Maintaining Single Taxation: Sec. 336(e) and S Corporations 

    S CORPORATIONS 
    by Edward J. Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D. 
    Published March 01, 2014

     

    EXECUTIVE
    SUMMARY

     
    • Photo by Kenneth Mellott/iStock/ThinkstockFinal regulations under Sec. 336(e) provide guidance, including special rules for S corporations and their shareholders, for making an election to treat a sale or disposition, including a distribution of control of a corporation’s stock of a qualified subsidiary, as a disposition of all the subsidiary’s assets.
    • As in the case of a sale for which a Sec. 338(h)(10) election has been made, the seller recognizes gain on the deemed sale of the subsidiary’s assets. The purchaser receives a step-up in basis of the target corporation’s assets.
    • For S corporation shareholders, the Sec. 336(e) election will not change the amount of gain recognized from the sale but may cause a significant amount of the gain to be treated as ordinary income instead of capital gains.
    • An S corporation can make the Sec. 336(e) election for a sale of a subsidiary, including a qualified subchapter S subsidiary (QSub).
    • A number of questions remain regarding the Sec. 336(e) election, including who should make the election in the case of multiple dispositions that together qualify for the election.

    In May 2013 Treasury issued final regulations under Sec. 336(e).1 This Code subsection allows taxpayers to elect to treat a corporation’s sale of at least 80% of its stock in a subsidiary as a sale of the subsidiary’s assets, with a result comparable to a Sec. 338(h)(10) election.

    Secs. 336(e) and 338(h)(10) both allow taxpayers to elect to treat the sale of a subsidiary’s stock as the sale by the subsidiary of its assets followed by a liquidation of the subsidiary. The major difference between these sections is that Sec. 338(h)(10) requires the stock sale to be to another corporation, while Sec. 336(e) does not restrict the entity of the purchaser. These new regulations should assist both small corporations and publicly traded corporations that wish to sell their subsidiaries by way of an initial public offering (IPO).2 The regulations include in the definition of an eligible transaction a taxable distribution of the stock, in addition to taxable stock sales.

    The major advantage of the Sec. 338 election is that the target corporation’s assets are restated to market value without an actual sale of the assets. Moreover, the price of the stock is enhanced because of the tax benefits the purchaser receives from the stepped-up basis in the corporation’s assets.

    In their proposed form,3 the Sec. 336(e) regulations did not include S corporation shareholder sales. Commenters on the proposed regulations asked Treasury to consider expanding the rules to include S corporation stock sales, since they are eligible under Sec. 338(h)(10). Accordingly, Treasury decided to allow S corporation stock sales to come under Sec. 336(e) so that the coverage would be consistent with Sec. 338(h)(10). The final regulations apply to qualified stock dispositions on or after May 15, 2013.

    Sec. 336(e): General Rules

    Sec. 336(e) covers the taxable disposition of a qualified subsidiary by sale, exchange, or distribution.4 It does not cover the transfer of a subsidiary in a nontaxable transaction covered by Secs. 351, 354, and 355. A qualified subsidiary is one whose ownership meets the requirements of Sec. 1504(a)(2), specifically, 80% of the subsidiary’s stock’s voting power and total value. As the rules are applied to an S corporation, the shareholders must sell at least 80% of the corporation’s outstanding stock. In addition, the subsidiary must be a domestic corporation. To match the Sec. 338(h)(10) requirement that both the buyer and seller must make the election, the Sec. 336(e) regulations require a binding written agreement that a Sec. 336(e) election will be made.5

    The subsidiary (target) whose stock is sold is treated as if it had sold all of its assets to a new corporation for the aggregate deemed asset disposition price (ADADP).6 The ADADP equals the grossed-up purchase price of recently purchased stock (or the fair market value (FMV) of recently distributed stock) minus selling costs of the seller, plus the liabilities of the target.7 The liabilities of the target include the tax liability from the deemed asset sale.8 If the stock is sold, then the ADADP equals the aggregate deemed sale price (ADSP) under Sec. 338.9 If the stock is distributed, then the ADADP equals the FMV of the distributed stock, since no sale price exists.

    Unlike Sec. 338(h)(10), which applies only to sales and exchanges, Sec. 336(e) also applies to distributions (dividends) of the subsidiary’s stock.10 In the proposed regulations under Sec. 336(e), Treasury decided to impose the equivalent of Sec. 311 on distribution transactions. Under the proposed rule, all the gains from the deemed sale of appreciated assets were to be recognized, while none of the deemed losses from the sale of depreciated assets were recognized. Commenters requested that Treasury reconsider this decision. In the final regulations, Treasury allowed deemed losses to offset deemed gains in these transactions. If the sum of all the gains and losses results in a net loss, the net loss is nonrecognizable, maintaining Sec. 311 on distribution transactions.

    As in Sec. 338, the acquired subsidiary is treated as a new corporation immediately after the stock disposition. This new corporation is treated as having purchased its assets for adjusted grossed-up basis (AGUB ).11 AGUB is defined in Regs. Sec. 1.338-5 generally as the grossed-up basis of the recently purchased stock plus the basis of the nonrecently purchased stock owned by the acquirer, plus liabilities. AGUB is allocated to the individual assets under the residual method in Regs. Sec. 1.338-6. The basic result of a Sec. 338(h)(10) or Sec. 336(e) election is to allow the purchaser of a corporation to write up the basis of the corporation’s assets to the amount paid for the target’s stock, thereby avoiding the double taxation of a straight stock purchase.

    Following the deemed sale by the target of all its assets, the target is deemed to have liquidated. In most cases, the liquidation comes under Secs. 332 and 337 and is therefore nontaxable. If the deemed liquidation does not meet the requirements of Secs. 332 and 337, it is treated as a taxable liquidation under Secs. 331 and 336.

    S Corporations

    Under the final regulations, if the shareholders of an S corporation sell control of the corporation (stock meeting the requirements of Sec. 1504(a)(2)), they can make a Sec. 336(e) election. The general rules in the regulations are applied with specific modifications.

    If the election is made, the S corporation (target) is treated as having sold all its assets. The regulations specifically state that the S corporation election will continue to the end of the day of the deemed asset sale.12

    The deemed asset sale price by the S corporation is the ADADP amount. As previously mentioned, this amount includes the corporation’s liabilities. These liabilities are increased by the tax liability on the deemed asset sale by a C corporation. Since S corporations do not pay tax, as a general rule, the computation of the ADADP does not include an adjustment for the tax liability. There are two potential modifications to the ADADP for S corporation taxes. If the S corporation was a C corporation that used the LIFO method at the time of the conversion, the corporation has to pay tax on the LIFO recapture.13 This tax is paid in four installments. If the installments have not all been paid at the time of the sale, the remaining installments are corporate liabilities that increase the ADADP.

    A more important potential adjustment is in Sec. 1374. Again, if the S corporation was a C corporation previously, the built-in gains at conversion that are recognized during the recognition period are subject to a corporate-level tax. If the stock sale occurs during the recognition period, the deemed asset sales generate taxable built-in gains. The tax liability is a corporate liability. Therefore, the ADADP is increased by this tax liability. If the corporation owns assets that have declined in value and/or has a net operating loss carryforward, the amount of tax due on the built-in gains from these deemed asset sales may not be equal to the net gain times the highest corporate tax rate.

    The gains and losses from the deemed asset sales by an S corporation (modified by the built-in gains tax) pass through and are recognized by the shareholders. The fact that a shareholder did not sell his or her stock is immaterial. All the shareholders recognize their share of the gains and losses. The fact that all the shareholders, including those that did not sell stock, must approve the Sec. 336(e) election is reasonable and prevents a tax burden from being assessed on a nonparticipating shareholder.

    After recognizing the gains and losses, the shareholders adjust their basis in the S corporation stock they owned before the sale by the amount apportioned to them. They increase basis by apportioned gains and income and reduce basis by deductions and losses.14 Some shareholders may not have sold their stock, and others may have sold only a portion of their stock. Shareholders who retain stock treat it as if purchased from an unrelated third party for its FMV.15 This is likely to change the basis of these shares from the adjusted basis discussed above. The holding period starts on the day after the deemed liquidation. The FMV of the retained shares is determined by the grossed-up amount deemed realized on the asset sale.

    The impact of a Sec. 336(e) election on an S shareholder who did not sell any stock is significantly different from that of a minority shareholder of a C corporation that did not sell any stock. The minority shareholder of a C corporation does not report any income as a result of the election and has the same basis in the unsold stock that he or she had before the qualified sale and election. The S shareholder who did not sell any stock reports the full amount of gain that he or she would have reported if the shareholder had sold the stock. The shareholder adjusts the basis of the retained stock to its FMV. The total amount of reported income is partly from the deemed asset sale and partly from the deemed distribution in liquidation. It is because these shareholders report the full amount of income (deemed sale and deemed liquidation) that they are permitted to change the basis of the retained stock to its FMV. This prevents double taxation in the future.16

    Immediately following the deemed asset sale, the S corporation is treated as having distributed the amount received from the asset sale to the shareholders, followed by a termination of the S election. In most cases, this distribution is considered a distribution in liquidation of the corporation, although the regulation states it may be treated as a redemption or reorganization.17 Since the shareholders of an S corporation are individuals or trusts, Sec. 331, not Sec. 332, governs the liquidation. The shareholders are likely to recognize a gain or loss as a result of this deemed liquidation, affecting their tax liability. The application of Sec. 331 and not Sec. 332 is a major difference under Sec. 336(e) for S corporation shareholders that make the election, compared with C corporations that make the election for the sale of a subsidiary.

    The sold S corporation is treated as a new corporation that has acquired its assets for an amount equal to AGUB. If the new corporation qualifies, an S election can be made for it. The election applies starting on the corporation’s first day; therefore, issues related to C corporations that have made S elections, such as a built-in gains tax or termination of the election, will not apply.

    Numerical Examples

    The effect of the Sec. 336(e) election is best discussed by using numerical examples. The effect of the increased sale price generated by the tax savings is discussed after the initial examples.

    Example 1: A, an individual, purchases a nondepreciable asset. The total cost is $110, paid with $100 cash and a $10 liability. A transfers the asset and liability to a new corporation, S, for 100% of S stock. A makes an S election for the corporation. A’s basis in the stock is $100 ($110 asset basis minus $10 liability transferred to the corporation). The corporation has a basis in the asset of $110 and a $10 liability. Assume S breaks even for a number of years, and the asset increases in value to $150. U wants to purchase the stock of S for $140.

    If A sells the stock, A will recognize a capital gain of $40. If A and U make a Sec. 336(e) election for the stock sale, S is treated as having sold its asset for $150 ($140 stock purchase price + $10 liability). S recognizes $40 income. The $40 income will be reported by A, increasing A’s basis in the S stock to $140. When S is deemed to liquidate, it will be deemed to have distributed the $140 cash it is deemed to have received in the asset sale. Because S is deemed to have distributed cash in the liquidation, it recognizes no gain or loss. A also recognizes no gain or loss on the liquidation, since she is deemed to have received cash equal to her stock basis ($140 received – $140 basis).

    Therefore, whether or not A makes the election, she reports $40 gain. If the gain is from a stock sale, it is a capital gain. If it is the result of a Sec. 336(e) election, the character of the gain is determined by the types of assets sold by the S corporation and the allocation of the purchase price among the assets. Because most S corporations typically have limited capital assets, a significant portion of the gain will usually be treated as ordinary income.

    Example 2: Assume the same basic facts as in Example 1, except A’s basis in the S stock is $80. If the stock is sold, A will recognize a $60 capital gain. If a Sec. 336(e) election is made, S will realize $40 ordinary income from the deemed asset sale, which A will recognize. This will increase A’s basis to $120, so when the deemed liquidation occurs, A will report $20 capital gain ($140 received – $120 basis). Again, A reports the same amount of income. The difference is that under Sec. 336(e), $40 is ordinary income and $20 is capital gain, while without the election, the $60 is all capital gain.

    Example 3: Assume the same facts as in Example 1, except A’s basis in the S stock is $125. When the stock is sold for $140, A has a $15 capital gain. If a Sec. 336(e) election is made, S again realizes $40 of income from the deemed asset sale, which A recognizes and which increases the basis of A’s stock to $165. When S is deemed to liquidate, A will be treated as receiving $140, resulting in a $25 capital loss. A’s total income is still $15, but this time it is $40 ordinary income and $25 capital loss.

    Reviewing the three examples, it is evident that when the shareholders of an S corporation sell the corporation, whether or not they make a Sec. 336(e) election, they report the same amount of income. It is the classification of the income that is different. The election can convert some or all of the capital gain into ordinary income if the shareholder’s outside basis equals or is less than the corporation’s net inside basis (asset basis minus liabilities). If the outside basis exceeds the net inside basis, the shareholders report a capital loss to offset the extra ordinary income realized by the corporation on the deemed asset sale and recognized by the shareholder. Although the total net income reported by the shareholder is the same, the classification can greatly affect the shareholder’s tax liability.

    The purchaser benefits from the Sec. 336(e) election by increasing the inside asset basis, assuming the assets have appreciated. In these cases, the election will make sense only if the reduction in the purchaser’s future tax liability (adjusted for the time value of money) exceeds the increased tax liability of the seller from the change in the character of the income. This usually requires an adjustment to the stock sale price. Given the basis increase in the assets following the stock purchase, the seller may be able to negotiate an increase in the stock sale price, offsetting any tax increase and allowing for a Sec. 336(e) election.

    The increase in the sale price affects both the buyer and the seller. From the seller’s prospective, the increased sale price is deemed received from the sale of goodwill or going concern. The S corporation reports a capital gain from this sale, which is passed through to the shareholder. Again, the total income reported by the seller does not change. From the buyer’s perspective, the increased sale price is assigned to goodwill, a Sec. 197 asset. This amount is amortized over 15 years. The amortization reduces the negative effect of the increased purchase price.

    If the corporation’s assets have decreased in value while the seller has owned the stock, the amount of loss to be reported by the seller is still the same with or without the election. In these cases, the seller benefits by converting the capital loss from the stock sale into ordinary loss from the deemed asset sale. The buyer has reduced asset basis, which reduces the loss to be reported on future asset sales or the depreciation deductions. This basis reduction may have a limited negative tax effect on the buyer if the built-in loss is large enough for Sec. 382 to apply following the ownership change.18 In these cases, the Sec. 336(e) election generally reduces the buyer’s and seller’s overall tax liability and should be elected if the benefit can be reasonably negotiated into the stock price.

    One additional question that may arise is the effect of the Sec. 336(e) election on the sale of stock by a shareholder who has a Sec. 1366 disallowed loss carryover. The simple answer is that the only effect is on classification.

    Example 4: A owns stock in corporation S with a zero basis and a $100 disallowed loss carryover. S owns an asset with a zero basis and an FMV of $300. It also has a $100 liability. If A sells the stock to U for $200, A will recognize a capital gain of $200 and the disallowed loss will disappear. If a Sec. 336(e) election is made, then S will realize $300 of income on the deemed asset sale. The deemed sale price is $300 ($200 cash + $100 liabilities). Since the asset basis is zero, all $300 of the deemed sale price is realized income. A recognizes the $300 income and is allowed to deduct the $100 loss carryover. A then has a basis in the stock of $200, resulting in no gain or loss on the deemed liquidation. The bottom line is that A reports net income of $200 with or without the election. Without the election, the $200 is a capital gain, and with it, the $200 is likely to be ordinary income. The result is that Sec. 336(e) does not assist shareholders with loss carryforwards.

    Subsidiaries

    It is possible for an S corporation to own a subsidiary corporation that is not a qualified subchapter S subsidiary (QSub), either because it owns less than 100% of the subsidiary’s stock or because it chose not to make the election. If the S corporation sells the subsidiary stock, it recognizes a capital gain or loss. It is possible for the S corporation to make a Sec. 336(e) election.19 If it does, the actual stock sale is replaced by the deemed transactions that occur when a corporation disposes of a subsidiary and makes the Sec. 336(e) election. Specifically, the subsidiary is treated as having sold its assets for the ADADP. In calculating the ADADP, the corporation must add the tax liability from the deemed asset sale to the subsidiary’s liabilities, since the tax liability remains with the subsidiary. Following the deemed asset sale, the subsidiary is deemed to have liquidated. The transaction is governed by Secs. 332 and 337, resulting in no gain or loss being recognized.20

    Since an S corporation is not an includible corporation, the S corporation and the subsidiary cannot file a consolidated return. The Sec. 336(e) election will result in the S corporation’s recognizing no income or loss from the sale of the subsidiary. Instead, the “new” corporation is responsible for paying the tax on the deemed asset sale and receives a basis step-up. Although the future tax benefit from the basis step-up may numerically offset the current tax liability, the time value of money makes them unequal. Therefore, a purchaser will not agree to a Sec. 336(e) election unless the purchase price is adjusted for the negative tax result arising from the deemed asset sale.

    Instead of selling the subsidiary stock, the S corporation may distribute the stock to its shareholders. This may be a beneficial transaction, especially if the shareholders plan to make an S election for the distributed corporation. If the stock is distributed without the Sec. 336(e) election, the distribution will come under Sec. 311 at the S corporation level. The S corporation will recognize gain equal to the excess of the value of the distributed stock over its basis. A loss is not recognized. This gain is allocated to the S corporation shareholders and reported on their tax returns and then added to the shareholders’ basis in the S corporation stock. The receipt of the stock is nontaxable at the shareholder level, provided the S corporation has a sufficient accumulated adjustments account (AAA) and the recipient’s basis in the S corporation stock exceeds the value of the stock received. If the basis of the S corporation stock is less than the value of the subsidiary stock distributed, the recipient will recognize a capital gain equal to the value of the distributed stock minus the basis in the S corporation stock.

    If a Sec. 336(e) election is made, a different outcome occurs. First, the subsidiary is deemed to have sold its assets for the ADADP. If these sales result in a net gain, the gain is recognized at the subsidiary level, and the subsidiary will pay tax on the net gain. Since the subsidiary will be paying tax, the ADADP will be increased by the tax liability. If the deemed asset sale generates a net loss, the loss is not recognized. The nonrecognition of the loss is designed to mirror the taxation under Sec. 311 on asset distributions. Following the deemed asset sale, the subsidiary is deemed to have liquidated by distributing the proceeds from the asset sale to its shareholder, the S corporation. The subsidiary’s liquidation is taxed under Secs. 332 and 337. Therefore, neither the subsidiary nor the S corporation recognizes any gain or loss.

    Following this deemed liquidation, the S corporation is treated as having purchased stock in the new corporation for its FMV.21 It is then treated as distributing this newly acquired stock to its shareholder. Since the stock was acquired for FMV, no gain or loss is realized or recognized by the S corporation. The shareholder reports this distribution under the general S corporation rules for property distributions discussed above. The Sec. 336(e) election appears to be very beneficial.

    QSubs

    An S corporation can obtain a QSub either by creating it under Sec. 351 or by purchasing the stock. In either case, the subsidiary is deemed to have liquidated and transferred its assets to its parent corporation following the QSub election. The liquidation is nontaxable under Sec. 332. The basis of the QSub stock disappears. Following the QSub election, the shareholders of the S corporation can sell the stock of the S corporation, or the S corporation can sell the stock of the QSub.

    If the S corporation’s shareholders sell their stock and make a Sec. 336(e) election, the final regulations issued in May 2013 state that the QSub election continues until the end of the day that includes the deemed transactions.22 Effectively, a QSub is treated as a disregarded entity, with the S corporation owning its assets. As a result, the S corporation is treated as selling the QSub assets and not the QSub stock, in addition to the sale of the other assets owned by the S corporation. The gains and losses from the deemed asset sales are recognized. The purchaser is treated as acquiring the stock of a new corporation that purchased all the assets. The purchaser, if qualified, can make an S election and a QSub election. If the purchaser does not make an S or QSub election, the purchased (new) corporation is deemed to have contributed the assets owned by the subsidiary to the subsidiary for the subsidiary’s stock. The subsidiary’s asset basis is the AGUB amount, which also is the basis of the subsidiary’s stock owned by the purchased corporation.

    If the S corporation sells the QSub stock, according to Sec. 1361(b)(3)(C)(ii), the stock sale is disregarded and the corporation is deemed to have sold a portion of the assets equal to the percentage of the QSub stock sold, followed by a transfer of the assets by the S corporation and the purchaser into a new corporation under Sec. 351. Since the Code reclassifies the transaction as an asset sale, a Sec. 336(e) election should not be available.23 The S corporation will recognize gains and losses on the deemed asset sale. The basis of the assets in the new corporation is the deemed purchase price of the assets by the purchaser, plus a carryover basis of the original asset basis multiplied by the percentage of the subsidiary stock still owned by the S corporation. In other words, a percentage of the gains and losses will be recognized and a basis adjustment equal to the gains and losses recognized will occur. If the Code allowed the stock sale to be treated as eligible for a Sec. 336(e) election, then 100% of the gains and losses would be recognized and the asset basis would be adjusted to equal AGUB, even if the S corporation retained some shares.

    The S corporation regulations adopted by Treasury in 200024 produce a different result. In Example 1 of Regs. Sec. 1.1361-5(b)(3), an S corporation sells 21% of the stock of a QSub. The S corporation is treated as having transferred all the QSub’s assets to a new corporation, followed by the sale of 21% of the new corporation’s stock. Since the stock sale is prearranged, it causes the S corporation to not meet the control requirements of Sec. 351. Therefore, the S corporation is deemed to have sold the assets to the new corporation. All assets that have an FMV greater than their basis will produce gains that are recognized. All the assets with an FMV less than basis will generate losses that are disallowed by Sec. 267. This rule applies because the S corporation still owns 79% of the stock in this example, and it is therefore a related party. On the other hand, if the S corporation sells at least 80% of the QSub stock, which meets the requirement of Sec. 336(e), it is not related to the new corporation formed under the regulations. As a result, all the gains and losses are recognized. This generates the same result that would occur if the transaction were considered a stock sale and a Sec. 336(e) election were made. Therefore, whether the IRS allows a Sec. 336(e) election for the sale of QSub stock is immaterial.

    If the S corporation distributes the QSub stock to its shareholders as a dividend or a divisive D reorganization, the result is different from a stock sale.25 Under Sec. 1361(b)(3)(C)(i), the S corporation is treated as having transferred the assets to a new corporation in exchange for the stock. This qualifies as a Sec. 351 transaction because Sec. 351(c) disregards the distribution of the stock in determining if the transferor is in control of the corporation after the transfer. The basis of the assets is carryover, and the stock has a substituted basis. If the stock is distributed as a dividend, Sec. 311 applies to the S corporation, causing gain, but not loss, to be recognized. The S corporation should be entitled to make a Sec. 336(e) election. The new corporation is treated as having sold the assets for the ADADP. It will recognize gain but not net loss on this transaction. The S corporation is then treated as having acquired the stock of the new corporation for its FMV, which it distributes without recognizing any gain or loss. This should be the same result as occurs when an S corporation distributes the stock of a non-QSub subsidiary to its shareholder and makes a Sec. 336(e) election.

    If the distribution of the QSub stock is a divisive D reorganization, Sec. 336(e) will not apply, as a general rule. If Sec. 355(d)(2) or (e)(2) would require the S corporation to recognize gain, then a Sec. 336(e) election can be made, resulting in a deemed asset sale for the ADADP by the QSub, producing recognized gain but not loss. Then the S corporation is treated as having distributed this stock in a tax-free D reorganization. Again, this should be the same result as a divisive reorganization of a non-QSub subsidiary because the S corporation is treated as creating a new subsidiary under Sec. 351 before the reorganization transaction.

    Net Investment Income Tax

    Sec. 1411 imposes a 3.8% tax on a taxpayer’s net investment income.26 Gain from the sale of stock is generally included in net investment income. However, Sec. 1411(c)(4) provides that S corporation stock sales are reconsidered as the corporation’s sale of its assets in determining the amount, if any, of the gain that is included in net investment income.

    Proposed regulations under Sec. 141127 provide the current approach to this rule. If the S corporation stock is a passive activity in the hands of the shareholder, the full amount of the gain is included in net investment income. On the other hand, if the S corporation is engaged in an active trade or business other than trading in financial instruments or commodities, the exception of Sec. 1411(c)(4) applies. The proposed regulations produce these results:

    1. If all of the corporation’s assets are used in the trade or business and the shareholder’s basis in the stock is equal to or greater than his or her share of the inside basis, none of the gain is net investment income.
    2. If all of the corporation’s assets are used in the trade or business and the shareholder’s basis in the stock is less than his or her share of inside basis, a portion of the gain equal to the difference between the outside basis and the share of the inside basis is net investment income.
    3. If the corporation owns assets that are not used in the trade or business, an amount equal to the shareholder’s share of the gain that he or she would recognize if the asset were sold for FMV is net investment income. The remainder of the gain from the stock sale is excluded from net investment income.

    The proposed regulations provide that if the S corporation shareholder makes a Sec. 338(h)(10) or Sec. 336(e) election on the stock sale, the disposition is treated as a fully taxable disposition of assets followed by a nontaxable liquidation.28 This occurs because there is a deemed asset sale that generates the full amount of business income and net investment income.

    Open Questions

    At a recent meeting between tax advisers and the principal author of the Sec. 336(e) regulations, several questions were raised.29 The facts for a scenario posed by one of the tax advisers were:

    Example 5: A and B equally own an S corporation, and A sells her interest to C. Later, but within 12 months, B sells her interest to D. Who must make the Sec. 336(e) election, and how are the rules applied?

    In the opinion of the authors of this article, all the taxpayers, A, B, C, and D should make the election. This conclusion is based on the fact that a Sec. 336(e) election should include all of the parties involved, since the election affects the taxation of each of the shareholders.

    Before addressing the specifics of the Sec. 336(e) election, one must consider how the income earned by the S corporation during its final year should be allocated. Recall that the S corporation election is deemed to continue until the date of the qualified stock disposition. In the above fact pattern, that would be on the date that B sold her interest to D. Since the disposition date is after C purchased the interest from A, to whom is the corporation’s income allocated? The authors recommend that the income be allocated among A, B, and C using the traditional S corporation allocation rules. This approach would allocate income to A up to the date she sold her interest. This is fair, since the sale price should have been based on the value of the stock (increased by prior income) on the date of the actual stock sale. The value of the interest purchased by C increases by her share of the earnings after the date of purchase, justifying allocating this income to her. B is entitled to and will receive the benefit of the income up to the date she sells her share to D, justifying the allocation of this income to her.

    A and B, the shareholders who sold their S corporation stock, should be the only ones affected by the Sec. 336(e) deemed transactions (asset sales and liquidation). Since these transactions replace the taxation of the actual sale transactions, the vendors should be the only ones affected. However, the actual results of the election need to be clarified and modified.

    As a result of the Sec. 336(e) election, the S corporation is deemed to have sold its assets on the disposition date for the ADADP, which is equal to the grossed-up purchase price of the recently purchased stock plus liabilities.30 As previously mentioned, liabilities do not include the tax liability, since the shareholders and not the corporation pay the tax. When recently purchased stock is obtained in two or more purchases, the amount that is grossed up is the sum of the purchase prices. If, in the questioned transaction, A and B sold their stock for the same amount, then the current rules produce the correct outcome. The corporation realized gains and loss on the deemed asset sale, and these are allocated to A and B equally, since they are equal shareholders. If the sale prices differ, the results under the current rules will not generate a completely correct outcome. To illustrate these outcomes:

    Example 6: A and B have basis in their S corporation stock of $50 each. Assume that the basis of the assets in the corporation is $100. If the assets increase in value to $180 and both A and B sell their stock to C and D for $90, each would realize $40 gain.

    If they make a Sec. 336(e) election, the stock sale gain is eliminated, and the corporation is treated as having sold the assets for $180, generating $80 gain, which is allocated $40 each to A and B. They receive $90 each in the deemed liquidation, generating no gain or loss. A and B would each report the same amount of gain as they realized on their stock sales. As an alternative:

    Example 7: Assume the same initial facts as in Example 6 and that A sells her stock to C when the assets are worth $180. The assets increase in value to $220, and B sells her stock to D.

    Under these facts, A would realize a $40 gain ($90 sale price – $50 basis), and B would realize a $60 gain ($110 sale price – $50 basis). The ADADP would be $200 (A’s $90 stock sale price + B’s $110 stock sale price). The deemed asset sale by the S corporation would generate $100 gain ($200 sale price – $100 basis). Under current rules, this would be allocated $50 each to A and B, since under the current regulations both are treated as owning the stock on the deemed disposition date. They would each be deemed to receive $100 in the liquidation, generating no gain or loss. Comparing the outcome of the Sec. 336(e) election with the actual sale transactions indicates that A would recognize $10 additional gain and B would recognize $10 less gain. Given the conversion of some or all of the gain from capital to ordinary income, A would not generally agree to a Sec. 336(e) election under these rules.

    If the rule were modified to allocate the distribution in liquidation based on the relative sale prices, the amount of income that A and B would recognize would equal the gain on the actual stock sales. Applying this rule, A and B would each recognize $50 gain on the deemed asset sale and would increase their stock basis to $100. The liquidation would distribute $90 to A and $110 to B. A would have a $10 loss recognized under Sec. 331, and B would have a $10 gain recognized. Netting these two transactions results in A recognizing a $40 net gain and B a $60 net gain. The difference with this outcome is that A is likely to recognize $50 ordinary income and $10 capital loss, rather than $40 capital gain. B, on the other hand, will have $50 ordinary income and $10 capital gain, rather than $60 capital gain.

    Both purchasers, C and D, in Example 7 benefit from the Sec. 336(e) election but to a different extent. The assets owned by the S corporation appreciate $40 after C purchases her interest; therefore, her share is $20. The basis of the assets in the corporation following the Sec. 336(e) election is AGUB, or $200. If the corporation were to sell the assets for their FMV, it would realize a $20 gain, allocated $10 each to C and D. C would recognize only $10 of the post-acquisition appreciation. The other $10 will be recognized when she disposes of her interest. The assets do not appreciate after D buys her interest. However, D would recognize $10 gain if the corporation sells the assets. This $10 gain increases D’s basis in the stock, creating a $10 built-in loss, which will be recognized when she disposes of her interest. Both purchasers will recognize less gain as a result of the Sec. 336(e) election than if the corporation had a carryover asset basis of $100 because of the stock purchase.

    If the allocation of both the income from the deemed asset sale and the deemed liquidation were based on the relative stock sale prices, the net amount of income that A and B would recognize would be the same as for the actual stock sale. These modifications would reduce the amount of ordinary income and capital loss that A reports and increase the amount of ordinary income and decrease the amount of capital gain that B recognizes.

    Treasury might also consider allocating the asset appreciation between the stock purchases to the initial stock purchaser. The authors prefer that the allocation rules be modified. If Treasury wants to modify just the deemed liquidation distribution rule, the result would be acceptable. Failure to modify these rules would probably prevent a Sec. 336(e) election unless the stock were sold for the same price by all the S shareholders.

    Conclusion

    Sec. 338(h)(10) and Sec. 336(e) both provide that a covered transaction is a stock sale by a corporation.

    Treasury has expanded the scope of both elections by allowing S corporation shareholders to make the election.31 The expansion adopted by Treasury is both reasonable and consistent with the congressional intent of the taxation of an S corporation. The section facilitates what is in effect a sale of corporate assets without requiring actual liquidation of the corporation.

    The sale of S corporation stock with a Sec. 336(e) election will benefit the buyer by increasing the asset bases, thereby eliminating the double taxation. Therefore, the buyer will usually pay a higher price for the stock, benefiting the seller. If the Sec. 336(e) election is not made, the buyer may demand a discount on the purchase price because of the future taxation of the built-in gains on the target corporation’s assets.

    Congress treats S corporations the same as partnerships in most cases. When a partner sells a partnership interest, Sec. 751(a) reclassifies some or all of the gain or loss as ordinary, based on a deemed sale by the partnership of its assets. If the partnership makes a Sec. 754 election, the partnership adjusts the basis of its assets under Sec. 743 as it applies to the purchaser to avoid double-counting of the built-in gains and loses. If the partnership does not make a Sec. 754 election, the built-in gains and losses are currently double-counted but will be offset in the future when the purchaser disposes of the interest, because of the change in the outside basis resulting from the purchaser’s recognition of the built-in gains and losses.

    There are no equivalents to Secs. 751 and 754 in subchapter S. Allowing the S corporation to make either a Sec. 338(h)(10) or 336(e) election results in the equivalent outcome. As previously discussed, the selling shareholder reports the same amount of gain or loss as a result of the Sec. 336(e) election that he or she would have reported on the stock sale. The difference is classification. If the S corporation owns noncapital assets, the S shareholder reports his or her share of ordinary income. Therefore, the Sec. 336(e) election produces the same result as Sec. 751(a).

    The determination of the basis of the assets in the hands of the new corporation, based on the stock sale price, prevents double-counting of the built-in gains and losses as would occur under Secs. 754 and 743. If the S shareholders do not make a Sec. 336(e) election and the purchasers are permitted and choose to continue the target as an S corporation, the double-counting of the built-in items will be offset when the new shareholders resell the stock. Again, this is the same result as would occur following the sale of a partnership interest without a Sec. 754 election. The bottom line is that the extension of these elections to S corporation shareholders maintains the single taxation of an S corporation.

    From a planning point of view, the S corporation shareholders should make a Sec. 336(e) election if the sale price is adjusted for the equivalent of a Sec. 754 election and that adjustment offsets the increased tax from the Sec. 751(a) equivalent result.

    Footnotes

    1 T.D. 9619.

    2 It is possible to create a transaction that qualifies as a Sec. 338(h)(10) election by structuring it as a putative Sec. 351 transaction followed by a prearranged IPO of the new corporation’s stock.

    3 REG-143544-04.

    4 For an alternate summary of the general rules, see Willens, “Another Way to Achieve a Basis Step-Up,” 2013 TNT 119-14 (June 17, 2013).

    5 Regs. Sec. 1.336-2(h).

    6 Regs. Sec. 1.336-2(b)(1)(i)(A).

    7 Regs. Sec. 1.336-3.

    8 If the seller and target file a consolidated return and the seller does not require the target to pay the tax on the deemed asset sale, liabilities do not include the tax liability.

    9 Regs. Sec. 1.338-4(b).

    10 Stock redemptions during the acquisition period reduce the number of outstanding shares. See Regs. Sec. 1.338-3(b)(5).

    11 Regs. Sec. 1.336-2(b)(1)(ii).

    12 Regs. Sec. 1.336-2(b)(1)(i).

    13 Sec. 1363(d).

    14 This affects the gain or loss recognized on the deemed liquidation, as discussed later.

    15 Regs. Sec. 1.336-2(b)(1)(v). This is considered stock of the new corporation that acquired the assets.

    16 How the S shareholders report the same amount of income is discussed later in this article.

    17 Regs. Sec. 1.336-2(b)(1)(iii).

    18 Some commentators do not think that Sec. 382 applies to S corporations. See Knight and Knight, “The S Corporation Loss Limitation Rules Are Not Too Clear,” Taxes: The Tax Magazine 45 (May 2013).

    19 This was confirmed by the IRS. See Elliott, “Author of Deemed Asset Sale Election Regs Discusses Qualifying Dispositions,” 2013 TNT 112-1 (June 11, 2013).

    20 See IRS Letter Ruling 201314003 (4/5/13), which ruled that Secs. 332 and 337 apply to the liquidation.

    21 Regs. Sec. 1.336-2(b)(1)(iv).

    22 Regs. Sec. 1.336-2(b)(1)(i)(A).

    23 See Regs. Sec. 1.1361-5(b)(3), Example (9), for a sale of 100% of the stock. A Sec. 336(e) election would be redundant.

    24 T.D. 8869.

    25 See IRS Letter Ruling 201115006 (4/15/11) for a discussion of a D reorganization involving a QSub.

    26 A complete discussion of the impact of Sec. 1411 on S corporations is beyond the scope of this article.

    27 The IRS first issued Prop. Regs. Sec. 1.1411-7, providing guidance on dispositions of interests in partnerships and S corporations, in REG-130507-11 in December 2012. In T.D. 9644, on Dec. 2, 2013, the IRS finalized some regulations under Sec. 1411 but concurrently issued new proposed regulations (REG-130843-13) for some sections, including Prop. Regs. Sec. 1.1411-7.

    28 Prop. Regs. Sec. 1.1411-7(a)(4)(i).

    29 Elliott, “Author of Deemed Asset Sale Election Regs Discusses Qualifying Dispositions,” 2013 TNT 112-1 (June 11, 2013).

    30 Regs. Sec. 1.336-3(b).

    31 See Elliott, “ABA Meeting: Author of Final Deemed Asset Sale Regs Explains Changes,” 2013 TNT 93-3 (May 14, 2013).

     

    EditorNotes

    Edward Schnee is the Hugh Culverhouse Professor of Accounting and director of the MTA Program at the University of Alabama in Tuscaloosa, Ala. Eugene Seago is the R.B. Pamplin Professor of Accounting at Virginia Polytechnic Institute and State University in Blacksburg, Va. For more information about this article, contact Prof. Schnee at eschnee@cba.ua.edu.




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