Dealing with S termination when an S corporation joins an affiliated group.

• Author: Ellentuck, Albert B.

Facts

RTB Corp. has been calendar-year S corporation since its inception 10 years ago. RTB has been negotiating to purchase the assets of an existing business. Corporate counsel advises RTB to operate this new business within a separate corporation rather than within RTB in order to:

1. Protect RTB's assets from potential liability associated with certain of the new company's products;

2. Segregate existing labor contracts of the two businesses; and

3. Segregate franchise and licensing agreements that are being purchased as part of the new company's assets, and that must be maintained within a separate corporation as a requirement of the franchisor.

On July 12, 1994, RTB filed Articles of Incorporation with the Secretary of State to form a new corporation, and a charter was granted on that day to the new entity, Subco, Inc. Because state law requires individual persons to file as incorporators, RTB's CEO and controller were listed as Subco's incorporators. The closing on the purchase of the new business occurred on July 20, 1994, at which time RTB transferred substantial capital to Subco, and Subco then purchased new business assets. In exchange for this capital, RTB received 100% of Subco's stock, so that Subco is its wholly owned subsidiary.

Issues

As of what date is RTB's S status terminated? What tax returns would be required, and what periods would they cover?

Analysis

Presumably, RTB recognizes the implications of forming and activating a subsidiary: by becoming a member of an affiliated group, RTB is no longer eligible for S status.

Clearly, RTB's 100% ownership of Subco would cause termination of RTB's S status. S status is terminated whenever the corporation loses its eligibility, such as when an electing corporation joins an affiliated group.

A termination caused by loss of eligibility for S status is effective on and after the date eligibility is lost. The S election remains in effect through the day before the terminating event. The day before the event is considered the last day of a short tax year for the S corporation, and the day of the terminating event is treated as the first day of a short tax year of a C corporation.

To determine when RTB's terminating event occurred, the tax adviser would turn to the rules governing S corporation qualification. In determining the existence of an affiliated group for this purpose, a subsidiary corporation is not considered if it --has not begun business at any time on or before the close...