338(h)(10) Sales Explained: What Every Business Owner Needs to Know Before Signing a Letter of Intent

You've spent years, maybe decades, building something real. A business that generates real revenue, employs real people, and has given you a genuinely different financial life than most people experience. And now someone wants to buy it. Congratulations, truly. That is no small thing.

But here's where things get complicated fast. Somewhere in the offer or letter of intent sitting on your desk, there may be a provision that reads something like "Buyer and Seller agree to make a joint election under Section 338(h)(10) of the Internal Revenue Code." And if you're like most business owners encountering this language for the first time, your eyes probably glazed over a bit, you nodded along with your attorney, and moved on to reviewing the purchase price.

That could be one of the most expensive moments of distraction in your entire financial life.

A 338(h)(10) election can mean the difference between walking away from the closing table with $6 million and walking away with $4.5 million, even if the purchase price on paper never changed. This article will walk you through exactly what this provision means, why buyers love it, why sellers are often caught off guard by it, and most importantly, what you can do to protect yourself and even use it to your advantage.

First, a Quick Primer on How Business Sales Are Usually Structured

Before diving into the 338(h)(10) election specifically, it helps to understand that there are generally two ways to sell a business, a stock sale or an asset sale, and the distinction matters enormously from a tax standpoint.

In a stock sale, you sell your actual ownership shares in the company. The buyer steps into your shoes as the owner. From a tax perspective, the gain you realize on those shares is generally treated as a capital gain, which at the federal level is taxed at rates between 0% and 20% depending on your income, plus the 3.8% net investment income tax if applicable. For many business owners, the blended federal rate on a stock sale lands somewhere around 23.8%, before state taxes.

In an asset sale, the business sells its underlying assets such as equipment, contracts, customer relationships, intellectual property, and goodwill, rather than stock. The proceeds are then distributed to you as the owner. The problem is that many of those assets are taxed at ordinary income rates when sold, which for high earners can reach 37% federally. Additionally, if the business itself recognizes the gain first and then distributes proceeds to you, there can be a double taxation scenario.

So from a pure tax standpoint, most sellers strongly prefer a stock sale. And most buyers strongly prefer an asset sale. Which sets up the central tension that a 338(h)(10) election is designed to navigate.

So What Exactly Is a 338(h)(10) Election?

Section 338(h)(10) of the Internal Revenue Code is a provision that allows a qualified stock purchase to be treated, for federal tax purposes, as if it were an asset purchase. The structure is this: the buyer actually purchases your stock, which is a stock sale on paper, but both parties make a joint election to have the transaction taxed as though the company sold all of its underlying assets at their fair market value on the closing date.

Why would a buyer want this? Because when they step up the cost basis of all the acquired assets to fair market value, they get to depreciate and amortize those assets from a fresh starting point. That translates to significant tax deductions for the buyer over the years following the acquisition. For a buyer in a 35% corporate tax bracket purchasing a $10 million business with largely appreciated assets, the tax value of that step-up in basis could easily be worth $1 million or more in present value terms.

The election can only be made if certain requirements are met. The buyer must be a corporation, either a C-Corporation or an S-Corporation. The seller must also be a corporation (an S-Corp is the most common scenario), though there is more flexibility on the seller side. Partnerships, LLCs taxed as partnerships, and sole proprietorships are generally not eligible for 338(h)(10) treatment.

The Critical Insight Most Articles Miss: A 338(h)(10) election requires the consent of BOTH buyer and seller. That means you have negotiating power. The buyer wants this election badly enough that they built it into their offer, which tells you something important about how much it's worth to them.

Why the 338(h)(10) Creates a Tax Problem for Sellers

Here is where things get uncomfortable for sellers. When the election is made, the tax treatment shifts away from what would otherwise be favorable capital gains treatment and toward something that looks more like an asset sale, with ordinary income implications on certain categories of assets.

Under a 338(h)(10) election, the purchase price gets allocated among several asset classes following what's known as the "residual method" under the tax regulations. The IRS specifies a hierarchy of asset classes, and how the purchase price gets allocated across them determines your tax bill. Here's the general progression from most favorable to least favorable for a seller:

1. Class I Assets (cash & cash equivalents) are taxed at ordinary income rates but these are usually a small piece of the deal.
2. Class II Assets (actively traded personal property like securities) are taxed at capital gains rates.
3. Class III & IV Assets (accounts receivable, inventory) can trigger ordinary income treatment on the gain.
4. Class V Assets (other tangible assets like equipment, furniture, computers) trigger depreciation recapture on any previously depreciated amount, taxed at ordinary income rates up to 25%, with capital gains on the remainder.
5. Class VI Assets (Section 197 intangibles like customer lists, non-compete agreements, licenses) are generally taxed as ordinary income as they are amortized and then recaptured on sale.
6. Class VII Assets (goodwill & going concern value) is where sellers often see the most value allocated, and for pure enterprise goodwill this is typically taxed at capital gains rates.

The practical problem is that in many businesses, particularly professional services firms and those with significant equipment or receivables, a meaningful chunk of the purchase price ends up allocated to asset classes that generate ordinary income. The net result is often a higher effective tax rate on the sale proceeds than a straight stock sale would have produced.

To put numbers on this, imagine a seller who agrees to a $10 million purchase price. In a simple stock sale, assuming a $1 million cost basis in their shares, they'd have a $9 million capital gain taxed at roughly 23.8% federally, producing a federal tax bill of about $2.14 million and net proceeds of approximately $7.86 million. Under a 338(h)(10) election with unfavorable asset allocation, that same seller might see $3 to $4 million of proceeds allocated to ordinary income assets, pushing their blended federal tax rate significantly higher and potentially reducing net proceeds by $500,000 to $1 million or more.

The Negotiating Opportunity Hidden Inside the 338(h)(10)

Here is the most important thing most sellers don't understand going into a deal with a 338(h)(10) provision. Because the election creates a meaningful tax benefit for the buyer, you have real negotiating leverage to demand a higher purchase price in exchange for your agreement to make the election.

This is sometimes called a "gross-up" negotiation. The concept is straightforward. If the buyer is going to receive, say, $800,000 in present-value tax savings from the step-up in basis, it is entirely reasonable to ask that some portion of that benefit be shared with you through a higher purchase price. After all, the buyer's ability to make that election depends entirely on your willingness to agree to it.

The gross-up math is real. Work with your financial advisor and tax professional to model what your net after-tax proceeds would look like both with and without the 338(h)(10) election. The difference between those two numbers represents the minimum additional purchase price you should demand in exchange for agreeing to the election. Anything above that is pure upside for you.

In practice, this negotiation often happens in one of two ways. Some sellers ask for a straightforward increase in the headline purchase price. Others negotiate a specific dollar indemnification from the buyer to compensate for the incremental tax cost. Either approach can work, but both require you to actually run the numbers before the letter of intent is signed, because after the LOI is executed it becomes much harder to renegotiate the fundamental economics of the deal.

Personal Goodwill: A Planning Opportunity Most Sellers Overlook

One of the most underutilized planning opportunities in a 338(h)(10) context involves something called personal goodwill. This concept is particularly relevant for business owners whose enterprise value is substantially tied to their personal relationships, reputation, expertise, or client connections rather than to the business entity itself.

In a traditional asset sale or 338(h)(10) transaction, the goodwill value of the business is owned by the company and flows through the entity. But in many professional service businesses, physician groups, consulting firms, and owner-operated businesses, a strong argument can be made that a significant portion of the goodwill belongs personally to the owner, not to the corporate entity.

The legal and tax basis for this comes from a body of case law, most notably the Tax Court's decision in Martin Ice Cream and other subsequent rulings, which established that personal goodwill can exist independently from enterprise goodwill under certain conditions. If personal goodwill can be separately identified and valued, the owner can sell it directly as a capital asset, generating long-term capital gain treatment at the individual level.

The practical implication is significant. Imagine a business with $5 million in total goodwill. If $2 million of that can legitimately be characterized as personal goodwill owned by the seller individually, those proceeds can bypass the corporate entity entirely, avoid any entity-level tax, and be taxed directly to the seller at capital gains rates. For a seller in a high tax bracket, that structural shift on $2 million could mean keeping an extra $200,000 to $400,000 after taxes.

It's worth noting that personal goodwill planning requires careful documentation and ideally pre-deal structuring. The stronger the evidence that the owner's personal relationships and expertise drive a meaningful portion of revenue independent of the entity, demonstrated through client contracts that follow the individual, referral patterns tied to the owner personally, and so on, the more defensible the personal goodwill position becomes.

The Asset Allocation Negotiation Inside the Deal

Most business owners negotiate the total purchase price but pay little attention to how that price gets allocated among the asset classes described above. This is a significant mistake. Both the buyer and the seller have preferences about where the allocation lands, and those preferences often conflict.

The buyer generally wants to allocate as much of the purchase price as possible to assets with shorter depreciation or amortization lives, because that maximizes their near-term tax deductions. Equipment depreciates faster than goodwill, so buyers often push for higher equipment allocations. Section 197 intangibles like customer lists amortize over 15 years, so buyers may prefer those allocations as well.

The seller generally wants the opposite. Maximum allocation to Class VII goodwill (taxed at capital gains rates) and minimum allocation to inventory, receivables, and equipment (subject to recapture taxed at ordinary income rates).

The purchase price allocation is typically addressed in the purchase agreement itself or in a separate allocation agreement. The IRS requires both buyer and seller to file consistent allocations using Form 8594, so both parties are legally bound to use the same numbers. This means the negotiation around allocation is real and consequential, not merely a paperwork exercise.

A skilled financial advisor working alongside your M&A attorney and tax professional can model the after-tax impact of different allocation scenarios before you agree to the final numbers. Moving $500,000 from equipment allocation to goodwill allocation might cost a buyer almost nothing but save you $50,000 to $100,000 in taxes. These are the negotiations that separate business owners who get great outcomes from those who leave real money on the table.

How the Timing of the Election Works

The 338(h)(10) election must be made jointly by the buyer and seller on IRS Form 8023 by the 15th day of the 9th month following the month in which the acquisition occurs. In practical terms, this is roughly 9 months after closing. Both parties must consent, and the election is irrevocable once made.

This timing element is important because it means the election is technically not finalized until months after the deal closes. In some cases, if the relationship between buyer and seller deteriorates post-closing or if unforeseen circumstances arise, there can be tension around the joint filing. Having the buyer's obligation to cooperate on the election clearly documented in the purchase agreement is important, as is having your own advisors review the completed Form 8023 before it is filed.

It's also worth noting that the 338(h)(10) election interacts with installment sale treatment in ways that require careful planning. If you have agreed to receive part of the purchase price in future installment payments rather than all cash at closing, the tax treatment of those future payments under a 338(h)(10) election is a nuanced area that requires specific attention from your tax advisor.

What If the Deal Includes an Earnout?

Many business sales, particularly those where there is some uncertainty about future performance, include an earnout provision, meaning a portion of the purchase price is contingent on the business hitting certain milestones after closing. Earnouts add a layer of complexity to 338(h)(10) planning that often goes unaddressed until it's too late.

The IRS treats earnout payments received by a seller as taxable income in the year received. Whether those payments are taxed as capital gains or ordinary income depends on how the underlying earnout is characterized. In a 338(h)(10) context, if the earnout relates to assets allocated to ordinary income categories, those payments may receive ordinary income treatment as well.

There are planning strategies around this, including the use of open transaction treatment for earnouts under the right circumstances, but this is highly fact-specific and represents exactly the type of scenario where having a financial advisor coordinate with your tax counsel before signing can save you a meaningful amount of money.

State Tax Considerations

Everything discussed so far has focused on federal tax treatment. But state taxes add another layer to this analysis, particularly for business owners in states with high income tax rates or states that do not automatically conform to federal treatment of 338(h)(10) elections.

Several states do not recognize the federal 338(h)(10) election for state income tax purposes, which can create a situation where a business sale is treated as a stock sale at the state level but an asset sale at the federal level. This misalignment can create complex reporting obligations and potentially higher combined state and federal tax costs than a seller might have anticipated.

For Kansas and Missouri residents selling a business, the state-level tax implications of a 338(h)(10) election should be explicitly modeled as part of any transaction analysis. The combined state and federal tax picture is what ultimately determines your take-home proceeds, not the federal analysis alone.

The Five Questions to Ask Before Agreeing to a 338(h)(10) Election

If you're looking at an offer that includes a 338(h)(10) provision, here are the five questions you need answered before you agree to anything.

1. What is my estimated after-tax net proceed under a 338(h)(10) versus a clean stock sale? This requires actual tax modeling, not a rule of thumb. The difference can be hundreds of thousands of dollars, and you need to understand it before you negotiate.
2. How has the purchase price been allocated among asset classes, and can I negotiate a better allocation? If the allocation hasn't been discussed yet, get it on the table now. The purchase agreement is the right place to address this, not after the fact.
3. Am I asking for a sufficient gross-up to offset my incremental tax cost? The buyer's tax benefit from the election should be at least partially shared with you. If you haven't modeled the buyer's benefit, you are negotiating blind.
4. Is there a personal goodwill argument available in my situation? This depends on the specific facts of your business, your role in generating revenue, and your relationship with clients. It is worth exploring before the deal closes, not after.
5. What are the state-level implications in my specific state? Federal treatment and state treatment may differ, and the combined picture is what matters for your financial plan.

How This Fits Into Your Broader Financial Plan

For many business owners, the sale of their business is the single largest liquidity event of their financial lives. The proceeds from a business sale often need to fund decades of retirement, provide for family, support charitable goals, and potentially seed the next chapter of a professional life. Getting the tax treatment right is not just an accounting exercise. It is a financial planning imperative.

At Oread Wealth Partners, we work with business owners who are navigating exactly these kinds of decisions. We build detailed after-tax projections that model different transaction structures, work collaboratively with your M&A attorney and CPA to stress-test deal economics, and help you understand how the net proceeds from a sale fit into your longer-term financial goals. Sometimes the 338(h)(10) election, with the right gross-up negotiated, is actually the best outcome for both parties. Other times, fighting for a clean stock sale is worth the effort. The answer depends on your specific situation.

What we know for certain is that business owners who engage their financial advisor before the letter of intent is signed consistently achieve better outcomes than those who loop in their advisor only at or after closing. The letter of intent stage is where the real economics of the deal get locked in, and it is the right moment to have experienced financial guidance in your corner.

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