07 Nov Franchise Tax Board Audits Sale of S Corp in 338(h)(10) Transaction
Shareholders of Subchapter S Corporations frequently sell their stock and are inspired, either by their own tax professionals or the tax professionals of the buyer, to make a Section 338(h)(10) Election to treat such sale of stock as a sale of assets for tax purposes. The expectation is that the buyer can obtain a valuable step-up in the basis of the assets purchased with little difference in the cost or tax position of the selling shareholder. However, when the consideration is paid to the selling shareholder on an installment basis (i.e. over the course of more than 1 tax year), the installment sale rules intersect with the Section 338(h)(10) rules in a manner that both (i) is frequently not anticipated by those same tax professionals and (ii) can create a significant difference in the timing of the taxes paid by the selling shareholder. The Franchise Tax Board (FTB) is now exploiting a huge tax trap that poorly advised taxpayers regularly fall into.
Generally in an installment sale, a seller recovers a ratable portion of his or her basis as each installment payment is received. For example, assume the seller has a basis of $4,000 and sells for $10,000, payable $5,000 in year 1 and $5,000 in year 2. Under the installment sale rules, the seller would recognize $3,000 of income ($5,000 – $4,000/2) with his or her receipt of each $5,000 payment.
Now assume the same facts for a Section 338(h)(10) transaction. According to IRS Treasury Regulations (see Reg. 1.338(h)(10)-1(e), Example 10), there is a tax difference because the Section 338(h)(10) transaction adds an intermediate step; the deemed liquidation of the target company. The target company is deemed to have sold its assets for $5,000 plus an installment note of $5,000. Here the target still recognizes $3,000 of income on its receipt of the first $5,000 cash, which taxable income flows through to the shareholder, increasing the shareholder’s basis to $7,000 ($4,000 + $3,000). Now comes the unexpected part. In the deemed liquidation, the target is deemed to distribute the $5,000 cash and the $5,000 installment note to the shareholder, and the shareholder’s basis is allocated between each distributed asset in proportion to their relative values. On the deemed distribution, the shareholder has another $1,500 of income ($5,000 – $7,000/2) and takes the installment note of $5,000 with a $3,500 basis. The shareholder in this example has $4,500 of taxable income in year 1 ($3,000 as a flow-through from the target + $1,500 on the deemed distribution), and will recognize just $1,500 of taxable income in year 2 ($5,000 – $3,500 basis). As you can see, in comparison to the example in the paragraph above, $1,500 of income is moved from year 2 to year 1.
While it is just a timing difference, accelerating income is not the goal of a noble tax professional. In addition, many states (CA included) do not permit carrybacks of net operating losses, so realizing additional income in the first year creates even more risk that the taxpayer will incur a loss in the second year that cannot be recovered. Because of the potential federal tax adjustments, the tax effect is much worse than just state taxes.
The FTB is actively auditing this transaction and aggressively applying the method found in IRS Treasury Regulations. For unwary or poorly advised taxpayers who have not planned into a 338(h)(10) with installment notes, the result can be both unexpected and devastating. Small changes in the structure of this transaction may avoid the adverse result described above. For example, if there is all installment note and no cash at the moment of close, theoretically, the acceleration would be avoided. Sellers of S corporations should seek specialized tax advice on this issue.