Sec. 338(h)(10) elections in business acquisitions

In business acquisitions, the buyer and seller often have competing tax objectives: The buyer generally prefers an asset purchase for the stepped–up basis in the acquired assets, while the seller negotiates for a stock sale to avoid double taxation. In the $2 million to $10 million range, this structural divide often stalls transactions for months. The Sec. 338(h)(10) election addresses this conflict by permitting both the buyer and the seller to characterize a statutory stock purchase as a deemed asset sale for federal tax purposes, provided both parties jointly elect to do so on Form 8023, Elections Under Section 338 for Corporations Making Qualified Stock Purchases, and specified entity and timing requirements are satisfied.¹ The election can be beneficial to both parties.

This article describes the mechanics of the Sec. 338(h)(10) election and explores eligibility requirements, tax effects, and practical deal considerations.

The mechanics: Deemed sale and deemed liquidation

As noted above, the Sec. 338(h)(10) election allows the buyer and seller in certain business acquisitions to characterize a statutory stock purchase as a deemed asset sale. When a qualified election is made, the target corporation is treated as having sold all of its assets to a new corporation at the aggregate deemed sale price, which equals the grossed–up amount realized on the purchasing corporation’s recently purchased target stock plus the liabilities of the old target. The target is deemed to have liquidated immediately thereafter.

For S corporation sellers, this structure produces a single layer of taxation: The deemed asset sale generates gain at the entity level, which passes through to shareholders under Sec. 1366, and the deemed liquidation generally produces minimal additional tax because shareholder basis has already been stepped up under Sec. 1367. The buyer receives a stepped–up basis in the acquired assets in an amount equal to the adjusted grossed–up basis. The acquired assets are then depreciated or amortized using the residual method across seven asset classes. Class I through Class VI assets are allocated to fair market value (FMV), with Class VII capturing the residual as goodwill and going concern value, amortizable over 15 years under Sec. 197(a).

This allocation mechanism is the critical driver of buyer value. The buyer gains the ability to deduct depreciation and amortization on the step–up in tax basis from the deemed asset purchase. For example, if the seller held $1.2 million in basis in assets that the buyer acquired for $5 million, the buyer may obtain up to an additional $3.8 million in tax basis. Depending on asset composition, a significant portion of that difference flows through as ordinary deductions subject to modified accelerated cost recovery system (MACRS) recovery periods or Sec. 197 amortization.

The qualification threshold is narrow: The election is available if the purchaser acquires target stock meeting the 80% vote and value requirements of Sec. 1504(a)(2) from a selling consolidated group, a selling affiliate, or the S corporation shareholders in a qualified stock purchase.² Stand–alone C corporations with individual or pass–through shareholders do not qualify. A stand–alone C corporation generally is limited to the regular Sec. 338(g) election, which produces the same double–taxation outcome the Sec. 338(h)(10) election was designed to eliminate and in most cases should not be recommended. If the target is a C corporation with individual shareholders, practitioners must evaluate whether alternative structures such as a Sec. 368(a)(1)(F) reorganization or a Sec. 336(e) election offer more desirable tax treatment. The distinction matters because it reshapes the deal structure at the earliest stage: If the target is a stand–alone C corporation, Sec. 338(h)(10) is not available, and the transaction must be evaluated under different frameworks.

Eligibility and shareholder consent

Every S corporation shareholder of the target must consent to the election, regardless of whether they are selling their shares.³ For example, in an S corporation with four shareholders, if one is a minority holder not participating in the sale, that shareholder must still sign Form 8023. A refusal to sign kills the election, and the seller cannot force the minority shareholder to consent. The consent requirement is absolute, and no exceptions are permitted. This consent requirement should be identified and negotiated at the earliest stage of deal discussions, because discovering minority holdouts at the closing table can be a dealbreaker, depending on the transaction’s sensitivities.

For making a Sec. 338 election for a target corporation, the filing deadline for Form 8023 is the 15th day of the ninth month after the acquisition date. A March 15 closing requires filing by Dec. 15 in the same year. The form is filed by fax to 844–253–9765 or by mail to Ogden, Utah, not with the federal tax return.⁴ This procedural distinction is the source of many misfiled or unfiled elections: The tax return is prepared; everyone assumes Form 8023 was filed; and six months later, the IRS disallows the election because the form never arrived at the service center. If a late failure is discovered, a 12–month automatic extension of time to file the election on Form 8023 may be available if the requirements of Rev Proc. 2003–33 are met,⁵ but it is preferable to avoid relying on that extension. The safer practice is to file the form with sufficient lead time before the deadline to ensure receipt and to obtain evidence of filing from the IRS service center.

Example. A$5 million acquisition: A seller who owns 100% of an S corporation has been taxed as an S corporation for more than five years, with no built–in gains (BIG) tax exposure under Sec. 1374. The buyer pays $5 million for the stock. The target’s assets have an adjusted basis of $1.2 million.

Without the Sec. 338(h)(10) election, this is a straight stock sale. The seller’s gain is $3.8 million. At a combined federal rate of 23.8%,⁶ the federal tax is approximately $904,400. The buyer receives $1.2 million in asset basis, and the $3.8 million premium above basis generates zero tax deductions.

With the election, the S corporation is deemed to sell its assets for $5 million, triggering $3.8 million in gain that flows through to the seller. Character is determined by asset composition: Depreciation recapture on equipment under Sec. 1245 is ordinary income, while goodwill is long–term capital gain. Assume $500,000 is treated as depreciation recapture taxed as ordinary income at 37% federal rates, $500,000 is a covenant not to compete also taxed as ordinary income at 37%, and the remaining $2.8 million is capital gain taxed at 23.8%. The seller’s federal tax is approximately $1,036,400, $132,000 more than the stock sale alternative.

But the buyer now holds assets with a $5 million stepped–up basis. Using the residual method (and Form 8883, Asset Allocation Statement Under Section 338, to report the allocation to the IRS), the buyer allocates $1.5 million to equipment (five–year MACRS property); $500,000 to a covenant not to compete;⁷ and $3 million to goodwill.⁸ In each of the first three years alone, the buyer picks up an average of over $500,000 in depreciation and amortization deductions. At a 21% corporate rate, that is more than $105,000 in annual tax savings.

The seller’s incremental cost is $132,000. The buyer’s benefit is hundreds of thousands of dollars in present–value deductions. In a well–negotiated deal, the buyer compensates the seller for the tax hit, either by increasing the purchase price by $50,000 to $100,000 or through working capital adjustments. The compensation mechanism can take several forms: a purchase price bump that flows to all shareholders, a retention pool held back and distributed to shareholders upon a successful filing of Form 8023, or an explicit gross–up calculation where the buyer pays the seller’s tax liability directly. Practitioners often structure transactions where the purchase price bump equals or exceeds the seller’s incremental tax cost, and both parties still come out ahead, compared to the alternative of extending the asset–versus–stock negotiation for months and potentially walking away. The buyer receives the benefit of a stepped–up basis and associated depreciation and amortization deductions for years to come. The seller receives compensation for the tax hit in the year of closing. The transaction closes faster because both parties have aligned incentives.

Purchase price allocation and Form 8883 coordination

The allocation of purchase price across asset classes is not mandated by statute alone; the residual method itself is prescribed by Regs. Secs. 1.1060–1(c)(2) and 1.338–6, while the specific dollar allocations within asset classes are negotiated by the parties. Both the buyer and the seller must agree on a valuation that complies with the residual method and must report that allocation on Form 8883. The allocation process is where the divergence between buyer and seller interests becomes most apparent.

Equipment in Class V benefits from short MACRS lives and generally is depreciated by the buyer over five to seven years, depending on the asset’s classification under Sec. 168. Sellers push for goodwill in Class VII because it may produce long–term capital gain, generally taxed at preferential long–term capital gains rates. Covenants not to compete are Class VI intangibles, amortizable by the buyer over 15 years under Sec. 197, but are generally ordinary income to the seller. A seller holding a covenant allocation of $1 million faces ordinary–income treatment at rates as high as 37%, whereas an allocation to goodwill may produce capital gain taxation.

Both parties report the allocation on Form 8883, and the IRS cross–references them. Mismatches trigger IRS scrutiny. The allocation is not binding on the IRS, and courts have reviewed allocations that appear inconsistent with FMV, particularly where the parties have been related or the transaction structure seems designed to minimize tax. A transaction that allocates 80% of purchase price to goodwill on a service business with minimal tangible assets may face heightened scrutiny, and both parties should maintain supporting documentation of the valuation methodology. Independent appraisals of intangible assets, including goodwill, customer relationships, and covenant allocations, provide the strongest defense against later audit adjustments. Practitioners should engage valuation specialists to support the allocation before signing Form 8883. The IRS frequently challenges allocations in examination, and having detailed valuation reports in the working papers protects both parties and demonstrates that the allocation was made in good faith based on professional analysis.

Installment reporting and gross-up mechanics

A practical question that divides practitioners is: Can a seller make a Sec. 338(h)(10) election and also use installment sale treatment under Sec. 453 to defer the recognized gain? The answer is yes. Regs. Sec. 1.338(h)(10)-1(d)(8) explicitly authorizes a seller to report the deemed asset sale gain on the installment method when the purchase price is paid over time, and Example (10) in Regs. Sec. 1.338(h)(10)-1(e) illustrates the mechanics. The deemed asset sale is treated as occurring in the acquisition year, but gain recognition is deferred to later installment payments under Sec. 453 mechanics (noting, however, that under Sec. 453(i)(1)(A), depreciation recapture under Secs. 1245 and 1250 must be recognized in the year of the deemed sale, regardless of installment payment timing). In the example above, the seller receiving payments over a three–year note can spread the $3.8 million gain (other than the depreciation recapture) across three years rather than recognizing it in full in year 1, which moderates the tax impact by spreading the gain recognition across multiple tax years and potentially lower marginal rate years.

Equally important is the gross–up negotiation. If the buyer is benefiting from the step–up in basis and the seller is incurring additional tax, should the buyer compensate the seller for the full amount of the incremental tax or only a portion? In institutional deals, a full gross–up is standard: The buyer covers the seller’s entire incremental tax bill, leaving the seller economically indifferent to the Sec. 338(h)(10) election. In lower–middle–market deals under $10 million, there is no consensus. Some buyers offer a 50–50 split. Some offer a full gross–up only if the seller accepts a lower purchase price. Some decline to gross up entirely and let the seller absorb the tax cost in exchange for the buyer’s credit risk and transition support. This negotiation should take place early in deal discussions because it materially affects the deal spread and closing dynamics.

When built-in gains tax applies

If the S corporation was previously a C corporation, Sec. 1374 applies to pre–conversion appreciation during the five–year period beginning with the first day of the first tax year for which the corporation was an S corporation (the recognition period). The BIG tax is imposed at the corporate level at 21%, on top of the pass–through tax to shareholders, and the combined rate on built–in gain can exceed 50%. On a $5 million deal where $2 million of the gain is subject to the BIG tax, it alone is $420,000. Once the recognition period closes, the BIG tax no longer applies, and the Sec. 338(h)(10) election becomes more attractive. Before making the election, practitioners should confirm whether BIG tax exposure remains and compare the combined Sec. 1374 plus pass–through rate to the benefits of the step–up.

De minimis step-up analysis

If the differential between the purchase price and the target’s adjusted basis is minimal, the step–up benefit for the buyer may not justify the administrative cost of the Sec. 338(h)(10) election. On a $2 million acquisition where the target already has $1.8 million in asset basis, the step–up is only $200,000. The present–value benefit of amortizing $200,000 over 15 years for a Sec. 197 asset depends on asset composition. If the $200,000 residual is allocable to goodwill, the present value of amortization is approximately $30,000 to $40,000 at standard discount rates. The administrative steps of obtaining shareholder consent from all shareholders, filing Form 8023 with the correct service center, and preparing Form 8883 with supporting valuation analysis may cost $5,000 to $15,000 in accounting and legal fees. If the buyer’s tax savings are minimal relative to transaction costs, the election simply does not make economic sense. In these situations, the parties are better served by proceeding with a straight stock sale unless other factors make the election attractive.

Net operating loss carryforwards

In consolidated group transactions, the target may hold valuable net operating loss (NOL) carryforwards, and how they are treated can affect the value of making a Sec. 338(h)(10) election. A consolidated group with a target holding $2 million in NOL carryforwards must evaluate whether those carryforwards can be used by other members of the consolidated group, whether they can offset gain recognized in a deemed asset sale, and whether their use is limited by consolidated–return rules or Sec. 382. If the NOL is worth $400,000 to $500,000 to the group in present–value terms and the step–up benefit to the buyer is $350,000, the NOL preservation may be more valuable. Those NOLs have value, and that value should be weighed against the step–up benefit. In some cases, preserving NOL carryforwards is more valuable than the step–up in basis, and the Sec. 338(h)(10) election should not be made. A thorough analysis of NOL availability and utilization must precede the election decision.

Alternative structures and state tax conformity

The Sec. 338(h)(10) election is not the only tool available to address the asset–versus–stock tension. For C corporations, an F reorganization under Sec. 368(a)(1)(F), as interpreted in Rev. Rul. 2008–18, can achieve similar results in some scenarios: The buyer forms a new corporation, the target merges into it in a tax–free transaction, and the buyer ends up with a stepped–up basis in certain assets. However, F reorganizations require specific continuity–of–business facts that are often absent in arm’s–length acquisitions. Additionally, if the buyer is a pass–through entity rather than a corporation, Sec. 336(e) may permit treatment of a stock sale as an asset sale, but the benefit flows to the corporation rather than the shareholders. Each alternative has different applications: Sec. 338(h)(10) applies only to S corporations and consolidated affiliates; F reorganizations apply to C corporations but with limited availability; and Sec. 336(e) applies to pass–through buyers but shifts the tax burden.

A critical issue that practitioners must address early is state tax conformity. Not all states conform to the federal Sec. 338(h)(10) election. Some states automatically respect the federal election. Others require a separate election or do not allow the election at all. New York, for example, conditionally conforms to the federal Sec. 338(h)(10) election and thus does not automatically eliminate state–level taxation. For S corporations, the election is recognized in New York only when the target has made a corresponding New York S election under N.Y. Tax Law Section 660 or is deemed to have made one under the mandatory rules of Section 660(i) where investment income exceeds the statutory threshold. When the election is recognized, the deemed asset sale gain is treated as New York—source income for nonresident shareholders under N.Y. Tax Law Section 632(a)(2). California conforms to the federal election if made, but it taxes goodwill as ordinary income, while federal law taxes goodwill as capital gain. This difference means that a buyer and seller may elect Sec. 338(h)(10) for federal purposes but still face state taxation as if the sale were a stock sale. The state tax cost should be quantified separately and incorporated into the gross–up negotiation. For multistate targets, the Sec. 338(h)(10) election substantially increases the state compliance burden, and the federal benefit of the election may be partially or wholly offset by state taxes.

Timing and deal structure integration

For acquisition targets in the $2 million to $10 million range that are S corporations with low asset basis and no BIG tax exposure, the Sec. 338(h)(10) election is almost always worth modeling. A $3 million acquisition of an S corporation with $500,000 in asset basis produces a $2.5 million step–up. The present value of 15 years of goodwill amortization on a $2 million residual is roughly $250,000 to $335,000 in federal tax savings, depending on the discount rate. On a $3 million deal, that represents more than 10% of the purchase price recovered through tax deductions and depreciation.

The challenge is not complexity but unfamiliarity, and this article is not a substitute for engaging a CPA and attorney experienced in Sec. 338(h)(10) elections and tax planning for mergers and acquisitions. Most buyers’ CPAs handle returns and compliance work. Most buyers’ attorneys perform general commercial mergers and acquisitions. Neither, in some cases, has negotiated a Sec. 338(h)(10) election before. The election never gets raised, the buyer overpays because the step–up was not factored into pricing, or the deal falls apart because the buyer insists on an asset deal and the seller refuses to sign consent documents.

The election must be on the table from the first conversation with both buyer and seller, not after the letter of intent or during diligence. At the beginning, when the parties are still exploring the structure, the conversation is open enough to address the tax implications, the gross–up mechanics, state conformity issues, and the competing alternatives. Once the parties are locked into negotiating the purchase price on a stock–sale basis, retrofitting the election is difficult and often impossible because the price was set without the tax benefit reflected in it. Early identification ensures that all parties understand the mechanical implications and can price the deal appropriately.

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Contributor

Delina Yasmeh, J.D., LL.M. (Taxation), is the principal of Delina ESQ PC in Woodland Hills, Calif., a remote solo practice focused on tax planning, entity structuring, and business formation. For more information about this article, contact thetaxadviser@aicpa.org.

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Footnotes

¹Regs. Sec. 1.338(h)(10)-1.

²Regs. Sec. 1.338(h)(10)-1(c).

³Regs. Sec. 1.338(h)(10)-1(c)(3).

⁴Instructions for Form 8023.

⁵The relief in Rev. Proc. 2003-33 is granted pursuant to Regs. Sec. 301.9100-3.

⁶A 20% long-term capital gains rate plus the 3.8% net investment income tax under Sec. 1411.

⁷Under Sec. 197, 15-year amortization for the buyer, ordinary income to the seller.

⁸Under Sec. 197, 15-year amortization for the buyer, capital gain to the seller.

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