United States: Step-Ups In Tax Basis: Utilizing Section 336(e) Elections In Structuring Private Equity Acquisitions

Last Updated: April 8 2015
Article by Timothy J. Santoli

The IRS and Treasury Department recently issued regulations that provide rules for making a "Section 336(e) election." This election is a relatively new tax-planning tool to achieve a step-up in the tax basis of the target corporation's assets for income tax purposes where an asset purchase or a deemed asset purchase under Section 338 of the Internal Revenue Code is not available. A Section 336(e) election combines substantially similar tax consequences as a Section 338(h)(10) election (i.e., a step-up in the tax basis of the target corporation's assets) with a simpler transaction structure.

Specifically, in a Section 338(h)(10) election, the purchaser must be a corporation, whereas a Section 336(e) election may be made where a target corporation is purchased by partnerships, limited liability companies, individuals or a combination thereof. This means that, in acquiring stock of a target corporation, a private equity fund would not be required to incur the cost and complexity in setting up and maintaining a corporation to obtain a stepped-up tax basis in the assets of a target corporation. A consortium of co-investing funds purchasing the stock of a target corporation could also organize their holding company vehicle as an LLC and retain eligibility to cause the target corporation to make a Section 336(e) election where a Section 338(h)(10) election would not be permitted. In addition, the ability of a private equity fund or funds to utilize a partnership or LLC as a holding company allows, in certain circumstances, the management of the target corporation to achieve a tax-free rollover of a portion of their target corporation shares where such tax-free rollover may not otherwise be available.

To make a Section 336(e) election, the seller must make a "qualified stock disposition." For this purpose, a qualified stock disposition means any taxable transaction, or series of taxable transactions, in which 80 percent (by vote and value) or more of the C corporation's or S corporation's (as the case may be) stock is sold, exchanged or distributed, or any combination thereof, within a 12-month period. Any sale, exchange or distribution to a "related person" is not counted towards the 80 percent threshold required to achieve the qualified stock disposition. For purposes of a Section 336(e) election, in the case of a C corporation target, the seller generally must be a single corporation. In the case of an S corporation target, the sellers must simply be persons that are eligible to be shareholders of an S corporation. Thus, in order to take advantage of the step-up in tax basis, it is important that the purchaser conduct a level of due diligence to ensure that the S corporation target properly qualifies as an S corporation.

As in the case with Section 338(h)(10) elections, if it is desirable for certain of the management of the target corporation to "roll over" a portion of their target corporation shares, consideration must be given to avoid the transaction from qualifying as a tax-free Section 351 transaction or other nontaxable transaction. This is because neither a Section 336(e) nor a Section 338(h) (10) election applies to nontaxable transactions, such as Section 351 transactions or tax-free reorganizations. In any such latter events, the purchaser would not be entitled to a step-up in the tax basis of the target corporation's assets.

If the Section 336(e) election is made, the seller is not treated as selling the stock of the target corporation; rather, similar to a Section 338(h)(10) election, the target corporation is treated as selling its assets to an unrelated fictional corporation in a single transaction as of the close of business on the disposition date in exchange for the consideration paid for the stock (and taking into account certain of the liabilities of the target corporation) and then liquidating. The purchaser(s) of the stock of the target corporation become the owner(s) of the fictional corporation that now has a tax basis in the assets of the target corporation equal to the then current fair market value.

Unlike the Section 338(h)(10) election, which is a joint election between the seller and purchaser, the Section 336(e) election is made by the seller(s) and the target corporation. Therefore, if the purchaser does not wish for the election to be made (because, for example, the assets of the target corporation have depreciated), the purchaser should make sure that the purchase and sale agreement requires that no such election will be made unless agreed to by the purchaser at the purchaser's sole and absolute discretion. Similarly, if the purchaser anticipates availing itself of the benefits of Section 336(e), it should make sure that the purchase and sale agreement provides for its ability to cause the election to be made. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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