The buyer wants us to agree to a Section 338(h)(10) election so they can treat the purchase of our S-corporation as an asset sale for tax purposes, but this creates ordinary income tax recapture for us. How do we calculate and negotiate the necessary purchase price gross-up to keep our net take-home cash whole?

Question

Tyler Smith · Accepted Answer

In an ordinary S-corporation stock sale, the seller pays federal long-term capital gains tax on the gain above their stock basis. However, buyers frequently request a Section 338(h)(10) election. This legal mechanism treats the stock purchase as an asset acquisition for tax purposes, giving the buyer a stepped-up basis in the acquired assets so they can depreciate them rapidly post-close.

While this generates immense tax savings for the buyer, it can create a financial disaster for you. Under an asset sale framework, your proceeds are allocated across asset classes. Gains attributed to inventory, accounts receivable, and previously depreciated equipment are subject to depreciation recapture and taxed at ordinary income rates rather than favorable capital gains rates. In high-tax jurisdictions, this election can erode fifteen to twenty-five percent of your net walkaway proceeds.

Never agree to a Section 338(h)(10) election without an explicit, contractually binding gross-up provision in the purchase agreement. Your transaction tax advisor must construct a detailed tax waterfall comparing a pure stock sale against the deemed asset sale.

The calculation must account for ordinary income recapture, federal capital gains rates, state income tax differentials, and the net investment income tax. The buyer must agree to increase the total enterprise purchase price dollar-for-dollar by the exact amount required to cover your additional tax liability, plus the incremental tax incurred on the gross-up payment itself.

Make the final asset allocation schedule a joint closing deliverable. If the buyer wants the economic benefit of accelerated depreciation, they must pay for the tax friction it creates.