The following article is adapted and reprinted from the M&A Tax Report, Vol. 8, No. 3, October 1999, Panel Publishers, New York, NY.


By Robert W. Wood

Section 338 of the Code has long been an enigma. It was enacted to clarify and simplify what many of us remember as old Code Section 334(b)(2). That old provision required a company seeking asset purchase treatment on a stock purchase to buy the stock and then promptly liquidate the target into itself. Section 338 was supposed to make this mechanical step unnecessary.

Perhaps I am in the minority, but I have long thought that all of the "traps for the unwary" that supposedly lived in old Section 334(b)(2) have long since been swallowed up by the trips, traps, footfalls and (help me with some more metaphors!) that have grown like weeds around the maw of Section 338. Section 338, at its root, does provide for asset purchase treatment to the buyer even though the buyer chooses to buy stock.

Beyond that, though, the matter gets messy. The regulations are voluminous, and the Service has just added to them (voluminously) again. Fortunately, this time there are some ameliorations that practitioners may find helpful. Of course, that assumes one has the patience to wade through this swampy sea of material. Here goes.

Basic 338

Under Section 338, in the case of a qualified stock purchase, a target is treated as if it sold all of its assets in a single transaction for an amount equal to the fair value of the assets, and as if the target was a Newco purchasing the assets for a similar amount on the following day. The target's assets thus acquire a new basis equal to their fair market value and, in the process, access to Section 197. Section 197, of course, permits the amortization of goodwill and other intangibles.

Notwithstanding these obvious benefits, Section 338 elections are rarely made. After all, since 1987, the gain on the deemed sale is fully taxable. The tax cost associated with that deemed sale gain will invariably outweigh the present value of the tax savings that a purchasing corporation can expect from the ability to amortize or depreciate the basis step-up afforded by Section 338. Few taxpayers want to pay tax now for a smaller benefit later.

Nonetheless, Section 338 elections can still make sense in cases where the target has a net operating loss. If the NOL can offset the deemed sale gain without limitation, then the election can be a good way of soaking up the NOL. A special variety of election, the Section 338(h)(10) election, which affords the purchasing corporation a basis step-up at the cost of only a single level of tax (imposed on the selling group), remains popular. In fact, 338(h)(10) is about the only life left in Section 338.

New and Old

The newly-issued regulations reiterate many of the elements of the prior regulations. In several important respects, though, they break new ground. Perhaps the most noteworthy element of the regulations involves the severing of the link between the "ADSP" (the amount for which the old target is deemed to have sold its assets) and the "AGUB" (the amount for which the new target is deemed to have purchased its assets). In cases where the transaction features contingent consideration, or where the target is burdened by a liability for which economic performance is delayed far into the future, the ADSP will, nonetheless, take these amounts into account in calculating the deemed sale gain.

On the other hand, these amounts will not be taken into account in determining AGUB until the contingency is resolved, or economic performance occurs, respectively. The impact is to make Section 338 elections even less attractive by minimizing, through a delay in the basis step-up afforded by Section 338, the present value of the tax savings provided by the step-up. On the plus side of the ledger, the basis allocation regime associated with Section 338 has been improved. Thus, seven categories of assets are identified and basis is assigned to each such category in a hierarchical fashion.

The Magnificent Seven

AGUB and ADSP are first reduced by Class 1 assets, cash and deposit accounts, other than CDs, held in banks. AGUB and ADSP, as reduced, are allocated among the Class 2 assets, which consists of "actively traded" personal property (within the meaning of Section 1092(d)(1)), CDs and foreign currency, in proportion to the values of these assets.

The innovation here is the creation of two new categories, Class 3 (consisting of accounts receivable, mortgages and credit card receivables) and Class 4 (consisting of stock-in-trade). These new categories contain what the regulations refer to as "fast pay" assets and, by assigning them a preferred position in the hierarchy, the allocation rules help insure that assets do not suffer a basis step-down. The result of a step-down would be the realization of additional taxable income when these assets, which may not have appreciated since their acquisition, are collected or sold.

In no event, by the way, may an asset, other than Class 7 assets (goodwill and going concern value) be allocated an amount of basis exceeding its value at the beginning of the day after the acquisition date.

Section 338(h)(10) Innovations

As we noted, Section 338(h)(10) elections remain popular. A Section 338(h)(10) election may be made if the purchasing corporation (Buyer) acquires an amount of stock meeting the standards of Section 1504 from a selling consolidated group or the shareholders of an S corporation. The election must be made jointly by Buyer and the selling consolidated group, or the S corporation shareholders. Indeed, even those shareholders (if any) who do not sell their stock must consent to the election.

If the election is made, Old Target realizes the deemed sale gain (from the deemed asset sale) while it is a member of the selling consolidated group, or owned by the S corporation shareholders. Old Target is treated as if, after such deemed sale, and while it is a member of the selling consolidated group (or owned by the S corporation shareholders), it transferred its assets to the members of the group or the S corporation shareholders and ceased to exist. These members or shareholders are treated as if, after the deemed sale, they received the assets transferred by Old Target.

In most cases, the transfer will be treated as a distribution in complete liquidation. The S corporation shareholders, whether or not they sell their stock, will take their pro-rata share of the deemed sale gain into account and, correspondingly, increase their basis in their stock. Furthermore, a member of a selling consolidated group (or an S corporation shareholder), retaining stock, will be treated as acquiring that stock for fair market value on the day after the acquisition date. The holding period of the stock will also commence on that day. In addition, minority shareholders (other than members of the selling group or S corporation shareholders) will not recognize gain or loss with respect to shares retained, and the basis and holding period of this "minority" stock will not be affected.

While all of this may be familiar, what is new in the Section 338(h)(10) arena is the extension of the installment method of accounting to these transactions. If a portion of the consideration conveyed for the target's stock consists of installment obligations of Buyer, Old Target is treated as receiving New Target installment obligations in the deemed asset sale. The terms of these obligaitons are considered identical to the Buyer obligations issued in exchange for the stock of Old Target.

This fiction clears up a technical defect that had long prevented (or at least technically seemed to prevent!) the use of the installment method of reporting in this area (technically the Buyer installment obligations were not evidence of indebtedness of the purchaser of Old Target's assets). The IRS is to be commended for making this sensible alteration to the Section 338 (h)(10) model. Now installment sales have been legitimized.

Expanding Section 1060's Reach

Section 1060 requires the use of the residual method of allocation. This is the same method utilized in Section 338 for the allocation of asset transfers that involve a group of assets constituting a trade or business (in the hands of either the buyer or seller), and with respect to which the purchaser's basis in such assets is determined wholly by reference to the purchaser's consideration. A group of assets constitutes a trade or business if its character is such that goodwill could, under any circumstances, attach to the group of assets.

The regulations expand the circumstances in which goodwill could be viewed as adhering to a group of assets and, in the process, expand the reach of Section 1060. Goodwill will almost certainly be seen as attaching to a group of assets in cases where:

Thus, it will be a rare asset transfer that is not subject to the residual method allocation principles of Section 1060.

Binding on Whom?

Finally, if, in connection with a covered transfer, the parties agree in writing as to the allocation of any amount, or as to the value of any asset, this agreement will be binding on them (but not, of course on the IRS!). The only exception is if the parties are able to refute the terms of the agreement under the standards set forth in the Commissioner v. Danielson case (378 F.2d 771 (3d Cir.), cert. denied, 389 U.S. 858 (1967)). As a practical matter, this standard represents a hurdle that virtually guarantees that such agreements will be rarely refuted.

IRS Issues Regulations Under Section 338, Vol. 8, No. 3, M&A Tax Report (October 1999), p. 1.