AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS QUALIFIED SUBCHAPTER S SUBSIDIARY (QSUB) PRACTICE GUIDE

Transcription

1 AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS QUALIFIED SUBCHAPTER S SUBSIDIARY (QSUB) PRACTICE GUIDE Developed by the AICPA QSub Task Force Gregory A. Porcaro, Chair Robert W. Jamison Stewart Karlinsky Kenneth N. Orbach Norman S. Solomon Deanna Walton Marc A. Hyman, AICPA Technical Manager Reviewed and Approved by the AICPA S Corporation Taxation AICPA S Corporation Taxation Technical Resource Panel Technical Resource Panel Laura M. MacDonough, Chair Kenneth N. Orbach, Chair Kenneth N. Orbach, Vice-Chair Laura M. MacDonough, Immediate Past Chair Jeffrey A. Erickson Alan S. Alport Mark A. Hajduch Laura Howell-Smith Stewart Karlinsky Stewart Karlinsky Gregory A. Porcaro Steven Pajakowski Greg W. Smith Gregory A. Porcaro P. Gerald Sokolski Larry Silver Deanna Walton Greg W. Smith P. Gerald Sokolski Copyright 2003 by the American Institute of Certified Public Accountants 1455 Pennsylvania Avenue, NW, Fourth Floor, Washington, DC All rights reserved. For information about the procedure for requesting permission to make copies of any part of this work, please call the AICPA Copyright Permissions Hotline at A Permissions Request Form for ing requests is available at by clicking on the copyright notice on any page. Otherwise, requests should be written and mailed to the Permissions Department, AICPA, Harborside Financial Center, 201 Plaza Three, Jersey City, NJ

2 TABLE OF CONTENTS CHAPTER Page No. Chapter 1. Overview of the Qualified Subchapter S Subsidiary (QSub)...1 I. Legislative History and Congressional Intent...1 II. What is a QSub?...2 Chapter 2. Eligibility Rules...4 I. General Rules...4 II. Special Rules to Determine Whether the Subsidiary is Wholly-Owned...4 A. Subsidiary Stock Legally Owned by Others Disregarded Entities Nominal vs. Beneficial Ownership...5 B. Stock Disregarded by Reference to the One Class of Stock Regulations...5 C. Debt vs. Equity and the Straight Debt Safe Harbor...6 Chapter 3. Making a QSub Election...8 I. Election Procedure...8 A. Timing and Effective Date of Elections...8 B. Elections Involving Tiered Structures...8 C. Late Elections...8 D. Signature Requirements...9 II. Acknowledgments of Election and Proof of Filing...10 III. Effects of the QSub Election...10 A. Deemed Liquidation and the Step Transaction Doctrine...10 B. Adopting a Plan of Liquidation...11 C. Treatment of QSub Stock...11 D. Transitional Relief from the Application of Step Transaction...11 E. Timing of the Deemed Liquidation Acquisitions of S Corporation Stock Acquisitions Involving a Section 338 Election...13 IV. LIFO Recapture Tax Triggered by Election...13 ii

3 CHAPTER Page No. Chapter 4. Termination of a QSub Election...15 I. General Rules...15 A. Cause of Termination and Prohibition on Re-election...15 B. Tax Consequences of a Termination...15 C. Reporting Requirements...16 II. Pitfalls...17 III. Tiered Subsidiaries...18 Chapter 5. Special Issues...19 I. Payroll Reporting (Notice 99-6)...19 II. State Tax Reporting...20 III. Banks as S Corporations or QSubs...20 A. Separate Application of the Banking Rules...20 B. Bank Director s Shares...20 C. Special Rules Applicable to Banks...20 IV. S Corporation and QSub Elections for Consolidated groups...21 A. Liquidation Timing Rules Timing of Simultaneous S and QSub Elections Timing of Deemed Liquidations for Tiered Subsidiaries...21 B. Consequences of Timing Excess Loss Accounts Deferred Inter-company Transactions Taxable vs. Nontaxable Liquidation Section 1374 Issues...23 V. Insolvent Subsidiaries...24 Chapter 6. Examples of QSub Usage...26 I. Benefits of QSub Usage...26 II. Comparison of QSubs with Single-Member Limited Liability Companies (SMLLCs)...32 iii

4 CHAPTER Page No. Appendix A. QSub Checklist...34 Appendix B. Subchapter C Code Sections Crucial to Understanding QSubs...43 Appendix C. Key Forms and Documents Form 8869 and Instructions Sample Revocation Letter Internal Revenue Code Section 1361(b) Treasury Decision 8869 [QSub Regulations] Notice Revenue Procedure iv

5 CHAPTER 1 OVERVIEW OF QSUBS I. Legislative History and Congressional Intent The Technical Amendments Act of 1958, P.L , enacted the first version of Subchapter S. It allowed certain small business corporations, which were known as Subchapter S corporations, to legitimately avoid the corporate income tax. This version of Subchapter S was restricted to corporations that had a single class of stock, had no more than 10 shareholders (which could be only individuals and estates), and were not members of affiliated groups or qualified for other special tax treatment (such as banks and life insurance companies). Although over the years the maximum number of shareholders has been increased several times and certain trusts have been added to the list of eligible shareholders, S corporations generally were still not allowed to own 80 percent or more of a corporate subsidiary. In addition, a corporation with a corporate shareholder could not be governed by the provisions of Subchapter S. Much of this changed with the Small Business Job Protection Act of 1996, P.L , ( 96 Act). Effective for years beginning after 1996, federal S corporation tax law now permits an S corporation to own any amount of stock in another corporation (whether foreign or domestic). A corporation is still not a permitted S corporation shareholder; however, if all of the stock of a domestic corporation is owned by an S corporation, an election may be made to treat the subsidiary as a qualified subchapter S subsidiary (QSub) under section 1361(b)(3). A QSub is a disregarded entity for federal income tax purposes. The 96 Act Committee Reports state the following reason for relaxing the rule regarding subsidiaries: The Committee understands that there are situations where taxpayers may wish to separate different trades or businesses in different corporate entities. The Committee believes that, in such situations, shareholders should be allowed to arrange these separate corporate entities under parent-subsidiary arrangements as well as brother-sister arrangements. H.R. Rep. No , at 88 (1996); S. Rep. No , at 52 (1996) The legislative intent of the 1996 Act is straightforward. C corporations had always been able to use subsidiaries to achieve legitimate business goals. However, S corporations with similar business needs were prohibited from utilizing 80 percent or more owned subsidiaries. This restriction stemmed, in part, from historical notions that S corporations should be kept simple and remain very limited in application and scope. With almost forty years having passed since S corporations came into law, however, their use had become widespread. By the mid-1990s, the ability of an S corporation to be a member of an affiliated group of corporations no longer seemed to offend any fundamental tax principles. After several years of prodding by the AICPA and other groups, Congress agreed to remove the restrictions 1

6 II. What is a Qualified Subchapter S Subsidiary? Section 1361(b)(3)(B) defines a QSub as any domestic corporation that is not an ineligible corporation (i.e., certain banks, insurance companies, domestic international sales corporations and corporations claiming a possessions tax credit) if: 1. An S corporation holds 100 percent of the stock of the corporation, and 2. The S corporation parent elects to treat the subsidiary as a QSub. Except for certain banks, a corporation for which a QSub election has been made will not be treated as a separate corporation for federal tax purposes even though it remains a separate legal corporate entity under state law. Instead, all of a QSub s assets, liabilities, and items of income, deduction, and credit are treated as belonging to the parent S corporation. The computation of taxable income or loss, built-in gains, passive investment income, and other federal tax items, as well as the characterization of distributions, is generally determined on an aggregate basis by the parent corporation. Although the 96 Act has been in effect for over five years, many tax practitioners are still unfamiliar with its QSub provisions. The S Corporation Taxation Technical Resource Panel of the AICPA Tax Division believes that if CPAs better understand the uses and mechanics of QSubs, they will better serve their clients. This QSub Practice Guide has been developed to help achieve this goal. The QSub rules are quite complex because they often look to longstanding rules under Subchapter C. Because of the great value of QSubs even for smaller S corporations, however, practitioners should become familiar with these technical rules. In particular, practitioners should be acquainted with the eligibility requirements, the formal election procedures, the effect of the election upon the corporation, pitfalls to avoid, the effect of termination, and special compliance requirements in certain cases. All these topics are described in the following chapters. In addition to the discussion of the technical aspects of QSubs, Chapter 6 contains a review, by way of examples, of the reasons why practitioners should seriously consider using QSubs, and also compares their use to that of single-member limited liability companies (SMLLCs). Cautionary Reminder: Although QSubs offer valuable benefits under the right conditions, taxpayers must be careful to consider all tax and non-tax features of the transactions. The following aspects should be reviewed in detail to make certain the decision to use a QSub is advisable: 1. A shareholder of the parent corporation may be a creditor of its wholly-owned subsidiary. If the parent makes a QSub election with regard to the subsidiary, the shareholder becomes a creditor of the parent for federal tax purposes. Although this will increase the shareholder s section 1366(d) loss flowthrough limitation, there are situations when the shareholder s at risk basis may not increase. In addition, the impact of the passive loss rules on the parent s shareholders must be considered. 2

7 2. The effect of judicial doctrines (such as business purpose, economic substance, step transaction, and continuity of interest) must be considered carefully. 3. Legal counsel should be consulted to assist with the transactions to make sure that all relevant state laws have been complied with. 3

8 CHAPTER 2 ELIGIBILITY RULES I. General Rules 1 A parent S corporation may elect to treat a subsidiary as a QSub if the subsidiary is: 1) wholly owned by the S corporation; 2) a domestic corporation; and 3) not an ineligible corporation (as that term is defined in section 1361(b)(2)). The requirements of section 1361(b)(1) do not apply to QSubs. For example, S corporations cannot have a corporate shareholder; however, a QSub must have a corporate shareholder, i.e., the parent. In addition, S corporations cannot have more than one class of stock; however, QSubs can have multiple classes of stock provided that each class outstanding is wholly owned by the parent S corporation. Example 1: X, an S corporation, owns 100 percent of the stock of Y, a domestic corporation. Y is an insurance company subject to tax under subchapter L. Because Y would be ineligible to be an S corporation under the rules of section 1361(b)(2), X may not elect to treat Y as a QSub. Example 2: X, an S corporation, owns 100 percent of the five classes of Y stock outstanding. Because X is an S corporation that owns 100 percent of each class of outstanding Y stock, X may elect to treat Y as a QSub. The one class of stock requirement of section 1361(b)(1)(D) does not apply to a QSub. II. Special Rules to Determine Whether the Subsidiary is Wholly-Owned A. Subsidiary Stock Legally Owned by Others The determination of whether an S corporation owns 100 percent of the stock of a QSub is made based on general principles of federal tax law. For example, a legal owner of subsidiary stock certificates is not necessarily treated as the owner of the stock for purposes of determining QSub eligibility. Specifically, this is true when 1) subsidiary stock is held by a disregarded entity owned by the S corporation or 2) a person or entity other than the S corporation holds nominal title to the shares. Each of these possibilities is discussed below. 1. Disregarded Entities The check-the-box regulations under section 7701 provide that business entities are classified as either partnerships, corporations, or disregarded entities. 2 Generally, the regulations allow a noncorporate business entity (an eligible entity) and its owners to elect its classification for federal tax purposes. Under the default rules, absent an election, an eligible domestic SMLLC is disregarded as an entity separate from its owner just as a QSub is disregarded as separate from its 1 This discussion assumes a general knowledge of the S corporation eligibility requirements. For further details concerning these requirements, please see section 1361(b)(1) and (2). 2 This discussion assumes a general knowledge of the check-the-box regulations. For further details, please see reg. sections and -3. 4

9 S corporation owner. Thus, assets (including corporate stock) held by these entities will be treated as owned directly by their owners for federal tax purposes. The examples below consider various QSub ownership structures that may arise by operation of these rules. Example 3: X, an S corporation, owns 100 percent of Y, a QSub. Y owns 100 percent of Z, a corporation otherwise eligible to be a QSub. Because the stock of Z owned by Y is treated as owned directly by X for federal tax purposes, X is treated as owning 100 percent of the stock of Z. Thus, X may elect to treat Z as a QSub. Example 4: X, an S corporation, owns 100 percent of Y, an SMLLC that is disregarded as separate from X for federal tax purposes. Y owns 100 percent of the stock of Z, a corporation otherwise eligible to be a QSub. Because the stock of Z owned by Y is treated as owned directly by X for federal tax purposes, X is treated as owning 100 percent of the stock of Z. Thus, X may elect to treat Z as a QSub. Example 5: X, an S corporation, owns 100 percent of Y, a QSub. Y owns 50 percent of the stock of Z, a corporation otherwise eligible to be a QSub. The remaining 50 percent of the Z stock is owned directly by X. Because the stock of Z owned by Y is treated as owned directly by X for federal tax purposes, X is treated as owning 100 percent of the stock of Z. Thus, X may elect to treat Z as a QSub. Example 6: X, an S corporation, owns 100 percent of Y and Z, both QSubs. Y owns 50 percent of Q, a corporation otherwise eligible to be a QSub. The remaining 50 percent of Q is owned by Z. Because the stock of Q owned by both Y and Z is treated as owned directly by X for federal tax purposes, X is treated as owning 100 percent of the stock of Q. Thus, X may elect to treat Q as a QSub. Example 7: X, an S corporation, owns 100 percent of Y, a C corporation otherwise eligible to be a QSub but for which no QSub election has been filed. Y owns 100 percent of the stock of Z, a corporation otherwise eligible to be a QSub. Because the separate corporate existence of Y is respected for federal tax purposes, X is not treated as owning 100 percent of the stock of Z directly. Thus, X may not elect to treat Z as a QSub. However, when a QSub election is in effect for Y, X could elect to treat Z as a QSub. 2. Nominal vs. Beneficial Ownership The determination of the identity of the holder of subsidiary stock for purposes of the 100 percent ownership requirement is a federal tax determination. Thus, ownership of shares by a nominee with no beneficial interest in the subsidiary stock is disregarded for purposes of determining whether an S corporation owns 100 percent of its stock. The nominee may have legal title to the shares of stock, but beneficial ownership of those shares would be held by another party. 5

10 B. Stock Disregarded by Reference to the One Class of Stock Regulations Regulation section (b) provides that to satisfy the 100 percent stock ownership requirement, all of the subsidiary s outstanding stock must be owned by the S corporation for federal income tax purposes. Any outstanding instruments, obligations, or arrangements that would not be considered stock of an S corporation for purposes of the one class of stock rule of section 1361(b)(1)(D) are not considered outstanding stock for this purpose. Example 8: X, an S corporation, owns 100 percent of the outstanding shares of Y, a QSub. On January 1, 2002, Y issues shares of stock to its employees. The stock is substantially nonvested within the meaning of section 83. None of the employees files an election under section 83(b) with respect to the stock. Under these facts, the nonvested shares issued to the employees are not treated as outstanding stock of the QSub. Thus, X will continue to be treated as the owner of 100 percent of the outstanding stock of Y until the stock of any employee vests. Example 9: Assume the same facts as in the previous example except that one of the employees files a section 83(b) election with respect to the receipt of Y stock. Under these facts, the stock received by that employee is treated as outstanding stock of Y for purposes of Subchapter S. Because X no longer owns 100 percent of the stock of Y, Y s QSub election terminates. See Chapter 4 below for the tax consequences of such a termination. Example 10: X, an S corporation, owns 100 percent of the outstanding shares of Y, a QSub. On January 1, 2002, the corporation adopts a phantom stock plan for the benefit of its employees. The plan does not provide for the actual issuance of stock to employees. X continues to be treated as the owner of 100 percent of the outstanding stock of Y. C. Debt vs. Equity and the Straight Debt Safe Harbor The QSub regulations provide that any subsidiary arrangements that meet the straight debt safe harbor of section 1361(c)(5) are not treated as outstanding QSub stock for purposes of determining QSub status even if that arrangement otherwise is treated as equity under general principles of federal tax law. For this purpose, an arrangement satisfies the straight debt safe harbor if it is a written, unconditional obligation to pay a sum certain on demand or on a specified due date, which: 1. Does not provide for an interest rate or interest payment dates that are contingent on profits, the borrower s discretion, or similar factors; 2. Is not convertible (directly or indirectly) into stock or any other equity interest of the S corporation; and 3. Is held by an individual (other than a nonresident alien), an estate, a trust eligible to be an S corporation shareholder, or a person that is actively and regularly engaged in the business of lending money. 6

11 Example 11: X, an S corporation, owns 100 percent of the outstanding shares of Y, an entity for which a QSub election is in effect. Y borrows money from Z. Even though this arrangement might be treated as Y equity owned by Z under general principles of federal tax law, if it meets the straight debt safe harbor provided in the regulations, it is ignored in determining whether X owns 100 percent of the Y shares. Accordingly, the debt will not affect Y s QSub eligibility. Example 12: Assume the same facts as in Example 11 except that the debt does not meet the straight debt safe harbor and is treated as an equity interest in Y for federal tax purposes. As a result, X no longer owns 100 percent of the stock of Y for federal tax purposes. Accordingly, Y s QSub election terminates. Example 13: Assume the same facts as in Example 11 except that, immediately prior to the issuance of the debt by Y, X causes Y to merge into a disregarded single-member LLC owned by X. No election is filed to treat the LLC as a corporation for federal tax purposes. Under these facts, the characterization of the debt between Z and Y as equity results in the formation of new partnership XZ. X is deemed to contribute the assets of Y; Z is deemed to contribute what it had, in form, loaned to Y. This transaction generally is nontaxable to all parties. 7

12 I. Election Procedure CHAPTER 3 MAKING A QSUB ELECTION A QSub election is made by filing Form 8869, Qualified Subchapter S Subsidiary Election, with the Service Center where the subsidiary filed its most recent income tax return. If the subsidiary was formed by the parent and it has never filed a return, Form 8869 should be filed with the Service Center where the parent filed its most recent corporate tax return. A. Timing and Effective Date of Election A QSub election can be made at any time during the year and will be effective on the date (if any) specified on the form. However, the effective date specified cannot be more than: 1. two months and fifteen days before the date the election is filed, or 2. twelve months after the date the election is filed. For example, a Form 8869 filed by a calendar year S corporation parent on July 25, 2002, to make a QSub election for its eligible subsidiary may specify that the election is to be effective any time between May 10, 2002 and July 24, If the election specifies an effective date earlier than the date in 1 above, it will be treated as being effective two months and fifteen days before the date of filing. If the election specifies an effective date later than the date in 2 above, it will be treated as being effective twelve months after the date of filing. If a Form 8869 is not timely filed for the desired effective date, relief may be available under Revenue Procedure (see below) or reg. sections , -2, and -3. Note: If no date is specified, the election is effective on the date the Form 8869 is filed. B. Elections Involving Tiered Structures QSub elections can also be made for eligible tiered subsidiaries, including those owned by disregarded entities such as LLCs. A subsidiary s deemed liquidation that occurs as a result of the QSub election is particularly important when considering QSub elections for a tiered group of subsidiaries. If the elections are effective on the same day, the regulations allow the parent to select the order of the deemed liquidations of the subsidiaries on an attachment to Form If no order is specified, the subsidiaries are treated as liquidating from the bottom up (i.e., the lowest-tier subsidiary liquidates into its parent and so on until the upper-tier subsidiary liquidates into the parent S corporation). 8

13 C. Late Elections Revenue Procedure , I.R.B. 998, provides relief if a QSub election is not timely filed for the desired effective date. An S corporation may be granted additional time to file Form 8869 if all of the following conditions are met: 1. The entity fails to qualify for its intended status as a QSub on the first day that status was desired solely because of the failure to file the QSub election with the applicable service center. 2. The parent has reasonable cause for its failure to timely file. Reliance on a tax advisor generally will qualify as reasonable cause (see, for example, PLRs and ); 3. Less than 24 months have passed since the original due date of the intended election; 4. Either, a) all of the following requirements are met: (i) the parent has not filed a tax return for the first year in which the QSub election was intended, (ii) the application for relief is filed under Rev. Proc no later than 6 months after the due date of the Parent s tax return (excluding extensions) for the first year in which the election was intended, and (iii) no taxpayer whose tax liability or tax return would be affected by the QSub election (including all shareholders of the S corporation) has reported inconsistently with the S election and QSub election, on any affected return for the year the QSub election was intended; or b) all of the following requirements are met: (i) the parent has filed a tax return for the first year in which the QSub election was intended within 6 months of the due date of the tax return (excluding extensions), and (ii) all taxpayers whose tax liability or tax returns would be affected by the QSub election (including all shareholders of the parent) have reported consistently with the S corporation election and the QSub election on all affected returns for the year the QSub election was intended, as well as for any subsequent years; and Note: Due to the calendar-year requirement, in most cases the due date of the parent s S corporation return will be March 15 of following year, which may not give practitioners sufficient time to determine if the QSub election was filed in a timely manner. Practitioners dealing with a new client should make this determination as soon as possible. Assuming all of the above conditions are met, the Form 8869 should be filed with the following modifications: 1. At the top of the form write FILED PURSUANT TO REV. PROC , If the parent has not filed a tax return for the first year in which the QSub election was intended, Form 8869 must be filed within 18 months of the form s original due date (but 9

14 not later than six months after the unextended due date of the parent s tax return for such first year). If the parent has filed a tax return for the first year in which the QSub election was intended within six months of its unextended due date, Form 8869 must be filed within 24 months of the form s original due date. 2. Attach a statement establishing reasonable cause for failure to file timely, 3. Attach a statement that the corporation satisfies the QSub requirements of section 1361(b)(3)(B), 4. Attach a statement that all assets, liabilities and items of income, deduction and credit of the QSub have been treated as assets, liabilities and items of income, deduction and credit of the S corporation (on all affected returns) consistent with the QSub election for the year the election was intended and for all subsequent years, and 5. Attach a dated declaration signed by an officer of the S corporation (who is authorized to sign) which states: Under penalties of perjury, I declare that, to the best of my knowledge and belief, the facts presented in support of this election are true, correct and complete. In situations where the parent s S corporation election (Form 2553) and the QSub election (Form 8869) were not timely-filed, the parent corporation may request relief under the conditions of Section 4 of Revenue Procedure , which are very similar to the conditions listed above. Revenue Procedure contains a flowchart relating to late QSub, as well as S corporation, ESBT and QSST elections. If you do not qualify for relief under Revenue Procedure , then you must request a private letter ruling under reg. sections , -2, and -3 and pay the user fee required by Revenue Procedure , I.R.B. 1 (or its successor), currently $6,000 (although a reduced user fee of $500 may apply if the S corporation s gross income is less than $1 million). D. Signature Requirement The Form 8869 must be signed by an officer of the parent corporation who is authorized to sign the parent s Form 1120S. II. Acknowledgments of Election and Proof of Filing The instructions to Form 8869 state that the Service Center where the election was filed will notify the parent corporation of the acceptance or rejection of the election within sixty days of filing. Practitioners should inform their clients to make an inquiry if notice of the election is not received within ninety days of the filing. In order to prove that an election was filed, it is recommended that any QSub election filed should be mailed certified and return receipt requested. 10

15 III. Effects of QSUB Election It is important that practitioners understand the effect of making a QSub election in order to properly advise clients as to implications of its use. In most cases, with the exception of the treatment of banks, the effect of a QSub election is straightforward. When an election is made, the subsidiary is no longer treated as a separate corporation for federal tax purposes. All of its assets, liabilities, income, deductions, and credits are treated as if they belong to the S corporation parent. The QSub becomes a disregarded entity (not an S corporation as some have assumed) for federal tax purposes. While QSubs are creatures of subchapter S, the tax consequences, if any, of their deemed liquidation generally are determined under the rules of subchapter C so that an understanding of certain subchapter C code sections, with their judicial interpretations, is required. Please see Appendix B for a summary of some of the subchapter C areas that QSub practitioners should understand. A. Deemed Liquidation and the Step Transaction Doctrine Regulation section (a)(2) provides that when an S corporation makes a QSub election with respect to a subsidiary, the subsidiary is deemed to have liquidated into the S corporation. Sections 332 and 337 generally govern the tax treatment of the liquidation. However, if the liquidation is part of a larger transaction, then other Code sections and general principles of tax law may apply, including the step transaction doctrine. The step transaction doctrine in general is applied to collapse formally distinct steps into a single transaction for federal income tax purposes. The application of the step transaction doctrine to QSubs is illustrated in reg. section (a)(2)(ii) by the following examples: Example 1: Corporation X acquires all of the outstanding stock of solvent corporation Y from an unrelated individual for cash and short-term notes. Thereafter, as part of the same plan, X immediately makes an S election for itself and a QSub election for Y. Because X acquired all of the stock of Y in a qualified stock purchase within the meaning of section 338(d)(3), the subsidiary s liquidation described in reg. section (a)(2) is respected as an independent step separate from the stock acquisition, and the tax consequences of the liquidation are determined under sections 332 and 337. Example 2: Corporation X, pursuant to a plan, acquires all of the outstanding stock of corporation Y from the shareholders of Y solely in exchange for 10 percent of the voting stock of X. Prior to the transaction, Y and its shareholders are unrelated to X. Thereafter, as part of the same plan, X immediately makes an S election and QSub election for Y. The transaction is a reorganization described in section 368(a)(1)(C), assuming the other conditions for reorganization treatment (e.g., continuity of business enterprise) are satisfied. Example 3: After the expiration of the transition period (applicable to related corporations that effect QSub elections prior to 2001) individual A, pursuant to a plan, contributes all of the outstanding stock of Y to his wholly owned S corporation, X, and immediately causes X to make a QSub election for Y. The transaction is a reorganization under section 11

16 368(a)(1)(D), assuming the other conditions for reorganization treatment (e.g., continuity of business enterprise) are satisfied. If the sum of the amount of liabilities of Y treated as assumed by X exceeds the total of the adjusted basis of the property of Y, then section 357(c) applies and such excess is considered as gain from the sale or exchange of a capital asset or of property which is not a capital asset, as the case may be. See also PLR (2/4/03). As illustrated in Examples 2 and 3 above, the tax treatment of a transaction may be different from what the parties had intended and planned. B. Adopting a Plan of Liquidation In general, a formal plan of liquidation must be adopted in order to comply with section 332. However, the making of a QSub election is treated as if a formal plan of liquidation was adopted (unless a formal plan was actually adopted previously in anticipation of the election) immediately prior to the deemed liquidation. C. Treatment of QSub Stock The regulations provide that stock of a QSub is disregarded for all Federal tax purposes except for the requirement of section 1361(b)(3)(B)(i) and reg. section (a)(1) that the S corporation own 100 percent of the QSub stock. A QSub can have more than one class of stock, which may be helpful when structuring acquisitions. D. Transitional Relief from the Application of Step Transaction The application of the step transaction doctrine was an expected but unwelcome development in the proposed QSub regulations. Practitioners and professional organizations repeatedly asked that the government not apply the step transaction doctrine. However, the best that could be obtained was transitional relief. In general, the regulations provide that for QSub elections effective before January 1, 2001, the step transaction doctrine does not apply to acquisitions of some or all of the stock of a corporation related to the acquiring corporation, as defined by IRC Section 267(b). Example 4: Individual A owns 100 percent of the stock of X, an S corporation. X owns 79 percent of the stock of Y, a solvent corporation, and A owns the remaining 21 percent. On May 4, 1998, A contributes its Y stock to X in exchange for X stock. X makes a QSub election with respect to Y effective immediately following the transfer. The deemed liquidation described in the regulations is respected as an independent step separate from the stock acquisition, and the tax consequences of the liquidation are determined under sections 332 and 337. The contribution by A of the Y stock qualifies under section 351, and no gain or loss is recognized by A, X, or Y. Example 5: Individual A owns 100 percent of the stock of two solvent S corporations, X and Y. On May 4, 1998, A contributes the Y stock to X which immediately makes a QSub election with respect to Y. Because the QSub election was effective before January 1, 2001, and X and Y were related before the transaction, each step of the transaction is given 12

17 independent effect. In particular, the liquidation of Y into X is respected for federal tax purposes. Compare Example 3. E. Timing of the Deemed Liquidation In general, the deemed liquidation resulting from a QSub election occurs at the close of the day before the election is effective. Example 6: On January 31, 2002, a C corporation makes an S election and a QSub election with respect to a subsidiary, both with an effective date of January 1, The subsidiary s liquidation is deemed to occur on December 31, 2001, while the parent is still a C corporation. As previously discussed, when dealing with a tiered group of qualified subsidiaries, the S corporation parent may specify the order of the deemed liquidation of each subsidiary. If no order is specified, then the deemed liquidations are treated as occurring at the lowest tier subsidiary first and proceeding successively upward until all of the liquidations have occurred. The timing of the deemed liquidation is deferred until the S corporation parent acquires the necessary 100 percent ownership interest in the subsidiary. Example 7: X, an S corporation, owns 85 percent of Y corporation. X corporation files a QSub election with respect to Y corporation with an effective date of June 1, 2002, which is also the day that X corporation acquires the remaining 15 percent of Y corporation. The deemed liquidation is considered to occur immediately after the June 1 acquisition. 1. Acquisitions of S Corporation Stock The regulations provide a special rule for the acquisition of an S corporation for which a QSub election is made effective on the acquisition date. The effect of the special rule is to time the deemed liquidation as occurring at the beginning of the day the termination of the subsidiary's S election is effective. The purpose of the rule is to avoid a period of time for which the subsidiary will be a C corporation. Example 8: On June 1, 2002, X corporation acquires an S corporation, Y, and makes an S election for itself and a QSub election for Y, with an effective date of June 1, Y is deemed to liquidate into X at the beginning of the day on June 1, Therefore there is no period between the termination of Y s S election and the deemed liquidation of Y during which Y is a C corporation. Y s taxable year ends at the close of May 31, Example 9: Assume the same facts as above, except Y owns Z corporation, a QSub. If X makes a QSub election for Y and Z, the transfer of assets to Z and the deemed liquidation of Z are disregarded. This special rule does not apply to transactions in which a section 338 election is made. 13

18 2. Acquisitions Involving a Section 338 Election An S corporation that makes a qualified stock purchase of a target may make an election under section 338 with respect to the acquisition if it meets the requirements for the election, and may make a QSub election with respect to the target. If an S corporation makes a section 338 election with respect to a subsidiary acquired in a qualified stock purchase, a QSub election made with respect to that subsidiary is not effective until after the acquisition date (within the meaning of section 338(h)(2), i.e., the day of the qualified stock purchase). If the QSub election is effective on the day after the acquisition date, the liquidation occurs immediately after the deemed asset purchase by the new target corporation under section 338. If an S corporation makes an election under section 338 (without a section 338(h)(10) election) with respect to a target, the target must file a final return as a C corporation reflecting the deemed sale. See reg. section (a). If the target was an S corporation on the day before the acquisition date, the final (one-day) return as a C corporation must reflect the activities of the target for the acquisition date, including the deemed sale. See reg. section (a)(3). IV. LIFO Recapture Tax Triggered by Election Making a QSub election for a wholly-owned subsidiary that accounts for inventory under the last-in-first-out (LIFO) method generally triggers the LIFO recapture tax under section 1363(d) because of the deemed liquidation of the subsidiary. The statute applies only to a C corporation that elects to be an S corporation and does not cover any form of indirect conversion to S status. Thus, an S corporation that acquires assets from another corporation via a tax-free reorganization or tax-free liquidation (an indirect conversion) does not fall within the literal language of the statute. However, reg. section extends LIFO recapture to the transfer by a C corporation to an S corporation of LIFO inventory that is transferred basis property in a nonrecognition transaction. In particular, because a QSub election is generally treated as a section 332 liquidation into an S corporation, reg. section (a)(2) governs the transaction, and mandates LIFO recapture for the corporation that is deemed to be liquidated. Example 10: P is an S corporation that owns 100 percent of the stock of Q, a C corporation. Q uses the LIFO method to account for its inventory. Both P and Q have 12/31 year ends. On August 1, 2002, P makes a QSub election with respect to Q. Pursuant to reg. section (b)(1), Q s liquidation takes place at the close of July 31, 2002, the day before the effective date of its QSub election. As a result of the deemed liquidation of Q, Q must file a final C corporation return for the period January 1, 2002 through July 31, Under reg. section (a)(2), Q must include in gross income the section 1363(d)(3) LIFO recapture amount in that short year. Under reg. section (b), Q must pay by October 15, 2002 with its final C corporation return, one-quarter of the additional tax imposed due to the inclusion of the LIFO recapture amount in its 2002 short year gross income. P must pay the remaining three equal installments of the additional tax on March 15 of 2003, 2004, and 2005 with its S corporation return. 14

19 I. General Rules CHAPTER 4 TERMINATION OF A QSUB ELECTION A. Cause of Termination and Prohibition on Re-election A QSub election in effect for a subsidiary may terminate in one of three ways: (1) by termination of the S election of the subsidiary s parent corporation; (2) by the subsidiary ceasing to qualify as a QSub, and (3) by revocation. If a QSub election terminates, the subsidiary generally cannot be treated as either a QSub or an S corporation for the five-year period following the termination unless the Commissioner consents to the election through the private letter ruling process. However, the regulations provide an exception for situations in which the corporation makes an S election or has a QSub election made with respect to it effective immediately after the termination of the QSub s election. Example 1: X, an S corporation, owns Y, a QSub. X sells all of the stock of Y to Z, an S corporation. This sale terminates the QSub election because X, the corporation that filed the election with respect to Y, no longer owns 100 percent of Y. If Z desires to do so, it may elect to treat Y as a QSub effective on the date of purchase without requesting the consent of the Commissioner. Example 2: Assume the same facts as in Example 1 except that Z does not make the QSub election effective on the date of purchase. Unless Z obtains the consent of the Commissioner through a private letter ruling, any election filed by Z with respect to Y in the five-year period following its purchase of the Y stock will be ineffective. Example 3: X, an S corporation, owns 100 percent of the stock of Y, a QSub. X distributes all of the stock of Y to its shareholders. The distribution would terminate Y s QSub election. However, the shareholders may elect to treat Y as an S corporation (provided that it satisfies the single class of stock requirement) effective on the date of the stock distribution. In order for the spin-off transaction in Example 3 to be tax-free, the requirements of section 355 and the related regulations must be met. In addition, suspended losses and earnings and profits must be allocated between the two corporations. (See reg. section (b)(2).) B. Tax Consequences of a Termination If the QSub election of a subsidiary terminates, the subsidiary will be treated as a new corporation (Newco) acquiring all of its assets and assuming all of its liabilities from the S corporation parent immediately before the terminating event in exchange for its stock. However, the regulations provide that a sale of 100 percent of the stock of the QSub will be treated as a sale of the QSub s assets followed by a contribution of those assets by the purchaser to a new corporation. 15

20 Example 4: X, an S corporation, owns 100 percent of Y, a QSub. On March 1, 2002, X sells 100 percent of the outstanding shares of Y to A for cash. As a result of the transfer, Y is no longer eligible to be a QSub. Under these facts, the sale of the Y stock will be treated for federal tax purposes as the sale of 100 percent of the assets of Y to A, followed by a transfer of the purchased assets by A to a new corporation. If A is an S corporation and files a QSub election with respect to Y effective as of the date of acquisition, the deemed transfer of the purchased assets to a new corporation would be ignored. Following the deemed formation of a new corporation, none of the tax elections in effect with respect to the assets of the QSub prior to the termination will carry over to the new corporation. Instead, the new corporation will need to make any election necessary for federal tax purposes (e.g., accounting period and accounting method). The formation of a new corporation that occurs on the termination of a QSub election may be tax free under section 351 (subject to, for example, sections 351(b) and 357(c)). Example 5: X, an S corporation, owns 100 percent of Y, a QSub. On March 1, 2002, X transfers 5 percent of the outstanding shares of Y to A, an individual, for cash. As a result of the transfer, Y is no longer eligible to be a QSub. Accordingly, its QSub election terminates on that date. Because X continues to own more than 80 percent of the stock of Y following the transfer, section 351 applies to prevent the recognition of gain (or loss) on the deemed formation of the new corporation provided that the other requirements of that section are met. Example 6: Assume the same facts as in the previous example except that, at the time of Y s QSub termination, Y owes X $100. Under these facts, the debt between X and Y was disregarded for federal tax purposes prior to the termination of Y s QSub election. As a result of the termination, however, the debt will spring into existence for federal tax purposes. Thus, on the formation of the new corporation that occurs as a result of the QSub termination, X will be treated as contributing assets to Y in exchange for stock and debt of Y. The debt issued by Y will be treated as boot in the section 351 exchange, and X will recognize any gain inherent in the assets to the extent of the $100 boot. Although the rules of section 351 apply to the formation of a new corporation that occurs as a result of many QSub terminations, the regulations provide that general principles of tax law (including the step transaction doctrine) apply to determine the ultimate tax consequences of this deemed formation of Newco and any related transactions. As discussed below, it is this aspect of the rules that can cause the most problems for the uninformed taxpayer. C. Reporting Requirements If a QSub election terminates (other than by revocation), the S corporation must attach to its return for the taxable year in which the termination occurs a statement that the QSub election has terminated, the date of the termination, and the names, addresses, and EINs of both the parent S corporation and the QSub. 16

21 II. Pitfalls The application of the step transaction doctrine and other principles of federal tax law may prevent the application of section 351 to the deemed formation of the new corporation that occurs upon the termination of a QSub election. The examples below illustrate some of the problems that may arise as well as planning ideas for solving them. Example 7: Assume the same facts as in Example 5 except that X transfers 21 percent (rather than five percent) of the stock of Y to A. In this situation, section 351 will not apply to the deemed formation of a new corporation because X will not own 80 percent or more of the stock of Y immediately following the deemed transfer of assets. Therefore, the exchange of assets for stock between X and Y will be taxable under section Thus, X must recognize all the gain inherent in the assets of Y at the time of the transfer. Any losses inherent in those assets at the time of the transfer are subject to the loss limitation rules of section 267. Y s assets will have a fair market value equal to their bases. Thus A, as the purchaser of a portion of the Y stock, will get the same result from the stock purchase that it would have received had the purchase been eligible for section 338 treatment. Example 8: Assume the same facts as in Example 7 except that, prior to the transfer of 21 percent of Y to A, X causes Y to merge into a single member LLC that is disregarded as separate from X for federal tax purposes. Immediately following the merger, X transfers a 21 percent interest in the LLC to A. No election is made to treat the LLC as a corporation for federal tax purposes. Under these facts, the sale of 21 percent of the disregarded entity is treated as a sale of a 21 percent undivided interest in each of the LLC s assets (for which gain or loss is recognized under section 1001), followed by a transfer of these assets to a partnership by both X and A (for which gain or loss is not recognized under section 721(a)). Thus, X will recognize gain or loss on only 21 percent of the assets of the LLC (as opposed to the 100 percent recognition if Y had remained a QSub until the transfer). Example 9: Assume the same facts as in Example 7 except that, instead of purchasing a 21 percent interest in Y, A contributes to Y an operating asset in exchange for 21 percent of Y s stock. Because A owns stock of Y, Y s QSub election terminates. In this situation, section 351 will apply to the transaction because X and A are co-transferors that satisfy the requirements of section 351 immediately following the formation of the new corporation. Accordingly, the transfers by X and A to form the new corporation generally do not result in the recognition of gain or loss, provided that the other requirements of section 351 are met. Example 10: Assume the same facts as in Example 7 except that, instead of transferring Y stock to A, X revokes the QSub election in effect for Y. Later, X sells 21 percent of the Y stock to A in a transaction unrelated, under general principles of federal tax law, to the QSub termination. Under these facts, X owns 100 percent of the stock of Y immediately following the formation of a new corporation occurring as a result of the revocation of Y s QSub election. Because that deemed formation is not treated as related to the sale of the Y stock to A, section 351 should apply to the formation provided that the other requirements of that section are met. 17

22 Example 11: Assume the same facts as in Example 5 except that, instead of selling the stock of Y, X distributes all of the Y stock pro rata to its shareholders. In this situation, X s QSub election terminates as a result of the distribution. The deemed formation of the new corporation and the distribution of its stock to the shareholders can qualify under sections 368(a)(1)(D) and 355 if the transaction otherwise satisfies the requirements of those sections. III. Tiered Subsidiaries The regulations provide rules applicable to the termination of a tiered group of QSubs on the same date. Under the regulations, if QSub elections terminate for a tiered group of subsidiaries, the formation of any higher tier subsidiary precedes the formation of its lower-tier subsidiary. Example 12: X, an S corporation, owns 100 percent of the stock of Y, a QSub. Y, in turn, owns 100 percent of the stock of Z, also a QSub. X revokes the QSub elections in effect for Y and Z effective on the same date. Under these facts, X would be treated as contributing all of the assets of both Y and Z to Y in exchange for stock therein. Immediately thereafter, Y is treated as transferring the assets of Z to Z in exchange for stock therein. Example 13: Assume the same facts as in Example 12 except that, prior to the revocation of the QSub elections of Y and Z, Y distributes the stock of Z to X. Under these facts, the distribution by Y to X is disregarded for federal tax purposes. Then, as a result of the revocation of the QSub elections, X is treated as contributing the assets of Y to Y and the assets of Z to Z in return for stock. 18

23 I. Payroll Reporting (Notice 99-6) CHAPTER 5 SPECIAL ISSUES The regulations do not specifically address the issue of how a QSub should be treated for employment tax purposes. Questions typically arise when a group of related C corporations, each of which has been separately withholding, depositing and reporting payroll taxes for its employees, is converted to a parent S corporation and QSub subsidiaries. Should they be treated as a single employer? Or may they continue to withhold, deposit, and report their payroll taxes separately, if they prefer to do so? The issue is important because the answer determines which entity is responsible for withholding, depositing and reporting federal payroll taxes. It also affects the frequency and timing of required deposits of withheld federal payroll taxes. In Notice 99-6, C.B. 321, the IRS provided interim guidance on the federal employment tax treatment of employees of QSubs. According to the notice, until additional guidance is issued, either of two approaches may be taken: 1. Employees of QSubs may be treated as employees of the parent S corporation. Under this option, calculation, reporting and payment of all employment tax obligations with respect to employees of the disregarded entity would be by its owner under the owner s name and taxpayer ID number; or 2. Separate calculation, reporting and payment of all employment tax obligations may be made by each entity, including otherwise-disregarded entities, under each entity s own name and taxpayer ID number. For example, each QSub with employees would be treated as the employer of its employees. They would not be treated as employees of the S corporation owning the QSub. If the second option is selected, the S corporation will nevertheless have the ultimate responsibility for all employment tax obligations with respect to employees of the QSubs. Accordingly, if a QSub fails to carry out its reporting or payment obligations, the S corporation will be held responsible. However, the notice states that if each QSub separately files the required reports and pays the required amount of taxes for its employees in its own name and under its own taxpayer ID number, the IRS will not impose any penalties against the S corporation even if there are differences in the timing or amount of payments or deposits under the second option, compared to what would be required under the first. In other words, if the second option is elected, the frequency and timing of deposits may be based on the facts of each separate entity; they do not have to be based on what would be required if all the entities were treated as a single employer. An owner of multiple QSubs (or other disregarded entities) is allowed to elect the first option for some entities and the second option for others. In general, if the second option is used for a taxable year, the entities may switch to the first option for any subsequent taxable year. However, once the first option (i.e., aggregation) has been elected, it cannot later be changed to the second option (i.e., separate reporting and payments) without obtaining IRS permission. 19

24 II. State Tax Reporting The tax treatment of QSubs can vary from state to state. Practitioners should check applicable local law to determine what the specific filing requirements are in the QSub s state of formation or operation. III. Banks as S Corporations or QSubs Prior to enactment of the 1996 Act, banks (as defined in section 581) could not be S corporations. Although this prohibition was designed to prevent individuals (through S corporation passthrough items) from taking advantage of the reserve method of bad debts described in section 585, it was not limited to banks that used the reserve method of accounting. Rather, the prohibition applied to all banks. In the 1996 Act, Congress amended the law to provide that banks that do not use the reserve method of accounting are eligible to elect S status. These banks may also qualify as QSubs if they are wholly owned by S corporations. In fact, it is very common for closely held bank holding companies to elect S status for themselves and QSub status for their subsidiaries. These situations raise special issues for QSubs. Certain of these issues are discussed below. A. Separate Application of the Banking Rules The QSub regulations provide that if an S corporation is a bank or if an S corporation makes a valid QSub election for a subsidiary that is a bank, any special rules applicable to banks under the Code continue to apply separately to the bank parent or bank subsidiary as if the deemed liquidation of the QSub had not occurred. For a QSub that is a bank, however, all assets, liabilities, and items of income, deduction, and credit of the QSub (as determined in accordance with the banking rules) are treated as those of the S corporation. B. Bank Director s Shares Federal or state law may require that a certain percentage of the shares of a bank s stock be owned by directors of the bank. If a bank is owned by an S corporation, this could prevent the subsidiary from being a QSub because it would fail the wholly owned requirement. In many situations, however, the director s shares can be structured such that the director has nominal but not beneficial ownership of the shares. If the shares are structured such that the directors do not have beneficial ownership of the shares, the QSub could be wholly owned by the S corporation and therefore eligible to be a QSub, provided that the other eligibility requirements are met. C. Special Rules Applicable to Banks Regulation section (a)(3) provides that banks (as defined by section 581) that have elected S corporation status or become a QSub are still subject to all of the Internal Revenue Code sections specifically applicable to banks such as sections 582(c) and 265(b) as if the deemed liquidation did not occur. The regulations provide the following examples: 20

25 Example 1: X, an S corporation, is a bank as defined in section 581. X owns 100 percent of Y and Z, corporations for which valid QSub elections are in effect. Y is a bank as defined in section 581, and Z is not a financial institution. Any special rules applicable to banks under the Internal Revenue Code continue to apply separately to X and Y and do not apply to Z. Thus, for example, section 265(b), which provides special rules for interest expense deductions of banks, applies separately to X and Y. That is, X and Y each must make a separate determination under section 265(b) of interest expense allocable to tax exempt interest, and no deduction is allowed for that interest expense. Section 265(b) does not apply to Z except as published guidance may provide otherwise. Example 2: X, an S corporation, is a bank holding company and thus is not a bank as defined in section 581. X owns 100 percent of Y, a corporation for which a valid QSub election is in effect. Y is a bank as defined in section 581. Any special rules applicable to banks under the Internal Revenue Code continue to apply to Y and do not apply to X. However, all of Y s assets, liabilities, and items of income, deduction, and credit, as determined in accordance with the special bank rules, are treated as those of X. Thus, for example, section 582(c), which provides special rules for sales and exchanges of debt by banks, applies only to sales and exchanges by Y. However, any gain or loss on such a transaction by Y that is considered ordinary income or ordinary loss pursuant to section 582(c) is treated as ordinary income or ordinary loss of X. IV. S Corporation and QSub Elections for Consolidated Groups A. Liquidation Timing Rules 1. Timing of Simultaneous S and QSub Elections As discussed in Chapter 3, if a QSub election is filed with respect to a subsidiary, the subsidiary will be deemed to liquidate into its S corporation parent for federal tax purposes. If a C corporation elects to be treated as an S corporation and makes a QSub election (effective the same date as the S election) with respect to a subsidiary, the liquidation of the subsidiary is treated as occurring at the close of the day before the S election of the parent becomes effective. In other words, the deemed liquidation occurs while the parent is still a C corporation. As discussed below, this timing can have positive tax consequences to the S corporation. 2. Timing of Deemed Liquidations for Tiered Subsidiaries When QSub elections are made for a tiered group of subsidiaries effective on the same date, the S corporation may specify the order of the deemed liquidations occurring as a result of the elections. If no order is specified, the deemed liquidations will be treated as occurring first for the lowest tier entity and then successively upward until all the deemed liquidations have occurred. Example 3: X, a corporation, owns 100 percent of the stock of Y, which owns 100 percent of the stock of Z. X files an S election to be effective on January 1, X also files elections to treat Y and Z as QSubs effective on the same date. If no order for the deemed 21

26 liquidations of Y and Z is filed, Z will liquidate into Y and then Y will liquidate into Z. If X desires a different liquidation order, X can elect to treat the liquidation of Y into X as occurring prior to the liquidation of Z. The timing and the order of deemed liquidations could cause problems in certain situations. Therefore, it is important to determine whether an election of a different order is necessary. B. Consequences of Timing 1. Excess Loss Accounts Under the consolidated return regulations, a corporation may have an excess loss account (ELA) with respect to its ownership of stock of another member of the consolidated group. An ELA is essentially a negative basis in an entity. If the stock of a corporation with respect to which another member of a consolidated group has an ELA is transferred out of the consolidated group, the ELA is triggered into the income of the stockholder. Generally, an S election by the common parent of a consolidated group that holds subsidiaries with respect to which it has ELAs would be treated as a transfer outside the consolidated group that would trigger the ELAs into the income of the common parent. However, the liquidation timing rules contained in the QSub regulations provide some relief from this application of the rule for situations in which the common parent of the consolidated group makes an S election and QSub elections for the subsidiaries with respect to which it has ELAs effective on the same date. Example 4: X, the common parent of a consolidated group, owns all of the stock of Y. Y owns all of the stock of Z. X elects S status for itself and QSub status for Y and Z, effective on the same date. If X does not specify otherwise, Z will be treated as liquidating into Y; Y will then be treated as liquidating into X. All of the liquidations will be treated as occurring prior to the effective date of C's S election. To the extent there are any excess loss accounts (ELAs) related to either subsidiary, they will not be triggered on the liquidation. If, on the other hand, a different ordering rule applied, the ELAs would be triggered into income. 2. Intercompany Transactions An intercompany transaction is a transaction between members of the same consolidated group. Intercompany items are the income, gain, deduction, and loss from an intercompany transaction where one member transfers property or provides services to another. Corresponding items are the tax items generated by the member receiving the property or services.. Generally, both intercompany and corresponding items are triggered (accelerated) when a party to the transaction leaves the consolidated group. An S election by the common parent (with or without QSub elections) of a consolidated group is an event that terminates the group and would trigger the intercompany and corresponding items that are attributable to transactions occurring in taxable years beginning on or after July 12, See reg. section (d), (l)(1), and (j)(6). See also TAM (7/16/02). 22

27 3. Taxable vs. Nontaxable Liquidation The order of subsidiary liquidations may affect whether one or more of the deemed liquidations is taxable or nontaxable. Example 5: S, an S corporation owns 100 percent of X, a C corporation. S also owns 100 percent of Y, another C corporation. X and Y each own 50 percent of Z, a solvent C corporation. S elects to treat X, Y, and Z as QSubs, each effective on the same date. If S does not specify otherwise, Z would be treated as liquidating into X and Y before X and Y liquidate into S. Under this scenario, the liquidation of Z would be fully taxable. In contrast, if X and Y liquidated into S first, the liquidation of Z into S (its 100 percent shareholder) would be a tax-free liquidation under section Section 1374 Issues The order of subsidiary liquidations may also have consequences under section Under section 1374, an S corporation can have different asset pools for purposes of both computing the built-in gains tax and using NOLs to offset that tax. For example, an S corporation would have a separate asset pool for assets held by the corporation when it elected S status and for assets acquired by the S corporation from a C corporation in a subsequent carryover basis transaction. In addition, in the case of multiple carryover basis acquisitions from C corporations, each separate acquisition would result in a separate pool. In situations in which an existing S corporation elects QSub status for its subsidiaries effective on the same date, the timing rules can affect the determination of the asset pools for section 1374 purposes. Example 6: X, a C corporation, owns 100 percent of the stock of Y. X files an S election for itself and a QSub election for Y, each effective on the same date. Under the general timing rules contained in the regulations, Y will be treated as liquidating into X while X is still a C corporation. As a result, all of the assets of Y will be treated as owned by X at the time of its S election. Accordingly, there will be just one pool of assets for section 1374 purposes. Thus, NOLs of Y can be used to offset built-in gains recognized on the sale of X s assets and vice versa. (More precisely, under reg. section (a), NOLs offset net recognized built-in gain.) Example 7: X, an S corporation, owns 100 percent of the stock of Y, which owns 100 percent of the stock of Z. X elects QSub status for both Y and Z, each effective on the same date. X does not specify an order for the deemed liquidations of Y and Z. Thus, under the general rules of the regulations, Z will be treated as liquidating into Y and, immediately thereafter, Y will liquidate into X. In this situation, all of the assets of both Y and Z (and any NOLs of those corporations) are treated as one pool of assets for section 1374 purposes. Thus, NOLs of Y can be used to offset built-in gains recognized on the assets of Z and vice versa. In contrast, if X elected to treat Y s liquidation as occurring prior to Z s, the assets of Y and Z would be treated as received in two separate transactions. Thus, NOLs of Y could only offset built-in gains of Y and NOLs of Z could only offset built-in gains of Z. 23

28 Practitioners should be aware that several code provisions are designed to prevent taxpayers from acquiring corporations for tax avoidance purposes. These sections limit or disallow certain net operating or built-in losses when there has been a prescribed change of ownership. See sections 269, 382, 383, and 384. V. Insolvent Subsidiaries The tax treatment of a QSub election when the subsidiary is insolvent is best analyzed by way of an example. Example 8: P is an S corporation that owns 100 percent of the stock of Q, a C corporation. Q has one asset with an adjusted basis of $25 and a fair market value of $10. Q has a fully recourse $20 note payable to P. P s basis in its Q stock is $10. P makes a QSub election with respect to Q. Q is insolvent (i.e., its $20 payable exceeds the $10 value of its asset). Thus, the deemed liquidation of Q into P does not qualify for tax-free treatment under sections 332 and The $15 loss that Q realizes upon the transfer of its asset in partial satisfaction of its $20 debt to P 4 may be subject to the limitation of section 267(a)(1) and (f)(2). 5 Q has cancellation of debt income of $10 ($20 payable minus $10 fair market value of the asset). Pursuant to section 108(a)(1)(B), the $10 is not included in Q s gross income. Since Q ceases to exist for federal tax purposes and therefore does not have a succeeding taxable year, there is no section 108(b) attribute reduction. 6 P has a bad debt in the amount of $10 ($20 receivable from Q minus $10 fair market value of Q s asset). If the debt is a nonbusiness debt, 7 the Service has ruled 8 that P must separately state the $10 loss as a short-term capital loss under section 166(d). The Service treats the S corporation P as other than a corporation for purposes of section 166 and would thereby deny ordinary loss treatment to P. In the ruling, the Service reasoned that an S corporation s taxable income is computed under section 1363(b) in the same manner as that of an individual, with certain exceptions. Since the treatment of bad debts is not one of the 3 See reg. sections (d), Ex. 5, and (b). 4 United States v. Davis, 370 U.S. 65 (1962); reg. section (c), Ex See reg. section (d) Ex. 5. But see, Northern Coal & Dock Co. v. Commissioner, 12 T.C. 42 (1949) (reviewed), acq., C.B. 3; and Rev. Rul , C.B Before the QSub election, P and Q are members of a controlled group for purposes of section 267(b)(3). Although the S corporation may be an excluded member under reg. section (b)(2)(ii)(c), it is still a member. See section 1563(b)(2). 6 Section 108(b)(4)(A). See also, section 1017(a) and Gitlitz v. Commissioner, 531 U.S. 206 (2001). 7 See Whipple v. Commissioner, 373 U.S. 193 (1963); United States v. Generes, 405 U.S. 93 (1972). 8 Rev. Rul , C.B See also Rev. Rul , C.B. 333 (section 170(a)(2) election not available to an accrual-basis S corporation; the corporation is treated as an individual rather than as a corporation for this purpose). 24

29 exceptions, the Service concluded that an S corporation is not a corporation for purposes of section 166(d). The Tax Court, however, appears to disagree with the Service in this regard. 9 P s stock in Q is worthless. Accordingly, in addition to the recognized bad debt loss, P recognizes a $10 worthless securities loss (equal to P s basis in its Q stock). Since P is a corporation, section 165(g)(3) generally provides that the loss is ordinary. The Service, however, may contend, as in Rev. Ruls and , that P, as an S corporation, computes its taxable income as an individual and that section 165(g)(3) is not available to an individual. The Service would conclude that P must recognize a $10 capital loss under section 165(g)(1). The Tax Court may, however, allow an ordinary loss under section 165(g)(3) based on its Rath rationale. Finally, because the deemed liquidation of Q into P fails to qualify under section 332, section 381 does not apply, and Q s tax attributes do not carry over to P. 9 Rath v. Commissioner, 101 T.C. 196 (1993) (Tax Court was dismissive of Rev. Rul and the corporationtaxed-as-an-individual argument in the section 1244 context; held that an S corporation is a corporation, not an individual). 25

30 CHAPTER 6 EXAMPLES OF QSUB USAGE There are many situations in which the utilization of a QSub will result in favorable tax and/or business benefits to the taxpayer. Examples of many of these are described below. Some of the same benefits may also be available through S corporation ownership of an SMLLC, discussed at the end of this chapter. However, an SMLLC will not always be available or desirable to the S corporation because of restrictive or unfavorable state law provisions. I. Benefits of QSub Usage A. Facilitate Utilization of Suspended Losses If stock of an S corporation (S2) is contributed to another S corporation (S1) and a QSub election is made with respect to S2, the S1 shareholders tax bases increase by their shares of the basis of any S2 stock contributed. In addition, any losses suspended in S2 under section 1366(d) will be treated as losses with respect to S1. Consequently, a shareholder who owns stock in a loss corporation may be able to achieve immediate tax benefits through this restructuring. Example 1: Assume X owns 100 percent of two S corporations, A (profitable) and B (loss corporation with suspended shareholder X losses). X has a tax basis of $100 in his A stock and $0 in his B stock. For good business reasons, X transfers his A and B stock to an S corporation holding company that makes a QSub election with respect to both A and B effective immediately. This will enable X to use up to $100 of B corporation suspended losses. (See reg. section (c).) Example 2: X owns 100 percent of S corporations A and B. Corporation A is very profitable. X has a basis of $150,000 in his A stock. Corporation B has consistently generated losses and X has utilized his entire basis to deduct these losses, resulting in $50,000 of suspended losses. For good business reasons, X has B acquire 100 percent of A in a tax-free merger. This will result in an increase in X s basis in B and trigger the suspended losses. Example 3: Assume the same facts as in Example 2. X could contribute the B stock to A in a tax-free transaction and A could make a QSub election with respect to B. However, before entering into such a transaction, X must consider the application of the step-transaction doctrine. Note: Taxpayers must be careful when stock of a loss corporation is involved in a proposed transaction to generate additional basis through the utilization of a QSub arrangement. The profitable company generally should be the parent; allowing the loss corporation to be the parent might enable the loss company s creditors to attach the profitable subsidiary s stock as one of the corporate assets. 26

31 B. Facilitate Aggregation of Shareholder Debt Bases Debt issued by a QSub to a shareholder of a parent S corporation is treated as debt of the parent for purposes of determining shareholder debt basis. Therefore, the logic that applies above with respect to the deductibility of losses through the aggregation of stock bases also applies to debt basis. It is not clear what impact the consolidation of debt will have on the determination of the basis of debt that has been affected by the utilization of losses or what impact the rules under section 465 will have. C. Eliminate Controversies Involving Intercompany Loans and Economic outlays One of the biggest problems encountered by practitioners is trying to establish proper tax basis in loans the shareholder has made to an S corporation that has experienced losses. Often the loans are made by transfers from one controlled corporation to another, with journal entries being made to reflect the transaction. Other times checks are exchanged between corporations. In either case, the substance of the transaction is questioned by the IRS. 10 There have been a considerable number of cases litigated, and taxpayers have lost most of them. See for example, Underwood, 535 F. 2d 309 (5 th Cir. 1976), and Bergman, 474 F. 3d 928 (8 th Cir. 1999) where the court found a lack of economic outlay (and, therefore, no tax basis). For a taxpayer victory on the issue of indirectly created basis, see Culnen, T.C. Memo (4/00). When a group of brother/sister S corporations is restructured and a QSub election is made, there is no longer a need to transfer funds among the parent S corporation and its QSubs, because the assets of the latter are considered the assets of the parent S. However, there could still be issues relating to fund transfers by entities outside the S corporation/qsub group. D. Reduce/Eliminate Section 1374 Taxes Sometimes an S corporation has potential built-in gains tax attributable to unrealized built-in gains that were on hand at the effective date of an S election made by a former C corporation. Since the section 1374 tax base amount does not exceed the corporation s taxable income during a particular taxable year (section 1374(d)(2)(A)), the ability to offset income of the S corporation with losses from a related corporation can result in a deferral of the built-in gains tax for one or more years. Where this type of netting occurs, the section 1374 tax can actually be reduced or even eliminated. It is important to note that generally only the taxable incomes of the parent and QSub may be combined for built-in gains tax purposes. (A single taxable income is allocated under Reg. section (c).)The pre-limitation amount (taxable income computed by taking into account only recognized built-in gains, recognized built-in losses, and recognized built-in gain carryovers), net unrealized built-in gain (NUBIG), and section 1374 attributes (NOL and capital loss carryforwards from C years; business credit and minimum tax credit carryforwards from C 10 For a good discussion of this topic see Porcaro, Restructuring Debt Basis in Light of the Economic Outlay Doctrine, The Tax Adviser, Sept. 2001, p

32 years) of the QSub generally cannot be combined with the corresponding amounts of the parent (reg. section (b)). However, if a C corporation with a 100 percent owned subsidiary makes simultaneous S and QSub elections, then the pre-limitation amounts and the NUBIGs of parent and sub are not treated separately. The reason is that in this case the liquidation of the sub into the parent occurs on the day before the QSub election is effective, and thus there is no section 1374(d)(8) situation (i.e., the now combined assets of parent and sub go into S solution at the same time). Example 4: X owns 100 percent of two S corporations, S1 and S2. S1 expects net realized built-in gains (i.e., pre-limitation amount) during year 200X of $100,000 and taxable income of $100,000. S2 expects to incur a taxable loss of $100,000 during year 200X. Without tax planning, S1 will incur a built-in gains tax of $35,000. However, if S1 and S2 are combined by using a QSub, the built-in gains tax can be deferred by offsetting the S2 losses against the S1 taxable income. As previously mentioned, practitioners should be aware that several code provisions are designed to prevent taxpayers from acquiring corporations for tax avoidance purposes. These sections limit or disallow certain net operating or built-in losses when there has been a prescribed change of ownership. See sections 269, 382, 383, and 384. E. Avoid Unwanted S Terminations and Reduce/Eliminate Section 1375 Taxes An S corporation exposed to either the loss of its election under section 1362(d)(3) or to the imposition of the excess net passive income tax under section 1375 may benefit from the aggregation of one or more other corporations. The combination of the non-passive investment income of one or more QSubs with the passive investment income of the parent S corporation may eliminate or reduce the section 1375 tax and may allow the S corporation to avoid the loss of its S status. In addition the ability to reduce taxable income by combining the income and losses of one or more QSubs can reduce or eliminate the section 1375 tax, because the tax is levied on the excess net passive income, which cannot exceed taxable income (section 1375(b)(1)(B)). Example 5: X Corporation is an S corporation with no passive investment income (PII) within the meaning of section 1362(d)(3)(C). It expects its gross receipts to be in the range of $1,000,000 per year. Y Corporation, X Corporation s commonly-owned S sibling, has substantial earnings and profits (E&P). Y s gross receipts are expected to be around $300,000 per year, most of which will be PII. Y can avoid section 1375 taxes by paying out its E&P as dividends. The shareholders want to avoid the payment of dividends and would like to maintain the corporations as separate legal entities for many more years. The combination of the two companies and the utilization of a QSub election may enable the corporations to combine their passive and non-passive receipts. This will cause Y Corporation s PII to be below the 25 percent threshold of section Example 6: X Corporation is an S corporation that expects to be subject to section Its taxable income is $100,000 and its excess net passive income is $80,000. Y Corporation has 28

33 operating losses of $60,000. If X and Y can be combined, X corporation s section 1375 tax will be based on a maximum of $40,000 (the combined taxable income). The 25 percent test is identical for both section 1362 and section 1375 purposes. However, in order for a termination of the S election to take effect, the corporation must have PII that exceeds 25 percent of gross receipts for three consecutive years (as well as positive accumulated earnings and profits). See section 1362(d)(3)(A)(i). Therefore, if the elimination of the requisite passive investment income can be accomplished once every three years, termination can be avoided. F. Accelerate the Move into S Corporation Solution Sometimes a C corporation expects losses that its shareholders would like to deduct on their individual tax returns. If the date has passed to make an S election for the current year, and there is no easy mechanism to change the year end to accelerate the time the election can be made, the conversion of that C corporation into a QSub could help the shareholders achieve their goals. If an existing S corporation were to obtain the shares of the C corporation and make a QSub election, to the extent there is adequate basis the shareholder goals will be achieved. Example 7: X Corporation (a calendar year C corporation) has a valid business purpose for wanting to combine with another company (e.g., desire to streamline business operations or achieve state tax savings). On July 1, 200X, X Corporation anticipates losses of $10,000 per month for the remainder of its taxable year. Its shareholders have adequate tax basis in the corporation to absorb such losses. The deadline for the S election for 200X (March 15, 200X) has passed, and the corporation is not eligible to file a short-period tax return to expedite the commencement of S corporation treatment. If the owners contribute the X Corporation shares to an existing S corporation that makes a QSub election with respect to X Corporation, the post-election losses will be reflected on each shareholder s 200X Schedule K-1. This restructuring could have other implications. The above technique would not be successful if a newly-formed S corporation were to be utilized. If such a corporation was established to become the S parent, the transaction would be viewed as an F reorganization and the election disallowed under the step-transaction doctrine. G. Offset Income and Losses of Previous Brother-Sister C or S Corporations A variation on the theme of items (D) and (E) above is the simple planning flexibility achieved when losses and profits can be combined through the use of a QSub. If tax basis is not at issue, this flexibility may not necessarily be significant, but the amount of a shareholder s tax basis in his stock and loans is often not calculated until year-end. H. Obtain Current Deduction for Expansion Costs The IRS has argued for some time that expansion costs cannot be currently deducted under section 162 when separate entities are used for the newly acquired or expanded operations. Depending on the circumstances, the IRS may allow amortization under section 195 or try to force capitalization of some or all of the costs under section 263. Since QSubs are disregarded 29

34 entities for all federal tax purposes, the use of a QSub should facilitate the immediate deductibility of the expansion costs. This is because the expansion costs are treated as having been incurred by the parent S corporation and not by a separate entity. Caution should be exercised if the entity incurring the expenses was not yet a QSub when the expansion costs were incurred. Prudent practitioners should advise clients to form the QSub(s) before the startup expenses or costs relating to expansion activities are incurred. I. Enjoy the Generic Business Benefits of Using Subsidiaries Prior to the 96 Act, S corporations simply could not have any 80 percent or more owned subsidiaries. S corporations may now operate more easily in a multiple-entity environment. They may now utilize tiered and brother-sister corporate entities as well as LLCs to achieve various tax and business goals. They can create a structure that will make corporate administration more flexible, utilize holding companies where appropriate, make it easier to evaluate management performance, facilitate budgeting considerations, and enjoy other benefits that are the product of the 96 Act. Example 8: Corporation S seeks segregation with respect to several of its business operations. The QSub rules enable S to form wholly-owned subsidiaries under local law while maintaining a single level of taxation. In doing so, S will accomplish its business objectives of segregating natural business lines either for operational purposes or to segregate liabilities of one company from another. Example 9: An S corporation has a risky business and a portfolio of investment assets. It would like to protect the investment assets from the risky business. If the corporation were to transfer the risky business to a newly-formed QSub, there would be no change for tax purposes, but the risky assets will be legally separated from the investment assets. The QSub s creditors may be prevented from reaching the investments. Example 10: If, in the above example, the risky business cannot be transferred (due to state law licensing or other restrictions), or if such a transfer is not otherwise feasible, the owners of the S corporation could form a holding company and transfer all of the S stock to it. An S election could then be made for the holding company and a QSub election made with respect to the original S corporation (now a wholly-owned subsidiary of the holding company). Both the risky business and the investment assets remain in the QSub. Following the deemed sections 332/337 liquidation of the original S corporation, the newly-disregarded subsidiary can transfer the investment assets to the holding company because all assets and other items are deemed to be owned by the parent s S corporation holding company. This will have the same net result as in the preceding example without the need to transfer the assets of the risky business to a new entity in cases where such outright transfers are not allowed or advisable. The risky business will remain in the original S corporation, now segregated for state law purposes. 30

35 J. Achieve Flexibility and Legal Liability Protection S corporations may utilize QSubs to achieve many goals that might otherwise be unachievable. Practitioners must keep in mind, however, that competent legal counsel should be retained by the affected parties to ensure that all legal ramifications have been considered. Example 11: If an S corporation acquires all of the stock of a corporation that has potential liabilities, the S corporation does not have to liquidate the target corporation in order to retain S status and expose itself (the parent corporation) to the liabilities of the target as would have been required prior to While under the 96 Act the S parent may have a C corporation subsidiary, electing QSub or disregarded status for the newly owned corporation would enable the two corporations to commingle all of their accounts for federal tax purposes, potentially yielding favorable offsets of gains and losses. Example 12: Often a lender will insist that a borrower set up a separate legal entity to which the lender will make a loan. The creditor does this to establish a bankruptcy remote entity thus providing more protection to the lender. A QSub will constitute this separate entity for legal purposes, yet all of the activities will still be combined with the parent for income tax reporting purposes. Example 13: If a taxpayer wants to acquire and segregate property in a section 1031 or section 1033 transaction, the use of a QSub will satisfy this objective. The QSub is disregarded for almost all federal tax purposes, so the receipt of the exchange or reinvestment property by a QSub will be treated at the federal level as if the S parent taxpayer itself received the property. Practitioners must be certain that this treatment conforms with applicable state laws. Example 14: If in a free-standing transaction (not a step-transaction) an S parent transfers into a QSub assets that are encumbered by liabilities, there will be no income or loss recognition, section 351 will not apply, and there will be no section 357(c) ramifications. This highlights the fact that the QSub is generally a disregarded entity. Example 15: The following transaction will be treated as a tax-free merger under section 368(a)(1)(A) (reg. section T(b)(1)(iv) Example 2): Target T corporation is merged into a QSub, the T shareholders receive stock of the S parent, and T goes out of existence. See reg. section T(b)(1)(iv), Example 2. However, a merger of the QSub into T will not qualify as an A reorganization. See reg. section T(b)(1)(iv), Example 6. K. Avoid State and Local Documentary Transfer or Sales Taxes If a taxpayer owns property outright and transfers it by sale or exchange, the transfer may be subject to various state and local transfer taxes. If the subject property is owned by a QSub, the transfer of the interest in the QSub (instead of a transfer of the property itself) may result in avoidance of the transfer taxes. 31

36 Many of the above strategies entail the conversion of a brother-sister group of corporations to a parent-qsub unit. In cases where there is a deemed liquidation, the technical analysis must include all general principles of tax law, including the step-transaction doctrine. Consequently, practitioners may wish to read the section of the Guide pertaining to potential pitfalls before making a QSub election. II. Comparison of QSubs with Single-Member Limited Liability Companies (SMLLCs) The above list contains many planning opportunities relating to the use of QSubs. As noted at the beginning of this chapter, practitioners should be aware that SMLLCs might also accomplish some of the same goals. Items (A) through (G) above generally are available only with the use of a QSub, because the elements involved are specific to QSubs. Items (H) through (K), however, may also be achieved through the use of a SMLLC. This is because the fundamental concept of being able to ignore the entity for income tax purposes, yet respecting the entity for state law purposes, is identical for both entities. When the desired benefits encompass, for example, the four items (H) through (K), quite often the decision will be based on distinctions of state law. Generally, an SMLLC is somewhat easier to form than a corporation (a requirement to have a QSub) and is less expensive to maintain and operate. Consequently, practitioners should give serious consideration to the use of an SMLLC in lieu of a QSub when that option is available. Unfortunately, some states restrict the availability of SMLLCs depending on the nature of the business enterprise. For example, California businesses licensed by either the Business and Professions Code or the Chiropractic Code are not eligible to form an LLC. Thus, if a professional S corporation wanted to utilize one of the above planning strategies through the use of an LLC, it would only be able to do so if the LLC were in a (different) business not needing licensure. With the LLC form unavailable, the choice defaults to a QSub. Also, California law imposes a gross receipts tax on LLCs that can be as high as $11,790 (in 2002) compared with an income tax on S corporations of 1 1/2 per cent of the S corporation s income measured as if it were a C corporation. Accordingly, state taxation should be evaluated before making a decision between a QSub and an LLC where both options are available. Finally, QSubs operate under well-established corporate case law, while case law based on LLC legislation is still in its infancy. Practitioners should become comfortable with the use of both of these disregarded entities so that they can offer clients the best of both options. 32

37 APPENDIX A QSUB CHECKLIST 1. Eligibility Rules YES NO COMMEN Confirm that a QSub election can be made for the corporation in question: Does the parent S corporation have beneficial ownership of 100 percent of all classes? NOTE: Ownership via another disregarded entity (SMLLC or QSub) is considered ownership by the parent. Is the corporation a domestic corporation? Is the corporation an eligible corporation as defined under section 1362(b)(2)? NOTE: If the answer to any of these questions is NO, then a QSub election cannot be made with regard to this corporation. Are there any instruments, obligations or arrangements, such as stock options, that may be considered outstanding stock under the single class of stock regulations? Has restricted stock been issued which is now vested or for which a section 83(b) election has been made? Is there outstanding debt that does not meet the straight debt safe harbor rules of IRC section 1361(c)(5), is treated as equity under general principles of federal tax law, and is held by other than the parent S corporation? NOTE: If the answer to any of these questions is YES, then a QSub election can not be made with regard to this corporation. 2. Making a QSub Election - Procedures Has Form 8869, Qualified Subchapter S Subsidiary Election, and its related instructions been reviewed? 33

38 YES NO COMMEN Does the effective date selected by the QSub election fall during the period beginning two months and fifteen days before the election is filed and ending twelve months after the election is filed? If no effective date is indicated on the form will the filing date of the election be appropriate? Does the parent S corporation control 100 percent of its subsidiaries via a tiered structure? If YES, has consideration been given to selecting the order of the deemed liquidations of each tier and has that order been indicated on an attachment to Form 8869? If the subsidiary was acquired via a stock purchase or tax-free reorganization, is there a substantial difference between the basis of its stock and the basis of its assets? NOTE: If YES, consider the consequences of the loss of stock basis from the deemed liquidation resulting from the QSub election. Did an officer of the parent S corporation sign the Form 8869 as required? Was Form 8869 filed with the appropriate service center as indicated in the instructions? Was Form 8869 mailed certified return receipt requested? Has a QSub election been filed, but an acknowledgement of the election has not been received within 90 days of filing? If YES, has a follow up inquiry been sent to the service center? If Form 8869 was not filed on time, determine whether the following conditions are present for late filing relief provided by Revenue Procedure : a) If the tax return has not been filed by the parent S corporation for the first year in which the election was intended: Was the late filing due to reasonable cause, such as reliance on a 34

39 tax professional? Will the late election be filed within eighteen months of the original due date of the intended election? YES NO COMMEN Will the late election be filed no later than 6 months after the due date of the parent s S corporation tax return (excluding extensions) for the first tax year it intended to treat the subsidiary as a QSub? Except for the lack of a timely filed election, did the corporation qualify as a QSub? Have all taxpayers whose tax liabilities or tax returns would be affected by the election (including all shareholders of the parent) reported consistently with the S election and the QSub election on all affected returns for the year the election was intended? NOTE: If the answer to all of the five questions above is YES, then relief under Revenue Procedure is available. If the answer to one or more questions is NO, relief may be available by filing a private letter ruling request with the IRS National Office under reg. sections through 3. b) If the tax return has been filed by the parent S corporation for the first year of the intended election: Was the late filing due to reasonable cause, such as reliance on a tax professional? Will the late election be filed within 24 months of the original due date of the intended election? Has the parent S corporation tax return been filed within 6 months of its due date (excluding extensions)? Except for the lack of a timely filed election, did the corporation qualify as a QSub? Have all taxpayers whose tax liabilities or tax returns would be affected by the election (including all shareholders of the parent) reported consistently with the S election and the QSub election on all affected returns for the year the election was intended, as well as any subsequent years? 35

40 NOTE: If the answer to all of the five questions above is YES, then relief under Revenue Procedure is available. If the answer to one or more questions is NO, relief may be available by filing a private letter ruling request with the IRS National Office under reg. sections through Making a QSub election - Effects YES NO COMMEN Has consideration been given to the deemed liquidation treatment provided for by reg. section ? Will the deemed liquidation be tax free as provided for by sections 332 and 337? When all the events leading up to the filing of the QSub election are taken account, could the step transaction doctrine be applicable to the deemed liquidation as provided for in reg. section (a)(2)?* See, e.g., PLR (2/4/03). Was there an acquisition of the subsidiary's stock immediately prior to the QSub election, which could qualify as a reorganization under section 368(a)(1)(C)? Was there a transfer of stock by an individual to a controlled corporation for which a QSub election will be made that could qualify as a reorganization under section 368(a)(1)(D)? In general, the deemed liquidation occurs at the close of the day before the election. Has the impact of this rule been evaluated? Did the acquiring S corporation own less than 100 percent of the stock of the subsidiary on the day before the QSub election is effective? NOTE: If YES, the deemed liquidation occurs immediately after the S corporation first owns 100 percent of the stock. *NOTE: If an S corporation acquires some or all of the stock of a related corporation (as defined in section 267(b)) and then makes a QSub election effective before January 1, 2001, with respect to that corporation, the step transaction doctrine does not apply to determine the tax consequences of the acquisition. See reg. section (a)(5)(i). Will a QSub election be made for an existing S corporation immediately upon its becoming a subsidiary of another S corporation? NOTE: If YES, then the deemed liquidation occurs at the beginning of the day the termination of the subsidiary's S 36

41 election is effective; therefore there is no time period for which the subsidiary will be a C corporation. Will a QSub election be made that relates to a target subsidiary for which a section 338 election will also be made? NOTE: If YES, then the deemed liquidation occurs immediately after the deemed asset purchase by the new target corporation under section 338. If a QSub election is being considered for a target C corporation, will the target be subject to the LIFO recapture rule of section 1363(d)(1)? If a QSub election is being considered for a target C corporation, have the implications of the built-in-gain tax rules of section 1374 on the S corporation parent been evaluated? If a QSub election is being considered for a target corporation that maintains a qualified retirement plan, including an ESOP, have the implications of the various qualified plan rules (particularly the affiliated entity rules) been evaluated? Have the state tax laws relating to the treatment of QSubs been reviewed? YES NO COMMEN 4. Termination of a QSub election Has the S corporation parent revoked its S election? Does the S corporation parent no longer qualify as an S corporation as defined in section 1361(b)(1)? Has the S corporation parent reduced its ownership of the QSub stock below 100 percent? Does the subsidiary no longer qualify as a QSub as defined in section 1361(b)(3)? Has the parent S corporation revoked the QSub election? NOTE: If the answer to any of these questions is YES, then the QSub election has terminated. Will a QSub or S corporation election be made for the former QSub immediately after the termination of the subsidiary s QSub election? NOTE: If NO, then a QSub or S election cannot be made with respect to the former QSub before its fifth taxable year beginning after the first taxable year for which the termination 37

42 was effective without the Service s consent. If Yes, then a QSub or S corporation election can be made with respect to the former QSub. YES NO COMMEN Was the termination due to the parent corporation no longer qualifying as an S corporation? NOTE: If YES, then the termination is effective at the close of the day of the parent s last taxable year as an S corporation. Was the termination due to the subsidiary no longer qualifying for QSub status? NOTE: If YES, then the termination is effective at the close of the day on which the subsidiary no longer qualifies as a QSub. Was the termination due to the revocation of the QSub election by the parent? Does the termination date selected by the parent fall during the period beginning two months and fifteen days before the revocation statement was filed and ending twelve months after the revocation statement was filed? NOTE: If YES, then the termination date is the date specified on the revocation statement, or the date the revocation was filed if no date was specified. Was the termination due to the S corporation parent becoming a member of a consolidated group? NOTE: If YES, then the QSub election and its parent s S election terminate at the close of the day before becoming members. Both the former S corporation and its former QSub become members of the consolidated group at the beginning of the acquisition date. 38

43 YES NO COMMEN The termination of a QSub election results in the creation of a new corporation that acquires all of its assets and liabilities from the S corporation parent immediately before the terminating event in exchange for its stock. Have the implications of this rule been properly evaluated? If S corporation status is desired for the new corporation, has an S election been filed effective immediately after the terminating event, in order to avoid the five year wait? Has the new corporation considered its options relating to specific income tax elections, such as accounting methods, accounting period, etc.? Does the new corporation have a federal identification number? If not has one been applied for? Is the termination of the QSub election due to the sale of 100 percent of the QSub s stock by the parent? NOTE: If YES, then the transaction is treated as a sale of assets by the parent directly to the purchaser, who then contributes the assets to a newly formed corporation. The tax consequences of the transaction are determined accordingly, resulting in the recognition of ordinary income or capital gain, based on the composition of the assets, by the parent, and the acquisition of assets by the purchaser. Is the termination of the QSub election due to the sale of no more than 20 percent of the QSub s stock by the parent? NOTE: If YES, then the transaction is treated first as a contribution of all of the QSub's assets and liabilities to a new corporation in a tax-free exchange for stock under section 351 (section 357(c) may be applicable). The parent then will recognize capital gain or loss due to the sale of stock. Was the subsidiary indebted to the parent prior to termination? NOTE: If YES, then the deemed contribution of assets will be in exchange for stock and debt, the latter of which will be considered boot and result in possible gain recognition under section 351(b). Is the termination of the QSub election due to the sale of more than 20 percent but less than 100 percent of the QSub s stock by the parent? NOTE: If YES, then the transaction is treated as a contribution of all of the QSub's assets and liabilities to a 39

44 new corporation in a taxable exchange for stock under section The parent will recognize 100 percent of the gain relating to the subsidiary's assets and the new corporation will receive a step up in basis. Is the termination of the QSub election due to the transfer of 100 percent of the QSub s stock to the shareholders of the S corporation parent? NOTE: If YES, then the transfer of stock is considered a contribution of the QSub's assets and liabilities to a controlled corporation followed by a spin-off of the QSub stock to the stockholders of the parent. This transaction will be tax-free provided that the requirements of section 368(a)(1)(D) and 355 and the related regulations are complied with. In addition any suspended losses, AAA and E&P must be allocated between the two corporations. YES NO COMMEN If the QSub election is terminated, other than by revocation, has a statement indicating the date of termination and the names, addresses and EINs of the parent and QSub been attached to the parent's income tax return for the taxable year? If the termination of the QSub election involves a tiered subsidiary structure, the formation of higher tier subsidiaries precedes the formation of the lower tier subsidiaries. No other ordering choice is available. Has this rule been considered? 5. Payroll Reporting Have all of the payroll reporting (see Notice 99-6) requirements been met by parent S corporation under its EIN? NOTE: If NO, then each QSub must report all payroll obligations under its own EIN. However, the parent S corporation remains responsible for all payroll reporting and related liabilities. 6. Examples of QSub Usage Will an aggregation of stockholder basis facilitate the current flowthrough of losses for the current tax year? Will an aggregation of stockholder basis facilitate the utilization of suspended losses created in prior years? 40

45 YES NO COMMEN Will an aggregation of stockholder debt basis facilitate the current flowthrough of losses for the current tax year? Will an aggregation of stockholder debt basis facilitate the utilization of suspended losses created in prior years? Should a brother-sister group of S corporations be restructured and a QSub election be made in order to avoid intercompany loans? Will the QSub election reduce or eliminate the parent/ subsidiary's taxable income for the purposes of section 1374 and defer the application of the built-in-gain tax? Will the QSub election reduce the portion of gross receipts attributable to passive investment income below 25 percent? Will the QSub election reduce or eliminate the parent/ subsidiary's taxable income for section 1375 purposes and defer the application of the excess passive income tax and protect the parent's S corporation status? Will a QSub election made for a C corporation subsidiary accelerate the utilization of its losses incurred after the effective date of the election? NOTE: This technique has not been addressed in any rulings, etc., and would not be advisable if an S corporation was formed specifically for this purpose. Can a QSub be utilized to facilitate a like-kind exchange and avoid the possible exposure to state and local real estate transfer taxes? Is the existing S corporation planning to expand or acquire another business? NOTE: If YES, the QSub may provide the opportunity to currently deduct expansion costs under section 162. The QSub may also provide the opportunity for the parent to segregate business operations and related liabilities from the parent's primary business operations. The parent may utilize a QSub to facilitate a tax-free merger or consolidation under section 368(a)(1)(A). 41

46 YES NO COMMEN Is the parent considering selling a portion of its business via a stock sale? NOTE: If YES, a QSub could be formed and capitalized with the necessary business assets from parent. The sale of 100 percent of the stock would be treated as an asset sale for the buyer and seller. Has consideration been given to utilizing an SMLLC in lieu of a QSub in situations where the underlying objective does not relate to subchapter S issues. 42

47 APPENDIX B SUBCHAPTER C CODE SECTIONS CRUCIAL TO UNDERSTANDING QSUBS The Small Business Job Protection Act of 1996 (SBJPA) liberalized the criteria for qualifying as an S corporation. It allowed an S corporation to have up to 75 qualified shareholders and to own 80 percent or more of the stock of a C corporation or 100 percent of the stock of a qualified subchapter S subsidiary (QSub). 11 However, only domestic corporations can elect S status and can have only one class of stock (albeit with differing voting rights); further, corporations, partnerships, IRAs and nonresident aliens still cannot be S shareholders. The SBJPA provisions expands the tax planning opportunities for S corporations; for example, they can help an S corporation to restructure its activities to grow more rapidly, reduce state taxes or liability exposure or conduct business overseas more efficiently. Various tax-free and taxable restructuring and acquisition/disposition techniques are now available that will provide an advantage for S corporations visa-vis limited liability companies (LLCs) and partnerships. Except for ESOP shareholders, the Taxpayer Relief Act of 1997 (TRA '97) had little direct effect on S corporations, but the change in capital gains rates will influence the structuring of asset and stock acquisitions and dispositions. The subsequent tax acts had only marginal impact on S corporations, most notably the ability of an S shareholder to borrow from the company pension plan. This appendix will help the tax adviser put the additional options available to an S corporation in perspective, especially in utilizing QSubs; it will discuss the S corporation's role as a buyer or seller in the context of a tax-free or taxable sale of assets or stock. Liquidation or Merger Often, a corporate liquidation (or its equivalent, a statutory cash merger) 12 can be a tax disaster if the target is a C corporation or an S subject to section 1374 built-in gains (BIG) tax, the result is two gains and a step-up in basis of the acquired assets. However, if an S corporation target is not subject to BIG tax, the result may be more palatable: the target S corporation's shareholders recognize gain and the acquirer takes a stepped-up basis in the target's assets. After the SBJPA, an acquiring S corporation could use a reverse triangular cash merger 13 (discussed below) to acquire a target C corporation or squeeze out dissident shareholders and treat the transaction as a stock purchase, resulting in gain only at the shareholder level. If the acquirer wants a step-up in the basis of the assets, it can make a section 338 election (discussed below). 14 Liquidating S Corporation A liquidating S corporation recognizes gain or loss on the distribution of assets to its shareholders, under section 336(a). If section 1374 does not apply, no corporate-level tax will be due. If the assets were sold to third parties and the proceeds distributed to the shareholders, the corporation again would not be 11 For a discussion, see Herskovitz, Lux and Rabun, "Tax Planning After the Small Business Job Protection Act," 28 The Tax Adviser 20 (Jan. 1997). 12 See, e.g., Rev. Rul. 69-6, C.B See, e.g., Rev. Rul , C.B See Rev. Rul , C.B. 67. See also Orbach, Karlinsky, Smith, Starr and Hyman, Section 338(h)(10) Checklist, 33 The Tax Adviser 174 (March 2002). 43

48 taxable. Section 336(d)(1) and (2) might apply if the corporation incurs losses on the liquidation or sale. Section 267 does not apply to losses incurred in a liquidation. When an S corporation liquidates, all of its tax attributes (including accumulated adjustments account (AAA), C corporation net operating losses (NOLs), suspended losses and accumulated earnings and profits (AE&P)) disappear. Thus, on the S corporation's final return, it is crucial to reflect all of the corporation's activities (including the short-period operating and investment income or loss, tax benefit rule income, write-offs of capitalized assets, organization costs, etc.). When a corporation plans to liquidate, Form 966, Corporate Dissolution or Liquidation, should be filed, as well as appropriate Forms 1099-DIV, Statement for Recipients of Dividends and Distributions, and 1096, Annual Summary and Transmittal of U.S. Information Returns. Because corporate status is a state right, the appropriate states should be notified of the planned dissolution and a plan of liquidation should be included in the minutes. S Shareholders Under section 331, an S shareholder computes gain or loss on the corporation's liquidation by comparing his adjusted basis in his S stock to the net fair market value (FMV) of property received in the liquidation. If the shareholder has a loss, section 267 does not limit its use. The shareholder's adjusted basis in his stock includes the corporation's gain or loss recognized on the liquidation, as well as any other income or loss on the final S return. If the sale of assets to third parties and subsequent liquidation do not occur in the same year, a shareholder could get "whipsawed" by a capital gain in Year 1 and a capital loss in Year 2. Under section 334(a), the shareholder's basis in the property received is its FMV, unreduced by liabilities. Because of the step-up to FMV, the holding period in the shareholder's hands starts anew. If, as part of a 12-month liquidation, the S corporation sells its assets on an installment basis to third parties, the shareholders step into the corporation's shoes with respect to the distributed installment obligation and postpone their gain until payments on the notes are received, under section 453(h)(1)(A). If the shareholder inherited the stock, the tax result may very be favorable: little or no gain and a step-up in basis of the assets. Example 1: G dies owning 100 percent of the stock of M Corp., an S corporation, with an adjusted basis of $100,000 and an FMV of $1,000,000. M's basis and FMV of its assets are the same as that of G's stock. G's grandson, T, inherits the stock, but has no intention of continuing the business. M sells its assets to a third party at a $900,000 gain. T's stock basis will be $1,900,000. When he receives the $1,000,000 in sales proceeds, he will have a capital loss of $900,000 to offset against his passthrough gain. The net result is $1,000,000 cash, little tax liability to T and a step-up in the basis of M's assets for the acquirer. Parent-Subsidiary Liquidation If an S corporation (Parent) owns 80 percent or more of a C corporation (Subsidiary), a special rule applies. Section 337(a) allows Parent to liquidate Subsidiary without the latter recognizing gain or loss on the distribution of property to Parent, whether in satisfaction of stock or debt. If Subsidiary sold property to third parties, gain or loss generally would be recognized. Under section 336(d)(3), if Subsidiary were to distribute property in liquidation to its minority shareholders, gain (but not loss) would be recognized. These rules also apply if a third-tier subsidiary of an S corporation were to liquidate into a second-tier subsidiary or into a QSub. If Parent lent Subsidiary funds and they are repaid with appreciated or depreciated property, Subsidiary recognizes no gain or loss. However, since Subsidiary was a C corporation, Parent S potentially would be subject to S corporate-level taxes (e.g., under section 1374 or 1375). 44

49 According to section 332(a), Parent does not recognize gain or loss on the receipt of property for Subsidiary's stock; instead, it takes a carryover basis in Subsidiary's assets and tax attributes, including AE&P, AAA, NOLs, accounting methods, etc., under sections 334(b) and 381(a)(1). Parent's basis in Subsidiary's stock disappears. If that stock basis (outside basis) is significantly higher than Subsidiary's basis in the assets (inside basis), tax-free treatment may not be optimal. QSubs If an S corporation wants to conduct business through a QSub, an election must be made by Parent; the existing subsidiary generally is deemed to be liquidated under sections 332 and 337. Thus, if an S corporation acquired 100 percent of a C corporation and wanted to convert it to a QSub, this could be accomplished tax-free: the former C corporation would be treated for tax purposes as Parent's branch or division. However, the S corporation will be subject to the section 1374 BIG tax, the section 1375 tax on excess passive investment income, and the section 1363(d) LIFO recapture tax payments. If the C corporation was acquired in a qualified stock purchase, section 338 could be elected, rendering these taxes inapplicable. The tax adviser should complete a Form 8869 to elect QSub status. When an S corporation terminates a QSub election, it will be treated as having transferred the latter's assets and liabilities to a new corporation, often, but not always, in a tax-free section 351 transaction. If section 351 otherwise applies and if liabilities exceed basis or the deemed transferee is an investment company, gain may be recognized under section 357(c) or 351(e). None of the tax attributes move with the assets in a section 351 transaction; further, the new corporation may not elect S or QSub status for five years, unless the IRS consents. However, if the newly-formed corporation immediately elects to be an S corporation or is immediately acquired by an S corporation, then the five year rule is waived as to that newly formed entity. Section 338 Election Section 338(a) allows a corporation (including an S corporation) that makes a qualified stock purchase to treat the transaction as an asset purchase. This treatment is available only when the acquiring corporation buys at least 80 percent of the target's stock in a taxable purchase that occurs over no more than 12 months. A taxable purchase includes the use of cash, installment notes or an invalid tax-free reorganization. Because an S corporation can now own 80 percent or more of a C corporation, or a QSub, and the acquiring S may want to acquire another corporation's stock or assets, the section 338 provisions will now apply more often in the context of an S corporation group. The S parent or QSub is not permitted to be part of a consolidated return, but a C corporation subsidiary may be. If section 338 is elected, the purchase price of the target's stock (properly adjusted for corporate liabilities) is allocated to all of the target's assets under the residual method of sections 338(b)(5) and In effect, the target's assets are deemed to be sold to itself at the last moment of the acquisition date. Thus, all attributes (including AAA and AE&P) not used in the final tax year are lost. If the S corporation is the target, the recognized gain will be subject to double taxation, because the one-day return is a C corporation return and a section 338 transaction must be allocated under the section 1362(e)(6)(C) closing-of-the-books method. Obviously, the above result is not optimal; thus, as permitted by reg. section 1.338(h)(10)-1(c), the application of the section 338(h)(10) election to the target S corporation should be explored. A section 338(h)(10) election ignores the stock sale; rather, it treats the target as though it first sold all of its assets, then liquidated under section 336. This results in only a single level of tax. If the target is an S corporation, reg. section 338(h)(10)-1(e)(2) allows its shareholders to be treated like an 80 percent parent for section 338 purposes. Assuming section 1374 does not apply, this results in one gain (at the shareholder level due to the passthrough) and a step-up in asset basis in the acquirer's hands. On 45

50 liquidation of the S corporation, an additional small gain or loss may be incurred by the shareholders, depending on the difference between inside and outside basis. The Residual Method Section 1060 applies to any applicable asset acquisition (defined in section 1060(c)) of trade or business assets, including a section 338 transaction, a section 331 liquidation or the purchase of a business by an S corporation. It requires the purchaser to allocate the purchase price first to Class I assets, defined by reg. section (b)(1) as cash and cash equivalents. The purchase price is then allocated to Class II assets, which under reg. section (b)(2)(ii), includes certificates of deposit, publicly traded stocks and U.S. government securities and foreign currency. Assets are then allocated to Class III assets, mark to market assets and debt instruments including accounts receivable pursuant to reg. section (b)(2)(iii). Purchase price is then allocated to Class IV assets, inventory. If purchase price has not been allocated to the first four classes, then it is allocated to Class V which is defined by reg. section (b)(2)(v) as all assets other than Class I, II, III, IV, VI and VII assets. Assets are then allocated to Class VI, defined by reg. section (b)(2)(vi) as section 197 intangibles other than goodwill and going concern value. Finally, purchase price, if any, is allocated to Class VII, defined by reg. section (b)(2)(vii) as goodwill and going concern value. The allocation on the buyer s Form 8594, Asset Acquisition Statement under section 1060, need not be the same as that on the seller s Form 8594 unless such allocations are agreed to in the buy-sell agreement. If a bargain purchase occurs, it is likely that the amount allocated to Class VII would be zero. For a 10 percent S shareholder who sells his stock in the target and enters into a covenant not to compete, employment, rental or royalty agreement, appropriate disclosure must be made to the IRS, under section 1060(e). Tax-Free Reorganizations As an alternative to a taxable acquisition or liquidation involving an S corporation, one or both parties may prefer a tax-free acquisition. This style of buying or selling stock or assets is very formalistic; specific requirements must be met. Because an S corporation may now own C corporation subsidiaries and/or QSubs, this is the area of greatest opportunity. Under pre-sbjpa law, S corporations could only engage in an A or C reorganization. Triangular and B reorganizations were not permitted for more than a fleeting moment. 15 With the QSub mechanism now available to acquiring S corporations and recentlyissued rules permitting disregarded entities to be controlled acquiring companies in a statutory merger, 16 the triangular acquisitions and B reorganizations are now permissible and often preferable. This is a significant structuring advantage to protect the acquiring company from potential undisclosed or contingent Target liabilities. Below are some important issues that need to be considered when structuring a tax-free reorganization. First, the judicial doctrines that underlie the reorganization area are presented; the alternative forms that an S corporation may use to reorganize are then explained. Judicial Doctrines Business Purpose Underlying the tax-free reorganization provisions is the basic assumption under reg. sections (b) and (b) that the transaction has a business purpose other than the avoidance of Federal income taxes. If this factor is not present, the IRS will disallow the tax-free nature of the transaction, even if the letter of the law has been met. 15 See, e.g., Rev. Rul , C.B Reg. section T. 46

51 Continuity of Business Enterprise Regulation section (d) requires that the acquiring corporation continue the target's historic business or use a significant portion of the target's historic business assets in a business. If this element is lacking, the parties will be denied tax-free treatment and the acquirer will not be able to use the target's NOLs, under section 382(c)(1). This criterion is known as the continuity-of-business-enterprise (COBE) requirement. Example 2: P Airlines, a passenger carrier, was acquired by Q Airlines in a tax-free acquisition and a significant portion of P's planes was converted to use for freight. Although P's business has not been continued, Q uses a significant portion of P's assets, meeting the COBE rules. Example 3: T Corp. has two equally sized lines of business. D Corp. acquires T and continues one line of T's business. The COBE rules are met. Regulation section (d)(4), has expanded the COBE rules to allow dropdowns of assets into subsidiaries (including a QSub) or a partnership. This will help an S corporation to restructure its activities to save on state taxes, conduct business overseas or reduce liability exposure. Continuity of Shareholder Interest Under reg. section (b), the target's shareholders must maintain some continuity of shareholder interest (COSI) in the acquirer. In some situations, this interest may be in the form of common nonvoting stock (an A reorganization); in most cases, however, it must be voting stock of the acquirer or its parent (but not both). A typical issue involves target shareholders receiving acquirer stock and disposing of the stock shortly thereafter. Regulation sections and -2 allow unlimited post-acquisition dispositions of stock, as long as such stock is not sold to the acquirer's group. Alternative Reorganization Methods The section 368 reorganization rules define various structures that will yield tax-free status to all the parties, assuming that no boot is involved in the transaction and that the principal amounts of securities received and tendered are the same. Many of these techniques are alternative means of accomplishing the same thing and look very similar in result. In the past, many commonly used structures (e.g., B reorganization and triangular mergers) were not available to an acquiring S corporation, except possibly for a fleeting momentulation This is no longer true and therefore, tax practitioners will find S corporations have more flexibility in structuring acquisitions. Discussed below are the advantages, disadvantages and limitations of each technique after the SBJPA. A Reorganizations Section 368(a)(1)(A) is the most flexible of the tax-free reorganizations. It allows the acquirer (possibly a QSub, an S subsidiary or a stand-alone S corporation) or its S parent (but not both) to give voting or nonvoting stock to the target's shareholders in return for the target's assets, in a statutory merger or consolidation. The S corporation acquirer must ensure that all of the target's shareholders are qualified, that the 75-shareholder limit is not exceeded and that the section 1361(b)(1)(D) one-class-of-stock requirement is not violated. Cash or notes could be given to both qualified and nonqualified shareholders. If the target is also an S corporation, then no Section 1374 BIG tax problem will arise. The target's attributes, including AAAs (whether positive or negative) will be merged with the acquirer's; their AE&P will also be merged if both are positive or negative. If one's AE&P is positive and the other's is negative, they must be tracked separately. Because the A reorganization is so flexible, there is a danger that the transaction will not meet the COSI requirement. The IRS will rule on this issue if more than 50 percent of the target shareholder's interest is 47

52 compensated for via acquiring corporation voting or nonvoting stock. 17 While the courts have allowed lesser amounts, most prudent practitioners will not go below 40 percent. If the boot is notes receivables and the transaction is treated as a section 302 redemption, installment sale treatment may be available. If the proceeds include cash or property, the shareholders will be taxed on the boot (usually as capital gain), to the extent of realized gain. In the case of an S corporation target shareholder, the consequences of a redemption or a distribution are generally the same, under section 1368(b). The C versus S distinction is important only if there is AE&P. The major benefit of structuring a tax-free transaction as a straight A reorganization is the ability to easily dispose of dissenting shareholders and unwanted assets. Because there is no 80 percent control requirement, no "substantially all property" criterion (discussed below) and no voting stock requirement, cash, property or nonvoting common stock can be used to advantage. If the target is an S corporation, section 381(b) provides that its taxable year ends on the date of asset transfer. Since a QSub is a disregarded entity for all tax purposes (but a separate entity for legal purposes), a straight A using a QSub allows an S corporation acquirer to protect its assets from claims of Target s creditors and still have the flexibility of the A reorganization structure. Triangular mergers Because foreign corporations cannot avail themselves of an A reorganization and both the target and acquiring corporations must obtain shareholder approval, a straight A reorganization is not always optimal. One way to avoid these problems is to set up a wholly owned subsidiary (QSub or wholly owned new subsidiary) into which the target merges or consolidates. This is a forward triangular merger under section 368(a)(2)(D). After the SBJPA, an S corporation can be either the target or the acquirer. In some situations, it may be preferable for the target to be the survivor of the merger, particularly if the target has name recognition or favorable lease or franchise terms. A reverse triangular merger under section 368(a)(2)(E) could be used to arrive at the desired structure. An S corporation could be the parent and/or the target now that C corporation subsidiaries and QSubs are permitted. If the acquirer is a C corporation, the target's S status will terminate. Section 1362(e)(6)(D) will require use of the closing-ofthe-books method to allocate the target's income between the S and C short-year returns. A major benefit of triangular mergers is that the target's liabilities do not taint the acquirer. This is particularly important when hazardous wastes or other environmental or undisclosed liabilities may be present. Another advantage is that transfer taxes and administrative costs may be reduced. However, forward and reverse triangular mergers are less flexible than straight mergers. Each requires that substantially all of the target's assets remain with the merged company; for ruling purposes, this means 90 percent of the FMV of the net assets and 70 percent of the FMV of the gross assets. 18 This may limit the ability to dispose of unwanted assets; however, the target can sell the assets and transfer the cash to the acquirer, assuming the COBE requirement is met. 19 However, in a reverse triangular merger, only voting stock can be issued to the target's shareholders in exchange for control of the target. ("Control" is defined by section 368(c) as 80 percent of the voting stock and 80 percent of each other class of stock.) B Reorganizations The B reorganization was not available for S corporations before the SBJPA. Although it is the least flexible, it is one of the more popular and simple forms of tax-free reorganization. Only voting stock of the acquirer (or its parent, but not both) can be received by (typically) the target's shareholders in return for their target stock. The acquirer must have control (as defined by section 368(c)) immediately after the 17 Rev. Proc , C.B. 568, and Rev. Rul , C.B Id. 19 Rev. Rul , C.B

53 exchange. There is no requirement that the voting stock exchanged has to be of equal weight. There is no substantially all requirement to a B reorganization which means that the Target can distribute assets to its shareholders or sell an unwanted business prior to the acquisition. Some major advantages of a B reorganization include: Escaping state or local property or transfer taxes, because stock is being transferred Eliminating administrative costs of transferring assets No appraisal is needed for the value of dissenting shareholders' stock The approval of the acquiring and target shareholders is not needed The acquirer may use cash to buy back notes or bonds and to enter into employment contracts or covenants not to compete; fractional shares may be paid for with cash Because there is no "substantially all" requirement, the target may dispose of unwanted assets, assuming the COBE test is met Sometimes, a minority shareholder does not want to receive stock in the acquirer. The acquirer or its parent may not cash out these dissenting shareholders and still have a valid B reorganization. 20 However, the target can redeem the stock or its shareholders could buy it out. Assuming the S corporation acquires 100 percent of a C or S target, the subsidiary may become a QSub: sections 1374, 1375 and 1363(d) taxes may then be applicable. Creeping B Reorganizations It is permissible to have a creeping B reorganization, in which an acquiring S corporation, for example, exchanges voting stock for 30 percent of the target's stock in one month, 40 percent more two months later and 15 percent more one month later. B reorganization treatment will be extended to all the transactions. Also, if an acquiring S corporation owned, for example, 79 percent of the target for several years and wanted to buy the remaining 21 percent of the target for voting stock, the B reorganization rules could be met, even though the prior stock acquisitions were taxable events. C Reorganizations An acquisition by an S corporation of "substantially all" of the assets of the target is a C reorganization if the acquirer gives only voting stock to the target's shareholders. A triangular C can also be effected, in which voting stock of the subsidiary or parent (but not both) is transferred to the target's shareholders. A C reorganization is often called a practical merger, because it does not have to be performed under state law, foreign corporations can participate and approval of the acquirer's shareholders is not necessary. However, it is much less flexible than the A reorganization because, for all practical purposes, no boot is allowed. If the acquirer and target are both S corporations, no section 1374 exposure arises and the companies would combine their AAAs. D Reorganizations There are two types of D reorganizations: (1) nondivisive and (2) divisive (equivalent to a combined sections 351 and 355 transaction). Nondivisive D reorganizations A nondivisive D and a C reorganization look very similar in both structure and results. If both set of rules apply, the D reorganization rules control. The major difference is that a D does not require solely voting stock, and the target's shareholders must control the acquirer immediately after the exchange. (For this 20 Rev. Rul , C.B

54 purpose, "control" is defined by section 368(a)(2)(H) as 50 percent of vote or value.) As in a C reorganization, the "substantially all" assets criteria must be met. This reorganization technique is a way to transform brother-sister S corporations into a parent-subsidiary group (S-QSub). Section 357(c) (liabilities greater than basis gain recognition) applies to a non-divisive D reorganization. Divisive D reorganizations/corporate divisions The main benefit is that neither the distributing corporation nor its shareholders recognize any gain or loss on a transaction that is essentially equivalent to a dividend, redemption or liquidation. This is a way to transform an S corporation division, QSub or group into brother-sister corporations. Example 4: ABD Corp., an S corporation, has two long-time businesses watchmaking and manufacturing calculators. ABD is owned equally by A and B. For various corporate business reasons, A and B decide to go their separate ways. If ABD were liquidated, there would be one level of tax; however, all the tax consequences could be avoided by structuring a divisive D reorganization in which, for example, the watchmaking business is contributed to a newly created subsidiary and then distributed to A in return for his ABD stock. A's basis in ABD would carry over and become his basis in the new S or C corporation, T. This would allow the shareholders to part tax-free. The favorable corporate division rules apply only to stock and securities (assuming securities of equal principal amount are tendered); any other property distributed is treated as boot that gives rise to dividend or redemption treatment, but not a loss. However, various statutory and judicial requirements limit potential abuse: ABD (in the above example) must control (80 percent or more) of T after the transfer (section 368(a)(1)(D)) ABD must distribute control (80 percent) of T to ABD's shareholders (section 368(a)(1)(D)) There must be a corporate business purpose for the transaction (reg. section (2)(b)) The transaction cannot be a device to distribute E&P to ABD's shareholders (section 355(a)(1)(B)) Both ABD and T must be actively engaged in a trade or business after the transaction and both trades or businesses must have been carried on for at least five years and not have been acquired in a taxable transaction (section 355(b) and reg. section (b)) ABD's shareholders must have a continuing proprietary interest in both companies (reg. section (c)) Regulation section (b) offers guidance and examples on corporate business purpose and its interplay with the device test. The purpose must be real and substantial and for non-federal tax purposes germane to the business of the distributing or controlled corporation. In the past, an S corporation may have wanted separate S subsidiaries, but was unable to create any, so it spun them off. Regulation section (b)(5), Example 6, states that electing S corporation status is not a valid business purpose. With the SBJPA changes allowing QSub and parent S-subsidiary C groups, the need to spin off subsidiaries will be diminished. 21 Also, significant state tax savings has been held to be a good corporate business purpose. The five-year history criterion has some interesting twists; for example, what if a corporation had a sevenyear history of making computers domestically and two years ago expanded into a foreign market? Do both the domestic and foreign businesses qualify under reg. section (b)? Regulation section 21 If a spin-off is desired, see Rev. Proc , C.B. 696, for guidance on good business purpose, including focus and fit and key employee criteria. 50

55 (c), Examples 4, 5 and 7, provide that the spin-off of the foreign business will qualify for the fiveyear history because it inherits the characteristic of longevity from the domestic business. However, a different business (e.g., developing video games) would not qualify. Similar reasoning would allow the spin-off of a relatively new dealership, supermarket or department store, when the parent store has a fiveyear history. Morris Trust transaction A common technique to prepare a target for a merger was to spin-off the unwanted assets to the shareholders and then be acquired in an A or B reorganization (a "Morris Trust" transaction). For distributions after April 16, 1997, section 355(e) will tax the distributing corporation on the gain that would have been recognized on the distribution of the subsidiary's stock, if a 50 percent-or-more change in ownership occurs as part of a plan during the four-year period beginning two years before the distribution. The shareholders will not be subject to tax. Corporate attributes: Similar to a section 351 transaction, if assets are transferred to a subsidiary, the tax attributes (NOLs, capital losses, general business credits (GBC), etc) do not follow the assets under section 381(a). An exception is found in reg. section (a) as to AE&P, and in reg. section (d)(3) as to AAA. Basically, only positive items are allocated to the newly formed subsidiary, based on the relative FMVs of the assets transferred. E Reorganizations Section 368(a)(1)(E) allows a corporation to recapitalize or reclassify its stockholders' equity or its liabilities, tax-free. This includes issuing common stock (voting or nonvoting) to preferred shareholders in return for their preferred stock. Thus, when a corporation wants to convert from C to S status and has multiple classes of stock, using an E reorganization will minimize shareholder tax liability. This is often a preferable way to convert to S status as compared to a redemption of the second class of stock which usually leads to one or two levels of tax liability. The new class of stock could be nonvoting common, as long as all shareholders have the same rights to distributions and liquidation proceeds. F Reorganizations Section 368(a)(1)(F) allows a corporation to change its name, state of incorporation, etc., tax-free. Corporate Tax Attributes: Under section 381(a), if assets are transferred under section 351 or 355 or in taxable purchase, corporate tax attributes do not move with the assets. (In a B reorganization, the assets do not change hands, so Section 381 also does not apply.) However, some tax-free transfers of assets do allow the transfer of attributes: Section 332 liquidation or an A, C or nondivisive D, F or nondivisive G reorganization. Although section 381(c) does not specifically list AAA as an attribute that is transferred with the assets, reg. section (d)(2) makes it clear that AAA is indeed a corporate attribute. This regulation takes a slightly different approach than the general E&P rules, in that it requires positive and negative AAA to be netted. In the E&P area, section 381(c)(2) provides that negative and positive E&P are not netted. Under section 1371(b), an acquiring S corporation cannot use tax attributes (e.g., NOLs, capital loss and credit carryovers) from a target C or S. However, section 1374(b) allows the use of NOL carryforwards, capital loss carryforwards, GBC carryforwards and minimum tax credit (MTC) carryforwards from C years against the built-in gains tax. Also, the tax-free acquisition of an S corporation by an S corporation requires the combining of AAA and AE&P. If a C corporation is acquired, under section 1374(d)(8) a new 10-year built-in gains tax recognition period is created and section 1374 applies to the acquirer. The E&P of the target is an important attribute, because it may create a section 1375 exposure, will affect the character of distributions under section 1368, and may subject the acquirer to S termination under section 1362(d)(3). 51

56 Section 382 Ordinarily, a tax practitioner would not expect to have to address section 382 in the S corporation context. However, because section 1374 allows NOL, capital loss, GBC and MTC carryforwards, a basic understanding of the sections 382 and 383 rules is necessary. If a "loss corporation" (defined by section 382(k) as a corporation with NOLs or net unrealized built-in loss) has a more-than-50 percentage point change in ownership of its 5 percent shareholders in a three-year testing period, the taxable income available for offset in a post change year is limited to the value of the loss corporation multiplied by the long-term tax-exempt bond rate. Example 5: B Corp., a C corporation, has a $300,000 NOL, its FMV is $1,000,000 and the longterm tax-exempt rate is 7 percent. If F Corp., an S corporation, acquires B's assets in a tax-free manner, B may offset its NOL against $70,000 of Section 1374 recognized BIG each year until the NOL expires (not to exceed the carryover period). If the BIG were $40,000 in 2002, a $100,000 ($70,000 + $30,000 unused limit) cap would apply in No NOL carryover is allowed if B does not meet the COBE requirement for its historic assets or business for the next two years. Section 383 closely parallels the rules of section 382, but applies to tax attributes other than NOLs. Thus, the ability of capital losses, GBCs and MTCs to offset section 1374 tax is also limited. Conclusion The SBJPA created a number of opportunities for S corporations to restructure, grow and minimize taxes. It allows S corporations to use reverse triangular cash and tax-free mergers, as well as B reorganizations; however, these opportunities also bring with them greater exposure to the S-level taxes in sections 1374, 1375 and 1363(d). Finally, the tax adviser will need to be more familiar with the tax attribute carryover provisions as they now relate to S corporations. 52

57 1. Form 8869 and Instructions APPENDIX C KEY FORMS AND DOCUMENTS The following IRS web address contains the PDF fill-in form for on-line completion: A reference copy is reprinted on the following pages. 53

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