"Check-the-box" and QSub guidance provide structuring opportunities.

AuthorPackard, Pamela
PositionS corporations; subsidiary corporations

Letter Ruling 200201005 shows practitioners how they can combine the "check-the-box" regulations (Regs. Sec. 301.7701-3) and the final qualified subchapter S subsidiary (QSub) regulations (Regs. Secs. 1.1361-2-6), which clarified the use of QSubs in structuring transactions, to create beneficial Federal tax results that differ significantly from state law results.

In the ruling, X is an S corporation wholly owned by T, a grantor trust owned as community property by a married couple (A and B), who propose the following steps:

  1. T will distribute 2.5% of its X stock to A and B.

  2. T, A and B will form Z, a state-law general partnership that, pursuant to Regs. Sec. 301.7701-3(a) will elect classification as an association (and thus a corporation) under Regs. Sec. 301.7701-2(b)(2).

  3. Z will immediately make an S election. (Its general partnership agreement provides for distributions of cash from operations and distributions on dissolution to the partners in the same proportion as their partnership interests.)

  4. T, A and B will contribute their X stock to Z in exchange for proportionately identical ownership interests in Z.

  5. Z will file a timely election to treat X as a QSub, effective as of the date of the contributions.

  6. Z will then contribute 1% of its X stock to W, a newly formed state-law limited liability company (LLC), in exchange for 100% of the ownership interest in W, and X will convert into state-law limited partnership Y. Neither W nor Y will make a check-the-box election under Regs. Sec. 301.7701-3(c).

Letter Ruling 200201005 stated that X represented that the series of transactions, through which X was "converted" to Z (a corporation that owned all of X's assets through its ownership of Y, a state-law limited partnership disregarded for Federal tax purposes) qualified as a Sec. 368(a)(1)(F) reorganization. Although this representation used the word "converted," it appears that X used this term to describe the effect of Z's QSub election on X, which is a deemed liquidation for Federal income tax purposes.

The ruling concluded that Z can elect taxation as an association and, provided it makes a timely election and otherwise satisfies the definition of a small business corporation under Sec. 1361(b), can elect S treatment under Sec. 1362.

Moreover, Z's transfer of 1% of X stock to W, a newly formed LLC, in exchange for 100% of the interest in W, will not terminate X's QSub election--if W does not make an election under Regs. Sec...

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