IRS Finalizes Regulations for Treating the Purchase of Stock as an Asset Purchase

IRS Finalizes Regulations for Treating the Purchase of Stock as an Asset Purchase

The Internal Revenue Service ("IRS") issued final regulations effective March 16, 2001, clarifying the rules allowing certain purchasers of a corporation's stock to make a Section 338 election to treat the purchase and sale of such stock as a purchase of the corporation's assets.  These regulations replace temporary regulations issued in January 2000.  In general, a corporation that makes a qualified stock purchase of another corporation that meets the requirements of the regulations may elect to treat it as a purchase of the corporation's assets.

Under these regulations, the target corporation ("Old Target") is treated for tax purposes as if it sold all of its assets at the close of the acquisition date at fair market value in a single transaction to a fictional entity known as the New Target.  The New Target purchases all of the assets as of the beginning of the day after the acquisition date.  If the purchasing corporation and the Target corporation agree to make an election under Section 338 of the Internal Revenue Code, all of the Old Target's gain or loss from the deemed asset sale to the fictional New Target is included in Old Target's final return unless the Old Target is a member of a consolidated group or is an S corporation. 

Generally, the 338 election is desirable to the purchaser, because the election will allow the purchaser to "write-up" the tax basis of the purchased assets to reflect the purchase price.  The purchaser will then be able to "write off" the purchase price over time, unlike a stock purchase in which the purchaser gets basis in the purchased stock, but no ability to write off the purchase price.  The Old Target will, however, be required to pay tax on any appreciation of its assets, since it will be deemed to have sold all of its assets to the New Target at the purchase price.  This may not adversely affect S corporation owners who would generally be responsible for one level of tax, whether the sale is an asset sale or a stock sale (although the character of certain portions of the gain in an asset sale may be ordinary income, as opposed to a stock sale where the entire gain is capital gain).

If the target is a member of a consolidated group, the purchasing corporation and the selling consolidated group can jointly elect to have the selling consolidated group recognize gains or losses as though the target sold all of its assets in a single taxable transaction while still a member of the selling group, and liquidated.

The final regulations also include relief for S corporation stock owners who do not receive identical amounts of consideration for their stock in a sale, provided that the varying amounts are negotiated in arms length negotiations with the purchaser. The IRS clarified that payments of different amounts to sellers of S corporation stock will not be treated as creating a second class of stock, a result that would otherwise violate the requirements for S corporations and cause the corporation to lose its S status.  Prior to this final regulation, there remained the possibility that sellers of S corporation stock who receive different amounts for their stock, because of the pass-through nature of an S corporation and the differing circumstances of the S corporation's stockholders, would inadvertently violate the second class of stock rule for S corporations.

The final regulations also expand the group of potential buyers that may participate in making 338 elections.  Under previously issued temporary regulations, the IRS required a purchaser to pay more than a nominal amount for a purchase of stock in order to participate in a Section 338 transaction.  The final regulations have dropped this requirement, enabling purchasers of insolvent corporations whose liabilities equal or exceed the value of assets to participate in a Section 338 transaction.  In these situations, the buyer will have a cost basis in the assets even though the seller will probably not have to pay taxes on any gain.