Section 338(h)(10) Election Explained for Business Sellers

A Section 338(h)(10) election is one of the most misunderstood tax tools in lower middle-market M&A. Most founders hear it for the first time on a buyer’s LOI, and the next 48 hours decide whether the deal closes at the headline number or with a six- or seven-figure tax surprise nobody modeled.

This guide covers what a 338(h)(10) election is, who qualifies, how the mechanics work on day 1 and day 2, the worked dollar math on a $10M S-corp, and where the §336(e) and F-reorganization workarounds fit. Written for sellers and seller-side advisors who need to price the trade-off before signing.

What is a Section 338(h)(10) election?

A Section 338(h)(10) election is a joint federal income tax election made by the buyer and the seller after a qualified stock purchase. Legally the buyer still buys stock. For income tax purposes the IRS treats the deal as if the target corporation sold all of its assets to a hypothetical “new” target, then liquidated and distributed the proceeds to the historic shareholders.

Two parties have to sign. The buyer has to file. Form 8023 is the operative document, and it is due by the 15th day of the 9th month after the acquisition date (8.5 months in plain English). Miss it and the election fails. Once filed, the election is irrevocable.

Why buyers want it: in an ordinary stock sale, the buyer inherits carryover basis. If the seller depreciated a $5M plant down to $400k, the buyer starts at $400k. A 338(h)(10) resets basis to fair market value, with fresh depreciation on tangibles and a 15-year amortization clock on goodwill.

The reason sellers care is that a deemed asset sale is not always tax-neutral compared with a clean stock sale. Sometimes it costs the seller real money. Sometimes the buyer’s tax savings are large enough that they will gross up the purchase price to compensate. The whole game is knowing which side of that line you are on before you negotiate.

Eligibility: who qualifies for a 338(h)(10) election?

Section 338(h)(10) is not available on every deal. Three eligibility gates have to clear.

1. The target must be eligible

Only two kinds of targets qualify under Treas. Reg. §1.338(h)(10)-1:

• S-corporations. The vast majority of 338(h)(10) elections in the lower middle market are on S-corp targets. The S-corp election has to be valid on the day of the acquisition (a common diligence finding is an inadvertently busted S election from years prior).
• Subsidiaries of a consolidated group as defined in IRC §1504(a)(2), where the selling parent owned at least 80% of vote and value of the subsidiary stock immediately before the sale.

A standalone C-corp owned by individuals is not eligible for 338(h)(10). A C-corp owned by individuals can do a plain §338(g) election, but that one is buyer-only and triggers double tax on the seller, which is why it almost never happens in private M&A.

2. The transaction must be a qualified stock purchase (QSP)

A QSP requires the buyer (a corporation, not a partnership or individual) to acquire at least 80% of the target’s vote and value within a 12-month acquisition period. Rollover equity counts against the buyer’s 80% only in narrow circumstances, but if the seller is rolling more than 20% into the buyer’s parent, the QSP gate can fail. This is a frequent issue in private equity deals with meaningful rollover.

3. The buyer must be a corporation

Section 338 requires the purchaser to be a corporation. If the buyer is structured as an LLC taxed as a partnership (common with PE funds), the buyer typically forms a blocker corporation specifically to make the acquisition and satisfy the QSP test. Without a corporate buyer, no 338(h)(10).

How the 338(h)(10) election deemed asset sale works mechanically

The mechanics are a two-step legal fiction the IRS layers on top of the actual stock sale. Understanding the day 1 / day 2 framework is the easiest way to keep the consequences straight.

Day 1: Deemed asset sale

At the end of the acquisition date, the target (now called “old target” in the regulations) is treated as if it sold all of its assets to a hypothetical “new target” in a single transaction in exchange for the Aggregate Deemed Sales Price (ADSP). Old target recognizes gain or loss on each asset class.

That gain is computed asset by asset under the seven-class residual method in Treas. Reg. §1.338-6:

1. Class I: Cash and demand deposits
2. Class II: Actively traded personal property and CDs
3. Class III: Accounts receivable and most debt instruments
4. Class IV: Inventory
5. Class V: All other tangible and intangible assets not in Classes VI or VII (FF&E, real estate, vehicles)
6. Class VI: Section 197 intangibles other than goodwill and going concern (customer lists, non-competes, trademarks)
7. Class VII: Goodwill and going concern value

Purchase price is allocated to each class up to fair market value, with the residual landing in Class VII goodwill. That allocation drives how much of the seller’s gain is ordinary income (depreciation recapture, inventory above cost) versus capital gain (most goodwill).

Day 2: Deemed liquidation

On the day after the acquisition date, “new target” (now sitting inside the buyer) is treated as having received those assets at stepped-up basis equal to the purchase price plus assumed liabilities. The shareholders of old target are treated as having received liquidation proceeds in exchange for their stock.

For an S-corp target, the day 1 gain passes through to the historic S-corp shareholders on the final S-corp K-1. The day 2 deemed liquidation is then a stock sale at the shareholder level, but because each shareholder’s outside basis in their S-corp stock was just increased by the day 1 gain, the day 2 capital gain on the deemed stock sale is usually near zero. That is the elegant part of the design: the federal tax is collected once, at the shareholder level, on the asset-sale character.

Buyer benefit: the basis step-up dollar math

The reason buyers will pay extra for a 338(h)(10) is the present value of incremental tax deductions. Walk through the math on a $10M deal and the number gets concrete fast.

Assumptions: $10M purchase price for an S-corp HVAC business. Pre-deal balance sheet shows $500k of fully-depreciated trucks and equipment, $300k of net working capital, no real estate. The buyer is a corporate blocker with a 25% combined federal/state effective tax rate. Discount rate of 10%.

Allocation under the residual method:

• Class III (AR): $300k, no step-up (recovered in cash)
• Class V (FF&E, trucks): $700k FMV, allocated under cost segregation and 5-7 year MACRS lives
• Class VI (customer list, 5-year non-compete from seller): $1.5M, 15-year amortization under §197
• Class VII (goodwill): $7.5M, 15-year amortization under §197

Incremental amortization the buyer gets from the step-up:

• $1.5M Class VI + $7.5M Class VII = $9M of new §197 intangibles, amortized straight-line over 15 years = $600k per year of deductions for 15 years
• $700k Class V tangibles: roughly $140k/yr over 5 years of accelerated MACRS

Present value of the buyer’s tax shield at 25% effective rate, 10% discount:

• $600k/yr × 25% = $150k cash tax savings per year for 15 years, PV ≈ $1.14M
• Plus ~$140k/yr × 25% = $35k/yr for 5 years on the FF&E, PV ≈ $133k
• Total PV of the step-up benefit to the buyer ≈ $1.27M

That $1.27M is the maximum amount a rational buyer should pay extra (gross-up) to get the 338(h)(10). In practice buyers will split the benefit, often offering a gross-up of 40% to 60% of the modeled shield, leaving $500k to $750k of extra purchase price on the table for the seller.

Seller cost: depreciation recapture and the ordinary-income bite

The seller’s tax bill in a 338(h)(10) is almost never the same as the bill in a clean stock sale. The character of the gain changes, and character is what drives the federal rate.

In a clean stock sale, the entire gain over the seller’s stock basis is long-term capital gain at 20% federal plus 3.8% NIIT for individual sellers (S-corp shareholders typically clear the material participation tests, so NIIT may not apply on the operating gain).

In a 338(h)(10), the day 1 deemed asset sale produces gain that flows through the S-corp K-1 with the same character it would have had if the corporation actually sold the assets. That means:

• Depreciation recapture (§1245 on FF&E, §1250 on real property): Ordinary income at the seller’s top marginal rate (up to 37% federal in 2026). In the worked example above, the $500k of fully-depreciated trucks generates $500k of ordinary recapture income, taxed at roughly $185k of additional federal tax vs. capital gains treatment.
• Inventory above cost: Ordinary income.
• Accounts receivable for cash-basis sellers: Ordinary income.
• Goodwill (Class VII): Long-term capital gain at 20% (self-created goodwill in a personal services business is a capital asset).
• Allocations to a personal goodwill side-letter or a non-compete paid directly to the founder: Treated as ordinary compensation income, taxed at 37% plus self-employment tax in some structures.

The seller’s “cost” of agreeing to a 338(h)(10) is the difference between the all-in tax bill on the deemed asset sale and the bill on a clean stock sale. On a clean lower middle-market services business with limited depreciable assets and no inventory, that delta is often $100k-$300k on a $10M deal. On a business with a heavy fixed asset base or a lot of fully-depreciated property, the delta can swallow $1M or more.

Rule of thumb: if the buyer’s shield exceeds the seller’s incremental tax, do the election and split the surplus. If the incremental tax exceeds the shield, refuse or insist on a full gross-up.

The §336(e) alternative: S-corp seller-only election

What happens when the buyer is not a corporation? PE funds buying through partnership vehicles cannot make a 338(h)(10) because the buyer-is-a-corporation gate fails. That is where IRC §336(e) lives.

A §336(e) election produces a substantially similar tax result: the target is treated as if it sold its assets and liquidated, the buyer gets a stepped-up basis, and the seller reports gain with the same asset-sale character. The key differences:

• Seller-only election. Only the S-corp shareholders (or the parent of a consolidated subsidiary) make the election. The buyer does not have to sign.
• Buyer can be any form. Partnership, LLC, individual, foreign acquirer, all fine.
• Election threshold is a “qualified stock disposition” (QSD): 80% of vote and value of the target disposed of in a 12-month period. Sale, exchange, or distribution all count.
• Mechanics are filed via a binding written agreement between the seller and the target, plus an election statement attached to the target’s final tax return. No Form 8023.

For a PE deal with an LLC blocker, §336(e) is often the cleaner path. The economics to the seller are essentially the same as §338(h)(10), so the gross-up negotiation runs the same way.

State conformity: where federal treatment breaks down

Most states piggyback on the federal asset-sale recharacterization, but several do not. Sellers should pull the state-by-state map before signing, because a non-conforming state can add a layer of tax that nobody modeled.

A meaningful share of seller surprises on closing day come from a state line item nobody priced. If your S-corp does business across multiple states, your apportionment factors on the deemed asset sale can move material dollars between jurisdictions.

The 8.5-month Form 8023 deadline

The election is made on IRS Form 8023, signed by both the buyer and the seller, and filed with the IRS Cincinnati service center by the 15th day of the 9th month beginning after the month of the acquisition date.

For an acquisition that closes on June 30, the deadline is March 15 of the following year. Acquisition closes on December 15, the deadline is September 15 of the following year. The IRS does not grant extensions on this deadline without a private letter ruling, and PLR requests on missed 338(h)(10) elections are expensive ($30k+) and not guaranteed.

Standard practice: build the Form 8023 signature into the closing checklist. The signed form lives in escrow with the closing binder and is filed by the buyer’s tax counsel within 30 days of close. Once a buyer has the cash, getting a signature on a piece of paper they no longer need can become surprisingly hard.

F-reorganization: converting a C-corp to S to enable a 338(h)(10) election

What if the target is a C-corporation, or the S-corp election has a defect? You can still get to 338(h)(10) treatment through a pre-deal restructuring, but the most common path runs through what tax counsel calls an “F-reorganization.”

An F-reorg under IRC §368(a)(1)(F) is a mere change in identity, form, or place of organization. The standard pre-acquisition F-reorg works like this:

1. The historic S-corp shareholders form a new holding company (NewCo) and contribute their target stock to it in a tax-free §351 transaction.
2. NewCo elects S-corporation status. The old target becomes a qualified subchapter S subsidiary (QSub).
3. The old target converts to a single-member LLC (or stays as a corporation and gets checked open) so the buyer can buy LLC interests.
4. The buyer acquires the LLC interests from NewCo. For tax purposes this is treated as an asset purchase (because a disregarded entity has no separate tax existence), giving the buyer a basis step-up identical to 338(h)(10).

The F-reorg path is often preferred over a pure 338(h)(10) for two reasons. First, it sidesteps the Form 8023 deadline risk because no 338 election is required. Second, it accommodates rollover equity cleanly: NewCo can retain a minority stake in the LLC, giving the seller passive rollover treatment without triggering the gain-recognition rules that can apply to a literal 338(h)(10) with rollover.

The F-reorg adds legal cost ($25k-$60k typical) and requires the steps to be completed before the closing, but for any S-corp deal above $5M the structural cleanliness is worth the spend.

Worked example: $10M S-corp stock sale vs. 338(h)(10)

Run the same $10M HVAC S-corp two ways and the trade-off becomes concrete.

Scenario A: Clean stock sale, no election. Seller’s basis in stock = $200k (original capital + retained earnings already taxed via S-corp pass-through). Gain = $9.8M, all long-term capital gain at 20% federal + 3.8% NIIT not applicable (material participation) = $1.96M federal tax. State tax in a no-income-tax state = $0. Seller nets $8.04M.

Scenario B: 338(h)(10) election, no gross-up. Same $10M purchase price. Allocation: $500k recapture (ordinary at 37%) + $1.5M Class VI intangibles (capital at 20%) + $7.5M Class VII goodwill (capital at 20%) + $500k working capital recovered at basis. Tax: $185k + $300k + $1.5M = $1.985M federal. Seller nets $8.015M. $25k worse than the stock sale.

Scenario C: 338(h)(10) with a 50% gross-up. Buyer’s PV-of-shield = $1.27M. Buyer offers a $635k purchase price increase. New price $10.635M. Re-run the allocation: extra $635k lands almost entirely in Class VII goodwill at 20% = $127k extra tax. Seller’s incremental cost vs. stock sale was $25k, plus $127k on the gross-up = $152k. Seller pockets the rest of the $635k gross-up = $483k of additional after-tax proceeds vs. Scenario A.

This is the entire game. Scenario B with no gross-up is a small concession the seller often makes to keep the deal moving. Scenario C with a meaningful gross-up is where seller dollars get made. If you cannot get the buyer to share at least 30-40% of their modeled shield, the deal probably should not have a 338(h)(10) in it.

Where the 338(h)(10) election breaks down: practical pitfalls

Five issues we see kill or damage 338(h)(10) elections in practice:

1. Busted S election. The target needs a clean S-corp status on the acquisition date. We routinely find S-corps that issued a second class of stock, exceeded the 100-shareholder limit briefly, or admitted an ineligible shareholder years earlier. A busted S election kills 338(h)(10) eligibility. Diagnose early and apply for late-election relief under Rev. Proc. 2013-30 if needed.
2. Built-in gains (BIG) tax. If the target was a C-corp that converted to S within the prior 5-year BIG recognition period, the deemed asset sale can trigger entity-level BIG tax at 21% on built-in gain assets, on top of the shareholder tax. This is a brutal surprise on recently-converted S-corps.
3. Rollover that breaks the QSP. If the seller is rolling more than 20% into the buyer’s acquisition vehicle, the buyer may not clear the 80% QSP threshold. The fix is usually to structure the rollover at a parent level above the acquisition corp, so the acquisition corp itself buys 100%.
4. Personal goodwill carve-outs that double-count. Some sellers try to allocate part of the purchase price to personal goodwill paid directly to the founder (Bross Trucking precedent). Done cleanly, this can shift income from ordinary recapture to capital gain. Done sloppily inside a 338(h)(10) framework, it triggers IRS scrutiny and can blow up the allocation.
5. Missed Form 8023 deadline. Already covered, but worth repeating. The 8.5-month clock is hard. Build the signature into closing.

When sellers should refuse a 338(h)(10) election

Sellers should walk away from the election in three fact patterns:

• The buyer refuses a meaningful gross-up. If the buyer’s offer to compensate for the seller’s incremental tax cost is under 30% of their modeled shield, the seller is subsidizing the buyer. Hold the line.
• Recent C-to-S conversion within the BIG window. Entity-level BIG tax on the deemed asset sale can wipe out any conceivable gross-up. Unless your tax advisor models a positive number, refuse.
• Heavy depreciated fixed asset base. If the target has $3M of fully-depreciated equipment, the recapture bite is structural. Plain stock sale at 20% capital gains is almost always better for the seller.

Sellers should welcome the election in three fact patterns:

• Services business with minimal depreciable assets. Almost all gain is capital. The recapture penalty is tiny. The buyer’s gross-up is largely incremental seller proceeds.
• Buyer is a financial sponsor planning to amortize goodwill. PE shops with sophisticated tax modeling will pay for the shield. Strategic acquirers sometimes will not.
• Seller has unused capital losses or NOLs. Capital character on the goodwill becomes more valuable when paired with offsets.

Frequently asked questions

How CT Acquisitions helps sellers navigate the 338(h)(10) decision

Most lower middle-market sellers see a 338(h)(10) request for the first time in a buyer’s LOI. The two-week exclusivity window is not enough time to learn the tax code from scratch and run defensible numbers.

We sit on the seller side of these deals weekly. We model the buyer’s present-value tax shield from the basis step-up, we model the seller’s incremental tax cost from depreciation recapture and ordinary-income classification, and we give sellers a defensible gross-up number before the buyer’s counsel sends the first draft of the purchase agreement.

If you have a live LOI with a 338(h)(10) clause or you are pre-LOI and want to know whether to allow it, book a confidential call.

Related reading: our deep dives on asset vs. stock sale tax implications, the 2026 update on asset sale vs. stock sale, which structure is better for sellers, the broader asset deal vs. stock deal framework, tax-free reorganizations, and our full tax structure decision tree for business sellers. When you are ready to talk numbers, start with the free valuation tool, book a call, or learn about our buyer network.