IRS Clarifies That a Former QSub Cannot Prorate Post-Termination Items of Income or Loss

By Bryan Keith, CPA, J.D., Washington

Editor: Greg A. Fairbanks, J.D., LL.M.

S Corporations

In Chief Counsel Advice (CCA) 201433014, the IRS addressed whether an S corporation (Corp. X) and its wholly owned subsidiary (Corp. Y), a qualified subchapter S subsidiary (QSub), must prorate annual income following a midyear voluntary revocation of Corp. X's subchapter S election. In the facts of the CCA, the revocation caused Corp. X to lose its status as an S corporation and convert to a C corporation. Correspondingly, the midyear revocation caused Corp. Y to lose its status as a QSub and become a newly formed C corporation for federal income tax purposes.

S Corporation Terminations

In general, an S corporation that terminates its status as an S corporation during a tax year must split the S termination year into a short S year and a short C year. Sec. 1362(e)(2) provides that, subject to certain exceptions, the corporation must allocate its items of income, loss, deduction, and credit between the short S year and short C year on a per-day basis.

In the alternative, however, the corporation may elect to close its books with the consent of the corporation's shareholders. If this alternative closing-of-the-books election is made, items of income, loss, deduction, and credit are specifically assigned to the short S year and short C year under normal tax accounting rules. Use of this alternate "cutoff" method can result in dramatic differences from the pro rata allocation method, depending on the amount and timing of various items throughout the year.

IRS Conclusion in the CCA

The IRS stated in CCA 201433014 that Corp. X, the terminating S corporation, must prorate its annual income between its short S corporation tax year and short C corporation tax year unless Corp. X voluntary elects an optional closing-of-the-books method. On the other hand, Corp. Y was not permitted to allocate between its short QSub tax year and its short C corporation tax year because Corp. Y was deemed to become an entirely new corporation when its QSub status terminated. Thus, Corp. Y must close its books when its QSub status is terminated, and all of Corp. Y's post-termination income (or loss) must be reported on Corp. Y's short C corporation tax return. In other words, the IRS permitted Corp. X to use the pro rata allocation method under Sec. 1362(e)(2) for those items of income, loss, deduction, and credit of the S corporation itself, but not for those of Corp. Y to the extent such items were incurred after the termination of its QSub status.

In the facts of the CCA, Corp. Y had sustained substantial losses after the termination date of its QSub status. If a proration method had been permitted, a portion of those losses would have been allocated to Corp. Y's pre-termination period and used to offset Corp. X's income on Corp. X's short S year tax return or would have passed through to Corp. X's shareholders, who apparently had sufficient tax basis in their Corp. X stock to absorb the losses.

As a result of the IRS's position in the CCA, however, Corp. Y must close its books as of the end of the day before its QSub termination, and all post-termination losses must be reported on Corp. Y's short C year tax return. An offset of post-termination items of Corp. Y against only the post-termination items of Corp. X is possible, however, if Corp. X and Corp. Y join in filing a consolidated tax return for each corporation's respective short C year beginning with the S corporation and QSub termination date.


Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

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