IRS guidance for post-reorganization QSub terminations.

• Author: Borczak, Barbara S.

One of the dangers inherent in any transaction involving the stock of a qualified Subchapter S subsidiary (QSub) is that it may inadvertently terminate the parent's QSub election. To illuminate the risks and eliminate some of the uncertainty, the IRS issued (1) Rev. Rul. 2004-85, to explain the effect certain transfers of QSub stock in Sec. 368(a)(1) transactions will have on a QSub election; and (2) related Rev. Proc. 2004-49, to offer retroactive relief to parties that may have unwittingly terminated a QSub election in a transaction described in Rev. Rul. 2004-85.

Understanding the QSub Election

Assuming a subsidiary meets all other S corporation requirements, Sec. 1361(b)(3)(B) allows an S corporation to elect to treat its wholly owned domestic subsidiary as a QSub. Under the election, the QSub enjoys the legal benefits of corporate status, but, for tax purposes, it is essentially treated as a disregarded entity; it is deemed to have liquidated into the parent at the close of the day before the QSub election goes into effect. As a result, all of the subsidiary's assets, liabilities and items of income, deduction and credit are treated as the parent's.

If the QSub election subsequently terminates (whether by choice or by a change in either the parent's or the subsidiary's eligibility for S or QSub status), Sec. 1363(b)(3)(c) treats the former QSub as a new corporation which, immediately before QSub status termination, acquired all of its assets and assumed all of its liabilities from its parent for stock in the new corporation. The advantages of the subsidiary's former QSub status are lost until the new parent is eligible to make--and makes--a new election.

Rev. Rul. 21104-85

Regs. Sec. 1.1361-5(b)(3), Example 9, describes the tax consequences of an exchange between two corporations of 100% of the transferor's QSub stock. The transaction is treated as if the parent-transferor delivered the former QSub's net assets to the acquirer-transferee, followed by the transferee's deemed contribution of same to a new company in exchange for its stock. If the transferee is an S corporation, it can opt to make its own QSub election, effective at the time of the acquisition. In such case, the transferee's deemed contribution of the QSub'S net assets in exchange for stock, followed by the immediate liquidation of the QSub into its new parent, is disregarded for Federal income tax purposes.

The Service issued Rev. Rul. 2004-85 to provide guidance on the...