Don't let your CPA sell you on a 338 election, it could cost you

We are almost halfway through 2026 (it's crazy I know!). They've seen my fair share of deals moving at this point. Almost every single time I talk with a potential buyer, they mention that they've spoken with their CPA and say something to the effect of, "We'll just make a 338 election." 

And almost every time, someone says something to that effect because they read it online or someone told them to do talk with me about it.

Here's the problem with that.

The 338 Election Is Only as Good as the Seller's S-Corp

While there are a couple of different tax elections one can make, i'll talk generically about 338(h)(10) elections for now.

A 338(h)(10) election is popular for a reason. It lets a buyer treat a stock purchase like an asset purchase for tax purposes, which means a step-up in basis and cleaner depreciation going forward. On paper, it's simple. In practice, it has a structural weakness that doesn't get talked about enough.

The election only works if the seller has a valid S-corporation election in place.

That sounds obvious. But in my experience, a surprising number of sellers have S-corp elections that are technically defective. There weren't pro-rata distributions, there was a non-qualifying shareholder at some point throughout the history of the company, or an operating agreement that created two classes of stock. The S-corp looks fine on the surface, and the seller believes in good faith that everything is in order. But ultimately there is a ticking time bomb for an unassuming buyer.

Unfortunately these issues don't always crop up in due diligence, and almost never get looked at during the QofE.

What Happens When the S-Corp Election Is Bad

If the S-corp election is invalid, you didn't buy an S-corp. You bought a C-corporation. And C-corporations come with an entirely different tax profile, embedded liabilities, and a set of structural problems that are very hard to unwind after the fact.

If you bought an S corporation with the 338 election, treating it as if you bought the assets, then typically after closing you, as an individual, think you're operating a flow-through entity. You don't necessarily realize that all those tax benefits you thought you were getting are now captured and locked in a C corporation instead.

Unfortunately once the S-corp election has been inadvertently terminated, depending on how that termination occurs, there may not be a way to remedy it. Even if there is, it is often caught during an audit, which can take time and money and create additional stress on the new owner. 

Why Indemnification Doesn't Save You

Buyers assume the statements of fact (otherwise known as Reps & Warranties, although Ken Adams makes a strong argument as to why this is confusing) in the purchase agreement will cover them here. The seller represented that the S-corp election was valid. If it turns out it wasn't, that's a breach, and the indemnification provision kicks in.

Sometimes that's true. But it's not the safety net most buyers think it is.

Language can matter. A rep that says "the company is taxed as an S-corporation" is not the same as a rep that says "the company's S-corporation election remains valid, and no event has occurred that would cause a termination of that election." The first one is easy to argue around. The second is clearer and will likely protect a buyer more.

Second, even a tightly drafted statement of fact only helps if the seller can pay. In small business acquisitions, sellers are often individuals walking away from their primary asset. By the time a problem surfaces, the money usually gone, the seller has moved on, and collecting on an indemnification claim becomes a litigation exercise that costs both time and money, all while you as a buyer remain on the hook for the outstanding tax issues currently.

Now you've both overpaid and possibly bought the wrong thing.

Why an F Reorganization Is Worth the Extra Conversation

An F reorganization takes a different path to achieve the same outcome with more assurances. Instead of relying on the validity of an existing S-corp election, you restructure the entity before the sale closes. 

In order to effectuate an F Reorg there is more coordination, and both sides have to move through additional steps before closing. This usually requires attorneys and tax advisors who know what they're doing. But it removes the single biggest point of failure in a 338 transaction.

The defective S-corp problem simply doesn't exist in a well-executed F reorg. 

It also gives you flexibility the 338 doesn't. If you want to build a holding company structure later, bring on a co-investor, add an operating subsidiary, or set up a platform for add-on acquisitions, the F reorg positions you to do that cleanly. You're not locked into the legacy structure of whatever the seller built. You're starting from a structure you designed with your own exit and growth plan in mind.

That optionality has real value and most buyers don't think about it at the time of acquisition.

Here's your takeaway

Using a 338 Election in the right circumstances can serve as a great tool in your acquisition toolbox. It works well when the underlying S-corp election is clean, the due diligence is thorough, and the statements of fact in the purchase agreement are drafted with brevity and clarity. 

If all the boxes are checked, a 338 election allows a buyer to gain asset sale treatment without the need for additional advisor fees before the deal closes.

But "the right situation" requires things to be true that you cannot always verify. You are relying on the seller's tax history, the seller's historical filing decisions, and a set of facts that were created years before you showed up. If any of those facts turn out to be wrong, the consequences are serious.

It's true, the F reorg is more work. However, it allows a buyer to sleep better at night knowing there isn't a massive question-mark hanging out there about their deal.

Before you default to a 338 because your advisor said it's easier, ask them one thing: have you validated the seller's S-corp election? Not just reviewed the returns. Actually validated the election, the shareholder history, and whether any termination events occurred.

If they don't have a clear answer, that's your answer.

Until next time,

Josh