In a case of first impression, the Tax Court recently held that nine shareholders of an S corporation improperly increased the adjusted basis of their S corporation stock when the S corporation made a qualified subchapter S subsidiary (QSub) election for its wholly owned C corporation subsidiary, resulting in a deemed liquidation of the subsidiary.
The Facts of Ball
In Ball, (1) a Pennsylvania family formed nine electing small business trusts to hold stock in American Insurance Service Inc. (AIS), a C corporation. In 1999, the trusts, along with an unrelated 10th shareholder, organized Wind River Investment Corp. (WRIC), also a C corporation. The taxpayer trusts and the unrelated shareholder of AIS then transferred the stock of AIS to WRIC in a Sec. 351 transfer, making AIS a wholly owned subsidiary of WRIC.
In 1999, WRIC elected to be taxed as an S corporation pursuant to Sec. 1361. For the next four years, WRIC continued to own all of the stock of AIS, which continued to be taxed as a C corporation.
During its tax year ended Sept. 4,2003, WRIC elected to treat AIS as a QSub, resulting in a deemed liquidation of AIS. As a result of the election, the trusts claimed a combined increase in adjusted basis of approximately $225 million in their WRIC stock, from $15 million to $240 million, to account for the unrealized appreciation inherent in the AIS stock at the rime of the deemed liquidation.
On Sept. 5, 2003, the trusts and the unrelated taxpayer sold all their WRIC stock to an unrelated buyer for $230.1 million. The trusts reported a combined $12.2 million loss on the sale ($227.8 million received net of transaction costs, less $240 million claimed adjusted tax basis).
The IRS denied the claimed losses by disallowing the trusts' basis increase in their WRIC stock resulting from the QSub election and issued deficiency notices to the trusts resulting in a combined assessment of $33.7 million.
Applicable Tax Law
Sec. 1361(b)(3) permits a parent S corporation to elect to treat a wholly owned domestic corporation as a QSub. Once the election is made, the subsidiary is no longer treated as a separate corporation. Rather, all assets, liabilities, and items of income, deduction, and credit of the subsidiary are treated as the assets, liabilities, and items of income, deduction, and credit of the parent S corporation. Regs. Sec. 1.1361-4(a)(2) accomplishes this result by creating a tax fiction in which the subsidiary corporation is deemed to have liquidated into...