When buyers and sellers start the negotiation process, the purchase price seems to get all of the attention, and for good reason. After all, price is what gets the conversation started. Shortly into negotiations, however, the nitty gritty of transaction structure becomes paramount. As they say, “the devil’s in the details.”
In part, transaction structure refers to what is being purchased – assets (tangible and intangible) or stock. The differentiating factors primarily stem from legal and tax consequences. As you might have guessed, buyers and sellers are typically at odds when it comes to how a transaction is structured.
All things being equal, buyers prefer an asset sale while sellers prefer a stock sale. An asset sale is advantageous to the buyer as it allows them a step-up in basis in the acquired assets, which accelerates greater depreciation and offers an opportunity to reduce taxable income. It also helps the buyer avoid assuming any unwanted or unknown liabilities, which can occur in a stock sale where any “past skeletons” of the seller become the buyer’s problem. From the perspective of the seller, a stock sale is advantageous because the proceeds are taxed at favorable capital gains rates and, if a C-Corporation, spares them from double taxation.
Of course, there are caveats in any given deal. Particularly, in the case of an asset sale, each individual asset must be conveyed to the buyer. This process can be a significant obstacle for certain contracts or licenses which may contain “change of control” restrictions resulting in considerable costs in order to transfer such assets to a buyer. Additionally, buyers must start fresh, re-hiring the target’s workforce.
What is a 338(h)(10) election?
In simple terms, a 338(h)(10) is a tax election for a qualified stock purchase (QSP), which recharacterizes a stock purchase as an asset purchase for federal tax purposes. It remains a stock purchase for all other legal purposes, such as contracts and licensing (more on that later).
Why do buyers like it?
The buyer receives a tax basis in the acquired assets equal to the purchase price and can depreciate at their purchased value, often times at an accelerated rate (tax reform supercharged these accelerated rates for qualifying assets placed into service after September 27, 2017, and before January 1, 2023, to “full expensing”). Further, because the transaction is treated as if assets were purchased, the buyer is able to record goodwill and enjoy amortization expense over the next 15 years for tax purposes. These factors all translate into significant tax benefits for the buyer.
In addition to the favorable tax characteristics, buyers are also able to avoid the change of control issues that can be present in traditional asset deals. Because a 338(h)(10) transaction is still a stock sale for legal purposes (other than for tax treatment), all contracts and licenses that would otherwise need to go through the assignment process in an asset deal are transferred uninterrupted as with a traditional stock transaction.
Why do sellers like it?
Frankly, sellers would likely still prefer to have a pure stock deal with no 338(h)(10) election. This is simply due to the concession being made in the form of tax benefits being enjoyed by the buyer rather than the seller. As a result, the 338(h)(10) election is often a compromise on behalf of a seller in order to close the deal. Having said that, as part of the negotiation, sellers will frequently demand a higher purchase price in response to a 338(h)(10) election, as additional compensation to offset the additional tax burden they will incur. If the cost (to the seller) outweighs the benefit (to the buyer), a 338(h)(10) election may not make sense.
Limitations of 338(h)(10) election
- Seller must be either a U.S. corporate subsidiary of a parent company or an S-Corporation.
- The buyer and seller (all stockholders) must jointly make the election – it cannot be unilaterally made by one side.
- For legal purposes, a 338(h)(10) election remains a stock sale despite being deemed an asset sale for tax purposes. Thus, while there are favorable tax benefits, it does not eliminate the buyer’s exposure to known or unknown liabilities included in the acquisition.
- Buyer must be a corporation making a QSP – at least 80 percent of the seller’s stock needs to be acquired by the buyer.
Is a 338(h)(10) election right for you? RKL can help you decide.
Deciding how to structure your next transaction can be a complicated process. When evaluating the merits and limitations of a 338(h)(10) election, it is important to have capable advisors, like RKL’s Transaction Advisory Services team, that can translate the complexities and provide meaningful guidance. Contact us to discuss this option within the confines of your particular transaction.
