QSSS prop. regs.
The QSSS provisions originated as part of the Small Business Job Protection Act of 1996 (SBJPA). Prior to the SBJPA, affiliated groups could not elect S status, because an S corporation could not have a corporate shareholder or own 80% or more of another corporation. Although S corporations are still restricted from having corporate shareholders, S corporations may now own 80% or more of other corporations.
Subchapter C clients that have 80%-or-more-owned corporate subsidiaries can now elect S status for themselves and for selected wholly owned subsidiaries. Once the common parent of an affiliated group elects S status, it can select which subsidiary to treat as a QSSS, if the subsidiaries are held as brothers and sisters. While QSSS status would not be desirable for profitable subsidiaries that have separate return limitation year net operating losses or tax credits, it would be desirable for profitable subsidiaries without any such tax attributes.
S clients can also benefit from these provisions. Complex brother-sister type arrangements formed for nontax purposes, such as segregating potential liabilities of one corporation from the assets of another corporation, can be eliminated. Moreover, S clients now have the ability to seek acquisitions of more than 79% of other corporations (other than for momentary ownership), without the need for immediate liquidation.
Prop. Regs. Sec. 1.1361-4 was issued last spring, providing taxpayers with the IRS's interpretation of the new tax law. This regulation is generally taxpayer friendly, easy to understand and contains many examples. Its rules address eligibility requirements, election and termination issues, restructuring and consolidated return issues.
The proposed regulation contains the following taxpayer-favorable rules pertaining to QSSSs:
1. Excess loss account and deferred intercompany gains and losses are generally eliminated when a common parent makes a simultaneous S election for itself, and a QSSS election for the respective subsidiaries of an affiliated group that previously filed consolidated tax returns,
2. QSSSs, although treated as divisions, can be spun off, split up or split off in tax-flee divisive reorganizations, and
3. Shareholder-suspended losses, due to lack of stock or debt basis from existing S corporations that become QSSSs, survive, and become suspended losses of the S parent (even though the QSSS is deemed to be effectively liquidated).
While the regulations are generally favorable and present many tax planning opportunities, they also contain some traps for the unwary. One of the traps includes the potential application of the step-transaction doctrine in the elimination of a brother-sister controlled group. The most common way in which to restructure a brother-sister controlled group is by having an individual contribute the stock of his wholly owned S corporation (S2) to another wholly owned S corporation (S1), followed by S1's making a QSSS election for S2.
Practitioners anticipated that the new proposed regulations would treat this transaction as a tax-free capital contribution followed by a tax-free liquidation. Unfortunately, Prop. Regs. Sec. 1.1361-4(a)(2) provides that the step-transaction doctrine may be applied under certain circumstances. Fortunately, Prop. Regs. Sec. 1.13614(a)(5) provides a moratorium on the application of the step-transaction doctrine for QSSS elections made up to 60 days after the final regulations are published. This moratorium provides practitioners with an opportunity to restructure corporations making QSSS elections before the moratorium expires. Because the final regulations have not yet been issued, the time to start planning for clients is now. In addition to the possible application of the step-transaction doctrine, the following two circumstances would also make each transaction taxable. First, the contribution to capital may result in a corporate-level gain if S2's liabilities exceed the tax basis of its assets at the time of contribution. Second, a corporate liquidation may not be tax-free if S2 is insolvent (i.e., its liabilities exceed the fair market value (FMV) of its assets).
On the other hand, the step-transaction doctrine will apply when a QSSS election terminates. A QSSS election termination normally occurs when the parent's S election terminates, a revocation statement is filed for the QSSS or the subsidiary no longer qualifies as a QSSS. The latter termination event normally occurs on a disposition of a portion of the parent's equity ownership in the QSSS.
Under the step-transaction doctrine, when an S corporation's equity ownership in the QSSS falls below 100%, a new corporation is deemed to have been formed. If the parent retains at least an 80% interest in the subsidiary, the formation of the subsidiary (S2) by the parent S corporation (S1) would be tax-free, as long as the liabilities deemed contributed to the newly formed corporation do not exceed the tax basis of the assets contributed. If the parent is not in control of S2 (i.e., does not retain at least 80% of the subsidiary) immediately following the formation, the essential control requirement for acquisitive related-party reorganizations and tax-free contributions to capital would not be met. Accordingly, S1 would be deemed to have sold its assets to S2 at FMV.
FROM RANDY SCHWARTZMAN, CPA, NEW YORK, NY
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|Title Annotation:||IRS proposed regulations concerning qualified Subchapter S subsidiary corporations|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 1999|
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