Traps and Pitfalls of the Final QSub Regulations

By Randy A. Schwartzman

In Brief

Navigating a MAze of Regulations

The IRS’s recent issuance of final qualified subchapter S subsidiary (QSub) regulations gives taxpayers and their advisors much-needed guidance in performing transactional analysis. However, the final regulations differ widely from those originally proposed, and the corporate reorganization provisions (including the application of the step-transaction doctrine) are complex in the extreme.

Fortunately, many of the traps and pitfalls associated with QSub formations, acquisitions, terminations, and dispositions can be avoided with proper tax planning. Consummating any acquisition, disposition, or other reorganization involving a QSub can be accomplished through careful study of the regulations; however, a consultation with a mergers and acquisition tax specialist is recommended.

Earlier this year, the IRS issued final regulations under IRC section 1361 regarding the treatment of qualified subchapter S subsidiaries (QSubs). The final regulations address many significant tax issues with respect to QSub acquisitions, formations, terminations, and liquidations that the proposed regulations, released on April 21, 1998, did not address. The final regulations help practitioners avoid certain traps, such as the triggering of excess loss accounts and built-in-gains tax exposure. However, many other traps, such as the complicated application of the step-transaction doctrine, remain.

What Is a QSub?

A QSub is a wholly owned subsidiary for which an S corporation parent makes a valid QSub election. Once a valid QSub election is made, the subsidiary is deemed to have been liquidated into its S corporation parent tax-free under IRC section 332 and would not be treated as a separate corporation for any other income tax purposes. All of a QSub’s assets, liabilities, and items of income, deduction, and credit will be treated as belonging to the S corporation parent.

Definition of stock.The final regulations provide needed guidance about what constitutes stock for purposes of determining whether a QSub is wholly owned by the S corporation parent. These rules provide that stock of a corporation is treated as owned by an S corporation when the S corporation is the owner of that stock for federal income tax purposes.

Instruments, obligations, and other arrangements that would not constitute equity under the one-class-of-stock rules of Regulations section 1.1361-1(l) are also disregarded in determining whether an S corporation is the owner of stock for federal income tax purposes. Moreover, the straight debt safe harbor provisions of Regulations section 1.1361-1(l)(5) continue to apply in determining whether an obligation issued by a QSub can be treated as debt rather than equity.

Electing QSub status.The final regulations provide that an S corporation may elect to treat an eligible subsidiary as a QSub by filing a form prescribed by the IRS; however, at the time the final regulations were issued, that form had not been finalized. Therefore, taxpayers should continue to use Form 966, Corporate Dissolution or Liquidation, as set forth in Revenue Notice 97-4, issued on January 13, 1997.

Revocation of QSub Status

The final regulations allow an S corporation parent to voluntarily revoke a QSub election by filing a signed statement with the service center where the parent S corporation filed its tax return. This is a welcome change from the proposed regulations, which provided that a QSub election could be terminated only when a subsidiary ceased to qualify as a QSub (i.e., where an ineligible shareholder held QSub stock or the S corporation parent held less than 100% of the QSub stock). In certain situations, a voluntary revocation can be beneficial when selling more than 20% of the QSub stock, assuming the revocation and subsequent sale cannot be integrated as one combined step.

The revocation takes effect the date the signed statement is filed; however, an S corporation can specify an alternative date not to exceed two months and 15 days prior to the filing date or 12 months following it. A QSub election can even be revoked before it becomes effective by filing a revocation statement within two months and 15 days of the date the election would have been effective.

Inadvertent Election and Termination Relief

A QSub election may be terminated even if an S corporation inadvertently transfers one share of QSub stock to another person without being aware that the election would terminate on the transfer. The subsidiary would then be ineligible for a QSub election while the parent owns less than 100% of its stock or for at least another five years.

Although the proposed regulations included a provision indicating that relief of inadvertent QSub termination may be available, the final QSub regulations include no such provisions. Nevertheless, if the termination of a QSub election results from the inadvertent termination of the parent’s S election, relief may be available under IRC section 1362(f). A favorable determination under that section will cause the subsidiary to continue to satisfy the requirements of section 1361(b)(3)(B)(ii) during the period the parent is accorded relief for inadvertent termination of its S election. Moreover, if the parent fails to make a timely QSub election, relief may be available under Revenue Procedure 98-55 or under the section 301.9100 regulations.

Exception to the Five-Year Waiting Period

Except for certain limited exceptions described below, a corporation whose QSub election has terminated may not elect S corporation status or reelect QSub status before the fifth taxable year beginning after the year in which the termination occurred.

Thus, for example, if an S corporation (S) owns a QSub (Q), and S distributes the stock of Q to the S shareholders, the QSub election with respect to Q will terminate because it no longer satisfies the requirements of a QSub. If, however, Q would otherwise be eligible to elect S corporation status, then the Q shareholders may elect S corporation status for Q effective as of the date of distribution without requesting the SEC’s consent.

The regulations are taxpayer-friendly in that Q would not be treated as a C corporation for any period as a result of the termination of its QSub election followed by an immediate S election. This treatment can prevent potential application of the built-in gains tax or triggering of an excess loss account. For the distribution to be tax-free, it must otherwise satisfy the requirements for a divisive reorganization under IRC sections 355 and 368(a)(1)(D). In a divisive reorganization, electing S status cannot be the primary business purpose of the split-off.

Another illustration of this rule occurs when an S corporation sells 100% of the stock of a subsidiary that was a QSub immediately prior to its acquisition by another S corporation. The acquiring S corporation may then make a QSub election for the acquired subsidiary, effective as of the date of acquisition. Once again, this should not require a waiver of the five-year waiting period to reelect, and the subsidiary should not be treated as a C corporation for the interim period.

Step-Transaction Doctrine

The final regulations clearly state that general principles of tax law, including the step-transaction doctrine, will apply immediately to determine the tax consequences of electing or terminating QSub status. However, another short transition period prior rule applies to applying the step-transaction doctrine to related-party QSub formations. The transition rule applies only to QSub elections effective before January 1, 2001.

For example, an S corporation receives as a contribution to capital the stock of another related corporation [specified in IRC section 267(b)] followed by a QSub election for the related corporation. The step-transaction doctrine will not apply in determining the tax consequences of the acquisition, and the transaction will be respected as an IRC section 351 contribution followed by an IRC section 332 liquidation. Absent the transition rule, this transaction could be treated as a D reorganization. In a D reorganization, the possibility for gain recognition exists under IRC section 357(c) if the liabilities deemed contributed to the S corporation exceed the adjusted tax basis of the assets deemed contributed by the QSub.

The final regulations contain an example that clarifies that the IRC section 332 regulations apply in determining the consequences of each step. In accordance with income tax regulation section 1.332-2(b), a QSub must be solvent (i.e., the fair market value of its assets must exceed its liabilities) for the liquidation to be considered tax-free. However, because a QSub election results in a constructive liquidation for federal tax purposes, a formal plan of liquidation does not need to be adopted unless a formal liquidation is desired. However, a formal liquidation runs contrary to the QSub goal of segregating liabilities.

Harsher results could occur to the seller when a subsidiary is acquired by an unrelated S corporation and followed by a QSub election. Based on the application of the step-transaction doctrine in other areas of tax law, this transaction should be treated as a deemed asset sale (similar to the consequences that occur under an IRC section 338 election). Absent a section 338 election, the matching principle should not apply, and because unrelated parties would be involved, the transition period should not apply. However, it appears that the IRS would respect the form of this transaction and disregard the separate interests of each party.

During the transition period provided by the proposed regulations, taxpayers voluntarily applied the step-transaction doctrine to certain reorganizations. For example, if an S corporation taxpayer wished to change its state of incorporation, an F reorganization could have used the step-transaction doctrine. The shareholders of the old S corporation could have incorporated a new S corporation in its desired state, then the shareholders could have contributed the old S corporation stock to the new S corporation and have the new S corporation make a QSub election for the old S corporation. The preamble to the final regulations provides that during the transition period the IRS will not challenge the application of the step-transaction doctrine to QSub elections to obtain similar tax treatment to reorganizations under section 368(a)(1)(F).

The final regulations contain several examples that describe the application of the step-transaction doctrine.

These examples provide useful insight into structuring transactions with QSubs so as to avoid complete or partial gain recognition.

In one example, an S corporation sells a 21% interest in a QSub to an unrelated corporation. The QSub is treated as a new corporation acquiring all of its assets and assuming all of its liabilities in exchange for issuing all of its stock immediately before the termination from the S corporation.

The deemed exchange by the S corporation of its assets for the former QSub’s stock does not qualify under IRC section 351 because the S corporation would not be in control of the former immediately after the transfer. Soon after the formation of the QSub, 21% of the stock is sold to an unrelated corporation; therefore, the 80% control requirement would not be met. The example then provides that the S corporation must recognize gain on the deemed sale of all of its assets to the former QSub upon the formation of the new corporation. On the other hand, any losses on the deemed sale are potentially subject to the loss disallowance rules of IRC section 267.

Another example uses the same fact pattern to avoid the undesirable results of taxing the deemed sale of all the assets. In this example, the unrelated corporation contributes capital in exchange for 21% of the QSub stock. The QSub is treated as a new corporation acquiring all of its assets and assuming all of its liabilities in exchange for the issuance of its stock. Because the S corporation and the unrelated corporation collectively are co-transferors that control the transferee immediately after the transfer, the transaction now qualifies as tax-free under IRC section 351.

If the S corporation wishes to receive some cash in the transaction, the cash should be treated as boot and any potential gain would be taxed only to the extent of boot received. However, if the S corporation receives cash representing the full 21% interest in the former QSub, the IRS could collapse the transaction as a deemed sale of stock, in which case the entire gain should once again be taxed to the contributing S corporation to reflect the substance of the transaction, irrespective of the form.

Alternatively, an S corporation could voluntarily revoke the QSub status of its subsidiary in advance of selling the 21% interest. If enough time elapses between the revocation and subsequent sale, the IRS should respect the independent steps of each transaction. In this instance, the S corporation would take on a basis in the stock of the QSub equal to the net inside basis of the assets deemed contributed at the time of the revocation. The total basis in the QSub stock would then be evenly allocated to each share. Upon the subsequent sale of 21% of the QSub shares, gain would only be recognized by the S corporation parent to the extent the proceeds received exceeded the adjusted basis of the disposed shares.

Termination of QSub Status

Under IRC section 1361(b)(3)(C), if a QSub ceases to qualify as such it is treated as a new corporation (Newco) acquiring all of its assets and assuming all of Newco’s liabilities immediately before the terminating event. Once again, under the final regulations, the tax treatment of the formation of Newco is determined under general principles of tax law, including the step-transaction doctrine.

While the formation of Newco generally occurs immediately prior to the terminating event, the final regulations provide for a different result when an unrelated party or entity acquires all of the stock of a QSub. In this situation, the deemed formation of Newco by the former parent S corporation is disregarded for federal income tax purposes. Alternatively, the transaction is treated as a sale of the assets of the QSub to the acquiring corporation, followed by a transfer of the assets to Newco in exchange for Newco stock. Under this characterization, assuming the parties are not deemed to be related (defined as more than 20% commonality), the anti-churning rules under IRC section 197 should not apply, because no momentary ownership of Newco by the selling S corporation is deemed to exist.

Tiered Corporations

A common parent of a consolidated group of corporations that elects S corporation status may also elect QSub status for some or all of the subsidiary corporations. When QSub elections are made for a tiered group of corporations on the same date, the S corporation may specify the order in which the subsidiaries are to be liquidated. However, if no order is specified, then the deemed liquidation of the subsidiaries starts with the lowest tier and continues upward.

The deemed liquidation of the lowest tier subsidiary first is usually very advantageous. Having the lowest tier subsidiaries treated as liquidating first eliminates any excess loss accounts (which would result in income in the deconsolidation of an affiliated group) and avoids the separate application of the built-in gains tax with respect to each subsidiary.

Upon termination of tiered QSubs, if the terminations occur on the same day the deemed formation of the new subsidiaries is treated progressively, starting with the highest tier subsidiary and then downward to the lowest. This ordering rule is also advantageous to taxpayers since each formation would then have the potential to be tax-free under IRC section 351. However, under the step-transaction doctrine, a determination would need to be made if the formations are part of a larger group of transactions.

Built-in Gains Tax

If an S corporation acquires assets through a transaction in which its basis is determined by reference to a C corporation’s basis in the assets, IRC section 1374 applies to the net recognized built-in gain attributable to the acquired assets. Under the final regulations, separate determinations of tax are made with respect to the assets that the S corporation acquires in one section 1374 transaction, from the assets it acquires in another section 1374 transaction, and from the assets it held when it became an S corporation.

Separate pools are normally created for purposes of calculating the tax imposed by section 1374. In connection with maintaining separate built-in-gains tax pools for an S corporation and each QSub, each corporation’s section 1374 attributes, such as loss and credit carryforwards, may be used only to reduce the section 1374 tax imposed on the disposition of assets held by that entity. Likewise, section 1374 attributes acquired in one transaction may be used only to reduce tax on the disposition of assets acquired in that transaction.

Fortunately, the final regulations are very friendly to unsuspecting taxpayers in this area as a result of the operation of the general timing rules. The final regulations provide that a single section 1374 pool is deemed to exist when the parent corporation’s S election is made effective for multiple QSubs. Moreover, no separate built-in gains tax exposure exists when an S corporation is deemed to acquire the assets of another S corporation under the step-transaction doctrine (or in an actual asset acquisition) if the acquired S corporation has no prior C corporation history.

Excess Loss Accounts

Income Tax Regulations section 1.1502-19 provides rules requiring, in certain instances, a member (P) of a consolidated group of corporations to include in income its excess loss account (ELA) in the stock of another subsidiary member (S) of the group. An ELA reflects P’s negative adjustments with respect to S’s stock to the extent the negative adjustments exceed P’s basis in the stock. An ELA must be included in P’s income if P is treated as disposing of S’s stock under IRC section 1.1502-19(b)(1).

A merger or liquidation of P into an S corporation or an S election by P is treated as a disposition that triggers income recognition with respect to an ELA in S stock. By contrast, P’s income or gain in certain cases is subject to special nonrecognition or deferral rules, including IRC section 332. As a result, if S liquidates into P in a transaction subject to section 332, there is no income recognition with respect to an ELA in S’s stock.

The final regulations provide the general timing rules of liquidation when the common parent elects S status and makes QSub elections on the same day. The deemed liquidation of subsidiary members of a consolidated group for which QSub elections are made occurs as of the close of the day before the QSub elections are effective. Therefore, the QSub election is deemed to be made while the S electing parent corporation is still a C corporation. As a result, there is no triggering of income with respect to ELAs in the stock of the subsidiary corporations if the liquidations qualify under section 332.

In contrast, if an S corporation acquires a consolidated group of corporations and makes QSub elections for the parent and members of the consolidated group, a deemed liquidation of the parent prior to the deemed liquidation of other members of the consolidated group may trigger income recognition with respect to ELAs in the subsidiaries’ stock. Therefore, a consolidated group with ELAs should consider making subchapter S and QSub elections (if possible) or curing ELA balances before merging into or being acquired by an S corporation.

Banking Provisions

Consistent with the proposed regulations, the final regulations provide that any special IRC rules applicable to banks continue to apply. These rules assume that the deemed liquidation brought about by a QSub election had not occurred for purposes of the banking provisions [i.e., application of IRC sections 582(c) and 585]. The banking provisions apply automatically to all bank taxpayers, and no special elections are necessary.

Effective Dates

Generally, the effective date of the final regulations is for tax years beginning on or after January 20, 2000, the date of publication in the Federal Register. However, taxpayers may elect to apply the regulations in whole (but not in part) for tax years beginning on or after January 1, 2000. The banking provisions apply retroactively to December 31, 1996. In addition, the transition period suspending the step-transaction doctrine will apply to related-party QSub formations prior to January 1, 2001.

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