Among the most strategically important tax decisions in any M&A transaction involving the sale of a corporate interest is whether to make a Section 338(h)(10) or Section 336(e) election. These elections allow the parties to treat a transaction that is legally structured as a stock sale as if it were an asset sale for federal income tax purposes, giving the buyer a stepped-up tax basis in the target’s assets while allowing the transaction to proceed with the legal and commercial simplicity of a stock deal. Understanding when these elections are available, what their economic consequences are for both sides, and how the resulting tax costs and benefits are allocated in the purchase price negotiation is essential for any business owner involved in a corporate transaction.

The Mechanics of Section 338(h)(10)

Section 338(h)(10) allows a corporate buyer and a selling consolidated group or S corporation to jointly elect to treat the acquisition of the target company’s stock as a deemed sale of the target’s assets. When the election is made, the target company is treated for federal income tax purposes as if it sold all of its assets to a hypothetical new corporation at fair market value on the acquisition date, and then immediately liquidated, distributing the deemed sale proceeds to its shareholders. The actual stock sale is ignored for tax purposes, and the entire transaction is treated as if it were an asset sale followed by a liquidation.

For the buyer, the deemed asset sale treatment means that the target’s assets receive a stepped-up tax basis equal to the purchase price (allocated among the assets using the Section 1060 residual method). This step-up generates future depreciation and amortization deductions that shelter the buyer’s post-acquisition income, creating significant long-term tax value. For the seller, the deemed asset sale creates a level of tax complexity that would not exist in a straightforward stock sale: the target company recognizes gain on the deemed sale of its assets, which is then distributed to the shareholders as a deemed liquidation. The character of that gain — and the total tax cost to the seller — depends on the nature of the assets being deemed sold.

Availability of Section 338(h)(10)

Section 338(h)(10) is available only in specific circumstances. The buyer must be a domestic or foreign corporation — the election is not available when the buyer is a partnership, limited liability company, or individual. The target must be either (1) a domestic corporation that is a member of an affiliated group that files a consolidated federal income tax return and is being acquired by a corporation outside the group, or (2) a domestic S corporation being acquired by any corporate buyer.

The S corporation target case is particularly common and commercially significant. When an S corporation is sold, the shareholders typically prefer stock sale treatment because the S corporation structure has already avoided corporate-level tax — all income has been taxed at the shareholder level as it was earned. However, a corporate buyer can offer a price premium in exchange for a Section 338(h)(10) election because the buyer benefits so substantially from the stepped-up basis. The resulting negotiation over price gross-up is the central economic question in these transactions.

The Mechanics of Section 336(e)

Section 336(e) was enacted to address situations in which Section 338(h)(10) is not available because the buyer is not a corporation. Under Section 336(e), the selling parent corporation (not the buyer) can unilaterally elect to treat a qualified stock disposition of a domestic subsidiary as a deemed asset sale, without the buyer’s participation. A qualified stock disposition includes a disposition in which the selling parent disposes of stock representing at least 80 percent of the vote and value of the subsidiary within a 12-month acquisition period.

The Section 336(e) election gives the target a stepped-up basis in its assets, similar to the Section 338(h)(10) result. However, because the election is made by the seller rather than jointly with the buyer, the interaction with the buyer’s tax position is more complex. The buyer does not automatically receive the step-up in the same way as in a Section 338(h)(10) election; the step-up exists at the target level but may or may not flow through to the buyer depending on the transaction structure. Buyers and their tax counsel must carefully analyze the specific mechanics to ensure they will actually receive the tax benefit they are expecting before agreeing to pay a price premium for the election.

The Gross-Up Negotiation

Making a Section 338(h)(10) or 336(e) election is not free for the seller. In a pure stock sale, all gain is typically taxed at long-term capital gains rates at the shareholder level. In a deemed asset sale under Section 338(h)(10), some of the gain is characterized as ordinary income (from depreciation recapture on tangible assets, from assets like accounts receivable and inventory, and from covenants not to compete) that would have been taxed at capital gains rates in a straight stock deal. The seller’s incremental federal and state income tax cost from agreeing to the election is called the gross-up.

The buyer, who benefits from the step-up in the form of future depreciation and amortization deductions, is expected to share the economic benefit with the seller by paying a higher purchase price. The gross-up negotiation thus involves calculating the present value of the buyer’s step-up benefit (a function of the amount of the step-up, the applicable tax rate, and the discount rate applied to the stream of future deductions) and the seller’s incremental tax cost, and then agreeing on how to allocate the net benefit between the parties.

In practice, sellers frequently demand full compensation for their incremental tax cost — a dollar-for-dollar gross-up — while buyers want to share the benefit by paying only a portion of the step-up value as additional purchase price. The negotiated outcome depends on the relative leverage of the parties and the size of the benefit. In many S corporation transactions, the step-up benefit and the seller’s gross-up cost are closely matched, meaning there is limited net economic benefit to share, and the parties must decide whether the complexity of the election is worth the effort.

State and Local Tax Implications

Federal tax analysis under Section 338(h)(10) and Section 336(e) is only part of the picture. State and local taxes can significantly complicate the analysis, because states do not uniformly conform to the federal deemed asset sale rules. Some states follow the federal treatment automatically; others require separate state-level elections or do not recognize the deemed sale at all. In states that do not conform, the transaction may be taxed as a stock sale at the state level (meaning no step-up for state tax purposes) even though it is treated as an asset sale federally.

This non-conformity creates two complications. First, the buyer may not receive a state tax step-up even if it receives a federal step-up, which reduces the total value of the election. Second, the seller may face different tax characterization at the state level than at the federal level, which affects the gross-up calculation. A complete analysis of the economics of a Section 338(h)(10) or 336(e) election must incorporate both federal and state tax consequences for both parties, in every state where the target company operates and has taxable income or property. This analysis requires qualified tax professionals with both federal and state tax expertise.