Qsub Election Didn't Increase Electing S Corporation Shareholders' Stock Bases

Chief Counsel Advice 201114017

In Chief Counsel Advice (CCA), IRS has concluded that a QSub election and the resulting deemed Code Sec. 332 liquidation did not give rise to an item of income under Code Sec. 1366(a)(1)(A). As a result, the electing S corporation shareholders' stock bases weren't increased under Code Sec. 1367(a)(1)(A).

Background on parent's liquidation of its subsidiary. No gain or loss is generally recognized by a parent corporation on property distributed in complete liquidation of a subsidiary whose ownership by the parent meets an 80% percent test (both 80% of the total voting power of the corporation's stock and 80% of the total value of the corporation's stock). (Code Sec. 332) Similarly, no gain or loss is recognized to the liquidating corporation on the distribution to the parent of any property in a Code Sec. 332 liquidation. (Code Sec. 337(a)) The basis of property received by a corporate distributee in a distribution in a Code Sec. 332 complete liquidation has the same basis in the hands of the distributee as it would have in the hands of the transferor, subject to certain exceptions. (Code Sec. 334(b)) The parent corporation in a Code Sec. 332 liquidation succeeds to and takes into account the subsidiary's tax attributes. (Code Sec. 381(a)(1))

Background on S corporations. An S corporation shareholder's tax liability is determined by taking into account the shareholder's pro rata share of the corporation's (1) items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder, and (2) nonseparately computed income or loss. (Code Sec. 1366(a)(1)) For this purpose, tax-exempt income is income that is permanently excludible from gross income in all circumstances in which the applicable provision of the Code applies. (Reg. §1.1366-1(a)(2)(viii))

Thus, each shareholder must take into account separately his pro rata share of any item of income (including tax-exempt income), loss, deduction, or credit of the S corporation that if separately taken into account by any shareholder could affect the shareholder's tax liability for that tax year differently than if the shareholder did not take the item into account separately. (Reg. §1.1366-1(a)(2)) Code Sec. 1367(a)(1)(A) provides that a shareholder's basis in the stock of an S corporation is increased by the items of income described in Code Sec. 1366(a)(1)(A), and Code Sec. 1367(a)(1)(B) provides that it is increased by any nonseparately computed income determined under Code Sec. 1366(a)(1)(B).

An S corporation may elect to treat a 100% owned subsidiary meeting certain requirements as a qualified subchapter S subsidiary (QSub). The QSub isn't treated as a separate corporation, and all of its assets, liabilities, and items of income, deduction, and credit are treated as those of the S corporation. () An S corporation's QSub election results in the deemed liquidation of the subsidiary into the S corporation, with its tax treatment determined under the Code and general principles of tax law (e.g., the step transaction doctrine). (Reg. §1.1361-4(a)(2)

In Gitlitz v. Com. (S Ct 2001), 87 AFTR 2d 2001-417, the Supreme Court held that cancellation of debt (COD) income excludible under Code Sec. 108 was an “item of income” that increases an S corporation shareholder's stock basis under Code Sec. 1367(a)(1)(A), noting that Code Sec. 61(a)(12) listed COD income among the items of gross income, and that Code Sec. 108 was an exception to Code Sec. 61(a)(12). The Court rejected the argument that COD income excluded under Code Sec. 108 was “tax deferred” rather than “tax-exempt” because tax attributes must be reduced by that income. Instead, the Court held that Code Sec. 1366(a)(1)(A) was worded broadly enough to include income, even tax-deferred income, that could affect the liability for tax of any shareholder. (During the tax year at issue in Gitlitz, the regs didn't define “tax-exempt income” in Reg. §1.1366-1(a)(2)(viii).)

Observation: The Job Creation and Worker Assistance Act of 2002 reversed the specific holding in Gitlitz. For discharges of debt after Oct. 11, 2001 in tax years ending after that date, Code Sec. 108(d)(7)(A), as amended by the Act, provides that the COD income of an S corporation that is excluded from income under the Code Sec. 108 rules isn't passed through to the shareholders. Thus, the shareholders do not increase their bases for the excluded COD income.

Facts. Electing small business trusts (Taxpayers) created S corporation Parent for the benefit of various members of a family. They contributed all of the shares of a C corporation (Sub) that they had previously owned outright to Parent, which elected to treat Sub as a QSub. Parent's basis in Sub's stock was close to zero. Later, Taxpayers sold all of Parent's stock to affiliates of Purchaser in exchange for a combination of notes, stock, and cash.

Taxpayers' position. Taxpayers took the position that the QSub election for Sub increased their bases in Parent's stock under Code Sec. 1367(a)(1)(A) by the amount by which the value of the Sub's stock exceeded its basis, and that they therefore recognized a loss rather than a gain on the later sale of their Parent stock to Purchaser. They argued that the nonrecognized gain on the Sub stock at the time of the deemed liquidation caused by the QSub election produced an item of income under Code Sec. 1366(a)(1), even though no gain was recognized in the Code Sec. 332 liquidation.

CCA's conclusion. The CCA determined that the S corporation shareholders didn't increase their stock bases by the amount of the S corporation's built-in gain in the subsidiary stock as a result of the subsidiary's deemed liquidation on the election by the S corporation to treat its wholly owned subsidiary as a QSub.

The CCA reasoned that because the Code didn't define “income” or “item of income,” it had to look to Code Sec. 332 to determine whether a liquidation of a subsidiary into its parent generated income that should be taxed. The CCA concluded that Congress clearly viewed a Code Sec. 332 transaction as a tax-free simplification of a corporate structure and did not believe that it produced income by itself. Unlike exclusion provisions—such as Code Sec. 103 (excluding state and local bond interest) and Code Sec. 108(a) (excluding COD income)—which resulted in a pecuniary economic benefit to the taxpayer, nonrecognition provisions merely resulted in a change in the form of owning property with a continuation of the investment. The CCA found that Code Sec. 332’s legislative history made it clear that such a liquidation changed only the form of property ownership. It didn't provide any Code Sec. 1366 item of income and didn't produce an accession to wealth that should be taxed.

The CCA found Taxpayers' reliance on Gitlitz to be misplaced. Gitlitz concerned the Code Sec. 108 exclusion of COD income—an item that produces a clear accession of wealth to a taxpayer that has been relieved of a debt. But the stock gain not recognized under Code Sec. 332 disappears. To allow a basis step-up for this gain would create “phantom” basis that doesn't reflect the true economics. Taxpayers' position would allow an S corporation to create phantom basis by forming a subsidiary and later liquidating it (or making a QSub election with a deemed liquidation). Further, this phantom basis could be multiplied by creating additional lower-tier subsidiaries and also liquidating them. The basis step-up would be possible only because the business was organized as a parent and a subsidiary before the Code Sec. 332 liquidation. It would not be available if the same business assets were held in a single corporation. This result was clearly not contemplated in Code Sec. 1366(a)(1)(A), which provides that S corporation shareholders take into account tax-exempt income. Taxpayers' attempt to interpret the Code in a manner that could produce such an absurd result was inconsistent with general principles of statutory construction.

The CCA also reasoned that Congress intended for Code Sec. 332 to provide a timing benefit (a delay in taxing the gain on appreciated assets of the liquidated subsidiary) and not a permanent exclusion from income. Taxpayers' position (in which the phantom stepped-up basis shielded a taxpayer from gain) would, in many cases, result in a permanent exclusion and not just a timing benefit—a result that Congress did not intend. Taxpayers' position would similarly allow the S corporation to avoid the corporate-level Code Sec. 1374 built-in gains tax.

References: For QSubs, see FTC 2d/FIN ¶D-1531; United States Tax Reporter ¶13,614.05; TaxDesk ¶611,006; TG ¶4704.