The buyer insists that we structure our S Corporation stock sale with a Section 338(h)(10) election so they get a tax basis step-up, but our tax advisor says this creates ordinary income tax for us. How do we negotiate the tax gross-up calculation to keep our net proceeds whole?

Question

Tyler Smith · Accepted Answer

A Section 338(h)(10) election allows a buyer to purchase company stock while treating the transaction as an asset purchase for federal income tax purposes. This gives the buyer a massive financial benefit: they get to step up the tax basis of your underlying assets to fair market value and depreciate them over time, creating substantial future tax shields.

For an S Corporation seller, however, this election can be disastrous without an agreed adjustment. In a pure stock sale, all your gain is generally taxed at favorable long-term capital gains rates. In a deemed asset sale under 338(h)(10), gain attributable to depreciable personal property, inventory, and certain intangibles is subject to depreciation recapture under Section 1245, taxed at significantly higher ordinary income rates. Furthermore, state tax liabilities often spike under asset sale rules.

To protect your net proceeds:

- Mandate an explicit gross-up provision in your LOI: The buyer must contractually agree to pay an additional cash amount at closing that completely offsets the seller's incremental federal and state tax liabilities, including the tax on the gross-up payment itself.
- Agree on the allocation methodology upfront: The gross-up dollar amount depends entirely on how the purchase price is allocated across asset classes on IRS Form 8594. Do not leave asset allocation negotiations for post-signing diligence.
- Require buyer funding for independent modeling: Require the buyer to reimburse your accounting firm for running the definitive side-by-side tax modeling.

Never consent to a 338(h)(10) election without an executed, binding tax gross-up agreement.