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Tax Geek Tuesday: A Buyer's Best Friend - Understanding The Section 338(h)(10) Election

This article is more than 8 years old.

Let's forget for a moment that you're a low-level employee who spends most lunch hours eating mustard packets in your car. Instead, let's pretend that you're the boss you always dreamed you'd be, and you own your company. And your company has eyes on acquiring another company.

Let's pretend further that the company you'd like to buy is worth $1 million, but if you got a chance to look at the target's balance sheet, you'd see that the tax basis of their assets is only $300,000.

You've decided to pull the trigger and pay the $1 million price tag, but you're left pondering how to get the deal done.

While acquiring a business can feel daunting, what with all of the fancy terms and high-priced attorneys and such, when you boil it all down, there are really just two ways to buy a business: you can either purchase the company's assets, or you can purchase the company's stock.

And in 99 situations out of 100, as the buyer, you are going to prefer to acquire the target's assets. Why?

It all has to do with tax benefits. When you buck up $1 million for the target's business, you're going to want some return on your investment in the form of immediate tax deductions. If you purchase the target's stock, under Section 1012 you will take a $1 million basis in that stock. And while that sounds nice, because stock has an indefinite useful life, it is neither depreciable nor amortizable. Thus, you simply retain the $1 million basis in the stock until you eventually sell the shares, at which point the basis will be available to offset the sales proceeds. No instant gratification here.

When you purchase the stock, nothing changes inside the target. Thus, even though you paid $1 million for the company, the $300,000 tax basis the target holds in its assets remains unchanged. As a result, even though you paid $1 million for the company, you are left depreciating the remaining $300,000 of tax basis. That's not the ideal return on a million dollar investment.

To the contrary, if you purchase the assets of the target, under Section 1012 you take a basis in the acquired assets of $1,000,000. Under Section 1060, you allocate the purchase price among the acquired hard assets, and any amount you paid in excess of the value of the hard assets is allocated to intangible assets like goodwill. This is what is referred to as a "stepped-up" tax basis, because as the buyer, you get to immediately begin depreciating or amortizing the entire $1,000,000 purchase price. In essence, your investment begins immediately paying for itself in the form of tax benefits.

It is the pursuit of this "stepped up" tax basis that almost universally inspires a buyer to pursue a target's assets rather than its stock.

In certain situations, however, a buyer cannot purchase a target's assets because certain non-tax goals or restrictions; for example, when the target has key contracts that are not freely transferable. When this is the case, the buyer must preserve the separate legal existence of the target so that the target's key contracts remain intact. This forces the buyer to acquire the target's stock, which is rather unfortunate, because as laid out above, the buyer loses the tax benefits that come from an asset purchase.

But what if there were a way the buyer could have the best of both worlds? What if a buyer could acquire a target's stock for legal purposes -- thereby keeping the target alive and preserving its non-transferable assets -- but acquire the target's assets for tax purposes, giving the buyer the stepped-up basis in the asset it seeks?

As you've probably guessed, such a solution exists, because if it didn't, I'd have just wasted five minutes of your life with those opening paragraphs. The magic lies in something called a "Section 338(h)(10) election," which surprisingly, is found in Section 338(h)(10) of the Code.

A Section 338(h)(10) election can be made when one corporation purchases the stock of another corporation, and the election must be made jointly by the buyer and the seller. If the election is made, even though the buyer acquired the target's stock, for tax purposes only the buyer is treated as acquiring the target's assets, which will make the buyer rather happy from a tax perspective.

A Section 338(h)(10) election is available only in limited situations. As you'll see below, only certain types of transaction -- with certain types of buyers and targets -- can give rise to a Section 338(h)(10) election. And while the consequences of an election can get a little tricky because a tax fiction is necessary to convert the stock sale for legal purposes into an asset sale for tax purposes, it has been my experience that most of the confusion surrounding a Section 338(h)(10) election is centered around what type of buyer and seller are eligible to make the election.

So let's start our analysis there...

Who can be the buyer in a Section 338(h)(10) transaction?

People often get this area confused, but it's quite simple: the buyer in a Section 338(h)(10) transaction MUST be a corporation. It can be either a C or S corporation, but that's it. No partnerships, no individuals, etc...

Who can be the target in a Section 338(h)(10) transaction?

Once again, the target must be a corporation. But not any old corporation will do; rather, a Section 338(h)(10) election is limited to the stock purchase of three specific types of corporate targets, all of which have something in common. The three types are:

1. A corporation that is a subsidiary in a consolidated group. Under Section 1504, this requires that the subsidiary's stock be owned at least 80% by other members of the group.

2. A corporation that is a subsidiary in a group that is eligible to file a consolidated return, but chooses not to. Again, this means that the corporation must be owned at least 80% by one of the members of the group.

3. An S corporation.

So what's the uniting thread? As we'll see shortly, when a Section 338(h)(10) election is made, there are two steps to the transaction: First, the target corporation is treated as having sold all of its assets in a taxable transaction. Then, however, the target corporation is deemed to liquidate and go out of existence, a matter we'll discuss in great detail. By limiting the eligible types of targets in a Section 338(h)(10) transaction to the three types of corporations listed above, it is ensured that the deemed liquidation will not result in a second taxable transaction. How is this accomplished in each scenario?

1. When a corporate subsidiary liquidates into a parent that owns 80% of the subsidiary's stock, the liquidation is governed by Sections 332 and 337, which provide that the subsidiary recognizes no gain or loss on the distribution of all of its assets to its parent corporation.

2. Sections 332 and 337 also apply when a corporate subsidiary liquidates into it's corporate parent -- provided the parent owned 80% of the subsidiary's stock -- even if no consolidated return is filed.

3. Under Section 1367(a)(1), when an S corporation target recognizes gain on the deemed asset sale, that gain increases the stock basis of its shareholders. On the deemed liquidation, the shareholders must recognize gain or loss on the difference between the FMV of the assets distributed and the shareholders' basis in the stock. Because that basis has been increased by the asset sale gain, mechanically speaking, the gain cannot be recognized a second time upon liquidation.

How does the buyer (P) acquire the target (T) in a Section 338(h)(10) transaction?

As we discussed in the introduction, a Section 338(h)(10) election allows a stock purchase to be treated as an asset purchase, so we know that, in general, P must acquire T's stock. The rules are more specific than that, however. P must acquire the T stock in what's called a "qualified stock purchase," which requires that in a transaction -- or a series of transactions that occur during a 12-month period, subject to the limitations discussed below -- P must acquire 80% of the voting power and value of all classes of T stock.

While that seems fairly straightforward, a couple of aspects of a "qualified stock purchase" require further analysis. The regulations require a purchase, meaning P must acquire the stock constituting control in a transaction that gives P a stepped up basis in the T stock, and that does not qualify as a tax-free incorporation under Section 351 or tax-free reorganization under Section 368. Stated in English, this means P must acquire at least 80% of the T stock in a taxable acquisition.

Ex: T is an S corporation with 100 shares of stock outstanding and a total value of $100. A owns 30 shares of the T stock. A and B form P when A transfers the 30 shares of T stock to P and B transfers $70 to P in exchange for P stock in a Section 351 transaction. P then takes the $70 transferred by B and acquires the remaining 70 shares of T stock from the remaining T shareholders. The purchase of T stock by P for $70 is not a "qualified stock purchase" because while P ends up owning 100% of the T stock, only 70% of the stock was acquired via purchase; the remaining 30% was acquired in a tax-free Section 351 incorporation.

Additionally, the regulations permit the qualified stock purchase to take place over a 12-month period. This would seem to indicate that the purchase of target stock can be done in a a so-called "creeping acquisition;" for example, where P acquires 20% of T in February, 20% in April, 35% in June and the remaining 25% in October. And while that may work fine for a regular Section 338 election, if you look above at the three types of targets that may be acquired in a Section 338(h)(10) transaction, you will notice that each type has specific requirements that largely preclude a creeping acquisition:

1. Target is a subsidiary in a consolidated group: remember, if P acquires T in a creeping acquisition, once it acquires more than 20% of the T stock, T will deconsolidate from its consolidated group because it is no longer "controlled" by the group under the 80% requirement of Section 1504. Thus, if P were to acquire 21% of the T stock in February and the remaining 79% in June, the transaction will fail to be eligible for a Section 338(h)(10) transaction because at the time the purchase is complete in June, T is not a subsidiary in a consolidated group.

2. Target is a subsidiary in an affiliated group that chooses not to file a consolidated return. The same problem as immediately above exists. In order for T to be an affiliated subsidiary at the time of acquisition, it must be 80% controlled by its parent corporation. Thus, P cannot acquire more than 21% of T prior to finalizing the qualified stock purchase.

3. Target is an S corporation. This one is pretty simple: P must be a corporation. An S corporation cannot have a corporate shareholder. Thus, P cannot acquire an S corporation target in a creeping qualified stock purchase because once it acquires the first share of T, T's S election will terminate. Thus, if P wishes to acquire an S corporation T in a qualified stock purchase, it must acquire the requisite 80% of T all at once.

What is the purchase price for the deemed asset sale?

The entire point of a Section 338(h)(10) election is that allows a buyer (P) and seller (T) who engage in a stock sale to pretend they instead engaged in an asset purchase. This requires some creativity, beginning with the determination of the deemed purchase price of T's assets.

Look at it this way: Assume T is an S corporation, with assets with a FMV of $100, liabilities of $40, and thus a net enterprise value of $60. If P acquires all of the T stock, it will pay $60 for the shares, because by acquiring the T stock, P is also acquiring its liabilities, meaning it will only pay the net enterprise value.

If P were to have acquired only the assets of T, however, things would have been different. P would pay an amount equal to the FMV of those assets, or $100. So how do we get from what P actually paid for the T stock ($60) to what P should be deemed to have paid for the T assets ($100)?

The regulations use a formula called the "aggregate-deemed sale price," or ADSP. Computing the ADSP has two steps:

1. First, in situations where P has not acquired 100% of the T stock, you must "gross up" the amount paid for the T stock to arrive at the 100% value. So if P acquired 90% of the T stock for $90, you must gross up the price by dividing $90 by 90% to arrive at an enterprise value for 100% of the T stock of $100.

2. Once you've grossed up the stock purchase price, you must increase the ADSP by T's liabilities as of the acquisition date. By adding back the liabilities, you arrive at the FMV of the underlying assets.

Example: applying the ADSP to our example above, where the FMV of the assets of T is $100, the liabilities are $40, and P acquires the T stock for $60 in a "qualified stock purchase," we start by grossing up the value of the T stock, if necessary, to represent the value of 100% of the T stock. Because P acquired all of the T stock, no gross up is necessary, and the stock value is $60. Next , we must increase the $60 stock value by the T liabilities, or $40. This arrives at an ADSP of $100, which represents the FMV of the T assets, and thus the selling price of the assets in the deemed asset sale.

Tax consequences of a Section 338(h)(10) election

In practice, the majority of Section 338(h)(10) elections are made in conjunction with an S corporation target. For that reason, for the remainder of this TGT, let's narrow our focus to those types of transactions; where P acquires an S corporation target T in a qualified stock purchase, and P and T jointly elect to make a Section 338(h)(10) election.

A Section 338(h)(10) election allows an electing buyer (P) and seller (T) to treat P as having purchased T's assets for tax purposes, even though P purchased T's stock for legal purposes. Because P purchased T's stock for legal purposes, T will remain in existence. Thus, a tax fiction is necessary to create the intended end results whereby 1) T is still a separate legal entity, and 2) P has obtained a stepped-up basis in the assets of T.  With that in mind, when a Section 338(h)(10) election is made, the following steps are deemed to occur:

1. T (now known as "Old T"), is treated as selling all its assets in a single transaction to a new corporation ("New T") owned by P. The deemed sale price in the asset sale is the ADSP as determined above. The purpose of having Old T treated as selling its assets to New T owned by P is to mirror the actual consequences of a stock sale; because P acquired the T stock for legal purposes, when the tax fiction is complete, P must own T -- albeit a "New T" -- as a corporate subsidiary. This creation of New T,  owned by P, to acquire the assets of Old T accomplishes that goal.

As a result of this deemed sale of its assets, old T recognizes gain or loss for the difference between the ADSP as determined under our formula and the tax basis of its assets. As a practical point, T will rarely recognize a loss on the deemed sale of its assets, because if the T assets are worth less than their tax basis, P will likely not seek a Section 338(h)(10) election because it would be required to step down the basis of the acquired assets to their FMV. And who wants that?

2. Old T's gain is generally not taxed at the corporate level when Old T is an S corporation; unless, of course, the built-in-gains rules of Section 1374 apply. Instead, the gain flows through to the corporation's shareholders, who will recognize the gain on their individual returns. Under Section 1367, this gain increases the shareholders' basis in their Old T stock.

3. Old T is treated as having received the ADSP proceeds in step 1 from P and distributing the proceeds to its shareholders in liquidation. Why the need for Old T to liquidate? Remember, while for tax purposes Old T is treated as selling its assets and liquidating, for legal purposes, a "T" remains in existence. We accomplish that fiction in step 1 by having Old T sell its assets to New T; however, we can't have two T's running around for tax purposes when only one exists for legal purposes. As a result, Old T MUST liquidate. Each shareholder will recognize capital gain or loss for the difference between the proceeds deemed received in liquidation and his or her stock basis in Old T. As discussed immediately above, the shareholders' stock basis in T will have just been increased by the deemed asset sale gain, ensuring that this gain is not taxed a second time upon liquidation.

Two important considerations about the deemed liquidation: first, the regulations make clear that Old T's S election terminates  as of the end of the day that includes the sale; thus, the deemed asset sale is simply reported on the final S corporation return for Old T. It is incorrect to file a one-day C corporation return reporting the gain. In addition, there is generally a prohibition on a corporation who had its S election terminate or revoked from making another S or QSub election for five years. In a Section 338(h)(10) election scenario, however, New T is treated as a different corporation from Old T for tax purposes. As a result, if P is an S corporation and wishes to make a QSub election for New T after the transaction, it need not wait five years to do so.

4. The fact that each shareholder actually sold his stock for legal purposes is disregarded for tax purposes; thus, each shareholder recognizes no gain or loss on the sale of their Old T stock, though as indicated in Step 3, they will recognize gain or loss on the deemed liquidation of Old T.

At this point, it makes sense to work through an entire Section 338(h)(10) transaction. Let's work with a fairly basic set of facts: Assume T, an S corporation with one shareholder, A, has the following tax basis balance sheet:

 Tax basis  FMV
 Cash  $400  $400
 Cash-basis accounts receivable  $0  $200
 Depreciable fixed assets (original cost basis of $700)  $200*  $500
Self-created intangibles  $0  $1,000
 Total Assets  $600  $2,100
Liabilities $300 $300
stock/retained earnings $300 $1,800
Total Liabilities/Equity $600 $2,100

-A has a basis in his T stock of $700.

-Corporation P would like to acquire T, and while it would prefer to acquire the assets of T in order to get a stepped up basis in the assets of $2,100, T has a number of key contracts that cannot be transferred, thus P must acquire the T stock.

-The individual federal and state blended rate on long-term capital gains is 25%, while the individual federal and state blended rate on ordinary income is 40%.

Before we examine the consequences of P and T jointly opting to make a Section 338(h)(10) election, we must have a baseline to which we can compare those consequences. So what happens if P simply acquires the T stock directly from A, with no Section 338(h)(10) election?

P acquires T stock, no Section 338(h)(10) election

If P acquires all of the T stock for its value of $1,800 with no Section 338(h)(10) election, under Section 1001 A will recognize long-term capital gain for the excess of the sales price ($1,800) over A's basis in the stock ($700), or $1,100. At the applicable tax rate of 25%, A will pay tax of $275, leaving A with after-tax cash of $1,525 ($1,800 - $275).

P acquires T stock, P and T make a Section 338(h)(10) election

Let's work through the consequences of a joint Section 338(h)(10) election by walking through the numbered consequences laid out above.

1. Step 1: T is treated as selling all of its assets to "New T" for an amount equal to the ADSP. The ADSP is the grossed up amount P paid for the T stock ($1,800) PLUS T's liabilities on the transaction date ($300), or $2,100, which, not coincidentally, is the FMV of the T assets.

The purchase price of $2,100 must be allocated to the Old T assets as it would be for any asset sale, in accordance with each asset's FMV. Thus, $400 of the purchase price is attributable to the cash, $200 of the purchase price is attributable to the cash-basis receivables, $500 is attributable to the fixed assets, and $1,000 is allocated to the self-created intangibles.

With that done, gain or loss on the sale of each asset can be computed. The sale of the cash results in no gain, the sale of the cash-basis receivables generates $200 of gain, the sale of the fixed assets results in $300 of gain, and the self-created intangibles generate $1,000 of gain. Total gain is $1,500.

As we'll discuss more fully below, one of the key considerations given by a seller to a Section 338(h)(10) election must be the character of the gain recognized. If A simply sells his T stock, the entire gain is long-term capital gain (assuming A has held the T stock for longer than one year). When Old T is treated as having sold it's assets, however, the character of the gain must be computed on an asset-by-asset basis. In this case, the sale of the cash-basis receivables and fixed assets result in ordinary income rather than capital gain. Thus, $500 of the total $1,500 gain is taxed at the higher rates applicable to ordinary income. The $1,000 of gain attributable to the self-created intangibles, however, is long-term capital gain.

2. Assuming T is not subject to the built-in gains tax of Section 1374, no corporate level tax is assessed on the $1,500 of deemed asset sale gain. Instead, the gain flows through to A, who will recognize the gain on his Form 1040. This $1,500 of flow-through gain also increases T's stock basis from $700 to $2,200. This gain is reported on the final S corporation return for Old T ending on the date of sale.

3. T is deemed to liquidate by passing out the cash deemed received from New T of $1,800 to A in exchange for A's T stock. Under Section 331, A recognizes capital loss for the difference between the $1,800 deemed received and A's adjusted $2,200 basis in the T stock. Thus, A recognizes $400 of long-term capital loss upon liquidation.

On his individual return, A will pay tax at 40% on the $500 of ordinary income and 25% on the $600 of long-term capital gain, resulting in a total tax bill of $350 and leaving A with after-tax cash of $1,450.

4. A's sale of the T stock for legal purposes is completely disregarded.

5. New T -- owned by P -- takes a basis in the assets acquired from Old T equal to the ADSP of $2,100. The basis is allocated $400 to the cash, $200 to the cash-basis receivables, $500 to the fixed assets, and $1,000 to Section 197 intangibles which are amortizable in the hands of New T. As a gentle reminder, this "stepped up basis" is the primary reason P sought the Section 338(h)(10) election.

Comparison of Consequences

While P has achieved the best of both worlds -- it has acquired the T stock for legal purposes, thus keeping alive any T contracts, but acquired the T assets for tax purposes, giving it a stepped up basis for depreciation and amortization purposes -- A is not indifferent to the Section 338(h)(10) election.

When A sells the T stock and does not make a Section 338(h)(10) election, all of his $1,100 gain is long-term capital gain subject to a favorable rate of 25%. When the election is made, however, $500 of the deemed asset sale gain is treated as ordinary income and taxed at 40%.

These two differences explain why A paid only $275 of tax on a straight stock sale, but $350 in tax when a Section 338(h)(10) election is made. This $75 excess is the difference between the ordinary (40%) and long-term capital gain rates (25%) or 15% on the $500 of gain taxed as ordinary income when the Section 338(h)(10) election is made.

What should A do?

If A is to agree to a Section 338(h)(10) election, he should expect to be made whole by P. Once A can identify what his after-tax cash would have been in a straight stock sale, he can insist that P "gross up" the sales price in conjunction with a Section 338(h)(10) election so that his after-tax cash is identical to a straight stock sale scenario.

Let's walk through it...

In a stock sale, A would have been left with $1,525 of after-tax cash. With a Section 338(h)(10) election, A would be left with $1,450. Thus, we need to get an extra $75 to A via a gross up.

We know that any extra sales price will all be treated as long-term capital gain, so I'm no Will Hunting, but the formula I use is as follows:

X - (long-term capital gain rate * X) = after-tax cash.

So in our facts, it would be:

X - (.25X) = $75

Drawing upon 10th grade math with Mr. Breece, it then becomes:

.75X = $75

x = $100.

Thus, if my math is right, if P pays A $1,900, rather than $1,800 for the T stock, A will be left in the same after-tax position then he would have been in had he simply sold his stock and not made a Section 338(h)(10) election. To prove it out, if P pays A $1.900, the ADSP becomes $2,200. The gain on the sale becomes $1,600; $500 of the gain remains ordinary income, and the remaining gain -- $1,100 -- is long-term capital gain. The gain increases A's basis from $700 to $2,300, and upon liquidation, A recognizes a $400 capital loss, making the net capital gain $700. The ordinary income, at a rate of 40%, continues to generate $200 of tax. The net l0ng-term capital gain of $700, at 25%, now generates $175 of tax, bringing the total tax bill to $375. Thus, A was paid $1,900 in cash and paid $375 in tax, leaving A with $1,525 in after-tax cash, the exact amount A was left with when he simply sold his T stock for $1,800 and did not make a Section 338(h)(10) election.

Now, on to some next-level geekiness.

A selling S corporation shareholder may also be negatively impacted when agreeing to a Section 338(h)(10) election by the presence of an entity-level state tax that could be avoided for a straight stock sale. If this is the case, the purchase price should be further grossed-up to account for the additional tax.

Building on the example above, before considering any entity level tax, P must pay A a total of $1,900 to make A whole for the extra tax it will pay on $500 of ordinary income. At this price, the gain on the sale is $1,600. Assume that in the state T is located, there is an entity-level tax of 3%. This means that T will pay an extra $48 of entity level tax on the deemed asset sale for which he should be compensated.

To compute the purchase price adjustment, it is not enough to gross-up the $48 of additional tax purely by the state tax rate. After all, any additional proceeds will also increase the overall gain, which will be taxed at capital gain rates of 25% (in our example). Thus, the formula to gross-up the $48 tax is

x-.03x - .25x = $48

.72x = $48

x=$66

If we gross up the payment by $66, the total cash purchase price becomes $1,967, and the total purchase price including liabilities is $2,267. Backing out the asset basis of $600, the gain becomes $1,667. Of this gain, $500 remains ordinary income, while the excess of $1,167 is long-term capital gain. Upon liquidation, however, A will recognize a capital loss of $400 ($700 basis + $1,667 flow-through gain - $1,967 of cash), making the net long-term capital gain to A $767. The tax is then computed as follows:

tax on flow through ordinary income: $500 * .40 = $200

tax on net long-term capital gain: $766 * .25 = $192

entity level state tax: $1,667 * .03 = $50

Total tax is $442. Subtract this from the cash received of $1,967 and the net after-tax cash is $1,525, or exactly what it was in a straight stock sale.

Purchase price adjustments even when A is not harmed by a Section 338(h)(10) election

If A's outside basis in T stock is aligned with T's inside basis of its assets and there is no ordinary income recognized by Old T on the deemed sale of its assets, A is generally indifferent to making the Section 338(h)(10) election because the after-tax cash will be the same in either scenario.

However, that does not mean that A isn't in a position to demand an increased purchase price for a Section 338(h)(10) election over what he would have received in a straight stock sale. Remember, P is still benefitting from a Section 338(h)(10) election in the form of stepped-up asset basis that results in higher depreciation and amortization deductions than P would have otherwise received. And more importantly, P can't make the election without A. So A, to borrow a phrase, has P over a barrel, and can insist on a little something extra, you know...for the effort.

P, if it is prudent, will usually be happy to part with a little additional cash in exchange for immediate tax benefits in the form of depreciation and amortization deductions. Both sides win.

Making the Election

P and T must jointly make a Section 338(h)(10) election no later than the 15th day of the 9th month beginning after the month in which the acquisition date occurs. The election is made by filing Form 8023 with the IRS Service Center in Ogden, Utah. The form must be signed by P and, in the case of an S corporation target, by all of the shareholders of T.

In addition to filing Form 8023, Old T and new T must each file a Form 8883, which allocates the ADSP among the acquired assets. This prevents the IRS from getting whipsawed by Old T allocating more of the purchase price to long-term gain producing assets like self-created intangibles while New T pushes more of the purchase price to short-lived assets like inventory or accounts receivable.

Rev. Proc 2003-33 grants an automatic extension of 12 months from the time that an inadvertent failure to file on time is discovered.

When should T be willing to make a Section 338(h)(10) election?

There is generally no tremendous incentive for T to make a Section 338(h)(10) election; in most cases, the seller will be better off simply selling the stock and recognizing all capital gain. An election can be particularly damaging when -- as seen in our example above -- the shareholder's outside stock basis is greater than the inside basis of the assets, because 1) the deemed asset sale gain will be greater than the actual stock sale gain, and 2) while the shareholder should be made whole on liquidation by virtue of recognizing a loss under Section 332 because the stock basis -- after further increase for the deemed asset sale gain -- will exceed the liquidation proceeds, there is a problem with character; specifically, the shareholder might be stuck recognizing ordinary income on the assets sale, but a capital loss on the liquidation.

So when should T agree to a Section 338(h)(10) election?

When T is an S corporation, a Section 338(h)(10) election is desirable when T's inside basis of its assets exceeds the shareholder's outside basis in the T stock. In this scenario, the deemed asset sale gain will be smaller than the gain resulting from an actual stock sale. In addition, if the S corporation has substantial ordinary income-producing assets -- such as cash-basis receivables or fixed assets subject to Section 1245 depreciation recapture -- the deemed asset sale will subject the shareholder to income subject to rates 20% higher than those applied to long-term capital gains.

Care must also be given to identify whether the S corporation T is subject to corporate-level tax on its built-in gains under Section 1374. This would make the deemed asset sale resulting from a Section 338(h)(10) election particularly painful, unless the S corporation has NOLs from prior C corporation years that could eliminate the BIG tax.

When T is a subsidiary in a consolidated or affiliated group, a Section 338(h)(10) election is most desirable when T has net operating losses -- either currently or carried forward -- that T may use to offset or reduce the deemed asset sale gain, thus making T indifferent to the corporate-level asset sale while still enabling T to negotiate a higher purchase price because of P's desire to obtain a stepped up asset basis.

Conclusion

A strong understanding of the merits and drawbacks of a Section 338(h)(10) election is a must for every tax advisor. If  your client is the seller, a properly-identified opportunity to make the election may bring a higher purchase price, and if your client is the buyer, it will yield immediate tax benefits in the form of stepped up tax basis.

An ill-advised election, however, may result in disaster, with a seller paying excess taxes over a straight stock sale, or a buyer being forced to step down the basis of acquired assets.

got an idea for a Tax Geek Tuesday? Send it along to anitti@withum.com or on twitter @nittigrittytax