In manufacturing mergers and acquisitions (M&A), buyers and sellers often negotiate the structure of a transaction to achieve favorable tax outcomes. Two primary structures dominate: stock sales and asset sales. While stock sales are generally more favorable to sellers for tax purposes, asset sales offer significant benefits to buyers, particularly through the ability to step up the tax basis of acquired assets and subsequently claim depreciation or amortization deductions.

However, specific provisions in the U.S. Internal Revenue Code (IRC) allow transactions to be structured as stock sales while providing buyers with the tax benefits of an asset sale. Below is a summary of these tax codes and their implications.

1. Section 338 Election

Overview: IRC Section 338 allows a buyer to treat a qualified stock purchase (QSP) of a corporation as an asset purchase for tax purposes. This election provides the buyer with a step-up in the basis of the corporation’s assets to their fair market value (FMV) as of the acquisition date.

Key Requirements:

• The buyer must acquire at least 80% of the stock of the target corporation within a 12-month period.
• The election must be made by the buyer within 8.5 months of the end of the month in which the acquisition occurred.

Benefits to the Buyer:

• The step-up in basis allows for increased depreciation or amortization deductions.
• Goodwill and other intangibles are amortized over 15 years under Section 197.

Considerations:

• The election may result in double taxation for the seller: once at the corporate level on the deemed asset sale and again at the shareholder level on the stock sale.
• The cost of the election should be factored into the negotiation.

2. Section 338(h)(10) Election

Overview: Section 338(h)(10) is a special provision that applies to certain transactions involving S corporations or subsidiaries of consolidated groups. This election treats the transaction as an asset sale for tax purposes while preserving stock sale treatment for legal purposes.

Key Requirements:

• The target must be either An S corporation or A member of a consolidated group.
• Both the buyer and seller must jointly consent to the election.

Benefits to the Buyer:

• The buyer receives a step-up in the basis of the target’s assets, enabling higher depreciation or amortization deductions.
• The seller is taxed only once at the shareholder level (for S corporations), which may make the transaction more attractive to sellers.

Considerations:

• The election is typically used to balance the tax advantages between buyers and sellers.
• Requires detailed coordination and agreement between both parties.

3. Section 754 Election

Overview:  While not directly analogous to Sections 338 or 338(h)(10), Section 754 provides another mechanism for achieving a step-up in the basis of partnership assets. This election is relevant when the buyer acquires a partnership interest rather than corporate stock.

Key Requirements:

• The partnership must elect to apply Section 754.
• The election must be filed with the partnership’s tax return for the year of the transaction.

Benefits to the Buyer:

• The buyer receives a step-up in the basis of the partnership’s assets equal to the excess of the purchase price over the buyer’s share of the partnership’s existing basis.
• Increased deductions from depreciation or amortization improve the buyer’s after-tax cash flow.

Considerations:

• The election impacts all future transactions involving the partnership and its interests.
• Compliance and administrative burdens may increase for the partnership.

4. F Reorganization

Overview: An F reorganization is a tax-free reorganization under IRC Section 368(a)(1)(F) that involves a mere change in the identity, form, or place of organization of a corporation. While it is not directly a method for stepping up the basis of assets, an F reorganization can be used as part of a broader transaction to facilitate tax-efficient structuring.

Key Features:

• The corporation undergoing the reorganization retains its tax attributes, such as net operating losses (NOLs).
• The process often involves forming a new corporation or restructuring an existing one to facilitate the transaction.

Applications in M&A:

• F reorganizations are often used in conjunction with a Section 338(h)(10) election to achieve tax efficiency.
• They provide flexibility in restructuring without triggering immediate tax consequences.

Benefits:

• Allows for the preservation of tax attributes while facilitating a transaction.
• Can simplify the integration process by aligning the legal structure with the buyer’s needs.

Considerations:

• Detailed planning is required to ensure compliance with the “mere change” requirement.
•  Typically used as part of a larger strategy rather than a standalone solution.

Practical Implications:

For buyers and sellers negotiating M&A transactions, understanding the interplay of these tax provisions is crucial. Buyers benefit from the ability to depreciate or amortize assets, which can significantly impact the financial viability of a transaction. Sellers, on the other hand, must consider the potential tax burden of elections like Section 338 or 338(h)(10).

To optimize outcomes:

• Engage tax advisors early in the transaction process to model the tax consequences for both parties.
• Structure the transaction to align with the strategic and financial goals of both buyer and seller.
• Consider state and local tax implications, as they may differ from federal tax treatments.

By leveraging these provisions, buyers can achieve the best of both worlds: acquiring a business as a stock sale while enjoying the tax benefits of an asset purchase.