IRS Guidance for Post-Reorganization QSub Terminations

One of the dangers inherent in any transaction involving the stock of a qualified Subchapter S subsidiary (QSub) is that it may inadvertently terminate the parent’s QSub election. To illuminate the risks and eliminate some of the uncertainty, the IRS issued (1) Rev. Rul. 2004-85, to explain the effect certain transfers of QSub stock in Sec. 368(a)(1) transactions will have on a QSub election; and (2) related Rev. Proc. 2004-49, to offer retroactive relief to parties that may have unwittingly terminated a QSub election in a transaction described in Rev. Rul. 2004-85.

Understanding the QSub Election

Assuming a subsidiary meets all other S corporation requirements, Sec. 1361(b)(3)(B) allows an S corporation to elect to treat its wholly owned domestic subsidiary as a QSub. Under the election, the QSub enjoys the legal benefits of corporate status, but, for tax purposes, it is essentially treated as a disregarded entity; it is deemed to have liquidated into the parent at the close of the day before the QSub election goes into effect. As a result, all of the subsidiary’s assets, liabilities and items of income, deduction and credit are treated as the parent’s.

If the QSub election subsequently terminates (whether by choice or by a change in either the parent’s or the subsidiary’s eligibility for S or QSub status), Sec. 1363(b)(3)(c) treats the former QSub as a new corporation which, immediately before QSub status termination, acquired all of its assets and assumed all of its liabilities from its parent for stock in the new corporation. The advantages of the subsidiary’s former QSub status are lost until the new parent is eligible to make—and makes—a new election.

Rev. Rul. 2004-85

Regs. Sec. 1.1361-5(b)(3), Example 9, describes the tax consequences of an exchange between two corporations of 100% of the transferor’s QSub stock. The transaction is treated as if the parent-transferor delivered the former QSub’s net assets to the acquirer-transferee, followed by the transferee’s deemed contribution of same to a new company in exchange for its stock. If the transferee is an S corporation, it can opt to make its own QSub election, effective at the time of the acquisition. In such case, the transferee’s deemed contribution of the QSub’s net assets in exchange for stock, followed by the immediate liquidation of the QSub into its new parent, is disregarded for Federal income tax purposes.

The Service issued Rev. Rul. 2004-85 to provide guidance on the application of the Sec. 1361 regulations to certain Sec. 368(a)(1) reorganizations involving transfers of QSub stock. The ruling specifically addresses the effect of an exchange involving QSub stock in Sec. 368(a)(1)(A), (C), (D) and (F) transactions.

The ruling advises that any transaction qualifying under Sec. 368(a)(1)(F), which involves a change in a corporation’s identity, form or place of organization, will not result in the termination of a QSub election. Alternatively, when a parent transfers 100% of its QSub stock to another corporation as part of a Sec. 368(a)(1)(A), (C) or (D) reorganization, the transfer will immediately terminate the existing QSub election; such a transaction will follow the steps outlined above, in accordance with Regs. Sec. 1.1361-5(b)(3), Example 9.

Rev. Proc. 2004-49

Generally, once a corporation’s QSub status terminates, unless the IRS grants consent, it is barred from making another S election or being the subject of a QSub election before the fifth year beginning after the tax year the termination became effective. Beginning after 1996, Regs. Sec. 1.1361-5(c)(2) grants an exception from this general rule when, immediately after QSub termination, a corporation is still eligible to make an S corporation or QSub election, and actually makes a new election.

Rev. Proc. 2004-49 offers additional relief, by allowing a qualifying corporation to make a late QSub election if it participated in any of the reorganization transactions described in Rev. Rul. 2004-85, without having filed a new QSub election. For transactions completed before Aug. 16, 2004, the new parent can make a late QSub election by attaching Form 8869, Qualified Subchapter S Subsidiary Election, to its timely filed return (including extensions) for the tax year in which the transaction that resulted in the terminated QSub election occurred. Alternatively, the new parent can make the election (subject to certain conditions) by filing Form 8869 with the appropriate service center before Aug. 16, 2005. In either case, the electing parent must be an S corporation that acquired 100% of an existing QSub’s stock as part of a reorganization described in Sec. 368(a)(1)(A), (C) or (D).

Conclusion

Rev. Rul. 2004-85 points out some of the often-unconsidered traps stemming from an ownership interest in a disregarded entity (e.g., a QSub or a single-member limited liability company). Rev. Proc. 2004-49 recognizes the existence of these traps; accompanied by its simplified relief procedures, it should make it easier to achieve the desired tax results when two S corporations engage in a reorganization involving a QSub.

From Barbara S. Borczak, CPA, Frazier & Deeter, LLC, Atlanta, GA