Reducing BIG for QSub Stock

The IRS issued proposed changes to Regs. Sec. 1.1374-3(b) and (c) (REG-131486-03) on June 25, 2004. The changes address a narrow problem that may occur when a C corporation parent and its subsidiaries convert to S corporation status. When this happens, each entity must compute and track net unrealized built-in gain (NUBIG).

Problem

The transaction may be viewed as having two parts. The first part is converting the parent to an S corporation and leaving the subsidiary as a C corporation, which requires the parent to comply with the NUBIG rules. A component of the parent’s NUBIG computation is the unrealized BIG/built-in loss (BIL) in the subsidiary stock ownership.

The second part of the transaction is the subsidiary’s conversion to a qualified Subchapter S subsidiary (QSub), which requires the subsidiary to compute Sec. 1374’s effects (i.e., “its own” separate NUBIG). The subsidiary’s value consists of two separate NUBIG components: (1) the subsidiary stock’s BIG/BIL; and (2) the BIG/BIL on the subsidiary’s assets. For Federal income tax purposes, the QSub no longer exists; thus, why continue to track the stock in NUBIG? The proposed regulation addresses this problem.

Correction

The proposed changes to Regs. Sec. 1.1374-3(b) and (c) will correct this problem with a NUBIG adjustment, which will be the BIG/BIL in the parent’s ownership of the QSub stock. The net result is to remove the QSub stock as a component of NUBIG. Unfortunately, the proposed regulation does not clearly illustrate the problem and solution; however, the preamble does and should be read before studying the proposed regulation.

As stated above, there is an adjustment to NUBIG. However, there are exceptions or modifications to that adjustment; see Prop. Regs. Sec. 1.1374-3(c), Examples (2), (3), and (4).

Planning

Although the proposed regulation will correct a “double” inclusion, it may also yield a negative effect. One such possibility occurs when the parent’s holding of the subsidiary’s stock has a BIL, and the parent has other NUBIG assets with unrealized gain, such that the gain will reduce the parent’s NUBIG to zero. Because of this, the S corporation will not owe any BIG tax, because the net recognized BIG is limited to the smaller of the “pre-limitation amount, taxable income limitation, and net unrealized built-in gain limitation”; see Prop. Regs. Sec. 1.1374-3(c), Examples (2) and (3). If NUBIG is zero, then no BIG will be recognized when disposing of assets subject to Sec. 1374. If this situation occurs after the proposed regulation is in effect, the BIL in the subsidiary stock will be a NUBIG adjustment. The net result is that NUBIG will be a positive value (i.e., no longer zero). Thus, what would have been nontaxable at the S level under the old regime may be taxable at the entity level under the new regime.

A key to applying the adjustment is the date of the QSub conversion: before that date, NUBIG will be computed based on the parent’s assets (i.e., no adjustment); after the conversion date, NUBIG will have to be adjusted for BIG/BIL in the subsidiary stock. Example (3) of Prop. Regs. Sec. 1.1374-3(c) serves as a guide for adjusting NUBIG after a QSub conversion.

Another potential planning scenario is delaying the subsidiary’s conversion date if there are plans to dispose of BIG assets at the parent level and NUBIG will be zero. This scenario assumes: (1) the potential recognized BIG will be sufficiently material to justify delaying the QSub conversion; (2) the subsidiary stock has BILs; and (3) removing such stock from NUBIG will create a positive NUBIG. The downside for delaying the conversion is the creation of two different 10-year tolling periods—one for the parent’s conversion, another for the subsidiary’s conversion.

As can be seen, the plan’s focal point is determining the best date to convert the subsidiary to a QSub given the assets held by the group. The deciding factor is the NUBIG computation both before and after that date.

Conclusion

Although the proposed regulations appear limited to C corporations electing to become S corporations, corporations electing S status since inception may also be affected by these rules. The proposed regulations will affect any S corporation to which Sec. 1374(d)(8) applies. While the proposed regulations resolve some issues, they do not address other fact patterns, for which additional guidance is needed.

From Domingo Valdez, Porter Keadle Moore, LLP, Atlanta, GA