The regulations issued in 2013 putting Section 336(e) into effect allow a result like that of a Section 338(h)(10) election when the buyer is not a corporation. Like the Section 338(h)(10) election, the Section 336(e) election can be made by shareholders selling an S corporation, as well as when one corporation sells the stock of another corporation. Therefore, unlike Section 338(h)(10), a Section 336(e) election can be made in a case like this:
Example 1: A and B each own 50 percent of the stock of S corporation. Partnership Private Equity Firm (PPEF) wants to buy the stock and have a Section 336(e) election made. A and B arrange to be partners of PPEF, and each will own five percent of PPEF after the sale.
This scenario may not be that unusual when the buyer is an investment partnership acquiring a high-growth target. It raises several issues that can prevent use of the Section 336(e) election.
Related-Party Purchaser
The sellers must make a “qualified stock disposition” (QSD) in order to make an election. A QSD generally includes the sale of stock having at least 80 percent of the vote and value of the target corporation. Reg. Section 1.336-1(b)(5) excludes from the definition of “disposition” a stock sale to a related person. Is PPEF a related person regarding A and B? It is, and so the Section 336(e) election cannot be made on these facts.
All that the statute requires for relatedness is that stock owned by the buyer be attributable in any amount to the seller under Section 318, with modifications to Sections 318(a)(2)(A) and (a)(3)(A) to apply attribution in those cases only to and from a partner who owns at least five percent of the partnership. Recall that those parts of the attribution rules attribute stock to and from a partnership based on the proportion of the partnership owned by the partner. By putting a fiver percent floor under those rules, such attribution cannot occur in the case of a four-percent partner, for example.
That means that fiver percent of the S corporation stock can be attributed from PPEF to each of A and B after the sale. They sell 100 percent of S corporation. Therefore, PPEF is a related person as to 100 percent of the stock sold because that stock could be attributed back to A and B in some degree; the degree does not matter. The related-purchaser rule does not concern itself with the amount of the stock that could be attributed. There is no 50-percent cross-ownership requirement for relatedness, for example.
Does This Make Sense?
This is a surprising result, because in the Section 338(h)(10) cases it would be much harder for this problem to arise, even if the target is an S corporation.
Example 2: Same facts as Example 1, but the buyer is Corp. X. Section 318(a)(2)(C) prevents any of X’s stock in S corporation from being attributed to A and B because they do not own 50 percent of X. Therefore, X is not a related person purchaser.
There is one other part of the Section 336(e) regulations that might seem to apply to this scenario, but it does not. It states that in determining whether stock is sold to a related person, the principles of Section 338(h)(3)(C) and Reg. Section 1.338-3(b)(3) shall apply. Those rules modify the basic rule of Section 338(h)(3)(A)(iii) defining a qualified stock purchase as one in which the stock is not acquired from a person whose stock would be attributed to the purchaser. Recall that for purposes of regular Section 338 elections and Section 338(h)(10) elections, the purchaser must be a corporation. Therefore, the only way a seller’s stock could be attributed to a corporate purchaser would be for the seller to own at least 50 percent of the purchaser.
These rules address an unusual problem of a purchasing corporation buying stock as to which an election will be made from a corporation that it also was buying from a related party, which has nothing to do with the issue addressed here. Reg. Section 1.338-3(b)(3)(iv), Example 3.
There is one final related-party issue under other facts of Example 1. What if each of A and B owned and sold only 10 percent of S corporation? Now a qualified stock disposition occurs. However, the relatedness of the purchaser can cause other problems. The sale price of the 20 percent they sold is not grossed up into the deemed sale price because those sales were not dispositions at all under the regulations.
Alternate Solution
A and B might reach a similar result, but with a good qualified stock disposition, if they keep some of their stock in S corporation as a substitute for being partners in PPEF. This would reduce the basis gross up. Alternately, the S corporation can sell assets.
Conclusion
What this all means is that when the target of a private equity buyout is an S corporation, the selling shareholders cannot be five-percent members of the purchasing partnership if they own more than 20 percent of the target.
Written by Jack Cummings, Partner, Tax | Alston & Bird LLP
