Section 336(e) Election: A Guide for Buyers and Sellers

When structuring the sale or acquisition of a business, understanding the tax implications is crucial because they can significantly affect the overall value of the transaction for both buyers and sellers. Among the various tax provisions available, two stand out for their ability to transform stock sales into asset sales for tax purposes: Section 336(e) and Section 338(h)(10) of the Internal Revenue Code. Here, we'll discuss the Section 336(e) election, explaining what it is, who qualifies to use it, how to make the election, and how it compares with the more commonly known Section 338(h)(10) election. We will also explore the practical considerations, advantages, and limitations of Section 336(e), supported by relevant statutes and case law.

What Is a Section 336(e) Election?

Section 336(e) of the Internal Revenue Code provides a mechanism whereby certain stock or membership dispositions can be treated as if the corporation or limited liability company itself sold all of its assets in a taxable transaction, followed by a liquidation. This election effectively recharacterizes a stock sale as an asset sale for tax purposes, allowing the buyer to receive a step-up in the tax basis of the businesses assets to their fair market value. This step-up can be highly beneficial because it increases depreciation and amortization deductions for the buyer, reducing future taxable income.

The Section 336(e) election was introduced as part of the legislative response to the repeal of the General Utilities doctrine, a longstanding principle established by the Supreme Court in General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935). Under the General Utilities doctrine, corporations could distribute appreciated property to shareholders without recognizing gain at the corporate level. The repeal of this doctrine necessitated new rules to address the tax consequences of corporate liquidations and stock sales, leading to the creation of Section 336(e).

Who Can Use a Section 336(e) Election?

The Section 336(e) election is available to certain sellers and transactions that meet specific criteria. Primarily, the seller must be a domestic corporation that owns at least 80% of the stock of the target corporation, or multiple members of a consolidated group that collectively own 80% or more of the target’s stock. This ownership threshold is critical because the election applies only to what is termed a “qualified stock disposition” (QSD), which generally involves the taxable disposition of at least 80% of the vote and value of the target’s stock within a 12-month period.

Importantly, the election is also available to owners of at least 80% of the stock of an S corporation who dispose of that stock in a taxable transaction to unrelated parties. This inclusion of S corporations broadens the applicability of Section 336(e) beyond C- corporations.

However, not all sellers or transactions qualify. Partnerships or individuals disposing of stock in a domestic C corporation generally cannot make the election. Additionally, the election is not available for nontaxable transfers such as those governed by Sections 351, 354, 355, or 356 of the Internal Revenue Code, nor is it available if either the seller or the target is a foreign corporation. These restrictions ensure that the election applies only in clearly taxable stock dispositions involving domestic entities.

How to Make a Section 336(e) Election

The process of making a Section 336(e) election varies depending on whether the target corporation is an S corporation or a C corporation. For S corporations, the election requires a binding written agreement signed by all shareholders, including those not participating in the stock disposition, as well as the S corporation itself. This agreement must be executed by the due date, including extensions, of the S-corporation’s federal income tax return for the tax year that includes the disposition date. The S-corporation must retain a copy of this agreement and attach the prescribed election statement to its timely filed tax return.

In the case of C-corporations, the election statement must be attached to the federal income tax returns of both the seller and the target corporation for the year in which the qualified stock disposition occurs. This dual filing requirement ensures that both parties acknowledge and report the election consistently.

If there is uncertainty about whether a transaction qualifies for the election, taxpayers may file a protective Section 336(e) election to preserve their rights while awaiting further clarification. It is important to note that once the election is made, it is irrevocable, so careful consideration and consultation with tax professionals are advisable before proceeding.

Tax Consequences of a Section 336(e) Election

The tax consequences of making a Section 336(e) election are significant. The target corporation is treated as if it sold all of its assets at fair market value, which triggers recognition of gain or loss at the corporate level. Following this deemed sale, the target corporation is considered to have liquidated, distributing the proceeds to its shareholders.

For the buyer, this results in a stepped-up basis in the acquired assets, which can translate into increased depreciation and amortization deductions over time, reducing taxable income and enhancing cash flow. For S-corporations, the gain recognized by the deemed asset sale flows through to the shareholders and is reported on their individual tax returns, preserving the pass-through nature of the entity.

This recharacterization of a stock sale as an asset sale can produce substantial tax benefits for buyers, but it also means that the seller may face corporate level tax on the deemed asset sale, which must be factored into deal negotiations.

Advantages of a Section 336(e) Election

One of the primary advantages of the Section 336(e) election is the step-up in basis it affords the buyer. This step-up allows the buyer to depreciate and amortize the acquired assets based on their fair market value, potentially leading to significant tax savings in future years. Unlike Section 338(h)(10), which requires the buyer to be a corporation, Section 336(e) is available regardless of the buyer’s entity type. This means individuals, partnerships, and other non-corporate entities can benefit from the election, making it more flexible in a broader range of transactions.

Another advantage is that the election is seller driven, meaning the seller and the target corporation control whether the election is made, rather than requiring the buyer’s consent. This can simplify negotiations and provide the seller with more control over the tax treatment of the transaction.

Section 336(e) also allows aggregation of multiple stock dispositions over a 12-month period to meet the 80% ownership threshold, which is particularly useful in transactions involving multiple buyers or staggered sales. This flexibility is not available under Section 338(h)(10), which requires a single qualified stock purchase.

Limitations and Considerations

Despite its benefits, the Section 336(e) election has limitations. Since the election is made solely by the seller and the target, buyers may have less certainty about whether the election will be made, potentially complicating deal negotiations. Buyers often seek contractual assurances that the election will be made to secure the step-up in basis.

Legally, the transaction remains a stock sale, so certain liabilities and obligations of the target corporation may transfer to the buyer, unlike a true asset sale where liabilities generally remain with the seller. This can affect the buyer’s risk profile and due diligence requirements.

State tax treatment of Section 336(e) elections may vary, as not all states conform to federal tax rules. This divergence can create additional complexity and potential tax exposure at the state level.

Finally, the election is not available for tax-free reorganizations or transactions involving foreign corporations, limiting its applicability in some cross-border or tax-deferred deals.

Section 336(e) vs. Section 338(h)(10): Key Differences

While both Section 336(e) and Section 338(h)(10) elections enable a stock sale to be treated as an asset sale for tax purposes, they differ significantly in their mechanics and applicability. Section 338(h)(10) requires a joint election by both the buyer and the seller, and the buyer must be a corporation. This election is generally used in qualified stock purchases where a single corporate buyer acquires at least 80% of the target’s stock.

In contrast, Section 336(e) is a seller-driven election that does not require buyer participation or consent and is available regardless of the buyer’s entity type. It also allows aggregation of multiple sales to meet the 80% ownership threshold, which is not permitted under Section 338(h)(10). Both elections result in a step-up in the basis of the target’s assets, but Section 336(e) offers more flexibility in transaction structure and buyer identity.

Practical Examples

Consider an S-corporation with three shareholders who collectively own 100% of the stock. If they sell 85% of their stock to an unrelated individual buyer, they can make a Section 336(e) election. This election treats the transaction as if the S-corporation sold all its assets, allowing the buyer to receive a stepped-up basis in those assets, even though the buyer is not a corporation.

In another scenario, a domestic parent corporation owns 100% of a subsidiary and sells 90% of the subsidiary’s stock to a private equity fund structured as a partnership. Because the buyer is not a corporation, a Section 338(h)(10) election would not be available. However, the parent corporation can make a Section 336(e) election, enabling the step-up in asset basis despite the buyer’s entity type.

Making the Election: Step-by-Step

To make a Section 336(e) election, the parties must first confirm that the transaction qualifies as a qualified stock disposition and that the seller and target meet the ownership and other requirements. Next, they must draft and execute a binding written agreement among all required parties to make the election. The election statement prescribed by the Treasury Regulations must then be prepared and attached to the timely filed federal income tax returns of the seller and the target corporation for the relevant tax year. Finally, all documentation, including the written agreement and election statement, should be retained in case of IRS inquiry.

Statutes and Regulations

The Section 336(e) election is governed primarily by 26 U.S.C. §336(e) and the accompanying Treasury Regulations found at 26 C.F.R. §1.336-2. The election’s foundation stems from the repeal of the General Utilities doctrine, as articulated by the Supreme Court in General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935). Additional guidance on related party rules and definitions of qualified stock dispositions can be found in Treasury Regulations §§1.336-1(b)(6) and 1.338-3(b)(3).

The Section 336(e) election is a powerful and flexible tax planning tool that allows sellers to convert certain stock sales into deemed asset sales, providing buyers with a valuable step-up in asset basis. Its applicability to a wide range of buyers, including non-corporate entities, and its seller-driven nature distinguish it from the more restrictive Section 338(h)(10) election. However, the election’s irrevocability, procedural requirements, and potential state tax implications require careful consideration.

For parties involved in corporate acquisitions or dispositions, understanding the nuances of Section 336(e) and how it compares to Section 338(h)(10) is essential for optimizing tax outcomes. Given the complexity of these elections and their significant impact on deal economics, consulting with experienced tax advisors and legal counsel is highly recommended.

This article is intended for informational purposes only and does not constitute legal or tax advice. For specific guidance tailored to your situation, please consult a qualified tax professional.

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