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:
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%.