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Focus on Taxation: Final Regulations for Qualified Stock Dispositions Issued

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The Internal Revenue Service (IRS) recently issued final regulations under Code Section (Sec.) 336(e) that allow individuals and partnerships, in certain circumstances, to step-up their basis in business assets acquired by stock acquisition.
December 9, 2013

The Internal Revenue Service (IRS) recently issued final regulations under Code Section (Sec.) 336(e) that allow individuals and partnerships, in certain circumstances, to step-up their basis in business assets acquired by stock acquisition.

This “deemed asset sale” treatment was previously available only to corporate purchasers under Sec. 338(h)(10). A combination of domestic and foreign corporate and non-corporate acquirers can now achieve step-up in stock deals even if all of the stock isn’t acquired at the same time, as long as 80% or more of the target’s stock is acquired by the purchaser group within in a 12-month period.

This new flexibility will have significant appeal to private equity firms and individual investors who desire stepped-up basis but choose not to operate in the corporate form, or who wish to team with other purchasers (both domestic and foreign) in structuring their acquisitions.

For many years, taxpayers have availed themselves of the deemed asset sale provisions afforded qualified stock purchases (QSP) under Sec. 338(h)(10). These provisions allow the purchaser of 80% or more of the vote and value of shares in the seller to treat the transaction as an asset purchase for tax purposes, where the transaction was legally structured as a purchase of stock.

This has the advantage to the purchaser of obtaining stepped-up basis in the assets of the seller for tax purposes, giving them depreciable basis to shield against future taxable income of the acquired target, while avoiding the complexities (title transfers, etc.) typically associated with asset deals.

However, the application of Sec. 338(h)(10) has been limited to corporate acquirers of stock in C-Corp subsidiaries (or nonconsolidated affiliates) and S-Corporations.

Detailed Explanation

On May 10, 2013 the IRS issued new and final regulations for Qualified Stock Dispositions (QSD) under Internal Revenue Code Section (Sec.) 336(e).

These new regulations, effective for QSD that occur on or after May 15, 2013, modify and supersede the proposed regulations that were issued on August 25, 2008 and allow for stepped-up basis on the transferred assets in stock acquisitions involving corporate and non-corporate purchasers.

Several requirements must be met in order for Sec. 336(e) to apply.

An aggregate of 80 percent (by vote and value) of the stock of:

  • A domestic corporation’s domestic subsidiary (at least 80 percent of the stock, by vote and value, of which is owned by the domestic corporation)
OR
  • A member of a consolidated group of corporations (other than the parent thereof)
OR
  • An S corporation’s stock is sold, exchanged, and / or distributed in a taxable transaction with unrelated parties within a 12-month period. The tax cost of these requirements is a single level of taxation at the target, equal to the net difference between the adjusted basis and fair market value of the assets.

Sec. 336(e) is similar to Sec. 338(h)(10) in that it permits basis step-up of assets in stock deals, it is available for acquisition of 80% or more (by vote and value) of the stock of a corporate subsidiary or an S corporation, and it requires that the 80% or more requirement be satisfied within a 12-month period.

Sec. 336(e) is distinguished from Sec. 338(h)(10 in that It is available to non-corporate purchasers, it is available for combinations of sales, exchanges and / or distributions, it permits multiple purchasers of the stock to participate in the transaction.

Sec. 336(e) is also distinguished from Sec. 338(h)(10) in that it refers to the sale or exchange of shares of stock of the target, whereas Sec. 338(h)(10) refers to the purchase of such shares by the acquirer. This last distinction is important to note. Since the election under Sec. 336(e) is made by the seller and the target, it is imperative that purchasers wishing to structure deals using Sec. 336(e) include the applicable provisions referencing Sec. 336(e) in their purchase agreements.

Three possible applications of an election under Sec. 336(e) for which an election under 338(h)(10) would not be available are as follows:

  • Sale of stock in a U.S. corporation to a group of individuals and /or partnerships
  • Distributions of U.S. corporation stock to stockholders in a taxable spin-off (i.e. when Sec. 355 does not apply)
  • Distributions of U.S. corporation stock to stockholders in a spin-off that would be nontaxable but for the fact the transaction is subject to tax under Sec. 355(d) or (e)

Sec. 336(e) does not apply to a transaction that qualifies under both Sec. 336(e) and Sec. 338(h)(10); In such case, Sec. 338(h)(10) must be used. Nor does it apply to a nontaxable transfer of stock under Sections 351, 354, 355 (other than Sec. 355(d)(2) and (e)(2)), or 356. It is also inapplicable to a transaction where the seller or target is a foreign corporation.

Example Transaction – Sale of C-Corp Target Stock to Partnership Purchaser

A owns 100% of the stock of S (a C-Corp) which owns 100% of the stock of T. S’s basis in the stock of T is $7,000 with E&P $11,000. T’s basis in its assets is $8,000 with fair market value $10,000. S sells the stock of T to partnership (P) for $10,000 and elects with T under Sec. 336(e) to treat the transaction as a qualified stock disposition. S distributes the $10,000 sale proceeds to A.

The transaction is illustrated below:



The tax consequences of the above transaction are summarized below:



NOTE: The above tax consequences have the same effect as if S sold T’s assets to P, and T liquidated into S under Sec. 332. However, election under Sec. 336(e) reduces the complexity of the transaction and the need to re-title assets, etc. that would be required in an actual sale of assets.

NOTE: The above transaction is only advantageous to the seller if the seller’s basis in target stock is less than target’s basis in the underlying assets. If S’s basis in the stock of T was instead $8,000 and its basis in T’s assets were instead $7,000, S would have preferred that no Sec. 336(e) election be made since S’s gain would have then been $3,000 with the Sec. 336(e) election versus $2,000 without. The tax consequences to the purchaser and seller should be fully analyzed in deciding whether or not to make an election under Sec. 336(e).

Conclusion

The new regulations under Sec. 336(e) provide for expanded and more flexible application of the deemed asset sale treatment for acquisitions of corporate stock to non-corporate acquirers.

Their application is complex and requires much foresight and planning for effective implementation.   Taxpayers contemplating a sale or purchase of corporate stock should work closely with their tax advisors to determine whether an election under Sec. 336(e) is advisable, and how best to structure a deal to conform with its detailed requirements.

 

Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.

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