Transaction Structure: Buyer vs. Seller
In the negotiation process, the purchase price starts the conversation. It is what brought everyone to the table. Shortly into negotiations, however, transaction structure becomes very relevant.
In part, transaction structure refers to what is being purchased – assets (tangible and intangible) or stock shares. The differentiating factors primarily stem from legal and tax consequences. Buyers and sellers are typically at odds regarding how a transaction is structured.
All things being equal, 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 increases depreciation deductions that reduce taxable income. The buyer also avoids assuming any unwanted, contingent, or unknown liabilities included in a stock sale that now becomes the buyer's liability. From the seller's perspective, a stock sale is advantageous because the proceeds are taxed at favorable capital gains rates and, if a C-Corporation, spares them from double taxation.
Asset sales have tax advantages for the buyer, but transferring assets also comes with complications where each asset must be conveyed to the buyer. This process can be a significant obstacle for contracts or licenses that may contain "change of control" restrictions resulting in considerable costs to transfer such assets to a buyer. Additionally, buyers must start fresh, re-hiring the target's workforce.
Why a 338(h)(10) election?
In simple terms, a 338(h)(10) is a tax election for a qualified stock purchase (QSP), which recharacterizes a stock purchase as an asset purchase for federal tax purposes. It remains a stock purchase for all other legal purposes, such as contracts and licensing.
Buyers like it
The buyer receives a tax basis in the acquired assets equal to the purchase price and can depreciate at their purchased value, frequently at an accelerated rate. Tax reform increased accelerated rates for qualifying assets placed into service after September 27, 2017, and before January 1, 2023, to "full expensing." Further, because the transaction is treated as if assets were purchased, the buyer can record goodwill and amortize the expense over 15 years for tax purposes. These factors are significant tax benefits for the buyer.
In addition to the favorable tax characteristics, buyers can also avoid the change of control issues that can be present in traditional asset deals. Because a 338(h)(10) transaction is still a stock sale for legal purposes, all contracts and licenses that would otherwise need to go through the assignment process in an asset sale are transferred with the sale of the corporation.
Sellers don't
Sellers generally prefer a stock purchase agreement without a 338(h)(10) election because it transfers tax benefits from the seller to the buyer. As a result, the 338(h)(10) election is often a compromise on behalf of a seller to close the deal. As part of the negotiation, sellers will frequently demand a higher purchase price to compensate for the tax benefits lost in a 338(h)(10) election. If the seller's cost outweighs the buyer's benefit, a 338(h)(10) election may not make sense.
Limitations of 338(h)(10) election
- The seller must be either a U.S. corporate subsidiary of a parent company or an S-Corporation.
-
The buyer and seller (all stockholders) must jointly make the election – it cannot be unilaterally made by one side.
- For legal purposes, a 338(h)(10) election remains a stock sale despite being deemed an asset sale for tax purposes; thus, favorable tax benefits do not eliminate the buyer's exposure to known or unknown liabilities included in the corporate acquisition.
- The buyer must be a corporation making a QSP – at least 80 percent of the seller's stock needs to be acquired by the buyer.
