Sec. 336(e) elections for S corp. targets: Get a step-up without a letter ruling

Editor: Kevin D. Anderson, CPA, J.D.

After Treasury finalized regulations under Sec. 336(e) in May 2013, it became possible for a qualified stock disposition (QSD) of S corporation stock to be treated as a sale of the corporation’s assets for tax purposes.

The Sec. 336(e) election is broadly similar to the Sec. 338(h)(10) election, with the most critical difference being the stock purchaser. In a Sec. 338(h)(10) election, the purchaser must be a corporation, and the term “qualified stock purchase” (QSP) is used when all criteria for the election are met. For a stock disposition to be considered a QSD for an S corporation, on the other hand, the types of purchasers are not restricted. This means individuals, partnerships, or other noncorporate entities that could not benefit from a Sec. 338(h)(10) election may be able to qualify for a Sec. 336(e) election. Crucially, Regs. Sec. 1.336-1(b)(6)(ii)(A) provides generally that if a stock disposition qualifies as both a QSD and a QSP, it will not be treated as a QSD (i.e., the QSP rules take precedence) and the Sec. 338(h)(10) election would be made in lieu of the Sec. 336(e) election.

For an S corporation stock disposition to qualify as a QSD, at least 80% of the vote and value of S corporation stock must be disposed of in a transaction or series of transactions within a 12-month period (Regs. Sec. 1.336-1(b)(6)(i)). Additionally, tax-free dispositions under Sec. 351, 354, 355, or 356 fail to meet the QSD criteria. Other situations that fail to qualify as a QSD include sales, exchanges, or distributions to related parties; transactions where the purchaser’s basis is determined in whole or in part by reference to the basis in the hands of the person from whom the stock is acquired; and stock acquired from a decedent with a basis determined under Sec. 1014(a) or 1022.

Making the Sec. 336(e) election for an S corporation target

Assuming the criteria for a QSD are satisfied, the election is made by meeting three requirements. First, all of the S corporation shareholders (including those that do not dispose of stock) and the S corporation must enter into a written, binding agreement to make the Sec. 336(e) election. This agreement must be entered into no later than the due date of the S corporation target’s federal income tax return, including extensions, for the tax year that includes the disposition date. Second, the S corporation target must retain a copy of the agreement. Finally, the Sec. 336(e) election statement prescribed in Regs. Secs. 1.336-2(h)(5) and (6) must be attached to the timely filed, including extensions, federal income tax return of the S corporation target for the tax year that includes the disposition date (Regs. Sec. 1.336-2(h)(3)).

Deemed steps related to the asset sale

While the legal form of a QSD is a stock sale, the tax fiction of an asset sale provides that for tax purposes, multiple steps are deemed to occur. First among these steps is the deemed asset sale of the target S corporation’s (old target’s) assets to the purchaser. Old target is deemed to sell all of its assets in a single transaction to an unrelated party at the end of the disposition date.

Assuming the disposition is not recognized on the installment method, the gain from this deemed sale is included in full on old target’s return for the tax year ending on the disposition date. If the disposition is recognized under the installment method, the rules of Regs. Sec. 1.338(h)(10)-1(d)(8) are applied (Regs. Sec. 1.336-2(b)(1)(i)(B)(1)). Old target’s S election remains in effect until the end of the day on the disposition date, including through the deemed asset sale and the deemed liquidation (Regs. Sec. 1.336-2(b)(1)(i)(A)). The deemed liquidation occurs immediately after the deemed asset sale and while the original shareholders still own the stock of old target. Old target is deemed to distribute all the consideration received in the asset sale to its shareholders in complete liquidation and then to have ceased its existence (Regs. Sec. 1.336-2(b)(1)(iii)(A)).

Under Regs. Sec. 1.336-2(g)(1), the corporation immediately after the deemed liquidation (new target) is deemed to be a separate corporation for most of the Code’s income tax provisions. New target is deemed to purchase all of the assets of old target at the end of the disposition date but before the deemed liquidation. If new target qualifies as an S corporation and desires to be an S corporation, it must make a new election under Sec. 1362(a) (Regs. Sec. 1.336-2(b)(1)(ii)).

Beating the clock

Due to the deemed liquidation of old target, taxpayers that wish to make the Sec. 336(e) election have only until the 15th day of the third month following the month in which the disposition date occurs to make a timely election. The deemed liquidation prevents the general S termination rules of Sec. 1362(e)(6)(B) from applying. Under those rules, if an S election terminates midyear, meaning any day other than the first day of the tax year, the due date for the S termination year return is the same as the due date for the C corporation return necessitated by the termination, including extensions. These rules do not apply to Sec. 336(e) elections because, under Regs. Sec. 1.336-2(g)(1), old target and new target are different corporations, not a continuation of the same corporation.

This result is further evidenced by Regs. Sec. 1.336-2(b)(1)(iii)(A), which specifically addresses the deemed liquidation and explicitly states that old target ceases to exist for income tax purposes. Since old target ceases to exist, it is subject to the general S corporation return due date, which is the 15th day of the third month following the end of the tax year. This due date complexity is a significant source of confusion for both taxpayers and tax professionals. This confusion arises because, if the legal form of the transaction were followed for tax purposes, the due date would be either the S corporation’s normal due date, if the purchasers were qualified S corporation shareholders, or the due date for the short C corporation tax year, if the purchasers were not qualified shareholders.

Taxpayers thus have a very narrow window in which to determine that an extension or return has to be filed. By contrast, this timing issue is greatly mitigated in a Sec. 338(h)(10) election because that election is due by the 15th day of the ninth month after the month in which the QSP occurred. Even if the taxpayer has reached a written, binding agreement and a copy has been retained by the due date of the return, if no extension or tax return is filed by that date, the only way to have a valid Sec. 336(e) election is via a request for a letter ruling. For requests filed in 2018, the applicable user fee for a ruling requesting relief under Regs. Sec. 301.9100-3 is $10,000, assuming old target’s gross receipts are over $1 million (Rev. Proc. 2018-1). This makes the election very easy to miss and very expensive to fix. The number of letter rulings on this point illustrate how challenging it is to beat the clock.

As of February 2018, the following letter rulings were published in the last 12 months granting an extension of time to make the Sec. 336(e) election for an S corporation: IRS Letter Rulings 201802008, 201751009, 201749004, 201740014, 201740003, 201739005, 201733003, 201730005, 201730004, 201721011, 201714019, and 201711007. Some of the letter rulings solely granted an extension of time to file the election statement, while others also granted additional time to reach or execute the binding, written agreement. The easiest way for a practitioner to avoid this trap for clients is to include the agreement to make a Sec. 336(e) election in the stock purchase agreement, file an extension as soon as possible after the disposition date, and then file the return by the extended due date with the election statement included.

If new target qualifies and desires to make a new S corporation election, it may have even less time to act. This is because an S corporation election must be made within two months and 15 days of the first day of its tax year to be effective for that tax year. This means that for a midmonth disposition, i.e., any disposition date other than the last day of the month, the new target actually has less time to make a timely S corporation election than old target has to file either an extension or a tax return. Fortunately, in this case, late election relief may be easier to achieve under Rev. Proc. 2013-30, assuming new target meets the criteria for the relief.

Avoiding the other traps

In addition to the complexities surrounding the due date, the Sec. 336(e) election provides a few other potential traps for the unwary. The most basic of these is an understanding of the impact to the selling shareholders of an asset sale versus a stock sale. For long-term shareholders, typically, an asset sale will result in ordinary income taxable at higher rates than the shareholders would have recognized under a stock sale where all gain was recognized as long-term capital gain. Accordingly, the seller will seek to negotiate a higher sales price with the buyer to mitigate this tax rate difference.

Another area that may be overlooked at first is the deemed liquidation of the entity; the gain on the deemed asset sale increases the shareholders’ stock basis so that their total gain will remain the same as it would have been under a stock sale. One potential complication occurs: If a shareholder’s basis at disposition, after accounting for the gain on the deemed asset sale, is greater than the share of disposition proceeds, the shareholder may have a capital loss on liquidation. Depending on a shareholder’s facts and circumstances, that capital loss may or may not be realized currently. Shareholders in this situation may want to further negotiate an increase in the sales price to compensate for any deductions that may not be realized for many years.

Sales of less than 100% of stock will also necessarily add some complexity. While the mechanics of these transactions are outside the scope of this discussion, suffice it to say that minority shareholders that remain as shareholders after the QSD will have to recognize gain in the same manner as those that sold their shares. Those shareholders are then deemed to have purchased these shares for their fair market value on the next day. Regs. Sec. 1.336-2(b)(1)(v) provides the rules for how minority shareholders that retain stock are treated in these situations.

The fictional asset sale for tax purposes also necessitates an assignment of value to each of the classes of assets of the business. This assignment of value is necessary not only for gain determination but also correspondingly for the basis step-up the buyer receives. Since the purchase is still legally a stock purchase, this might not be at the forefront of the buyer’s and seller’s minds, but an agreement on asset values is crucial. Both old target and new target will be required to file Form 8883, Asset Allocation Statement Under Section 338 (or an appropriate successor form), with their final and initial returns, respectively (Regs. Sec. 1.336-2(h)(7)).

Thus, a best practice would be to agree to the asset values in the stock purchase agreement upfront to avoid a disagreement later. Similar to the Sec. 338(h)(10) election, the amounts reflected on Forms 8883 filed by old target and new target will differ by their respective transaction costs. Since the Form 8883 is designed for asset purchases under Sec. 338, it may require slight modifications to report the QSD information.

Avoid a missed opportunity

Sec. 336(e) elections for S corporation targets is a complex area for tax compliance. It is crucial that at least an extension is filed by the initial due date for old target’s return to ensure the ability to make the Sec. 336(e) election without the need for a private letter ruling. A thorough reading of the regulations under Sec. 336(e) is crucial for understanding all the deemed transactions triggered by the election. With careful planning, the clock can be beat and the traps avoided. And the practitioner’s client can receive a basis step-up without the added cost and headache of obtaining a private letter ruling.

EditorNotes

Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.

For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.