IRS clarifies that a former QSub cannot prorate post-termination items of income or loss.

• Author: Keith, Bryan

In Chief Counsel Advice (CCA) 201433014, the IRS addressed whether an S corporation (Corp. A) and its wholly owned subsidiary (Corp. Y), a qualified subchapter S subsidiary (QSub), must prorate annual income following a midyear voluntary revocation of Corp. As subchapter S election. In the facts of the CCA, the revocation caused Corp. X to lose its status as an S corporation and convert to a C corporation. Correspondingly, the midyear revocation caused Corp. Y to lose its status as a QSub and become a newly formed C corporation for federal income tax purposes.

S Corporation Terminations

In general, an S corporation that terminates its status as an S corporation during a tax year must split the S termination year into a short S year and a short C year. Sec. 1362(e)(2) provides that, subject to certain exceptions, the corporation must allocate its items of income, loss, deduction, and credit between the short S year and short C year on a per-day basis.

In the alternative, however, the corporation may elect to close its books with the consent of the corporation's shareholders. If this alternative closing-of-the-books election is made, items of income, loss, deduction, and credit are specifically assigned to the short S year and short C year under normal tax accounting rules. Use of this alternate "cutoff" method can result in dramatic differences from the pro rata allocation method, depending on the amount and timing of various items throughout the year.

IRS Conclusion in the CCA

The IRS stated in CCA 201433014 that Corp. A, the terminating S corporation, must prorate its annual income between its short S corporation tax year and short C corporation tax year unless Corp. A voluntary elects an optional closing-of-the-books method. On the other hand, Corp. Y was not permitted to allocate between its short QSub tax year and its short C corporation tax year because Corp. Y was deemed...