Tax Structuring
Asset vs. stock purchases, Section 338(h)(10) elections, and carried interest taxation
~20 min read
Tax structuring is not a back-office detail in private equity. It is a core driver of deal economics. The difference between an asset purchase and a stock purchase can swing a deal's after-tax return by hundreds of basis points. A Section 338(h)(10) election can create tens of millions of dollars in tax savings through depreciation and amortization shields. And the tax treatment of carried interest has been one of the most debated topics in U.S. tax policy for over a decade.
This lesson covers three areas where tax structuring has the greatest impact on PE economics: (1) the asset vs. stock purchase decision, (2) Section 338(h)(10) elections and step-up in basis, and (3) the taxation of carried interest. These are not obscure technical matters. They show up in every deal model, every investment committee memo, and every fund structure negotiation.
| Asset Purchase | Stock Purchase | |
|---|---|---|
| What is acquired | Individual assets and liabilities of the business (equipment, inventory, contracts, IP), selected by the buyer | The entity's equity (shares or partnership interests). Everything comes with the entity, including all liabilities. |
| Tax basis | Buyer gets a stepped-up tax basis in all acquired assets equal to the purchase price. This creates new depreciation and amortization deductions. | No step-up. The buyer inherits the seller's existing tax basis in the assets, which may be partially or fully depreciated. |
| Buyer preference | Strongly preferred. Step-up in basis creates a tax shield that can be worth 15-25% of the purchase price over time. | Less preferred from a tax perspective, but often necessary for practical reasons. |
| Seller preference | Less preferred. The seller faces potential double taxation: the entity pays tax on the gain from selling assets, then the shareholders pay tax on the liquidating distribution. | Strongly preferred. Shareholders pay capital gains tax once on the sale of their shares. |
| Liabilities | Buyer can cherry-pick which liabilities to assume. Unknown or contingent liabilities generally stay with the seller. | Buyer inherits all liabilities, including unknown, undisclosed, or contingent liabilities. |
| Contracts and permits | Must be individually assigned, which may require third-party consent. Some contracts and permits may not be transferable. | Generally transfer automatically with the entity. Change-of-control provisions may still be triggered. |
Step-Up in Basis and the Tax Shield
When a buyer acquires assets at a purchase price above their existing tax basis, the buyer 'steps up' the basis to the purchase price. This new, higher basis creates incremental depreciation and amortization (D&A) deductions that reduce taxable income in future years.
Consider a $500 million acquisition where the target's existing asset tax basis is $100 million. In a stock purchase with no step-up, the buyer inherits $100 million of remaining depreciable basis. In an asset purchase (or a stock purchase with a Section 338 election), the buyer steps up the basis to $500 million, creating $400 million of incremental depreciable basis. At a 25% effective tax rate and a 15-year amortization period for goodwill, that step-up generates approximately $6.7 million per year in tax savings, or roughly $100 million in total undiscounted tax savings. This is real money that flows to the buyer's bottom line and improves the deal's IRR.
Section 338(h)(10) Elections
In many PE transactions, a true asset purchase is impractical. The target may have hundreds of contracts, licenses, and permits that would need to be individually assigned. The entity may operate in regulated industries where transferring licenses is difficult or time-consuming. Or the seller may simply refuse an asset deal due to the double-taxation problem.
Section 338(h)(10) of the Internal Revenue Code provides an elegant solution. It allows the buyer and seller to jointly elect to treat a stock purchase as if it were an asset purchase for tax purposes only. The legal form is a stock acquisition (the buyer purchases shares), but for tax purposes, the target is treated as if it sold all of its assets and liquidated. This gives the buyer the stepped-up basis it wants without the operational complexity of an actual asset purchase.
The catch: Section 338(h)(10) requires the seller to be a domestic corporation (specifically an S-corporation or a subsidiary of a consolidated group). It is not available for all deal structures. When available, the buyer typically compensates the seller for the additional tax cost by paying a modestly higher purchase price (a 'gross-up'), because the election triggers an immediate tax hit for the seller that would not occur in a straight stock sale.
Section 338(h)(10) is one of the most commonly discussed tax provisions in PE deal-making. When a deal team evaluates a target, one of the first questions tax counsel asks is: 'Is a 338 election available, and what would it cost?'
Carried Interest Taxation
Carried interest is the GP's share of fund profits, typically 20%. The taxation of carried interest has been one of the most politically contentious issues in U.S. tax policy because of how it is classified: despite being compensation for the GP's services (managing the fund), carried interest has historically been taxed as long-term capital gains (currently at a 20% federal rate plus the 3.8% net investment income tax) rather than as ordinary income (which would be taxed at rates up to 37%).
The argument for capital gains treatment is that carry represents a return on the GP's invested capital and risk. The argument against is that carry is fundamentally compensation for services (the GP's work in sourcing, managing, and exiting investments) and should be taxed like any other income from labor.
In 2017, the Tax Cuts and Jobs Act added a three-year holding period requirement: to qualify for long-term capital gains treatment, the underlying investment must be held for at least three years (rather than the standard one year). Since most PE investments are held for 3-7 years, this requirement has had limited practical impact on buyout funds. However, it affects shorter-duration strategies like certain credit funds or deal-by-deal carry arrangements.
Multiple legislative proposals have sought to tax all or a portion of carried interest as ordinary income. As of 2025, none have passed, but the debate continues with each new administration and tax policy cycle. PE professionals should understand that the current tax treatment is not guaranteed to persist.
Blocker Corporations for Tax-Exempt LPs
Tax-exempt investors (pension funds, endowments, charitable foundations) face a specific problem when investing in PE funds: Unrelated Business Taxable Income (UBTI). When a PE fund uses debt to acquire a portfolio company, the income generated by that company can flow through to LPs as UBTI, which is taxable even for otherwise tax-exempt entities.
The solution is a blocker corporation. The tax-exempt LP invests in the PE fund through a separate C-corporation (the blocker) rather than investing directly. The blocker receives the income, pays corporate tax on it, and distributes the after-tax proceeds to the tax-exempt LP. Because the LP receives dividends from a corporation rather than direct pass-through income, the UBTI issue is eliminated.
Blocker corporations add complexity and cost (entity formation, tax filings, corporate-level tax), but they are standard practice for large tax-exempt LPs. The PE fund's legal counsel typically sets up the blocker structure during fund formation. Foreign LPs also use blocker corporations to manage their U.S. tax exposure, particularly to avoid filing U.S. tax returns and to reduce withholding taxes on certain types of income.
Tax Impact: Asset vs. Stock in a $600M Buyout
A PE fund acquires a manufacturing company for $600 million. The target's existing tax basis in its assets is $150 million. The fund's tax counsel evaluates two structures:
Stock purchase (no step-up): The buyer inherits $150 million of depreciable basis. Remaining D&A deductions are minimal. The fund pays full corporate taxes on the company's operating income throughout the hold period.
Asset purchase (or 338 election with step-up): The buyer steps up the asset basis to $600 million, creating $450 million of incremental depreciable basis. Assuming a blended 15-year amortization and a 25% tax rate, the annual tax savings are approximately $7.5 million ($450M / 15 years x 25%). Over a 5-year hold, that is $37.5 million in cumulative tax savings.
On a $250 million equity check (the rest funded with debt), that $37.5 million in tax savings improves the equity return by roughly 15% (equivalent to a 0.15x MOIC improvement). In competitive auctions, PE firms that can efficiently structure the tax basis step-up can afford to bid higher than buyers who cannot, giving them an edge in winning deals.
Composite example based on typical middle-market manufacturing LBOs
Quiz: Tax Structuring
5 questions · ~3 min