What Is a 338(h)(10) Election and How Does It Work?

A 338(h)(10) election is a tax provision that allows buyers and sellers in specific corporate transactions to treat a stock purchase as an asset acquisition for tax purposes. This approach offers potential tax advantages, such as a step-up in the basis of acquired assets, leading to increased depreciation deductions.

Qualified Stock Purchase Requirements

To make a 338(h)(10) election, the transaction must qualify as a stock purchase involving the acquisition of at least 80% of the voting power and value of the target corporation’s stock within 12 months. This ensures the transaction is substantial enough to merit the tax benefits of asset acquisition treatment. The election is common in corporate acquisitions where the buyer is a corporation, often a subsidiary. Both the buyer and seller must agree to the election, as it affects their respective tax liabilities. The seller, typically a parent corporation, recognizes gain or loss as if it sold the assets directly. This agreement is formalized via a joint election statement filed with the IRS by the 15th day of the ninth month following the acquisition.

The election is frequently used in transactions involving S corporations or subsidiaries within consolidated groups. For S corporations, it allows the buyer to benefit from a stepped-up basis in the assets without terminating the S corporation status. This is particularly advantageous in industries with significant depreciable assets, such as manufacturing or real estate, where depreciation deductions can improve cash flow.

Purchase Price Allocation Factors

Allocating the purchase price in a 338(h)(10) election directly impacts tax outcomes for both parties. This allocation follows the residual method under IRC Section 1060, which assigns the purchase price to acquired assets based on their fair market value. Accurate valuations, often conducted by professionals, are critical to meet IRS standards. Tangible assets like machinery are typically valued using market comparables, while intangible assets, such as patents or trademarks, may require advanced valuation techniques like the income approach.

The allocation also considers the tax implications of asset classification. Depreciable assets provide the buyer with valuable depreciation deductions, affecting taxable income and cash flow. Conversely, assigning excessive value to non-depreciable assets like land can limit tax benefits. Strategic allocation is essential to maximize overall tax advantages.

Adjustments to Basis

Adjusting the basis of acquired assets is a central component of a 338(h)(10) election. This process aligns the tax basis of assets with their fair market value at the time of acquisition, affecting future depreciation schedules and taxable income. For buyers, the step-up in basis can be particularly advantageous when dealing with assets eligible for accelerated depreciation under the Modified Accelerated Cost Recovery System (MACRS) or bonus depreciation.

For example, if a manufacturing company acquires another entity, the adjusted basis of the machinery will reflect current market value, increasing depreciation deductions and enhancing cash flow. This adjustment also applies to intangible assets, including intellectual property and goodwill. Valuing these assets often requires a detailed understanding of tax regulations and case law to account for factors like future income streams, which influence amortization deductions.

State Tax Variations

State tax treatment of a 338(h)(10) election varies, adding complexity to the process. While federal tax rules are clear, state-level interpretations can differ significantly. Some states fully conform to federal treatment, recognizing the election as an asset acquisition, while others partially conform or treat the transaction as a stock purchase for state tax purposes.

These differences can lead to varying tax outcomes. For instance, California, which does not automatically conform to federal provisions, may impose additional reporting requirements or adjustments, potentially resulting in double taxation or missed benefits. States like New York, which align more closely with federal rules, simplify administration and minimize discrepancies. Understanding each state’s tax code is crucial to avoid unexpected consequences.

Filing Steps

Executing a 338(h)(10) election requires strict adherence to IRS procedures. The process begins with a mutual agreement between buyer and seller, formalized through IRS Form 8023, “Elections Under Section 338 for Corporations Making Qualified Stock Purchases.” Both parties must sign the form, which must be filed by the 15th day of the ninth month following the acquisition date.

The form must be accompanied by documentation detailing the purchase price allocation among the acquired assets. This allocation must follow the residual method outlined in IRC Section 1060 and be supported by valuations to substantiate fair market values. Both buyer and seller must adjust their tax returns accordingly. The seller reports the transaction as if the assets were sold, while the buyer incorporates the stepped-up basis into its depreciation and amortization schedules.

Coordination between the buyer, seller, and their tax advisors is essential to ensure compliance with federal and state laws. Errors in documentation or late submission can invalidate the election, leading to penalties. Since the election is irrevocable, thorough planning and due diligence are critical to avoid unintended financial consequences. Both parties should also consider the election’s impact on deferred tax liabilities, net operating losses, and other tax attributes to optimize outcomes.