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Exercise caution when taking advantage of new S corporation legislation.

By the time this article is published, the 1996 legislation relating to S corporations will have been in effect for almost a year. Much has been written on the new provisions, which range from increasing the maximum number of shareholders to expanding the IRS's ability to accept late or invalid elections. This article will focus on the provisions allowing an S corporation to own stock in another S corporation. As a result of this change, corporations that have not considered S elections in the past because of their size may find operating as S corporations to be a desirable structure.

Following are three areas in which caution should be exercised prior to making the election to be treated as a qualified subchapter S subsidiary (QSSS).


Prior to the Small Business Job Protection Act of 1996 (SBJPA), various restrictions made the switch between operating as a C corporation and an S corporation extremely difficult. With the reduced restrictions on corporations electing S status, individual shareholders of C corporations that are in consistent loss positions may consider making the election. Some corporations in this situation that have been filing on a consolidated basis will have created excess loss accounts (ELAs) with respect to the parent corporation's basis in subsidiary stock.

The legislative history behind the new law indicates that when the "parent" S corporation makes the election to treat a subsidiary as a QSSS, the subsidiary will be deemed to have liquidated under Secs. 332 and 337 immediately before the election is effective. In a typical Sec. 332 liquidation between a parent and a subsidiary, the existence of an ELA does not create income. Income is created in the amount of the ELA, however, if the consolidated group terminates or the subsidiary leaves the group.

When making a QSSS election (which will cause termination of the consolidated group), it is not clear whether the IRS will deem the liquidation to occur before or after the termination. If deemed to occur after termination, income or gain will be recognized to the extent of the ELA. If the liquidation is deemed to occur first, no income will be recaptured. Note: This issue is currently being considered by the Service and further guidance is expected this summer.


A similar issue involves deferred intercompany transactions (DITs; referred to only as intercompany transactions in the new regulations) between the electing parent corporation (or any member of the consolidated group) and the potential qualified subsidiary. One of the more common DITs that could trigger income on a deemed liquidation is the sale of property of one consolidated group member to another member at a gain.

Example: Parent corporation A files a consolidated return with group ABCD, directly holding 100% of corporation B, which holds 100% of C and D. In 1996, A sold property to B at a gain. While this is considered to be an intercompany transaction (with A's gain subject to deferral under Regs. Sec. 1.1502-13), if A or B were to leave the group, the outstanding intercompany gain would be between two separate taxpayers. A termination of the consolidated group as a result of A's electing S status would accelerate A's gain into income.

State Taxation

Another item that will be a key consideration in making the election to be treated as a QSSS is the law of any state in which the electing corporation has nexus. Because many states still base their treatment on the 1986 tax law with various modifications, the QSSS election may not be respected in a particular state. This could have significant negative tax consequences.


Any corporation considering electing S status when there is an existing consolidated group should exercise caution. The income that may be triggered by ELAs and DITs resulting from a QSSS election could prove more costly than potential future benefits. A thorough analysis of existing ELAs and DITs should be performed prior to making a QSSS election. A corporation making a QSSS election should also examine the tax laws in states in which it has nexus, to ensure the election will be respected or that any negative state tax consequences will not be substantial.
COPYRIGHT 1997 American Institute of CPA's
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Article Details
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Author:Willden, Lynn
Publication:The Tax Adviser
Date:Jul 1, 1997
Previous Article:Application of sec. 1503(d) to separate units of S corporations.
Next Article:State tax implications of the expanded sec. 338(h)(10) election.

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