Exercise caution when taking advantage of new S corporation legislation.

• Author: St. Clair, Scott

By the time this article is published, the 1996 legislation relating to S corporations will have been in effect for almost a year. Much has been written on the new provisions, which range from increasing the maximum number of shareholders to expanding the IRS's ability to accept late or invalid elections. This article will focus on the provisions allowing an S corporation to own stock in another S corporation. As a result of this change, corporations that have not considered S elections in the past because of their size may find operating as S corporations to be a desirable structure.

Following are three areas in which caution should be exercised prior to making the election to be treated as a qualified subchapter S subsidiary (QSSS).

ELAs

Prior to the Small Business Job Protection Act of 1996 (SBJPA), various restrictions made the switch between operating as a C corporation and an S corporation extremely difficult. With the reduced restrictions on corporations electing S status, individual shareholders of C corporations that are in consistent loss positions may consider making the election. Some corporations in this situation that have been filing on a consolidated basis will have created excess loss accounts (ELAs) with respect to the parent corporation's basis in subsidiary stock.

The legislative history behind the new law indicates that when the "parent" S corporation makes the election to treat a subsidiary as a QSSS, the subsidiary will be deemed to have liquidated under Secs. 332 and 337 immediately before the election is effective. In a typical Sec. 332 liquidation between a parent and a subsidiary, the existence of an ELA does not create income. Income is created in the amount of the ELA, however, if the consolidated group terminates or the subsidiary leaves the group.

When making a QSSS election (which will cause termination of the consolidated group), it is not clear whether the IRS will deem the liquidation to occur before or after the termination. If deemed to occur after termination, income or gain will be recognized to the extent of the ELA. If the liquidation is deemed to occur first, no income will be recaptured. Note: This issue is currently being considered by the Service and further guidance is expected this summer.

DITs

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