Why S Corporations Should Consider Making the Section 338 Election in an M&A Transaction

Written by Jonathan Ciccotelli | Jun 15, 2023 8:44:33 PM

How you structure a business acquisition matters.

There are two ways you can structure the purchase of an S corporation: (1) as an acquisition of the target company’s stock, or (2) as an acquisition of the target company’s assets. There are benefits to each approach.

*Benefits of Acquiring of Stock*	*Benefits of Acquiring Assets*
The transaction is simple and efficient.	The transaction is more flexible.
Business operations can continue seamlessly through the sale.	The buyer can purchase only the assets (and assume only the liabilities) they want.
The buyer immediately controls all the business’s assets and liabilities.	The buyer “steps up” the tax value of the assets they purchase, which can unlock larger depreciation deductions and help reduce the tax burden when those assets are later sold.
Business licenses and permits need not be reassigned.
Customer contracts need not be renegotiated.

For ease of completing the transaction and to avoid administrative headaches, many businesses choose to structure their transaction as a purchase of stock. Fortunately, Congress created a way for taxpayers who pursue stock purchases to also reap the tax benefits of an asset acquisition.

What is a Section 338 election?

Section 338 of the Internal Revenue Code lets certain taxpayers treat the purchase of an S corporation as an acquisition of assets rather than a qualified stock purchase. There are two versions of this election: Section 338(g) and Section 338(h)(10). Section 338(g) elections are typically only used in foreign acquisitions, so today we want to focus on the Section 338(h)(1) election.

Under Section 338(h)(1), buyers that acquire the stock of an S corporation can treat the transaction as if it were a purchase of assets (for tax purposes) if the following conditions are met:

The seller must be an S corporation or a US corporate subsidiary of a parent corporation.
All shareholders—of both the buyer and the seller—must agree to the Section 338 election.
The buyer must make a qualified stock purchase, i.e., acquire at least 80% of the target company’s stock.
Election must be made no later than the 15^th day of the 9^th month beginning after the month in which the acquisition occurs.

Why is a Section 338 election so beneficial?

A Section 338 election provides the buyer with two key tax benefits.

First, because the transaction is treated as a deemed asset sale, the buyer gets to “step up” the basis in business assets to the transaction’s purchase price. By raising the assets’ tax bases, taxpayers can take larger depreciation deductions, which helps reduce taxable income every single year until the assets are fully depreciated.

Second, when and if the buyer later sells those assets, their stepped-up bases will help reduce their capital gain.

What are the downsides of a Section 338 election?

Sellers are typically better off not agreeing to a Section 338 election unless the buyer can compensate them for the difference.

The calculation can get complicated, but in general, a qualified stock purchase that’s completed without making a Section 338 election produces better after-tax proceeds to the selling shareholders. In practice, buyers who wish to make a Section 338 election will account for this cost in the transaction price so that in the end, both the buyer and the seller can benefit from the transaction.

Should you make a Section 338 election?

Section 338 elections can be useful when the buyer has a good business reason to acquire the stock of their target corporation (like the continuity of customer contracts) but would like to reap the tax benefits of an asset acquisition. Legally, there is no difference; the purchase will be treated as a purchase of S corporation equity. The only difference will be the tax savings for the buyer and the higher purchase price for the seller.

If you want to discuss this election with our M&A group, our CPAs are well-versed in Section 338 and can help you decide if making the election will be worthwhile.

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