Current developments - eligibility, elections and terminations; operations; and legislation.

From a tax perspective, during the period covered in this update -- September F1996 through August 1997 -- the focus has been on implementing the significant S changes made by the Small Business job Protection Act of 1996 (SBJPA) (enacted on Aug. 20,1996).(1) At the same time, numerous operational issues were also addressed by the courts and Treasury.

Because of the many newly created or C corporate-converted S corporations, there have been a considerable number of letter rulings, announcements, notices and revenue procedures reflecting the 1996 legislative changes. A smaller number of letter rulings involved qualified subchapter S trust (QSST) beneficiaries not making a timely election (due to the SBJPA and Rev. Proc. 94-23(2)) and an even smaller number were released on proposed corporate divisions (Sec. 355) as they apply to S corporations. Some interesting S corporation issues came to the fore: final Sec. 1377 regulations; passive activity loss PAL) utilization; earnings md profits (E&P) determinations; qualified subchapter S subsidiary (QSSS) issues; built-in gain on timber harvesting; the cash method of accounting; Sec. 351 incorporations in which liabilities may exceed adjusted basis; and the joint Committee on Taxation's "Blue Book" comments(3) on recent S corporation legislation. Tax advisers should be aware that many more issues will arise at the state level, as some states have conformed to the Federal S corporation law changes; others have not.

This update is presented in three major categories: eligibility, elections and terminations; operations; and legislative changes, including the provisions of the Taxpayer Relief Act of 1997 (signed into law on Aug. 5, 1997) that affect S corporations, as well as some SBJPA issues that remain unresolved. (Note: Although past updates have included a section on reorganizations, this year's does not, because many fewer letter rulings were issued in the area.)

Eligibility, Elections and Terminations

The general definition of an S corporation in Sec. 1361 includes significant restrictions on the type and number of shareholders, as well as the type of corporations, that can qualify for S status.

If an S corporation violates any of these restrictions, its S election is automatically terminated. However, taxpayers can request an inadvertent termination ruling under Sec. 1362(f) and retain S status continuously. The IRS, at the urging of Congress, has been reasonable in granting inadvertent termination rulings.

Filing an S Election

To qualify as an S corporation, the corporation and all the shareholders on the date of the election (as well as other affected shareholders) should file a valid, timely Form 2553, Election by a Small Business Corporation (under section 1362 of the Internal Revenue Code). It is generally recommended that this election be sent by certified mail/return receipt or by registered mail. Section 1210 of the Taxpayer Bill of Rights 2 allows the use of certain preapproved private delivery services (PDSs) for purposes of Sec. 7502, the "timely mailed as timely filed/paid" rule. Rev. Proc. 97-19(4) provides the criteria to be a designated PDS; according to Notice 97-26,(5) Federal Express, Airborne Express, DHL and United Parcel Service next-day and two-day delivery services qualify as the equivalent of certified mail for such purposes.

Prior to the SBJPA, the Service had no authority to allow late-filed S elections. Sec. 1362(b)(5) now gives the IRS the power to correct inadvertent errors in electing S status if the corporation shows that it made the mistake inadvertently and that it qualified to be an S corporation and acted as though it were an S corporation. Ann. 97-46 offers the taxpayer guidance on how to apply for inadvertent election relief. In most rulings to date, an employee, lawyer, accountant or owner forgot to mail or fin out the Form 2553, but the company filed Form 1120-S, US. Income Tax Return for an S Corporation7 The IRS granted inadvertent relief in each of these rulings.

Continuing the trend, Rev. Proc. 97-408 allows late-filed S elections to be approved without requesting a letter ruling. Now, if a Form 2553 is filed by all the shareholders within six months of the election's due date, and is identified as filed under Rev. Proc. 97-40, no letter ruling (and attendant fee) is necessary. This procedure does not cover QSST and electing small business trust (ESBT) errors.

The fact that this error correction may be retroactive creates the need for amended tax returns at both the corporate and shareholder levels. For example, in Letter Rulings 9720019,9 972201 1 10 and 972202 1,11 the corporation filed as an S corporation, amended the return to file Form 1120, US. Corporation Income Tax Return, and then amended the corporate return again after permission to file S status was granted. Likewise, the shareholders of these corporations were required to amend their individual tax returns many times; because these changes affected multiple years, amended returns were required for aD those years. An interesting but unanswered) question is the proper treatment if some of these years are closed by the statute of limitations.

Corporate Year-End

When a C corporation decides to switch to S status, generally a calendar year-end is required. Notice 97-2012 facilitates this transition. Basically, the notice waives certain limitations of Regs. Sec. 1.442-1 (c) (2) (i) and (v), as well as Sections 4.01 (2) and 5 of Rev. Proc. 92-13.13 This liberalization is in effect for the short period ending Dec. 31, 1996, and assumes that special filing procedures are followed. These include properly completing Forms 2553 and 1128, Application To Adopt, Change, or Retain a Tax Year, and writing "Filed Under Notice 97-20" at the top of both forms.

Corporate Eligibility

One class of stock: Sec. 1361 b) (1) (D) prohibits an S corporation from having more than one class of stock, defined as stock having differing economic rights (distributions and liquidations), rather than different voting rights. In Letter Ruling 9728019,14 an S corporation issued to its shareholders a second class of stock that differed in liquidation rights. From the corporation's inception, the shareholders of both classes of stock were allocated income, loss and separately stated items as though there was only one class of stock. The IRS ruled that this was an inadvertent termination. Reorganizing under Sec. 368(a)(1)(E) results in a more benign tax effect than a redemption under Sec. 302.

In the past, when an S corporation set up employment or consulting agreements or a profit-sharing pool for its employee-owners, there was some concern that this could be interpreted as a second class of stock. Letter Ruling 972002115 allays taxpayers ears. Similarly, Letter Puling 9649039(16) held that an S corporation's notes payable on purchase of property from related shareholders did not give rise to a second class of stock.

Letter Ruling 972801817 dealt with an S corporation whose shareholders were engaged in succession planning. The older generation was going to redeem all of its stock and take back notes from the S corporation. (The family members were not attributed stock from other family members because a Sec. 302(c)(2) election was in effect.) The notes were secured by the corporation's accounts receivable, inventory and equipment, and the collateral was subordinated to the bank's security interest. The Service held that the notes were not a second class of stock. (It is preferable not to secure a debt with the S stock, because, if a default occurs, the conditions of a Sec. 302(c) election may be violated.) This ruling is also instructive because it elaborated on what involvement senior redeeming shareholders may maintain with the corporation without jeopardizing a Sec. 302(c) election. For example, the founder may maintain an office and use corporate equipment and secretarial support for personal and charitable activities, if he pays a fair rental; he may also go to trade shows in his capacity as a retired executive.

Affiliated group: For years prior to the SBJPA's effective date, Sec. 1361(b)(2)(A) prohibited an S corporation from having an 80%-or-greater parent-subsidiary relationship. In Letter Rulings 9643010,(18) 9724009,(19) 9723019(20) and 9722024,(21) S corporations set up or purchased wholly owned subsidiaries; the Service granted them inadvertent termination relief In Letter Ruling 9642031,(22) a planned asset purchase was converted into a stock purchase at the last minute. The purchasers did not realize that the created affiliated group, which was not momentary, would terminate the corporation's S status; the Service again granted inadvertent termination relief.

In similar fact patterns dealing with foreign subsidiaries, S corporations bought or formed 100% foreign corporations or established foreign sales corporations. Presumably, the taxpayers thought that, because the consolidated tax rules do not apply to a foreign subsidiary under Sec. 1504(b), foreign wholly owned stock would be allowed. However, Sec. 1361(b)(2)(a) requires that foreign subsidiaries be counted in determining an affiliated group. When it was discovered that S status was terminated, the taxpayers took corrective action and requested inadvertent termination relief, which was granted.(23) In Letter Ruling 9648031,24 a domestic corporation acquired a foreign subsidiary. When the corporation's tax advisers realized that the S corporation was technically terminated, they advised management, which distributed some of the foreign stock to the S-shareholders. Practitioners should be aware that Secs. 311, 301 and 1248 would probably apply to this distribution. Beginning in 1997, affiliated group structure is permitted for a parent S corporation; corrective actions will no longer be required.

Letter Ruling 971600725 presented a tax planning structure that the government has continued to rule on favorably. What if an S corporation owns 99% of a limited liability company (LLC) that owns 99% of a foreign corporation? Assuming the nominal owners are the real owners, this is not an affiliated group for S purposes.

Banks

SBJPA Section 1315 allows banks that do not use the Sec. 585 reserve method of accounting for bad debts to elect S status. To facilitate this change in accounting method to become an S corporation, Rev. Proc. 97-1826 allows an automatic change to the Sec. 166 specific write-off method, without filing Form 3115, Application for Change in Accounting Method, within the first 180 days. Instead, two copies of Form 3115 must fie completed by the due date (including extensions) of the first S return; one copy should be attached to the tax return and the other should be sent to the IRS National Office. No user fee is required. Also, the bank must have filed a Form 2553 within the first 2 Y2 months of its 1997 tax year. As a condition of this change, the Sec. 481 (a) adjustment will be due over the next six years.

E&P Issues

If an S corporation has accumulated subchapter C E&P (AE&P), it must carefully monitor the composition of its gross receipts, for two reasons. First, if it does not purge its AE&P and has too much passive investment income (more than 25% of gross receipts) for three consecutive years, its. S status will terminate in the fourth year. Second, there is a Sec. 1375 tax imposed on excess net passive income, as defined in Sec. 1375(b)(1).

The issue of how much AE&P a corporation has is not always self-evident. In Broadaway,(27) the Eighth Circuit upheld the ruling in Cameron(28) that a corporation that misestimated its Sec. 312(n)(6) percentage of completion adjustment to E&P for its years as a C corporation could not revise its E&P once it became an S corporation. The court ruled that, because electing S status was voluntary, a freezing of the extant E&P is required even if the number is wrong. The moral is, an estimate of E&P should be accurate.

Shareholder Eligibility

In Letter Ruling 9716022,(29) a stock warrant was issued to a person not eligible to be an S shareholder. Because this person exercised the warrant, the S corporation had an ineligible shareholder. The corporation corrected the error soon after realizing the problem. The IRS granted relief, but required the eligible shareholder to pick up all the S income. Letter Ruling 9714021(30) also dealt with a stock transfer to a corporation, an ineligible shareholder. The corporation's original accountant died and a new accountant discovered the error. Soon afterward, the corporation rescinded the sale to the ineligible corporate shareholder and reissued the stock to an eligible shareholder. The Service granted Sec. 1362(f) relief, but required the ineligible shareholder to include the separately and nonseparately reported income on its tax return and to adjust its stock basis accordingly. The inconsistency of who is required to pick up the income is perplexing.

It is widely recognized that a nonresident alien (NRA) is not an eligible S shareholder. Often, this error occurs in a community property state in which the spouse with indirect ownership is an NRA. In Letter Ruling 9650011,(31) an NRA directly bought stock in an S corporation. When the error was recognized, another qualified shareholder bought out the offending party. The IRS ruled that the correction was timely md therefore granted inadvertent termination relief. One of the conditions of the ruling was that the NRA would not be treated as a shareholder. The ruling was not clear whether all the other qualified shareholders would include the income, or just the acquiring shareholder.

An individual retirement account (IRA) is not an eligible S shareholder,32 a rule not changed by the SBJPA. In Letter Rulings 9644030,(33) 9728022(34) and 9725029,(35) the corporations' officers and directors were unaware that an IRA trust was not a qualified shareholder until their tax advisers informed them of their technical violations. Inadvertent termination relief was requested and granted. These rulings required the individuals, and not the trust, to include the S corporation's separately and nonseparately reported income in their individual tax returns.

Letter Ruling 970202036 addressed a situation that for tax years beginning after 1997 will no longer be a problem (because Sec. 501(c)(3) charitable organizations and Sec. 401 (a) pension trusts are now permitted to be S shareholders). A shareholder donated S stock to a charitable organization. When the mistake was recognized, the charity gave the stock back to the contributor and the Service allowed inadvertent termination relief. The IRS also required that the donor treat the gift as though it had never occurred, negating a charitable deduction.

Trusts

S corporations and their tax professionals must carefully monitor trust shareholders. During this past year, a variety of inadvertent termination letter rulings dealt with several different trust issues. For example, in Letter Rulings 9722025(37) and 9718008,(38) the IRS granted relief even though the trusts' elections were made late or not at all. In Letter Ruling 9701017,(39) a nontimely filed QSST election was rectified within two months of the error being discovered. The Service granted Sec. 1362(f) relief, provided that the trust picked up the income. In Letter Ruling 9701033,40 the election was mistakenly filed with Form 1041, U S. Income Tax Return for Estates and Trusts; inadvertent termination relief was granted.

The QSST rule's require that current income be distributed to the beneficiary. Letter Ruling 9710026(41) addressed the issue of what is current income. A QSST redeemed S stock that was subject to Sec. 302(d) and Sec. 301 ordinary distribution treatment. The trustee allocated the income to corpus (as permitted under state law). The IRS allowed this allocation to principal, and the trust continued to qualify as an S shareholder.

In Letter Ruling 9642011,42 an S shareholder died; the S stock was included in the estate and placed in a trust. Unfortunately, the executor did not know that the stock had to be released from the trust within 60 days, per Sec. 1361 (c) (2) (A) (iii). The Service granted inadvertent termination relief. In Letter Ruling 9714024,43 the sole shareholder died and the living trust assets were included in the estate. The stock was transferred to a QSST on a timely basis (within two years), but the QSST had not been properly set up. Again, the IRS granted relief.

Operations

An S corporation has often been described as mirroring a partnership as to operations and a C corporation as to formation, liquidation, reorganization and liability issues. Unfortunately, this is an oversimplification. For example, the question of whether the S corporation and its shareholders are to be treated under the aggregate theory or the entity concept is problematic.

For example, in Letter Ruling (TAM) 9722007,(44) passive losses engendered from renting property to a wholly owned S corporation were not part of the same activity as the S corporation's auto dealership activities (in which the shareholders materially participated), because, undertemp. Regs. Sec. 1.469-4T(c) and (d), the activities were operated by different owners (the S corporation and the individual shareholders). This result was decided under the old Sec. 469 regulations, which were effective through May 10, 1992. Current Regs. Sec. 1.469-4(d)(i)(c) may allow this aggregation of activities, so that the real estate losses could offset the S corporation's active income.

Similarly, Letter Ruling (TAM) 972000345 dealt with a dairy farming S corporation whose active manager-owner personally hedged grain contracts, which the corporation used to feed its cattle, to reduce market risks. The ruling held that individual losses incurred on the grain futures contracts were capital in nature (40% short term and 60% long term). If the hedging had occurred at the entity level, they would most likely have been ordinary losses (under the Corn Products46 doctrine). The moral is to keep the farming and hedging activity at the same level.

On the other hand, the issues in Russon(47) would have been moot if the aggregate theory that applies to S corporations, partnerships and LLCs was involved. This case dealt with a closely held C corporation that never paid dividends. Family members bought stock from the older generation to earn a living and perpetuate the companies their ancestors started. The court held that the Sec. 163(d) investment interest expense limitations applied. In dicta, the judge suggested that if the companies were S corporations, one would look through the entity to allocate interest expense between business assets and investment assets.

Loss Limits

One of the common motivations for electing S status (as opposed to a C corporation) is die ability to flow through the entity-level losses to the shareholders. Shareholders face several hurdles, however, before a loss may be used: the hobby loss (Sec. 183), basis for loss (Sec. 1366) and passive activity loss (Sec. 469) rules.

Sec. 193 hobby loss: In two recent cases, S corporation losses were disallowed due to lack of profit motive. In Lucid,(48) a plastic surgeon and his psychotherapist wife tried to deduct losses from a yacht and boating equipment business, arguing that they had advertised in boating magazines and attended boat shows. During a six-year period, the Lucids had no income for four years and an aggregate income of $1,400 in two years; yachting expenses averaged $60,000 a year. The court held that, overall, the activity was not carried on in a business like manner, and disallowed the loss under Sec. 183. In Garrett,(49) a Florida businessman collected "muscle" cars (he owned over 30, including a 1970 Ford Mustang Boss and a 1966 Corvette). He financed his acquisitions through various S corporations that he controlled. The court capitalized some costs and disallowed losses from the maintenance and racing of the cars under the hobby loss rules.

Sec. 1366 limitation: If a taxpayer does not have sufficient adjusted basis in stock or debt, passthrough losses are suspended until the shareholder's basis increases. In Bhatia,(50) the court held that when a 1 00% owner assumed the debt obligations of an S corporation from another S corporation he wholly owned, an economic outlay had not occurred and no basis for loss was created.

The AICPA has long endorsed the position that cancellation of indebtedness income (CODI) should increase a shareholder's basis under Sec. 1366(a)(1)(A); the IRS, however, has maintained that it should not.51 In Winn,(52) the Tax Court held that CODI does increase a shareholder's adjusted basis.

Cash Method of Accounting

One of the advantages of the S corporation form is that if the cash method of accounting is otherwise appropriate, an S corporation can use this method, regardless of the size of its gross receipts. THEIRS has been attacking contractors' use of the cash method in the last few years, whether the taxpayer was a C or S corporation. The latest battle occurred in the non-S corporation arena, in which a hospital provided medical services and incidental supplies to its patients. The Service asserted that the accrual method was required. The Tax Court held in Hospital Corporation of America(53)) that the hybrid or cash method was available to m acute care hospital when supplies, medicines and drugs were provided. The court examined prior cases54 and found that the cash method may clearly reflect income, as long as it is applied on a consistent basis, and that the Regs. Sec. 1.471-1 inventory rules do not apply to these incidental sales. Despite these decisions, Letter Ruling (TAM) 9637003(55) held that when an S corporation sold technical supplies and accessories ancillary to its main business, the accrual method was required.

Sec. 1374 Built-in Gain

Sec. 1374 imposes a tax on an S corporation's net recognized built-in gain for C corporations that elected to switch to S status after 1986. One might expect to see many rulings and court cases involving built-in gain issues, but to date, they have been few and far between. In a series of letter rulings,(56) the Service has made it clear that timber harvesting is not subject to Sec. 1374.57

Sec. 1363(d) LIFO Recapture Tax

In Letter Ruling TAM) 9716003,(58) a C corporation maintained its inventory on the LIFO method. Prior to switching to S status, it contributed the inventory to a partnership. The Service applied the LIFO recapture tax to the conversion under the aggregate theory.

Passive Investment Income

If an S corporation switches from C to S status or acquires trade or business assets in a tax-free manner (as enumerated in Sec. 381), the Sec. 1375 tax and the Sec. 1362(d)(3) termination rules must be taken into consideration. Sec. 1362(d)(3) provides that if, for three consecutive years, an S corporation has subchapter C E&P and passive investment income that exceeds 25% of gross receipts, in the fourth year S status is terminated.

Letter Ruling 964201559 involved an S corporation that met these rules and technically had become a C corporation. The IRS allowed a deemed consent dividend at the end of the third year and thereby eliminated the corporation's AE&P.

Regs. Sec. 1. 1362-2(c) (5) (ii) (B) requires that for the rental of real or personal property, substantial services or substantia] costs must be incurred to avoid classification as passive investment income. Several letter rulings in this area deal with the nature of the activity.(60)

Final Sec. 1377 Regulations

Regs. Sec. 1.1377-161 reflects the change made by the SBJPA that only affected shareholders and the corporation must make an election to close the books when an S shareholder sells his entire interest in the corporation. A statement attached to the corporate tax return, noting that the corporation and the affected shareholders agree to the closing of the books method, is all that is required. If die shareholder disposition is by way of a corporate redemption, all the shareholders must approve the election. The final regulations also provide that if there is no actual ownership of the S corporation (i.e., subscribed stock), the beneficial owners will be allocated its income. These regulations are effective after 1996.

Incorporation Issue

Letter Ruling (TAM) 964000162 dealt with a Sec. 351 transfer to an S corporation in which property (and related liabilities) previously leased to the corporation were transferred. The majority shareholder (98%) and the S corporation signed cross-collateralized and cross-default agreements with the bank. The IRS held that Sec. 357(c) applies to the shareholder; his basis in the corporate stock would be zero under Sec. 358(d), even though the shareholder still had primary liability for the outstanding debt.

Legislative Changes

In addition to those already discussed, the SBJPA includes several other important provisions that expand the efficacy of S corporations. Many of these changes will simplify the S rules or eliminate procedural traps for the unwary; a few will complicate the small business provisions to benefit a small subset of S corporations.

Effective Date

Unless otherwise stated, the effective dates of these provisions apply to tax years beginning after 1996. Also, because these changes were viewed as major and favorable, the law allows current C corporations that converted from S status in the past five years to automatically reelect S status without waiting for the five-year period required by Sec. 1362(g). Those entities that elect S status should realize that the corporate tax regimes of Secs. 1374,1363(d) and 1375 will apply.

Expanding the Qualified Shareholder Definition

The permissible number of qualified shareholders in an S corporation has been increased to 75. In the past, the number of shareholders matched the Reg. D requirement. What impact the "Blue Sky" laws will have on large S. formations remains to be seen.

ESBT

SBJPA Section 1302 created a new type of qualified S shareholder, the ESBT It is still not clear whether the requirement that "no interest in such trust was acquired by purchase" (Sec. 1361 (e) (1) (A) (ii)) means that the beneficial interest or the S interest must not have been bought. The Blue Book interprets this rule to mean that the trust may acquire property (including the S corporation interest) by purchase, but the beneficiaries may not acquire their interest by purchase. This interpretation does not make a lot of sense, because a purchase of a beneficial trust interest would likely convert the entity into a business trust taxable as a partnership or a corporation.

Sec. 1361 (e) (1) (A) (i) is not clear on whether the trust beneficiaries must be qualified shareholders, but the Committee Reports and Blue Book do require eligibility. The law and Notice 97-1263 state that only the trustee must make the ESBT election within 2 Y2 months of the beginning of the tax year. For a newly electing S corporation, the election should be attached to the Form 2553. The beneficiaries are not required to sign the election. However, the trustee must file a copy with the Service Center with which the Form 1120-S is filed. The election should include a list of all current and potential beneficiaries, and state that they are qualified shareholders. Each beneficiary counts toward the 75-shareholder limit.

This ESBT flexibility does not come without a price. The trust is taxable on the flowthrough income at the trust level at the 39.6% rate (capital gains at 28%/20%); no deduction is allowed for distributions to beneficiaries.

SBJPA Section 1302 also clarifies that if the ESBT (or QSST, estate, etc.) is terminated before the S corporation's year-end, a pro rata share of income and deductions is allocated to the trust. Similarly, Letter Ruling 9721020(64) holds that when the corporation liquidates, the QSST is taxed on both the corporation's liquidation gain under Sec. 336 and the shareholders' Sec. 331 gain.

Streamlining Administrative Procedures

An error in the original filing of an S election is much less of a problem than ever before; SBJPA Section 1305 gives the IRS discretion to grant inadvertent error relief under Sec. 1362 (f) guidelines for failure to provide a signature or missing a filing requirement. This is a major step forward on the simplification front.

Similarly, if there is reasonable cause, the IRS may relax the first 2 1/2-month filing deadline rule. The effective date of the inadvertent election error is for tax years beginning after 1982. As discussed, this has already led to a plethora of letter rulings and to multiple amended corporate and individual tax returns.

A simplifying trust administrative provision extends the time that certain testamentary and grantor trusts own S stock from 60 days to two years. This will eliminate a significant trap for the unwary.

Expanding the S Corporation Capital Structure

SBJPA Section 1308 allows m S corporation to own 80% or more of a C corporation, but the consolidated tax rules would not apply to the S corporation. This will reduce the need for a number of inadvertent termination rulings. Such a corporate structure may be useful in setting up foreign subsidiaries and for multiple state tax purposes. In the context of an S corporation using foreign sales corporation subsidiaries, such use is limited by the fact that an S corporation is not eligible for dividends-received deduction benefits.

QSSSs: SBJPA Section 1308 created the QSSS, which is a 100%-owned subsidiary of an S corporation that otherwise would be qualified to be an S corporation, if the owners of the parent company were the subsidiary's shareholders. For tax purposes, the subsidiary is ignored and the group is treated as a single entity, by treating the subsidiary as liquidated under Secs. 332 and 337 immediately before the QSSS is effective.

The Blue Book points out that it is permissible to have a QSSS of a QSSS, which would allow a three-or-more-tiered S group. It is also possible to have one corporation elect to be a QSSS and its brother-sister corporation keep its C status. This will give S corporations tremendous flexibility to do business in foreign countries, reserve names in multiple states, or protect the parent's assets from creditors or lawsuits.

Notice 97-465 requires the liquidating subsidiary to file a Form 966, Corporate Dissolution or Liquidation, within 30 days of the liquidation plan adoption and enumerates the information to be provided. A short-period return may be required. If the subsidiary was a C corporation, Sec. 1374 and 1363(d) taxes may be applicable, and the parent S corporation may be exposed to the Sec. 1375 tax.

There are still some unresolved issues, however, such as the impact of the conversion to QSSS status on any consolidated return excess loss account. Also, if an S corporation owns less than 80% of a subsidiary and buys back the remaining ownership to qualify it as a QSSS, it may be viewed under Rev. Rul. 67-274(66) as a D reorganization, so that liabilities greater than adjusted basis of assets may give rise to gain under Sec. 357(c). Also, Notice 97-4 points out that if a qualified stock purchase occurs before the QSSS election, if Sec. 338 is elected, its consequences will be effective before the Sec. 332/337 rules apply.

A further complication occurs if QSSS status is lost and Sec. 351 applies to the new entity. It is again likely that Sec. 357(c) could trigger gain on this reincorporation. Also, Notice 97-4 points out that after electing out of QSSS status, the group must wait five years before reelecting such status.

Taxpayer Relief Act of 1997

The Taxpayer Relief Act of 1997 (TRA `97) has very little direct impact on S corporations. However, for tax years beginning after 1997, employee stock option plans (ESOPs) as S shareholders become slightly more attractive; they may make cash distributions to retiring participants under TRA `97 Section 1506(a).

In addition, the unrelated business income tax and prohibited transaction rules were liberalized for S corporation ESOPs undertra '97 Sections 1523(a) and 1506(b)(1).

(1) For a discussions of Some of these changes, see Karlinski, "Current Developments -- Eligibility, Elections and Terminations; Operations; Reorganization; and Legislation," 27 The Tax Adviser 614 (Oct. 1996).

(2) Rev. Proc. 94-23, 1994-1 CB 609.

(3) Joint Committee on Taxation, General Explanation of the Small Business Job Protection Act of 1996 (hereinafter, the "Blue Book") (JCS-12-96). (Although the Blue Book does not have the same level of authority as the legislation, the Joint Committee's insights are valuable.)

(4) Rev. Proc. 97-19, IRB 1997-10, 55.

(5) Notice 97-26, IRB 1997-17, 6.

(6) Ann. 97-4, IRB 1997-3, 14.

(7) See, e.g., IRS Letter Rulings 9652016 (9/30/96), 9719009 (1/29/97), 9719016 (2/4/97), 9715021 (1/10/97), 9716024 (1/21/97), 9717020 (122/97), 972007 (2/13/97), 9728024 (4/11/97) and 9728036 (4/14/97).

(8) Rev. Proc. 97-40, IRB 1997-33, 50.

(9) IRS Letter Ruling 9720019 (2/10/97).

(10) IRS Letter Ruling 9722011 (2/14/97).

(11) IRS Letter Ruling 9722021 (2/26/97).

(12) Notice 97-20, IRB 1997-10, 52.

(13) Rev. Proc. 92-13, 1992-1 CB 665.

(14) IRS Letter Ruling 9728019 (4/10/97).

(15) IRS Letter Ruling 9720021 (2/11/97).

(16) IRS Letter Ruling 9649039 (9/10/96).

(17) IRS Letter Ruling 9728018 (4/10/97).

(18) IRS Letter Ruling 9643010 (7/17/96).

(19) IRS Letter Ruling 9724009 (3/13/97).

(20) IRS Letter Ruling 9723019 (3/7/97).

(21) IRS Letter Ruling 9722024 (2/27/97).

(22) IRS Letter Ruling 9642031 (7/16/96).

(23) IRS Letter Rulings 9715032 (1/14/97), 9725017 (3/20/97) and 9723020 (3/7/97).

(24) IRS Letter Ruling 9648031 (11/29/96).

(25) IRS Letter Ruling 9716007 (1/8/97).

(26) Rev. Proc. 97-18, IRB 1997-10, 53.

(27) John Broadway, 111 F3d 593 (8th Cir. 1997)(79 AFTR2d 97-2072, 97-1 USTC [paragraph] 50,355).

(28) John M. Cameron, 105 TC 380 (1995).

(29) IRS Letter Ruling 9716022 (1/21/97).

(30) IRS Letter Ruling 9714021 (1/21/97).

(31) IRS Letter Ruling 9650011 (9/10/96).

(32) Rev. Rul. 92-73, 1992-2 CB 224.

(33) IRS Letter Ruling 9644030 (7/26/96).

(34) IRS Letter Ruling 9728022 (4/4/97).

(35) IRS Letter Ruling 9725029 (3/21/97).

(36) IRS Letter Ruling 9702020 (10/10/96).

(37) IRS Letter Ruling 972025 (2/28/97).

(38) IRS Letter Ruling 9718008 (1/28/97).

(39) IRS Letter Ruling 9701017 (9/30/96).

(40) IRS Letter Ruling 9701033 (10/3/96).

(41) IRS Letter Ruling 9710026 (21/9/96).

(42) IRS Letter Ruling 9642011 (7/10/96).

(43) IRS Letter Ruling 9714024 (1/6/97).

(44) IRS Letter Ruling (TAM) 9722007 (2/11/97).

(45) IRS Letter Ruling (TAM) 9720003 (1/15/97).

(46) Corn Products Refining Co., 350 US 46 (1955)(47 AFTR 1789, 55-2 USTC [paragraph] 9746).

(47) Scott C. Russon, 107 TC 263 (1996).

(48) Morgan Lucid, TC Memo 1977-247.

(49) Floyd L. Garrett, TC Memo 1997-231.

(50) Arun Bhatia, TC Memo 1996-429.

(51) See IRS Letter Ruling (TAM) 9541006 (7/5/95).

(52) Phillip D. Winn, TC Memo 1997-286.

(53) Hospital Corporation of America, TC Memo 1996-105.

(54) See, e.g., Ansley-Sheppard-Burgess Co., 104 TC 367 (1995), and Kenneth H. Van Raden, 650 F2d 1046 (9th Cir. 1981)(48 AFTR2d 81-5607, 81-2 USTC [paragraph] 9517).

(55) IRS Letter Ruling (TAM) 9637003 (4/16/96).

(56) IRS Letter Rulings 9726015 (2/28/97), 9719032 (2/5/97), (TAM) 9727001 (9/30/97) and 9712028 (4/7/97).

(57) See IRS Letter Ruling 9648035 (8/29/96) for an explanation of the interaction between new Sec. 1374 )post-1986) and old Sec. 1374 (pre-1987), and their transition rules.

(58) IRS Letter Rulings (TAM) 9716003 (9/30/96).

(59) IRS Letter Ruling 9642015 (7/11/96).

(60) IRS Letter Rulings 9643017 (7/22/96), 9710014 (12/4/96), 9728006 (4/13/97) and 9702007 (10/3/96).

(61) TD 8696 (12/20/96).

(62) IRS Letter Ruling (TAM) 9640001 (11/29/94).

(63) Notice 97-12, IRB 1997-3, 3.

(64) IRS Letter Ruling 9721020 (2/20/97).

(65) Notice 97-4, IRB 1997-2, 24.

(66) Rev. Rul. 67-274, 1967-2 CB 141.