Qualified stock purchase

A qualified stock purchase (QSP) is a specific type of corporate acquisition where one corporation acquires at least 80% of the voting power and value of the stock of another corporation (the target corporation) within a 12-month period. Although legally structured as a stock acquisition, a QSP, when accompanied by an election under Internal Revenue Code (IRC) Section 338, allows the acquiring company to treat the transaction as an asset acquisition for federal income tax purposes. This critical election falls under the domain of corporate finance and Mergers and acquisitions (M&A) tax strategy.

History and Origin

Prior to the enactment of Internal Revenue Code Section 338 in 1982, the tax treatment of corporate acquisitions often led to complexities and potential inconsistencies, particularly after the repeal of the Kimbell-Diamond doctrine. The Kimbell-Diamond rule allowed certain stock purchases to be treated as asset purchases, giving buyers a "stepped-up" adjusted basis in the acquired assets for tax purposes. However, its application was often uncertain and based on the intent of the purchaser.¹⁹

Congress introduced Section 338 to provide clear statutory rules for when a stock purchase could be treated as an asset purchase for tax purposes, offering more predictability and consistency. The core intent was to allow an acquiring corporation to achieve a "stepped-up basis" in the target's assets, similar to an asset purchase, even when the legal form was a stock acquisition. This move was part of broader tax reforms aimed at simplifying and standardizing corporate taxation. Subsequent regulations, including final regulations issued by the Internal Revenue Service (IRS) in 2001, have further clarified the rules for making a Section 338 election.¹⁸ The evolution of these regulations aimed to provide clearer guidance for practitioners navigating the complexities of taxable acquisition structures.¹⁷

Key Takeaways

A qualified stock purchase (QSP) involves acquiring at least 80% of a target company's stock within 12 months.
The primary benefit of a QSP is the ability to make a Section 338 election, allowing the transaction to be treated as an asset purchase for tax purposes, despite being a stock acquisition legally.
This election typically allows the acquiring company to "step up" the tax basis of the target's assets to their Fair market value (FMV), leading to higher future depreciation and amortization deductions.
There are two main types of Section 338 elections: Section 338(g) and Section 338(h)(10), with the latter being more common due to its single level of corporate tax on the deemed asset sale.
The decision to make a Section 338 election involves weighing immediate tax costs (gain on deemed asset sale) against future tax benefits (increased deductions).

Interpreting the Qualified Stock Purchase

A qualified stock purchase (QSP) fundamentally recharacterizes a stock acquisition for tax purposes. Without a Section 338 election, a stock purchase results in the buyer inheriting the target company's historical tax basis in its assets. This "carryover basis" means that the buyer cannot increase the value of the assets for tax purposes, and therefore, cannot claim increased depreciation or amortization deductions post-acquisition.¹⁶

However, when a Section 338 election is made following a QSP, the target corporation is treated, for tax purposes, as if it sold all its assets to a "new target" corporation at their fair market value on the acquisition date. Simultaneously, the "new target" is treated as having purchased these assets. This "deemed asset sale" allows the acquiring corporation to establish a new, stepped-up tax basis for the target's assets, reflecting the purchase price paid for the stock. This increased basis can then be depreciated or amortized over time, providing significant future tax deductions.¹⁵ The allocation of the purchase price to these assets, including identifiable intangible assets and goodwill, is governed by specific IRS regulations.¹⁴

The decision to make a Section 338 election is a strategic one, primarily driven by the tax implications for both the buyer and seller. For instance, a Section 338(h)(10) election, often used when the target is a subsidiary of a consolidated group or an S corporation, typically results in a single level of tax on the deemed asset sale, making it more attractive for both parties.¹³

Hypothetical Example

Consider Tech Solutions Inc. (TSI), an acquiring corporation, which decides to purchase 100% of the voting stock of DataFlow Corp. (DFC), a privately held data management company, for $200 million. DFC's historical tax basis in its assets is $100 million.

Qualified Stock Purchase: TSI's acquisition of 100% of DFC's stock within a 12-month period constitutes a qualified stock purchase.
Section 338(h)(10) Election: TSI and DFC's selling shareholders jointly decide to make a Section 338(h)(10) election.
Deemed Asset Sale: For federal income tax purposes, DFC is treated as if it sold all its assets to a newly formed DFC (New DFC) for $200 million (the purchase price) on the acquisition date. Old DFC is then deemed to liquidate.
Tax Basis Step-Up: New DFC's assets are recorded with a tax basis of $200 million. This means that if DFC had tangible assets with a historical basis of $80 million and identifiable intangible assets plus goodwill with a historical basis of $20 million, New DFC would now allocate the $200 million purchase price to these assets, stepping up their basis to their fair market values. For example, if the tangible assets are valued at $100 million and identifiable intangibles at $50 million, the remaining $50 million would be allocated to goodwill.
Future Deductions: New DFC can now claim depreciation and amortization deductions based on this stepped-up basis of $200 million, rather than the old $100 million basis. This results in higher deductions over time, reducing future taxable income for TSI.

For the selling shareholders of DFC, the stock sale is disregarded for tax purposes, and they are treated as if they received the proceeds from the deemed asset sale and subsequent liquidation. This structure often allows for a single layer of tax at the seller level on the deemed asset sale.

Practical Applications

The qualified stock purchase, combined with a Section 338 election, is a critical tool in Mergers and acquisitions (M&A) for managing tax outcomes. Its practical applications include:

Tax Basis Step-Up: The most significant application is enabling the acquiring corporation to step up the adjusted basis of the target's assets to their fair market value. This is highly advantageous for the buyer as it generates higher future depreciation and amortization deductions, effectively reducing future taxable income and cash outflows.¹²
Structuring Acquisitions: A QSP allows buyers to achieve the tax benefits of an asset purchase while maintaining the legal and administrative simplicity of a stock purchase. This is particularly useful when acquiring numerous contracts, licenses, or permits that would be difficult to reassign in a direct asset transfer.¹¹
Eliminating Tax Attributes: For the buyer, a Section 338 election can eliminate certain unfavorable tax attributes of the old target, such as net operating losses (NOLs) that may be subject to limitations under IRC Sections 382, 383, and 384.¹⁰
Foreign Acquisitions: Section 338(g) elections are often considered in cross-border acquisitions involving foreign target corporations to step up asset bases for U.S. tax purposes, potentially minimizing future U.S. tax on the foreign corporation's income.⁹
Joint Elections (Section 338(h)(10)): This is the most common form of the election, particularly for targets that are S corporations or subsidiaries of consolidated groups. It allows both the buyer and seller to benefit from the tax efficiency of a single level of tax on the deemed asset sale, making it a powerful negotiation tool in deal structuring. The IRS provides detailed regulations governing these elections.⁸

Limitations and Criticisms

While a qualified stock purchase with a Section 338 election offers significant advantages, it also comes with notable limitations and potential criticisms:

Tax Cost to Seller: For the seller, especially in a Section 338(g) election (where the target is a standalone C corporation), there can be two levels of tax: one at the shareholder level on the stock sale and another at the corporate level on the deemed asset sale. This "double taxation" makes Section 338(g) less common for domestic acquisitions compared to Section 338(h)(10), which aims for a single layer of tax.⁷ ⁶
Buyer Bears Deemed Sale Tax: In a Section 338(g) election, the tax liability arising from the deemed asset sale generally falls on the buyer (as the new owner of the target corporation). This immediate tax cost must be weighed against the present value of future depreciation and amortization deductions. If the present value of future tax savings does not exceed the current tax cost, the election may not be beneficial.⁵
Complexity and Administrative Burden: The process of making a Section 338 election is complex, requiring precise calculation and allocation of the purchase price to various assets. It necessitates careful tax planning and compliance with detailed IRS regulations, often requiring specialized tax and legal expertise.
Inheritance of Liabilities: Even with a Section 338 election, the legal form remains a stock acquisition. This means the acquiring corporation generally inherits all of the target company's liabilities, both known and unknown, unlike a true asset acquisition where specific assets and liabilities are chosen.⁴
Anti-Abuse Rules: The IRS includes anti-abuse rules within its Section 338 regulations to prevent transactions structured solely for tax avoidance.³ This means tax planners must ensure the transaction has legitimate business purposes beyond just tax benefits.

Qualified Stock Purchase vs. Stock Acquisition

A fundamental distinction exists between a generic stock acquisition and a qualified stock purchase (QSP). While all QSPs are technically stock acquisitions, not all stock acquisitions are QSPs, and critically, not all stock acquisitions allow for the special tax treatment of a Section 338 election.

In a standard stock acquisition, the buyer purchases the shares of a target company, and for tax purposes, the target company's historical tax attributes, including the basis of its assets, generally carry over to the new owner. There is no revaluation of assets for tax purposes, and the buyer does not get new depreciation or amortization deductions based on the purchase price of the stock. The seller generally recognizes a capital gains or loss on the sale of their stock.

A qualified stock purchase, however, is a specific type of stock acquisition that meets strict criteria outlined in IRC Section 338, primarily involving the acquisition of at least 80% of the target's voting power and value within a 12-month period by another corporation. The key differentiator is the ability to make a Section 338 election. This election allows the transaction, though legally a stock purchase, to be treated as a "deemed asset sale" for tax purposes. This results in a "stepped-up" adjusted basis in the target's assets for the buyer, enabling higher future tax deductions. Without meeting the QSP requirements and making the Section 338 election, these tax benefits are generally unavailable.

FAQs

What are the main types of Section 338 elections?

There are two main types: Section 338(g) and Section 338(h)(10). A Section 338(g) election applies when the target corporation is a freestanding C corporation. A Section 338(h)(10) election is available when the target is a subsidiary of a consolidated group or an S corporation. The 338(h)(10) election is generally preferred because it typically results in only one level of corporate tax on the deemed asset sale, making it more tax-efficient for both buyer and seller.²

Why would a buyer choose a Qualified Stock Purchase over an Asset Purchase?

A buyer might choose a qualified stock purchase (QSP) even if they desire an asset basis step-up for tax purposes due to non-tax reasons. For example, a stock purchase is often simpler legally and administratively, as it avoids the need to formally transfer individual assets, contracts, and licenses. This can be crucial in industries with complex regulatory approvals or numerous third-party contracts. The QSP with a Section 338 election allows the buyer to get the tax benefits of an asset acquisition while maintaining the legal form and benefits of a stock acquisition.

What is a "stepped-up basis" in the context of a Qualified Stock Purchase?

A "stepped-up basis" refers to the upward adjustment of the tax basis of the target company's assets to their fair market value (FMV) following a qualified stock purchase (QSP) with a Section 338 election. Without this election, the buyer would inherit the target's historical, often lower, tax basis in its assets. By stepping up the basis, the acquiring corporation can claim higher future depreciation and amortization deductions on those assets, which reduces its taxable income and, consequently, its tax liability over time.¹