Introduction
When selling or acquiring a business there are numerous tax considerations that should not be ignored. The tax consequences of a sale or acquisition can have a significant impact on the value of the transaction. One tax planning strategy that is often used in an acquisition is the Section 338(h)(10) election, which can have both benefits and drawbacks that you should consider depending on the specific circumstances of the transaction.
Overview of a Section 338(h)(10) Election
A Section 338(h)(10) election is a tax planning strategy used in acquisitions where the acquiring company purchases the stock of the target company and allows the acquiring company to treat the stock purchase as if it were an asset purchase for tax purposes. This can be beneficial because the acquiring company can then step up the tax basis of the target company’s assets to their fair market value at the time of the transaction, which can result in significant tax savings for the purchaser.
When to Use a Section 338(h)(10) Election
There are several factors that should be considered when deciding whether to use a Section 338(h)(10) election in an acquisition. One important consideration is the tax consequences of an asset purchase versus a stock purchase. In an asset purchase, the acquiring company can step up the tax basis of the assets to their fair market value, which can result in significant tax savings. However, an asset purchase can also trigger a variety of tax liabilities, including depreciation recapture, state and local taxes, and sales taxes. Additionally, as service centered industries will have a portion of the sale price allocated to goodwill,[1] the acquiring company should consider the tax impact of making a Section 338(h)(10) election.
In contrast, a stock purchase generally does not trigger any atypical tax liabilities for the target company, but it also does not allow the acquiring company to step up the tax basis of the target company’s assets. This can result in higher tax liabilities for the acquiring company in the future. Generally, the purchase price will serve as the tax basis for the acquired stock.
Another important consideration when deciding whether to use a Section 338(h)(10) election is the availability of net operating losses (“NOLs”) and other tax attributes that can be used to offset future taxable income. If the target company has significant NOLs or other tax attributes, using a Section 338(h)(10) election may not be beneficial for the acquiring company because it can limit their ability to use these tax attributes to offset future taxable income. Acquiring companies should consult with their tax professionals to determine if a Section 338(h)(10) election would be tax efficient given the existence of NOLs. Generally, when a target company has substantial NOLs or tax credit carryovers, it may be more advantageous to structure the deal under a Section 338(g) election.
Benefits of a Section 338(h)(10) Election
One of the primary benefits of a Section 338(h)(10) election is the ability to step up the tax basis of the target company’s assets to their fair market value. This can result in significant tax savings for the acquiring company, particularly if the target company has a large amount of built-in gain in its assets.
In addition, a Section 338(h)(10) election can provide the acquiring company with greater flexibility in structuring the transaction. For example, the acquiring company may be able to avoid certain tax liabilities that would be triggered by a pure asset purchase such as depreciation recapture, state and local taxation, or taxes on the built-in gain of the assets.
Drawbacks of a Section 338(h)(10) Election
While there are benefits to using a Section 338(h)(10) election, there are also drawbacks that should be considered. One of the primary drawbacks is that the election can be expensive to implement, particularly if the target company has a large number of assets with significant built-in gain. In addition, the election can be complex, and it may require significant tax planning and analysis to ensure that it is being used appropriately. If considering a Section 338(h)(10) election you should work with a tax professional to ensure you fully understand the ramifications of the election and the impact to the entire transaction.
Another potential drawback of a Section 338(h)(10) election is that it may limit the acquiring company’s ability to use the target company’s NOLs and other tax attributes to offset future taxable income. This is because the election effectively eliminates the target company as a separate tax entity, which can limit the acquiring company’s ability to use the target company’s tax attributes.
Finally, it is worth noting that a Section 338(h)(10) election is not available in all circumstances. There are very specific conditions that the transaction must meet to ensure that the transaction can use a Section 338(h)(10) election, prior to considering this tax election you should consult with your tax professional.
Other Considerations Before Proceeding With a Section 338(h)(10) Election
In addition to the tax considerations discussed above, it is also important to consider the legal and business implications of an acquisition. For example, it may be necessary to obtain regulatory approvals or to negotiate complex contracts as part of the acquisition process. Furthermore, tax laws and regulations are subject to change, and the specific tax consequences of an acquisition will depend on a variety of factors, including the specific facts and circumstances of the transaction. Therefore, it is often beneficial to work with a team of professionals, including attorneys, tax professionals, and business advisors, to ensure that all aspects of the acquisition are being considered and addressed.
It is also worth noting that a Section 338(h)(10) election is not the only tax planning strategy that can be used in acquisitions. There are other strategies, such as a Section 336(e) election[2], that may be more appropriate depending on the specific circumstances of the acquisition. It is important to evaluate all available options to determine the best strategy that will optimize tax advantages and minimize potential tax pitfalls in a specific transaction.
Concluding Thoughts
When considering a Section 338(h)(10) election, it is important to weigh the benefits and drawbacks of the election against the specific circumstances of the acquisition. The decision to use a Section 338(h)(10) election should be based on a careful analysis of the tax implications of the transaction, as well as the legal and business implications. Section 338(h)(10) election can be complex and expensive to implement. It is important to work with a team of experienced professionals including a tax attorney, who can provide guidance and support throughout the process.
At Jacko Law Group, our team of Tax and Mergers and Acquisitions attorneys provide customized legal solutions to assist in your next sale, merger or acquisition; support due diligence efforts; and accelerate outcomes for your firm. For more information on how JLG can help, please contact us at (619) 298-2880.
[1] Treas. Regs. Sec. 1.197-2(b)(1) defines goodwill as “the value of a trade or business attributable to the expectancy of continued customer patronage,” and that “[t]his expectancy may be due to the name or reputation of a trade or business or any other factor.” See MacDonald, 3 T.C. 720 (1944).
[2]Like a Section 338(h)(10) election, a Section 336(e) election allows for an acquirer to treat a stock purchase as an asset purchase. Unlike a Section 338(h)(10) election, a Section 336(e) election does not require (1) the acquirer to be a corporation, (2) the acquisition be completed by a single acquirer, or (3) that both the seller and acquirer to agree to the tax election.