It goes without saying that this article does not constitute legal advice. It is necessarily a high-level summary of a complex topic. Tax outcomes in M&A are incredibly fact specific. Consult with a tax specialist (by all means, come and speak with ours, she’s great) before finalizing the structure of your deal.
Buyers generally prefer to buy assets: They can pick and choose the assets they want; the risk of assuming unwanted liabilities is less; and they may receive a stepped-up cost basis in the assets acquired. A stepped-up basis results in greater depreciation and amortization deductions, and offers protection against future taxable gains.
Sellers generally prefer to sell stock. In a stock acquisition, the buyer purchases the entire operating entity, including its liabilities (which may be the subject of indemnification provisions). The company’s cost basis in its assets generally remains the same. But any tax disadvantage on that front is the buyer’s problem to bear.
Smaller transactions are generally structured as asset purchases. But not always. Sometimes, there are key contracts that cannot be assigned, the simplicity of a stock sale prevails, or the parties agree to a stock purchase for some other reason.
Whatever the explanation, a buyer can still capture the tax advantages of an asset deal when buying stock. Under certain circumstances, Internal Revenue Code Sections 338(g), 338(h)(10), and 336(e) permit the parties to treat a stock acquisition as if it were an asset acquisition for tax purposes.
Sections 338(g) and 338(h)(10)
Elections are available under Section 338 when a purchasing corporation acquires the stock of a target corporation in a qualified stock purchase. A qualified stock purchase is one in which the purchaser acquires at least 80 percent of the total voting power and value of the stock of the target.
Section 338 elections come in two forms: Section 338(g) and Section 338(h###-###-#### Under Section 338(g), the IRS waves its hands and conjures two target corporations, old and new. The old target is treated as selling assets and discharging liabilities; the new target is treated as acquiring assets and assuming liabilities. When the hand waving stops, the corporate buyer owns the stock of the target corporation (which has become a subsidiary of the buyer), and the target has a stepped-up basis in its assets.
However, in a Section 338(g) purchase, the seller potentially suffers two levels of taxation. The seller recognizes a gain on the sale of the stock, and, on the seller’s watch, the old target recognizes a gain on the sale of its assets.
Section 338(h)(10) avoids this double taxation pitfall. Under Section 338(h)(10), the IRS again waves its hands to conjure two targets, old and new. But at the conclusion of the hand waving, the old target is deemed to liquidate following the asset sale, and the seller is treated as receiving a tax-free liquidating distribution of the proceeds. Thus, a Section 338(h)(10) election results in a single level of taxation imposed on the seller at the entity level.
Yet a Section 338(h)(10) election comes with its own issues. For one, because the seller takes the tax hit at the entity level rather than the stockholder level (as would be the case in a straightforward stock purchase), the seller may still suffer an adverse tax outcome. For instance, if the seller’s basis in the stock exceeds the target company’s basis in its assets.
Additionally, a Section 338(h)(10) election is available in a comparatively narrower range of circumstances when compared with Section 338(g), limiting its application. The purchasing corporation must generally acquire stock from a selling corporation. It can only acquire stock from individuals, if the target company is an S-corporation. Nonetheless, because of the double taxation problem, a Section 338(h)(10) election is far more commonplace than a Section 338(g) election (at least, in the context of domestic M&A).
Section 336(e)
Section 336(e) is modeled after Section 338(h)(10), but expands the categories of deals that can be included. Notably, non-corporate buyers can benefit from a Section 336(e) election. This is in contrast to elections under Sections 338(g) and 338(h)(10), which require corporate buyers.
A Section 336(e) election is only available in the absence of a possible Section 338(g) or Section 338(h)(10) election. For instance, where the buyer is an individual rather than a company. And all the same tax caveats apply to a Section 336(e) deal as to a Section 338(h)(10) deal. The seller is at risk of an adverse tax outcome. And if so, the buyer may need to sweeten the terms of any deal.
Beware: General rules do not always hold true.
 Generally, buyers are better off for tax purposes when buying assets. But elections under Sections 338(g), 338(h)(10), and 336(e) can result in adverse tax consequences for buyers too. If a target company’s basis in its assets exceeds their fair market value, an asset acquisition could result in a stepped-down basis. This is because the buyer’s basis in the acquired assets is limited by that fair market value.
This scenario is most likely to occur in an economic downturn. Of course, economic downturns may present the best buying conditions for the adventurous. So it bears repeating our earlier disclaimer: Consult with a tax specialist before finalizing the structure of any deal, as you may be leaving money on the table or walking into avoidable losses. Getting a tax attorney’s advice upfront may save you money later.
For those interested in pursuing a Section 338(g), 338(h)(10), or 336(e) election in an upcoming acquisition, the relevant section of your letter of intent could include language as simple as the following:
Buyer and Seller will cooperate to make any tax election or elections to treat the Transaction as though Buyer were purchasing substantially all of the assets of the Company.