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Beware when liquidating following a section 336(e) transaction

TAX ALERT | February 27, 2023 | Authored by RSM US LLP

Executive summary: Contingent consideration/liability effect on section 336(e) elections

Transactions involving section 336(e) elections present the buyer with the opportunity to achieve a step-up in the tax basis in the underlying assets of a purchased corporation. Where a purchaser wants to operate the business in a pass-through structure, the corporation is often converted into an LLC or otherwise liquidated for tax purposes. The liquidation generally does not result in corporate, or shareholder gain under section 331 and 336. However, in transactions involving the issuance of contingent consideration or the assumption of contingent liabilities, unexpected corporate and shareholder gain could occur. This alert addresses potential tax pitfalls from a buyer’s perspective.

Contingent consideration and liabilities can result in unintended gain

Section 336(e) transactions followed by a section 331 liquidation

Similar to the section 338(h)(10) transactions, section 336(e) provides for asset sale/acquisition treatment for a qualifying stock transaction a qualified stock disposition1 (QSD). The election is available upon a QSD of an S corporation stock, a domestic corporation in a consolidated group, or an affiliated but non-consolidated domestic corporation.

In general,2 when a section 336(e) election is made a series of transactions are deemed to occur:

  1. The target corporation, (old target) is treated as selling its assets to an acquiring corporation (new target) and realizes gain or loss on the deemed sale and then old target liquidates; 
  2. New target is treated as acquiring all of its assets from old target and allocates the consideration paid (the adjusted grossed up basis) under the rules of section 338.3  

One of the benefits of a section 336(e) transaction to noncorporate taxpayers, is the ability to operate the target business in pass-through format post-transaction as there is no requirement to have a corporate acquirer. To get to pass-through treatment, the target corporation needs to convert into an LLC (taxed as either a partnership or disregarded entity), which represents a liquidation for tax purposes. Since the acquirer in this case is a noncorporate taxpayer, the liquidation does not fall under sections 332 and 337 but rather sections 331 and 336.

Liquidations that are covered under sections 331 and 336 are taxable liquidations where both ethe corporation and shareholder could recognize gain if the fair market value of the property exceeds the tax basis in the assets or stock of the target. A section 331 immediately after a transaction to which a section 336(e) election was made would generally not create any additional tax liability because the assets received a stepped-up basis in the section 336(e) transaction. However, taxpayers should look closely at the transaction consideration before assuming a liquidation will not generate gain. For example, contingent consideration, such as an earnout, is common when the buyer and seller are not able to agree upon the purchase price at closing, which results in purchase price being paid post-closing. Here in lies the potential trap for the unwary.

Contingent consideration in deemed asset sales

As a result, if the corporation liquidates prior to paying the contingent consideration, gain could result to both the corporation and shareholder.

Example of the pitfall

The following example is meant to illustrate a scenario where a buyer may have unanticipated taxable gain as a result of a section 336(e) election followed by a 331 liquidation.

Situation 1

Facts: An S corporation (Target) is acquired by a partnership (Acquirer) in an acquisition which qualifies as a QSD for $100x. The parties make a section 336(e) election; however, Acquirer ultimately wants to hold the assets out of the corporate solution, and thus causes Target to convert under local state law into an LLC that is disregarded for tax purposes. This conversion is treated as a taxable liquidation under section 331.

Analysis: In this scenario, a new target is deemed to have acquired all of the assets of old target and has fair market value basis in the assets, as such the liquidation under section 331 does not trigger any additional gain.

Situation 2

Facts: Same as above, except they the Acquirer and Target shareholder are not able to agree on the purchase price and so in addition to the $100x paid, Acquirer also provides contingent earnout of up to $50x to be paid to seller if certain financial objectives are met. Assume that for financial statement accounting purposes the earnout receives $25x in value and the assets are reported as $125x.

Analysis: Here, the fair market value of the assets acquired appears to equal $125x, but the tax basis at the time of the liquidation is only $100x. The section 331 liquidation triggers a $25x of gain and corporate tax liability at new target. Moreover, the shareholder may also have a short term again of approximately $25x short term gain at the Acquirer level. Once the contingent amount is actually paid out, the Acquirer would then arguably recognize a capital loss.

Assume further that the full $50x is actually paid out (as opposed to the $25x estimated value at closing), Acquirer would not receive an additional $25x in asset basis, rather Acquirer would reflect the $50x as a capital loss on the stock of new target.

Planning Considerations

The safest course of action to avoid this situation is to perform a pre-transaction F reorganization on the Target prior to the sale as follows:

  1. Target shareholders form a new corporation (Holding)
  2. Target shareholders contribute Target to Holding in exchange for all of Holding’s shares. 
  3. A qualified subchapter S subsidiary election is made, and or, Target is converted into a limited liability company disregarded from Holding.4

At this point the target is an LLC disregarded from holding and the acquisition of Target by Acquirer represents an asset acquisition for federal income tax purposes and Target is already in pass-through form and no section 331 liquidation is necessary, thus avoiding the potential for gain recognition.

In the case of a sale of a consolidated subsidiary, an alternative to an F reorganization would be for the Target to convert under state law into an LLC and in turn a disregarded entity. Thereafter the acquisition of Target by Acquirer represents an asset acquisition for federal income tax purposes and thus no section 331 liquidation is necessary.

1 See Treas. Reg. Sec. 1.336-1(b)(6).

2 Other than transactions falling under sections 355(d)(2) or 355(e)(2); See Treas. Reg. Sec. 1.336-1(b)(3).

3 Treas. Reg. Sec. 1.336-1(a)(1).

4 IRS, Rev. Rul. 2008-18, 2008-13 I.R.B. 674.

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This article was written by Nick Gruidl, Nate Meyers and originally appeared on 2023-02-27.
2022 RSM US LLP. All rights reserved.

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