New S corporation law opens pitfalls for unwary.

Caution must be used when entering into transactions with S corporations and the new qualified subchapter S subsidiaries (QSSSs). In particular, one transaction involving a QSSS may trigger a tax when the QSSS election is made.

Transaction

Many S corporations have appropriately avoided terminating S status under prior law by owning less than 80% of another corporation. The other 21% of these 79% subsidiaries are often owned by the shareholders. If the S corporation owns 100% of a domestic subsidiary, a QSSS election can be made and the subsidiary is generally liquidated taxfree under Sec. 332. What many companies will want to do is to have their shareholders contribute the 21% to the S corporation (achieving the 100% ownership requirement) and then elect QSSS status for the subsidiary. Ideally, the contribution would be governed by Sec. 351 and the liquidation by Sec. 332, resulting in tax-free treatment for the transaction.

It is not completely clear whether the above transactions could be collapsed into one integrated transaction. According to Rev. Rul. 67-274, the acquisition of stock combined with the liquidation of the subsidiary whose stock was acquired win convert the transaction into a direct acquisition of the subsidiary's assets. In Rev. Rul. 67-274, the transaction resulted in a reorganization under Sec. 368(a)(1)(c). However, because of the relationship of the corporations through the shareholders, the C reorganization was also an acquisitive D reorganization.

When the liabilities of the target corporation exceed the tax basis of its assets, Sec. 357(c) requires that gain be recognized in a D reorganization. The gain is equal to the amount by which target liabilities assumed by the S corporation exceed die tax basis of the target's assets. Although the intended result is a taxfree restructuring under current S rules, an unintended tax may be the consequence.

These consequences could also result when two commonly owned S corporations are combined by a contribution of stock of one S corporation to the other, followed by a QSSS election for the now wholly owned subsidiary.

This result for the described transaction is not entirely certain, and guidance on the use of QSSSS and transactions involving them has not been issued by the IPS. The analysis is made under the assumption that a QSSS election is literary equivalent to a Sec. 332 liquidation and that the Service will integrate a QSSS election with other steps of an overall restructuring. The IRS has requested comments in Notice 97-4 on issues surrounding QSSSs. Notice 97-4 provided temporary guidance on filing QSSS elections, but did not elaborate on the spectrum of resulting consequences. Taxpayers can expect guidance on these transactions shortly.