QUALIFIED SUBCHAPTER S SUBSIDIARIES
By Stewart Berger, CPA,
Weinick Sanders Leventhal & Co. LLP
The Small Business Job Protection Act of 1996 modified IRC section 1361 to permit an S corporation to own 80% or more of the stock of a C corporation and to elect to own a qualified subchapter S subsidiary (QSSS).
Under current and prior law, the S election of a corporation with subchapter C earnings and profits terminated if the S corporation received passive investment income, including dividends, in excess of 25% of gross receipts for three consecutive years. IRC section 1362 has been modified to exclude dividends from passive investment income to the extent that the dividends are attributable to the active trade or business of a C corporation in which the S corporation owns 80% or more.
If an S corporation holds 100% of a subsidiary's stock and elects to treat it as a QSSS, it qualifies as such under IRS section 1361. Since an S corporation cannot file a consolidated tax return, IRC section 1361(b)(3)(A) provides that a QSSS is not treated as a separate corporation. All assets, liabilities, and items of income and deduction of the QSSS are treated as part of the parent S corporation.
The statute did not provide guidance on how a QSSS election is made. The IRS has provided temporary guidance by issuing Notice 97-4 and proposed regulations under IRC section 1361.
When a parent corporation makes an election to treat a subsidiary as a QSSS, the subsidiary will be deemed to have been liquidated under IRC sections 332 and 337 immediately before the election is effective. To make a QSSS election, the parent corporation files Form 966 with the IRS. The instructions on the form should be followed with the following modifications:
* At the top of Form 966, print "Filed Pursuant to Notice 97-4."
* In the employer's identification number box, enter the subsidiary's identification number. If the subsidiary was not in existence prior to the time of the election and does not have an employer identification number, there is no need to obtain one. In this case, print "QSSS" in the box.
* The effective date of the election may be up to two months and 15 days prior to the day the QSSS election is made.
* In Box 7c on Form 966, enter the name of the parent. The parent's employer identification number should be entered in Box 7d.
* In Box 10 on Form 966, enter "IRC section 1361(b)(3)(B)."
The QSSS status of a corporation continues until terminated. A termination can occur by revocation of the QSSS election, termination of the parent's S election, or by an event that renders the subsidiary ineligible for QSSS status. If a QSSS election terminates, the corporation is treated as a new corporation acquiring all of its assets and liabilities from the S corporation in exchange for stock of the new corporation just prior to termination. The tax treatment of this transaction is determined by other provisions of the tax code and general provisions of tax law including the step transaction doctrine. A corporation that has terminated its QSSS election may not make an S election or have a QSSS election made for five taxable years without IRS consent. Exceptions exist if the election terminates as a result of a stock disposition.
New York State QSSS Treatment
In most cases, New York State follows the Federal QSSS paradigm. The assets, liabilities, income, and deductions of the QSSS subsidiary will be included in the parent's franchise tax return. With regard to other taxes, such as sales and excise taxes, the QSSS will continue to be recognized as a separate corporation. If the parent is a New York C corporation, New York will follow Federal QSSS if a) the QSSS is a New York taxpayer, or b) a QSSS inclusion election is made.
The QSSS inclusion election can be made by submitting a letter to the New York State Tax Department. The letter should include the name and employer identification number of the parent and the QSSS and state that a QSSS inclusion election is being made. If the QSSS does not have and there is no intention to obtain an employer identification number, the letter should so indicate.
New York City QSSS Treatment
If either the parent S corporation or the QSSS would be subject to the general corporation tax based on its separate activities, it must file a separate general corporation tax return. If the stock ownership and other requirements for combined reporting are met, a parent S corporation and its QSSS may file a combined return. With regard to other taxes, the QSSS will be treated as a separate corporation.
In general, because the QSSS is to be treated as a separate corporation for New York City tax purposes, the provisions applicable in a parent/subsidiary relationship will apply. Because the QSSS is treated as a separate corporation for city tax purposes, the termination or revocation of the QSSS election and the making of a QSSS election are disregarded. *
RECENT CHANGES TO THE SRLY RULES
By Mary McLaughlin, American Express Tax & Business Services
The ability to offset one member's losses against another member's income is one of the primary reasons for filing consolidated returns. Losses can generally offset income without limitation provided the losses were generated while part of the consolidated group. One exception is when a consolidated group acquires new members. The "separate return limitation year" (SRLY) provisions limit the use of the acquired corporation's preacquisition losses and credits.
A SRLY is generally defined as a tax year of a subsidiary in which the subsidiary was not a member of the consolidated group. The provisions apply as shown in the Exhibit.
In June 1996, the IRS issued temporary regulations (TD 8677) amending the SRLY provisions for net operating losses (NOLs), capital losses, and built-in losses. In January and March of 1998 the IRS issued temporary regulations (TD 8751 and 8766) changing the SRLY provisions for general business credits, minimum tax credits, foreign tax credits and overall foreign losses. Both sets of regulations apply a single set of SRLY principles to a corporation's preacquisition tax attributes. The cumulative contribution and subgroup principles introduced in the 1991 proposed regulations were adopted in the 1996 and 1998 temporary regulations.
The 1996 Temporary Regulations
NOL SRLY Limitation. Although the new SRLY rules retain the concept of limiting the use of a member's SRLY losses based on the contribution to consolidated taxable income (CTI), the measurement method has changed. The member's contribution to CTI is now measured cumulatively over the entire period during which the corporation is a member of the group. Under prior rules, a member's contribution to CTI was measured on a year-by-year basis. In addition, a member's contribution to CTI is now determined only by looking at the member's items of income and deduction. Previously, a member's contribution to CTI was determined by comparing CTI with and without the member's items.
Example 1: Cumulative Contribution to Income. P and S become affiliated on January 1, 1996, when S had a $40 NOL carryover. The income and loss for the group are--
1996 1997 1998
P $85 $30 $(35)
S 15 (25) 37
CTI $100 $5 $2
The new SRLY rules apply to S's NOL carryover as follows:
1996: S can use $15 of its SRLY NOL, $25 SRLY NOL remains (4015=25).
1997: S cannot use any of its SRLY NOL since it does not have cumulative taxable income [(151525=(25)].
1998: S can use $2 of its SRLY NOL. Although S has cumulative taxable income of $12 (151525+37=12) the group only has CTI of $2. A $23 SRLY NOL remains (40152=23).
Another change is that the SRLY rules now apply on subgroup basis. When a consolidated group acquires two or more members of a different consolidated group, the SRLY limitation is calculated on an acquired subgroup basis and not separately for each acquired member.
Example 2: Subgroup Basis. On January 1, 1995, M Corp., parent of the M-N consolidated group, purchases all the stock of P, parent of the P-S consolidated group. The income and loss for 1994 and 1995 are--
P and S become a subgroup of the
M-N consolidated group in 1995; the P-S $40 NOL from 1994 is SRLY with respect to the new consolidated group. Under the new rules P and S's contribution to CTI is calculated on a subgroup basis; for 1995, it is $70.
Built-in Loss and Capital Loss SRLY Limitation. The built-in loss rules are now based on IRC section 382 concepts. A corporation has a net unrealized built-in loss if, immediately before it joins the consolidated group, the fair market value of the acquired corporation's assets is less than its aggregate adjusted basis. A recognized built-in loss is one that accrued during the period before the acquisition but is recognized during the five-year period after the acquisition.
The SRLY cumulative contribution and subgroup principles apply to built-in losses. One difference in applying the rules for built-in losses is that members of the subgroup must have been consolidated for a continuous period of 60 months prior to joining the new consolidated group.
The general SRLY principles also apply to net capital losses of acquired members.
Effective Dates. The 1996 amendments to the SRLY rules generally apply to tax years beginning after 1996. Retroactive application to years ended after January 28, 1991, is available provided certain conditions are met.
The 1998 Temporary Regulations
General Business Credit SRLY Limitation. The general SRLY principles (i.e., cumulative contribution and subgroups) also apply to a corporation's general business credits (IRC section 38 credits). IRC section 38(c) limits the general business credit. For general business credits generated in consolidated return years, these limitations are applied on the basis of the group's consolidated tax
liability. A consolidated group may include a member's SRLY section 38 credits based on the member's cumulative contribution to the consolidated section 38(c) limitation for all consolidated return years it was a member of the group.
Minimum Tax Credit SRLY Limitation. The temporary regulations extend the subgroup and cumulative principles to the minimum tax credit (IRC section 53 credits). Under section 53(c), the amount of minimum tax credit that a corporation may claim is limited to the excess of its regular tax liability over the tentative minimum tax. In general, a consolidated group may include a member's SRLY minimum tax credits based upon the member's cumulative contributions to the consolidated section 53(c) limitation for all consolidated return years.
Foreign Tax Credit and Overall Foreign Loss. A taxpayer-friendly provision in the new regulations provides that foreign tax credits are no longer subject to the SRLY provisions. Thus, a foreign tax credit carryover or carryback from a SRLY is treated in the same manner as a foreign tax credit from a consolidated or a non-SRLY separate return year. A group can include a member's unused foreign tax credit arising in a SRLY without regard to the member's contribution to consolidated tax liability for the consolidated return year.
The regulations, however, also eliminated SRLY restrictions on overall foreign loss (OFL) recapture. In general, the OFL rules mandate that if foreign source losses reduce U.S. income, future foreign source income is recharacterized as U.S. source to the extent of the prior years' reduction.
Effective Dates. The 1998 amendments to the SRLY rules are applicable to consolidated return years ending after March 13, 1998 (without extension). Taxpayers may elect to apply the 1998 regulations retroactively to tax years beginning on or after January 1, 1997. Taxpayers making this election must apply all of the 1998 provisions. One exception was announced in Notice 98-40, issued August 14, 1998: Taxpayers may elect specifically not to apply the overall foreign loss account provisions to consolidated return years beginning before January 1, 1998. *
PROPOSED REGULATIONS ON CORPORATION BASIS ADJUSTMENTS AND PASS-THROUGH ITEMS
By Scott M. Cheslowitz, CPA,
Rothenberg & Peters, PLLC
The IRS has issued proposed regulations concerning pass-through of S corporation items to its shareholders, distributions, and basis adjustments. These regulations generally conform previously issued final regulations to amendments made by the Small Business Job Protection Act of 1996.
Guidance for the pass-through of separately stated items is provided under IRC section 1366, which states that items must be separately stated if they would affect the shareholder's individual tax liability. Examples include short-term and long-term capital gains and losses, charitable contributions, portfolio income and expenses related thereto, section 1231 gains and losses, tax-exempt income, and passive income and loss (on an activity-by-activity basis).
The proposed regulations define "tax-exempt income," which can increase stock basis, as items permanently excluded from gross income. Examples are income excluded under IRC sections 101 or 103, certain death benefits, and interest on state and local bonds. Items not considered tax-exempt are those that have the effect of deferring income (such as discharge of indebtedness income) where the attribute reduction provisions of IRC section 108 may result in a tax at a later date. This conforms to the tax court decision in Nelson, which prevented a shareholder from increasing basis for cancellation of debt income excluded under section 108.
Proposed Regulations section 1.1366-1(b) stipulates that the character of a pass-through item is determined at the corporate level. For example, if a capital gain or loss on sale or exchange of an asset passes through from the S corporation, the gain or loss will be characterized as a capital gain or loss on the shareholder's return, even if the shareholder is a dealer in that type of property.
There are two exceptions to the conduit rule.
* If noncapital gain property is contributed by the shareholder(s) for the principal purpose of sale or exchange of that property, the sale is not considered to be a capital gain.
* Similar rules apply to capital loss property, where the intent is to change the character of the gain or loss on the shareholder(s) return by converting it to an ordinary loss (e.g., using an S corporation that is a dealer in that type of property).
The proposed regulations and IRC section 1366(d)(i) stipulate that the amount of losses and deductions taken into account by any shareholder may not exceed the total of her stock and debt basis. Any suspended loss due to a basis limitation is carried forward into the first succeeding tax year and subsequent tax years until basis is established. The suspended losses are personal on the individual and cannot be transferred, which means that if a shareholder transfers all of her stock, any disallowed loss or deduction is permanently disallowed. If a shareholder transfers part of her stock, suspended losses are not reduced.
The proposed regulations also provide rules for a shareholder to carry over losses and deductions to any post-termination transition period whereby the basis measurement for loss deductibility is relative to the adjusted basis of the shareholder's stock and not the total of stock and debt.
The new proposed regulations reflect the changes made by the 1996 act to the basis and adjustment rules by stating that distributions are first taken into account by the C corporation before applying losses for the year. Therefore, the ordering of basis adjustments is as follows:
* Increases for income items and the excess of deductions for depletion over the basis of property subject to depletion;
* Decreases for distributions;
* Decreases for noncapital, nondeductible expenses, and certain oil and gas depletion deductions; and
* Decreases for items of loss or deduction [proposed Regulations section 1.1367-1(f)].
Consistent with this change, the proposed regulations also amend Regulations section 1.1368-2 to provide that adjustments to the accumulated adjustments account are made in the same order.
The new ordering rules, which now conform to the partnership basis adjustment rules, will increase the likelihood that a distribution will be tax-free and that a loss will be suspended under the basis limitation rules. *
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner
Alan Ted Frankel, CPA
Frankel Loughran Starr &
Alfred Grillo, CPA
Consolidated Edison, Inc.
Gerard P. O'Beirne, CPA
American Express Tax & Business Services
Richard M. Barth, CPA
The last paragraph of the article in the July Federal Taxation column should have read as follows:
Interestingly enough, the U.S. House of Representatives recently passed a bill limiting the amount of recourse liability assumed for purposes of IRC section 357(e) to liabilities the transferee both has agreed to pay and is actually expected to pay. This bill awaits Senate approval.
Our apologies to author Zev Landau for this omission.
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