Final Qsub regs.

• Author: Schwartzman, Randy A.
• Position: IRS regulations concerning qualified Subchapter S subsidiary corporations

The IRS issued final regulations under Sec. 1361 on the treatment of qualified subchapter S subsidiaries (QSubs). The final regulations addressed many significant tax issues for QSub acquisitions, formations, terminations and liquidations that were not addressed in the proposed regulations. While the final regulations help practitioners avoid certain unexpected traps (e.g., triggering of excess loss accounts (ELAs) and built-in-gains (BIG) tax exposure), many other traps (e.g., application of the step-transaction doctrine) still exist for the unwary.

What Is a Wholly Owned QSub?

A QSub is a wholly owned subsidiary for which a valid QSub election is made by an S parent. Once a valid QSub election is made, a subsidiary is deemed to have liquidated into its S parent tax-free under Sec. 332 and would not be treated as a separate corporation for any other income tax purposes. All assets, liabilities and items of income, deduction and credit of a QSub will be treated as assets, liabilities and items of income, deduction and credit of the S parent.

Regs. Sec. 1.1361-1(1) provides much-needed guidance as to what constitutes stock for purposes of determining if a QSub is wholly owned by an S parent. Stock of a corporation is treated as owned by an S corporation if the latter is the owner of that stock for Federal income tax purposes. Instruments, obligations and other arrangements that would not constitute equity under the one-class-of-stock rules of Regs. Sec. 1.1361-1(1) are disregarded in determining whether a subsidiary is the owner of stock for Federal income tax purposes. Moreover, the straight-debt safe-harbor provisions of Regs. Sec. 1.1361-1(1)(5) continue to apply in determining if an obligation issued by a QSub can be treated as debt.

Electing QSub Status

Regs. Sec. 1.1361-3(a) provides that an S corporation may elect to treat an eligible subsidiary as a QSub by filing a completed form prescribed by the Service. However, at the time the final regulations were issued, the IRS-prescribed form had not been designed. Therefore, practitioners should continue to use Form 966, Corporate Dissolution or Liquidation, as set forth in Notice 97-4.

Revocation of QSub Status

Regs. Sec. 1.1361-3(b) allows an S parent to voluntarily revoke a QSub election. The revocation is accomplished by filing a signed statement with the IRS Service Center where the S parent filed its most recent S return. This rule represents a pleasant change from the proposed regulations, which provided that a QSub election could only be terminated when a subsidiary ceased to qualify as a QSub (i.e., when an ineligible shareholder held QSub stock or the S parent held less than 100% of the QSub's stock). A voluntary revocation can prove beneficial when selling a more-than-20% interest in the stock of a QSub, assuming the revocation and subsequent sale cannot be integrated together as one step.

The revocation is effective on the date the signed statement is filed with the appropriate service center. However, an S corporation can specify an alternative date, not to exceed two months and 15 days before the filing date of the revocation statement or 12 months following the date of the filing. A QSub election may even be revoked before it becomes effective, by filing a revocation statement within two months and 15 days of the date the election would have been effective.

Inadvertent QSub Election and Inadvertent Termination Relief

A termination of a QSub election could occur if an S corporation inadvertently transfers one share of QSub stock to another person, without being aware that the QSub election would terminate on the transfer. The subsidiary would then not be eligible to have a QSub election in effect for the period during which the parent does not own 100% of its stock or for at least another five years.

While the proposed regulations included a provision indicating that inadvertent QSub termination relief may be available, Regs. Sec. 1.1361-5 does not include any analogous provisions. However, if the termination of a QSub election results from the inadvertent termination of the parent's S election, relief may be available under Sec. 1362(f). A favorable determination under that section causes the subsidiary to continue to satisfy the requirements of Sec. 1361(b)(3)(B)(ii), during the period in which the parent is accorded relief for inadvertent termination of its S election. Moreover, if the parent fails to make a timely QSub...