Application of step-transaction doctrine to Qsub elections.

S shareholders who restructure their holdings to benefit from opportunities created by the Small Business Job Protection Act of 1996 (SBJPA) should be alerted to provisions in final regulations issued earlier this year that apply the step-transaction doctrine in certain circumstances. On the positive side, these final regulations offer transitional relief from application of the step-transaction doctrine for certain S restructurings completed before 2001.

Background

Congress historically has given S corporations special benefits under the tax law. Initially, only businesses without subsidiaries could qualify; an S corporation could not own 80% or more of another corporation. Congress recognized that this "no subsidiary" limitation was unwarranted and, in the SBJPA, allowed S corporations to own any percentage of another corporation.

Congress also understood that some S corporations wished to separate different trades or businesses into different corporate entities for legal purposes, but to report the tax results of all the trades or businesses on one S tax return. In these situations, Congress concluded that S shareholders should be allowed to use parent-subsidiary arrangements as well as brother-sister arrangements. Thus, the qualified subchapter S subsidiary (QSub) was born.

Proposed Regulations

In April 1998, the IRS issued proposed regulations on the treatment of QSubs. The regulations provided that, when an S corporation makes a QSub election for a subsidiary, the subsidiary is deemed to have liquidated into the S parent immediately before the QSub election is effective. The tax treatment of this liquidation, alone or in the context of any larger transaction (e.g., a transaction that also includes acquisition of the subsidiary's stock), is generally determined under the Code and general principles of tax law, including the step-transaction doctrine.

The proposed regulations included a special transition rule suspending application of the step-transaction doctrine for a stock acquisition followed by a QSub election when the S corporation and subsidiary are related (as defined in Sec. 267(b)) immediately before acquisition of the subsidiary's stock. Under the proposed regulations, this transitional rule would have applied to certain elections effective before the 60th day after publication of final regulations.

Trap for the Unwary

Many tax practitioners expressed concern over application of the step-transaction doctrine to transactions that include a deemed liquidation created as a result of a QSub election. For example, if the Service were to apply the step-transaction doctrine to S taxpayers that acquire stock of a related corporation and immediately make it QSub election for the related corporation, that transaction could be recast as an asset acquisition under Sec. 368(a)(1)(D). The results might be inconsistent with the taxpayer's expectations (see, generally, Rev. Rul. 67-274). The most significant risk relating to this type of transaction would be if the related corporation has aggregate liabilities in excess of aggregate asset basis and the IRS applies the step-transaction doctrine. Under this scenario, gain would be triggered under Sec. 357(c) to the extent liabilities exceed asset basis.

Restructuring of S holdings has been common since 1996. Related S shareholders often choose to simplify their Federal income tax reporting requirements by contributing the stock of other S corporations to one S corporation in a tax-free Sec. 351 exchange and then immediately electing QSub status for the contributed S corporations to treat them as disregarded entities. Many less-sophisticated taxpayers could be unaware of the consequences of the restructuring if the step-transaction doctrine were applied.

Some tax practitioners concluded that the legislative history of the QSub provisions reflected congressional intent that the deemed liquidation should be an independent, tax-free Sec. 332 liquidation. The IRS disagreed with this analysis in the preamble to the final regulations. It specifically referred to the technical correction made to Sec. 1361(b) by Section 1601(c)(3) of the Taxpayer Relief Act of 1997 (which gave the Service authority to draft regulations addressing the liquidation of a subsidiary deemed to occur on a QSub election).

Transition Relief Extended

Concerns raised by tax practitioners after the proposed regulations were issued in 1998 were not completely ignored. The IRS extended transition relief from the step-transaction doctrine to cover QSub elections effective before 2001, thus giving taxpayers an additional nine-month transition relief period (Regs. Sec. 1.1361-4(a)(5)).

Conclusion

The SBJPA created significant opportunities for related S shareholders to consolidate their S holdings, thereby simplifying income tax reporting requirements while still obtaining legal separation of trades or businesses. Taxpayers wishing to take advantage of such opportunities should complete their restructurings before 2001, to avoid possible application of the step-transaction doctrine.

FROM GREG W. SMITH, CPA, WASHINGTON, DC

Robert Zarzar, CPA
Partner
Washington National Tax Services
PricewaterhouseCoopers
Washington, DC