Selling shareholders recognize gain or loss

Buyer recognizes gain (or loss) on any appreciated (depreciated) property used to acquire Target stock

• Other than its own stock

Buyer has a fair market value basis in the acquired stock

No change to the basis of Target assets or to the other tax attributes of Target

• Target's future use of net operating loss carryovers
  may be limited, however (NOLs)

Purchase of Target stock can be treated as
a purchase of Target's assets

• At least 80% of Target's stock must be acquired by purchase during a 12-month period

Gives Buyer the opportunity to step up the tax basis of Target's assets

• Price paid for the stock, together with the amount of Target's liabilities, is deemed to be the purchase price paid for the assets
• Allocation of that price among the categories of acquired assets is based upon their relative fair market values
• Target is treated as having sold all its assets, subject to all its liabilities, at the close of the acquisition date and then to have purchased those assets as a new corporation as of the beginning of the next day
• The tax imposed on the deemed sale of Target assets is
  borne by the Buyer

After the repeal of General Utilities, a section 338 election rarely makes sense as it generally results in recognized gain at least equal to the increase in the basis of Target's assets

• The tax on the gain is payable immediately while the benefit from the increased basis is realized over time
• But see Section 338(h)(10) election

Variant on Section 338 Election

• If Target is a member of a consolidated return group
  then the parties can elect under section 338 and section 338(h)(10) to treat Target as selling all its assets to itself, but prior to Target leaving the selling consolidated return group
• If a section 338(h)(10) election is made, the tax cost of increasing the basis of Target's assets is borne by the selling consolidated return group
• But then the selling consolidated return group won't have any gain on the sale of the Target stock (single taxation)
• So that the tax cost of the transaction to the selling group will not increase substantially by virtue of the section 338(h)(10) election
• Even if that tax cost does increase, it can be in the buyer's interest to compensate the selling group for making the section 338(h)(10) election

Typical net effect is:

• Seller pays a single tax on appreciated value of Target
• Buyer gets a stepped-up tax basis in Target's assets

• Future deductions can be valuable for Buyer
• Buyer will share this value by paying a higher purchase price to Seller

S corporations can make a section 338(h)(10) election

• If all shareholders join in the election
• Under 1994 regulations

Precedent

• Citigroup's life insurance business (MetLife) 2005
• GE's reinsurance business (Swiss Re) 2005
• Federated's credit card business (Citibank) 2005
• JPMorgan's online brokerage (E*Trade) 2005
• HarrisDirect's online brokerage (E*Trade) 2005

M&A Tax Index