Final Qsub regs.
What Is a Wholly Owned QSub?
A QSub is a wholly owned subsidiary for which a valid QSub election is made by an S parent. Once a valid QSub election is made, a subsidiary is deemed to have liquidated into its S parent tax-free under Sec. 332 and would not be treated as a separate corporation for any other income tax purposes. All assets, liabilities and items of income, deduction and credit of a QSub will be treated as assets, liabilities and items of income, deduction and credit of the S parent.
Regs. Sec. 1.1361-1(1) provides much-needed guidance as to what constitutes stock for purposes of determining if a QSub is wholly owned by an S parent. Stock of a corporation is treated as owned by an S corporation if the latter is the owner of that stock for Federal income tax purposes. Instruments, obligations and other arrangements that would not constitute equity under the one-class-of-stock rules of Regs. Sec. 1.1361-1(1) are disregarded in determining whether a subsidiary is the owner of stock for Federal income tax purposes. Moreover, the straight-debt safe-harbor provisions of Regs. Sec. 1.1361-1(1)(5) continue to apply in determining if an obligation issued by a QSub can be treated as debt.
Electing QSub Status
Regs. Sec. 1.1361-3(a) provides that an S corporation may elect to treat an eligible subsidiary as a QSub by filing a completed form prescribed by the Service. However, at the time the final regulations were issued, the IRS-prescribed form had not been designed. Therefore, practitioners should continue to use Form 966, Corporate Dissolution or Liquidation, as set forth in Notice 97-4.
Revocation of QSub Status
Regs. Sec. 1.1361-3(b) allows an S parent to voluntarily revoke a QSub election. The revocation is accomplished by filing a signed statement with the IRS Service Center where the S parent filed its most recent S return. This rule represents a pleasant change from the proposed regulations, which provided that a QSub election could only be terminated when a subsidiary ceased to qualify as a QSub (i.e., when an ineligible shareholder held QSub stock or the S parent held less than 100% of the QSub's stock). A voluntary revocation can prove beneficial when selling a more-than-20% interest in the stock of a QSub, assuming the revocation and subsequent sale cannot be integrated together as one step.
The revocation is effective on the date the signed statement is filed with the appropriate service center. However, an S corporation can specify an alternative date, not to exceed two months and 15 days before the filing date of the revocation statement or 12 months following the date of the filing. A QSub election may even be revoked before it becomes effective, by filing a revocation statement within two months and 15 days of the date the election would have been effective.
Inadvertent QSub Election and Inadvertent Termination Relief
A termination of a QSub election could occur if an S corporation inadvertently transfers one share of QSub stock to another person, without being aware that the QSub election would terminate on the transfer. The subsidiary would then not be eligible to have a QSub election in effect for the period during which the parent does not own 100% of its stock or for at least another five years.
While the proposed regulations included a provision indicating that inadvertent QSub termination relief may be available, Regs. Sec. 1.1361-5 does not include any analogous provisions. However, if the termination of a QSub election results from the inadvertent termination of the parent's S election, relief may be available under Sec. 1362(f). A favorable determination under that section causes the subsidiary to continue to satisfy the requirements of Sec. 1361(b)(3)(B)(ii), during the period in which the parent is accorded relief for inadvertent termination of its S election. Moreover, if the parent fails to make a timely QSub election, relief may be available under Rev. Proc. 9855 or under Regs. Sec. 301.9100.
Five-Year Waiting Period
Except for certain limited exceptions, a corporation whose QSub election has terminated generally may not elect S status or reelect QSub status before the fifth tax year beginning after the year in which the termination occurred.
Regs. Sec. 1.1361-5(c) provides for an exception to the onerous five-year waiting requirement, if the following two criteria are met:
1. The corporation (or its successor corporation) is otherwise eligible to make an S election or QSub election immediately following the termination; and
2. The election is made immediately following the termination of the QSub election.
Thus, for example, if an S corporation owns a QSub and distributes the QSub's stock to the S shareholders, the QSub election for the QSub will terminate, because it no longer satisfies the QSub requirements. If, however, the QSub otherwise would be eligible to elect S status, the QSub shareholders may elect S status for the QSub, effective as of the date of distribution, without requesting IRS consent.
The regulations are taxpayer friendly in that the QSub would not be treated as a C corporation for any period as a result of the termination of its QSub election followed by an immediate S election. This treatment can prevent the potential application of the BIG tax or a triggering of an ELA. For this distribution to be tax-free, it must otherwise satisfy the requirements for a divisive reorganization under Secs. 355 and 368(a)(1)(D). In a divisive reorganization, electing S status cannot be the primary business purpose of the split-off.
Another example to illustrate this rule occurs when an S corporation sells 100% of the stock of a subsidiary that was a QSub immediately before its acquisition by another S corporation. The acquiring S corporation may then make a QSub election for the acquired subsidiary, effective as of the acquisition date. Once again, this should occur without having to obtain a waiver of the five-year waiting period to re-elect, and the subsidiary should not be treated as a C corporation for the interim period.
Regs. Sec. 1.1361-5(b)(1) makes clear that general principles of tax law, including the step-transaction doctrine, will apply immediately to determine the tax consequences of electing or terminating QSub status. However, the final regulations provide another short transition period before applying the step-transaction doctrine to related party QSub formations. The transition rule only applies to QSub elections effective before 2001. For example, if an S corporation receives as a contribution to its capital the stock of another related corporation (persons specified in Sec. 267(b)), followed by a QSub election for that corporation, the step-transaction doctrine will not apply to determine the tax consequences of the acquisition. The transaction will be respected as a Sec. 351 contribution, followed by a Sec. 332 liquidation. Absent the transition rule, this transaction could be treated as a D reorganization. In a D reorganization, the possibility for gain recognition exists under Sec. 357(c) if the liabilities deemed contributed to the S corporation exceed the adjusted tax basis of the assets deemed contributed by the QSub.
It should also be noted that the final regulations contain an example that clarifies that the Sec. 332 regulations apply in determining the consequences of each independent step. According to Kegs. Sec. 1.332-2(b), a QSub must be solvent (i.e., the fair market value of its assets must exceed its liabilities) for the liquidation to be considered tax-free. However, because a QSub election results in a constructive liquidation for Federal tax purposes, a formal plan of liquidation need not be adopted (unless, of course, a formal liquidation is desired).
Although no examples on point are contained in the final regulations, harsher results should occur from the acquisition of a subsidiary by an unrelated S corporation, followed by a QSub election. Based on the application of the step-transaction doctrine in other areas of tax law, this transaction should be treated as a deemed asset sale (similar to the consequences that occur when a Sec. 338 election is made). Moreover, because unrelated parties would be involved, the transition period should not apply in these situations.
During the transition period provided by the proposed regulations, taxpayers voluntarily applied the step-transaction doctrine to certain reorganizations. For example, if an S taxpayer wished to change its state of incorporation, an F reorganization could have accomplished that result. The shareholders of the old S corporation could have incorporated a new S corporation in its desired state, and the shareholders could have contributed the old S stock to the new S corporation and have the new S corporation make a QSub election for the old S corporation. The preamble to the final regulations provides that, during the transition period, the Service will not challenge the application of the step-transaction doctrine to QSub elections to obtain similar tax treatment for reorganizations under Sec. 368(a)(1)(F).
Regs. Sec. 1.1361-5(b)(3) contains several examples describing the application of the step-transaction doctrine. These examples provide useful insight into structuring transactions with QSubs, to avoid complete or partial gain recognition. One example describes a situation in which an S corporation sells a 21% interest in a QSub to an unrelated corporation. The QSub is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) in exchange for issuing all of its stock immediately before the termination from the S corporation.
The deemed exchange by the S corporation of its assets for the former QSub's stock does not qualify under Sec. 351, because the S corporation would not be in control of the former QSub (i.e., 80% under Sec. 368(c)) immediately after the transfer. If, soon after the formation of the QSub, there is a sale of 21% of the stock to an unrelated corporation, the 80% control requirement would not be met. The example then provides that the S corporation must recognize gain on the deemed sale of all its assets to the former QSub on the formation of the new corporation. On the other hand, losses (if any) on the deemed sale are potentially subject to the Sec. 267 loss disallowance rules.
Another example uses the same fact pattern to avoid the undesirable results of taxing the deemed sale of all the assets. In this example, the unrelated corporation contributes a sufficient amount of capital to the QSub in exchange for 21% of the QSub stock. In this instance, the QSub is treated as a new corporation acquiring all of its assets and assuming all of its liabilities in exchange for the issuance of its stock. Because the S corporation and the unrelated corporation collectively are co-transferors that control the transferee immediately after the transfer, the transaction now qualifies as tax-free under Sec. 351.
If the S corporation wishes to receive some cash in the transaction, it should be treated as boot and any potential gain would be taxed only to the extent of boot received. However, if the S corporation receives an amount of cash representing the full 21% interest in the former QSub, the Service could collapse the transaction as a deemed sale of stock. In this instance, the entire gain should once again be taxed to the contributing S corporation to reflect the substance of the transaction, regardless of its form.
As an additional alternative in this situation, an S corporation could voluntarily revoke the QSub status of its subsidiary in advance of selling the 21% interest in the QSub. If a sufficient amount of time elapses between the revocation and subsequent sale, the Service should respect the independent steps of each transaction. In this instance, the S corporation would take on a basis in the QSub's stock equal to the net inside basis of the assets deemed contributed at the time of the revocation. The total basis in the QSub stock would then be evenly allocated to each share of QSub stock. On the subsequent sale of 21% of the QSub shares, gain would only be recognized by the S parent, to the extent the proceeds received exceeded the adjusted basis of those shares sold.
Termination of QSub Status
Under Sec. 1361(b)(3)(C), if a corporation that was a QSub ceases to qualify as a QSub, that corporation is treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) immediately before the terminating event. Once again, under the final regulations, the tax treatment of the formation of the new corporation is to be determined under general principles of tax law, including the step-transaction doctrine.
While the deemed formation of the new corporation generally occurs immediately before the terminating event, the final regulations provide for a different result when an unrelated person acquires all of the QSub's stock. In this situation, the deemed formation of the new corporation by the former S parent is disregarded for Federal income tax purposes. The transaction is treated as a sale of the QSub's assets to the acquiring corporation, followed by a transfer of the assets by the acquiring corporation to the new corporation in exchange for the new corporation's stock. Under this characterization, assuming the parties are not deemed to be related (as defined) in excess of a 20% commonality threshold, the anti-churning rules under Sec. 197 should not apply, because no momentary ownership of the new corporation by the selling S corporation is deemed to exist.
A common parent of a consolidated group of corporations that elects S status may also elect QSub status for some or all of the subsidiary corporations. When QSub elections are made for a tiered group of corporations on the same date, the S corporation may specify the order in which the subsidiaries are to be liquidated. However, if no order is specified, the deemed liquidation of the subsidiaries starts with the lowest-tier corporation and continues upward to the highest-tier corporation.
The deemed liquidation of the lowest-tier subsidiary first is usually very advantageous. Having the lowest-tier subsidiaries treated as liquidating first eliminates any ELAs (which would result in income in the deconsolidation of an affiliated group) and avoids the separate application of the BIG tax for each subsidiary.
On termination of tiered QSubs, if the terminations occur on the same day, the deemed formation of the new subsidiaries are treated as progressively occurring, starting with the highest-tier subsidiary and progressing downward to the lowest-tier subsidiary. This ordering rule is also advantageous to taxpayers, because each formation would then have the potential to be tax-free under Sec. 351. However, a determination would need to be made if the formations are part of a larger group of transactions under the step-transaction doctrine.
If an S corporation acquires assets in a transaction in which its basis in the assets is determined by reference to a C corporation's basis in the assets, Sec. 1374 applies to the net recognized BIG attributable to the acquired assets. Under the final regulations, separate determinations of tax are made for the assets the S corporation acquires in one Sec. 1374 transaction, from the assets the S corporation acquires in another Sec. 1374 transaction and from the assets the corporation held when it became an S corporation.
Separate Sec. 1374 pools are normally created for purposes of calculating the tax imposed by Sec. 1374. In connection with maintaining separate BIG tax pools for an S corporation and each QSub, each corporation's Sec. 1374 attributes (such as loss and credit carryforwards) may be used only to reduce the Sec. 1374 tax imposed on the disposition of assets held by that entity. Likewise, Sec. 1374 attributes acquired in one Sec. 1374 transaction may be used only to reduce tax on the disposition of assets acquired in that transaction.
Fortunately, the final regulations are very friendly to unsuspecting taxpayers in this area as a result of the operation of the general timing rules. A single Sec. 1374 pool is deemed to exist when the parent's S election is made effective for multiple QSubs. Moreover, no separate BIG tax exposure exists when an S corporation is deemed to acquire the assets of another S corporation under the step-transaction doctrine (or in an actual asset acquisition), if the acquired S corporation has no prior C corporation history.
Regs. Sec. 1.1502-19 provides rules requiring, in certain instances, a member of a consolidated group of corporations to include in income its ELA in the stock of another subsidiary member of the group. An ELA reflects the member's net negative adjustments with respect to the other subsidiary member's stock, to the extent the negative adjustments exceed the member's stock basis. An ELA must be included in the member's income if the member is treated as disposing of the other subsidiary member's stock under Regs. Sec. 1.1502-19(b)(1).
A merger or liquidation of the member into an S corporation or an S election by the member is treated as a disposition that triggers income recognition with respect to an ELA in the other subsidiary member's stock. By contrast, the member's income or gain in certain cases is subject to special nonrecognition or deferral rules, including Sec. 332. As a result, if the other subsidiary member liquidates into the member in a transaction subject to Sec. 332, there is no income recognition with respect to an ELA in the other subsidiary member's stock.
The final regulations provide the general timing rules of liquidation when the common parent elects S status and makes QSub elections on the same day. The deemed liquidation of subsidiary members of a consolidated group, for which QSub elections are made, occurs as of the close of the day before the QSub elections are effective. Therefore, the QSub election is deemed to be made while the S-electing parent is still a C corporation. As a result, there is no triggering of income with respect to ELAs in the stock of the subsidiary corporations if the liquidations qualify under Sec. 332.
In contrast, if a consolidated group is acquired by an S corporation and the acquiring S corporation makes QSub elections for the parent and members of the consolidated group, a deemed liquidation of the parent prior to the deemed liquidation of other group members may be a disposition that triggers income recognition for ELAs in the subsidiaries' stock. Therefore, a consolidated group with ELAs should consider making S and QSub elections (if possible) or implementing strategies to cure any ELA balances prior to merging into or being acquired by an S corporation.
Consistent with the proposed regulations, the final regulations provide that any special rules applicable to banks under the Code continue to apply separately to banks. These rules assume that the deemed liquidation brought about by a QSub election had not occurred for purposes of the banking provisions (i.e., application of Secs. 582(c) and 585). The banking provisions apply automatically to all bank taxpayers; no special elections are necessary.
Generally, the effective date of the final regulations is for tax years beginning on or after Jan. 20, 2000 (the date the final regulations were published in the Federal Register). However, taxpayers may elect to apply the regulations in whole (but not in part) to tax years beginning after 1999. The banking provisions apply retroactively to Dec. 31, 1996. In addition, the transition period suspending the step-transaction doctrine will apply to related-party QSub formations prior to 2001.
The issuance of the final QSub regulations provides practitioners with much-needed guidance in performing transactional analysis for their clients. However, given the complexity of the corporate reorganization provisions (including the application of the step-transaction doctrine), a mergers-and-acquisition tax specialist should be consulted prior to consummating any acquisition, disposition or other reorganization involving a QSub. Fortunately, many of the hidden traps and pitfalls associated with QSub formations, acquisitions, terminations and dispositions can be avoided with proper tax planning.
FROM RANDY A. SCHWARTZMAN, CPA, MST, NEW YORK, NY
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|Title Annotation:||IRS regulations concerning qualified Subchapter S subsidiary corporations|
|Author:||Schwartzman, Randy A.|
|Publication:||The Tax Adviser|
|Date:||May 1, 2000|
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