Tax step-up in M&A: How it works and when it applies

In M&A, the deal structure can determine the after-tax value as much as the headline purchase price. A tax step-up in M&A can increase the buyer’s basis in acquired assets, creating future depreciation and amortization deductions that may improve the transaction’s economics.

Because the buyer receives those deductions while the seller may incur additional tax costs, a tax step-up is often a point of negotiation rather than a purely technical tax decision. The parties must balance transaction structure, tax treatment, and the allocation of the resulting benefit.

Key takeaways

• Buyers and sellers should evaluate step-up benefits alongside transaction costs, tax consequences, and negotiation positions.
• The purchase structure determines whether the buyer receives a new asset basis or inherits the target’s existing tax basis.
• Section 338 elections and F reorganizations provide alternative paths when a direct asset purchase is not suitable.
• Tax elections require planning because eligibility rules, approvals, and filing deadlines can affect the outcome.
• The economic benefit of a step-up is measured by the additional deductions and tax savings generated over time.

What is a tax step-up in M&A?

A stepped-up basis in M&A is mainly relevant to an asset purchase or a stock transaction treated as an asset purchase for tax purposes. The buyer assigns the acquisition price among the purchased assets, which establishes the tax basis for each asset. When the allocated value exceeds their historical tax basis, the difference is the step-up.

The buyer can generally recover the higher basis through depreciation or amortization over the applicable periods for each asset. These deductions may reduce the amount of the buyer’s future income subject to tax and increase the acquisition’s after-tax value.

Why buyers pursue a tax step-up while sellers oppose it

Buyers and sellers often have opposing tax incentives because a tax step-up, beneficial to the buyer, can increase the seller’s current tax cost. Under asset-sale treatment, some of the seller’s gain may be taxed as ordinary income instead of receiving capital gains treatment.

For a C corporation seller, the transaction may also create tax at the corporate level and a second tax when sale proceeds are distributed to shareholders. 

Sellers often prefer a stock sale because it can:

• Produce one level of tax at the shareholder level
• Preserve capital gains treatment for more of the proceeds
• Avoid the double taxation that may arise in a C corporation asset sale

Because one party’s benefit may involve a disadvantage to the other, the expected tax value is often reflected in the purchase price or a negotiated gross-up.

Ways to achieve a tax basis step-up in an acquisition

A buyer can obtain a tax basis step-up in an acquisition by purchasing assets directly or by using a stock transaction that is treated as an asset sale for federal income tax purposes. The appropriate method depends on the target’s tax classification, the percentage acquired, and whether the seller agrees to the structure.

The differences between asset and stock acquisitions determine whether the buyer automatically receives a new basis in the target’s assets or needs to make an election or undertake a pre-closing reorganization.

Asset acquisitions

A direct asset acquisition gives the buyer a new tax basis in the purchased assets. The buyer generally allocates the acquisition cost among tangible assets, identifiable intangible assets, and goodwill.

When the allocated purchase price exceeds the seller’s historical asset basis, the buyer receives an asset step-up. The buyer may then recover the higher basis through depreciation or amortization, subject to the rules for each asset category.

Section 338(g) election

By making an election under IRC Section 338(g), a corporate buyer can obtain asset-acquisition tax treatment for an eligible stock purchase. Legally, the buyer acquires the target’s shares.

For tax purposes, the target is treated as selling its assets and acquiring them again with a new basis. The Section 338(g) election is a unilateral election by the buyer. The purchasing corporation makes this election by filing Form 8023 and does not need the seller’s consent.

The deemed asset sale may create tax at the target company in addition to the selling shareholders’ tax on the actual stock sale. Because the buyer owns the target when the deemed-sale tax arises, the buyer generally bears that cost economically.

These two levels of tax often make a Section 338(g) election unattractive in domestic acquisitions of companies with appreciated assets.

Section 338(h)(10) election

An IRC Section 338(h)(10) election also treats a stock acquisition as an asset acquisition for tax purposes. However, it coordinates the deemed asset sale with the target’s deemed liquidation to avoid the separate stock-sale treatment that applies under Section 338(g).

The election is available only for a qualified stock purchase. To meet this requirement, a corporate buyer must purchase stock representing at least 80% of the target’s voting power and value within 12 months. The target must generally be an S corporation or an eligible subsidiary sold by a consolidated group or an affiliated corporate seller.

The buyer and eligible seller file Form 8023 jointly. For an S corporation target, every shareholder must consent, including shareholders who retain their stock.

F reorganizations

An F reorganization under IRC Section 368(a)(1)(F) can prepare an S corporation target for a sale that gives the buyer a tax basis step-up in the acquired assets.

The reorganization changes the target’s structure before the acquisition. Typically, the shareholders form a new S corporation holding company. The original operating company becomes its qualified subchapter S subsidiary and may then be converted into an entity disregarded for federal income tax purposes.

The buyer then acquires interests in the disregarded operating entity. For tax purposes, that transaction is treated as a purchase of the underlying assets, creating a new asset basis.

Because this structure does not rely on a Section 338(h)(10) election, the buyer does not need to satisfy Section 338(h)(10)’s requirement to acquire at least 80% of the target’s voting power and value.

The structure may also accommodate a partial acquisition or rollover equity, although these features require deal-specific tax planning.

Section 338(h)(10) election vs. F reorganization: Which is better?

A buyer should generally choose the Section 338(h)(10) election when it will acquire at least 80% of an eligible target and wants a stock-purchase form with asset-sale tax treatment. An F reorganization step-up may be more suitable when the target is an S corporation and the parties need greater flexibility, particularly for a partial sale or rollover equity.

Choose a Section 338(h)(10) election when…	Consider an F reorganization when…
A corporate buyer will acquire at least 80% of an eligible target’s voting power and value	The buyer will acquire less than 80% of the target’s voting power or value
The parties want a direct route from a stock purchase to asset-sale tax treatment	The parties need more flexibility for a partial sale or rollover equity
The buyer and seller are prepared to make a joint election on Form 8023	The seller is prepared to complete additional restructuring before closing

How the step-up affects deal economics

Traditional M&A valuation methods estimate the value of the operating business, while step-up analysis measures the present value of the additional tax savings created by the transaction structure.

A buyer measures the economic value of a tax step-up by calculating the additional tax savings created by the higher asset basis. Timing matters because deductions received soon after closing are more valuable than those received many years later.

Simplified tax step-up example

Assume a buyer pays $10 million for a business in a transaction treated as an asset purchase for tax purposes. Before the sale, the transferred assets (equipment, customer lists, and goodwill) had a combined historical tax basis of $4 million.

The buyer allocates the full $10 million purchase price among the acquired assets. This allocation establishes the buyer’s combined new tax basis of $10 million.

The difference between the two amounts is the step-up:

$10 million new tax basis − $4 million historical tax basis = $6 million step-up

The buyer calculates its actual deductions from the full $10 million new basis. How the buyer recovers the basis depends on the classification of each asset. Equipment is tangible property, so its basis is recovered through depreciation. For simplicity, this example assumes even depreciation over five years.

Customer lists and goodwill are intangible assets. When acquired as part of a qualifying business acquisition, IRC Section 197 intangibles are amortized over 15 years.

Asset	Historical tax basis	New tax basis	Step-up	Recovery period	Annual deduction
Equipment	$1 million	$2 million	$1 million	5 years	$400,000
Customer lists	$1 million	$3 million	$2 million	15 years	$200,000
Goodwill	$2 million	$5 million	$3 million	15 years	$333,333
Total	$4 million	$10 million	$6 million	—	$933,333

Total tax savings and the step-up benefit

Assume the buyer can use every deduction and has an effective tax rate of 25%. The estimated tax savings equal the available deduction multiplied by that rate.

Recovery period	Deductions from full new tax basis	Tax savings at 25%
Annual amount in years 1–5	$933,333	$233,333
Annual amount in years 6–15	$533,333	$133,333
Nominal total over full recovery periods	$10 million	$2.5 million
Nominal total attributable to tax step-up	$6 million	$1.5 million

The annual benefit is higher during the first five years because the buyer claims depreciation of equipment and amortization of intangible assets. After the assumed 5-year equipment recovery period ends, only the customer list and goodwill amortization continue.

Over the full recovery periods, the buyer deducts the entire $10 million new basis. At a 25% rate, those deductions produce $2.5 million in nominal tax savings.

Of that amount, $1.5 million is attributable to the step-up:

$6 million step-up × 25% = $1.5 million

How buyers and sellers negotiate the tax value

The buyer and seller compare the present value of the buyer’s benefit with the seller’s incremental tax cost. They may reflect that difference in the deal terms by:

• Increasing the purchase price through a gross-up
• Sharing the estimated benefit through a price adjustment
• Exchanging part of the tax value for another favorable term

The purchase price allocation also affects how quickly the buyer receives deductions and how the seller’s gain is characterized. In a qualifying direct asset acquisition, the buyer and seller generally report the allocation on Form 8594 under IRC Section 1060.

For transactions treated as asset acquisitions through a Section 338(g) or Section 338(h)(10) election, the parties report the allocation on Form 8883. Other contingent terms, including earnouts in M&A, should be modeled separately because their timing and tax treatment can affect the parties’ final after-tax proceeds.

Common pitfalls in structuring a tax step-up

A tax step-up can fail to deliver the expected benefit when the transaction structure, timing requirements, or economic terms are not addressed early enough. The main pitfalls include: