Approximately one-third of all banks in the United States are organized as subchapter S corporations. Since a potential buyer is likely to encounter a seller that is a subchapter S bank, it is important to understand the unique tax consequences to the selling corporation and its shareholders. For example, the selling shareholders may seek concessions, in the form of additional consideration, to reimburse them for any additional tax liability they might incur based upon the chosen structure. Board members, whether representing the seller or buyer, will need to consider these tax issues in order to properly evaluate a proposed acquisition structure and obtain the desired results.
Any buyer purchasing a corporation at a premium typically prefers to structure the transaction in a way that allows the buyer to receive a “stepped-up basis” in purchased assets. In other words, the buyer wants to directly allocate the amount paid for the corporation’s stock to the acquired assets for tax and accounting purposes. While this treatment may be required under U.S. generally accepted accounting principles, it does not automatically apply for federal income tax purposes. In fact, a buyer acquiring the stock of a corporation generally will take a carryover tax basis in purchased assets, as opposed to a stepped-up tax basis, thus potentially leaving tax dollars on the table. While a buyer can purchase assets directly without purchasing stock in order to receive this stepped-up tax basis, it might not always be practical (or permissible) to structure a transaction this way. So what’s a buyer to do?
Internal Revenue Code Section 338(h)(10) provides a special election for “qualified stock purchases,” which are defined as any transactions, or series of transactions, in which at least 80 percent of the stock of one corporation (the target corporation) is purchased by another corporation (the acquiring corporation) during a 12-month period. If the election is made, a purchase of target corporation stock is treated as though the acquiring corporation directly purchases the assets of the target corporation. In other words, the purchase of the stock is disregarded for tax purposes—and for tax purposes only.
There are two situations in which a Section 338(h)(10) election can be made:
- The target corporation is a subsidiary in a consolidated group; or
- The target corporation is a subchapter S corporation.
It is the latter of these two situations that is more common among bank holding company acquisitions.
It should be noted that a Section 338(h)(10) election can be made only if all parties involved in the transaction agree to the election. If the target is a subchapter S corporation, the approval of every shareholder of the S corporation must be obtained—no exceptions. A single dissenting shareholder can disrupt the entire process (although there are some strategies to avoid that). It should also be noted that the acquiring corporation assumes all liabilities of the target corporation, including tax liabilities.
Now that we have set the table as to why, and under what circumstances, a Section 338(h)(10) election can be made, let’s take a look at the tax consequences for the parties involved, assuming the target corporation is an S corporation bank holding company with a single 100 percent-owned qualified subchapter S bank subsidiary.
For the target corporation:
- All holding company and bank assets are sold in a taxable transaction.
- All holding company and bank liabilities are assumed by the acquiring corporation.
- Corporate-level S corporation built-in gains tax could apply.
- Corporate-level state income tax applies to net gains from taxable sale of assets (presuming the relevant states follow the federal Section 338(h)(10) treatment).
- Holding company is liquidated.
For the selling shareholders:
- Gains (and losses) from the sale of assets pass through to shareholders and are reported on the shareholders’ personal income tax returns; the tax basis in the S corporation stock is increased or decreased accordingly.
- Shareholders recognize the gain or loss upon liquidation of holding company shares.
For the acquiring corporation:
- Tax basis of purchased assets, including intangible assets, is stepped up (or stepped down).
- Premium paid above fair market value of hard assets generally is converted into a tax-deductible intangible asset that can be deducted on a straight-line basis over 15 years.
- No tax attributes of the target corporation carry over, which would commonly occur in the context of a stock purchase without a Section 338(h)(10) election.
As discussed earlier, subchapter S corporations make up about one-third of all banks in the United States. Because potential buyers are likely to encounter a selling S corporation, it is important to understand the unique tax consequences affecting the parties involved, including the target corporation, its shareholders, and the acquiring corporation. The Section 338(h)(10) tax rules are detailed, and there might be exceptions to the general rules described here. Taxpayers should review their specific fact patterns before deciding on a course of action.