Royal Financial

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When it comes to M&A, tax considerations can play a crucial role in negotiating deal terms. Among the various tax elections available, the §338 election is particularly relevant as it allows certain acquirers in a stock-sale to mark-up the basis of the assets purchased in exchange for increased cost recovery in future periods. This increased cost recovery could be beneficial, especially if the corporate tax rate increases from 21% to 28% as proposed in President Biden FY2025 budget.

In this post we will highlight §338 elections, including which entities they apply to, tax consequences to buyers and sellers, advantages and disadvantages of making the election, deadline to make the election, and how to determine if the election makes sense. 

A. The Elections

338(g) Election

1. Applies to targets that are freestanding C corporations.
2. Election is unilaterally made by the acquirer after purchasing stock from the target shareholders.
3. Acquirer tax treatment: Acquirer will generally recognize gain on the deemed asset sale to the extent there are no qualifying offsets (NOL’s or tax credits) that can be used. Note, these tax attributes are available only for immediate use and do not survive the acquisition if the target is liquidated.
4. Selling shareholder tax treatment: Election has no impact on the seller since the deemed asset sale occurs after the transaction is complete and selling shareholders already sold their stock.
5. Advantages: Acquirer has a marked up basis in assets which increases cost recovery through depreciation & amortization. No impact to seller.
6. Disadvantages: Theoretically there are two levels of tax paid with respect to the target. One on the selling shareholders and the second on the target entity upon recognizing gain on the deemed asset sale. The gain on the deemed asset sale, however, usually becomes the liability of the acquiring entity. Again, NOLs may be used if they are available and the target doesn’t liquidate.

338(h)(10) Election

1. Applies to target’s that are freestanding C corporation subsidiaries and / or S corporations. 
2. Election is jointly made by the acquirer and seller before the deal is consummated. 
3. Acquirer tax treatment: No impact other than receiving the increased basis in the assets deemed as acquired for tax purposes.
4. Selling shareholder tax treatment: Seller bears any incremental tax cost resulting from the deemed asset sale which typically involves depreciation recapture, state and local taxes, and sales / transfer taxes.
5. Advantages: Acquirer has a marked up basis in assets which increases cost recovery through depreciation & amortization.
6. Disadvantages: Sellers realize gain on the deemed asset sale which generally leads to a higher purchase price for the buyer to compensate the seller. 

B. Does the election make sense?

Like everything in finance, the decision on whether to make the election will vary deal-to-deal since buyers and sellers, and their respective tax attributes, vary from deal to deal. However, at a high-level, the decision will be based on if the PV of the tax benefits provided to the acquirer exceed the cost of making the election. See a high-level example below.

Example: Cherry Corp. is considering purchasing 100% of Banana Corp. stock for $1m. Inside basis of Banana Corp.’s assets are $200k. If no election is made, the acquirer will only have $200k in assets to depreciate post-transaction, even through they paid $1m for the business. However, if an election is made, the taxpayer will have the ability to mark-up the assets of the business even though this transaction is legally a stock deal. These marked up assets will be depreciated in accordance with the recovery periods assigned via a purchase price allocation.

C. Important Deadlines

Any §338 election must be made by the fifteenth day of the ninth month following the month in which the 80% control (voting and value) of the target was acquired. Once made, the election is irrevocable.  

D. Conclusion

Understanding these elections are crucial for both buyers and sellers and, as a result, you should seek professional tax guidance that considers your unique situation before making any tax-related decisions.

Disclaimer: The information provided herein is intended solely for informational purposes and no person(s) or other third-party may rely upon it as financial, tax, or legal advice or use it for any other purposes. As a result, Royal Financial, and any affiliates, assume no responsibility whatsoever to readers, or any other persons for that matter, as a result of the information contained herein.