A buyer is not entitled to a step-up in the tax basis of acquired net assets to fair value (FV) in taxable stock acquisitions but, rather, a carryover basis. However, if an Internal Revenue Code (IRC) Section 338 election is made in connection with a taxable stock sale, the transaction is treated as a hypothetical asset deal for tax purposes, and the buyer’s basis is accordingly revalued to reflect the purchase price.
The depreciation and amortization of all asset write-ups and intangibles, including goodwill, identified in the purchase price allocation then become tax-deductible expenses. Since the transaction is treated as an asset deal, IRC Section 197 applies and all intangible assets, including goodwill, recognized in the transaction are thus amortized over 15 years for tax purposes.
The disadvantage of a Section 338 election is that it triggers a taxable gain on the deemed asset sale. So, the Section 338 election only makes sense when the present value (PV) of future tax savings from tax-deductible depreciation and amortization expenses exceeds the current tax cost of the step-up. Additionally, a stock deal accompanied by a 338 election is still considered a stock deal for legal purposes, so the buyer inherits all of the target’s liabilities.