Section 338 Elections in Qualified Stock Purchases

1. The Anatomy of a Section 338 Election

As we touched on previously, a Section 338 election allows a buyer to achieve the tax benefits of an asset purchase while executing the legal form of a stock purchase. Let's start by recapping the concept and then formalizing the requirements.

As the video explains, this isn't a simple choice. To make this election, several strict criteria must be met.

The key takeaway from that reading is the Qualified Stock Purchase (QSP). This is the gateway to any Section 338 election. It requires a corporate buyer to purchase at least 80% of the target's stock (both voting power and value) within a 12-month period.

Once a QSP has occurred, the buyer can elect to treat the transaction, for tax purposes, as a hypothetical or "deemed" asset sale. This legal fiction works as follows:

1. The "old" target corporation is treated as having sold all its assets to an unrelated person at fair market value. This triggers a taxable gain or loss.
2. A "new" target corporation is treated as having purchased all those assets on the following day. This "new" target gets a stepped-up basis in the assets equal to the price paid for the stock, plus the liabilities assumed.

Legally, nothing has changed—the buyer simply owns the stock of the target corporation. But for tax accounting, the books of the target are wiped clean and reset to fair market value.

2. The Two Flavors: Section 338(g) vs. 338(h)(10)

The consequences of this "deemed" sale depend entirely on which type of Section 338 election is made. This is the most important distinction in this lesson.

The "Regular" Section 338(g) Election

This is the default version of the election.

• Who Elects? The buyer makes the election unilaterally (alone).

• Tax Consequences: This structure results in two levels of immediate tax.

  1. Shareholder-Level Tax: The selling shareholders of the target pay tax on the gain from their stock sale. This is the standard outcome of a stock sale.
  2. Corporate-Level Tax: The target corporation (which is now owned by the buyer) recognizes a full gain on the deemed sale of its assets. This tax liability is an economic cost to the buyer.

• When is it Used? Very rarely. The cost of the second layer of tax is usually prohibitive. A 338(g) election generally only makes financial sense if the target company has enormous Net Operating Losses (NOLs) or other tax attributes that can be used to absorb the gain from the deemed asset sale. In this scenario, the buyer uses the target's own tax attributes to shelter the gain created by the election, gets a stepped-up basis, and the NOLs disappear.

The "Joint" Section 338(h)(10) Election

This special variant of the election is far more common and strategically important.

• Who is Eligible? The target corporation must be either:
  • A subsidiary member of a consolidated group (i.e., its stock is owned by a parent corporation).
  • An S Corporation.
• Who Elects? The buyer and the seller(s) must make the election jointly.
• Tax Consequences: This is where the magic happens. The tax law ignores the stock sale and re-characterizes the entire transaction as:
  1. Deemed Asset Sale: The target sells all its assets. The tax on this gain is borne by the seller (either the parent corporation in the consolidated group or the S Corporation shareholders).
  2. Deemed Tax-Free Liquidation: The seller is then treated as having received the sale proceeds in a tax-free liquidation of the target.

The result is a single level of tax, paid by the seller, on an asset sale. This elegantly resolves the double-taxation problem of a regular asset sale while giving the buyer the desired stepped-up basis.

The following diagram illustrates the legal versus tax treatment of a 338(h)(10) election. Legally (solid lines), it's a stock sale. For tax purposes (dashed lines), it's treated as an asset sale followed by a liquidation.

To solidify your understanding of these two elections, the following resource provides an excellent breakdown.

3. The Negotiation: Price and Practical Consequences

Because a 338(h)(10) election shifts the tax burden to the seller in exchange for a future tax benefit for the buyer, it becomes a major negotiation point.

• Benefit to Buyer: The stepped-up basis allows for future depreciation and amortization deductions, reducing the buyer's future tax payments. The present value of these future tax savings can be substantial.
• Cost to Seller: The seller pays an immediate tax on the asset gain. This gain might be larger than the gain they would have recognized on a simple stock sale, especially if their basis in the subsidiary's stock ("outside basis") is much higher than the subsidiary's basis in its own assets ("inside basis").

To make the deal happen, the buyer typically has to compensate the seller for the incremental tax cost. This is often done by increasing the purchase price—a "gross-up"—to make the seller whole, as if they had done a regular stock sale. The buyer is willing to do this as long as the present value of their future tax savings is greater than the extra cash they have to pay the seller today.

Let's walk through a concrete example that puts numbers to this trade-off.

This example clearly shows the tension. Sierra (the seller) is worse off with the election, so it would not agree unless Alpha (the buyer) offered a higher purchase price. Alpha would only do so if the future tax savings from the stepped-up basis are worth more than the extra price it has to pay.

Conclusion

You have now completed your deep dive into corporate taxation by unpacking one of its most sophisticated tools. The Section 338 election is a prime example of how corporate law is not just about legal form but also about economic substance and strategic negotiation. It allows parties to a stock sale to achieve the tax results of an asset sale, but only through a complex and carefully negotiated process.

Key Takeaways:

• A Section 338 election allows a corporate buyer to treat a Qualified Stock Purchase (QSP) as an asset purchase for tax purposes, thereby obtaining a stepped-up basis in the target's assets.
• A Section 338(g) election is made unilaterally by the buyer and creates two levels of tax, making it financially unappealing in most cases.
• A Section 338(h)(10) election must be made jointly by the buyer and seller. It applies only to targets that are subsidiaries or S corporations. It results in a single level of tax, paid by the seller, on a deemed asset sale.
• The 338(h)(10) election is a powerful tool to deliver tax benefits to the buyer, but the buyer must typically compensate the seller with a higher purchase price for the seller's immediate tax cost.

Preview of the Next Module:

Congratulations on completing the Corporate Taxation module! You've built a strong foundation in how tax law shapes corporate transactions.

Our journey now shifts from transactions to operations. When a company is acquired, the buyer doesn't just get assets and liabilities; it gets a workforce. The legal status of that workforce carries immense significance. In our next module, Employment Law for Corporations, we will begin by tackling a foundational issue: distinguishing between employees and independent contractors and understanding the critical legal and tax implications of that classification.