An S corporation can participate as a corporate entity in a corporate reorganization (see the conference committee report to Section 1310 of the Small Business Job Protection Act, H.R. Conf. Rep’t No. 737, 104th Cong., 2d Sess. 226 (1996)). This leads to a substantive advantage of S corporations over partnerships: S corporations and their shareholders can accomplish stock exchanges, corporate divisions, mergers, and the other forms of transactions known as tax-free reorganizations, whereas subchapter K of the Code provides no such opportunity for partnerships. However, an S corporation participating in one of these transactions can face the loss of its S status in a number of ways—if, for example, any of its stock is owned by another corporation.
Termination of S Status in Type A, B, or C Reorgs.
If an S corporation is merged or consolidated out of existence in a type A reorganization, its S status will cease. If the S corporation is the acquiring corporation, it can lose S status by exceeding the maximum shareholder limitation, adding an ineligible shareholder, or absorbing a corporation with outstanding stock or debt that constitutes a prohibited second class of stock. Furthermore, it can acquire assets (or earnings and profits) from the target corporation that lead to excess net passive investment income and termination of S status after three consecutive years.
If the S corporation is the acquired corporation in a type B stock-for-stock reorganization, it can lose its S status because it has a corporate shareholder or goes out of existence in a subsequent liquidation.
If the S corporation is the acquiring corporation in a type C reorganization, it can lose its S status because of the existence of a corporate shareholder. However, this risk can be avoided if the stock is transferred to the shareholders of the target corporation. As an alternative, the S corporation can liquidate the target, in which case the “transitory subsidiary” exception should protect its S election. Other risks include gaining an ineligible shareholder, exceeding the shareholder limitation, assuming nonqualifying debt, or acquiring assets (or earnings and profits) from the target that lead to excess net passive investment income and termination of S status after three consecutive years.
If the S corporation is the acquired corporation, it generally will be liquidated following the reorganization, although the IRS has the authority to waive this requirement (Sec. 368(a)(2)(G)). If it remains in existence but transfers away its operating assets, its remaining assets may generate sufficient passive income to subject it to termination of S status after three years.
Termination of S Status in Type D or E Reorgs.
Rules similar to those discussed in the preceding paragraphs apply to various steps in either acquisitive or divisive type D reorganizations.
Termination of the S election can occur in a type E recapitalization if the stock or debt issued in exchange for the outstanding stock or debt violates the single-classof-stock requirement. For example, in a stock-for-stock exchange, the newly issued stock could have distribution or liquidation rights that differ from the original outstanding stock.
In a debt-for-stock exchange, the newly issued debt could fail to meet the straight-debt rules of Sec. 1361(c)(5), which would result in a second class of stock if the debt constituted equity under general principles of tax law and a principal purpose of the debt was to circumvent the distribution or liquidation rights conferred by the outstanding stock or to circumvent the maximum shareholder limitation.
Termination Due to Shareholder Control
Finally, if the new shareholders hold more than 50% of the S corporation’s outstanding stock after the reorganization, they can revoke the S election. If the revocation occurs by the 15th day of the third month of the tax year, it can be retroactive to the beginning of the tax year.
Allocating Passthrough Items
If an S corporation terminates its S status as the result of a merger or other tax-free reorganization, the S corporation year (the S short year) ends on the day before the terminating event. If the corporation remains in existence as a C corporation, it must determine which method will apply for allocating income to the S short year:
- The general pro-rata method, in which the income for the year is allocated to the S short year and the following C short year based on the number of days in each short period (Sec. 1362(e)(2)); or
- The specific accounting method, which is made via an election to close the books of the corporation at the end of the S short year (Sec. 1362(e)(3)).
If the reorganization has caused a termination of S status and an exchange of 50% or more of the corporation’s stock, the general pro-rata method is not available. The specific accounting method must be used, with the books closed as of the last day of the S short year (Sec. 1362(e)(6)(D)).
When S status terminates as a result of a reorganization, it may seem that the general distribution rules of Sec. 1368 do not apply because that statute pertains only to distributions “made by an S corporation.” However, Sec. 1371(e) allows a one-year (or more) post-termination transition period (PTTP) during which a corporation may make distributions of its accumulated adjustments account (AAA) following termination of S status.
The ability to distribute money as a reduction against stock basis, to the extent of the AAA, during the one-year PTTP is an important privilege for an S corporation that is a party to a reorganization. It is important to note that the post-termination privilege applies only to cash distributions, not property distributions.
Planning tip: If the shareholders of an S corporation that will lose its S status want to withdraw specific items of property from the corporation, they should do so prior to the reorganization.
Deducting Suspended Passthrough Losses
A one-year post-termination privilege is provided for carryover passthrough losses and deductions that have been limited because of insufficient shareholder basis (Sec. 1366(d)(3)). During the post-termination transition period, the shareholder is allowed to restore basis in stock (but not debt) to achieve deductibility of suspended passthrough losses.
This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 23d Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, James A. Keller, and Brooke Paschall, published by Practitioners Publishing Company, Ft.Worth,TX,2009 ((800) 323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.