338(h)(10) Election: A Negotiation Tactic

Buyers and sellers often are trepid towards the negotiation portion of an M&A deal, especially when they have little experience with M&A or no professional advisor. The thought of walking away having compromised too much, or without having made a deal at all, can be daunting. An M&A intermediary can be quite beneficial at this point in the deal, as they are well-versed in a variety of negotiation tactics that will be favorable for both the buyer and the seller.

Tax implications can have a dramatic effect on the purchase price in M&A negotiations, due to how profoundly they weigh on the allocation of the purchase price. In an M&A deal, a seller will typically want to minimize capital gains taxes, while the buyer will want a higher number allocated to the hard assets being acquired. Unfortunately, both of these requirements are not often feasible to achieve at once.

However, when a buyer and seller reach this position, implementation of a certain provision may be able to bring both sides to a settlement, if the correct requirements are met. If the business is an S corporation or a C corporation that is a subsidiary of an S corp, a member of a consolidated group, or a non-consolidated selling affiliate, then the 338(h)(10) election may be deemed appropriate. This lesser known tax provision can assist in building a compromise between buyer and seller when utilized correctly.

A section 338(h)(10) election allows the business owner to structure the deal as a stock sale, while the transaction is treated as an asset sale for tax purposes. The sale of stock is no longer subject to federal income taxation, and the taxes are solely on the sale of the assets. The company’s assets are reset or “built up” to their fair market value and then taxed accordingly. When the assets are then liquidated, the payment of taxes will flow through to the shareholders, due to the S corporation status. The seller is therefore not taxed for the sale of the assets, while the buyer gains a step-up in the tax basis of the acquired assets.

It is imperative that the tax benefit to the buyer be valuable enough to vindicate a tax gross-up payment to shareholders. If the assets depreciate, then the seller will be subject to income taxes on the depreciation or amortization. Therefore, the tax cost for the seller must not outweigh the buyer’s tax benefits in order for the 338(h)(10) election to be a viable option. The step-up should exceed the tax costs for the seller, unless the buyer offsets this cost with a higher payout.

If you are interested in learning more about how a 338(h)(10) election may benefit you when buying or selling a business, or if you would like assistance in negotiating your M&A deal, please contact George & Company. We are well-versed in M&A negotiation and would be happy to assist you.