Editor: Frank J. O’Connell Jr., CPA, Esq.
Corporations & Shareholders
On May 10, 2013, the IRS issued final regulations (T.D. 9619) under Sec. 336(e) allowing a domestic corporation (S) to make an irrevocable unilateral election to treat the sale, exchange, or distribution of a domestic corporation’s (T’s) stock meeting the 80% vote and value requirements of Sec. 1504(a)(2) within a 12-month disposition period (a qualified stock disposition, or QSD) as a deemed sale of T’s underlying assets. The election provides relief from potential multiple levels of taxation at the corporate level by providing a corresponding basis step-up of T’s assets.
Similar to the Sec. 338 election, the Sec. 336(e) election can be advantageous when S’s basis in the T stock is lower than T’s basis in its underlying assets. However, unlike Sec. 338, which requires a corporate purchaser, the Sec. 336(e) election is available for stock transfers to noncorporate purchasers. The Sec. 336(e) election is available to both domestic C corporation and S corporation shareholders for qualifying transactions occurring on or after May 15, 2013.
Sec. 336(e) was enacted as part of the repeal of the General Utilities doctrine in 1986 (see General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935)) to authorize the issuance of regulations that, under certain circumstances, would allow an election to treat the disposition of a corporation’s stock meeting the 80% vote and value requirements as a deemed sale of all of its underlying assets. The IRS and Treasury issued proposed regulations under Sec. 336(e) in 2008 (REG-143544-04), which were modified in the final regulations.
The Sec. 336(e) election generally is comparable to the election under Sec. 338(h)(10) for purchases of T stock. However, unlike a transaction qualifying for the Sec. 338(h)(10) election, the Sec. 336(e) election is also available for the sale of T’s stock to noncorporate purchasers, including individuals, private-equity funds, and partnerships. The election also is available even if there is not a sale or exchange. For example, the Sec. 336(e) election is available for a distribution by S of T stock to S’s shareholders.
Also, unlike Sec. 338(h)(10), the disposition of T stock can be made to a number of purchasers aggregated over 12 months to determine qualification for the election instead of a disposition to a single purchasing corporation. However, T stock sold, exchanged, or distributed to a related person, as determined under the principles of Sec. 338(h)(3)(C) and Regs. Sec. 1.338-3(b)(3), is not counted as a disposition. Also, a transaction that qualifies both as a QSD and as a qualified stock purchase (QSP) as defined under Sec. 338(d)(3) is not treated as a QSD. Furthermore, the final regulations do not permit an election in a nontaxable transfer of T stock under Secs. 351, 354, 355 (other than Secs. 355(d)(2) and (e)(2)), or 356, or in a transaction where S or T is a foreign corporation.
The overall tax effect to all parties of a QSD with a Sec. 336(e) election depends on whether: (1) the stock of T is sold or exchanged, (2) S distributes T stock to which Sec. 355 doesn’t otherwise apply, or (3) S distributes T’s stock to its shareholders in a Sec. 355(d)(2) or (e)(2) transaction. Additionally, S needs to understand the overall federal income tax effect in the situation where its basis in T is different from T’s inside basis in its underlying assets.
Sale or Exchange of Target
In general, in a sale or exchange transaction, “old” T is treated as selling all of its assets to an unrelated person while owned by S, and “new” T is treated as acquiring all of the assets from an unrelated person in exchange for the aggregate deemed asset disposition price (ADADP) on the close of the disposition date. ADADP is the sum of the grossed-up amount realized on the disposition plus the liabilities of old T. The disposition date is the first day on which there is a QSD of T. ADADP is allocated among T’s assets in the same manner as the aggregate deemed sales price is allocated under Regs. Sec. 1.338-6 to determine the amount for which assets are deemed to have been sold. Similar to an election under Sec. 338(h)(10), old T recognizes the federal income tax consequences from the deemed asset disposition before the close of the date of the QSD. Subsequently, on that date, old T is then deemed to have liquidated into S, generally in a complete liquidation to which Secs. 332 and 336 or 337 apply. The purchaser is treated as acquiring new T stock for the value of the consideration exchanged. Any losses of old T can be used to offset the gain, if applicable, on the deemed asset disposition, and any remaining attributes of old T, including excess losses, carry over to S under Sec. 381.
In a sale or exchange transaction, if S’s basis in T’s stock is less than T’s basis in its assets, S obtains a tax benefit for making the Sec. 336(e) election. Additionally, the basis of new T’s assets is stepped up for the gain recognized, providing the purchaser with a benefit.
Example 1: A owns all of S’s stock. S owns all of T’s stock with a $7,000 adjusted basis and has earnings and profits (E&P) of $11,000. T’s assets have an adjusted basis of $8,000 and fair market value (FMV) of $10,000. T does not have any liabilities. S sells all of T’s stock to an unrelated partnership, P, for $10,000 in a single transaction, distributes $6,500 of the proceeds to A, and makes the Sec. 336(e) election.
The sale of T’s stock is a QSD. Old T is deemed to sell its assets to new T with an ADADP of $10,000, resulting in a $2,000 gain to old T. Immediately thereafter, old T is treated as liquidating into S under Sec. 332, resulting in no gain to S. S’s $6,500 distribution to A is taxable as a dividend because sufficient E&P exists. P’s basis in new T’s stock is $10,000. New T’s basis in its assets is $10,000. If S does not make the Sec. 336(e) election, S’s gain on the sale of T stock would be $3,000 instead of $2,000, and new T’s basis in its assets would be $8,000 instead of $10,000.
On the other hand, if S’s basis in T’s stock in the above example is $8,000 and T’s basis in its underlying assets is $7,000, a Sec. 336(e) election would result in a $3,000 gain to T. If S does not make the election, S’s gain on the sale of T stock is only $2,000. Accordingly, the election is not always beneficial to S.
The overall federal income tax effect to all parties if S makes the Sec. 336(e) election is the same as T’s selling its assets to a purchaser, T’s liquidating into S under Sec. 332, and then T’s distributing $6,500 of the proceeds to S’s shareholders. However, asset transactions are generally more expensive, time-consuming, and cumbersome to complete than stock transactions, for a number of reasons including retitling assets, obtaining specific consents, etc. The flexibility of S’s being able to make the election when the sale or exchange is to a noncorporate buyer not qualifying for the Sec. 338(h)(10) election could prove beneficial in negotiating and structuring a transaction that qualifies as a QSD. Furthermore, as the Sec. 336(e) election is unilaterally made by S, a purchaser must ensure that the purchase agreement contains the necessary provisions either requiring S to timely make the election or precluding it from doing so.
Distribution of Target Stock
Perhaps the most common disposition for which a Sec. 336(e) election would be made to prevent potential multiple levels of taxation is a distribution of T’s appreciated stock to S’s shareholders. The overall deemed steps of the transaction are similar to those of a sale or exchange; however, a significant difference is that any realized losses in excess of realized gains from T’s deemed asset disposition are permanently disallowed.
Example 2: A owns all of S’s stock. S owns all of T’s stock with a $7,000 adjusted basis and has E&P of $11,000. T’s assets have an adjusted basis of $8,000 and FMV of $10,000. T does not have any liabilities. S distributes all of T’s stock to A in a single transaction that is not described in Sec. 355 and makes the Sec. 336(e) election.
The distribution of T’s stock is a QSD. Old T is deemed to sell its assets to new T, which is treated as an unrelated person, at the close of the disposition date for the ADADP of $10,000, resulting in a $2,000 gain to old T. S is treated as acquiring new T stock immediately thereafter for $10,000. Old T is treated as liquidating into S under Sec. 332, resulting in no gain or loss to S. New T’s basis in its assets is $10,000. S does not have a gain on the $10,000 stock distribution to A, which is fully taxable to A as a dividend because sufficient E&P exists. A’s basis in T’s stock is $10,000 under Sec. 301(d). If S does not make the Sec. 336(e) election, S has a $3,000 gain under Sec. 311(b), A has $10,000 of dividend income, and A’s basis in T’s stock is $10,000 under Sec. 301(d). However, T does not step up the inside basis in its assets for the deemed asset sale. Accordingly, if T later sells its assets for $10,000 while owned by A, T will recognize another $2,000 of gain.
The final regulations allow S to make the Sec. 336(e) election in a disposition under Secs. 355(d)(2) and (e)(2), which is referred to as the “sale-to-self model.” The election limits the taxation of the transaction to two levels instead of three, which is consistent with the repeal of the General Utilities doctrine.
Sec. 355(d)(2) describes what is otherwise a Sec. 355 transaction in which there is a corporate level of tax for a disqualified distribution. In general, if immediately after the corporate distribution any person holds disqualified stock, which is stock that is purchased within five years of the distribution and that represents a 50%-or-greater interest in such corporation, the corporation has a disqualified distribution. Sec. 355(e)(2) applies a corporate-level tax to any distribution that is part of a plan (or series of related transactions) by which one or more persons acquire, directly or indirectly, stock representing a 50%-or-greater interest in the distributing or any controlled corporation.
Under the sale-to-self model, old T is treated as if it sold its assets to an unrelated person and then repurchased those assets. Old T is not deemed to liquidate into S. After old T is deemed to reacquire its assets from the unrelated person, S is treated as distributing the stock of old T to its shareholders. S does not recognize any gain or loss on the distribution. Old T generally retains the tax attributes, after any adjustments for the transaction, it would have had if the election had not been made.
Loss Disallowance Rule
The final regulations modify from the proposed regulations a disallowed loss rule pertaining to a distribution of T stock. Under the final regulations, if S has a distribution of T stock that is a QSD or part of a QSD and makes the election under Sec. 336(e), S can generally offset T’s realized losses from the deemed asset disposition against T’s realized gains. However, any excess losses of T are permanently disallowed. In determining the disallowed loss, S takes into account any stock of T distributed during the 12-month disposition period, whether it is or is not part of a QSD.
As previously discussed, the final regulations stipulate that in transactions where there is both a QSD and a QSP, the QSP rules under Sec. 338 and the corresponding regulations are used to determine the tax effect of the transaction. In a situation where T is part of a tiered structure and owns the stock of a subsidiary, and the stock of T is sold to a noncorporate domestic purchaser, under the final regulations, the deemed sale of old T subsidiary to new T is also a QSP, since new T is a corporate entity. Accordingly, S cannot make the election under Sec. 336(e), since the overlap rules stipulate that the tax treatment of a QSP trumps that of a QSD. The IRS and Treasury addressed the unintended consequences of the overlap rule to such a tiered structure and provided an exception under Regs. Sec. 1.336-1(b)(6)(ii)(B) that allows S to treat the sale of old T and the deemed sale of old T subsidiary to new T as a QSD, even though it is also a QSP.
Making the Election
The irrevocable unilateral election under the final regulations is made by S for transactions occurring on or after May 15, 2013. To make the election for a distribution, the final regulations require S and T to enter into a written binding agreement on or before the due date, including extensions, of the group’s consolidated federal income tax return for the tax year that includes the disposition date; S must attach the election statement to the relevant return.
In dispositions where T is an S corporation, all of its shareholders must also make the election, whether or not they are selling their stock, for the election to be effective.
The final regulations provide that the Sec. 336(e) election statement must be titled, “This is an election under Section 336(e) to treat the disposition of the stock of [insert name and employer identification number of T] as a deemed sale of such corporation’s assets.” The election statement must also include the information described in Regs. Sec. 1.336-2(h)(6).
Old T and new T also must report information to the IRS related to the deemed sale of T’s assets. The IRS intends to modify Form 8883, Asset Allocation Statement Under Section 338, or create a new form for the election. Until Form 8883 is modified or a new form is created, old T and new T should file Form 8883 for the deemed asset disposition and make the necessary adjustments to the form to properly reflect the transaction.
Inasmuch as the election is unilateral, if S sells or exchanges T stock to a purchaser in a QSD and the purchaser requires S to make the Sec. 336(e) election or prohibits it from doing so, it is imperative that the purchaser ensures that the purchase agreement contains the necessary requirements for S to timely make the election and attach it to its relevant federal income tax return or stipulates that S will not make the election.
Final regulations under Sec. 336(e) allow certain domestic corporations, for QSDs occurring on or after May 15, 2013, to make an election to treat a sale, exchange, or distribution of T’s stock as a deemed sale of T’s assets. The election provides relief from the potential multiple levels of taxation on the distribution of built-in gain T stock to S’s shareholders by providing a corresponding basis step-up of T’s assets. Additionally, the same benefits of making a Sec. 338(h)(10) election are available in a sale or exchange of T stock to a noncorporate purchaser. However, the Sec. 336(e) election is generally advantageous only when S’s basis in T’s stock is lower than T’s basis in its underlying assets. The regulations also allow the election to apply in transactions described in Secs. 355(d)(2) and (e)(2) that otherwise would result in three levels of taxation.
Frank J. O’Connell Jr. is a partner with Crowe Horwath LLP in Oak Brook, Ill.
For additional information about these items, contact Mr. O’Connell at 630-574-1619 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.