Buyers and sellers are often at odds over whether a transaction is structured as a purchase of assets or stock of a corporation.
Buyers are motivated to purchase the assets of a business in order to obtain a step-up in the tax basis of the assets to the purchase price allowing for an increase in post-transaction cash flow from depreciation and amortization deductions.
Sellers, on the other hand, are motivated to sell the stock of their corporation, as any resultant gain will be taxed at the preferential capital gain tax rates.
In the case of a Subchapter C-Corporation, an asset sale results in both tax on the gain from the sale of the assets at the corporate level and an additional tax on the distribution of cash from the remaining proceeds. This is commonly referred to as the double taxation regime.
Comparing the double taxation of an asset sale in a C-corporation with an asset sale in a S-Corporation results in substantially different tax results. In S-Corporations, the gain from the sale of assets will generally not incur a corporate level tax but instead will be passed through to its shareholder and be taxed on the shareholder’s tax return. The subsequent liquidating distribution, unlike the case of a Subchapter C–Corporation, escapes taxation as a return of capital.
With the exception of certain items, such as depreciation recapture, the gain passed out to the S-Corporation shareholder is taxed as a capital gain to the individual. The maximum individual tax rate is 20% on this gain. Thus, with S-Corporation asset sales, the selling shareholders get their single level of tax at capital gains rates, and the buyers acquire the assets with a tax basis stepped up to the purchase price.
In many S-Corporation asset sales, the physical transfer of the assets and contracts can be so time-consuming and problematic that the buyer is put in a position of acquiring the stock instead, thus potentially losing the tax step-up afforded. In the case of an S-Corporation, relief has been available from this problem in the form of a Section 338(h)(10) election. This election allows the buyers and sellers to treat the transaction as a sale of assets for tax purposes with the aforementioned favorable tax consequences while legally transferring the stock of the corporation.
Effective August of 2013, the Treasury issued regulations that allow for an alternative approach to a Section 338(h)(10). Regulations under Section 336(e) allow for a similar election allowing for a purchase of stock to be treated as a sale of assets for federal income tax purposes.
In a 338(h)(10) election, the buyer must be a single corporation. That corporation can be either a C-Corporation or an S-Corporation. With S-Corporations, the pass through benefits discussed above also comes with some strict rules as to ownership and organization. S-Corporations are limited as to the number of shareholders, can only have one class of stock and the shareholders must be US individuals and United States residents and only certain qualifying trusts can be included.
Using a C-Corporation in a 338(h)(10) election requires some caution as to subsequent actions. If the C-Corporation acquirer is liquidated immediately after the acquisition, generally this should not result in federal income tax since both the inside and outside basis of the assets would presumably be equal to its fair market value. However, the regulations under Section 338(h)(10) would most likely treat the acquiring corporation as transitory, thus disallowing treatment as a Qualified Stock Purchase (QSP) and thereby invalidating the 338(h)(10) election resulting in no step up in basis.
Section 336(e) does not require the acquirer to be a corporation. It can be any type of a person with no limit on the number of acquirers. Since they would own the stock of the target directly, a liquidation of the target as discussed above should not invalidate the Section 336(e) election.
In this case, upon liquidation, the acquirers could end up with an LLC taxed as a partnership holding the new target’s assets and liabilities. LLC’s can have any type and number of owners and different ownership interests (preferred interest for example). This allows for much greater flexibility and ease of subsequent financings and capital raises. However, it should be noted that often the reasons that a stock acquisition is required (for example difficulty of transfer of assets) may still exist after the acquisition and could remain problematic in a post-acquisition liquidation.
Comparing the Section 336(e) election to a Section 338(h)(10) election, some differences become clear. Section 338(h)(10) elections require the purchase of 80% or more of the stock of an S-Corporation within a 12-month period (QSP). A Section 336(e) election focuses the aggregate amount of dispositions (Qualified Stock Disposition (QSD)) with the threshold remaining at 80%.
Included in a QSD is any stock that is sold, exchanged or distributed in a taxable disposition to any acquirer. One note of interest here is that a QSD can include taxable distributions of stock; for example, in a taxable distribution of stock to shareholders (cannot be a related party under IRS definitions) that does not qualify as a tax-free spinoff.
It may also apply in situations where tax-free spinoffs become taxable due to subsequent events. For this reason, a protective election is made under Section 336(e) for spinoffs otherwise intended to be tax-free. The difference in definitions of a QSP and a QSD will allow the application of the benefits of a tax-efficient step-up of the inside basis of assets to their fair market value upon the acquisition of the stock of an S-Corporation in a greater number of situations than previously.
Looking at the manner of election, both Section 338(h)(10) and Section 336(e) require that both the selling shareholders and the buyers agree to the election. In the case of a Section 338(h)(10), the IRS has a specific form that needs to be completed jointly by the sellers and buyer. It must be completed by the 15th day of the ninth month beginning after the month in which the acquisition occurs. While no such form currently exists for Section 336(e), a statement would need to be included in the tax return of the Target for the period ending on the disposition date. This means the election must be made on the final tax return of the Target by the due date, including extension.
The Section 336(e) election, while enacted in 1986, became available in August 2013 when the IRS issued regulations, so it is relatively new. There could be subsequent changes or interpretations to the regulations that need to be considered in the evaluation and implementation of an election. State interpretations of a Section 336(e) in states that do not automatically adopt the federal law and regulations may add some additional uncertainty.
The availability of a Section 336 election is one more tax structuring tool that will help mitigate the unfavorable tax consequences that can result when overriding business and legal issues mandate the acquisition of the stock of an S-Corporation.
If you have question about this article or would like more information, please contact James Cordova at jcordova@windes.com or 844.4WINDES (844.494.6337).