Maintaining single taxation: sec. 336(e) and S corporations.

• Author: Schnee, Edward J.

In May 2013Treasury 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 marker 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)(t0). 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 ot 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 Mick, 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 DOimpose the equivalent of Sec. 311 on distribution transactions. Under the proposed rule, all the gams 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 non recognizable, 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 nonrcccntly 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(c) 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 bv 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 UFO method at the time ot 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. It 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 nor 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 m 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 ot 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...