Basic Tax Tips for Negotiating a Sec 338(h)(10) Transaction

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In an acquisition scenario where an S Corporation is the target, it is common for the S Corporation’s shareholders and the qualified acquiring entity (the purchaser must be a corporation and/or members collectively of an affiliated group of corporations acquiring 80% of the underlying stock ownership of the target measured in terms of voting shares and fair market value within a 12-months prescribed period) to agree to making a joint election under Sec 338(h)(10). Under the Sec 338(h)(10) tax regime, the stock acquisition transaction is entirely disregarded by the selling shareholders and instead, the transaction is reported as a deemed asset sale by the target followed by its deemed liquidation (i.e., the remaining selling price considerations are deemed distributed to the selling S Corporation’s shareholders in exchange for the cancellation of ownership in the target’s stock and the S Corporation status is terminated). Accordingly, throughout the described deemed asset sale/ liquidation construct provision, the target’s S Corporation status remains in effect, and any gains or losses recognized on the deemed sale passes through to the shareholders (and their stock bases are adjusted for purposes of determining gain or loss on the deemed liquidation). Please be aware that the deemed asset sale tax construct provision described above might be subject to certain S Corporation-level tax implications such as built-in gain tax, which is beyond the scope of this article.

It is important to keep in mind that public companies typically will not pay a premium for participating in a Sec 338(h)(10) election. Public companies are driven by future earnings and the tax deduction might be alluring, but it generally does not drive the price of the majority of deals. In a private equity scenario, you might be able to negotiate part of the benefit. For purposes of this article, we will limit our discussion exclusively to an S Corporation target scenario and assume that the purchasing party is only willing to make you whole on the deal, meaning that the buyer is only willing to compensate you for the additional tax bite that you would pay on the ordinary portion of the deemed asset sale under a Sec 338(h)(10) tax regime.

Complicating and clouding the calculation and negotiation process is the newly enacted 20% top long-term capital gain rate, and 3.8% Medicare tax provisions applicable to certain passive shareholders with modified adjusted gross-income in excess of $250,000, as well as unique factors such as:

  • Whether you have outside tax basis in your stock investment
  • Is your entire holding period in the stock investment long-term?
  • Was the S Corporation formerly a C corporation subject to built-in gains?
  • Were previous Sec 338(h)(10) acquisitions transacted by the target?
  • Are there undistributed Subchapter C Corporation earnings?
  • What the state tax rate is for the home resident state, etc.

Negotiation consideration: As a purchaser, agreeing to reimburse for the 3.8% Medicare tax should generally be disregarded because it has nothing to do with the ordinary taxation of certain hot assets. However, agreeing to reimburse the 3.8% Medicare tax or part thereof might come into play as an inducement with regards to meeting the 80% ownership requirements, etc. Also, be fully aware that the list of overall factors above is not all-inclusive and is beyond the scope of this blog.

Under an ordinary S Corporation deal (i.e., the target S Corporation is non-leveraged, all the third party debt obligation will be paid at settlement, etc. ), the additional tax to be incurred from making a joint Sec 338(h)(10) election) should generally range from between 1.4% to 3% of the total overall maximum expected consideration. Another shortcut used to estimate the incremental tax bite is to simply multiply the calculated taxable portion of the target’s current net working capital at closing plus assumed nondeductible liabilities by the buyer times a factor ranging between approximately 16% to 17.4% (i.e., the incremental tax rate differential between the top long-term capital gain of 20% versus the ordinary rate of 39.6% adjusted for state tax benefit prepayment using DC, MD and VA income tax rates).

The aforementioned shortcut calculation approach should only be used as a working tool to estimate a preliminary sum to be agreed on in principle, but will need to be proven prior to closing by performing a formal calculation process. Furthermore, the percentage range being applied assumes that the current tax regime structure will not change in the future because of legislative action by Congress and/or court case rulings and that the entire purchase price allocation to be allocated to the intangible asset classes (including contract rights and goodwill) will be effectively taxed at the preferential long-term capital gains rate not to exceed 20%.

If you have questions or need additional information on Sec 338(h)(10) election-related matters, please contact yourAronson tax advisor or Tax Director, Jorge Rodriguez, CPA at 301.222.8222.

About Jorge Rodriguez

Jorge Rodriguez has written 26 post in this blog.

Jorge L. Rodriguez, CPA, serves as a partner in Aronson's Tax Services Group. He is a seasoned professional with more than 25 years of public accounting experience. He is known for delivering a broad, in-depth tax perspective, informed by his deep, wide-ranging industry knowledge, to every engagement for the benefit of his diverse clientele. Jorge specializes in federal tax consulting and compliance with a special focus on M&A transaction structuring, planning, and modeling. He routinely helps his clients resolve highly complex tax matters including: entity formation, classification, and conversion planning issues; accounting method and period elections and changes; consolidated tax return filling elections and tax accounting concerns; Sec 382 analysis and study; and all aspects of ASC 740 compliance involving purchase accounting and foreign operation reporting areas. Jorge works with a broad cross section of companies. His clients include emerging businesses, middle-market firms, and public business enterprises engaged in a wide variety of industries including government contracting, software development, light manufacturing, IT technology services and products sales, and specialty construction contracting. Jorge is passionate about helping his clients formulate tax strategies that make business sense. He shares his expert insights freely as a regular contributor to Aronson’s Tax Matters blog with series such as “M&A Shop Talk.” Prior to joining Aronson in 2009, Jorge was a practicing tax partner with several regional public accounting firms. He is licensed to practice in Maryland and Virginia. Professional & Community Involvement: Maryland Association of Certified Public Accountants: Member American Institute of Certified Public Accountants: Member Education: University of Maryland: Bachelor of Science in Accounting -Ongoing education in tax matters

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