7 www.loubar.org July / August 2026 stock) take their pro rata share of the deemed sale tax consequences into account…and in- crease or decrease their basis in [Old Target] stock.” Treas. Reg. § 1.338(h)(10)-1(d)(5). In step three, after the deemed asset sale, the Code treats Old Target as distributing all of its remaining assets (the deemed sale proceeds) to its shareholders in complete liquidation before the acquisition date. Treas. Reg. § 1.338(h)(10)-1(d)(4). If Old Target belonged to a consolidated group, this deemed distribution generally quali- fies as a tax-free liquidation under Code § 332. If Old Target was an S corporation, then this deemed distribution is a taxable liquidation under Code § 331; however, the upward basis adjustments from step two may offset most or all of the liquidation gain. See Treas. Reg. § 1.338(h)(10)-1(d) (5); Code § 1367. Regardless of whether the seller recognizes gain or loss on Old Target’s deemed liquidation, the seller “recognize[s] no gain or loss on the sale or exchange of [New Target] stock included in the qualified stock purchase” because steps two and three already capture the entire economic gain or loss. Treas. Reg. § 1.338(h)(10)-1(d)(5)(iii). Lastly, in step four, the parties disregard the seller’s actual sale of New Target stock to the buyer for cash. The Code treats New Target as a new corporation that purchased all of Old Target’s assets at fair market value, giving it a stepped-up basis in those assets. Code § 338(a); Treas. Reg. § 1.338(h)(10)- 1(d)(2) (citing Treas. Reg. § 1.338-5(c)). This stepped-up basis represents the buyer’s primary economic benefit, while the reduc- tion in sales proceeds from additional taxes constitutes the seller’s economic cost. Best Practices and Planning Considerations The parties should weigh a Code § 338(h) (10) election carefully; once they make the election, they cannot revoke it. Treas. Reg. § 1.338(h)(10)-1(c)(4). The seller should begin by comparing its net tax basis in its Target stock (“outside basis”) against Target’s net tax basis in its assets (“inside basis”) to preliminarily gauge the election’s possible tax impact. When the gap between outside basis and inside basis is minimal, the elec- tion is unlikely to generate significant incre- mental tax on the seller, making the decision more straightforward. In that scenario, the buyer obtains a stepped-up basis at minimal tax cost to the seller. Even in such a scenario where a Code § 338(h)(10) election results in only a minimal amount of additional gain for the seller, when the target is an S corporation, the selling shareholders should be aware of the possible differences in the tax charac- ter of the gain that results from asset-sale treatment. For example, gain that would have qualified for long-term capital gain treatment may instead be taxed as ordinary income on account of depreciation recapture on the sale of assets under Code §§ 1245 and 1250. The election may also create a char- acter mismatch on the deemed liquidation (causing a capital loss with limited benefit) or trigger corporate-level built-in gains tax under Code § 1374. Because the election primarily benefits the buyer—who receives a depreciable and amortizable stepped-up basis in Target’s assets—and the seller of- ten bears the added tax liability, the seller should leverage the election’s joint nature to negotiate a purchase price premium and gross-up that compensates for, inter alia, the increased tax liability from ordinary income recognition and state and local taxes tied to the assets’ location. One important caveat to the general upside for buyers is, although step three deems Old Target to have wound up, “[New Target] remains liable for the tax liabilities of [Old Target] (including the tax liability for the deemed sale tax consequences).” Treas. Reg. § 1.338(h)(10)-1(d)(2). Consequently, the buyer should negotiate a robust indemnity provision in the stock purchase agreement to guard against this residual exposure. It is also worth noting that the ultimate decision whether to make a § 338(h)(10) election should be based on both tax and nontax considerations, such as third-party consents or non-assignable licenses. More- over, although a Code § 338(h)(10) election can be a valuable mechanism for obtain- ing a basis step-up, a selling consolidated group can often achieve a similar result by first liquidating the subsidiary in a tax-free transaction and then selling Target’s assets. Under that approach, the acquiring corpora- tion generally would take a cost basis in the acquired assets under Code § 1012. Ross D. Cohen is a Partner in Dentons’ Tax group. His practice focuses on advis- ing business entities and nonprofit organizations on corporate structuring and tax issues, including those arising in the context of M&A transactions. He also works with businesses on executive compensa- tion tax matters. Kseniya A. Buck, CPA, is a Senior Managing Associ- ate in Dentons’ Tax group, where she advises clients on complex tax matters arising from business op- erations, growth initiatives and strategic transactions. Caitlin G. Rieser is a Managing Associate in FBT Gibbon’s Tax group. Her focus is on federal transactional tax issues of business entities, includ- ing partnerships, limited liability companies and S and C corporations. Lucy L. McAfee is a Man- aging Associate in Dentons’ Tax group, where she assists with tax planning and con- troversy, subnational tax and more. She also assists with business formation and development, regula- tory and due diligence. Rieser and McAfee are chair and vice-chair, re- spectively, of the LBA Taxation Law Section. n (Continued from previous page) Don’t roll the dice on your practice’s future. Sure, there is a chance you’ll never need us. But why take that chance? Lawyers Mutual is dedicated to Kentucky lawyers and makes your work our priority. Call (502) 568-6100 or visit LMICK.com for more information on how you can cover and protect your practice. We want you to focus on what matters. Cohen Buck Rieser McAfee
