The buyer is insisting on a Section 338(h)(10) election so they can treat our stock sale as an asset purchase for tax purposes, but our CPA says this will increase our tax bill. How do we negotiate a tax gross-up or equalization payment to protect our net cash proceeds?

Question

Tyler Smith · Accepted Answer

A Section 338(h)(10) election allows a buyer to purchase the stock of an S corporation or a consolidated group but treat the transaction as an asset purchase for federal income tax purposes. This is highly advantageous for the buyer because they get a step-up in the tax basis of your assets, allowing them to claim substantial depreciation and amortization deductions post-close.

For you, the seller, this election is often a major tax disadvantage. It can trigger ordinary income tax rates on certain assets, such as depreciation recapture on equipment or software, rather than the lower long-term capital gains tax rate you would get in a pure stock sale.

To protect your proceeds, you must negotiate a tax gross-up or tax equalization clause. This clause requires the buyer to pay you an additional sum at closing to ensure your net, after-tax proceeds are exactly the same as they would have been in a straight stock sale.

Do not wait until the final purchase agreement is drafted to bring this up. You must establish this principle in the Letter of Intent. Specify that the buyer is responsible for calculating and paying the tax equalization amount.

Have your CPA run a detailed tax model simulating both scenarios. Use this model during negotiations to show the exact dollar-for-dollar difference. If the buyer refuses to fund the gross-up, use this as leverage to negotiate a higher base multiple or a reduction in their post-close indemnity demands.