NEGOTIATING A 338(H)(10) ELECTION IN A MERGER AND ACQUISITION TRANSACTION
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If you are involved in a merger and acquisition (M&A) transaction, it is important to understand the tax implications of the deal. Typically, buyers prefer an asset sale while sellers prefer a stock sale. An asset sale is advantageous to the buyer as it allows them a step-up in basis in the acquired assets, which accelerates greater depreciation and offers an opportunity to reduce taxable income. It also helps the buyer avoid assuming any unwanted or unknown liabilities. On the other hand, a stock sale may be advantageous from the seller's perspective because the proceeds are taxed at favorable capital gains rates and, if a C-Corporation, spares them from double taxation.
In a M&A transaction, the buyer usually acquires the stock of the target corporation. This means that the buyer is not entitled to a stepped-up basis in the assets of the corporation. However, there is an exception to this rule, known as a 338(h)(10) election, and negotiating a 338(h)(10) election can provide significant tax benefits to both the buyer and the seller.
What is a 338(h)(10) Election?
A 338(h)(10) election is a tax election that allows the buyer of a corporation's stock to be treated as if they have acquired the assets of the corporation for tax purposes. This means that the buyer can take advantage of a stepped-up basis in the assets of the corporation to fair market value (FMV). The stepped-up basis allows the buyer to depreciate or amortize the assets over their new FMV basis, which can result in significant tax savings.
Why Negotiating a 338(h)(10) Election is Important in a Merger and Acquisition Transaction
As negotiations between buyers and sellers begin, the purchase price often takes center stage. However, as the details of the transaction are hashed out by the professionals, the structure of the deal becomes increasingly important. The old adage "the devil's in the details" rings true in this scenario.
Without a 338(h)(10) election, the buyer would not be entitled to a stepped-up basis in the assets of the corporation. This can result in higher tax liabilities for the buyer.
On the other hand, the seller can benefit from a higher purchase price for their stock if a 338(h)(10) election is made. This is because the election allows the buyer to take advantage of the stepped-up basis, which generally results in the buyer willing to pay a higher purchase price for the stock.
Negotiating a 338(h)(10) election is crucial in an M&A transaction because it can offer significant benefits to both the buyer and the seller.
Limitations of a 338(h)(10) Election
There are limitations to a 338(h)(10) election that should be considered before making the decision to elect.
Time Constraints
One of the most significant limitations of a 338(h)(10) election is the time constraint. The election must be made within thirty (30) days after the acquisition of the corporation's stock. This is a strict deadline, and failure to make the election within this time frame can result in the loss of the tax benefits associated with the election.
The time constraint can be challenging for both the buyer and the seller. The buyer may need to quickly analyze the assets of the corporation to determine their FMV, which can be a time-consuming process. The seller may also feel pressured to make a decision within a limited time frame.
Cost
To make a 338(h)(10) election, the buyer must determine the fair market value (FMV) of the assets of the corporation. This requires a detailed valuation of the assets, which can be time-consuming and expensive. The buyer may need to pay for a valuation of the assets to determine their FMV, and there may be additional legal and accounting fees associated with the election.
The cost of a 338(h)(10) election can be particularly challenging for small businesses or individuals who may not have the resources to cover the expenses. These expenses can reduce the overall benefit of the election for the buyer. Additionally, the IRS may challenge the valuation if they believe it is not accurate, which can result in additional costs and delays.
Increased Liability
By making a 338(h)(10) election, the buyer is responsible for the tax liability associated with the assets of the corporation. This means that if the value of the assets decreases or if there is a tax audit, the buyer may be liable for additional taxes.
Recapture of Depreciation
While a 338(h)(10) election can provide significant tax benefits, it can also result in the recapture of depreciation. This can occur when the buyer sells the assets of the corporation and realizes a gain that is subject to recapture under the tax code.
The recapture of depreciation can result in additional tax liabilities for the buyer, reducing the overall benefit of the election.
Ineligible Assets
Another limitation of a 338(h)(10) election is that not all assets are eligible for the stepped-up basis. Certain assets, such as goodwill and some intangible assets, may not be eligible for the stepped-up basis.
This can result in the buyer not being able to take advantage of the full tax benefits of the election, reducing its overall value.
If the buyer plans to sell the assets of the corporation soon after the acquisition, the election may not provide significant tax benefits.
Qualification Limitations
The transaction must meet certain qualification requirements to be eligible for the election. For example:
- The target corporation must be either a U.S. corporate subsidiary of a parent company or an S-Corporation;
- The buyer must be a U.S. taxpayer.
- The buyer and seller (all stockholders) must jointly make the election – it cannot be unilaterally made;
- For legal purposes, a 338(h)(10) election remains a stock sale despite being deemed an asset sale for tax purposes. Thus, while there are favorable tax benefits, it does not eliminate the buyer’s exposure to known or unknown liabilities included in the acquisition; and
- Buyer must be a corporation making a qualified stock purchase (QSP) – at least eighty (80%) percent of the seller’s stock needs to be acquired by the buyer.
Failure to meet these qualification requirements can result in the loss of the tax benefits associated with the election.
Tips for Negotiating a 338(h)(10) Election
Negotiating a 338(h)(10) election requires careful planning and attention to detail. Here are some tips for negotiating a successful election:
Identify the Benefits
Before negotiating a 338(h)(10) election, it is important to identify the potential tax benefits of the election. This includes understanding the stepped-up basis and how it can reduce future tax liabilities.
Determine the Purchase Price
The seller may receive a lower purchase price for their stock if a 338(h)(10) election is not made. This is because the buyer will not be able to take advantage of the stepped-up basis in the assets of the corporation. The purchase price for the stock should be determined before negotiating a 338(h)(10) election because the election can impact the purchase price, and it is important to ensure that all parties agree on the price.
Consider the Time Frame
As mentioned earlier, the 338(h)(10) election must be made within thirty (30) days after the acquisition of the corporation's stock. It is important to consider this time frame when negotiating the election and ensure that all parties are aware of the deadline.
Work with Experienced Professionals
Negotiating a 338(h)(10) election can be complex, and it is important to work with experienced professionals, such as attorneys and accountants. These professionals can help ensure that the election is negotiated properly and that all parties understand the implications of the election.
Is a 338(H)(10) election right for you?
Deciding how to structure your next M&A transaction can be complicated and negotiating a 338(h)(10) election is a critical aspect of an M&A transaction. The election can provide significant tax benefits to both the buyer and the seller. Overall, a 338(h)(10) election can be a valuable tool in reducing tax liability and creating value in a transaction, but it requires careful consideration and planning to ensure that all parties receive the maximum tax benefits possible. By identifying the benefits, determining the purchase price, considering the time periods, and working with experienced professionals, you can negotiate a successful election and ensure that all parties receive the maximum tax benefits possible. For buyers, the election can result in higher tax deductions and lower future tax liability, but it can also be expensive and may not always be advantageous. For sellers, the election can result in a higher purchase price for their stock and can help to avoid the recapture of depreciation, but it can also be expensive and may result in tax liability on any gains realized from the sale of their stock.
The M&A team at Pasricha & Patel, LLC can help translate the complexities and provide meaningful insight and guidance. Contact the M&A team at Pasricha & Patel, LLC to discuss this option and how it can benefit you in the context of your specific transaction.