Acquisitions by S corporations - -beware the QSub election.

• Author: Smith, Annette B.
• Position: Qualified subchapter S subsidiaries

Tax practitioners should be alert to unexpected potential consequences of an S corporation's acquiring another corporation, electing to treat the target as a qualified subchapter S subsidiary (QSub), and later selling the QSub's stock.

Background

Prior to 1997, S corporations were prohibited from owning 80% or more of another corporate entity. The Small Business Job Protection Act of 1996 eliminated that restriction by allowing S corporations to own any percentage of any other corporation. Further, it provided that an S corporation that wholly owns another domestic corporation can elect to treat such subsidiary as a QSub, allowing flowthrough treatment of the QSub's tax items. The QSub is a disregarded entity similar to a single-member limited liability company.

An S corporation may acquire a C corporation in a taxable stock acquisition. The decision whether to elect QSub stares for the newly acquired C corporation should be examined closely, because the disadvantages of a subsequent sale of the QSub's stock can outweigh the advantages of the flowthrough treatment afforded by the election.

QSub Election Consequences

If an S corporation wants to treat its wholly owned domestic subsidiary as a flowthrough entity, it could elect QSub status for the subsidiary on Form 8869, Qualified Subchapter S Subsidiary Election. The election is treated as a deemed liquidation of the subsidiary into the S parent for Federal income tax purposes. (Note, however, that if the original acquisition of the subsidiary was part of a larger related-party transaction, the step-transaction doctrine could recast the deemed liquidation into something else (e.g., an acquisitive D reorganization).) For state law purposes, the subsidiary remains in existence. Once the QSub election is made, the subsidiary is treated as an integrated division of the S parent (Sec. 1361(b)(3)(A)).

Because the QSub election requirements mandate a 100% stock ownership in the domestic subsidiary, the liquidation generally will be tax-free for the S parent under Sec. 332, and tax-free for the subsidiary under Sec. 337, assuming those provisions' requirements are met.

In a Sec. 332 liquidation, the shareholder of the liquidating corporation (i.e., the S corporation) is treated as exchanging its subsidiary's shares for the liquidation proceeds (i.e., the subsidiary's assets) in a tax-free exchange. The parent takes a carryover basis in the subsidiary's assets under Sec. 334(b), and the stock basis...