The Step-Up Trade-Off in M&A: Buyers’ Basis vs. Sellers’ Exclusion
by Dan O’Connor, Excendio Advisors
Introduction
In M&A tax structuring, one of the sharpest valuation flashpoints arises from how tax benefits are allocated between buyer and seller. On one side, buyers seek a step-up in asset basis, which generates future deductions and enhances cash flow. On the other side, sellers often qualify for gain exclusions that eliminate or reduce capital gains tax, directly increasing after-tax proceeds.
This tension is most visible in transactions involving Internal Revenue Code §338(h)(10) (buyer step-up) and §1202 (Qualified Small Business Stock exclusion). Each side of the deal table favors a different provision, and the trade-off can shift millions in value. Structuring around this conflict requires careful modeling, negotiation, and sometimes creative sharing mechanisms.
This article breaks down the step-up vs. exclusion trade-off with:
- A side-by-side comparison table
- A $50M modeled case with guardrails
- A cap-binding variant
- Term-sheet–ready gross-up logic
The Competing Tax Benefits
| Feature | Buyer’s Step-Up | Seller’s Exclusion |
| Who benefits? | Buyer | Seller |
| Main effect | Tax basis step-up in assets → larger depreciation/amortization | Federal capital gain exclusion (50–100%) |
| Holding period requirement | None | 5+ years for 100% exclusion (OBBBA tiering allows 50% at 3 yrs, 75% at 4 yrs) |
| Valuation impact | Higher after-tax cash flows | Higher after-tax proceeds |
| Negotiation leverage | Buyer seeks to capture value via price adjustment | Seller resists giving up exclusion |
Case Study: $50 Million Transaction
Facts:
- C-Corp target, stock basis $0, sale price $50M
- Buyer tax rate: 21% federal, 5% state
- Seller qualifies for 100% exclusion
- Step-up election available
Scenario A – Step-up (no gross-up):
- Buyer gains ~$10.5M NPV from increased amortization/depreciation.
- Seller loses exclusion and is taxed on deemed asset sale. This includes capital gain plus depreciation recapture:
- $50M gain × 28.8% composite capital gains rate (20% LTCG + 3.8% NIIT + ~5% state, assuming state conformity) ≈ $14.4M.
- If a portion of the gain is recapture (assume $10M), that portion is taxed at ordinary rates (~37% federal + 5% state = 42%). $10M × 42% = $4.2M.
- Adjusting for capital gain on the balance, blended liability ≈ $12M–$13M.
- Net wedge: Seller down ~$12M, Buyer up $10.5M.
Scenario B – Exclusion honored:
- Seller excludes $50M gain → $0 federal tax.
- Buyer loses step-up, but pays only negotiated stock price.
- Net wedge: Seller up ~$12M relative to Scenario A.
Scenario C – Gross-up with cap:
- Buyer agrees to increase price by up to $10M to compensate seller for lost exclusion.
- If seller’s tax exceeds $10M, seller bears excess.
- Creates balanced sharing of tax benefit.
📌 Note: Tax liabilities vary significantly depending on state conformity and recapture allocations. The numbers here assume a blended 24%–26% effective rate for illustrative purposes. Actual liabilities may be higher where recapture dominates.
Who Pays the Recapture Tax?
In a §338(h)(10) transaction, the seller bears the tax burden on any gain, including depreciation recapture, because the stock sale is treated as if the seller sold the corporation’s assets. The buyer benefits from the step-up in basis, but does not directly pay recapture tax. In contrast, in a §338(g) election (common for foreign subs), the target corporation itself pays the tax, indirectly reducing value to the buyer.
Cap-Binding Variant
A cap-binding clause is one of the most practical tools for breaking deadlock in step-up vs. exclusion negotiations. Without a cap, the buyer risks writing a blank check if the seller’s incremental tax liability exceeds expectations. With a cap:
- The buyer’s liability is capped at a negotiated dollar figure, typically aligned with the buyer’s modeled NPV benefit from the step-up.
- The seller gains predictability — they know that at least part of their forgone exclusion value will be recaptured through a price adjustment.
- The negotiation shifts from an open-ended fight to a bounded sharing of economics, which increases deal certainty.
Practical implications:
- Caps are usually set just below the buyer’s expected step-up value (e.g., $10M cap for $10.5M benefit).
- Caps can be structured as either a flat dollar amount or a percentage of buyer benefit.
- Buyers often tie payment timing to tax realization, while sellers push for immediate gross-up at closing.
The cap-binding approach reduces deal friction, provides a clear economic guardrail, and creates a defensible compromise for both parties to present to boards, ICs, and financing partners.
Term-Sheet–Ready Gross-Up Logic
Gross-up clauses need to be formula-driven and transparent, not vague promises. The standard formula:
Gross-Up Payment = min( Seller’s Incremental Tax from Loss of Exclusion , Negotiated Cap )
Expanded detail:
- Seller’s Incremental Tax is modeled as the difference between the tax with no exclusion vs. tax with exclusion.
- The cap is pre-agreed, often pegged to the buyer’s modeled benefit from the step-up.
- The payment mechanism should specify timing: upfront at closing, deferred, or contingent on buyer tax benefit realization.
Why it matters:
- Board-friendly: Boards and ICs want clarity, not ambiguity. A simple formula de-risks approvals.
- Defensible in diligence: Buyers can show lenders that their liability is capped, protecting debt covenants.
- Negotiating leverage: Sellers can point to the explicit calculation to prove fairness and transparency.
Well-drafted gross-up logic transforms the issue from a zero-sum fight into a quantifiable, negotiable number.
Why This Matters Now
The passage of the One Big Beautiful Bill Act (OBBBA) in 2025 changed the playing field. Its tiered holding periods mean sellers can still qualify for partial exclusions even if they exit earlier than five years. This flexibility raises the stakes in deal negotiations:
- Market Timing: A sale just before the 3-year mark can forfeit the 50% exclusion. A delay of a few months can swing millions in seller proceeds.
- Valuation Leverage: Buyers know sellers are motivated by exclusion deadlines. This can tilt negotiating leverage if one side understands the tax timeline better.
- Competitive Dynamics: Strategic buyers vs. PE firms may value the step-up differently, making competitive bidding processes more sensitive to tax structuring.
- Cash Flow vs. Liquidity: Buyers value future tax shields; sellers value immediate liquidity. Timing pressures under OBBBA sharpen this contrast.
Quick Comparison — Step-Up vs. Exclusion
| Item | Buyer’s Step-Up | Seller’s Exclusion |
| Federal Impact | Creates future tax deductions | Eliminates/reduces capital gains tax |
| Value Realization | Spread over years via amortization | Immediate at exit |
| Cash Flow Timing | Future benefit | Immediate benefit |
| Risk Profile | Sensitive to tax law changes, discounting | Sensitive to holding period qualification |
| Net Effect | Higher enterprise value for buyer | Higher after-tax liquidity for seller |
Why This Matters for Founders & Owners
For founders and owners, the step-up vs. exclusion decision goes beyond tax mechanics:
- Wealth Outcomes: The swing between keeping $50M tax-free or losing $12M+ to taxes is transformative. It affects liquidity, reinvestment capacity, and generational wealth planning.
- Negotiating Leverage: A founder who can credibly demonstrate QSBS eligibility has stronger deal leverage. Buyers know they must compensate sellers meaningfully to override the exclusion.
- Timing Strategy: Liquidity events must be timed against OBBBA’s holding thresholds (3, 4, and 5 years). Delaying a sale by months can add millions in savings, which directly influences deal strategy.
- Governance Signal: Proactively documenting QSBS eligibility and modeling trade-offs signals operational discipline. Buyers interpret this as a readiness marker, which can smooth diligence and even support higher valuations.
In short, for founders and owners, this trade-off is not about obscure tax law — it’s about control over wealth outcomes and bargaining power.
Example Impact – $50M Exit
Expanding the scenarios:
| Scenario | Seller After-Tax Proceeds | Buyer NPV Benefit | Strategic Outcome |
| Step-Up, No Gross-Up | $37M–$38M (depending on recapture mix) | $10.5M | Buyer capture; seller resentment; potential deal friction |
| Exclusion Honored | $50M | $0 | Seller maximizes outcome; buyer loses incentive to pursue step-up |
| Step-Up with $10M Cap Gross-Up | $40M–$48M (depending on tax) | ~$0.5M–$2.5M | Balanced sharing; deal proceeds smoothly |
Insight: The range of outcomes shows why clear modeling is essential. A cap/gross-up framework can close the gap enough to align incentives and avoid broken negotiations.
Negotiating Strategy
- Model First, Negotiate Second: Both sides should model the NPV of benefits under multiple scenarios before setting positions. Anchoring the discussion in numbers reduces emotional deadlock.
- Leverage Deadlines: Sellers should use OBBBA timelines to pressure for faster closings when they are within reach of a holding threshold. Buyers should recognize this urgency and demand price concessions in return.
- Use Caps to Build Trust: Buyers can offer capped gross-ups as a sign of goodwill. Sellers can accept caps to avoid appearing unreasonable. This middle ground often keeps deals alive.
- Document Eligibility: Sellers should provide documentation of QSBS eligibility upfront. This strengthens negotiating leverage and reduces buyer skepticism.
- Board-Friendly Framing: Present options in a simple table showing buyer/seller economics under each structure. Decision-makers prefer clarity over tax jargon.
Call to Action
The step-up vs. exclusion trade-off is not a technical footnote — it is a central driver of M&A value allocation. Founders, owners, and boards should:
- Model the buyer and seller economics under multiple scenarios.
- Anticipate how OBBBA’s tiered exclusions interact with exit timing.
- Negotiate cap-binding or gross-up provisions to share value fairly.
👉 Connect with Excendio for a strategic conversation. We help founders, owners, and boards frame these trade-offs, sharpen negotiating positions, and avoid leaving millions on the table in M&A structuring.