In mergers and acquisitions, tax planning can significantly impact the value and structure of a deal. One of the most powerful-but often misunderstood-tools available to buyers and sellers of corporations is the Section 338(h)(10) election under the Internal Revenue Code. This election allows certain stock sales to be treated as asset sales for federal income tax purposes, offering substantial tax advantages when properly executed.
If you are considering buying or selling a business structured as an S corporation or a subsidiary of a consolidated group, this strategy may be a critical component of your M&A tax planning. Contact us by either using the online form or calling us directly at 414-253-8500 for legal assistance.
Understanding Section 338(h)(10) Election
What Is It?
The Section 338(h)(10) election is a joint election made by both the buyer and the seller in certain corporate transactions. Although the buyer purchases stock, the IRS allows the transaction to be treated as if the buyer had instead purchased assets directly from the corporation.
This duality offers the best of both worlds:
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The seller gets to sell stock, which can result in capital gains treatment.
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The buyer gets a step-up in basis for the corporation's assets, allowing for accelerated depreciation and amortization.
Key Requirements
Not all transactions qualify for a Section 338(h)(10) election. The election can only be made if:
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Target is an S Corporation or a subsidiary in a consolidated group.
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The buyer is a corporation (often a C corporation).
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The buyer acquires at least 80% of the vote and value of the stock in a qualified stock purchase (QSP).
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Both the buyer and seller jointly elect under IRC Section 338(h)(10) by filing IRS Form 8023.
Failing to meet any of these criteria will disqualify the parties from making this election.
Benefits of a Section 338(h)(10) Election
A properly structured 338(h)(10) election can create a win-win for both buyers and sellers. Below are some of the most significant advantages:
For the Buyer
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Step-up in Basis: The buyer is treated as having purchased assets at fair market value, increasing the basis and enabling greater depreciation deductions.
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Avoiding Hidden Liabilities: Since the transaction is treated as an asset purchase, the buyer avoids many of the liabilities associated with buying stock (e.g., contingent liabilities, tax exposures).
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Tax Shield: The enhanced depreciation/amortization can generate a tax shield that offsets future income.
For the Seller
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Capital Gains Treatment: In many cases, especially for S corporation shareholders, the stock sale is taxed at favorable capital gains rates.
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Simplified Sale Structure: The seller avoids the complexity and potential double taxation that often accompanies actual asset sales.
Risks and Considerations
While the benefits can be substantial, a Section 338(h)(10) election also carries drawbacks and complexities that need to be carefully evaluated.
For the Buyer
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Purchase Price Allocation Rules: The buyer must allocate the purchase price across asset classes according to IRS regulations, which may not match financial accounting treatment.
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Loss of NOLs and Tax Attributes: Net operating losses (NOLs) and other favorable tax attributes of the target company are generally lost.
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Increased Transfer Taxes: Since it's treated as an asset sale, the transaction may trigger sales tax, transfer tax, and other filing requirements.
For the Seller
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Double Tax Risk in C Corps: If the selling corporation is a C corporation, the proceeds from the asset sale (deemed under the election) may be taxed at the corporate level before being distributed and taxed again at the shareholder level.
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Complexity in Tax Reporting: Making the election requires coordinating joint filings and careful planning to ensure tax compliance.
When Should You Consider a Section 338(h)(10) Election?
Whether a Section 338(h)(10) election makes sense will depend on a variety of legal, financial, and tax factors. It is most commonly considered in:
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Sales of S Corporations where shareholders want capital gains treatment.
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Sales of subsidiaries in consolidated groups where buyers seek a stepped-up basis in the target's assets.
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Situations where the buyer is wary of inheriting legacy liabilities from the target entity.
In general, buyers are more likely to push for this election due to the tax basis step-up, while sellers must weigh the tax cost and complexity.
Mechanics of Making a Section 338(h)(10) Election
Understanding the procedural aspects of a Section 338(h)(10) election is essential to avoid missteps that can negate the election's benefits.
IRS Form 8023 Filing
To make the election, both the purchasing corporation and the selling shareholders or parent company must file IRS Form 8023 (Elections Under Section 338 for Corporations Making Qualified Stock Purchases). Key points include:
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Deadline: The form must be filed by the 15th day of the ninth month after the month in which the acquisition occurs.
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Joint Election: It is a joint election, meaning both buyer and seller must sign the form.
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Timely Filing: Missing the deadline can make the election null and void, unless relief is granted by the IRS under specific procedures.
Allocation of Purchase Price
The purchase price is allocated among the target's assets under IRC Section 1060 rules, using the "residual method" across seven asset classes. This allocation determines the basis for the buyer and must be reported on Form 8883, Asset Allocation Statement.
Notification Requirements
There are additional reporting and compliance obligations, including:
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Filing Form 8883 by both the buyer and seller with their tax returns.
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Retaining and sharing records related to the transaction and asset allocations.
Section 338(h)(10) vs. Section 338(g): Key Distinctions
Many business owners and even professionals confuse Section 338(h)(10) with Section 338(g). Understanding the distinction is critical:
| Feature | Section 338(h)(10) | Section 338(g) |
|---|---|---|
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Who Can Elect |
Buyer and Seller jointly |
Buyer only |
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Type of Entity |
S Corp or subsidiary in consolidated group |
Any target corporation |
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Tax Impact to Target |
Deemed liquidation is ignored |
Deemed liquidation is taxable |
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Double Taxation Risk |
Generally avoided |
Higher risk of double taxation |
|
Common Use Case |
S corp sale or consolidated group spin-off |
Foreign acquisitions or C corp targets |
Most buyers and sellers will prefer the h(10) election when eligible, due to its favorable treatment and reduced risk of double taxation.
Practical Examples of Section 338(h)(10) in Action
Example 1: Selling an S Corporation
A family-owned S Corporation is sold to a larger corporate buyer. The buyer wants to avoid legacy liabilities and get a step-up in basis. A Section 338(h)(10) election is made.
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Seller's Tax Result: Shareholders pay capital gains tax on stock sale.
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Buyer's Tax Result: Treated as buying assets-depreciates equipment, amortizes goodwill.
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Outcome: Increased post-acquisition cash flow due to depreciation deductions.
Example 2: Spin-Off from Consolidated Group
A parent company sells a wholly-owned subsidiary to an unrelated buyer. They elect Section 338(h)(10) to treat the deal as an asset sale.
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Parent Group: Recognizes gain/loss on the deemed asset sale.
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Buyer: Receives stepped-up basis in assets and avoids historical liabilities.
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Outcome: Efficient exit strategy for the seller and clean acquisition for the buyer.
Professional Guidance Is Critical
The Section 338(h)(10) election is highly technical. Errors in execution or misunderstandings in structure can lead to adverse tax consequences, compliance issues, or IRS disputes. Working with a knowledgeable M&A attorney and tax advisor is essential.
Heritage Law Office provides tax planning and legal representation for business sales and acquisitions. If you're evaluating a transaction that may qualify for a Section 338(h)(10) election, we can help assess whether it's the right strategy and walk you through the filing and documentation requirements.
Contact an Attorney for Section 338(h)(10) Election Transactions
If you're considering the sale or acquisition of a business and want to understand how a Section 338(h)(10) election can impact the tax outcome, contact Heritage Law Office for strategic legal guidance. Our attorneys provide support for complex M&A transactions and post-sale planning.
Call us today at 414-253-8500 or use our online contact form to schedule a consultation.
Frequently Asked Questions (FAQs)
1. What is the purpose of a Section 338(h)(10) election?
The purpose of a Section 338(h)(10) election is to treat a stock sale as an asset sale for federal tax purposes. This allows the buyer to receive a step-up in the basis of the target company's assets, which can result in valuable depreciation and amortization deductions. Meanwhile, the seller may still receive capital gains treatment on the stock sale.
2. Who is eligible to make a Section 338(h)(10) election?
A Section 338(h)(10) election can be made when the target is either an S Corporation or a subsidiary in a consolidated group, and the buyer is a corporation acquiring at least 80% of the target's stock in a qualified stock purchase. Both parties must agree and jointly file IRS Form 8023 to make the election valid.
3. What are the tax benefits for the buyer in a Section 338(h)(10) election?
The primary benefit for the buyer is the step-up in asset basis to fair market value. This provides increased depreciation and amortization deductions that reduce future taxable income. Additionally, buyers may avoid inheriting historical liabilities of the target, as the deal is treated as a new acquisition of assets.
4. Does a Section 338(h)(10) election eliminate the risk of double taxation?
It can reduce or eliminate double taxation risk in many cases, especially when the seller is an S corporation or a consolidated group. Since the target is treated as if it sold its assets and then liquidated, and S corporations generally don't pay corporate tax, the sale can be more tax-efficient. However, C corporation sellers may still face corporate-level tax before distributing proceeds to shareholders.
5. Is a Section 338(h)(10) election mandatory in M&A deals?
No, it is not mandatory. A Section 338(h)(10) election is optional and must be mutually agreed upon by the buyer and seller. Whether it is beneficial depends on various factors including entity type, tax structure, and the goals of the parties. Legal and tax professionals should always be consulted before making the election.