Unlocking Tax Savings: Understanding Section 338(h)(10)

Introduction: Elections That Shift Tax Realities

Section 338(h)(10) of the Internal Revenue Code allows certain stock purchases to be treated as asset acquisitions for tax purposes. This election creates significant opportunities for basis step-ups and tax optimization, but also brings complexity in qualification and downstream consequences. Understanding when and how to use this tool, particularly in relation to affiliation tests, is essential for strategic M&A planning.

The Mechanics of 338(h)(10)

The election is available when a purchasing corporation acquires at least 80% of the stock of a target corporation that is either a subsidiary of a consolidated group or an S corporation. Both buyer and seller must agree to make the election.

By treating the stock sale as a deemed asset sale, the buyer receives a step-up in the tax basis of the target’s assets to their fair market value. This results in increased amortization and depreciation deductions, potentially lowering post-close tax liabilities significantly.

We once structured a $60 million acquisition of a wholly owned subsidiary with a 338(h)(10) election. The basis step-up in developed technology and customer contracts yielded $15 million in tax savings over five years, improving deal IRR by 130 basis points.

Affiliation Tests and Eligibility

A common mistake is assuming the election is available without validating group status. The target must be part of a consolidated group or an S corporation. An LLC or standalone C corporation would not qualify unless part of a broader structure.

We encountered a situation where the seller’s legal entity chart showed the target as a subsidiary, but the parent had not filed consolidated returns for five years. That disqualified the 338(h)(10) path, forcing a workaround using 336(e), with different results and state tax complications.

Buyers must validate:

• Consolidated return filings
• 80% ownership threshold (vote and value)
• Stock vs asset acquisition structure

State Tax Conformity

Federal tax treatment under 338(h)(10) does not automatically carry to state jurisdictions. Some states do not conform, which means buyers must account for bifurcated basis schedules and deferred tax complexities.

In one multi-state transaction, the federal election produced favorable amortization, but three key states did not recognize the step-up. We had to maintain dual fixed asset ledgers and reconcile DTA/DTL impacts during close audits.

Financial Reporting and Purchase Accounting

The election affects opening balance sheets. GAAP requires asset revaluation and recognition of deferred taxes. It also changes goodwill calculations.

We once failed to sync tax modeling with purchase accounting, leading to a restatement six months post-close. Since then, we mandate joint review of tax elections, accounting entries, and auditor alignment before closing.

338(h)(10) vs 336(e)

If 338(h)(10) is not available, 336(e) may serve as a fallback. It allows similar treatment when a qualified stock disposition occurs, but only the seller makes the election.

However, 336(e) is not as widely accepted and carries more ambiguity. We treat it as a tool of last resort when 338(h)(10) is unavailable or infeasible.

Conclusion: The Right Election Creates Real Value

Section 338(h)(10) is a powerful instrument in M&A tax structuring, allowing alignment of legal and tax form. But it requires diligence, coordination, and careful state-level modeling. When used properly, it enhances post-close tax efficiency and can be a key value lever in competitive deal environments.

Insight

Over my three decades as an operational CFO, I have come to appreciate how often the value of a deal hinges not just on the price negotiated but on the tax elections made behind the scenes. Section 338(h)(10) elections stand among the most strategic tools available in U.S. tax planning, allowing for the alignment of legal form and tax form in ways that unlock substantial financial benefits. Yet their utility is frequently misunderstood, misapplied, or overlooked entirely. For CFOs navigating complex M&A, understanding the nuances of this election is not optional—it is a mandate.

In essence, a Section 338(h)(10) election lets the buyer of a corporation’s stock treat the transaction as if the target sold all its assets and then liquidated. The magic here lies in the tax basis step-up. When structured correctly, the buyer receives a fair market value basis in the acquired assets, creating future tax shields through accelerated depreciation and amortization. The implications for cash flow and internal rate of return can be profound.

I vividly recall one acquisition of a data services company where the 338(h)(10) election unlocked $18 million in net present value savings over seven years. Without that election, the deal economics would not have cleared our internal hurdle rate. It was not a matter of whether we liked the business. It was about whether the after-tax returns justified the premium. That election changed the calculus.

But the election is not a blank check. It can only be made when specific conditions are met: the target must be either a subsidiary of a consolidated group or an S corporation. This is where the affiliation test comes in. The acquirer must buy at least 80% of the vote and value, and the selling entity must have filed as part of a consolidated return. Many buyers assume incorrectly that any wholly owned entity qualifies. In one deal, we wasted weeks building a model around a 338(h)(10) only to find that the seller’s group had been filing separate returns for the last four years. The entire structure collapsed. We pivoted to a 336(e) alternative, which, while functional, introduced uncertainty and compliance friction.

Due diligence must therefore include an affiliation audit. Validate tax filings, legal ownership, and historical changes. I require our tax counsel to provide a memo certifying qualification before we model any benefits from the election. That memo is not ceremonial; it is foundational.

Beyond eligibility, the interplay with state taxes must be carefully managed. Not all states conform to the federal treatment of 338(h)(10). This creates a bifurcated basis regime, where the same asset has different tax values across jurisdictions. In one recent acquisition, we had to maintain dual ledgers for fixed assets and intangibles. This introduced complexity into our ERP implementation, tax provisioning, and audit disclosures. While the federal benefits remained attractive, the administrative overhead nearly offset the advantage in some states. Modeling must reflect this reality.

Financial reporting is also impacted. The election changes the purchase accounting landscape. Instead of treating the transaction as a stock acquisition with residual goodwill, the buyer must allocate fair value to acquired tangible and intangible assets. Deferred tax assets and liabilities must be recalculated. Any misalignment between the tax and accounting teams can lead to control deficiencies or restatements. I have seen it happen.

One time, we closed a deal with a 338(h)(10) election but failed to update our opening balance sheet assumptions. The auditors flagged inconsistencies in our deferred tax schedules and goodwill calculations. We had to restate our 10-Q and absorb the reputational hit. Since then, we require synchronized review by tax, accounting, and audit teams at least 30 days pre-close.

There is also a negotiation element. The seller must consent to the 338(h)(10) election. This is often a sticking point, as it may trigger immediate gain recognition for the seller. To compensate, we have used gross-up clauses or purchase price adjustments. In one deal, we offered an additional $2 million to the seller to accommodate the tax impact. It worked because we projected $8 million in tax benefit over five years. That trade created alignment.

Sometimes, the election is not possible, and we must explore Section 336(e). This provision allows similar treatment but is made unilaterally by the seller. It is less well understood and carries more ambiguity in its application. States vary in their acceptance, and the IRS has issued fewer interpretive rulings. We use 336(e) sparingly and only when 338(h)(10) is definitively unavailable.

What makes 338(h)(10) so strategic is not just the immediate tax benefit, but the optionality it creates in deal structuring. It enables more aggressive amortization schedules, better alignment with integration cost structures, and improved visibility for DCF modeling. It also gives the buyer a fresh start with asset-level documentation, which can reduce post-close tax risks and audit exposure.

In competitive deal processes, especially in private equity or corporate carve-outs, the ability to offer a cleaner, more tax-efficient bid can tip the scales. I have used a 338(h)(10) model to outbid a competitor by $3 million, knowing that our after-tax returns would still exceed targets. That is the power of smart structuring.

For CFOs, the takeaway is clear: Section 338(h)(10) should be a standard part of the M&A toolkit. But it must be used with precision. That means:

• Validating group affiliation early
• Aligning tax and accounting treatments
• Modeling federal and state impacts
• Negotiating seller cooperation transparently
• Coordinating with legal and audit teams throughout

It is not just a tax play. It is a governance discipline. When executed well, it adds real dollars to shareholder value. When mishandled, it creates noise, risk, and distraction. Like many aspects of M&A, it rewards those who prepare thoroughly and engage cross-functionally.

Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or financial advice. Always consult qualified advisors before making Section 338 elections or interpreting affiliation rules.