Acquisition of control of a C corporation by an S corporation.

Since the repeal of the General Utilities doctrine, it is not uncommon for the selling shareholders of a C corporation to demand that a sale be structured as a stock transaction. This is typically the case when the outside basis of the stock is substantially in excess of the inside basis of the underlying assets. A significant double tax results if the selling corporation sells assets and subsequently distributes the proceeds in liquidation.

If the acquiror of the target stock is an S corporation, particular problems are raised with respect to the effect on the acquiror's S election and the taxability to the S shareholders on the distribution of the target's assets to the S corporation in complete liquidation.

Under Sec. 1361(b)(2)(A), an S corporation cannot be a member of an affiliated group of corporations, as defined in Sec. 1504(a), without regard to the exceptions in Sec. 1504(b). Obviously, the target must be liquidated immediately after the acquisition. Therefore, the first issue is whether the momentary ownership of the target stock violates the affiliated group test and will result in the termination of the acquiror's S election.

Sec. 1371(a)(1) provides that, except as otherwise provided and except to the extent inconsistent with subchapter S, subchapter C applies to an S corporation and its shareholders. Sec. 1371(a)(2) provides that, for subchapter C purposes, an S corporation in its capacity as a shareholder of another corporation is treated as an individual. Accordingly, if target stock is deemed to be held by an individual, the required liquidation of the target results in gain or loss recognition to the target under Sec. 336, to the extent the fair market value of the corporation's assets exceeds its tax basis. If the target stock is deemed to be held by a corporation, no gain or loss is recognized to the target under Secs. 332 and 337(a).

Recently, the IRS issued Letter Ruling (TAM) 9245004, which not only ruled favorably on both issues but also ruled that the purchase of the target stock was a "qualified stock purchase" under Sec. 338(d)(3) for purposes of making a Sec. 338(g) election.

Under the facts of the TAM, S acquired 100% of the stock of T and immediately dissolved T and distributed its assets to S. The Service ruled that acquisition of the stock was a "qualified stock purchase" under Sec. 338(d)(3) and T's dissolution was governed by Sec. 332.

In a lengthy analysis of the legislative history of Sec. 1371(a)(2), the IRS concluded that the purpose of the provision was to deal with Sec. 301 distributions and the nonapplication of the dividends-received deduction; it was not inconsistent with any policy underlying subchapter S nor did it give rise to any abuse of the Federal tax system, such as the avoidance of General Utilities gain. Further, the Service ruled that the momentary ownership of the T stock did not cause S to be ineligible under Sec. 1361(b)(2)(a). (Subsequently, the IRS issued Letter Ruling 9250038, which ruled that an S corporation could participate in a divisive reorganization under Sec. 368(a)(1)(d) and that Secs. 361(c)(1) and 355(a)(1) applied. Additionally, the momentary ownership of the controlled subsidiary did not terminate the distributing corporation's S election.)

While letter rulings cannot be cited as precedent, it appears that the IRS will apply Secs. 1361(b)(2)(a) and 1371(a)(2) very narrowly, which will give S corporations greater flexibility in structuring acquisitions and obtaining the same benefits available to C corporations. For example, an acquiring S corporation now has the option of electing Sec. 338(g) or liquidating the target with carryover basis of assets under Rev. Rul. 90-95. Additionally, if the target is a member of an affiliated group of corporations, the S corporation can make a joint election with the selling group under Sec. 338(h)(10).