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M&A Tax

M&A Tax Due Diligence: Asset vs Stock, Section 338(h)(10), Purchase Price Allocation, and Acquisition Tax Planning

Updated May 2026 · 13 min read

A business acquisition goes wrong in tax in two distinct ways. The first is the surprise: a due diligence review that missed a $2 million payroll tax liability, an employment tax exposure from worker misclassification, or a state nexus problem in four states the target was selling into without registering. The surprise arrives as an IRS notice or a state tax assessment after the deal closes, and the indemnification provisions that were supposed to cover it were negotiated too broadly to be useful. The second way it goes wrong is the missed opportunity: a buyer who never considered the Section 338(h)(10) election, paid a stock purchase price that gave them no basis step-up, and is now depreciating goodwill over 40 years instead of 15. Both failures come from the same root cause: tax was treated as a checklist item instead of a deal variable.

Silicon Valley Tax provides M&A tax due diligence and transaction structuring advisory from our office at 2051 Junction Ave, San Jose CA 95131. Our advisory practice is led in coordination with Adam Morris, whose CFO Advisory practice brings transaction experience across the Bay Area small and mid-market. To discuss a pending transaction, call (408) 383-9870 or book a consultation online.

The M&A Tax Due Diligence Scope

Tax due diligence on a business acquisition is a review of the target's historical tax compliance and tax positions, with the goal of identifying liabilities that the buyer would inherit, quantifying the value of tax attributes (NOLs, credits, deferred tax positions), and informing the deal structure. The scope depends on the size and complexity of the target, but for a typical Bay Area small or mid-market transaction, the tax DD review covers:

Federal and state income tax returns: three to five years, reviewing tax positions, elections, method changes, NOL carryforwards, credit carryforwards, and open audit years.
Payroll tax compliance: 941 filings, state unemployment tax, worker classification (employee vs. independent contractor), and any EDD or IRS employment tax examinations.
Sales and use tax: California CDTFA registration, return filing history, and nexus analysis for any states where the target sold goods or services.
Property tax: California business property tax returns (Form 571-L), assessment history, and any pending appeals.
Transfer pricing: for targets with international operations or related-party transactions, whether the intercompany pricing is supportable under IRC Section 482.
Tax representations in the purchase agreement: evaluating whether the seller's tax reps cover the areas of risk identified in the review.

Asset Purchase vs. Stock Purchase: The Core Trade-Off

The fundamental tension in any M&A tax negotiation is the asset-versus-stock trade-off. Buyers want asset purchases for the stepped-up basis. Sellers want stock sales for capital gain treatment and liability severance. Understanding both sides of this trade-off quantitatively is the starting point for any deal structure negotiation.

Why Buyers Prefer Asset Purchases

In an asset purchase, the buyer's purchase price is allocated among the acquired assets. Each asset receives a new tax basis equal to its allocated purchase price. Tangible personal property classified as 5-year or 7-year MACRS property can be depreciated immediately through bonus depreciation (20% in 2026 under the phasedown schedule) or expensed under Section 179. Section 197 intangibles (customer lists, trademarks, non-compete agreements, goodwill) amortize over 15 years from the date of acquisition.

On a $5 million asset acquisition where $2 million is allocated to customer lists and goodwill (Section 197 intangibles) and $1 million to equipment (5-year MACRS), the buyer can deduct $666,000 per year for 15 years on the intangibles and depreciates the equipment rapidly. These deductions reduce taxable income from the acquired business from day one. A stock purchase of the same business, with no basis step-up in the underlying assets, produces none of these deductions because the buyer's basis in the stock does not create deductions at the asset level.

Why Sellers Prefer Stock Sales

From the seller's perspective, a stock sale means a single capital gain transaction on the difference between the stock's adjusted basis and the sale price. If the seller has held the stock for more than one year, the gain is taxed at the long-term capital gain rate (0%, 15%, or 20% federal, plus 3.8% NIIT for high-income sellers) plus California's rate of up to 13.3% on all capital gains.

An asset sale produces multiple categories of gain. Depreciation on tangible personal property is recaptured as ordinary income under IRC Section 1245. Depreciation on real property is recaptured as unrecaptured Section 1250 gain at 25% federal. Accounts receivable are ordinary income. Only the appreciation on goodwill above the seller's basis, and capital assets held for more than a year, produces capital gain. For many sellers, the asset sale produces significantly more ordinary income relative to a stock sale on the same transaction economics.

Quantifying the Difference

The right way to evaluate the asset-versus-stock trade-off is to model the present value of the buyer's tax benefit from the basis step-up, and compare that to the additional tax cost imposed on the seller by the asset form. If the buyer's present value benefit from the step-up exceeds the seller's incremental tax cost, the parties can reach a deal where the buyer pays a higher price (sharing the benefit with the seller) and both come out ahead relative to a stock deal at the lower price.

We build this model for every deal where the structure is being negotiated. It requires inputs from both sides: the target's asset basis schedule (from the tax returns), a projected asset allocation, the seller's basis in the stock, the applicable tax rates for the seller, and a discount rate for the buyer's future tax savings. The output is a price-adjustment range that represents the indifference zone for both parties.

Section 338(h)(10) Elections

The Section 338(h)(10) election is the mechanism that allows a stock acquisition to be treated as an asset acquisition for tax purposes. It is available when the target is either an S-corporation or a corporation that is a member of a consolidated group (a subsidiary), and when the acquirer is a corporation that purchases 80% or more of the target's stock within a 12-month period.

How It Works

When a 338(h)(10) election is made, the target corporation is treated as if it sold all of its assets to an unrelated person at their aggregate deemed sale price (ADSP), which is based on the purchase price paid for the stock plus any liabilities assumed. The target then liquidates into the acquiring corporation. The buyer treats the acquisition as a purchase of the target's assets and gets the stepped-up basis. The seller (the target's shareholders) recognize gain on the deemed asset sale, not on the stock sale.

For an S-corporation acquisition, the key advantage is that the deemed asset sale passes through to the S-corp shareholders, who report the gain on their individual returns. The S-corp itself does not pay corporate tax on the deemed sale (because the S-corp is not a taxpayer at the entity level). This makes the 338(h)(10) election particularly useful for S-corp acquisitions where the deal would otherwise be structured as a stock sale.

When Not to Use 338(h)(10)

The election is not always beneficial. If the target has large NOL carryforwards that would be lost under Section 382 limitations after the acquisition anyway, the stepped-up basis may not provide proportionally more benefit than the ordinary income recapture cost to the seller. If the target has assets primarily in the form of cash, accounts receivable, and other Class I-III assets (which have basis already at or near fair market value), the step-up is minimal and may not justify the seller's additional tax cost. We evaluate these situations on a case-by-case basis.

Purchase Price Allocation Under Section 1060

In every asset acquisition (including a deemed asset acquisition under Section 338(h)(10)), the total consideration is allocated across seven classes of assets in a prescribed residual order. The allocation directly determines the buyer's future tax deductions and the seller's gain characterization by asset class.

Class	Asset Type	Buyer's Tax Life	Seller's Gain Type
I	Cash and cash equivalents	No deduction	No gain
II	Actively traded personal property, CDs	No deduction (fair value)	Capital gain
III	Accounts receivable, mortgages	Short-term	Ordinary income
IV	Inventory and similar property	COGS when sold	Ordinary income
V	Other tangible assets	MACRS (5, 7, or 39 yr)	Capital gain / Sec. 1245 recapture
VI	Section 197 intangibles (not goodwill)	15 years straight-line	Ordinary income / capital gain
VII	Goodwill and going-concern value	15 years straight-line	Capital gain

The buyer wants to maximize allocation to Class V tangible assets (for rapid depreciation through bonus) and minimize Class I-III (no deductions). The seller wants to minimize ordinary income assets (Classes III, IV, and recapturable VI) and maximize capital gain assets (Class VII goodwill, where gain is capital). Negotiating the allocation requires understanding both sides' after-tax costs and building an agreed Form 8594.

Earn-Out Structuring

Earn-outs appear in transactions where the buyer and seller cannot agree on current-year valuation, or where the buyer wants post-closing performance assurance before paying full price. A properly structured earn-out defers payment and aligns incentives. A poorly structured earn-out creates a tax problem that neither party anticipated.

Capital Gain vs. Compensation Recharacterization

The critical tax risk in earn-outs is recharacterization of earn-out payments from capital gain (for the seller) to compensation. The IRS looks at whether the earn-out is economically driven by the performance of the business or by the personal services of the seller. If the seller stays on as an employee and the earn-out targets are driven primarily by metrics that track the seller's personal performance (billings attributable to the seller, new clients generated by the seller), the IRS may argue the payments are disguised compensation rather than deferred purchase price.

Avoiding recharacterization requires that the earn-out be based on entity-level financial performance metrics (revenue, EBITDA, gross profit) tied to the business as a whole, not to the seller's individual production. Non-compete agreements should be valued and compensated separately from the purchase price, not bundled into the earn-out. The purchase agreement should clearly articulate the earn-out as contingent consideration, not compensation.

Installment Sales and the Open Transaction Method

Earn-outs that are contingent and unascertainable at closing may qualify for installment sale treatment under IRC Section 453, deferring gain recognition until payments are received. The calculation of gain on each installment payment requires determining the gross profit ratio (gain over gross selling price) and applying it to each payment received. When the total consideration is not determinable at closing, the open transaction method may apply, treating each payment as return of basis first until basis is recovered, then gain.

California conforms to the installment sale rules, though California's tax on deferred gain must be paid in the year the sale occurs for California-resident sellers under certain circumstances, regardless of when cash is received. We analyze the federal and California installment sale treatment for every earn-out structure.

Working Capital Adjustments

The purchase price in a business acquisition is typically based on a "normalized" or "target" working capital at close. If the actual working capital at close differs from the target, the price is adjusted upward (if working capital is above target) or downward (if below). The tax consequences of working capital adjustments depend on the asset categories in the adjustment and whether the adjustment is treated as additional purchase price or as a separate settlement.

Working capital adjustments that increase the purchase price increase the buyer's tax basis in the acquired assets (additional allocation required to specific classes) and increase the seller's gain. Adjustments that decrease the purchase price reduce basis and gain. Getting the tax treatment of working capital adjustments right requires coordination between the deal team and the CPA during the drafting of the purchase agreement.

Tax Representations and Warranties

The purchase agreement's tax representations and warranties are the primary contractual protection for the buyer against undisclosed tax liabilities. Standard tax reps include representations that:

All tax returns have been filed and are accurate and complete
All taxes shown as due on those returns have been paid
There are no pending or threatened audits, examinations, or tax proceedings
The seller has not waived any statute of limitations with respect to any tax
All tax elections made by the target are properly documented
All payroll taxes have been properly withheld, deposited, and remitted
The target has properly collected and remitted sales and use taxes
There are no tax sharing agreements between the target and any affiliate that would survive closing

We review the tax representations in the purchase agreement against the findings from the tax due diligence review to identify gaps and recommend specific representations or exceptions that should be added or tightened. A due diligence finding of a specific risk area (unpaid EDD assessments, state nexus exposure, disputed worker classification) that is not clearly addressed in the reps is a liability that the buyer may absorb without recourse.

Net Operating Loss Carryforwards and Section 382

Bay Area technology companies, professional services firms, and startups often carry large NOL carryforwards generated in early operating years when revenue was building and losses were running. These NOLs are a tax asset that theoretically offset future income. The operative word is "theoretically," because IRC Section 382 severely limits NOL use after an ownership change.

The Section 382 annual limitation is calculated as:

Annual limitation = Value of loss corporation x Long-term tax-exempt rate

For a target worth $8 million, the 2026 long-term tax-exempt rate of approximately 3.5% per month (annualized), the annual Section 382 limitation is approximately $280,000. A target with $4 million of NOLs could use only $280,000 per year, taking 14+ years to fully absorb the losses. If the acquired company is expected to generate only $500,000 of annual taxable income in the first three years post-acquisition, the NOLs provide limited near-term value and should be priced accordingly in the deal.

Section 382 also has a built-in gain provision (NUBIG) that can increase the limitation if the target had unrealized appreciation in its assets at the time of the ownership change. We model the NUBIG adjustment and the full Section 382 limitation on every deal with material NOL carryforwards.

California-Specific M&A Considerations

California conforms to most federal M&A tax rules, but with notable differences:

California does not recognize S-corporation status for California tax purposes in the same way as federal. California S-corporations pay a 1.5% franchise tax on net income (minimum $800). A California Section 338(h)(10) election on a California S-corp requires separate analysis of the California deemed sale implications.
California capital gains tax rate: California taxes all capital gains at ordinary income rates up to 13.3%, with no preferential rate for long-term gains. This significantly increases the seller's after-tax cost of a California stock sale or asset sale compared to a federal-only analysis.
California NOL conformity: California has its own NOL rules, which generally conform to federal but with differences in carryforward periods and no carryback. Section 382 limitations apply for California as well.
Change of ownership for property tax: the transfer of a controlling interest (more than 50%) in a legal entity that owns California real property triggers a change of ownership for Proposition 13 purposes, requiring reassessment of the property to current fair market value. This can add significant ongoing property tax costs to the acquisition. We advise on structures that defer or avoid the property tax change of ownership.

Working With Adam Morris and the CFO Advisory Practice

M&A tax due diligence does not happen in isolation. The tax findings must integrate with the financial due diligence, the quality of earnings analysis, and the deal structure negotiations. Silicon Valley Tax's M&A tax work is coordinated with Adam Morris and the CFO Advisory practice, which brings fractional CFO and transaction advisory experience across Bay Area small and mid-market deals.

For sellers preparing for a process, Adam's team can help with financial statement presentation, management projections, and deal readiness. For buyers in active due diligence, the combined team provides tax DD findings integrated with the financial model. For management teams navigating a first transaction, the coordination between tax, financial, and advisory removes the learning curve from a process that has a compressed timeline.

If you are evaluating an acquisition, preparing for a sale, or need a second opinion on a current deal's tax structure, we are glad to take a consultation call. Our office is at 2051 Junction Ave, San Jose CA 95131. Call (408) 383-9870 or book at contact.html#book.

Frequently Asked Questions

What is the difference between an asset purchase and a stock purchase for tax purposes?

In an asset purchase, the buyer receives a stepped-up tax basis in all acquired assets equal to the purchase price allocation, creating immediate new depreciation and amortization deductions. In a stock purchase, the buyer inherits the target's existing tax basis in all assets and assumes all historical liabilities. Sellers generally prefer stock sales (single capital gain); buyers prefer asset purchases (basis step-up). The Section 338(h)(10) election can bridge this conflict for eligible acquisitions.

What is a Section 338(h)(10) election and when should a buyer request one?

A 338(h)(10) election allows a stock acquisition of an S-corporation or subsidiary to be treated as an asset purchase for tax purposes. The buyer gets a stepped-up basis in the target's underlying assets; the seller recognizes gain as if the corporation sold its assets directly. Both parties must consent, and the seller typically negotiates a higher price to compensate for the additional gain. We model the tax cost to the seller and the present value of the basis step-up to the buyer to determine the price adjustment that makes both parties economically indifferent.

How is purchase price allocated across asset classes and why does it matter?

Under IRC Section 1060, purchase price is allocated across seven asset classes in a prescribed residual order. The allocation determines the buyer's future depreciation and amortization schedule and the seller's gain characterization. Tangible personal property in Class V may qualify for rapid bonus depreciation; Section 197 intangibles in Class VI and VII amortize over 15 years. The buyer and seller must report consistent allocations on Form 8594; mismatches trigger IRS scrutiny.

How are earn-out payments taxed for the buyer and the seller?

If the seller has no continuing employment relationship, earn-out payments are generally additional purchase price taxed as capital gain. If the seller remains an employee and the earn-out is conditioned on continued employment, the IRS may recharacterize the payments as compensation, taxable as ordinary income. Avoiding recharacterization requires basing the earn-out on entity-level financial metrics rather than the seller's personal performance metrics. For buyers, earn-outs treated as purchase price increase cost basis; those treated as compensation are immediately deductible.

What happens to the target company's net operating losses (NOLs) after an acquisition?

NOL carryforwards become subject to IRC Section 382 annual use limitations after an ownership change (more than 50-percentage-point change by 5% shareholders). The annual limitation equals the fair market value of the loss corporation multiplied by the long-term tax-exempt rate. For a $10M target with a 3.5% rate, the annual NOL limitation is approximately $350,000. Large NOL carryforwards in a high-value target may be worth little in practice because of this limitation, and the price should reflect the present value of the restricted NOL use.

Why Bay Area Buyers and Sellers Choose Silicon Valley Tax for M&A Tax

M&A tax is not where you learn on the job. A missed Section 382 limitation analysis, an earn-out that gets recharacterized as compensation, or a purchase price allocation that conflicts with the seller's Form 8594 can each cost more than the CPA fee for the entire deal. We bring deal experience from dozens of Bay Area small and mid-market transactions, from CPA practice acquisitions to technology company sales to professional services firm succession.

We are not a Big Four firm and we do not price like one. We work with private equity buyers, strategic acquirers, individual business owners selling their first company, and management teams evaluating a buyout. Our tax DD reports are readable, actionable, and integrated with the deal economics. Our transaction structuring advice comes with the financial model that supports it.