Generally, a buyer in a stock sale does not obtain a step-up (or down) in the basis of the acquired corporation’s assets, unlike in an asset sale. However, if the acquired corporation in a stock sale is an S corporation, an election may be available under Internal Revenue Code § 338(h)(10), pursuant to which the stock sale will be treated as a deemed asset sale for federal tax purposes. For buyers of S corporations desiring the benefits of a stock sale for non-tax purposes and the benefits of an asset sale for tax purposes, a § 338(h)(10) election can be a valuable tool.

In order to make a valid § 338(h)(10) election, among other requirements, a “qualified stock purchase” must occur. A qualified stock purchase generally means a purchase of 80% or more of voting power and value of the acquired corporation’s stock within a 12 month period. A “purchase” for this purpose does not include any transactions resulting in a carry-over basis in the stock purchased, such as a § 351 exchange or a gift transaction, or any purchase by a related corporation within the scope of § 318 attribution rules.

In an acquisition involving equity rollover by the selling stockholders of the acquired corporation, if not correctly planned, the equity rollover can preclude a valid § 338(h)(10) election. A straight forward example of an ineligible transaction is an equity rollover of greater than 20% of the acquired corporation’s stock. A less obvious but equally fatal example is a transaction in which the rollover stockholders holding 20% or more of the acquired corporation’s stock roll over 20% or less of the stock. In such case, if not properly structured, the rollover may be characterized as a § 351 exchange and may fail to qualify as a “purchase”. Therefore, a buyer considering a stock sale with a § 338(h)(10) election should consult with its tax advisor to ensure that the deal will be properly structured to be eligible for a § 338(h)(10) election.