FEDERAL TAXATION

July 2000

FINAL REGULATIONS ON S CORPORATIONS ENTERING A CONSOLIDATED RETURN

By Jeffrey A. Kelson and Randy A. Schwartzman

The IRS issued final regulations under IRC section 1502, effective November 10, 1999, relating to acquisitions of S corporations. These rules apply to the acquisition of 80% or more of an S corporation's stock by a member of a consolidated group. The final regulations adopt the proposed regulations issued in December 1998 providing for the elimination of a major compliance burden arising from the interaction of the consolidated return rules and the S corporation rules.

Prior to the issuance of the proposed regulations, three separate tax returns needed to be filed for the year in which an S corporation was purchased and became part of a consolidated group:

* The short S corporation tax year that ended the day before the acquisition,
* The one-day C corporation return consisting of the day of the acquisition, and
* The short C corporation tax year after the acquisition (included in the consolidated return of the acquirer).

Under the final regulations, an S corporation becomes a consolidated group member at the beginning of the day of its acquisition, and its tax year ends as of the end of the day before its acquisition. Accordingly, the acquired corporation will only have two short tax years: one for the period in which it was an S corporation and one for the period in which it was a consolidated group member. The final regulations thereby eliminate the need for the one-day return.

The due date for the acquired corporation's final S corporation return will be consistent with the current consolidated return rules for subsidiaries entering a consolidated return group. These rules provide that the short-period S corporation tax return is due on the earlier of

1) the date its S corporation return would be due had its tax year not ended or
2) the due date of the consolidated group's return for the tax year that includes the acquisition.

Please note that these rules normally apply when

1) an S corporation is acquired by another corporation that is a member of an existing consolidated group or
2) by a stand-alone C corporation that elects to include the newly acquired S corporation (which automatically becomes a C corporation upon the acquisition by an ineligible shareholder) in a consolidated return. These rules will not apply if the stock of an S corporation is acquired in a transaction for which a section 338(g) election is made.

The income is allocated between the short S corporation tax year and the C corporation tax year based on a "closing of the books" under IRC section 1362(e)(6)(D). A closing of the books is required when there is a 50% or greater purchase of an S corporation that terminates its S status. Since an S corporation cannot have C corporation shareholders, any 50% or greater acquisition by a C corporation would mandate the use of the closing of the books method.

With these final regulations, the IRS has relieved a major compliance burden and provided clearer guidance with respect to acquisitions of S corporation stock by consolidated groups. *

Jeffrey A. Kelson, CPA, BDO Seidman LLP, is the tax partner in charge of the firm's pass through taxation committee and
Randy A. Schwartzman, CPA, BDO Seidman LLP, is a member of the NYSSCPA Corporate Distributions, Liquidations and Reorganizations Committee and the Closely Held and S Corporations Committee.

Editor:
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editor:
Ira D. Fox, CPA
Faber & Fox CPAs

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