Treating a Stock Purchase as an Asset Purchase for Tax Purposes: When is a 338(h)(10) Election Appropriate?
As a matter of non-tax law, it is often preferable and less cumbersome to structure the sale of a business as a stock sale rather than as a sale of assets. Stock sales, however, do not allow purchasers to benefit from a “step up” in the basis of the acquired company’s assets. In such circumstances, parties to a transaction can utilize one of the few, genuine diathroses of the tax code — an election under Section 338(h)(10), which permits taxpayers to achieve the tax benefits of an asset sale while structuring the transaction as a stock sale.
If the target is (i) a member of a consolidated group, (ii) a non-consolidated selling affiliate, or (iii) an S corporation, and the purchaser acquires a minimum percentage of the target’s stock by vote and value (after excluding any non-voting, non-convertible preferred stock) within a defined acquisition period, the buyer and seller may jointly elect under Section 338(h)(10) of the Internal Revenue Code to treat the stock sale as a sale of assets for tax purposes.
From a technical standpoint, the 338(h)(10) election causes the target to be deemed to have sold its assets in a taxable transaction and then distributed the proceeds in a constructive liquidation while still a member of the selling consolidated group or while still owned by the selling affiliate or S corporation shareholders. The sale of the target’s stock will accordingly be ignored, and the distribution of the proceeds from sale will be treated as a complete liquidation under Sections 336 and 337 of the Code. The parties then allocate the purchase price for the stock (grossed up to 100 percent if less than 100 percent is sold) and liabilities of the target amongst the target’s assets (including goodwill) in the same manner as an asset sale.
A purchaser benefits from a 338(h)(10) election if the stock purchase price is greater than target’s basis in its assets (the “Inside Basis”). In such cases, the purchaser is able to step up the Inside Basis to equal the purchase price, and thereby claim higher depreciation deductions from the increased Inside Basis.
Additionally, if the target was a member of a consolidated group, the deemed asset sale will be considered to have occurred while the target was still a member of the selling consolidated group. This makes it possible to shelter the gain on the deemed asset sale with operating losses of the selling group.
However, in situations where the Inside Basis is lower than the seller’s basis in its target corporation stock (the “Outside Basis”), a 338(h)(10) election will tend to disadvantage the seller, who may incur additional taxes due to the disparity between Inside and Outside Bases. In such situations, it is often advantageous for the purchaser to pay some or all of any additional tax incurred by the seller. Because any additional payment by the purchaser for the increased taxes is itself taxable, the entire indemnification amount must be “grossed up” by the highest applicable tax rate.
A Section 338(h)(10) election often provides parties to stock sale with the best of all worlds. However, due to the existence of certain complexities in the tax law, the election should be made only in certain circumstances and only after careful evaluation, particularly in the case of S corporations.