By: Kapil Handa
When negotiating the sale of a corporation, buyers and sellers can choose to structure the transaction as a stock sale or as an asset sale. Sellers and buyers have conflicting interests because these transactions are taxed differently. Stock sales are better for sellers because they get preferential capital gain tax treatment. However, buyers prefer asset purchases since they can reduce the amount buyers owe on taxes by claiming accelerated depreciation/amortization expense. Luckily, a 338 (h) (10) election is beneficial to both parties and can serve as a compromise.
Asset Sale: Buyer Friendly
During an asset sale, the seller retains legal ownership of the business. The buyer purchases the individual assets and liabilities of the business, which may include equipment, trade secrets, licenses, inventory, and more. Cash and debt are generally not included in these sales. However, net working capital such as accounts receivable and payable, accrued assets, and more are usually included. Each asset and liability is conveyed to the buyer individually.
Asset sales are structured to benefit buyers. These sales allow buyers to “step-up” depreciation in the company’s assets, meaning that they can allocate higher value to assets that depreciate quickly, such as equipment, and allocate lower value to assets that amortize slowly, such as goodwill. This way, buyers can reduce the business’s taxes in its critical early years. Additionally, buyers can avoid taking on liabilities of the business, like product liabilities, contract disputes, employee lawsuits, and more.
Sellers are subject to higher taxes with this asset sales, and they can face double taxation when selling a C corporation.
Stock Sale: Preferred by Sellers
In stock sales, the buyer purchases the owner’s shares of the corporation. Unlike asset sales, stock sales do not require conveyances of each individual asset. These sales favor sellers, because the proceeds receive a lower capital gains tax and sellers are less responsible for future business liabilities. Buyers do not prefer structuring sales this way however, because it can result in higher future taxes compared to an asset sale. Additionally, they take on more risk by purchasing the company’s stock, including undisclosed or unknown risk. Liabilities such as lawsuits become the responsibility of the purchaser.
C corporation and S corporation sales can be structured as stock sales, while the sales of sole proprietorships, partnerships, or limited liability companies (LLC) must be structured as asset sales.
What is a 338 (h) (10) Election?
One powerful solution is the 338 (h) (10) election, because for federal tax purposes the seller can treat the sale as a stock sale while the buyer can treat it as an asset purchase. For state tax and all other legal purposes, the transaction is considered as a stock sale for both parties.
From a tax standpoint, a transaction using the 338 (h) (10) election allows the buyer to establish a new corporation. The new corporation purchases the assets and assumes the liabilities of the old corporation, and the old corporation is liquidated.
Under section 338 (h) (10) of the federal tax code
Below are the major points to keep in mind before making this election:
- The buyer must be a corporation making a qualified stock purchase of 80% or more of the selling (old) company.
- The old corporation must be a S corporation or member of a consolidated group.
- The buyer must buy 80% of the old company’s stock within 12 months from the date of the first transaction.
- The buyer and seller must both make the 338 (h)(10) election and file Form 8023 with the Internal Revenue Service by the 15th day of ninth month following the sale’s closing date.
The 338 (h) (10) election is still less advantageous to the seller than a pure stock deal, because some of the original tax benefits are enjoyed by the buyer. Sellers may compromise and allow a 338 (h) (10) election to close the deal, but they may want to negotiate a higher purchase price to cover their additional tax burden.
338 (h) (10) Election Example
A company is being sold with the following values:
- Sales price: $400,000
- Cost basis, or original asset value for tax purposes: $100,000
By making a 338 (h) (10) election, the seller would pay a federal capital gain tax of approximately 15% on their capital gain of $300,000. Their capital gain is calculated by subtracting the cost basis from the sales price, or $400,000 – 100,000. This capital gain is lower than their regular income tax, which is taxed based on their personal tax bracket.
The buyer can capitalize the total amount of $400,000 invested to buy the company, meaning they can accelerate the depreciation/amortization expense and save on taxes over time. This reduces their taxable income and allows them to pay less in taxes. Without making the 338 (h) (10) election, the buyer would lose this deduction.
Buying and selling your business is one of the most important decisions you can make. Contact your trusted Chugh CPA for personalized professional advice that works best for your situation.
eement that protects your business.