Hurricane, Inc., is an S corporation. Orleans, Inc., wants to acquire Hurricane for cash. Hurricane’s shareholders have a tax basis in their stock of $3,000 and Hurricane has assets with a net tax basis of $3,000 (cost = $4,500, accumulated depreciation = $1,500). Hurricane has no liabilities. Assume the transaction can be structured one of two ways: Option 1: As a taxable stock acquisition without a Section 338(h)(10) election Option 2: As a taxable stock acquisition with a Section 338(h)(10) election Further assume that Orleans is willing to pay $5,000 to acquire Hurricane under either structure, and that all depreciation claimed to date must be recaptured to the extent of the purchase price. Assume that all recaptured depreciation is taxed at the highest ordinary income rate and that no additional taxes will apply in an asset sale due to U.S. Tax Code restrictions relating to S corporations.
a. How much cash after tax will Hurricane’s shareholders have under Option 1? Assume the tax rate appropriate for capital gains is 20% and for ordinary income is 40%.
b. How much cash after tax will Hurricane’s shareholders have under Option 2? Assume the tax rate appropriate for capital gains is 20% and for ordinary income is 40%.
c. Assume that Orleans is willing to pay $5,000 using Option 1. At what purchase price P when employing Option 2 are Hurricane’s shareholders indifferent between the two transaction structures?
d. What is the maximum price that Orleans will pay under Option 2 assuming that Orleans will pay $5,000 under Option 1? Assume that any step-up amount is depreciated/amortized over 10 years using the straight-line method, that the marginal tax rate for Orleans is 35%, and that the after-tax discount rate is 10%.
e. Should the Section 338(h)(10) election be made? Why or why not?
f. If the answer to part (e) was yes, how much better off are Orleans and Hurricane at the midpoint price between the amounts you computed in parts (c) and (d), if the election is made, relative to no election at a price of $5,000?