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Acquisitions by S corporations - -beware the QSub election.

Tax practitioners should be alert to unexpected potential consequences of an S corporation's acquiring another corporation, electing to treat the target as a qualified subchapter S subsidiary (QSub), and later selling the QSub's stock.

Background

Prior to 1997, S corporations were prohibited from owning 80% or more of another corporate entity. The Small Business Job Protection Act of 1996 eliminated that restriction by allowing S corporations to own any percentage of any other corporation. Further, it provided that an S corporation that wholly owns another domestic corporation can elect to treat such subsidiary as a QSub, allowing flowthrough treatment of the QSub's tax items. The QSub is a disregarded entity similar to a single-member limited liability company.

An S corporation may acquire a C corporation in a taxable stock acquisition. The decision whether to elect QSub stares for the newly acquired C corporation should be examined closely, because the disadvantages of a subsequent sale of the QSub's stock can outweigh the advantages of the flowthrough treatment afforded by the election.

QSub Election Consequences

If an S corporation wants to treat its wholly owned domestic subsidiary as a flowthrough entity, it could elect QSub status for the subsidiary on Form 8869, Qualified Subchapter S Subsidiary Election. The election is treated as a deemed liquidation of the subsidiary into the S parent for Federal income tax purposes. (Note, however, that if the original acquisition of the subsidiary was part of a larger related-party transaction, the step-transaction doctrine could recast the deemed liquidation into something else (e.g., an acquisitive D reorganization).) For state law purposes, the subsidiary remains in existence. Once the QSub election is made, the subsidiary is treated as an integrated division of the S parent (Sec. 1361(b)(3)(A)).

Because the QSub election requirements mandate a 100% stock ownership in the domestic subsidiary, the liquidation generally will be tax-free for the S parent under Sec. 332, and tax-free for the subsidiary under Sec. 337, assuming those provisions' requirements are met.

In a Sec. 332 liquidation, the shareholder of the liquidating corporation (i.e., the S corporation) is treated as exchanging its subsidiary's shares for the liquidation proceeds (i.e., the subsidiary's assets) in a tax-free exchange. The parent takes a carryover basis in the subsidiary's assets under Sec. 334(b), and the stock basis the S corporation previously had in the subsidiary "disappears." Any C corporation earnings and profits (E&P) the subsidiary had immediately before the liquidation would carry over to the parent (Secs. 381(a)(1) and (c)(2)).

Subsequent Sale of QSub Stock

In general. The disposition of 100% of the QSub stock to an unrelated purchaser is treated as a disposition of the QSub's assets (Regs. Sec. 1.1361-5(b)(3), Example 9). If the purchaser acquires less than 100%, the other rules would apply. As noted previously, the S corporation's basis in a QSub's assets will be determined on a carryover basis.

If the S corporation acquired a target's stock in a taxable stock acquisition and elected QSub status for the target, the assets' fair market values (FMV) may exceed their adjusted tax basis. A subsequent sale of 100% of the QSub stock triggers gain recognition on the assets, even though the S corporation paid FMV for the target's underlying assets (the gain would be ordinary if the assets were of ordinary character (e.g., zero-basis receivables)). In comparison, if the S corporation had not elected QSub status for the target and subsequently sold 100% of the target's stock, it would trigger capital gain only to the extent the sales proceeds exceeded the original cost basis of the target's stock.

BIG tax. The built-in-gains (BIG) tax can be triggered on disposition of an asset that had unrealized appreciation when it was transferred from a C corporation to an S corporation in a carryover-basis transaction (Sec. 1374(d) (8)). If the target was a C corporation and had appreciated assets, the QSub election would create a BIG tax problem for the S purchaser if it sells 100% of the QSub stock within 10 years of the effective date of the QSub election. The BIG tax is a corporate-level tax, applied at the maximum corporate income tax rate on the amount of unrealized gain in an asset on the date the asset was transferred to the S corporation. Even if the acquiring S corporation always has been an S corporation, the acquisition of 100% of the C stock, coupled with a QSub election, taints the S corporation for BIG tax purposes for the assets of the former C corporation for the 10-year recognition period.

E&P. In addition to the pass0through gain and BIG tax concerns, an S corporation that acquires a C target with E&P could subject the S shareholders to ordinary dividend treatment if it elects QSub status for the C target. (The E&P could also be problematic for the excess passive income tax under Sec. 1375.) S distributions are generally tax-free for shareholders to the extent the corporation maintains a positive balance in the accumulated adjustments account (AAA) and the shareholders have basis in their S shares (Sec. 1368(b)). As noted, under Sec. 381, the E&P of a C subsidiary will carry over to an S transferee when the S corporation elects QSub status and the deemed liquidation is tax-free under Sec. 332.

To the extent an S corporation makes distributions to its shareholders in excess of its AAA, it will be treated as distributing the E&P carried over from the subsidiary (Sec. 1368(c)). This will result in ordinary income treatment for the S shareholders until all the E&P is exhausted.

Example 1: S corporation S has no E&P and no BIG tax exposure. It purchases 100% of the stock of C corporation T with E&P of $100 on Jan. 1, 2003. T's assets have a $100 FMV and a zero adjusted basis. S takes a $100 purchase price basis in T shares. On Jan. 1, 2005, S decides to sell 100% of the T stock to an unrelated purchaser for $100.

S did not elect to treat T as a QSub, but instead operated T as a wholly owned C subsidiary. On Jan. 1, 2005, s recognizes $100 proceeds on its sale of T's stock and recovers its $100 of original basis. Accordingly, neither S nor its shareholders pay any tax on the transaction, and S has no problem about distributing any E&P to its shareholders.

Example 2: The facts are the same as in Example 1, except that S elected to treat T as a QSub, effective Jan. 1, 2003. The QSub election caused a deemed Sec. 332 liquidation of T. S takes a carryover basis of zero in T's assets. Because S is deemed to exchange its T shares for T's assets, S's basis in the T stock disappears. Further, S succeeds in T's E&P under Sec. 381.

On Jan. 1, 2005, S is deemed to have sold all of T's assets for $100. The deemed asset sale triggers the 35% BIG tax on the $100 in unrealized appreciation inherent in T's assets at Jan. 1, 2003, resulting in a $35 corporate-level tax. S's shareholders recognize a flowthrough $65 gain ($100 gain, less a $35 BIG tax) and pay an additional $13 of capital-gain tax at the shareholder level (assuming the asset was a capital asset and the capital-gain rate was 20%). S distributes $13 to its shareholders to cover the shareholder tax liability, leaving it with $52 ($100 of proceeds, less $35 of BIG tax, less a $13 distribution) of after-tax, after-distribution proceeds. Further, S must now be careful not to make distributions in excess of its AAA, to avoid E&P ordinary dividend treatment to its shareholders.

Comparison. In Example 2, S's after-tax, after-distribution proceeds are $48 less than in Example 1. However, during the two years that T was a QSub in Example 2, its operating earnings were not subject to corporate level tax and could have been distributed to S's shareholder tax-free. Further, in Example 2, S's shareholders' stock basis is increased by $52.

Observations

If an S corporation acquires 100% of the stock of a target corporation with high-value, low-basis assets, it should consider carefully the consequences of electing QSub status for the C corporation if it anticipates selling the target's stock in the future. As an alternative, S shareholders could directly acquire the target stock and consent to an S election for the target. This may allow the S shareholders to obtain flowthrough treatment on the target's operating income and allow them more flexibility in a subsequent stock disposal.

FROM GREG W. SMITH, CPA, AND KEVIN C. NICHOLS, CPA, WASHINGTON, DC
Editor:
Annette B. Smith, CPA
Partner
Washington National Tax Service
PricewaterhouseCoopers
Washington, DC
COPYRIGHT 2002 American Institute of CPA's
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Title Annotation:qualified subchapter S subsidiaries
Author:Smith, Annette B.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jul 1, 2002
Words:1472
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