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Important New Rules on QSubs

by Elliot Pisem, Ronald A. Morris, Ellen Seiler Brody
Published: February 28, 2000
Source: R & H Letter to Clients & Friends

With the development of e-commerce and Internet companies, as well as liberalizing federal income tax rules enacted in recent years, S corporations are experiencing a resurgence in popularity. While still not appropriate or available in every circumstance, there are a wide variety of areas in which S corporations, and particularly Qualified Subchapter S Subsidiaries (or "QSubs") offer an important planning choice.

Recently the Internal Revenue Service issued final regulations relating to the treatment of S corporations and their QSubs. These regulations are intended to provide guidance, and in many instances the new regulations have clarified or eliminated QSub issues. In quite a few other respects, however, the new regulations either have created new uncertainties, or have highlighted the importance of thorough planning, and given notice of potential traps.

This letter outlines important provisions of the new regulations you should be aware of when planning QSub transactions. It is important to note that, due to the operation of the final regulations' transitional relief rules, some taxpayers may be facing a March 15, 2000 deadline for taking action.

Background

In 1996 Congress enacted amendments to the S corporation rules to permit S corporations to own 80% or more of the stock of subsidiary corporations. In the case of 100%-owned subsidiaries, this legislation further authorized S corporations to make an election (a "QSub election"). Under a QSub election, the separate existence of the subsidiary is disregarded, and its assets, liabilities, and items of income, deduction and credit are instead treated as owned or derived by the S corporation directly. The QSub election thus transforms a 100%-owned subsidiary from an entity separately recognized as a corporation for federal income tax purposes, into a branch or division of the S corporation parent with no separate existence or status for income tax purposes.

Like a single-member LLC, a QSub is disregarded for federal income tax purposes -- it simply does not exist. Unlike a single-member LLC, however, the state law existence of a QSub as a corporate entity, as well as certain longstanding federal tax doctrines regarding corporate entities, create issues and complexities that are unique to the QSub regime. The new regulations address many of these issues but, as is evident from the points discussed below, there remain important areas in which the use of a QSub continues to raise planning opportunities, as well as potential pitfalls. As a result, while the QSub appears in many respects to represent an important simplification there remain, even after the final regulations, significant areas in which oversimplification can be dangerous.

Step Transaction Doctrine

When an S corporation makes an election to treat a previously-existing corporate subsidiary as a QSub, the subsidiary is deemed to have liquidated into the S corporation parent immediately before the QSub election becomes effective. The liquidation is deemed to occur at the close of the day before the QSub election is effective. As a result of this deemed liquidation, the subsidiary's taxable year, and its separate existence for federal tax purposes, end at the close of the day before the QSub election is effective.

The tax treatment of this deemed liquidation is determined under all the relevant provisions of the tax law, including the application of the step transaction doctrine. Under the step transaction doctrine, interrelated transactions may be reordered or collapsed into one single transaction, and that recharacterization may lead to dramatically different tax results. For example, consider the common case of an individual A who contributes all of his stock in corporation Y to X, his wholly-owned S corporation. X then immediately makes a QSub election for Y. Under classic step transaction analysis, this series of transactions would be combined into one single transaction, and that single transaction may then be characterized as a "D reorganization." As so recharacterized, if the total liabilities of Y exceed the total adjusted bases of the assets of Y, that excess will be treated as currently taxable gain. Alternatively, if the transaction fails to qualify as a reorganization, it may be fully taxable. Two simple steps which appeared to be tax free thus become one single step, which may be taxable, in whole or in part.

In order to avoid this possibly unfavorable result, the Service has provided transitional relief, under which the step transaction doctrine will not apply in the case of an S corporation that acquires some or all of the stock of a related corporation, and then makes a QSub election for the related corporation. During this transitional period, the transaction described above would be tax free. The contribution by A of the Y stock would qualify for nonrecognition as to A, X and Y under section 351 or 368(a)(1)(B), and the liquidation of Y would be tax free under sections 332 and 337. During this transitional period, therefore, the liquidation of Y will be respected as a step independent from the stock acquisition by X.

Significantly, transitional relief only applies if a QSub election is effective prior to January 1, 2001. QSub elections can be effective any time during the year, and thus a QSub election in the simple example above could be made at any time through December 31, 2000, and qualify for transitional relief. However, a QSub election can only be made when the electing parent corporation is an S corporation. The only way a calendar year corporation could have an S election effective before January 1, 2001 would be to have an S election effective on or before January 1, 2000. If the calendar year parent corporation (X in the above example) has not yet made an S election, its S election would have to be made no later than March 15, 2000 to be effective January 1, 2000. Therefore, in any circumstance in which the step transaction doctrine poses risks, entities anticipating making S elections and QSub elections should seriously consider taking immediate action, by March 15, 2000, in order to qualify for the final regulations' transitional relief from the step transaction doctrine.

The Service has announced that it intends to publish final regulations during the transitional period to solve at least one step transaction problem. Consider a case in which individual A owns 50% of the stock of Y and A's corporation, X, owns the other 50% interest in Y. Under the step transaction doctrine, A's contribution of his 50% interest in Y to X, followed by X's QSub election for Y, would be a taxable transaction. The transitional period mitigates this unexpected result. Further, the Service has indicated that it intends to promulgate new substantive regulations, applicable to all corporations, to eliminate this often unexpected result. Such a regulation certainly will improve the predictability of tax treatment when an S corporation acquires the remainder of the stock of any partially-controlled subsidiary, and then makes a QSub election. But until new regulations are finalized this remains an area of risk; and even with these promised regulations the step transaction doctrine will pose other risks for S corporations and QSubs. Corporate families that are potentially eligible for S corporation/QSub status should therefore carefully consider the window of opportunity provided by the transitional period.

Finally, the transitional period relief only applies with respect to related corporations. If an S corporation acquires an unrelated subsidiary and then makes a QSub election, the tax results will be determined under the general corporate reorganization provisions of the Code. In many cases, these rules will be entirely workable. For example, an acquisition by a parent S corporation of all of the stock of another corporation in exchange for its own stock, followed by a QSub election and deemed liquidation, generally would qualify as a "C" reorganization; and the acquisition could still qualify as a "C" reorganization even if the parent corporation paid consideration consisting 90% of stock and 10% in cash.

However, one cannot assume that every QSub transaction will escape the step transaction doctrine unscathed. As a result, in current dealings with unrelated entities, and in all QSub planning that is effective after 2000, it will be important to evaluate the transaction carefully, to ensure that any less-than-apparent tax consequences have been taken into account.

Liquidation Requirements

In order for the deemed liquidation of the QSub to be tax free under section 332, a plan of liquidation must be adopted at a time when the corporation receiving the assets owns at least 80% of the stock of the liquidating corporation. Since no formal plan of liquidation is generally adopted in connection with a QSub election, the final regulations provide that the making of a QSub election itself satisfies the requirement of adopting a plan of liquidation. The plan of liquidation is deemed adopted immediately before the deemed liquidation (unless a formal plan is actually adopted selecting an earlier date). If an S corporation did not own 100% of the subsidiary on the day before the QSub election is effective, the liquidation is deemed to occur immediately after the S corporation acquires 100% ownership of the stock, and immediately before the election is effective.

In order to determine whether a subsidiary is wholly-owned by an S corporation, and thus whether section 332 will apply to the deemed liquidation of the subsidiary, the regulations provide that an option, or any other instrument or arrangement that would not be considered stock under the one-class-of-stock rules normally applicable to S corporations, will be disregarded in determining stock ownership for these purposes as well. (Such instruments and arrangements are also disregarded for purposes of determining whether the control requirement of the reorganization provisions is met when a QSub election terminates.) The effect of these provisions is to simplify the tests for qualification for the QSub election, and for qualifying for tax-free liquidation. Again, however, it is important to bear in mind that a QSub election can only be made if an S corporation owns all of the QSub's stock; that inquiry may well require investigating and analyzing interests beyond traditional stock ownerships.

Section 1374

Because C corporations are subject to an income tax while S corporations are not, an S corporation election affords existing corporations a very simple means to eliminate future federal income taxes. However, lest this planning technique be too attractive, the S corporation rules also provide for a 10-year "taint." Under this rule, any net built-in gain that has accrued prior to the date a C corporation becomes an S corporation, and that is recognized within the first 10 years of S corporation status, remains subject to a corporate-level tax. The 10-year rule is set forth in Code section 1374.

The 10-year taint also applies to any net recognized built-in gain attributable to assets that an S corporation acquires from a C corporation with a carryover basis. Moreover, a separate determination of tax is made with respect to the assets acquired by an S corporation in each separate section 1374 transaction, and loss and credit carryforwards from one section 1374 transaction can only be used to offset tax on the disposition of assets acquired in that same section 1374 transaction.

The conversion of a C corporation to an S corporation is treated as an event that is covered by the section 1374 rules. However, the final regulations provide some relief, mitigating certain applications of the 10-year taint. First, the regulations provide that when a C corporation with subsidiaries makes an S election and QSub elections, the deemed liquidations of the subsidiaries occur on the day before the parent's S election becomes effective. All of the deemed liquidations of the subsidiaries are treated as one section 1374 event, and thus create one aggregated pool for section 1374 purposes.

The final regulations also clarify certain other section 1374 issues. Section 1374 will not apply, for example, when a parent S corporation is acquired by a C corporation, if the acquiring C corporation immediately makes an S election and QSub elections for its subsidiaries. In addition, when an S corporation acquires a tiered group of corporations and immediately makes QSub elections for all of them, the assets deemed acquired will be treated as acquired in a single section 1374 event.

Excess Loss Accounts

One of the oddest QSub problems involved the treatment of consolidated groups who sought to utilize the new S corporation/QSub structure. Where a C corporation in a consolidated group had an "excess loss account" in any subsidiary, filing S and QSub elections often turned into a taxable event.

Specifically, the consolidated return regulations provide for an excess loss account ("ELA"). An ELA is essentially negative basis, which one consolidated corporation may have in a subsidiary by virtue of its use of the subsidiary's losses or distributions from the subsidiary. The consolidated return regulations generally require that a member of a consolidated group of corporations include an ELA in income if it is treated as disposing of the subsidiary's stock. An S election by a corporation, or a merger or liquidation of a corporation into an S corporation, are all treated as dispositions that can trigger income recognition with respect to an ELA.

Now, however, when a parent elects S status for itself and makes QSub elections for the subsidiaries in its group, the deemed liquidations of the subsidiaries are treated as occurring on the day before the S election is effective. Thus, such liquidations are deemed to occur while the parent is still a C corporation, and under the technical consolidated return rules will not trigger recognition of any of the group's ELAs.

In order to ensure that similar treatment occurs when a parent C corporation is acquired by an S corporation, the final regulations provide that the parent will not be deemed to liquidate into the acquiring corporation until after its S election is effective, that is, the day after the deemed liquidations of the subsidiaries occur. Thus the final regulations also avoid the problem of triggering (and taxing) separate ELAs for each subsidiary when a consolidated group is acquired by an S corporation.

Timing Issues

When QSub elections are made for a tiered group of subsidiaries all on the same day, the final regulations allow an S corporation to specify the order of the deemed liquidations. If no election is made, the deemed liquidations will take place on the effective date beginning with the lowest tier subsidiary and proceeding successively up the chain. Taxpayers may, however, elect to reverse that order, and proceed with the liquidations from the top down. Simultaneous terminations of QSub elections made for a chain of companies are deemed to occur with the highest tier subsidiary first, and then succeed down the chain. No election is available to reverse the order of the terminations; however, these incorporation transactions should generally qualify for tax free treatment when done in top-down order.

The order of the deemed liquidations of the tiered subsidiaries is important for purposes of section 1374, as well as ELAs. In some cases it is preferable to liquidate from the lowest tier subsidiary to the highest tier subsidiary, and other times it will be preferable to have the deemed liquidations occur in the reverse order. When the order is from the lowest to the highest, the liquidation of the highest tier subsidiary will result in a single section 1374 pool for the group, no deemed deconsolidation will occur, and no ELAs will be triggered. In certain cases, however, the results might be more preferable if the highest tier subsidiary is liquidated first.

If an S corporation is acquired by another S corporation, a QSub election made by the acquiring S corporation is deemed effective immediately upon acquisition, such that no intervening C period arises for the entity. In fact, as long as the appropriate election (S or QSub) is made effective as of the termination of any previous S or QSub election, a corporation can move back and forth between S and QSub status without any intervening C corporation period.

Revocation of QSub Election

Just as disregarded QSub status is achieved by filing a QSub election with the IRS, a QSub can be terminated, and reconstituted as a separately respected corporation, by filing a revocation of QSub election. The final regulations detail some of the mechanics and consequences of such a revocation. The regulations also address the sometimes significant consequences of terminating QSub status by breaking the 100% stock ownership requirement.

First, revocation of a QSub election is effective on the date specified on the revocation statement, or on the date the statement is filed if no other date is specified. The effective date in the statement cannot be more than two months and 15 days prior to the date the revocation statement is filed, nor more than 12 months after the filing date.

A revocation that is effective as of the first day the QSub election was to be effective will not be treated as a termination for purposes of the five year prohibition against electing QSub status after a termination without consent of the Commissioner. The five-year prohibition also will not apply if the corporation is still eligible to make an S election, or to have a QSub election made for it, immediately after the termination, and such election is made effective immediately after the termination of the QSub election.

If the QSub election is terminated because the parent's S corporation election is terminated, the QSub termination is effective at the close of the last day of the parent's last taxable year as an S corporation. If the election is terminated because an event occurs that renders the QSub ineligible for QSub status, the termination is effective as of the close of the day that the event occurs.

When a QSub election is terminated, the old QSub is treated as a new corporation that acquired all of its assets and assumed all of its liabilities from the parent corporation immediately before the QSub termination, in exchange for stock. If the parent continues to own at least 80% of the stock of the terminated QSub, this deemed incorporation transaction generally will be tax-free.

However, if the parent is not in control of the new corporation after the termination, due for example to a sale of more than 20% of the stock of the subsidiary, then the deemed exchange of assets for stock will be a taxable transfer. The parent will have to recognize gain on the assets transferred to the new corporation. (Losses might be limited by other provisions in the Code, e.g., section 267). This is an important element of the final regulations, and one that was not liberalized, notwithstanding significant criticism from the private sector. It must therefore be borne in mind that a transfer of a partial interest in the stock of a QSub can trigger gain on all of the QSub's assets.

While this may well be the correct theoretical answer, this result can come as quite a surprise. There are ways to plan to avoid a taxable event, for example by revoking the QSub election while a deemed incorporation can still satisfy Search7RH351, or by having the new shareholder contribute assets to the acquired corporation (rather than purchase its stock), so as to be part of the transferor group for purposes of section 351. It also may be desirable to trigger tax on the deemed incorporation, for that taxable event will step up the basis of the shareholders in their stock, and of the corporation in its assets. It is impossible to generalize, however, other than to note that transfers of QSub stock require careful planning.

Following a termination of a QSub election, whether by revocation or by disqualification, the new corporation will have to make all new tax elections, and adopt any desired accounting methods. Again, while nothing has changed in the local law characterization of the entity, for federal income tax purposes the termination of QSub status means that the former QSub has become a brand new corporation.

Inadvertent Elections and Terminations

The final regulations do not include any provisions providing relief in the case of an inadvertent termination of a QSub election (such as when a corporation inadvertently transfers one share of QSub stock to another person). This underscores the importance of evaluating all potential tax consequences before, for example, issuing any QSub shares to employees, creditors, etc. Separate entity status will result whenever the QSub has any shareholder other than its S corporation parent. Even where the deemed incorporation of a QSub is not itself a taxable event, the loss of disregarded QSub status may prove costly.

The final regulations do offer some limited failsafes. If the termination of QSub status occurs because of an inadvertent termination of the parent's S election, QSub relief may be available where the parent receives S corporation relief for its inadvertent termination. QSub relief also may be available when a parent corporation fails to make a timely QSub election.

Banking Provisions

Consistent with the 1996 legislative history and later clarifying legislation, the final regulations provide that any special rules applicable to banks under the Internal Revenue Code will continue to apply separately to each bank QSub, as if the deemed liquidation of the QSub has not occurred. All assets, liabilities, and items of income, deduction and credit, of a QSub bank, as determined under the special banking rules, are still treated as assets, liabilities, and items of income, deduction and credit of the S corporation parent -- it is just that such items also remain subject to the special tax rules applying to banks, which rules are applied first, at the QSub level. The rules applicable to banks apply to all taxable years beginning after December 31, 1996, and are applicable to all taxpayers, without election.

Employer Identification Numbers (EINs)

The final regulations provide that, as a disregarded entity, a QSub must use the EIN of its parent S corporation, unless regulations or other guidance provides otherwise. The guidance promulgated in IRS Notice 99-6, which permitted disregarded entities to use their own EIN's (and not that of their owners) in certain circumstances, remains in effect.

When an entity's classification changes because it makes a QSub election, it will still maintain its previous EIN. If a QSub election is terminated, the new subsidiary must resume using its own EIN; if it did not previously have an EIN, it must apply for a new one.

Effective Dates and Transition Rules

The newly finalized regulations generally apply to taxable years beginning on or after January 20, 2000. Taxpayers, may, however, elect to have the regulations apply to taxable years beginning on or after January 1, 2000, as long as all affected taxpayers apply these regulations in a consistent manner. This election can be useful in some circumstances. It is to be made by filing all tax returns in a manner consistent with the new regulations.

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If you have any questions on these or related matters, please call Elliot Pisem (903-8777), Ronald A. Morris (903-8781), Carolyn Joy Lee (903-8761), or Ellen S. Brody (903-8712) all of whom work extensively in this area.