IRC §338(h)(10) election: how to treat a stock sale as an asset sale for tax purposes, the buyer's stepped-up basis advantage, the seller's phantom-sale mechanics, and when the election makes sense for both parties

When a buyer acquires a business, the transaction is typically structured as either a stock purchase (the buyer acquires the target company's equity, getting the company as a whole including all assets, liabilities, and tax attributes) or an asset purchase (the buyer acquires the individual assets, leaving the corporate shell with the seller).

The two structures produce fundamentally different tax outcomes. In a stock purchase, the buyer inherits the target's existing tax basis in its assets (no step-up). In an asset purchase, the buyer gets a new cost basis in each asset equal to the purchase price allocated to it (a stepped-up basis that generates fresh depreciation and amortization deductions).

For buyers, the asset purchase is almost always preferable from a tax standpoint: the stepped-up basis produces deductions that reduce taxable income for years. For sellers of C corporations, the asset purchase is tax-disadvantageous because it creates two levels of tax: the corporation pays tax on the asset sale, and the shareholders pay tax on the liquidating distribution.

IRC §338(h)(10) creates a hybrid: the transaction is structured as a stock purchase (which is often simpler from a legal and operational perspective), but the parties jointly elect to treat it as an asset sale for tax purposes. The buyer gets the stepped-up basis. The seller reports the deemed asset sale. And the legal and operational advantages of a stock purchase (contract assumption, license transfer, entity continuity) are preserved.

When §338(h)(10) applies

The election is available in two contexts:

S corporation acquisitions. When a buyer purchases 100% of the stock of an S corporation, the buyer and seller can jointly elect §338(h)(10) treatment. This is the most common use of the election, because S corporation sales are common in small and mid-market M&A, and the single level of taxation at the S corporation level makes the deemed asset sale less costly to the seller than it would be for a C corporation.

Consolidated subsidiary acquisitions. When a buyer purchases 80% or more of the stock of a subsidiary from a parent corporation that files a consolidated return, the election is available. This is more common in larger transactions involving divestitures of business units.

The election is not available for standalone C corporation acquisitions (a buyer purchasing the stock of a standalone C corporation directly from its shareholders). For those transactions, the §338(g) election exists but is rarely used because it triggers a double tax: the deemed asset sale is taxed at the corporate level, and the stock sale is taxed at the shareholder level. The §338(h)(10) election eliminates the double tax by treating the transaction as a single event (the deemed asset sale) rather than two events (asset sale plus liquidation).

How the mechanics work

When the §338(h)(10) election is made, the legal reality (a stock purchase) and the tax fiction (an asset sale) diverge:

Legal reality. The buyer purchases 100% of the target's stock from the selling shareholders. The target corporation continues to exist as a legal entity. All contracts, licenses, leases, and obligations remain with the target. The employees remain employed by the target. The buyer owns the target as a subsidiary.

Tax fiction. The IRS treats the transaction as if the target corporation sold all of its assets to a hypothetical buyer at fair market value (the deemed sale), recognized gain or loss on the deemed sale, distributed the proceeds to the selling shareholders in liquidation, and then the "new" target corporation (owned by the buyer) purchased the assets at the deemed sale price.

The result for the buyer: the target's assets have a new, stepped-up cost basis equal to the purchase price allocated among them. The buyer can depreciate and amortize these assets over their applicable recovery periods, generating tax deductions that reduce taxable income. For assets with significant appreciation (goodwill, real estate, equipment), the step-up can produce millions of dollars in deductions over the recovery period.

The result for the seller: the selling shareholders report the gain on the deemed asset sale as if it flowed through the S corporation to them (for S corporation targets) or as part of the consolidated return (for consolidated subsidiaries). The character of the gain depends on the assets: ordinary income on inventory and receivables, capital gain on capital assets and goodwill. This differs from a straight stock sale, where the seller would report only capital gain on the stock.

The allocation under §1060

The deemed purchase price (the total amount paid for the stock, adjusted for assumed liabilities) is allocated among the target's assets using the same §1060 residual method that applies to actual asset acquisitions. The seven asset classes (cash, actively traded securities, receivables, inventory, tangible and intangible assets, §197 intangibles, and goodwill/going-concern value) are filled sequentially, with goodwill absorbing the residual.

The allocation determines the buyer's depreciable and amortizable basis in each asset class and the seller's character of gain on each class. The buyer wants more allocated to depreciable assets with shorter recovery periods; the seller wants more allocated to capital-gain assets (goodwill). The negotiation dynamics are identical to an actual asset purchase under §1060.

Both parties must report their allocations on Form 8594 (Asset Acquisition Statement), and the allocations should be consistent. The §338(h)(10) election itself is made on Form 8023 (Elections Under Section 338 for Corporations Making Qualified Stock Purchases).

Why the election benefits the buyer

The buyer's primary benefit is the stepped-up basis. Without the election, a stock purchase gives the buyer the target's historical (carry-over) basis in its assets. If the target purchased its equipment ten years ago for $500,000 and has depreciated it to $50,000, the buyer inherits the $50,000 basis and the remaining depreciation schedule. If the buyer paid $5 million for the stock, the $4.95 million of purchase price attributable to asset appreciation generates no deductions.

With the election, the same $5 million purchase price is allocated among the assets at fair market value. The equipment might be allocated $200,000 (its current fair market value), generating $200,000 of depreciable basis. Goodwill and other intangibles absorb the remainder, generating 15-year amortization deductions under §197. The buyer gets deductions on the full purchase price rather than inheriting the seller's depreciated basis.

The present value of these deductions can be substantial. On a $5 million acquisition with $3 million allocated to 15-year goodwill, the annual amortization deduction is $200,000, worth approximately $50,000-$70,000 per year in tax savings (at a 25-35% effective rate) for 15 years. Over the life of the amortization, the step-up can be worth $750,000 to $1 million in tax savings.

Why the election may cost the seller

The seller's tax treatment under the election differs from a straight stock sale in character and timing:

In a straight stock sale, the seller reports the gain as capital gain on the sale of stock. For S corporation shareholders, this is generally long-term capital gain (if the stock was held more than one year), taxed at rates up to 20% plus the 3.8% NIIT.

Under the §338(h)(10) election, the deemed asset sale produces a mix of ordinary income (on inventory, receivables, and §1245 recapture on depreciable personal property) and capital gain (on capital assets, §1231 assets, and goodwill). The ordinary income component is taxed at higher rates than pure capital gain, so the seller may pay more tax under the election than under a straight stock sale.

This is why the election requires both parties' agreement. The buyer benefits from the step-up; the seller may bear additional tax cost from the character conversion. The negotiation typically involves the buyer compensating the seller for the additional tax cost (either through a higher purchase price or a specific tax-adjustment payment), so that both parties benefit from the election on a net basis.

When the election makes sense for both parties

The election is most commonly beneficial when the target is an S corporation (single level of tax eliminates the double-tax problem that makes §338(g) impractical for C corporations), the target has assets with significant built-in appreciation (creating a large step-up for the buyer), the ordinary income component of the deemed asset sale is manageable relative to the buyer's step-up benefit, and the parties can negotiate a purchase price adjustment that makes the seller whole for the character-conversion cost.

The election is less beneficial (or harmful to the seller) when the target has substantial §1245 recapture (depreciable assets with large gains that convert to ordinary income), when the target has significant inventory or receivables (ordinary income on the deemed sale), or when the seller's tax cost from the character conversion exceeds the buyer's willingness to compensate.

Coordination with other small business provisions

The §338(h)(10) election coordinates with several other Halstonberg small business provisions:

§1060 asset acquisition allocation governs the allocation of the deemed purchase price among the target's assets. The seven-class residual method is the same whether the acquisition is an actual asset purchase or a deemed asset purchase under §338(h)(10).

§1245 and §1250 depreciation recapture applies to the deemed sale of depreciable assets, converting what would otherwise be capital gain into ordinary income to the extent of prior depreciation.

§168 MACRS depreciation and §179 bonus depreciation apply to the buyer's stepped-up basis in the target's depreciable assets. The step-up creates new depreciable basis that begins a fresh recovery period.

Business succession planning and buy-sell agreements should address the §338(h)(10) election in advance, specifying whether the parties will make the election and how the tax cost will be shared.

Cost segregation studies can be applied to real property acquired in the deemed asset purchase to accelerate depreciation on the stepped-up basis.

Practical guidance

For buyers considering a §338(h)(10) election:

Model the step-up benefit. Calculate the present value of the depreciation and amortization deductions generated by the stepped-up basis, compared to the carry-over basis without the election. The difference is the buyer's benefit, and it determines how much the buyer can afford to pay the seller to compensate for the character-conversion cost.

Negotiate the allocation as part of the purchase agreement. The allocation determines which assets get the step-up and the seller's character of gain, and both parties have opposing interests. The allocation should be agreed upon before closing, supported by an independent appraisal.

For sellers evaluating a §338(h)(10) election:

Model the tax cost of the deemed asset sale versus a straight stock sale. The difference between the ordinary income tax on the deemed sale and the capital gain tax on a stock sale is the seller's incremental cost. This cost should be compensated by the buyer, either through a higher purchase price or a tax-adjustment payment.

If the buyer won't compensate for the tax cost, the seller should decline the election and insist on a straight stock sale. The election requires both parties' agreement; the seller has veto power.

For both parties:

File Form 8023 (the §338(h)(10) election) by the 15th day of the 9th month following the month of the stock acquisition. File Form 8594 (the asset allocation) with the tax returns for the year of the acquisition.

Engage tax counsel on both sides. The interaction between the step-up benefit, the character conversion, the allocation negotiation, and the purchase price adjustment is complex enough to require professional modeling. The stakes (hundreds of thousands to millions of dollars in tax outcomes) justify the advisory cost.

The §338(h)(10) election is one of the most powerful structuring tools in M&A tax planning. It combines the legal simplicity of a stock purchase with the tax advantages of an asset purchase, producing a result that can benefit both buyer and seller when the economics are properly negotiated. The key is modeling the numbers before agreeing to the election, because the tax consequences are real, material, and irreversible.