Massachusetts Rules that Credit Recapture Applies in a §338(h)(10) Transaction

When purchasing or selling a business, don’t ignore the potential state income tax impacts of a 338(h)(10) election.

By Jess Johannesen, SALT manager

In the context of business acquisitions, a corporation can purchase either the stock of another corporation (i.e., the target) or the assets of that corporation.  From an income tax perspective, the buyer will almost always prefer an asset acquisition so that it gets a “step-up” in the basis of the acquired assets, which provides greater depreciation deductions.  However, there are times when an asset purchase is just not viable, such as when a target has contracts that cannot be transferred to a new entity.  In those situations, a stock deal would be required to preserve the legal status of the target.

So, how can a buyer have its cake and eat it too?  This is where the Internal Revenue Code comes to the rescue and allows, in certain situations, the buyer and seller to make what is called a “338(h)(10) election” (which, not surprisingly, is found in §338(h)(10) of the Internal Revenue Code).  Pursuant to a 338(h)(10) election, the purchaser acquires the stock of the target corporation for legal purposes, but the transaction is treated as an asset sale for income tax purposes, thereby preserving the legal status of the target but giving the purchaser the desired basis step-up. While the federal tax impact of the election is often analyzed during the due diligence process, businesses may overlook the state income tax implications.[1]  On Feb. 23, 2018, Massachusetts issued a letter ruling that highlights the importance of considering the state income tax impacts of this election.[2]

In that letter ruling, the state was asked to address how a 338(h)(10) election would impact certain Massachusetts income tax credits previously claimed by the target corporation (“Target”) upon its acquisition by the purchasing corporation (“Purchaser”).  Purchaser and Target were both manufacturers, and the Purchaser acquired 100 percent of the Target’s stock.  Purchaser and the Target’s shareholder (“Seller”) agreed to make a 338(h)(10) election.  Prior to this transaction, the Target generated Massachusetts investment tax credits (the “Credits”).  These Credits were generated by assets that the Target owned at the time of the transaction.

As a result of the election, for federal income tax purposes the following fiction is treated as having occurred:

  • Target is treated as if it is two unrelated corporations – Old Target (owned by the Seller) and New Target (owned by the Purchaser).
  • Old Target is deemed to have transferred all of its assets to New Target for consideration and the discharge of liabilities. Old Target recognizes gain/loss on the sale of those assets based on the consideration received less the basis in its assets.
  • Old Target is then deemed to liquidate into the Seller.

Under Massachusetts Corporate Excise Tax law, when a taxpayer disposes of property which generated Credits prior to the end of the property’s useful life, the taxpayer is subject to recapture provisions.[3]  Massachusetts, like almost all states, recognizes and follows the treatment of a 338(h)(10) election for state income tax purposes.[4]  Therefore, although the Purchaser had legally acquired the stock of the Target, for state income tax purposes the deemed sale of assets triggered Massachusetts’ recapture provision for Target (i.e., Old Target), which was required to add back certain recaptured credit amounts and pay additional state income tax on its short-period income tax return ending on the date of the transaction.

The ruling also addresses the fact that the Target (i.e., New Target) may be entitled to new Credits since it is treated as having purchased assets.  It is unclear from the ruling whether the state tax benefits of any new Credits outweigh the state tax cost of the recapture, as this will depend on the specific facts of each situation.

This letter ruling illustrates how the 338(h)(10) election can impact state income tax credits.  Had the transaction been structured as a stock deal, the transaction would not have triggered any credit recapture.  The full federal and state tax impact of the 338(h)(10) election to the buyer and seller must be analyzed (including state income tax credits) in order for the parties to agree to make the election.  Aprio’s SALT team understands all of the potential state tax consequences of a 338(h)(10) election so that we can properly advise businesses, whether the seller or the purchaser, how to obtain the maximum benefit from the election.  We constantly monitor these and other important state and local tax issues, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Jess Johannesen, SALT manager at jess.johannesen@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the April 2018 SALT Newsletter

[1] Often, the election will result in the seller having a higher federal income tax liability since the stock deal would have produced capital gains (taxable at a lower rate), whereas the deemed asset deal will result in some amount of ordinary income (e.g., depreciation recapture, sale of inventory, etc.).  As part of the due diligence process, the parties will quantify the additional consideration required to make the seller “whole.”  State income tax implications can also be significant, particularly if the seller is located in tax favorable state.

[2] Massachusetts Letter Ruling No. 18-1, 02/23/2018.

[3] Mass. Gen. L. c. 63 §31A(e)

[4] Generally, for other state tax purposes, like sales/use taxes, the 338(h)(10) election is ignored and the transaction is treated as a stock deal.

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