Deemed liquidation on electing QSub status

A qualified Subchapter S subsidiary (QSub) is a subsidiary corporation 100% owned by an S corporation that has made a valid QSub election for that subsidiary. In addition to being 100% owned by an S corporation, a QSub must be a domestic corporation that otherwise qualifies to be an S corporation.

When a parent S corporation makes a QSub election for an existing corporation (whether or not the subsidiary’s stock is acquired from another person or previously held by the S corporation), the subsidiary is generally deemed to have engaged in a tax–free liquidation under Secs. 332 and 337 if the relevant requirements are met (Regs. Sec. 1.1361–4(a)(2)). Thus, where a QSub election is made for an insolvent subsidiary, the deemed liquidation is not a Sec. 332 liquidation (Regs. Sec. 1.1361–4(d), Example (5)). Filing a QSub election is treated as the adoption of a plan of liquidation for purposes of Sec. 332 (Regs. Sec. 301.7701–3(g)(2)(ii)).

Note: The Third Circuit ruled that an election by an S corporation to treat its subsidiary as a QSub did not increase the basis of the S corporation’s shareholders in their S corporation stock (Ball ex rel. Ball, 742 F.3d 552 (3d Cir. 2014)). The court concluded that a QSub election did not create an item of income for the parent corporation under Sec. 1366(a)(1)(A). The QSub election did not add wealth but merely changed the tax treatment of the income flowing from the QSub. This reformation by liquidation did not provide an accession to wealth for the corporation and therefore could not create income for the shareholders. The court concluded that Sec. 332, which governs the liquidation of certain subsidiaries, applied, not Sec. 331, which governs all other liquidations. The court noted that Sec. 332, by its plain text, applied to a special set of liquidations that were treated under a different statutory scheme and did not create items of income. In addition, under Regs. Sec. 1.1361–4, a QSub election results in a Sec. 332 liquidation.

The tax treatment of the deemed liquidation (or of a larger transaction that includes the deemed liquidation) must be determined under the general principles of federal tax law, including the step–transaction doctrine (Regs. Sec. 1.1361–4(a)(2)). According to the step–transaction doctrine, the steps of a corporate reorganization, if related, will be treated as one transaction. Thus, the tax consequences of the transaction (e.g., whether the transferors are in control of the transferee) will be determined after all the steps are completed rather than at each step of the transaction.

If the deemed liquidation does not qualify as a tax–free parent/subsidiary liquidation under Secs. 332 and 337, the subsidiary will normally recognize gain on the transaction (Regs. Sec. 1.1361–4(a)(2)). Losses are generally not recognized due to the related–party limitations imposed by Sec. 267 (Sec. 1563(a)(1), via Secs. 267(a), (b)(3), and (f)(1)).

Example 1. Step–transaction doctrine applies and deemed liquidation fails to qualify as a parent/subsidiary liquidation: P owns 100% of the stock of Z, an S corporation. Z owns 79% of the stock of D, a solvent corporation, and P owns the remaining 21%. On May 1 of the current year, P contributes her D stock to Z in exchange for additional Z stock. Z makes a QSub election for D effective immediately after the transfer. Assuming the transaction is collapsed under the step–transaction doctrine, the liquidation fails to qualify under Secs. 332 and 337 because the 80% control test is not met. Thus, the subsidiary would recognize gain on the deemed liquidation transaction.

Example 2. Taxable deemed liquidation on electing QSub status: E, an S corporation, owns 100% of the stock of Q, a C corporation. Q is indebted to E for an amount that exceeds the fair market value of Q’s assets. E makes a QSub election for Q that is effective on the day it is filed. The deemed liquidation does not qualify under Secs. 332 and 337 because Sec. 332(a) requires the parent corporation to receive property. Even though E receives assets, Q’s insolvency prevents the application of Sec. 332 because E is not considered to have received property in the distribution (see Rev. Rul. 68–602 and Regs. Sec. 1.1361–4(a)(2)). Under these facts, Q recognizes gain or loss on the assets distributed, subject to the limitations of Sec. 267.

Because the liquidation is a taxable rather than a tax–free transaction, Q’s tax attributes generally will not carry over to E under Sec. 381. However, E may be able to deduct a loss under the worthless stock rules of Sec. 165(g) (Regs. Sec. 1.332–2(b)).

Tiered subsidiaries

When QSub elections for a tiered group of subsidiaries are effective on the same date, the S corporation may specify the order of the liquidations. If no order is specified, the deemed liquidations are treated as occurring first for the lowest–tier entity and proceed successively upward until all of the QSub liquidations have occurred (Regs. Sec. 1.1361–4(b)(2)).

Example 3. Timing of the deemed liquidations for a group of tiered subsidiaries: T, an S corporation, owns 100% of B, the C corporation common parent of an affiliated group that includes L and M. B owns all of the stock of L, and L owns all of the stock of M. T elects to treat B, L, and M as QSubs effective on the same date. If no order is specified for the elections, they are deemed to occur from the bottom up. Accordingly, M is treated as liquidating into L, then L is treated as liquidating into B, and finally B is treated as liquidating into T. Each successive liquidation occurs on the same day immediately after the preceding liquidation.

Liabilities in excess of basis

Under the corporate reorganization rules, a corporation transferring assets to another corporation generally recognizes gain on the transfer if the sum of the liabilities assumed by the transferee corporation exceeds the total adjusted basis of the assets transferred (Sec. 357(c)). However, this rule does not apply to acquisitive Type D reorganizations (Sec. 357(c)(1)(B); Rev. Rul. 2007–8).

Example 4. Transaction treated as an acquisitive Type D reorganization under the step–transaction doctrine: V owns 100% of the stock of two solvent corporations, M and P. M is an S corporation and P is a C corporation. On May 1 of the current year, V contributes the stock of P to M, and M elects QSub status for P effective immediately following the stock transfer. On the date of the transfer, M’s liabilities exceed the adjusted basis of its property. However, the value of M’s assets exceeds its liabilities. Immediately after the exchange, the value of P’s assets exceeds the amount of its liabilities. Under these facts, the transaction qualifies as a Type D acquisitive reorganization and as a Sec. 351 exchange. Even though M’s liabilities exceed the adjusted basis of its property on the transaction date, M is not required to recognize gain under Sec. 357.

Variation 4A: Assume that on May 1, M’s liabilities exceed both the basis and the value of its assets (rather than only the basis of its assets). Under these revised facts, the deemed liquidation of M would not qualify under Secs. 332 and 337, and M would recognize gain or loss as explained in Example 2.

Variation 4B: Assume under the original facts that M has two divisions, T and D, and that only the D division is transferred to P on May 1. Assuming the transaction is treated as a divisive Type D reorganization under these revised facts, gain would be recognized under Sec. 357(c)(1)(B).

A deemed QSub liquidation may not be necessary for a newly formed subsidiary

A deemed QSub liquidation does not occur when the QSub election is effective on the date of a subsidiary’s formation (Regs. Sec. 1.1361–4(a)(2)).

Example 5. Deemed QSub liquidation is unnecessary: E, an S corporation, forms a subsidiary and makes a valid QSub election (effective upon the date of the subsidiary’s formation) for the subsidiary. There is no deemed liquidation of the new subsidiary. Instead, the subsidiary is deemed to be a QSub from its inception.

Carryover of S corporation losses suspended under the basis limitation rules

In certain reorganizations, losses suspended under the basis limitation rules of Sec. 1366(d) remain available to the shareholder who initially incurred them (Regs. Sec. 1.1361–4(c)).

Example 6. Suspended shareholder losses carry over when S corporation becomes a QSub: E, an S corporation, acquires K, another S corporation, in a Type A merger. E elects to treat K as a QSub effective on the day of the acquisition. Any loss or deduction disallowed under Sec. 1366(d) with respect to a former shareholder of K remains available to that shareholder as a shareholder of E. Thus, a loss or deduction of a former K shareholder disallowed prior to or during the year of the transaction is treated as incurred by E with respect to that shareholder, provided the shareholder is a shareholder of E after the transaction.

Built-in gains tax

If the subsidiary was a C corporation or an S corporation subject to the built–in gains (BIG) tax before the QSub election, its assets are subject to the BIG tax (Sec. 1374(d)(8); see also IRS Letter Rulings 9801015, 9801056, 199924008, and 199924024).

LIFO recapture tax

If the subsidiary was a C corporation using the LIFO method for inventory prior to the QSub election, the LIFO recapture tax applies (Sec. 1363(d)). However, the transfer of LIFO inventory from an S corporation parent to its QSub is not an event that triggers liability for the LIFO recapture tax (IRS Letter Rulings 9746011, 9746015, and 9807023).

Debt of the QSub issued to a shareholder of the parent S corporation

Debt issued by a QSub to a shareholder of a parent S corporation is treated as debt of the parent for purposes of determining the shareholder’s debt basis. This can be advantageous to the shareholder if the S corporation and its QSubs pass through loss and deductions in excess of gain and income items because such passthrough losses and deductions can be deducted to the extent of basis (Sec. 1366(d)(2)). Loss and deduction items reduce debt basis after they have reduced stock basis to zero. If the shareholder’s portion of passthrough losses and deductions exceeds the shareholder’s stock and debt bases, the limitation on losses and deductions is allocated among the shareholder’s pro rata share of each loss or deduction (Regs. Sec. 1.1366–2(a)(5)). If the shareholder holds more than one debt at the end of the corporation’s year, the basis reduction applies to each debt proportionately (Regs. Sec. 1.1367–2(b)(3)).

Similarly, an ordering rule applies to increases in debt basis when the shareholder holds multiple notes and one note has been partially or fully repaid in the current year (Regs. Sec. 1.1367–2(c)(2)). First, debt basis of the note that was repaid during the year is increased by the “net increase” to the extent necessary to offset any gain that would otherwise be realized on the repayment. Next, remaining income restores basis of the other outstanding notes in proportion to the amount that the basis of each outstanding debt has been reduced. “Net increase” is generally the amount by which the sum of passthrough income and gains exceeds the sum of passthrough loss and deductions and distributions.

The IRS is authorized to issue rules for determining the order in which losses pass through when debt of both the parent and QSub are held by the parent S corporation shareholders. The QSub regulations do not address this, and as of the date of publication, the IRS had issued no such rules.

To the extent a shareholder of the parent S corporation is subject to the at–risk rules of Sec. 465, the QSub’s passthrough losses may be nondeductible and carried over to future years (see the committee reports to the Small Business Job Protection Act of 1996, P.L. 104–188, §1308).