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QSSS prop. regs. offer planning opportunities.

This article is an adaptation of an interview on the recently issued proposed regulations on qualified subchapter S subsidiaries. The interview is part of an audiotape series produced by the Deloitte & Touche LLP Washington National Tax Group on various tax topics.


Don: The IRS and Treasury recently issued proposed regulations(1) on qualified subchapter S subsidiaries (QSSSs). Mike, these rules have caused a lot of excitement in the passthrough area. What are practitioners talking about; what issues have you already begun to see?

Mike: We have been waiting since 1996 for these regulations. Before the enactment of the Small Business Job Protection Act of 1996 (SBJPA), a C corporation that owned 80% or more of a subsidiary could not elect S status. The SBJPA changed that; practitioners have been anxiously awaiting the IRS's interpretation of the new, almost revolutionary, changes. Now, the ability of C corporations and affiliated groups to elect S status gives them increased latitude to segregate assets and liabilities into separate business lines without creating complex brother-sister relationships, while maintaining a single level of taxation. In addition, an S corporation can now acquire a C corporation target without having to immediately liquidate it to maintain S status. Finally, the proposed regulations provide simplified tax reporting; if an S corporation owns 100% of another corporation for which it makes a QSSS election, the QSSS becomes a disregarded entity. Thus, only one tax return is filed for both entities.

Don: Give us a brief overview of the SBJPA's provisions concerning S subsidiaries?(2)

Mike: After the SBJPA, a C corporation can own 80% or more of another corporation and still elect S status. Further, an S parent doesn't have to elect QSSS status for all of its subsidiaries. However, if QSSS status is desired for a subsidiary, the parent must wholly own the subsidiary. The possibilities are almost infinite, depending on how many subsidiaries there are. The point, however, is that a C parent can own an 80%-or-more subsidiary, elect S status for itself and elect QSSS status for its wholly owned subsidiaries.

Don: Let's see if I can summarize this. If an S parent owns an 80%-or-more subsidiary, that subsidiary can be a C corporation, but cannot be a QSSS unless the parent wholly owns it. If the S parent owns 100% of the subsidiary, the QSSS election can be made. The QSSS then becomes a disregarded entity. Is that correct, Mike?

Mike: Yes.

Don: Now, an S parent can also own the stock of C corporations. Prior to the SBJPA, an S corporation could not own 80% or more of a C corporation. Now, an S corporation may own any percentage of a C corporation and make a QSSS election for its wholly owned C corporation subsidiaries.

Mike: However, in the past, an S corporation had to own 79.99% or less of a subsidiary to retain its S status. Now, it may own 80% or more of a C corporation's stock and still retain its S status. In addition, it may choose which subsidiaries it wants to be C corporations or QSSSs.

Don: Thus, if an S parent had two subsidiaries, the parent could elect QSSS status for one subsidiary and the other subsidiary could continue its C status?

Mike: That's right.

Scot: However, despite the flexible rules, an S corporation cannot own a C corporation that retains its C corporation status, and then elect QSSS status for the C corporation's subsidiaries. The QSSS-S corporation chain must not be broken.

Don: Scot and Mike, let's discuss this last point in more detail later in connection with consolidated return issues. What's the effective date of the new provisions?

Mike: The provisions are effective for tax years beginning after 1996.

Don: Scot, which practitioner issues have you been seeing?

Scot: Three issues come to mind. First, before getting into the specifics, when a QSSS election is made for an S subsidiary, SBJPA legislative history(3) suggests that the deemed liquidation is governed under Secs. 332 and 337. However, Sec. 1361 doesn't specify the treatment of such liquidation; practitioners were concerned about that. Second, when the common parent of a consolidated group makes an S election, then a QSSS election for its subsidiaries, practitioners wondered about the effect of certain provisions relating to deconsolidating the consolidated group. This isn't specifically addressed in Sec. 1361. Third, when a QSSS election is terminated or revoked, Sec. 1362 provides that a new corporation is deemed to be formed immediately before the termination or revocation. Practitioners were concerned about the implications of this deemed formation. There are other issues as well (see below under "Other Issues").

Don: Mike, what's your view of the proposed regulations?

Mike: For the most part, these regulations are well written, easy to follow and include many examples. They address most common transactions and, with the exception of the potential application of the step-transaction doctrine (discussed below under "Corporate Restructurings"), they are generally taxpayer-favorable.

Eligibility Rules

Don: Scot, what are the QSSS eligibility requirements?

Scot: The proposed regulations simply restate the Sec. 1361 requirements. First, under Prop. Regs. Sec. 1.1361-2(a), a QSSS may only be a domestic corporation, not a foreign corporation. Second, prior to a QSSS election being effective, the S corporation must own 100% of the domestic corporation and must make an election to treat it as a QSSS. In addition, certain domestic corporations may not be treated as QSSSs, under Sec. 1361(b)(2): (1) a financial institution that uses the reserve method of accounting for bad debts, (2) an insurance company, (3) a corporation to which a Sec. 936 election applies (Puerto Rico and possessions tax credit) and (4) a domestic international sales corporation (DISC) or former DISC.

Mike: Interestingly, there is apparently no requirement in the proposed regulations that a QSSS have only a single class of stock. As we all know, for an S parent to be an S corporation in the first place, it can have only one class of stock outstanding. For example, an S corporation cannot have outstanding preferred stock. The only difference that may exist between classes of stock is in voting rights. However, a QSSS apparently can have two classes of stock. For example, the parent can own 100% of the QSSS's common stock and theoretically, own 100% of the preferred stock--the corporation would still qualify as a QSSS. This may provide some tax planning opportunities. For example, if there is an eventual plan for the parent to sell preferred stock in the future, the capital structure could be set up without violating the QSSS rules. This is a curious exception. I spoke with Deanna Walton, the author of the proposed regulations; she confirmed that this is exactly what was intended. A QSSS can have more than one class of stock.

Don: Could a QSSS chain have common and preferred stock outstanding as long as it's wholly owned by an S parent?

Mike: Yes. One of the big questions that arose shortly after the SBJPA's enactment was in the consolidated group context. Can the parent make a QSSS election only for the immediate wholly owned subsidiary or for a whole string of wholly owned subsidiaries? The examples in the proposed regulations make it clear that the parent may make the QSSS election for the entire chain of companies (see, e.g., Prop. Regs. Sec. 1.1361-2(c), Example 1); theoretically, each QSSS could have more than one class of stock. However, once the election is made for the entire chain, all of the wholly owned subsidiaries for which a QSSS election has been made are disregarded and are deemed divisions of the parent for Federal tax purposes. Prop. Kegs. Sec. 1.1361-2, Example 3, is an interesting illustration of the rules. An S parent wholly owns a subsidiary for which a QSSS election has been made (Sub 1). Sub 1 owns 50% of Sub 2 directly, and the S parent owns the other 50% of Sub 2. The question is whether the parent can make a QSSS election for Sub 2 even though it owns only 50% of Sub 2 directly under state law? The Example makes it clear that the parent can make the QSSS election for Sub 2 because, once it makes the election for Sub 1, Sub 1 becomes a disregarded entity. Therefore, all of the assets owned by Sub 1 (including Sub 2 stock) are deemed to be owned by the parent for Federal tax purposes.

Don: Scot, you mentioned earlier that a foreign corporation cannot qualify for QSSS status. But there are still some ways in which an S corporation can own stock in a foreign entity and obtain the benefit of the equivalent of a QSSS election. Could you explain that?

Scot: As you know, there is no prohibition against an S corporation owning stock in a foreign corporation; however, that S corporation may not make a QSSS election for the foreign subsidiary. Nevertheless, there may be ways to achieve disregarded treatment for that foreign corporation. If the foreign corporation, for example, isn't a corporation per se, under the check-the-box regulations, an election to treat that foreign corporation as a disregarded entity may be made.(4) Second, if QSSS status is desired, the foreign corporation could perhaps be domesticated under a state law domestication statute, which generally results in a deemed liquidation of the foreign corporation, followed by a reincorporation of the entity into a dual-resident corporation. Of course, both of these transactions contain tax implications. Extreme caution should be exercised before liquidating (or causing a deemed liquidation of) a foreign corporation.

Don: In other words, international tax implications arise under Sec. 367.

Scot: Yes. The Sec. 367 regulations contain inclusion rules that might require a U.S. shareholder to include in its income the earnings and profits of the liquidating foreign corporation. Thus, extreme caution should be exercised before converting a foreign corporation into a disregarded entity.

Don: What happens if an S parent owns 80% of a foreign entity? The QSSS provisions are not available to the foreign subsidiary. Nevertheless, could the S parent have an affiliated foreign corporation without destroying its S status?

Scot: It's clear that an S corporation may own 80% of a foreign corporation.

Don: By 80%, of course, you mean from 80% to 100%? It's just that a QSSS election may not be made for the foreign subsidiary in that circumstance.

Scot: Correct.

Procedural Issues

Don: Let's discuss some of the procedural issues that have been raised by the proposed regulations, particularly, making the election and late elections.

Scot: Prior to the issuance of the proposed regulations, the Service issued temporary guidance on the QSSS election in Notice 97-4.(5) Essentially, Notice 97-4 instructed taxpayers to use Form 966, Corporate Dissolution or Liquidation, which is normally the form used to disclose an actual liquidation of a corporate subsidiary, to make the QSSS election. Notice 97-4 also informed taxpayers that the QSSS election could be made effective up to 75 days before the filing of Form 966. However, an S election must be made within 15 days and two months of the beginning of the tax year for which the election is effective. Thus, the flexibility with respect to a QSSS election is clear. The proposed regulations conformed the timing of the QSSS election to the S election. Thus, instead of 75 days, Prop. Regs. Sec. 1.1361-3(a)(3) refers to two months and 15 days; as soon as the regulations are finalized, a QSSS election may be made effective any time during the period 15 days and two months before the actual filing of Form 966. The proposed regulations also indicate that, until they are finalized, taxpayers should follow Notice 97-4 in making QSSS elections.

Mike: Scot, the ability to make a QSSS election at any time during the year provides tremendous flexibility. For example, a calendar-year C corporation would like to elect S status, but it's now October 1, too late to make an S election for the current year (unless automatic relief is obtained under Rev. Proc. 97-40(6) or 97-48(7)). However, if 100% of the stock of the C corporation is acquired on October 2 by another S corporation, an immediate QSSS election could be made for the newly acquired C corporation effective for the date of acquisition. Thus, the C corporation, which could not have made an S election as a free-standing company, may be a QSSS for the remainder of the year, beginning on the date of the acquisition.

Don: Is there an opportunity for tax planning?

Mike: Well, I would not buy a company just to accelerate an S election, although it's an interesting point. Unfortunately, the rules are not as liberal when it comes to late QSSS elections. Normally, for a late S election, automatic relief is often available under either Kev. Proc. 97-40 or Kev. Proc. 97-48; there are no such provisions for late QSSS elections. If a QSSS election is late, Sec. 9100 relief must be sought, according to Prop. Regs. Sec. 1.1361-3(a)(5), which means filing a ruling with the IRS and incurring a user fee. However, the Service has started issuing relief for late QSSS elections, for example, Letter Ruling 9814009(8); I have seen in practice quite a few late QSSS elections.

Scot: Mike, might we expect the Service to provide automatic relief for late QSSS elections, given that they probably are going to receive a large volume of relief requests under Sec. 9100?

Mike: I predict that such relief will eventually be provided, because it doesn't make sense that late QSSS elections should be treated differently from late S elections. However, the proposed regulations do not indicate that automatic relief will be provided; rather, they mention Sec. 9100 relief. So it may not happen that soon. It doesn't make any sense to have a separate standard for late QSSS elections, because a QSSS election is basically a de facto S election.

Scot: I think you're right; the Service will hear in comments that such relief is desired by practitioners and taxpayers.

Election Revocation

Don: What do the proposed regulations say about the revocation of QSSS elections?

Mike: The QSSS revocation rules are a little more flexible than the S election revocation rules. An S election can only be revoked prospectively. For example, a calendar-year S corporation may not make a revocation effective for January 1 unless it's made by March 15 of the same year. However, under Prop. Regs. Sec. 1.1361-3(b), a QSSS revocation may be made at any time during the year, and may be effective up to two months and 15 days before the filing date. This provisions offers more "look back" flexibility, which isn't available with the revocation of an S election. But, the revocation or termination of a QSSS election has its own baggage.

Corporate Restructurings

Don: A common problem occurs when two or more brother-sister S corporations are to be put together in a parent-subsidiary structure. What are the tax consequences under the statute and the proposed regulations? How does one form the parent-subsidiary relationship?

Scot: Clearly, the proposed regulations were designed to facilitate tax-efficient restructurings of brother-sister S corporations. For example, individual Y owns 100% of two S corporations. Y would like these S corporations to be treated as one corporation for Federal tax purposes and would like to use the QSSS provisions to accomplish that. Typically, Y would contribute the stock of one of the S corporations to the other S corporation, thereby temporarily creating a parent-subsidiary group with an S parent and one S subsidiary. However, an S corporation cannot have a corporate shareholder. A question arose prior to the issuance of the proposed regulations as to whether the subsidiary's S election would terminate. Prop. Regs. Sec. 1.1361-4(a) (2) clarified this concern by stating that, if the S parent makes a QSSS election for the subsidiary effective for the day of the transfer of the subsidiary's stock, the momentary ownership of the S subsidiary by the S parent will be disregarded. Immediately after the contribution of that stock, the subsidiary will be deemed to liquidate into the parent under Sec. 332.

Mike: Does this deemed liquidation have to qualify as a Sec. 332 liquidation? When a QSSS election is made, a deemed Sec. 332 liquidation occurs, rather than an actual liquidation. Thus, the QSSS is still a separate legal entity under state law. But, for Federal tax purposes, it's a disregarded entity. This is a critical point. Is it important whether the QSSS is solvent, as is normally a concern with a Sec. 332 liquidation?

Scot: If the Service is going to apply Sec. 332, practitioners have to be concerned about its requirements. Regs. Sec. 1.332-2(a) states that a parent must receive property in a liquidation. If property isn't received from the subsidiary, the liquidation doesn't qualify as a Sec. 332 transfer. The QSSS would have to be solvent.

Don: If Sec. 332 applies, no gain or loss is recognized by the recipient corporation (here, the parent). If the transaction qualifies under Secs. 332 and 337, there is no gain or loss to the distributing corporation (the subsidiary). On the other hand, if the transaction is taxable, neither Sec. 332 nor 337 applies; the liquidation would be governed under Secs. 331 and 336.

Mike: This leads to some interesting questions. As we all know, with brother-sister S corporations, there are usually many intercompany loans and advances. I have seen quite a few situations in which the subsidiary (i.e., a sister corporation) is indebted to its brother. If the brother corporation were to cancel that debt, the subsidiary would become solvent. This raises several issues. What happens if, prior to the QSSS election, the brother corporation, which is going to become the S parent, cancels the note receivable from the subsidiary, making the subsidiary solvent and the liquidation governed by Sec. 332? There have been cases and rulings involving a parent that cancels debt or contributes additional property to a subsidiary before a liquidation.(9) This is a meaningless gesture immediately before an actual liquidation, because the parent gets its own property back. However, the QSSS election is a deemed liquidation; thus, any transaction that occurs before the deemed liquidation has more validity, because the subsidiary remains a separate corporation with its own creditors. If the parent loans money to the subsidiary subject to the claims of creditors, it will not return to the parent, as is the case in an actual liquidation. Thus, there is a much stronger argument that the subsidiary can be made solvent, prior to the QSSS election, and have the arrangement respected, although the issue is far from clear.

Don: In describing that transaction, is it possible that the Service might view this as a D reorganization or does the Sec. 332/337 language, which is described in the regulations, prevail over a possible recast as a D reorganization?

Scot: In the brother-sister example described above, the Service has not specifically stated that such transaction will be treated as a D reorganization or as an asset acquisition. However, it has alluded to the potential application of the step-transaction doctrine in Prop.

Regs. Sec. 1.1361-4(a)(5). Thus, the concern is that, rather than having a Sec. 351 contribution of the subsidiary stock to the S parent, followed by a Sec. 332 liquidation, the Service will recast the transaction as a D reorganization to which Sec. 357(c) applies; gain would then be recognized by the subsidiary to the extent that its liabilities exceeded its asset bases.

Don: Your point is that Prop. Kegs. Sec. 1.1361-4(a)(5) treats the deemed liquidation as a Sec. 332/337 liquidation, rather than as a D reorganization?

Scot: Correct.

Mike: Recently, the Ninth Circuit decided Peracchi,(10) dealing with the avoidance of Sec. 357(c). The taxpayer had contributed his own note to his wholly owned C corporation, along with land encumbered by debt that exceeded its basis. The taxpayer's position was that the full face amount of the note constituted additional asset basis for purposes of Sec. 357(c). The general rule has always been that one cannot obtain basis by executing a note. However, the Ninth Circuit held that because the transferor was a solvent individual who had a great deal of net worth, and there was a valid promissory note, he could obtain full face value basis for the note. The only other case that has held similarly was Lessinger,(11) back in 1989. But, Peracchi is much more well-reasoned and comes to a conclusion based on more relevant tax law. It's much stronger than Lessinger and could become a landmark case. Unfortunately, in footnote 16 of Peracchi, the court states that the result doesn't apply to a transfer to an S corporation, because it could be abusive. For example, Q executes a note, and thus creates basis that allows him to deduct passthrough losses that otherwise would be suspended. However, if Peracchi is good law in the Ninth Circuit, or anywhere else, a transfer by an S shareholder of his own note to the corporation shouldn't be treated any differently from a similar transfer to a C corporation. Both C and S corporations are governed by Sec. 351; Sec. 357(c) is a subset of Sec. 351. It seems rather inconsistent; it's going to be fascinating to see how Peracchi plays out.

Scot: What is amazing about Peracchi is that a shareholder could obtain basis in S corporation stock (if the ruling were extended to S corporations) without actually making a cash outlay, either through a loan to the corporation or as an additional capital contribution.

Mike: As the dissenting judge said, it was creating something out of nothing. As you know, Scot, Prop. Regs. Sec. 1.1361-4(a)(5)(i) provides for a moratorium in applying the step-transaction doctrine to QSSS elections made up to 60 days after the effective date of the final regulations. Thus, grandfathered QSSS elections involving brother-sister corporations should escape application of the step-transaction doctrine; that is both good and bad news. It sounds like a compromise was reached, because, if all existing QSSS elections were suddenly found to be step transactions taxable under a D reorganization theory, it would be disastrous. In addition, it might spell the end of future QSSS elections, because of the uncertainty associated with the step-transaction doctrine. This issue is extremely important for the future of this area; we encourage readers to write to the IRS to express their views that this moratorium should be made indefinite; the step-transaction doctrine shouldn't apply to QSSS elections, because it creates so much uncertainty.

Scot: I agree. The IRS correctly provided taxpayers with this moratorium. Prior to the issuance of these regulations, Notice 97-4 provided no guidance as to the potential application of the step-transaction doctrine; taxpayers relied on that notice to consummate nonabusive restructurings. Therefore, this moratorium is clearly appropriate and should be extended indefinitely.

Don: Earlier we spoke of the Sec. 332/337 liquidation. Some issues under the proposed regulations relate to those transactions and the effect of the timing of the deemed liquidation. Mike, could you describe those problems?

Mike: Timing is critical, particularly to maintain an S election. For example, Corporation A and Corporation B are owned by the same shareholder. The shareholder would like to form a parent-subsidiary group without terminating either S election. He could transfer all of the stock of B to A; alternatively, he could create a holding company and elect S status for it. He could then contribute all of the stock of A and B to the holding company and elect QSSS status for A and B effective on the date of the contribution. When does the deemed liquidation of A and B occur? Prop. Regs. Sec. 1.13614(b)(1) provides that the deemed liquidation generally occurs as of the close of the day immediately preceding the effective date of the QSSS election. However, if the S parent did not own the subsidiaries' stock on the day before the date the QSSS election is effective, the deemed liquidation would occur immediately after the acquisition. If the QSSS election is made effective on the date of the transfer (as is the case with A and B), the subsidiaries will not be treated as C corporations, under Prop. Regs. Sec. 1.1362-2(b)(4). This is critical; by making the QSSS election effective on the day of the contribution, the subsidiaries never have a disqualified corporate parent. Thus, they never lose their S elections; as a result, they do not create Sec. 1374 built-in gain or Sec. 1363(d) LIFO recapture problems. In other words, they do not lose their S status immediately before the deemed liquidation.

Consolidated Return Issues

Don: What are the implications in a consolidated return regarding the timing questions and the deemed liquidation?

Scot: The proposed rules are critical in the consolidated return context, especially as to excess loss accounts (ELAs). An ELA essentially represents a parent's negative basis in its investment in subsidiary stock. The negative basis is triggered as income when the subsidiary's stock is disposed of or in a deconsolidation of the group. There is an exception to ELA triggering if the subsidiary is liquidated into the C parent in a Sec. 332 liquidation. The Service has stated that if a C corporation makes an S election and a QSSS election effective on the same day, the deemed liquidation of the subsidiary for which a QSSS election is made occurs immediately before the effective date of the C parent's S election; thus, any ELA disappears under the consolidated return rules. The proposed regulations' timing rules are taxpayer-favorable. The same general rule exists for deferred intercompany gains and losses that occur between members of a consolidated group; such gains and losses continue to be deferred if a subsidiary is liquidated. However, if deconsolidation occurs before the liquidation, those deferred gains and losses are triggered in the last consolidated return. Again, it appears that deferred gains and losses are not triggered in the QSSS context. However, for deferred intercompany transactions, two sets of regulations apply--one set to transactions occurring in tax years beginning before July 12, 1995 and one set to all subsequent transactions. A QSSS election, which causes the deemed liquidation of a C subsidiary, prevents the triggering of deferred gains from transactions occurring in tax years beginning before July 12, 1995. However, for subsequent transactions, guidance still needs to be issued. Thus, caution should be exercised for consolidated groups, especially in the deferred intercompany transaction area.

Planning Opportunities

Don: Mike, what are some of the potential problems and planning areas in the proposed regulations?

Mike: I've been seeing many S corporation brother-sister restructurings and existing S restructurings. Assume an S corporation has several divisions. The new QSSS rules provide a wonderful opportunity to form tax-free, wholly owned S subsidiaries, while maintaining a single level of taxation and segregating natural business lines either by function or with a view toward segregating liabilities of one company from another. In the past, it was virtually impossible to distribute an S corporation's assets to the shareholders, who in turn would recontribute the assets to another corporation to segregate them, without triggering a Sec. 311 gain. That undesirable solution can now be avoided. One common transaction is the following: an S corporation has a risky business and a portfolio of investment assets. It would like to protect the investment assets from the risky business. The first recommendation might be to drop the risky business down into a wholly owned subsidiary and elect QSSS status. That results in a separate subsidiary for legal purposes, but a single entity for tax purposes, with the investment assets being held by the parent. If the subsidiary is sued by its creditors, they cannot reach the parent's investment assets. On the other hand, it would not be desirable to drop the investment assets down below the risky business; if the latter were sued, creditors could pursue the stock owned by the parent, which contains the investment assets. However, it's often impossible (or impractical) to transfer the operating assets of the risky business to a new entity, due to regulatory or transfer restrictions. Instead, the S shareholders could form a holding corporation and cause it to elect S status immediately. The shareholders contribute the stock of the existing corporation, which contains the operating assets and the investment assets, to the holding company. QSSS status is then immediately elected for the operating subsidiary. Following the deemed liquidation, the QSSS distributes the investment assets up to the S parent. These rules work beautifully, because once QSSS status is elected, it's all one company. The dividend of the investment assets is a non-event for Federal tax purposes, and Sec. 311 doesn't apply. After the smoke dears, the investment assets are in the new parent and the risky operating assets are down below; the risky assets do not have to be transferred, which was not permitted, anyway. This is just one of many examples. There are many ways to divide an S corporation into natural business lines.

Scot: There's another technique; in many instances, an S corporation that is struggling (e.g., a start-up company) needs additional capital from its shareholder, either through a shareholder loan or an additional capital contribution. However, the shareholder may be reluctant to infuse additional capital into a struggling enterprise. There is perhaps a way under these provisions to mitigate that risk. For example, if the S corporation creates a QSSS subsidiary, it could make a loan to the QSSS, which would retain the cash. If the S corporation became insolvent or filed for bankruptcy, its creditors would receive all of the parent's assets, which would include the QSSS stock. However, the parent S shareholder is still a creditor of the QSSS; therefore, it has priority over the new QSSS shareholders (i.e., the former creditors of the S corporation). This technique may enable a shareholder to make a loan and obtain additional deductible basis for passthrough losses.

Mike: Another common situation involves brother-sister S corporations owned by the same shareholder. One company is profitable; the other loses money. There is plenty of outside stock basis in the profitable company. In the loss company there are suspended losses because losses have exceeded basis; there may even be intercompany loans between the two companies, with the profitable company pumping money into the loss company. Yet, the shareholders of the loss company have suspended losses. Scot, do the QSSS proposed rules provide any planning opportunities?

Scot: I think they do. In fact, Prop. Regs. Sec. 1.1361-5(b)(2) allows an individual to contribute stock of the S corporation in which he has suspended Sec. 1366(d) losses to another, profitable S corporation. A QSSS election is then made for the S corporation that created the suspended losses. The Sec. 1366(d) losses are treated as carryovers of the S parent; thus, the carryovers survive a QSSS restructuring.

Mike: This is a painless way to restructure brother-sister S corporations. The corporations are still separate corporations under state law; there is no actual merger.

Scot: Exactly. There is also a real opportunity to use the suspended losses of the losing enterprise against the profits of the profitable enterprise.

Mike: For those readers who practice in the S corporation area, it's well-established that the Service's position through the years is that loans between brother-sister S corporations do not give rise to basis. There is now a simple way to accomplish the same result under the QSSS rules.

Don: We should mention the recent Bergman(12) case.

Mike: The Bergman case is an unpublished Minnesota district court case decided earlier this year. The court rejected Letter Ruling (TAM) 9423003,(13) in which the taxpayer had basis in one S corporation and no basis in a sister S corporation. The profitable S corporation lent its S shareholder funds that he then lent to the loss company. The Service's position was that there was no economic outlay; thus, no basis was created. The court ruled that basis was created. I have always believed that the TAM was incorrect because the reason why basis was inadequate in the first place is that the loans were not structured properly. But shouldn't one be allowed to restructure the loans by taking cash out of the profitable company and putting it into the loss company to cure the problem?

Don: Scot, a number of planning techniques are available to use a QSSS to dispose of a division that is either unwanted or heavily regulated. Could you explain how that happens?

Scot: It's an example similar to one that Mike just explained; it's especially relevant in states that impose a transfer tax on capital contributions and tangible assets. For example, an S corporation has two businesses: a regulated business and another business. The shareholder is approached by a potential buyer wishing to acquire the regulated business. In doing so, it must acquire stock, because the corporation holds a valuable license that cannot be transferred. The shareholder could contribute his stock to a holding company, immediately make an S election for it and then make a QSSS election for the subsidiary operating company. In so doing, the operating corporation is now a QSSS and the holding company is the S corporation. Immediately prior to the sale, the QSSS could then distribute up the assets that the shareholder wishes to retain. Now, the assets going to be sold reside in the QSSS, and the S parent is free to sell the stock of the QSSS to the potential buyer. The result is that a QSSS has been incorporated with the assets sought to be sold, `while avoiding the transfer tax on capital contributions that might apply under local law.


Don: How do single-member limited liability companies (SMLLCs) interact with the QSSS proposed regulations?

Mike: An SMLLC is a structuring option also available to S corporations in states that permit them. Between 20 and 25 states permit SMLLCs(14); the number is growing. Perhaps within a year or two, all 50 states will provide for SMLLCs. The advantage of an SMLLC over a QSSS is that, with the latter, once the S corporation disposes of even one share of the QSSS stock, it loses its single level of taxation. In general, the mere disposition of only one share of QSSS stock by the S parent causes a deemed incorporation of the QSSS assets and the single level of taxation is lost. That is the big disadvantage of a QSSS. On the other hand, on the disposition of any interest in an SMLLC, the entity becomes a partnership; flow through treatment continues. However, the QSSS has a lot of practical business advantages. Not every state recognizes SMLLCs; many companies are already in corporate form and they are reluctant to unincorporate. The body of law for liability protection for a corporation is much more well-established than that for LLCs. There are a lot of issues involved, but the SMLLC is clearly a structuring option; nothing prevents an S corporation from having a whole myriad of entities under it. The options are limitless, but there are a lot of business issues that have to be considered as well.

Other Issues

Don: Scot, what are some of the remaining issues under the proposed regulations?

Scot: We did not address in detail the implications of a termination of QSSS status. As Mike mentioned previously, if one share of stock of a QSSS is disposed of, the QSSS election terminates; there are specific implications. A QSSS election can also be revoked. When a QSSS election is terminated or revoked, a new corporation is deemed to be formed; there are specific consequences to that deemed transaction. Also, we did not address in detail the use of QSSSs in acquisition transactions or mergers and reorganizations.

(1) REG-251698-96 (4/22/98).

(2) See Herskovitz, Lux and Rabun, "S Corporations: Tax Planning After the Small Business Job Protection Act of 1996," 28 The Tax Adviser 20 (January 1997).

(3) See H. Rep't No. 104-586, 104th Cong., 2d Sess. 89 1996).

(4) See Heller and Carnevale, "Check-the-Box Final Kegs. Simplify Entity Classification," 28 The Tax Adviser 296 (May 1997).

(5) Notice 97-4, IRB 1997-2, 24.

(6) Rev. Proc. 97-40, IRB 19978-33, 50.

(7) Rev. Proc. 97-48, IRB 1997-43, 19.

(8) IRS Letter Ruling 9814009 (12/22/97).

(9) See, e.g., Kev. Rul. 78-330, 1978-2 CB 147; Braddock Land Co., Inc., 75 TC 324 (1980).

(10) Donald J. Peracchi, 9th Cir. 1998 (81 AFTR2d 98-1754, 1998-1 USTC [paragraph] 50,374), rev'g TC Memo 1996-191.

(11) Sol Lessinger, 872 F2d 519 (2d Cir. 1989)(63 AFTR2d 89-1055, 1989-1 USTC [paragraph] 9254).

(12) Larry Bergman, DC Minn., 1998.

(13) IRS Letter Ruling (TAM) 9423003 (2/28/94).

(14) See Boucher, "State Conformity to the Check-the-Box Regs.," 29 The Tax Adviser 166 (March 1998).

For more information about this article, contact Mr. Lux at (202) 879-5330.
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Title Annotation:qualified Subchapter S subsidiary corporations, IRS proposed regulations
Author:McLean, Scot A.
Publication:The Tax Adviser
Date:Oct 1, 1998
Previous Article:The new CPA-client confidentiality privilege.
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