Tax structuring in M&A: asset vs stock sale

Asset vs stock sale is one of the more important tax decisions in LMM M&A. The buyer almost always wants asset (for stepped up basis depreciation). The seller almost always wants stock (for capital gains treatment). The 338(h)(10) election is a hybrid that resolves the conflict in many deals.

The tax delta on a typical $30M LMM deal is $2-5M depending on structure choice and seller's tax position. This is not a small number. Sellers and bankers who don't understand the math leave money on the table.

This post covers the basic tax difference, buyer and seller incentives, the 338(h)(10) election, the tax delta on a typical deal, and when stock is the only option.

The basic tax difference

Asset sale. Buyer purchases the assets of the company. Seller's company keeps the legal entity. Buyer gets a stepped up tax basis in the assets, which means they can depreciate them again from the new basis. Seller may face double taxation: corporate tax on the asset gain, plus shareholder tax on the proceeds distribution.

Stock sale. Buyer purchases the stock of the company. The legal entity transfers. Buyer inherits the existing tax basis (no step up). Seller pays capital gains on the stock sale at one level only.

The economic effect depends on the seller's entity type:

• C corporation. Asset sale results in double taxation. Stock sale is single taxation at capital gains rates. Sellers of C corps strongly prefer stock.
• S corporation. Asset sale and stock sale are roughly equivalent for the seller (single level of taxation). Buyer prefers asset.
• LLC (taxed as partnership). Asset sale is tax-pass through; stock sale (membership interest sale) similar. Variances exist.

Most LMM sellers are S corps or LLCs. For these, the seller is more flexible on structure. C corp sellers strongly resist asset.

Buyer's incentive: stepped up basis

The buyer's incentive in asset sale: stepped up tax basis on the assets acquired. This unlocks depreciation deductions over the next 5-15 years (depending on asset class). The present value of these deductions can be 15-25% of the asset basis.

For a $30M deal with $20M of depreciable assets, the buyer's tax savings from step up might be $4-5M (NPV at typical discount rate). That's why buyers push asset.

In a stock sale, no step up. Buyer's tax basis equals the seller's existing basis (likely much lower). The depreciation savings disappear.

Buyers will pay a premium of roughly 1-3 percent of price for asset structure when the step up is available. This is the gross-up the seller can negotiate.

Seller's incentive: single level of taxation

The seller's incentive in stock sale: capital gains treatment, single level of taxation, no recapture of accelerated depreciation.

For an S corp seller in a $30M deal with $5M of asset basis:

• Stock sale: $25M gain at 20% federal capital gains plus state tax = roughly $5-7M in tax depending on state. Net to seller: $23-25M.
• Asset sale (without 338(h)(10)): Gain split between ordinary income (depreciation recapture, inventory) and capital gains. Higher tax rate on a portion of the gain. Net to seller: $21-23M.

The delta is $1-2M for the seller. Worth fighting on.

For C corp sellers, asset sale produces double taxation. The delta is much larger ($3-5M+ on a $30M deal).

The 338(h)(10) election

The 338(h)(10) election is a hybrid that resolves the conflict in many cases. The mechanics:

• Seller is an S corp (or qualified subsidiary of a consolidated group).
• Transaction is structured as a stock sale.
• Buyer and seller jointly elect to treat the stock sale as an asset sale for tax purposes.
• Buyer gets stepped up basis on the assets (the full economic benefit of asset).
• Seller is taxed as if they sold the assets, but at capital gains rates because they're an S corp.

When 338(h)(10) works, both buyer and seller win. Buyer gets step up; seller gets capital gains. The election is widely used in LMM S corp deals.

Constraints:

• Seller must be an S corp or qualified subsidiary (not C corp, with limited exceptions).
• Buyer must be a corporation acquiring 80%+ of the stock.
• Buyer and seller must jointly file the election (Form 8023).
• Allocation of purchase price across asset classes is negotiated separately.

For non-S corp sellers, the parallel is 338(g) election or other structures. These are less common in LMM but exist.

Tax delta on a typical $30M deal

| Structure | Buyer tax benefit (NPV) | Seller tax cost | Net economic delta | |---|---|---|---| | Pure stock sale | 0 | $5-6M | -$5-6M | | Asset sale (S corp seller) | $4-5M | $6-8M | -$1-3M | | Asset sale (C corp seller) | $4-5M | $9-11M | -$4-6M | | Stock + 338(h)(10) (S corp) | $4-5M | $5-6M | +$1M |

The 338(h)(10) election produces the best joint outcome for S corp deals. Pure asset is bad for S corp sellers and terrible for C corp sellers. Pure stock is suboptimal because the buyer doesn't get step up.

Sellers should ask their banker and tax counsel which structure works given the entity type and buyer.

When stock is the only option

Some deals can only be done as stock sales:

1. Customer contracts that don't transfer. If material customer contracts are non-assignable in change of control, asset sale would require renegotiation with each customer. Stock sale (where the legal entity transfers) avoids this.

1. Regulated sectors. Healthcare licenses, broadcasting licenses, government contracts often require regulatory approval for asset transfer. Stock sale may avoid the approval process.

1. Real estate transfer tax. Some states have steep real estate transfer taxes on asset sales. Stock sale (no real estate transfer) avoids the tax.

1. Existing debt. If the seller has loans with change of control covenants but those covenants apply only to control changes (not asset sales), asset structure may avoid lender consent. Conversely, if the loans are tied to the assets, stock sale may be required.

In these cases, structure choice is constrained. The seller and banker work with what's available.

The gross-up provision

In a stock sale where the buyer wants asset structure (and the seller resists), the parties may negotiate a gross-up: the buyer pays a premium to compensate the seller for the tax differential.

The gross-up math: buyer's tax savings from step up minus the seller's incremental tax cost from asset structure. If the buyer saves $5M and the seller's incremental cost is $2M, the buyer pays the seller $2M extra to make them whole, and the buyer pockets the remaining $3M.

This is how buyers extract value from structure flexibility. Sellers should require the gross-up if they're flexing on structure.

Common tax structuring mistakes

Mistake 1: Banker assumes structure is the buyer's call. Bankers should advocate for the seller's preferred structure. Asset sales often emerge by default when the seller doesn't push back.

Mistake 2: Tax counsel engaged too late. Tax structure decisions made in the LOI need tax counsel's input. Don't wait until definitives.

Mistake 3: Not exploring 338(h)(10) for S corps. This is the standard middle ground. Sellers and bankers who don't ask about it miss the opportunity.

Mistake 4: Ignoring state tax. State capital gains rates vary widely. Texas and Florida sellers may face less state tax than New York and California sellers. Structure choice may matter more in high-tax states.

Mistake 5: Hidden gross-up. Buyers sometimes negotiate the gross-up into the headline price, then claim the seller already received the gross-up. Sellers should keep gross-up separate from price.

Bottom line

Asset vs stock is a $2-5M decision on a typical $30M LMM deal. Buyers default to asset for the step up; sellers default to stock for capital gains. 338(h)(10) is the hybrid that resolves the conflict for S corp deals.

Engage tax counsel early, advocate for the seller's preferred structure, negotiate gross-ups when flexing, and recognize that some deals are stock-only by necessity.

Bankers who don't understand the tax math undersell their value to sellers.

FAQ

What's the basic difference between asset and stock sale? Asset sale: buyer buys assets, seller's entity remains, buyer gets stepped up basis. Stock sale: buyer buys stock, entity transfers, no step up. Tax treatment for seller varies.

Why does the buyer prefer asset? Stepped up tax basis on assets unlocks depreciation deductions worth 15-25% of asset basis (NPV). Buyers will pay a premium for this benefit.

Why does the seller prefer stock? Single level of capital gains taxation. Asset sales can produce double taxation (especially for C corps) or higher ordinary rates on portions of the gain.

What's a 338(h)(10) election? Joint election allowing a stock sale to be treated as an asset sale for tax purposes. Buyer gets step up; seller gets capital gains. Available for S corp sellers when buyer is a corporation acquiring 80%+ of stock.

What's the tax delta on a typical $30M deal? $1-3M for S corp asset vs stock. $4-6M for C corp asset vs stock. The 338(h)(10) election can produce a +$1M joint outcome relative to pure stock.

When is stock the only option? Customer contracts with anti-assignment clauses; regulated sectors with license transfer issues; states with high real estate transfer taxes; certain debt structures.

What's a gross-up provision? Buyer pays seller a premium to compensate for incremental tax cost of asset structure. The gross-up should be negotiated separately from the headline price.

When should I engage tax counsel? Before LOI signing. Tax structure decisions in the LOI lock in many downstream choices. Tax counsel should review the LOI alongside legal counsel.

Related reading

• LOI clause dissection
• Indemnity cap structures
• LOI checklist