IRC Section 338(h)(10) Elections: Tax Implications for Buyers and Sellers

Let’s chat about a question that comes up a lot when it comes to business sales and acquisitions.

That question is…

“What is a 338(h)(10) election and is it right for my transaction?”

The quick answer is… IT DEPENDS!

We’re going to elaborate more on this.

Understanding Asset Sales vs. Stock Sales

Before diving into the 338(h)(10) election, let’s clarify the fundamental difference between asset and stock sales:

Asset Sale

• Buyer Benefits: “Step-up” in the tax basis of the acquired assets, allowing larger depreciation and amortization deductions post-closing.
• Seller Drawback: Proceeds are allocated among asset classes (tangible assets, receivables, intangibles like goodwill), and some components may generate ordinary-income treatment rather than favorable capital gains.

Stock (Equity) Sale

• Seller Benefit: Sales of equity interests are generally taxed at long-term capital gains rates on the entire purchase price.
• Buyer Drawback: Inherits the seller’s historic tax basis (no step-up), so depreciation/amortization continues on the old basis, and any potential hidden tax liabilities stay with the buyer.

What is a 338(h)(10) Election?

A 338(h)(10) election is a tax strategy available under IRC Section 338 that creates a hybrid approach: the parties execute a stock sale for legal purposes but elect to treat it as an asset sale for tax purposes.

This isn’t just some obscure tax code—it’s a powerful tool that can significantly impact both parties in an M&A transaction.

Here’s the deal: when you make this election, you’re essentially telling the IRS to ignore the actual stock transaction and pretend that:

1. The target corporation sold all its assets to a new corporation
2. The target corporation liquidated and distributed the proceeds to its shareholders

When Can You Use a 338(h)(10) Election?

Not every transaction qualifies. For a 338(h)(10) election to be available:

• The target must be either an S corporation or a subsidiary member of a consolidated group (or an affiliated group that can file a consolidated return)
• The buyer must be a corporation (not an individual or partnership)
• The buyer must acquire at least 80% of the target’s stock in a qualified stock purchase
• Both buyer and seller must agree to make the election

This isn’t something you can decide unilaterally—both parties must be on board and file Form 8023 with the IRS.

Why Consider a 338(h)(10) Election?

Let’s break down the pros and cons for both sides of the table.

Benefits for Buyers

For buyers, a 338(h)(10) election is often highly attractive because:

• Step-up in asset basis: You get to “step up” the tax basis of the acquired assets to fair market value, which means larger future depreciation and amortization deductions.
• Clean slate for tax attributes: You don’t inherit the target’s tax history, liabilities, or attributes.
• Stock purchase advantages: You still get the legal benefits of a stock purchase, including simplified transfer of contracts, licenses, and permits.

Drawbacks for Buyers

It’s not all upside for buyers:

• Higher purchase price: Sellers typically demand compensation for their increased tax burden.
• Complexity: These transactions require more sophisticated tax planning and compliance.
• State and local tax considerations: The treatment may vary by jurisdiction, creating additional complexities.

Benefits for Sellers

Sellers might appreciate that:

• Premium price: Buyers are often willing to pay more to compensate for the tax benefits they receive.
• Single level of tax for S corporation shareholders: Avoid the double taxation that might occur in a C corporation asset sale.
• Clean exit: Possibly fewer ongoing liabilities or representations compared to a straight stock sale.

Drawbacks for Sellers

The 338(h)(10) election comes with significant downsides for sellers:

• Higher tax rate: Ordinary income on certain assets versus potentially lower capital gains rates on stock.
• Immediate tax recognition: All gain is recognized immediately, with no option for installment sale treatment on many assets.
• More complex tax reporting: The deemed asset sale creates a more complicated final tax return.

In Which Situation Are Buyers Capable of Taking Advantage of Sellers?

This is a critical question. Sellers can be at a disadvantage if they don’t fully understand the tax implications of a 338(h)(10) election.

Inexperienced sellers might agree to this structure without demanding adequate compensation for the increased tax burden they’ll bear. The difference between long-term capital gains rates on stock (potentially as low as 20%) versus ordinary income rates on certain assets (up to 37%) can be substantial.

A savvy buyer might propose this structure highlighting only the benefits, while downplaying the true tax cost to the seller. That’s why having a securities lawyer who understands the 338(h)(10) election tax consequences to sellers is absolutely crucial.

Additional Tax Planning Considerations

When contemplating a 338(h)(10) election, it’s worth exploring these additional strategies:

Goodwill and Intangible Amortization

Regardless of the transaction structure, the allocation to goodwill and intangibles can be amortized over 15 years for tax purposes. Properly negotiating the purchase price allocation (PPA) to maximize goodwill can shelter more proceeds with tax-deductible amortization over time.

Installment Sale (IRC §453)

Instead of a lump-sum sale, structuring part of the purchase price as payments over multiple years:

• Defers recognition of gain into the years payments are received
• Avoids “bunching” all income in one year, potentially keeping you in lower tax brackets
• May reduce exposure to Medicare surtaxes and AMT

Note that installment sales have limitations and require filing Form 6252.

Alternative Structures

Depending on your specific situation, other approaches might be worth considering:

• Charitable Remainder Trust (CRT): Transfer business interests before sale to defer gains and create income streams
• ESOP: Selling to an Employee Stock Ownership Plan can provide tax benefits while rewarding employees
• Rollover Equity: Retaining a minority stake in the combined firm can defer taxes on that portion until a future sale

Determining if a 338(h)(10) Election Makes Sense

When evaluating whether this election is right for your transaction, consider:

1. Tax modeling: Run the numbers both ways—with and without the election—for both parties.
2. Purchase price adjustment: Calculate the appropriate premium to compensate the seller for increased tax costs.
3. Asset composition: The nature of the company’s assets significantly impacts the tax consequences.
4. Future plans: Consider the buyer’s post-acquisition plans and how the stepped-up basis might benefit them.
5. 338(h)(10) election requirements: Ensure all technical requirements are met.

The Bottom Line

The 338(h)(10) election isn’t inherently good or bad—it’s a strategic choice that must be carefully evaluated based on the specific circumstances of your transaction.

Like most things in the financial world, there’s no one-size-fits-all answer. It all comes down to PLANNING.

Taking Action—Doing Nothing, Changes Nothing

As you prepare for a significant business transaction, consider these key action items:

1. Start Early: Structure and elections (like §338(h)(10)) must often be decided well before closing.
2. Engage Specialists: Work with M&A advisors experienced in deals to negotiate purchase-price allocations and elections.
3. Balance Cash vs. Tax Efficiency: Sometimes buyers pay more for simpler stock deals; other times they demand asset deals for step-up benefits.
4. Consider Your Future Role: If you stay on as an advisor, rollover equity or earn-outs can tie your compensation into future growth of the firm.

Each merger or sale is unique. A comprehensive tax plan aligned with your liquidity needs, risk tolerance, and post-exit goals is essential to maximize after-tax proceeds.

Our team at My RIA Lawyer understands the nuances of complex business transitions. Whether you need help with securities law challenges, outsourced compliance support during your transition, or want to enhance your team’s knowledge through our Compliance University, we’ve got your back.

You’re not alone. Contact us today to ensure your next business transaction is structured for optimal tax efficiency.