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Subchapter C provisions applicable to S corps.

IRS Letter Ruling (TAM) 9245004 held that an S corporation that purchased all of the stock of a target corporation and immediately liquidated the target could use the provisions of Sec. 332 or 338. The TAM contradicted Letter Ruling 8818049, which held that an S corporation could not use Sec. 338.

Sec. 332 generally allows the purchaser to treat the liquidation of an 80% -owned subsidiary as tax free. Sec. 338 generally allows the corporate purchaser of the stock of a corporate target to elect to step up the asset basis. Since the repeal of the General Utilities doctrine in 1986, the step-up is a taxable event. The TAM thus allows an S corporation that acquires a target the freedom to choose how to account for the acquisition. The S corporation can cause the purchase to be taxable (Sec. 338) and get a fair market value basis in the target's assets, or it can treat the transaction as tax free (Sec. 332) and continue to use the target's basis in the assets. This decision is usually the subject of negotiations between the buyer and seller, since both have a large stake in the outcome.

Sec. 338 is generally preferable when the seller has significant net operating losses to offset the gain. Also, under Sec. 338(h)(10), the purchaser and seller could jointly elect to have the stock sale treated for tax purposes as if the target sold its assets to a fictional subsidiary of the purchaser. Gain or loss would be ignored on the stock sale and the selling group would recognize gain or loss as if it actually sold the target's assets. Sec. 338(h)(10) is generally used when a target's inside asset basis is higher than its outside stock basis.

Letter Ruling 9245004 is significant for two reasons. First, it allows an S corporation to own, at least momentarily, the stock of a subsidiary, notwithstanding Sec. 1361(b)(2) (which prohibits an S corporation from being a part of an affiliated group). (Rev. Rul. 73-496, cited by the TAM, allows the S corporation up to 30 days to liquidate the target.) Although Sec. 338 does not require the target to be liquidated, Sec. 1361(b)(2) prevents an S corporation from owning 80% or more of the stock of another corporation.

Second, the ruling allows an S corporation to use two sections (Secs. 332 and 338) that are part of subchapter C, which are not applicable to shareholders who are individuals. Sec. 1371(a)(1) provides, in general, that subchapter C applies to S corporations, except to the extent inconsistent with subchapter S; however, Sec. 1371(a)(2) provides that an S corporation acting in its capacity as a shareholder is treated as an individual. The TAM concludes, based on the legislative history of the Subchapter S Revision Act of 1982 (SSRA), that this later provision was meant to apply individual rather than corporate rules to an S corporation receiving distributions on stock it held - presumably in the calculation of the dividends received deduction.

For a purchase in which Sec. 332 will be used, the S corporation would probably make a carryover basis election (as described in Temp. Regs. Sec. 1.338-4T (f)(6)(i)(a)), to prevent the IRS from asserting that a taxable acquisition took place.

In allowing S corporations to use Sec. 332, the ruling does not make clear what is meant by an "immediate" liquidation of the target. Presumably the 30-day rule cited in the ruling applies, or else the Service would probably allow the amount of time necessary to liquidate as quickly as practicable under state law. Under Sec. 337, the target would not recognize any gain or loss on the liquidation.

The TAM states that there is no potential for avoidance of the General Utilities gain on the target's assets since there will either be gain recognized immediately (under Sec. 338 or 338(h)(10)), or the S corporation will inherit the seller's basis in the assets (under Sec. 332). Thus, any built-in gain on acquired assets would be subject to tax under Sec. 1374. The target company in the ruling was on the FIFO method of accounting for inventory, although there is no indication that the result-would be different if the S corporation or the target were on LIFO.

Letter Ruling 9245004 concluded by observing that S corporations should be allowed to be parties to a reorganization, citing GCM 39768 and several revenue rulings issued under pre-SSRA law. The TAM noted that it is the intent of Congress to grant corporations "maximum flexibility" in electing between a cost basis and a carryover basis in the assets of a target company. It should be noted that the TAM allowed short-term stock ownership by an S corporation; the ruling would probably not apply to allow short-term ownership of an S corporation by another corporation.

From Michael 1. Goldberg, f.d., CPA, New York, N. Y.
COPYRIGHT 1993 American Institute of CPA's
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Article Details
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Author:Goldberg, Michael J.
Publication:The Tax Adviser
Date:Feb 1, 1993
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