S corporation acquisitions.

Corporate

S CORPORATION ACQUISITIONS

If an S corporation acquires the stock of another corporation, by virtue of such ownership, it becomes a member of an affiliated group. This membership would terminate the buyer's S corporation election, because the corporation would cease to be considered a small business within the meaning of Internal Revenue Code section 1361(b).

Relief from the termination, however, is available if the buyer liquidates the target stock within 30 days of the acquisition. In revenue ruling 73-496, the IRS concluded such a brief period of stock ownership would be regarded as merely "momentary ownership" that is "insufficient to cause a termination of an S election." (Revenue ruling 72-320 reaches a similar conclusion regarding the ownership by an S corporation of a newly created subsidiary as a prelude to a tax-free spinoff.)

This relief, unfortunately, is not without penalty. The doctrine of momentary ownership means, of necessity, that the transaction will be viewed as a taxable asset acquisition. Thus, the gains inherent in the target's assets will be triggered into income and the acquiring entity will bear the tax.

Although a purchase and liquidation by a C corporation is tax-free under section 332, this provision is unavailable to an S corporation because section 332, of necessity, requires giving credence to the buyer's stock ownership--which would, in turn, terminate its S election.

Observation: The momentary ownership concession is a double-edged sword. The better approach is a multistep transaction in which

1. The S corporation shareholders individually purchase the target's stock.

2. Target effects an S election.

3. The original S corporation merges into the target.

This approach preserves S status and avoids triggering the target's inherent asset gains.