Discussion of Sections 338 and 338 Election of the Internal Revenue Code - Research Proposal Example

Discussion of Sections 338 and 338 (h)(10) Election of the Internal Revenue A. Legislative History of Section 338 As part of the government’saim to have tax equity and fiscal responsibility, Section 338 was enacted in 1982 (Silverman, 2007). A few amendments were then made but significant changes were made under Tax Reform Act in 1984 (Silverman, 2007). To reflect the changes made in Section 338, repealing the General Utilities Doctrine, the Congress made some changes in 1986 (Silverman, 2007). The enactment of the Technical and Miscellaneous Revenue Act of 1988 further made changes to Section 338 and added Section 338 (h)(16), which limited the foreign tax credit consequences which would otherwise result from a Section 338 election, stating that Section 338 does not apply for purposes of determining the source or character of any item in Sections 901 and 908 of the Code (Silverman, 2007; IRS Memorandum No. AM-2007-006). The requirement of information reporting was then added in Section 338 (h)(10)(c) under the Omnibus Budget Reconciliation Act of 1990 (Silverman, 2007). Final regulations were also issued starting 2001 by the Treasury to replace the temporary regulations related to Section 338 (Silverman, 2007). B. Overview of Section 338 Under Section 338, if a purchasing corporation acquires 80 percent or more of the stock of the target corporation in a qualified stock purchase then the election in Section 338 may be done to treat the stock purchase as an asset purchase (Silverman, 2007). This election must be not later than the fifteenth day of the ninth month, after the month in which the acquisition date occurs (Silverman, 2007). If however the purchasing corporation decides not to or fails to make such an election, then it will be a carryover basis in the target’s assets (Silverman, 2007). Such an election in Section 338 will benefit or have an economic value to the purchasing corporation only “if the present value of future tax savings resulting from the ‘step-up’ in basis of the targets assets exceeds the current tax cost of such a step-up” (Silverman, 2007). As explained by Silverman, in order to achieve this basis step-up, the target corporation must recognize the full gain or loss inherent in its assets (2007). Hence, election in Section 338 will make economic sense only in limited situations such as in case of a foreign target or where the target corporation has sufficient loss carryovers to offset the section 338 gain (Silverman, 2007). To determine the present value of future tax savings, the allocation of basis among the target’s assets must be taken into consideration (Silverman, 2007). Thus, as explained by Silverman, the deemed purchase price shall be “shall be allocated among the assets of the target corporation under regulations prescribed by the Secretary” (Silverman, 2007). Regulations were issued to this effect, for instance Treas. Reg. § 1.338-6(b) provides for the basis for asset acquisition on or after March 16, 2001 according to seven asset classes: if it is cash and general deposit accounts; if actively traded personal property; if the assets are those that taxpayer marks to market for Federal income tax and so on (Silverman, 2007). The Regulation also provided for asset acquisition completed after January 5, 2000 and before March 16, 2001 in the same manner as previously described, except for Class II and III assets (Silverman, 2007). The former Temp. Treas. Reg. § 1.338(b)-2T also provided for basis allocation for asset acquisitions completed on or after February 14, 1997 and on or before January 5, 2000 (Silverman, 2007). A provision for asset acquisitions completed before February 14, 1997 which, applies transition rules was also provided for (Silverman, 2007). The allocation to assets within a class of assets was based on the relative fair market value of such assets (Silverman, 2007). The fair market value of an asset is understood to be the gross fair market value of the asset or that, which is without regard to mortgages, liens, pledges or other liabilities (Silverman, 2007). Under the final regulations, the Service may challenge a taxpayer’s determination of the fair market value of any asset by any appropriate method (Treas. Reg. § 1.338-6(a)(2)(iii)). Furthermore, one should take into consideration that all of the allocations are subject to the limitation that the basis allocated to each asset cannot exceed its fair market value FMV and any other limitation imposed on an acquisition of assets from an unrelated person, as required under Treas. Reg. § 1.338-6(c) (Silverman, 2007). If there be any excess over the fair market value, it would then be allocated to the next class of assets, the residual excess allocated to “intangible assets in the nature of goodwill and going concern value” (Treas. Reg. § 1.338-6(b)(2)). C. Operation of Section 338 In transactions occurring within a 12-month period or within the ‘acquisition period’, the purchasing corporation (‘P’) must purchase at least 80 percent of the stock of a target corporation (‘T’) (Silverman, 2007). The “acquisition date” refers to the date on which P has purchased at least 80 percent of Ts stock (Silverman, 2007). In this, P must then elect to have section 338 apply within 81/212 months after the month in which the acquisition date occurs which corresponds to the period of filing of corporate income tax return for the ‘old T’ (Silverman, 2007). If there occurs a qualifying purchase and election, the target corporation will be treated as if it has sold all of its assets in a single, fully taxable transaction or deemed as sale of assets (Silverman, 2007). The target corporation is both the seller and the purchaser in this hypothetical sale (Silverman, 2007). The target corporation being considered a seller, terminates its existence for tax purposes on the acquisition date, while the new corporation, begins to exist for tax purposes, on the day after the acquisition date (Silverman, 2007). The hypothetical selling price is determined by the ‘grossed-up amount’ of all of the assets of the targeted corporation realized on the sale of the purchasing corporation’s stock plus the liabilities of old targeted corporation (Silverman, 2007). The hypothetical purchase price, on the other hand, is the purchasing corporations grossed-up basis of the recently purchased targeted corporation’s stock, “to reflect the value of any targeted corporation’s stock not held by purchasing corporation on the acquisition date, plus purchasing corporation s basis in any non-recent purchased stock, plus the liabilities of the new corporation” (Silverman, 2007). The result of this sale is that the purchased corporation incurs all the appropriate tax liabilities, and its tax attributes disappear, with the new corporation now holding the assets with a fair market value cost basis if the fair market value was paid for the T stock (Silverman, 2007). The deemed asset sale by T, however would not affect the tax treatment of the actual sale of T stock by its shareholders and the selling shareholders of T would recognize any gain or loss on the actual sale of the T stock (Silverman, 2007). However, he minority shareholders who retain their T stock, are not deemed to have engaged in sale of their old T shares for new T shares even though they have become shareholders in new T (Silverman, 2007). The liquidation of T is not anymore needed in order to obtain a basis step-up for T’s assets under Section 338, as it will still result in a carryover basis to P under Section 334(b)(1) (Silverman, 2007). Hence, Section 338 conclusively eliminates the non-statutory rule upheld in the case of Kimbell-Diamond Milling Co. v. Commissioner, 14 T.C. 74 (1950), affd, 187 F.2d 718 (5th Cir. 1951), which held that the purchase of stock followed by a liquidation of the target corporation would be treated as an asset acquisition for tax purposes (Farnan, 1990). Finally, all acquisitions from the target corporation and its affiliates, by purchasing corporation (including its affiliates), as either stock purchases or asset purchases (Silverman, 2007). C. Discussion of Section 338 (h)(10) Election Some of the advantages under Section 338 (h)(10) Election includes the following: there would only be one level of corporate tax imposed; “ordinary income generated in an asset sale should not be taxed at a higher rate than capital gain income on a stock sale”; and application of this provision may allow a group to use losses that would otherwise be disallowed under Treas. Reg. §§ 1.337-2T, 1.1502-20(a) (Silverman, 2007). The disadvantage however under 338 (h)(10) election is that “the amount of gain in such a transaction will exceed that in a straight stock sale if the aggregate inside asset basis is less than the outside stock basis” (Woods Investment Co. v. Commissioner, 85 T.C. 274 (1985)). But with the enactment of section 1503(e) or and the issuance of a revised Treasury regulation, a corporations inside basis is more likely to match the outside stock basis (Silverman, 2007). D. Requirements and Rules of Section 338 (h)(10) Election Under Section 338 (h)(10) “the purchasing corporation and the common parent of the selling consolidated group shall, at such times and in such manner as may be provided in regulations, furnish to the Secretary the following information: a. The amount allocated to goodwill and going concern value. b. Any modification to the amount allocated to goodwill and going concern value. c. Any other information the Secretary deems necessary to carry out the provisions of the section 338(h)(10). Although the Service has yet to issue regulations under the said section on reporting requirements, regulations however provide that section 338(h)(10) election shall be made on Form 8023 in accordance with the instructions as to the form stated in Treas. Reg. § 1.338(h)(10)-1(c)(2) (Silverman, 2007). However, section 338 transactions now entail filing with the IRS at least two or as many as five different forms --- Forms 8883, 8023, 8806, 1096 and 1099-CAP (Silverman, 2007). Form 8883 must be filed by both the Old Target and the New Target, attached to and filed with the Federal income tax returns that reflect the tax effects of the section 338 transaction (Silverman, 2007). If section 338(h)(10) election is being made, Form 8023 must be filed jointly by the purchasing corporation and the common parent of the selling consolidated group, selling affiliate, or all of the S corporation shareholders (Silverman, 2007). Otherwise, the purchasing corporation making the section 338(g) election must file the Form (Silverman, 2007). Form 8023 must be filed with the Ogden processing center by the 15th day of the 9th month after the acquisition date to make a section 338 election for target (Silverman, 2007). Recent temporary regulations require domestic corporations involved in certain large taxable transactions covering $100,000,000 and above, to report information describing the transaction and filed along with the income tax return, (Temp. Treas. Reg. § 1.6043-4T, T.D. 9022, 2002-48 I.R.B. 909 (Dec. 2, 2002)). Form 8066 must be filed by the reporting corporation within 45 days after control of the corporation is acquired, or when the corporation undergoes a substantial change in capital structure, or if earlier, on or before January 5th of the year following the calendar year in which the acquisition of control or substantial change in capital structure occurs (Silverman, 2007). Reporting Corporations may elect on Form 8806 to consent to the publication by the IRS of information necessary for brokers to file information returns with respect to their customers. The temporary regulations further require reporting corporations to file with the IRS information returns on Forms 1096 and 1099-CAP for each shareholder of record in the corporations, who receives cash, stock, or other property in the reportable transaction (Silverman, 2007). Furthermore, the reporting corporation must furnish to each shareholder the Form 1099-CAP filed with respect to that shareholder by January 31 of the year following the calendar year in which the shareholder receives cash, stock, or other property as part of the acquisition of control or the substantial change in capital structure (Silverman, 2007). Form 8883 must be filed by both the Old Target and the New Target and then attached to the timely filed tax returns that reflect the tax effects of the section 338 transaction (Silverman, 2007). For the Old Target, in the case of a section 338(h)(10) election for an S corporation target, Form 8883 must be attached to Form 1120S or the U.S. Income Tax Return for an S Corporation (Silverman, 2007). If the old target is a member of a selling group that will file a consolidated Federal income tax return, Form 8883 must be attached to the selling groups consolidated return for its tax year that includes the acquisition date (Silverman, 2007). If the old target is a member of an affiliated selling group that does not file a consolidated Federal income tax return, Form 8883 must be attached to the return that reflects the tax effects of the section 338 transaction (Silverman, 2007). The information required under Form 8883 includes: a) The name, address, and employer identification number of the filing party, b) The name, address, and employer identification number of the taxpayer that files the U.S. income tax return, if any, that reflects the tax results under section 338 for the other party to the transaction, c) The name, address, employer identification number, and the state or country of incorporation of the target corporation, d) Certain general information, including the acquisition date, what percentage of the target stock was acquired during the 12-month acquisition period and on the acquisition date, the stock price, the acquisition or selling costs, the amount of the targets liabilities, the AGUB or ADSP, and information regarding the status of the target, e) The aggregate fair market value of the Class I, II, III, IV, V, and VI and VII assets and the allocation to each of those asset classes, f) the filing party must specify the amended aggregate fair market value of the classes in previously filed statements and the allocation of AGUB or ADSP to each of those asset classes (Silverman, 2007). The filing party must also specify the reasons for the subsequent increase or decrease in AGUB or ADSP (Silverman, 2007). Form 8023, on the other hand, must be filed jointly by the purchasing corporation and the common parent of the selling consolidated group (Silverman, 2007). The final regulations clarify that all S corporation shareholders, selling or not, must consent to the making of the section 338(h)(10) election (Treas. Reg. § 1.338(h)(10)-1(c)(2)) and must be filed by the 15th day of the 9th month after the acquisition date to make an election under this section and filed with the Internal Revenue Service (Silverman, 2007). The required information includes: a) The purchasing corporations name, address, employer identification number, the date its tax year ends, and the state or country of incorporation, b) If the purchasing corporation is a member of a consolidated group, the common parents name, address, employer identification number, the date its tax year ends, and the state or country of incorporation, c) The target corporations name, address, employer identification number, the date its tax year ends, and the state or country of incorporation, d) If the target was either a member of a consolidated group or a controlled foreign corporation, the name, address, tax identification number(s), and the date the tax year ends for the common parent of the selling consolidated group, selling affiliate, U.S. shareholders of the foreign target corporation, or S corporation shareholders, e) The acquisition date and information regarding the percentage of the target stock acquired during the 12-month acquisition period and on the acquisition date, f) The type of election being made by the party or parties and whether an election is being made for a corporation or corporations other than the target, g) The signature(s) of the purchasing corporation(s) or the signature of the common parent, selling affiliate, or the S corporation shareholders (Silverman, 2007). All these then must be taken into consideration when filing. References Farnan, Lori (1990). A Mandatory Section 338: Can It Be Implemented?. Florida Law Review, 42 (672). Internal Revenue Service. Memorandum No. AM-2007-006. Retrieved on 20 November 2008 [http://www.irs.gov/pub/irs-utl/am2007006.pdf]. Silverman, Mark J. (2007). Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings. Practicing Law Institute, 770 Tax 155. Temp. Treas. Reg. § 1.6043-4T, T.D. 9022, 2002-48 I.R.B. 909 (Dec. 2, 2002). Treas. Reg. § 1.338-6(a)(2)(iii). Treas. Reg. § 1.338-6(b)(2). Treas. Reg. § 1.338(h)(10)-1(c)(2). Woods Investment Co. v. Commissioner, 85 T.C. 274 (1985) Read More