Election to Treat the Sale of Stock as an Asset Sale
Here are some key points about IRC Section 336(e):
- Stock Sale or Disposition: Section 336(e) primarily applies when a corporation sells or disposes of at least 80% of its assets, measured by value, within a 12-month period. This could be through the sale of stock or assets.
- Deemed Asset Sale: Under Section 336(e), if the conditions are met, the transaction is treated as if the corporation had sold its assets to a third party. This is often referred to as a "deemed asset sale."
- Electing Section 336(e): To use Section 336(e), both the selling corporation and the purchasing corporation must make a joint election. This election must be filed with the IRS, and once it's made, the transaction is treated as an asset sale for tax purposes.
- Implications: The use of Section 336(e) can have several tax implications. For example, it may allow the selling shareholders to access favorable capital gains rates on the sale of their stock, rather than ordinary income rates. Additionally, it can impact the corporation's ability to use any built-in losses or credits it may have.
- Anti-Abuse Rules: The IRS has implemented anti-abuse rules to prevent taxpayers from using Section 336(e) in abusive tax-avoidance schemes.
- Qualified Stock Purchase: Section 336(e) also has provisions related to what constitutes a "qualified stock purchase," which is a requirement for its application.
A Section 336(e) election, also known as a "deemed asset sale," can be beneficial for both the buyer and the seller in certain situations, particularly in the context of corporate mergers and acquisitions. However, it's important to understand the implications and requirements of such an election and consult with your agent to determine whether it is the right choice for your specific transaction.
This topic has been on my mind for a couple of weeks now, as I am working on a 336 transaction for a corporate client who is the seller of a Sub-Chapter S Corporation that just occurred in July 2023. Coincidentally, a potential new client came to see me to request I review a 336 transaction from last year (2022) where they were the buyer.
Is a Section 336 E Election Good for the Buyer and Seller?
Buyers and sellers often have opposing interests because they are participating in a transaction with different goals and objectives. Despite these opposing interests, successful transactions typically involve finding a balance that satisfies both parties to some extent. This balance can be achieved through negotiation.
Benefits for the Seller:
Tax Efficiency: One of the primary benefits for the seller is the potential for more favorable tax treatment. In a typical stock sale, the seller may be subject to capital gains tax on the sale of their stock. In a Section 336(e) election, the sale is treated as if the corporation sold its assets, potentially allowing for a more tax-efficient outcome. This can be particularly advantageous if the corporation has a lower tax basis in its assets than the fair market value.
Flexibility: Sellers may have more flexibility in structuring the transaction and allocating the purchase price among different asset classes. This flexibility can help optimize the tax consequences for the seller.
Avoiding Double Taxation: In a stock sale, there can be potential double taxation, as the corporation is taxed on any gain from the sale of its assets, and then shareholders are taxed again when they receive the proceeds from the stock sale. A Section 336(e) election can help avoid this double taxation.
Benefits for the Buyer:
Step-Up in Basis: A Section 336(e) election can result in a step-up in the tax basis of the acquired assets to their fair market value. This can be beneficial for the buyer as it may allow for higher depreciation or amortization deductions in the future, reducing taxable income.
Enhanced Asset Valuation: The buyer may have more flexibility in allocating the purchase price to specific assets, which can be advantageous for accounting and financial reporting purposes.
Avoiding Liabilities In some cases, a deemed asset sale can help the buyer avoid assuming certain liabilities of the target corporation, which can reduce the risk associated with the transaction.
So generally, the 336 E Election is one thing that both sides of the transaction can agree on. The area where "what's good for the seller, is bad for the buyer", and vice-versa, is in cost/price allocation to the various assets. Assets are catagorized by Class, of which there are seven (7) classes. These seven classes involve different tax treatments from the seller's and buyer's perspectives.
Asset Categories or Classes
Class I assets are cash and general deposit accounts (including savings and checking accounts) other than certificates of deposit held in banks, savings and loan associations, and other depository institutions.
Class II assets are actively traded personal property within the meaning of section 1092(d)(1) and Regulations section 1.1092(d)-1 (determined without regard to section 1092(d)(3)). In addition, Class II assets include certificates of deposit and foreign currency even if they are not actively traded personal property. Class II assets do not include stock of target affiliates, whether or not actively traded, other than actively traded stock described in section 1504(a)(4). Examples of Class II assets include U.S. government securities and publicly traded stock.
Class III assets are assets that the taxpayer marks-to-market at least annually for federal income tax purposes and debt instruments (including accounts receivable). However, Class III assets do not include (a) debt instruments issued by persons related at the beginning of the day following the acquisition date to the target under section 267(b) or 707; (b) contingent debt instruments subject to Regulations sections 1.1275-4, and 1.483-4, or section 988, unless the instrument is subject to the noncontingent bond method of Regulations section 1.1275-4(b) or is described in Regulations section 1.988-2(b)(2)(i)(B)(2); and (c) debt instruments convertible into the stock of the issuer or other property.
Class IV assets are stock in trade of the taxpayer or other property of a kind that would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business.
Class V assets are all assets other than Class I, II, III, IV, VI, and VII assets.
Note: Furniture and fixtures, buildings, land, vehicles, and equipment, which constitute all or part of a trade or business as defined in Regulations section 1.1060-1(b)(2) are generally Class V assets.
How Long Should I Keep Records?
Class VI assets are all section 197 intangibles (as defined in section 197) except goodwill and going concern value. Section 197 intangibles include:
- Workforce in place;
- Business books and records, operating systems, or any other information base, process, design, pattern, know-how, formula, or similar item;
- Any customer-based intangible;
- Any supplier-based intangible;
- Any license, permit, or other right granted by a government unit;
- Any covenant not to compete entered into in connection with the acquisition of an interest in a trade or a business; and
- Any franchise trademark, or trade name.
The term “section 197 intangible” does not include any of the following:
- An interest in a corporation, partnership, trust, or estate;
- Interests under certain financial contracts;
- Interests in land;
- Certain computer software;
- Certain separately acquired interests in films, sound recordings, video tapes, books, or other similar property;
- Interests under leases of tangible property;
- Certain separately acquired rights to receive tangible property or services;
- Certain separately acquired interests in patents or copyrights;
- Interests under indebtedness;
- Professional sports franchises acquired before October 23, 2004; and
- Certain transactions costs.
Class VII assets are goodwill and going concern value (whether or not the goodwill or going concern value qualifies as a section 197 intangible).
While there are potential benefits to both the buyer and the seller in a Section 336(e) election, it's essential to consider the specific circumstances of the transaction, as well as the associated legal and tax implications. Additionally, there may be specific requirements and elections that need to be made to qualify for this treatment.
Therefore, it's crucial to work closely with qualified professionals, such as tax advisors and attorneys, to determine the most appropriate structure for the deal and ensure compliance with tax regulations.
Business valuation is typically based on three major methods: the income approach, the asset approach and the market (comparable sales) approach. Among the income approaches is the discounted cash flow methodology calculating the net present value ('NPV') of future cash flows for an enterprise.
As an alternative to the more abbreviated income capitalization approach, this methodology is more relevant where future operating conditions and cash flows are variable or not projected to be materially consistent with current performance levels.
If you are considering either buying or selling a business, my staff and I can assist with valuation and structuring the transaction for the best tax benefit.
Why all the sudden interest in buying and selling businesses?
The recent increase in business sales is due in large part to the Baby Boomers retiring.
Workforce Makeup in 2018
- Baby Boomers—born 1946 to 1964 – 29%
- Generation X—born 1965 to 1980 – 36%
- Millennials—born 1981 to 2000 – 35%
Workforce Makeup Today
- Baby Boomers—born 1946 to 1964 – 6%
- Generation X—born 1965 to 1980 – 35%
- Millennials—born 1981 to 2000 – 35%
- Generation Z—born 2001 to 2020 – 24%
Looking at the 2018 workforce makeup numbers compared to today's numbers, illustrates a stark difference. The prepandemic and postpandemic workforces are very different. The uptick in death rates during the pandemic years 2020-2021, also was a contributing factor to business turnover.
