see IRC § 381), subject to limitations in the IRC. Therefore, the acquisition of all of the

outstanding stock of the target company with a Section 338(h)(10) election results in a single level of tax

imposed at the entity level. A stock sale also results in a single level of tax, but that tax is imposed at the

stockholder level.

Because a stock sale with a Section 338(h)(10) election results in an entity level tax and a stock sale

without a Section 338(h)(10) election results in a stockholder level tax, the election can have adverse tax

consequences for a seller. The election can:

Increase the amount of any gain recognized if the seller's basis in the target company's stock exceeds

the target company's basis in its assets.

Convert a certain amount of gain to ordinary income.

Result in significantly higher state taxes.

For example, assume that a target company has assets with a basis of $50,000 and the target company's

sole stockholder has a basis of $80,000 in its target company stock. If the buyer purchases the target

company stock from the seller for $100,000, then:





The stock sale without a Section 338(h)(10) election results in $20,000 of gain (amount realized of

$100,000 minus stock basis of $80,000).

The stock sale with a Section 338(h)(10) election results in $50,000 of gain (amount realized of

$100,000 minus asset basis of $50,000).

In this example, the seller generally will not want to make a Section 338(h)(10) election unless any of the

following:

The target company has NOLs or other tax attributes that reduce the entity level gain to $20,000 or

less.

The buyer agrees to increase the purchase price to compensate the seller for the increased tax costs of

the election.

The buyer agrees to indemnify the seller for the increased tax costs of the election.


After the stock sale, the buyer owns all of the stock of the target company which is now a subsidiary of the

buyer and the target company has a cost basis in its assets. In a stock sale without a Section 338(h)(10)

election, the target company's basis in its assets remains unchanged (see Tax Consequences to the Target

Company).

State Tax Considerations

In considering the tax consequences of a Section 338(h)(10) election, the buyer and seller should

determine the state law treatment of the election, and whether a separate election is required under

state law.

Section 338(g) Election

If a Section 338(g) election is made, the stock sale is not ignored. Instead:

The target company generally recognizes taxable income, gain or loss on the deemed sale of its

assets.

The seller generally recognizes a taxable gain or loss on the sale of its stock.

After a stock sale with a Section 338(g) election, the buyer owns all of the stock of the target company that

is now a subsidiary of the buyer and the target company has a cost basis in its assets.

Because a stock sale with a Section 338(g) election potentially results in two levels of tax (at the entity and

stockholder level), a seller generally would object to this election unless either:

The target company has NOLs or other tax attributes that eliminate the entity level gain recognized on

the deemed asset sale.




The target company is a foreign corporation that does not have any US assets. In this case, there

generally would be no US tax on the deemed asset sale.

Because the Section 338(g) election is a unilateral election made by the buyer, a seller should evaluate

whether a Section 338(g) election would cause it adverse tax consequences. If it would, a seller should

consider any of the following:

Including a provision in a stock purchase agreement that prevents a buyer from making a Section 338(g)

election.

Requiring the buyer to increase the purchase price to compensate the seller for the increased tax costs

of the election.

Requiring the buyer to indemnify the seller for the increased tax costs of the election.

Proposed Section 336(e) Election

The IRS has issued proposed treasury regulations under IRC Section 336(e). If finalized, a US corporate

seller will, among other things, be able to make a unilateral election to treat certain stock acquisitions

(that do not qualify for a Section 338(h)(10) election) as asset acquisitions for tax purposes. The

proposed treasury regulations adopt a Section 338(h)(10) model. This means that the stock purchase is

ignored for tax purposes. Instead, the target company generally is treated as making a deemed taxable

sale of its assets and then liquidating tax-free into the seller (resulting in a single level of tax at the entity

level).

A Section 336(e) election requires a qualified stock disposition (see Proposed Treasury Regulations §

1.336-1(b)(5)) which generally requires both:

A taxable sale or disposition of at least 80% of a US target corporation within a 12-month period.

A US corporate seller.

Under the proposed treasury regulations, a Section 336(e) election generally cannot be made if a

Section 338(h)(10) election could be made (see Proposed Treasury Regulations § 1.336-1(b)(5)(ii)). A

Section 336(e) election also is not available if the target company an S-corporation.

Unlike a Section 338(h)(10) election, a Section 336(e) election provides that:

There can be multiple buyers.

The buyers do not need to be corporations.

For example, a Section 336(e) election would be available to the seller (but a Section 338(h)(10) election

would not) if a US corporation that owns 100% of the stock of a target corporation both:

Sells 50% of the target company's stock to a noncorporate buyer on January 1.



Distributes 30% of the target company's stock to unrelated target company stockholders on August

1.

The Section 336(e) election is a unilateral election made by the seller (which cannot be made until the

proposed treasury regulations are finalized). The seller likely would make a Section 336(e) election if the

target company's basis in its assets exceeds the seller's basis in the target company's stock.

However, a Section 336(e) election would have adverse tax consequences for the buyer if it results in a

step-down in the basis of the target company's assets. This would happen if the target company's basis

in its assets exceeds their fair market value. For this reason, a buyer should evaluate whether a Section

336(e) election would cause it adverse tax consequences. If it would, a buyer should consider any of the

following:

Including a provision in the stock purchase agreement that prevents a seller from making a Section

336(e) election.

Decreasing the purchase price to compensate the buyer for the step-down in basis.

For example, assume that a noncorporate buyer purchases all of the stock of the target company for a

purchase price of $125,000. At the time of the sale, the seller has a $50,000 basis in the target

company stock and the target company has assets with a basis of $100,000 (and fair market value of

$75,000). The tax consequences for the seller are as follows:

The stock sale without a Section 336(e) election results in a $75,000 gain (amount realized of

$125,000 minus $50,000 stock basis).

The stock sale with a Section 336(e) election results in a $25,000 gain (amount realized of $125,000

minus $100,000 asset basis).

In this case the seller likely would make a Section 336(e) election. However, there are adverse tax

consequences to the buyer including:

The stock sale without a Section 336(e) election results in a $100,000 basis in the assets (basis

remains unchanged).

The stock sale with a Section 336(e) election results in a step-down in the basis of the assets to

$75,000 (basis is limited to fair market value).

There are circumstances where the buyer would want the seller to make the Section 336(e) election. For

example, if both:

The election results in a stepped-up basis in the target company's assets.

The stock acquisition is not eligible for a Section 338(h)(10) election (because, for example, the

buyer is not a corporation or there are multiple buyers).

If the seller agrees to make a Section 336(e) election, the seller can ask the buyer to either:



Increase the purchase price to compensate the seller for any increased tax costs of the election.

Indemnify the seller for any increased tax costs of the election.

Resource information

Resource ID: 9-383-6719

Products: PLC US Corporate & Securities, PLC US Law Department, PLC US Tax

This resource is maintained, meaning that we monitor developments on a regular basis and update it as soon as

possible.

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