The structure of a business sale determines more of the after-tax outcome than almost any other single decision. Asset sales and stock sales produce fundamentally different results for both buyer and seller - and what is good for one is often bad for the other. The §338(h)(10) election, installment sale planning, and earnout structuring can bridge those competing interests. Understanding these mechanics before engaging in sale negotiations is the difference between an optimal exit and leaving significant money behind.
The §338(h)(10) election allows what is structured as a stock sale to be treated as an asset sale for tax purposes. Both buyer and seller must consent to the election. The target corporation is deemed to have sold all its assets to a new corporation and immediately liquidated. The result: the buyer gets a stepped-up basis (the asset sale benefit), and the seller - if the target is an S-corporation - avoids double taxation.
For an S-corporation seller, the §338(h)(10) election is often favorable: the deemed asset sale generates gain at the shareholder level at individual rates (typically capital gains rates on goodwill and most assets), the buyer gets the step-up, and everyone avoids the S-corp's built-in gains tax complexity. The election is most valuable when the buyer strongly prefers asset treatment - they may pay a higher price to compensate the seller for any additional tax cost of the deemed asset sale versus a pure stock sale.
§336(e) is a broader version of §338(h)(10) that can apply when the buyer is not a corporation - for example, when individuals or a private equity fund structured as a partnership buys S-corp stock. If a §336(e) election is made, the target is treated as having sold all its assets, giving the buyer a stepped-up basis through a "qualified stock disposition."
In any asset sale (actual or deemed), the purchase price must be allocated among the acquired assets under the residual allocation method of IRC §1060 and Treas. Reg. §1.1060-1. Both buyer and seller must use the same allocation, reported on Form 8594. The seven asset classes determine whether the seller recognizes ordinary income, §1231 gain, or capital gain:
| Class | Assets | Seller Tax Character | Buyer Recovery |
|---|---|---|---|
| I | Cash and cash equivalents | No gain (basis = FMV) | Immediate |
| II | Actively traded personal property, CDs, foreign currency | Ordinary or capital depending on asset | Amortized or immediate |
| III | Accounts receivable, mortgages, credit card receivables | Ordinary income | As collected |
| IV | Inventory and stock in trade | Ordinary income | COGS when sold |
| V | All other assets (equipment, real estate) | §1231 gain; recapture as ordinary under §1245/§1250 | MACRS depreciation |
| VI | §197 intangibles (customer lists, non-competes, licenses, patents) | Ordinary income (recapture) or capital gain | 15-year straight-line amortization |
| VII | Goodwill and going concern value (residual) | Capital gain (long-term if held 1+ year) | 15-year straight-line §197 amortization |
The negotiation over purchase price allocation is a zero-sum game: every dollar allocated to Class VII goodwill (capital gain for the seller, 15-year amortization for the buyer) is worth more to the seller than to the buyer. Every dollar allocated to Class IV inventory (ordinary income for the seller, immediate COGS deduction for the buyer) is neutral at equal tax rates but painful for the seller.
Under IRC §453, a seller who receives at least one payment after the year of sale may report gain on the installment method - recognizing gain proportionally as payments are received. The gross profit percentage (total gain divided by contract price) is applied to each payment received to determine the taxable gain in each year.
Installment sales are most valuable when: (a) the seller expects to be in a lower tax bracket in future years; (b) spreading recognition keeps the seller below the NIIT or SALT phaseout thresholds in any single year; (c) the buyer cannot pay all cash at closing; or (d) the seller wants to defer recognition while earning interest on the unpaid balance. The interest rate on the installment note must meet the applicable federal rate (AFR) or interest will be imputed under IRC §483.
An earnout is a component of the purchase price that is contingent on future performance of the business after sale. Earnouts are common when seller and buyer disagree on valuation - the earnout bridges the gap by tying additional payment to future results.
For tax purposes, if the earnout is contingent on post-closing performance and the amount is not fixed at closing, the open transaction doctrine may apply - the seller defers recognizing gain on the earnout until it is received or fixed. Under the installment method, contingent payment installment sales under Treas. Reg. §15a.453-1(c) have specific rules for reporting contingent payments: if there is a stated maximum selling price, that maximum is used for the gross profit ratio; if there is no maximum but there is a fixed period, basis is ratably recovered over that period.
For founders and early investors in C-corporations meeting the qualified small business stock requirements of IRC §1202, up to 100% of gain on the sale is excluded from federal income tax if the stock was: (a) acquired at original issuance directly from the corporation; (b) held for more than 5 years; (c) acquired when the corporation had gross assets of $50 million or less; and (d) the corporation was an active business in a qualified industry. The exclusion is the greater of $10 million or 10 times the taxpayer's basis. NIIT does not apply to §1202 excluded gain.