On May 10, 2013, the Internal Revenue Service (IRS) and Treasury Department released the long-awaited final regulations under Section 336(e) of the Internal Revenue Code, treating certain sales, exchanges, and distributions of at least 80 percent of the voting power and value of the stock of a domestic corporation (“target”) as a sale of all of the target’s underlying assets. We believe the ability to apply Section 336(e) in sales to non-corporate entities and certain spin-offs taxable to the parent (i.e., the distributing corporation) may have broad implications for our clients.
Background
To complement the more familiar Section 338(h)(10) of the Internal Revenue Code, Section 336(e) was enacted in 1986 to provide taxpayers relief from potential multiple corporate taxation of the same economic gain that can result when a transfer of appreciated corporate stock is taxed without a corresponding step-up in the basis of the assets of the corporation. In many cases, it has been possible to engineer a step-up in asset basis, but often at the cost of significant complexity, which can be disruptive to a transaction. The IRS has maintained that Section 336(e) is not operative in the absence of implementing regulations. The final regulations put a definitive end to this long period of dormancy and allow a relatively straightforward procedure for obtaining an asset basis step-up in a variety of transactions.
Applicability
Under the final regulations, an election may be made to treat a qualifying sale, exchange, or distribution (qualified stock disposition or QSD) as an asset sale. The term QSD refers to any transaction or series of transactions in which at least 80 percent of the voting power and value (“80/80 vote/value”) of a target’s stock is either sold, exchanged, or distributed (or any combination thereof) by another domestic corporation or, if the target is an S corporation, by the S corporation shareholders, during a 12-month period. So, to constitute a QSD, either both the target and the seller must be a domestic corporation or the target must be an S corporation.1
Two aspects of the applicability of the final regulations are important. First, there does not need to be a single purchaser or distributee, and as described below, the election mechanics do not involve the transferees, so a Section 336(e) election could be available for certain creeping transactions involving multiple counterparties, without, at least for some, full knowledge of the possibility of the election.
Second, a transaction does not need to constitute a purchase—a requirement under Section 338—in order to constitute a QSD. Any “disposition” to an unrelated party would generally qualify, provided that the disposition is a sale, exchange, or distribution of stock other than (i) certain stock acquired from a decedent, or (ii) certain stock sold, exchanged, or distributed in a transaction under Section 351 (tax-free incorporation or contribution), 354 (tax-free reorganization), 355 (tax-free spin-off), or 356 (certain property received in a tax-free reorganization or spin-off not eligible for tax-free treatment), or otherwise sold, exchanged, or distributed in a transaction in which the transferor did not recognize the entire amount of the gain or loss realized in the transaction. Importantly, however, a distribution of stock under Section 355 will still be a QSD if the full amount of stock gain would be recognized to the distributing corporation pursuant to either Section 355(d)(2) (imposing a tax on the distributing corporation in an otherwise tax-free spin-off if a 50-percent-or-greater interest is acquired by any person by purchase in either the distributing or the controlled corporation during the preceding five-year period) or 355(e)(2) (imposing a tax on the distributing corporation in an otherwise tax-free spin-off if there is a related transaction in which a change of control occurs with respect to either the distributing or the controlled corporation).
Consequences of the Election
If a Section 336(e) election is made, the corporate seller (or S corporation shareholders) is not treated as having sold, exchanged, or distributed the stock disposed of in the QSD. Instead, the target is treated as selling its assets to an unrelated person in a single transaction at the close of the disposition date (the first date on which there is a QSD) in exchange for a certain price determined in accordance with the final regulations.
The final regulations represent an elaborate regulatory regime. Many aspects of the rules, such as the detailed treatment of the target involved in a transaction under Section 355 and the treatment of cases involving retention of stock by a transferor or minority shareholders, are technical and must be carefully considered.
Time and Manner of Making the Election
The time and manner of the Section 336(e) election solely involve the selling corporation (or, if applicable, the S corporation shareholders) and the target, and not the transferees in the disposition. In general, an election can only be made if (i) the selling corporation (or the S corporation shareholders) and the target enter into a written, binding agreement on or before the date when the election is to be filed with the IRS, and (ii) the election is filed in the tax returns for both the selling corporation and the target for the taxable year that includes the disposition date. In the case of an S corporation target, the binding agreement must include all of its shareholders regardless of whether or not they are a party to the QSD, and the election must be filed in the S corporation target's tax return for the taxable year that includes the disposition date.
Closing Comments
From a transaction planning point of view, the final regulations raise numerous additional tax considerations for both buyers/transferees and sellers/transferors in a QSD.
For a buyer/transferee, it is important to recognize that any stock of a target received may be subject to a Section 336(e) election without its participation, potentially resulting in very different tax consequences for the buyer/transferee. For a buyer/transferee seeking to secure or prohibit such an election, it is critical to incorporate such terms in the transaction documents, beginning ideally at the term-sheet stage.
For a seller/transferor, it is equally important to consider the eligibility for and the advisability of the election early in the process.
In some cases, the Section 336(e) election, similar to an election under Section 338(h)(10), could result in improved overall economics for the buyer and seller combined, and it may be possible for them to share in the improvement.
Finally, the availability of the Section 336(e) election in certain spin-offs taxable to the parent (i.e., the distributing corporation) is a unique aspect of the Section 336(e) election and represents a significant opportunity for the spun-off subsidiary (i.e., the controlled corporation) to obtain a basis step-up without undue complication, especially in cases where the parent has offsetting losses (including net operating loss carryforwards) that may otherwise go unused.
For additional information about the final regulations or any related matter, please contact any member of Wilson Sonsini Goodrich & Rosati's tax practice.
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under federal, state, or local tax law or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
