A buyer and seller sit across the table at closing. The buyer wants an asset purchase: a stepped-up tax basis, fifteen-year goodwill amortization, and a clean break from the target's historical liabilities. The seller wants a stock sale: a single layer of capital-gains tax, no messy retitling of contracts and licenses, and a faster path to a wire transfer.
For decades, deals like this stalled on the gap between those two positions. Then the IRS gave both sides a way to have it both ways — a stock purchase on paper that is treated as an asset purchase for federal income tax. That fiction lives in Internal Revenue Code Section 338(h)(10), and for sales of S corporations and consolidated-group subsidiaries it has become one of the most common tax structures in middle-market M&A.
Getting it right requires understanding what triggers the election, who has to sign, how the deemed asset sale reshuffles the seller's tax bill, and how the buyer recovers the premium over time. Miss any of those, and the "compromise" structure can quietly cost one side hundreds of thousands of dollars.
What a Section 338(h)(10) Election Actually Does
Section 338(h)(10) is a joint federal income tax election made by the buyer and seller of a target corporation's stock. The election rewrites the transaction's tax character.
For tax purposes only, the deal is recast as a two-step transaction:
- The target is deemed to sell all of its assets to a new corporation ("New Target") at fair market value on the closing date.
- The target is then deemed to liquidate into its old shareholders, distributing the sale proceeds.
The actual legal transaction — a purchase of the target's stock — is ignored for federal income tax purposes. Everywhere else (contracts, employment relationships, licenses, leases, employer identification number), it is still a stock deal. Nothing has to be retitled or assigned. The election lives entirely on Form 8023 and on the tax returns of the parties.
That fiction unlocks a stepped-up basis in the target's assets, which is the whole point of the structure.
When the Election Is Available
Section 338(h)(10) is not available for every stock purchase. Three conditions must be met.
A Qualified Stock Purchase (QSP)
The buyer must be a corporation and must acquire at least 80% of the target's voting power and 80% of the value of its stock during a 12-month acquisition period. The threshold mirrors Section 1504(a)(2). Partnerships, LLCs taxed as partnerships, and individuals cannot make a 338(h)(10) election directly — they need to either drop a blocker corporation into the structure or look at the Section 336(e) election, which has different mechanics.
The Right Kind of Target
The target must be either:
- An S corporation, or
- A subsidiary of a U.S. consolidated group (i.e., a member of a group that files a consolidated federal return with a common parent).
A stand-alone C corporation owned by individuals does not qualify for 338(h)(10). For that deal, the parties are looking at a Section 338(g) election (rarely used voluntarily, because it triggers double taxation) or a true asset deal.
Unanimous Seller Consent
For an S corporation target, every shareholder during the acquisition period must consent to the election. For a consolidated-group subsidiary, the common parent signs. Anyone whose signature is missing can blow up the election after closing — which is why purchase agreements always include covenants requiring sellers to execute the election forms and file timely returns.
The Filing Mechanics
The election lives on Form 8023, signed by both the buyer (purchasing corporation) and the seller (S corporation shareholders or consolidated-group parent). It must be filed by the 15th day of the 9th month beginning after the month containing the acquisition date.
A few practical notes:
- Example deadline. Close on June 15, 2026, and the election is due by March 16, 2027 (the 15th falls on a Sunday).
- Late filings. Once the deadline passes, the election is generally gone. Limited relief under Rev. Proc. 2003-33 may be available, but the parties cannot count on it.
- Form 8883 follows. Each party also files Form 8883 with their next income tax return to report how the purchase price was allocated across asset classes under Section 1060's residual method.
- Electronic filing. Form 8023 can be filed electronically with the IRS, but most practitioners still mail by certified mail with return receipt as belt-and-suspenders proof of timely filing.
The Seller's Tax Math
This is where the election bites the seller — and where most 338(h)(10) negotiations live.
In a vanilla S corporation stock sale, the shareholders recognize a single capital gain equal to the purchase price minus their outside basis in the stock. Most or all of that gain qualifies for long-term capital-gain rates (currently up to 20% federal, plus 3.8% Net Investment Income Tax if applicable, plus state).
In a 338(h)(10) deal, the S corporation is treated as having sold its assets, and the resulting gain flows through to the shareholders character by character:
- Inventory generates ordinary income.
- Accounts receivable at a cash-basis target generate ordinary income.
- Depreciation recapture on equipment (Section 1245) is ordinary up to prior depreciation.
- Real property depreciation recapture (Section 1250) is taxed at up to 25%.
- Goodwill, going-concern value, and customer relationships are generally capital, taxed at long-term rates.
The shareholder's outside basis in the S corp stock — usually irrelevant in an asset sale — is then used to absorb any gain on the deemed liquidation, often producing a small basis-recovery loss that cushions the ordinary income hit.
For asset-heavy businesses with significant depreciation recapture (manufacturers, equipment-intensive service firms, restaurant chains with hood systems and walk-ins), the ordinary-income portion can be substantial. For service businesses with most value in goodwill (software companies, professional services, agencies), the seller's tax delta versus a plain stock sale is often surprisingly small.
The Gross-Up
When the deemed asset sale increases the seller's federal and state tax bill, the seller demands a higher purchase price to make them whole. This "gross-up" is itself taxable, so it has to be calculated on an iterative or "circular" basis. A typical formula:
Gross-up = (Seller incremental tax) ÷ (1 − Seller marginal tax rate on the gross-up)
A clean way to think about it: the buyer should be indifferent between paying X for an asset deal and X for a 338(h)(10) deal, and the seller should be indifferent between receiving Y on a stock sale and Y on a 338(h)(10) deal. The gross-up bridges those two points. Modeling the gross-up before signing the LOI prevents fights at closing.
The Buyer's Tax Math
The buyer's prize is a stepped-up "inside basis" in the target's assets. That basis flows into:
- Bonus depreciation on qualifying tangible personal property (still 100% for property acquired in 2026 under current law for many asset classes, subject to phase-down rules).
- MACRS depreciation over the assets' normal recovery periods.
- 15-year amortization of goodwill, going-concern value, workforce in place, customer lists, trade names, and other Section 197 intangibles.
For a deal where most of the purchase price ends up allocated to goodwill — common in services businesses — the buyer recovers the entire premium as a tax deduction over fifteen years. At a 21% federal corporate rate, that is roughly a 1.4% per year deduction against taxable income for every dollar of purchase price.
The buyer also inherits a clean basis history. No more tracking the target's pre-acquisition NOLs through Section 382 limitations on the same assets (the deemed liquidation step generally absorbs those at the corporate level). No more old built-in gain exposure on assets that have been on the books since the 1990s.
The Purchase Price Allocation
Both parties file Form 8883 reporting how the deemed purchase price (called the "Aggregate Deemed Sale Price" on the seller side and "Adjusted Grossed-Up Basis" on the buyer side) is split across asset classes. The residual method works in seven steps:
- Class I: Cash and demand deposits.
- Class II: Actively traded personal property, CDs, foreign currency.
- Class III: Accounts receivable and certain mark-to-market assets.
- Class IV: Inventory.
- Class V: All other assets not in I–IV or VI–VII (most tangible property goes here).
- Class VI: Section 197 intangibles other than goodwill and going concern.
- Class VII: Goodwill and going-concern value (the residual).
Allocations are made in order. After fair-market value is assigned to Classes I–VI, whatever is left of the purchase price lands in Class VII goodwill. The buyer's Form 8883 must match the seller's. Mismatched allocations are an audit magnet.
How 338(h)(10) Differs From Its Cousins
Practitioners often weigh three related elections against each other.
Section 338(g)
A unilateral buyer election available for any qualified stock purchase of a corporation. The target recognizes gain on the deemed asset sale and the selling shareholders are still taxed on their stock sale — double taxation. Almost never used for U.S. domestic deals because of that. It does appear in cross-border acquisitions of foreign targets, where the seller is outside the U.S. tax net and doesn't care.
Section 336(e)
A joint election introduced in 2013 that mirrors 338(h)(10) for situations where the buyer is not a corporation — for example, an LLC, partnership, or individual buying an S corporation. It opens up the step-up benefit to private equity buyers using LLC acquisition vehicles. The mechanics are similar to 338(h)(10), but the election is reported on a statement attached to the tax return rather than on Form 8023.
F-Reorganization Drop-Down
For S corporations, an increasingly popular alternative is to do a pre-closing F-reorganization: the historic S corporation forms a new holding company, becomes a Q-Sub of that holding company, then converts to a single-member LLC and sells its interest. The buyer gets the same step-up as a 338(h)(10) deal but with more structural flexibility (rollover equity, partial sales, non-corporate buyers). The F-reorg has become the dominant structure when private equity buys S corporations because it doesn't require a corporate buyer or buyer-side blocker.
The State Tax Trap
Federal conformity is not universal. Some states do not follow the federal 338(h)(10) election. Pennsylvania, New Jersey, and a handful of others either tax the deemed asset sale differently or require separate state-level elections. For multi-state targets, the parties need to model state tax consequences before signing — the federal gross-up calculation alone is incomplete.
Even states that conform may treat the resulting income as apportionable business income rather than non-apportionable capital gain, shifting the tax base to states where the seller has limited filing history. Sellers in particular often discover state surprises after closing.
Common Mistakes That Kill the Election
A handful of errors show up over and over:
- Missing a shareholder signature. All S corporation shareholders during the acquisition period must sign Form 8023. Forgetting an estranged minority shareholder or a former-spouse co-owner is fatal.
- Failing the QSP threshold. A staged acquisition where the buyer first picks up 70% of the stock and then takes a long pause before grabbing the rest can blow the 12-month QSP window.
- Cash-basis receivables. Sellers often forget that AR on a cash-basis target becomes ordinary income on the deemed sale. The hit shows up at K-1 time.
- Stale S election. If the S corporation's S election was invalid (busted by a shareholder loss of eligibility years earlier), the entity is actually a C corporation — and 338(h)(10) for S corps is unavailable. An S-corp Q sub status check is part of every diligence.
- Allocation mismatches. Buyer and seller filing inconsistent Forms 8883 is a standard IRS audit trigger and can void the allocation's protection from challenge.
- State elections. Some states require their own election forms in addition to the federal election. Missing those creates state-only mismatches.
Diligence Checklist Before You Commit
Whether you're on the buy side or sell side, walk through this list before signing an LOI that contemplates a 338(h)(10) election:
- Confirm target eligibility. Verify S election validity going back at least the past three years; for subsidiary targets, confirm consolidated-group membership.
- Identify all stockholders. Locate every shareholder for the acquisition period, including former employees with old grants.
- Model the gross-up. Calculate seller incremental tax based on a draft purchase price allocation and proposed asset values. Build in state tax effects.
- Test the 80% threshold. If there's any rollover equity, escrow, or earnout, run the QSP arithmetic carefully.
- Build the purchase price allocation early. Get a quality-of-earnings firm or independent valuation specialist involved before signing if intangible allocation is material.
- Lock in the election in the agreement. The purchase agreement should commit both sides to make the election, sign Form 8023, file Form 8883 consistently, and cooperate on post-closing tax adjustments.
Where Clean Books Pay Off
The 338(h)(10) election is unforgiving for a target whose books are a mess. The deemed asset sale requires a credible purchase price allocation across every asset class — and that allocation starts with the target's tax basis records, fixed-asset registers, and inventory accounting. If those records have not been maintained, the seller either accepts an unfavorable allocation by default or burns time and money reconstructing them under deal pressure.
Keeping your accounting in a transparent, version-controlled format from the start removes that risk entirely. Every transaction is auditable, every depreciation schedule is tied to source documents, and a buyer's diligence team can verify the asset register against the books in hours instead of weeks. That kind of provenance also makes the post-closing Section 1060 allocation easier to defend in an IRS exam.
Keep Your Financial Records Deal-Ready
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