Section 338(h)(10) Election: How It Works and Tax Consequences

A Section 338(h)(10) election is a joint tax election by a buyer and seller that treats the purchase of a corporation’s stock as if the corporation had sold all of its assets instead. The buyer gets a stepped-up tax basis in those assets, which produces larger depreciation and amortization deductions going forward. The seller pays tax once, at the asset-sale level, rather than facing the two layers of tax a real corporate asset sale would trigger. The election is only available when the target is an S corporation or a subsidiary within a consolidated corporate group, and both sides have to agree in writing.¹

Who Qualifies

Three conditions all have to be satisfied. The acquisition has to be a qualified stock purchase, the target has to be an eligible type of entity, and both parties have to consent.

Qualified Stock Purchase

A single corporation must acquire at least 80 percent of both the voting power and the value of the target’s stock within a 12-month window.¹ The clock starts on the first purchase that counts toward the threshold. Every share included in that 80 percent must come from a taxable transaction. Stock received by gift, inheritance, or tax-free exchange doesn’t count, and neither, as a general rule, does stock acquired from a related party.²

The buyer also has to be a corporation. If the acquirer is a partnership, LLC, individual, or private equity fund, the 338(h)(10) election is off the table entirely; Section 336(e) may be an alternative in that case, discussed below.

Eligible Target

Only two kinds of targets work:

An S corporation. Gain from the deemed asset sale flows through to the selling shareholders on their individual returns.
A subsidiary in a consolidated group. The target is a C corporation that files a consolidated return with its parent, and the gain is reported on the group’s consolidated return.

A standalone C corporation cannot use this election. Without the S corp pass-through or the consolidated-return mechanism, the deemed asset sale would trigger corporate-level tax plus a second tax on the stock sale, making the election worse than a plain stock deal.³

Joint Consent

Buyer and seller both have to agree. For an S corporation target, every shareholder who owned stock on the acquisition date must sign, including any shareholder who didn’t sell.⁴ For a consolidated group target, the common parent signs on behalf of the group. One missing signature and the election fails. The transaction then defaults to an ordinary stock sale with no basis step-up.

How the Deemed Asset Sale Works

Once the election is made, the IRS ignores the actual stock deal and treats two fictional events as having taken place just before closing.

First, the “old target” is treated as selling all of its assets to a “new target” at a price called the Adjusted Grossed-Up Basis, or AGUB. Old target recognizes gain or loss on that fictional sale, exactly as it would in a real asset deal. New target then holds those same assets with a fresh tax basis equal to the AGUB.⁵

Second, old target is treated as liquidating and distributing the proceeds to its shareholders (or, for a consolidated subsidiary, to its parent). The actual stock sale disappears for tax purposes.

The AGUB is the total economic cost of the acquisition from the buyer’s side. It is the grossed-up basis of the stock the buyer just purchased, plus the buyer’s basis in any target stock it already held, plus all of the target’s liabilities, including the tax liability triggered by the deemed sale itself.⁶ Because purchase prices in real acquisitions usually exceed the target’s historical book value, the AGUB is typically higher than the old asset basis. That’s the step-up.

Why Buyers Want the Election

The entire point for the buyer is that the new target starts with asset values reflecting what the buyer actually paid, not what the target paid years ago. A company with $5 million in depreciated equipment and $20 million in customer relationships acquired for $40 million ends up with about $40 million of tax basis to allocate across its assets (adjusted for liabilities), rather than the old historical numbers.

Higher asset values mean larger depreciation and amortization deductions every year after the deal. Those deductions reduce taxable income and cash taxes. Over the recovery period of the assets, a substantial step-up can save the buyer millions at the current 21 percent corporate rate, plus whatever the state rate adds. The present value of those future tax savings is a central number in the negotiation.

The reverse is also possible. If the target’s existing tax basis already exceeds the purchase price, the election would produce a step-down and shrink future deductions. In that case no rational buyer asks for the election and no rational seller offers it.

What the Seller Pays

The tax picture depends on which kind of eligible target is being sold.

S Corporation Shareholders

The deemed asset sale produces gain or loss at the corporate level, and that gain flows through to the shareholders under normal S corp pass-through rules. Each shareholder picks up their pro rata share of the deemed sale gain, and their stock basis increases by the same amount.⁵

After that basis bump, the deemed liquidation under Section 331 usually produces little or no additional gain, because the stock basis has already caught up with the deemed sale proceeds. The actual stock sale is disregarded. The net result is a single level of tax on the deemed sale gain, paid by the individual shareholders at their own rates.⁷

Character matters here. A straight stock sale produces capital gain. The deemed asset sale produces a mix: depreciation recapture on equipment is ordinary income, inventory gains are ordinary, and only gains on capital assets and goodwill qualify for capital gain treatment. Shareholders who assumed an all-capital-gain result from a stock sale often push back when they see the ordinary income component. Buyers typically address the difference through a purchase price adjustment, but this is a common friction point.

The Built-In Gains Trap

If the S corporation used to be a C corporation, or received assets from one in a carryover basis transaction, the deemed asset sale can trigger the built-in gains tax under Section 1374. That’s a corporate-level tax at 21 percent on net recognized built-in gain attributable to assets held at the time of conversion, if the deemed sale falls within the recognition period (generally five years from conversion).⁸ This sits on top of the shareholder-level tax and effectively creates double taxation on the affected gains. Diligence on the target’s conversion history is essential before agreeing to the election.

Consolidated Subsidiaries

When the target is a consolidated subsidiary, the deemed sale gain is recognized by the old target and reported on the selling group’s consolidated return. The deemed liquidation that follows is treated as a tax-free liquidation of a subsidiary under Section 332, so the parent recognizes no additional gain on the deemed proceeds.⁹ The parent’s stock basis in the subsidiary is eliminated.

Gain is measured against the Aggregate Deemed Sale Price, or ADSP: the grossed-up amount realized on the stock sale plus the target’s liabilities, including the tax liability the deemed sale itself creates.¹⁰ Because part of the number depends on the answer, the calculation can be circular and often requires iteration.

Allocating the Purchase Price

The stepped-up basis is only useful once it lands on specific assets, because the allocation controls the pace of the deductions. A dollar allocated to inventory gets deducted when the inventory is sold, often within months. A dollar allocated to goodwill amortizes over 15 years. Allocation follows the residual method under Section 1060.¹¹

The Seven Asset Classes

AGUB is allocated across seven classes in strict order. Each class is filled up to the fair market value of its assets before anything spills into the next:

Class I: Cash and cash equivalents, at face value.
Class II: Actively traded securities and certificates of deposit.
Class III: Accounts receivable and similar debt instruments.
Class IV: Inventory and property held for sale to customers.
Class V: Other tangible and intangible assets not assigned to another class, including equipment, real estate, and furniture.
Class VI: Section 197 intangibles other than goodwill and going concern value, such as patents, customer lists, and non-compete agreements.
Class VII: Goodwill and going concern value.

Class VII is the residual. Whatever is left after Classes I through VI have been filled lands here and is amortized over a fixed 15-year period, regardless of its actual economic life.¹²

Form 8594

Both buyer and seller file Form 8594 with their income tax returns for the year of the acquisition, reporting the total consideration and the amount in each class.¹³ A written allocation agreement between the parties is binding on both for tax purposes unless the IRS finds the allocation inappropriate.¹¹

Allocation is one of the most contested parts of a 338(h)(10) deal. Buyers want as much as possible in short-lived assets (Classes IV and V) to accelerate deductions. Sellers often prefer heavier goodwill allocation, because goodwill produces capital gain rather than ordinary income from depreciation recapture. Both parties report the same allocation, so the gap gets bridged through price.

Installment Sale Limitation

If the buyer pays part of the price with a note, the seller may be able to defer some of the gain under the installment method. The regulations allow this by treating the old target as receiving installment obligations from the new target on terms matching the buyer’s actual note, and then deeming those obligations distributed to the shareholders in the liquidation.⁵

There is a hard limit. Installment reporting in a 338(h)(10) is only available when the target uses the cash method of accounting. Accrual-method targets recognize the full gain immediately, no matter when the cash actually arrives. For S corporation targets with significant gain, whether the company is on the cash or accrual method can change the deal economics considerably.

Filing the Election

The election is made on Form 8023. The form is filed separately from either party’s tax return, though copies are usually attached to each return for the acquisition year.¹⁴

The Deadline

Form 8023 is due by the 15th day of the ninth month after the month containing the acquisition date.¹⁵ A March 15 closing produces a December 15 deadline. The purchasing corporation files, but the form is signed by authorized representatives of both sides. For an S corporation target, every shareholder who owned stock on the acquisition date has to sign.⁴

Late Election Relief

Missing the deadline is serious. The IRS can grant relief under Treasury Regulation 301.9100-3, but the taxpayer has to show two things: that they acted reasonably and in good faith (typically, that they relied on a professional who missed the deadline), and that relief will not prejudice the government. Prejudice exists if the late election would produce a lower overall tax liability than a timely one, considering the time value of money. Relief is discretionary and not routine. Treat the deadline as absolute.¹⁶

Protective Elections

When there is real uncertainty about whether the transaction is a qualified stock purchase, the buyer can file a protective election. If the transaction is later determined to qualify, the election is already in place. Without it, the deadline can run out while the parties are still figuring out the answer.

When the Buyer Isn’t a Corporation: Section 336(e)

A 338(h)(10) election requires a corporate buyer. When the acquirer is a partnership, LLC, individual, or private equity fund, the election is unavailable. Section 336(e) covers a similar gap. It lets a selling corporation that owns at least 80 percent of a subsidiary’s stock elect deemed asset sale treatment when it sells, exchanges, or distributes that stock, regardless of what kind of entity the buyer is.¹⁷ The mechanics are similar: the target is treated as selling its assets and liquidating, the buyer gets a stepped-up basis, and the seller recognizes gain on the deemed sale. In private equity acquisitions, where the buyer is rarely a corporation, Section 336(e) is usually the first alternative to look at.

State Tax Considerations

Most states follow the federal election automatically, so one federal filing does the work for both. A few states allow taxpayers to elect into or out of deemed asset sale treatment independently, which creates both opportunities and traps.

The most common trap comes up when the parent and target file separate state returns. There may be no mechanism for the target’s deemed sale gain to reach the parent’s state return, so the state tax lands on the target, which the buyer now owns. Buyers who don’t negotiate a price reduction for that exposure end up paying a cost the seller should have absorbed. State corporate income tax rates range from zero up to about 11.5 percent, so on a large deal this can matter.

On the other hand, most states don’t treat the deemed asset sale as a real transfer of tangible property for sales and use tax purposes, so the election generally doesn’t trigger sales tax. Confirm the treatment in the specific states involved before closing.

1
Office of the Law Revision Counsel. 26 USC 338 – Certain Stock Purchases Treated as Asset Acquisitions
2
Office of the Law Revision Counsel. 26 USC 338 – Certain Stock Purchases Treated as Asset Acquisitions
3
CCH AnswerConnect. What Is a Section 338(h)(10) Election and Other Definitions for Purposes of the Section 338 Election Rules
4
Thomson Reuters Practical Law. Section 338(h)(10) Election
5
eCFR. 26 CFR 1.338(h)(10)-1 – Deemed Asset Sale and Liquidation
6
eCFR. 26 CFR 1.338-5 – Adjusted Grossed-Up Basis
7
Office of the Law Revision Counsel. 26 USC 331 – Gain or Loss to Shareholder in Corporate Liquidations
8
Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-In Gains
9
Office of the Law Revision Counsel. 26 USC 332 – Complete Liquidations of Subsidiaries
10
eCFR. 26 CFR 1.338-4 – Aggregate Deemed Sale Price
11
Office of the Law Revision Counsel. 26 USC 1060 – Special Allocation Rules for Certain Asset Acquisitions
12
Office of the Law Revision Counsel. 26 USC 197 – Amortization of Goodwill and Certain Other Intangibles
13
Internal Revenue Service. Instructions for Form 8594
14
Internal Revenue Service. About Form 8023, Elections Under Section 338 for Corporations Making Qualified Stock Purchases
15
IRS.gov. Instructions for Form 8023
16
Internal Revenue Service. Late Election Relief
17
Office of the Law Revision Counsel. 26 USC 336 – Gain or Loss Recognized on Property Distributed in Complete Liquidation