In a case of first impression, the Tax Court recently held that nine shareholders of an S corporation improperly increased the adjusted basis of their S corporation stock when the S corporation made a qualified subchapter S subsidiary (QSub) election for its wholly owned C corporation subsidiary, resulting in a deemed liquidation of the subsidiary.
The Facts of Ball
In Ball,1 a Pennsylvania family formed nine electing small business trusts to hold stock in American Insurance Service Inc. (AIS), a C corporation. In 1999, the trusts, along with an unrelated 10th shareholder, organized Wind River Investment Corp. (WRIC), also a C corporation. The taxpayer trusts and the unrelated shareholder of AIS then transferred the stock of AIS to WRIC in a Sec. 351 transfer, making AIS a wholly owned subsidiary of WRIC.
In 1999, WRIC elected to be taxed as an S corporation pursuant to Sec. 1361. For the next four years, WRIC continued to own all of the stock of AIS, which continued to be taxed as a C corporation.
During its tax year ended Sept. 4, 2003, WRIC elected to treat AIS as a QSub, resulting in a deemed liquidation of AIS. As a result of the election, the trusts claimed a combined increase in adjusted basis of approximately $225 million in their WRIC stock, from $15 million to $240 million, to account for the unrealized appreciation inherent in the AIS stock at the time of the deemed liquidation.
On Sept. 5, 2003, the trusts and the unrelated taxpayer sold all their WRIC stock to an unrelated buyer for $230.1 million. The trusts reported a combined $12.2 million loss on the sale ($227.8 million received net of transaction costs, less $240 million claimed adjusted tax basis).
The IRS denied the claimed losses by disallowing the trusts’ basis increase in their WRIC stock resulting from the QSub election and issued deficiency notices to the trusts resulting in a combined assessment of $33.7 million.
Applicable Tax Law
Sec. 1361(b)(3) permits a parent S corporation to elect to treat a wholly owned domestic corporation as a QSub. Once the election is made, the subsidiary is no longer treated as a separate corporation. Rather, all assets, liabilities, and items of income, deduction, and credit of the subsidiary are treated as the assets, liabilities, and items of income, deduction, and credit of the parent S corporation. Regs. Sec. 1.1361-4(a)(2) accomplishes this result by creating a tax fiction in which the subsidiary corporation is deemed to have liquidated into the parent S corporation.
Corporate liquidations are governed by either Sec. 331 or Sec. 332. Under Sec. 331, liquidations are generally taxable events, with the shareholder recognizing gain or loss for the difference between the amount received for the subsidiary’s stock and the shareholder’s adjusted basis in that stock. Sec. 332 governs liquidations of a subsidiary into its parent when the parent owns at least 80% of the vote and value of the subsidiary’s stock. Contrary to liquidations under Sec. 331, liquidations under Sec. 332 are generally tax free. Sec. 332 specifies that no gain or loss is recognized by a parent corporation on property distributed in a qualifying complete liquidation of a subsidiary. To preserve the gain inherent in the subsidiary’s assets for potential future recognition, the parent corporation in a Sec. 332 liquidation must take a carryover basis in the subsidiary’s assets under Sec. 334(b)(1).
Because by definition a parent S corporation that makes a QSub election must own 100% of the subsidiary, the deemed liquidation resulting from the election is always governed by Sec. 332.
In general, S corporations do not pay tax at the entity level; instead, like a partnership, an S corporation is a conduit through which income is allocated to the shareholders. Under Sec. 1366, an S corporation shareholder must take into account the shareholder’s pro rata share of the corporation’s items of income (including tax-exempt income), loss, deduction, or credit.
To prevent double taxation of the same income, S corporation shareholders are required by Sec. 1367 to increase their basis in the S corporation stock by items of income (including tax-exempt income) and decrease it by items of loss and deduction, distributions, and nondeductible expenses. Regs. Sec. 1.1366-1(a)(2)(viii) defines tax-exempt income for purposes of Sec. 1366 and Sec. 1367 as “income that is permanently excludible from gross income in all circumstances in which the applicable provision of the Internal Revenue Code applies.” The purpose of providing an increase in stock basis for tax-exempt income is to preserve the tax-exempt nature of the income.
Example 1: A invests $100 in an S corporation in exchange for 100% of the corporation’s stock, taking an initial basis of $100 in the stock. The S corporation invests the $100 in municipal bonds. The bonds generate $20 of interest that is tax exempt under Sec. 103, increasing the value of the stock to $120. If A does not increase the basis in his stock from $100 to $120 upon passthrough of the $20 of tax-exempt income, the sale of the corporate stock for $120 would yield $20 of gain, effectively converting the tax-exempt interest income into taxable gain from the sale of stock.
The Trusts’ Position
In Ball, the trusts argued that the combined effect of these provisions was to require a basis increase in the WRIC stock upon the QSub election for AIS. Specifically, the trusts maintained that the deemed liquidation of AIS generated gain under Sec. 331 that was an item of income for purposes of Sec. 1366. Then, they argued, Sec. 332 exempted the gain from taxable income because of WRIC’s more-than-80% ownership of AIS. In essence, the trusts posited two theories supporting a basis increase under Sec. 1367: First, that the liquidation created an item of income under Sec. 331, and, alternatively, that because the gain was subsequently excluded from income pursuant to Sec. 332, it constituted tax-exempt income.
The Tax Court’s Opinion
In its opinion, the Tax Court first discussed the role of realization and recognition in determining what is gain and the effect of nonrecognition provisions. The court differentiated between exclusion provisions (such as Sec. 108) and nonrecognition provisions (such as Sec. 332) by noting that exclusion provisions forgive taxation of realized gain, while nonrecognition provisions merely defer its recognition. Sec. 332 achieves this deferral when the parent corporation takes a carryover basis in the assets received in liquidation under Sec. 334.
The Tax Court next clarified the interplay between Sec. 331 and Sec. 332. The court explained that Sec. 332 applies to a complete liquidation of a subsidiary, where a parent corporation owns more than 80% of the stock of the corporation being liquidated. All other complete liquidations of a corporation are governed by Sec. 331. Either Sec. 331 or Sec. 332 applies to a particular liquidation, not both.
Because a QSub election is predicated on the parent’s owning 100% of the subsidiary’s stock, the Tax Court found that the resulting deemed liquidation is governed by Sec. 332, not Sec. 331. Accordingly, no item of income was first recognized by WRIC under Sec. 331, as the taxpayers contended, because WRIC did not first engage in a Sec. 331 liquidation. Rather, the liquidation was governed from the outset by Sec. 332, which prevented any gain from being recognized.
The taxpayers largely relied on the Supreme Court’s decision in Gitlitz2 to support their position. In that case, the Court held that where an S corporation received discharge-of-indebtedness income that was excluded by the corporation’s insolvency, the excluded income constituted tax-exempt income for purposes of Sec. 1366 that allowed the shareholders to increase the adjusted basis of their stock. (Note, however, that Congress in 2002 reversed Gitlitz by amending Sec. 108(d)(7)(A) to provide that any discharge-of-indebtedness income excluded from gross income by Sec. 108(a) is not an item of income under Sec. 1366(a).)
Contrasting Gitlitz with the instant case, the Tax Court explained that discharge of indebtedness is explicitly included in income under Sec. 61(a)(12) and then excluded from income for insolvent taxpayers by Sec. 108(a)(1)(B) and that the Supreme Court held that the nature of discharge of indebtedness as income was not changed by the Sec. 108(a) exclusion. To the contrary, the nonrecognition of gain under Sec. 332 merely prevents that gain from rising to the level of income because of the application of that section. The court further found that unrecognized gain is conceptually different from discharge-of-indebtedness income. As a result, the court found that Gitlitz was not on point and declined to view it as governing authority.
Lastly, the Tax Court noted that permitting a basis increase upon a tax-free liquidation would produce anomalous results, as it would effectively convert the single level of taxation of S corporations into a zero level of taxation. By increasing the adjusted basis of their stock in WRIC upon the deemed liquidation of AIS, the shareholders would have forever avoided paying tax on their gain in the AIS stock.
The Tax Court’s decision in Ball has important planning implications, as it confirms that S corporations should think twice before buying the stock of a corporation and then making a QSub election. Upon purchasing the stock, the S corporation would be paying for the net fair market value (FMV) of the underlying assets. If the S corporation subsequently makes a QSub election, the deemed liquidation will be governed by Sec. 332, requiring the parent corporation to take a carryover basis in the subsidiary’s assets pursuant to Sec. 334. This can yield painful results.
Example 2: S Co., an S corporation, acquires the stock of a company with assets having a basis of $100 and an FMV of $1,000, by paying $1,000 for the stock. If S Co. immediately makes a QSub election for the subsidiary, S Co. takes a basis in the liquidated assets of $100. As a result, S Co. has paid $1,000 for the stock, but now owns assets with a basis of only $100. The $1,000 stock basis disappears.
In such a situation, if an acquiring S corporation is planning to sell a subsidiary soon after its acquisition, continuing to hold the stock as a separate C corporation may prove advantageous, as the subsequent transfer could be structured as a stock sale, allowing the selling S corporation to take advantage of its FMV stock basis.
Example 3: Expanding upon Example 2, if S Co. makes a QSub election for the acquired subsidiary and subsequently sells its assets for their $1,000 FMV, S Co. will recognize $900 of gain ($1,000 sale price less $100 basis) even though it paid $1,000 for the stock. Conversely, if S Co. does not make a QSub election and subsequently sells the stock of the subsidiary for its $1,000 FMV, S Co. will not recognize any gain or loss on the disposition ($1,000 sale price less $1,000 stock basis).
1 Ball, T.C. Memo. 2013-39.
2 Gitlitz, 531 U.S. 206 (2001).
Tony Nitti is a partner with WithumSmith+Brown PC, in Aspen, Colo. For more information about this article, contact Mr. Nitti at firstname.lastname@example.org.