A founder I had not heard from in two years called me in early April. He runs an S-corporation that he started in 2011, has been profitable since 2014, and was finally talking to a Midwest strategic about a real offer. The LOI in his hand had a number on it he was happy with. It also had two short sentences buried in the tax-structure section that he did not understand. The seller would cooperate with a § 338(h)(10) election. The seller’s after-tax economics would not be grossed up.
He wanted to know what those two sentences meant. I told him they meant the buyer wanted the founder to pay for the buyer’s tax benefit, and that the offer he was happy with was probably not the offer he thought it was. The next forty minutes we spent running the math.
If you are a founder of an S-corporation considering a sale and a § 338(h)(10) election shows up in the LOI or the term sheet, this is the math you need to run, and it is the conversation you need to have with the buyer before you sign anything substantive.
What a 338(h)(10) election actually does
Set aside the federal-tax jargon for a second. A § 338(h)(10) election is a joint election by the buyer and the seller that takes a transaction structured legally as a stock sale and treats it, for federal income-tax purposes only, as a sale of the company’s assets followed by a liquidation of the company. The buyer pays cash for stock, signs a stock purchase agreement, takes the company’s contracts and licenses and EINs intact — and the tax law nevertheless pretends the buyer bought a bag of assets and the seller wound up the company.
The election is available only in a narrow band of deals. The target has to be either a subsidiary of a consolidated group or an S-corporation, the buyer has to be a corporation (or, with a sister election under § 336(e), in some pass-through configurations), and at least 80% of the target’s stock has to be acquired in a qualified stock purchase within a 12-month period. For founder-owned S-corps, the election is one of the most common structuring choices in middle-market private deals — common enough that buyer’s counsel often drafts it into the term sheet as if it were a default rather than a negotiation.
Why does the buyer want it? Because the buyer gets a stepped-up tax basis in the target’s assets. The buyer’s depreciation and amortization schedule starts over from the purchase price. For an acquired business with meaningful goodwill — and almost every founder-built business has meaningful goodwill — that step-up generates a 15-year amortization deduction under § 197 that produces real cash savings against the buyer’s future tax bill. Strategic buyers and private equity buyers both want this. On a $30 million deal where, say, $20 million is goodwill, the present value of the buyer’s incremental tax shield can sit in the $3–5 million range depending on the buyer’s marginal rate and discount rate.
Where the cost lands
The election does not create that tax benefit out of nothing. The federal fisc is roughly indifferent to the structure; what changes is who pays the tax and when. In a plain stock sale without the election, the founder reports long-term capital gain on the difference between the purchase price and the founder’s outside basis in the stock. Federal long-term capital-gain rates top out at 20% plus the 3.8% net-investment-income tax, plus state — call it roughly 25% federal-blended for the typical founder, plus whatever the state takes.
In a stock sale with a § 338(h)(10) election, the math at the seller level looks different. The election deems the company to have sold its assets. The S-corporation reports gain on the asset sale, which passes through to the founder on the founder’s K-1. The character of that gain depends on the asset. Goodwill and most intangibles are capital. Depreciable tangible assets — equipment, furniture, leasehold improvements — are partly ordinary because of § 1245 recapture. Receivables and certain inventory are ordinary. The ordinary-income portion of the founder’s deemed-asset-sale gain is taxed at the founder’s ordinary marginal rate, which for a successful founder is 37% federal plus net-investment-income tax plus state. The deemed liquidation that follows is generally a non-event for an S-corporation founder because the inside-and-outside basis match up — but the ordinary-versus-capital recharacterization at the asset-sale step is the cost.
The size of that cost is the variable nobody runs at the LOI stage. For a service business with very little depreciable equipment and most of the value in goodwill, the recharacterization cost is small — sometimes a few hundred thousand dollars on a $30 million deal. For a manufacturer with heavily depreciated equipment that has been written down to a small fraction of its replacement cost, the recapture pickup can run into seven figures. For a business that holds appreciated real estate, you have an even larger pickup at the entity level, and you have to think hard about whether the real estate should be carved out of the deal entirely.
The gross-up nobody asks for
The standard middle-market negotiation around a § 338(h)(10) election is the gross-up. The founder agrees to make the election if — and only if — the buyer pays additional consideration that puts the founder in the same after-tax position the founder would have been in on a plain stock sale. The math is iterative because the gross-up itself is taxable, but the formulas are well-worked-out and any competent deal accountant runs them in an afternoon.
Founders who do not ask for the gross-up give the buyer the entire benefit of the election. Founders who ask for and get a partial gross-up split the benefit somewhere along the spectrum. Founders who ask for and get a full gross-up have made the election economically neutral on their side and have transferred all of the surplus to the buyer in exchange for the buyer’s after-tax pickup.
The reason founders give away the gross-up is almost always the same. It is not in the LOI because nobody negotiated it into the LOI. By the time the founder sees the words “the parties will make a joint § 338(h)(10) election” in the draft purchase agreement, the founder’s leverage has dropped. The LOI is signed. Diligence is in flight. The buyer’s counsel knows that the founder will not blow up the deal over a tax provision that the founder does not fully understand. The right time to fight for the gross-up is at the term sheet, before the LOI is fully papered, when the founder still has the meaningful option of walking. The wrong time is after the founder has spent four months living with the deal.
The pattern of giving away seller-friendly value at the LOI stage is something I have written about in other contexts, and the 338(h)(10) decision is one of the cleanest examples of it. The terms that get fought over after the LOI are by definition the terms that are hardest to move.
Three specific moves at the term-sheet stage
First, ask whether the buyer needs the election, or whether the buyer wants the election. Strategic buyers operating in their own line of business may not actually need the step-up — they may already have substantial NOLs, or their effective tax rate may make the step-up worth less than it looks. PE buyers structuring a platform almost always do need it for the next exit. The conversation is different depending on the answer, and the founder is entitled to ask.
Second, name the gross-up explicitly. Do not let the LOI say “the parties shall cooperate with respect to a § 338(h)(10) election.” That phrasing concedes the election without addressing the cost. Make it say “the parties shall make a § 338(h)(10) election, and the purchase price shall be increased by an amount that puts the seller in the same after-tax position as a plain stock sale, calculated by a mutually agreed methodology set forth in the definitive agreement.” If the buyer pushes back on the gross-up concept, the founder needs to know that early — that is the negotiation, and it should happen before the founder signs.
Third, get the asset allocation negotiated in the definitive agreement, not left for post-closing. The § 338(h)(10) deemed-asset-sale gain depends on how the purchase price is allocated across asset classes, and the allocation is the place where the founder can shift the gain from ordinary back toward capital. Goodwill is capital; the more of the price the parties allocate to goodwill, the better for the founder. Inventory and recapture-laden equipment are ordinary; the less of the price that lands there, the better. Buyers and sellers have natural-tension positions on allocation but they often agree at the price-allocation stage if the conversation is structured. Leaving allocation to a post-closing Form 8594 exercise is leaving the founder exposed to whatever allocation the buyer’s accountants prefer.
The deals where the election is genuinely the right answer
There are deals where a § 338(h)(10) election makes sense for the founder, and not just because the buyer wants it. The clearest case is the S-corporation that recently shed its C-corporation history. If the company converted from a C-corp to an S-corp within the last five years, the built-in-gain tax under § 1374 applies to gain on asset sales during the recognition period, and the math gets complicated in a way that sometimes pushes toward the election as the cleanest path. The other case is the seller with a meaningful capital-loss carryforward looking for ordinary-character offsets — though those founders are unusual.
The rest of the time, a founder agreeing to a § 338(h)(10) election without a gross-up is doing the buyer a favor. The statute itself does not require the favor. The customs around the election have made it so common that the negotiation is often skipped. Founders who skip it leave money on the table. Founders who negotiate it get paid for the consent.
If you would like to see how this fits into the broader structuring conversation around middle-market M&A, our M&A practice page walks through the structuring questions we work on with founders. And the merger-agreement template I have annotated for entrepreneurs covers the surrounding contract architecture.
If you are a founder of an S-corp staring at a buyer’s draft purchase agreement asking for a 338(h)(10) election and trying to understand what it actually costs you on the seller’s side, feel free to reach out to my firm manager, Magda, at Magda@montague.law, or fill out our contact form. Mention you read this post.
— John
