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"Check-the-box" and QSub guidance provide structuring opportunities.

Letter Ruling 200201005 shows practitioners how they can combine the "check-the-box" regulations (Regs. Sec. 301.7701-3) and the final qualified subchapter S subsidiary (QSub) regulations (Regs. Secs. 1.1361-2-6), which clarified the use of QSubs in structuring transactions, to create beneficial Federal tax results that differ significantly from state law results.

In the ruling, X is an S corporation wholly owned by T, a grantor trust owned as community property by a married couple (A and B), who propose the following steps:

1. T will distribute 2.5% of its X stock to A and B.

2. T, A and B will form Z, a state-law general partnership that, pursuant to Regs. Sec. 301.7701-3(a) will elect classification as an association (and thus a corporation) under Regs. Sec. 301.7701-2(b)(2).

3. Z will immediately make an S election. (Its general partnership agreement provides for distributions of cash from operations and distributions on dissolution to the partners in the same proportion as their partnership interests.)

4. T, A and B will contribute their X stock to Z in exchange for proportionately identical ownership interests in Z.

5. Z will file a timely election to treat X as a QSub, effective as of the date of the contributions.

6. Z will then contribute 1% of its X stock to W, a newly formed state-law limited liability company (LLC), in exchange for 100% of the ownership interest in W, and X will convert into state-law limited partnership Y. Neither W nor Y will make a check-the-box election under Regs. Sec. 301.7701-3(c).

Letter Ruling 200201005 stated that X represented that the series of transactions, through which X was "converted" to Z (a corporation that owned all of X's assets through its ownership of Y, a state-law limited partnership disregarded for Federal tax purposes) qualified as a Sec. 368(a)(1)(F) reorganization. Although this representation used the word "converted," it appears that X used this term to describe the effect of Z's QSub election on X, which is a deemed liquidation for Federal income tax purposes.

The ruling concluded that Z can elect taxation as an association and, provided it makes a timely election and otherwise satisfies the definition of a small business corporation under Sec. 1361(b), can elect S treatment under Sec. 1362.

Moreover, Z's transfer of 1% of X stock to W, a newly formed LLC, in exchange for 100% of the interest in W, will not terminate X's QSub election--if W does not make an election under Regs. Sec. 301.7701-3(c) to be treated as an association--because Z will continue to be treated as owning 100% of X.

Finally, X's merger into Y, as a state-law limited partnership owned 1% by W (an entity wholly owned by Z) and 99% by Z will be disregarded for Federal income tax purposes (if no election is made under Regs. Sec. 301.7701-3(c) to treat W as an association); at the end of the series of transactions, X's assets continue to be held by Z for Federal tax purposes.

The exhibit illustrates how the structure looked before and after the transactions.


The bottom line in the series of transactions is that X, which started out as an S corporation, is converted to a state-law limited partnership without triggering what may have been (but for the check-the-box regulations) a taxable liquidation of the former S corporation. The ruling's analysis is very helpful, because it provides clear guidance as to the timing of the events, and affirmatively concludes that the underlying entities (W, X and Y) are disregarded for Federal income tax purposes. On the other hand, the question not addressed in the ruling is why A and B even proposed this series of transactions.

However, one benefit that may result from the proposed transactions is that they may provide different results for Federal and state tax purposes. For example, depending on the state, Y may be considered a limited partnership for state tax purposes and an S corporation for Federal tax purposes. In any event, tax practitioners should be aware of this ruling; it may provide an opportunity to create a desired Federal-tax result that differs significantly from the state-tax result.

Caution: Practitioners should beware of possible state action to preclude such results. For instance, the California governor's fiscal year 2002-2003 proposed budget includes a provision that may require corporations to use their Federal elections (such as S elections) for state tax purposes as well.

Pamela Packard, CPA
Vice Chairman
Tax Services
BDO Seidman LLP
New York, NY
COPYRIGHT 2002 American Institute of CPA's
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Title Annotation:S corporations; subsidiary corporations
Author:Packard, Pamela
Publication:The Tax Adviser
Geographic Code:1USA
Date:May 1, 2002
Previous Article:TC decides Sec. 6330's jurisdiction.
Next Article:Impact of income taxes on S stock valuation.

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