Business Sale by IRC Sec. 338

Every business purchase and sale transaction must be structured as either an asset sale or stock sale. But the method chosen has substantial tax and liability implications for the buyer and seller – in completely opposite directions.

The seller benefits greatly from a stock sale. The buyer wants an asset purchase. This begs the question “Why can’t we have it both ways?” Believe it or not, the Internal Revenue Code (IRC) contains a set of laws that allows just that – sort of.

IRC Section 338 allows the seller to sell stock and enjoy the favorable tax attributes of doing so. It also allows the buyer – in the same transaction – to get the desired step-up in basis of the purchased assets (and the attractive depreciation expense enjoyed in the years that follow). This is quite an amazing trick, and mind-blowing for people accustomed to business purchase and sale transactions but unfamiliar with Sec. 338.

But here’s the catch:

1.    The buyer is responsible for the tax that arises from the step-up in basis of the acquired assets, and

2.    Legally, the transaction was effected with stock, so the buyer takes on liabilities of the acquired corporation, including any not known at time of purchase.

You might ask, “How can this be attractive to a buyer when he is paying in full for the step-up in basis and assuming all liabilities of the selling corporation?”

Good question. Here’s the answer: If certain tax characteristics are present within the entities involved in the deal, the buyer may not actually have to pay the tax bill “out of pocket.” So the buyer gets his step-up but owes no tax.

For example, if the acquired corporation has net operation loss carry-forwards and tax credit carry-forwards, these tax attributes can be used to offset tax liability created by Sec. 338 election.

Under what conditions might a transaction lend itself to IRC Section 338?

• The corporation being acquired has unused net operating losses, capital losses or tax credit carry-overs.
• The corporation being acquired has assets with a market value that is less than their book value, and the corporation has owed and paid income taxes the past few years. The deemed sale of the depreciated assets may create a taxable loss that can be carried back to obtain a tax refund.
• The corporation being acquired has non-depreciable built-in loss property as well as depreciated built-in gain property. Subsequent to the sale, these gains and losses have the effect of canceling each other out. Additionally, the depreciated property will have a stepped-up basis that will provide a larger depreciation deduction going forward.
• The corporation being acquired is a member of a consolidated return group that has tax attributes to offset the gain and any resulting tax liability from the deemed sale of assets.

If you find yourself involved in a transaction where the company being acquired has tax attributed in some way similar to the above, ask your tax expert if Sec. 338 is right for you. Granted, the buyer will have to get comfortable with taking on liabilities of the purchased company, but assuming this is achievable, Sec. 338 could create a real win-win situation.

IRC Sec. 338 is complex and filled with conditions and provisions. Always consult a tax professional before applying any of these rules.

Jeffrey J. Presogna, CPA CVA, contributed his expertise to this article. Mr. Presogna maintains a tax and accounting practice and is a partner in Vercor, a mergers and acquisitions advisory firm that serves companies with annual revenue between $2 million and $100 million. You can reach him at Jeff@VercorAdvisor.com.