Understanding the 338(h)(10) Election
The Section 338(h)(10) election allows a qualifying stock acquisition to be treated, for tax purposes, as if the buyer purchased the target’s assets directly. In practice, this means the buyer receives a stepped-up tax basis in the target’s assets, while the seller is treated as having sold assets rather than stock. The legal form of the transaction remains a stock purchase, which can be attractive for purposes of operational continuity, contract assignments, and licensing, while the tax form mirrors an asset sale. This hybrid treatment is powerful but nuanced, and it requires meticulous coordination between tax, legal, accounting, and valuation professionals to execute correctly.
Although often described informally as a “simple way to get an asset deal,” a 338(h)(10) election layers substantial complexity onto an M&A process. The parties must satisfy eligibility requirements, mark the target’s assets to fair market value, compute the aggregate deemed sales price and adjusted grossed-up basis, allocate value under Section 1060 and the residual method, and file multiple forms on strict deadlines. Errors at any stage can jeopardize the election, distort the buyer’s future deductions, and trigger costly disputes with tax authorities. An experienced advisor can differentiate between a defensible step-up and an audit-ready fire drill.
Eligibility and When the Election Is Available
A 338(h)(10) election is available only when the buyer makes a qualified stock purchase (QSP) of a target corporation. A QSP generally requires the buyer to acquire at least 80 percent of the total voting power and value of the target’s stock within a 12-month acquisition period. The target must be a domestic corporation that is either a member of a consolidated group, an S corporation (with all shareholders consenting), or a subsidiary of an affiliated group filing a consolidated return. Public targets and targets with dispersed shareholder bases can present additional consent and procedural hurdles.
Not every transaction that superficially resembles a qualifying stock purchase will satisfy the technical rules. For example, preferred stock with unusual rights may affect the value computation, options and warrants may impact the measurement of ownership thresholds, and staggered closings or rollover equity can complicate the acquisition period analysis. Advisors often discover late-stage impediments because the parties assumed an “equity deal with a tax step-up” would automatically qualify. A rigorous eligibility review early in the deal process is indispensable to avoid discovering ineligibility after definitive agreements are executed.
Buyer and Seller Economic Objectives
The 338(h)(10) election redistributes tax consequences between buyer and seller compared to a plain stock sale. The buyer benefits from higher depreciation and amortization deductions on the stepped-up basis, including potential amortization of Section 197 intangibles. The seller, in contrast, is generally treated as selling assets, which may produce ordinary income from depreciation recapture, hot asset treatment on certain items, and state tax implications that differ from a stock sale. Negotiation of purchase price, a tax gross-up, or a specific allocation can resolve the delta between buyer and seller preferences.
Laypeople often assume a 338(h)(10) is a “win-win” because the legal form remains a stock sale. In reality, the election can materially increase the seller’s current tax burden while accelerating the buyer’s deductions. Whether the net present value is favorable depends on the nature of the target’s asset base, the magnitude of intangible value, the expected holding period, the buyer’s projected taxable income, and state tax conformity. Sophisticated modeling that integrates federal and state rules, purchase price allocation, and capitalization policies is essential before committing to the election in the purchase agreement.
Timeline and Required Filings
The election requires filing Form 8023 by the 15th day of the ninth month after the month in which the qualified stock purchase occurs. The timing rule is deceptively strict: a closing late in a calendar month can shorten the effective filing window by almost a full month. Extensions for the income tax return do not extend the Form 8023 deadline. If the target is an S corporation, all S shareholders during the acquisition period must consent. If the target is a consolidated group member, the selling consolidated group must join the election. Late or incomplete filings risk loss of the election and the intended basis step-up.
After the election, both buyer and seller must report the transaction consistently. The buyer files Form 8883 to report purchase price allocation under Section 1060, and the seller reports the deemed asset sale. State filings may be required, and not all states conform. Meticulous calendaring, coordination among counsel, and document control are critical. A best practice is to assign a single owner for tracking the filing package, gathering all consents, reconciling tax identification data, and verifying that the target’s historical accounting supports the asset classification used on Form 8883.
Purchase Agreement Provisions That Make or Break the Election
A purchase agreement that contemplates a 338(h)(10) election should include precise provisions addressing tax treatment, filing responsibilities, and dispute resolution. The agreement should obligate the parties to make the election, specify who will prepare Form 8023 and Form 8883, and require cooperation to obtain all consents. It should articulate a binding purchase price allocation methodology, typically the residual method under Section 1060, and provide mechanisms to update the allocation for post-closing adjustments to purchase price (for example, working capital true-ups and earnouts). Absent these provisions, post-closing disagreements can produce inconsistent filings and attract regulatory scrutiny.
Representations and warranties should cover the target’s tax status, S corporation validity (if applicable), existence of tax elections, asset classification, and historical treatment of intangibles. Covenants should restrict pre-closing actions that could jeopardize eligibility, such as issuing additional equity or changing accounting methods. A tax matters section should allocate control over tax audits, define cooperation obligations, and establish tax indemnities for breaches and pre-closing taxes. Importantly, the agreement should address the economic sharing of the election’s consequences, including any seller gross-up to offset incremental ordinary income or recapture.
Computing and Allocating Aggregate Deemed Sales Price
The 338(h)(10) mechanics hinge on determining the aggregate deemed sales price (ADSP) and the adjusted grossed-up basis (AGUB). ADSP equals the total consideration deemed received by the target for its assets, including the buyer’s purchase price for stock, liabilities of the target, and other amounts properly taken into account. AGUB reflects the buyer’s cost for the assets, including the price paid for stock and the target’s liabilities. While the terms appear similar, they are not interchangeable, and confusion between them can distort the allocation between asset classes.
Once ADSP and AGUB are computed, the parties must allocate the amounts among the asset classes prescribed by Section 1060 and the applicable regulations. This residual method places fair market value first to Class I cash and deposit accounts, then to receivables, inventory, tangible personal property, real property, and finally to intangibles, with any residual value to goodwill and going concern value. The allocation must be grounded in defensible valuations. Discrepancies between legal documentation, the valuation report, and tax forms invite challenges and can undermine the buyer’s future deductions, especially for intangibles and self-created software, customer relationships, and trade names.
Tax Basis Step-Up and Depreciation/Amortization
With a valid 338(h)(10) election, the buyer receives a stepped-up basis in the target’s assets equal to AGUB as allocated under the residual method. This increases future depreciation and amortization deductions, which can materially reduce cash taxes. The profile of those deductions depends on the specific assets. Real property is depreciated over long recovery periods; tangible personal property may qualify for bonus depreciation; and Section 197 intangibles, including goodwill, are amortized straight-line over 15 years. Accurately classifying assets at closing is critical because it governs the timing and character of deductions for years to come.
Buyers often overestimate the immediate cash tax benefit by assuming an aggressive allocation to short-lived assets or by overlooking limitations such as bonus depreciation phase-outs, interest expense caps, or limitation rules triggered by change in ownership. Additionally, anti-churning rules can disallow amortization of certain intangibles in related-party contexts. An informed advisor will test multiple allocation scenarios, run multi-year tax models, and incorporate state apportionment and conformity rules to confirm that the forecasted benefits are realistic and supported by market data and valuation principles.
Impact on S Corporations and QSubs
For an S corporation target, a 338(h)(10) election treats the transaction as if the S corporation sold its assets and then liquidated. The S shareholders are treated as selling interests in assets, potentially recognizing ordinary income on recapture and capital gain on the balance. All S shareholders must consent to the election on Form 8023, which can be challenging when there are numerous small shareholders or historical transfers that were not properly documented. Maintaining S status prior to closing is vital; inadvertent terminations can derail eligibility and require remedial filings or closing delays.
If the S corporation owns a qualified subchapter S subsidiary (QSub), the election’s deemed asset sale can terminate QSub status and trigger complex intercompany and state law consequences. Intercompany debt, tax attributes, and built-in gains considerations demand careful review. A seasoned professional will validate the S corporation’s eligibility, verify shareholder consents, and reconcile any historical basis and AAA (accumulated adjustments account) computations to ensure that the S-level and shareholder-level tax reporting aligns with the election’s effect.
Consolidated Groups and Target Affiliates
When the seller is a consolidated group, a 338(h)(10) election treats the target as selling assets immediately before leaving the group. This can accelerate recognition of intercompany items, trigger deferred gains, and require the seller’s consolidated return to reflect the deemed sale. Separate return limitation year rules and attribute redeterminations may apply. The seller’s group must consent to the election, and the purchase agreement should allocate responsibility for preparing the seller’s consolidated return and managing any audit involving pre-closing periods.
Targets with domestic and foreign affiliates, disregarded entities, and partnerships require a meticulous entity chart and tax classification analysis. Disregarded subsidiaries’ assets are included in the deemed sale. Interests in partnerships raise special rules for hot asset characterization and inside basis considerations. Without a comprehensive diligence of intercompany agreements, transfer pricing policies, and historical tax sharing arrangements, parties risk unexpected ordinary income, attribute limitations, or mismatches between book and tax that can complicate post-closing integration and compliance.
State and Local Tax Conformity
State conformity to a 338(h)(10) election is uneven. Some states follow the federal election fully, others partially, and a few do not recognize it at all, treating the transaction as a stock sale for state purposes. The result is a mosaic of outcomes: the buyer may receive a federal step-up but not a state step-up, or the seller may face state-level asset sale treatment without corresponding buyer benefits. Apportionment, nexus, and filing methodology can also change after the transaction, particularly if the target’s separate company becomes part of the buyer’s combined group.
It is a mistake to assume that the federal allocation on Form 8883 can be replicated verbatim for state returns. States can impose their own class definitions, intangible tax regimes, transfer taxes on real property, and franchise tax base rules. In multistate contexts, an advisor should produce a state-by-state matrix of conformity, evaluate the effect on deferred tax balances, and update the purchase price allocation to reflect state tax economics where the purchase agreement requires alignment with GAAP purchase accounting.
Common Pitfalls, Anti-Churning, and Hot Asset Considerations
Frequent pitfalls include failing to obtain all necessary consents, miscomputing ADSP or AGUB by omitting liabilities or contingent consideration, and adopting an allocation that is inconsistent with contemporaneous valuation evidence. Another common error is assuming that a post-closing price adjustment need not be reflected in an updated allocation; in fact, the regulations require the allocation to track consideration changes. Additionally, earnouts, rollover equity, seller notes, and indemnity escrows must be modeled as part of ADSP and AGUB with attention to their fair value at closing and subsequent adjustments.
The anti-churning rules can deny amortization of certain intangibles acquired from related parties or where the intangible was held or used in a trade or business before August 10, 1993. Hot asset rules under Section 751 can recharacterize gain as ordinary income for partnership interests; analogous concepts arise with inventory and receivables in corporate contexts, generating ordinary income on the deemed sale. Depreciation recapture under Sections 1245 and 1250 can produce significant ordinary income for sellers. Identifying and quantifying these items during diligence informs negotiation of purchase price and any seller gross-up to leave both sides economically whole.
Valuation, Appraisals, and Documentation
A defensible purchase price allocation depends on robust valuation work that ties to market evidence and the target’s financial realities. Independent appraisals for tangible assets should reconcile with fixed asset ledgers, engineering reports, and, where applicable, cost segregation analyses. For intangibles such as customer relationships, trademarks, technology, and noncompete agreements, qualified appraisers should use recognized methods like the multi-period excess earnings method, relief-from-royalty, and with-and-without analyses. The allocation’s inputs should align with deal documents, board materials, and internal forecasts to avoid inconsistencies that erode credibility.
Documentation is a core audit defense strategy. Maintain a comprehensive file that includes the signed purchase agreement, election and consent forms, valuation reports, accounting memos, tax models, correspondence evidencing the parties’ agreement on allocation, and state conformity analyses. Meticulous documentation also facilitates future divestitures, impairment testing, and tax planning, as subsequent transactions will build upon the established basis and allocation. Without this documentation, future teams are forced to recreate analyses under time pressure, increasing the risk of misreporting and penalties.
Modeling Cash Taxes, Gross-Up, and Tax Sharing Agreements
Before committing to a 338(h)(10) election, both sides should perform detailed multi-year cash tax modeling. The buyer’s model should forecast the timing of deductions by asset class, limitations on interest and NOL usage, and the interaction with capital expenditure plans. The seller’s model should quantify ordinary income from recapture, capital gain, state taxes, and the effect on estimated tax payments and safe harbors. Only with this information can the parties negotiate an appropriate purchase price adjustment or a tax gross-up to equitably share the costs and benefits of the election.
A well-drafted tax sharing or indemnity agreement specifies responsibility for pre-closing taxes, tax audits, amended returns, and any transfer taxes. It should define control of controversies, settlement thresholds, cooperation obligations, and access to records. The agreement must also address how post-closing adjustments to consideration will be treated for tax purposes and how updated allocations will be prepared, agreed, and filed. Absent clear rules, even modest disputes over working capital or earnouts can cascade into inconsistent tax reporting and exposure to penalties.
Post-Closing Compliance and Controversy Readiness
After closing, the administrative work begins. The buyer must compute tax depreciation and amortization schedules consistent with the final allocation, track book-tax differences for financial reporting, and implement controls to capture subsequent adjustments that may require amended Form 8883 filings. The seller must report the deemed asset sale properly, recognizing ordinary and capital components, and must file any required short-period returns. If the target operated across multiple jurisdictions, both parties should expect state notices and information requests that require coordinated responses.
Audit readiness is not optional. Tax authorities scrutinize 338(h)(10) elections because they recharacterize the transaction’s form and materially affect taxable income. A strong defense includes reconciliations from legal consideration to ADSP and AGUB, valuation reports with clear methodologies, tie-outs to fixed asset registers, and evidence of consistent reporting by both sides. Advisors should prepare an internal memo explaining key judgments, allocation choices, and assumptions, so that the rationale is preserved if personnel change before an audit arises several years later.
Working With Lenders, Insurers, and Financial Reporting
Lenders often impose covenants that affect the structure and timing of elections, especially where debt-financed acquisitions interact with interest limitation rules and deferred tax balances. Coordination ensures that the forecasted tax shield from the step-up is appropriately reflected in debt service coverage ratios and that financial covenants remain attainable. Where applicable, tax insurance can mitigate specific risks, such as uncertainty around S status validity or anti-churning exposure, but underwriters require robust diligence and cogent documentation of the tax position.
From a financial reporting perspective, purchase accounting under GAAP requires recognition of identifiable intangible assets and goodwill, which should align with the tax allocation to avoid creating unnecessary permanent differences or deferred tax complexity. The finance team must reconcile the tax and book basis, record deferred tax assets and liabilities, and ensure that internal controls capture the post-closing depreciation and amortization profile. A disconnect between the tax file and the accounting file is a common source of restatements and audit adjustments.
International and Cross-Border Considerations
Although a 338(h)(10) election applies to domestic targets, cross-border elements can complicate execution. The target may own foreign subsidiaries, branches, or controlled foreign corporations with earnings and profits, hybrid instruments, or intercompany loans. The deemed asset sale may interact with Subpart F, GILTI, and foreign tax credit rules in ways that change the buyer’s projected effective tax rate. Transfer pricing policies and historical documentation should be reviewed to ensure that the deemed sale pricing aligns with arm’s-length standards for any cross-border intercompany arrangements.
Foreign jurisdictions may not respect the U.S. tax election, producing a mismatch between domestic and foreign tax treatment. This can affect creditability of foreign taxes and the recognition of deferred tax positions. Early involvement of international tax specialists ensures that the election’s benefits are not offset by unintended foreign tax costs or compliance burdens. Even where the target’s operations seem domestic, intangible development arrangements and contract R&D relationships may introduce cross-border considerations that demand careful analysis.
When to Consider Section 336(e) Instead
When a 338(h)(10) election is unavailable or impractical, a Section 336(e) election may offer a path to similar deemed asset sale treatment. Section 336(e) can be made by the seller in certain qualifying dispositions, including taxable sales and distributions that do not meet the 80 percent threshold within a 12-month period in the same manner as a QSP. However, the procedural rules, consent requirements, and state conformity differ. Section 336(e) is not a perfect substitute; it requires careful coordination to achieve consistent reporting and to manage the seller’s and buyer’s tax outcomes.
Parties sometimes default to a 336(e) election without appreciating differences in mechanics, especially with respect to reporting, timing, and the scope of affected parties. Advisors should compare both paths early, model the economics under each, and draft the purchase agreement to preserve flexibility. Preserving optionality can be valuable where shareholder consents for a 338(h)(10) are uncertain, or where transaction timing threatens the Form 8023 filing window.
Practical Step-by-Step Plan for Execution
First, confirm eligibility by mapping the ownership structure, analyzing the acquisition period, and reviewing any instruments that could affect voting power or value. Second, align on economic objectives through integrated modeling that quantifies the buyer’s step-up benefits and the seller’s tax costs, including state and local effects. Third, embed the election mechanics in the purchase agreement: mandate the election, define filing responsibilities, attach a draft allocation or methodology, and specify audit control and tax indemnities. Establish a detailed closing checklist that includes obtaining consents from all required parties, especially S shareholders and selling consolidated groups.
After signing, commission independent valuations that will support the residual allocation across asset classes. Build a working model to compute ADSP and AGUB and to track contingent consideration, seller notes, rollover equity, and post-closing adjustments. Prepare Form 8023 with all consents, and calendar the deadline based on the closing month. Post-closing, finalize Form 8883, update allocation for any true-ups, and align book and tax fixed asset records. Maintain a comprehensive audit file that reconciles all numbers and assumptions, and institute controls to capture subsequent changes that may require amended filings. Throughout, involve seasoned tax and legal advisors to navigate nuanced issues and prevent irreversible errors.
Key Misconceptions and How Professionals Add Value
Common misconceptions include the belief that a 338(h)(10) election is merely a box to check, that it always benefits both sides, and that the allocation can be “fixed later.” In reality, the election recharacterizes the transaction with significant consequences for current and future taxes, requires precise calculations and coordinated reporting, and is highly sensitive to valuation and documentation quality. Missing the Form 8023 deadline, failing to obtain all consents, or adopting an indefensible allocation can erase the intended benefits and invite controversy.
Experienced professionals bring rigor to eligibility analysis, negotiation strategy, valuation oversight, modeling, and compliance. They anticipate anti-churning and hot asset traps, reconcile federal and state differences, and draft contract provisions that convert tax planning into enforceable obligations. Equally important, they build the audit file contemporaneously so that years later, when questions arise, the parties can demonstrate consistency and credibility. The complexity inherent in even “simple” deals means that do-it-yourself approaches often cost more in the long run through lost deductions, penalties, and disputes.
Final Considerations and Action Items
Executing a 338(h)(10) election effectively is a multidisciplinary effort that spans structuring, negotiations, valuation, tax compliance, and financial reporting. Begin with a clear articulation of objectives and constraints, validate eligibility early, and incorporate the election into the transaction documents with specificity. Invest in qualified valuations and build models that capture federal, state, and cross-border effects. Assign clear ownership for forms, deadlines, and recordkeeping, and maintain meticulous documentation to support the position in audits and future transactions.
For buyers, confirm that forecasted tax benefits are realistic given asset mix, bonus depreciation rules, and limitations on interest and NOLs, and ensure that the step-up aligns with integration and capital plans. For sellers, quantify ordinary income exposure and negotiate compensatory economics where appropriate. Both sides should align on allocation and controversy protocols to minimize risk. Involving experienced counsel and advisors from the outset is the most reliable way to convert a complex statutory election into a durable, value-creating outcome.
