Application of step-transaction doctrine to Qsub elections.

• Author: Smith, Greg W.
• Position: S corporation qualified subsidiary corporations

S shareholders who restructure their holdings to benefit from opportunities created by the Small Business Job Protection Act of 1996 (SBJPA) should be alerted to provisions in final regulations issued earlier this year that apply the step-transaction doctrine in certain circumstances. On the positive side, these final regulations offer transitional relief from application of the step-transaction doctrine for certain S restructurings completed before 2001.

Background

Congress historically has given S corporations special benefits under the tax law. Initially, only businesses without subsidiaries could qualify; an S corporation could not own 80% or more of another corporation. Congress recognized that this "no subsidiary" limitation was unwarranted and, in the SBJPA, allowed S corporations to own any percentage of another corporation.

Congress also understood that some S corporations wished to separate different trades or businesses into different corporate entities for legal purposes, but to report the tax results of all the trades or businesses on one S tax return. In these situations, Congress concluded that S shareholders should be allowed to use parent-subsidiary arrangements as well as brother-sister arrangements. Thus, the qualified subchapter S subsidiary (QSub) was born.

Proposed Regulations

In April 1998, the IRS issued proposed regulations on the treatment of QSubs. The regulations provided that, when an S corporation makes a QSub election for a subsidiary, the subsidiary is deemed to have liquidated into the S parent immediately before the QSub election is effective. The tax treatment of this liquidation, alone or in the context of any larger transaction (e.g., a transaction that also includes acquisition of the subsidiary's stock), is generally determined under the Code and general principles of tax law, including the step-transaction doctrine.

The proposed regulations included a special transition rule suspending application of the step-transaction doctrine for a stock acquisition followed by a QSub election when the S corporation and subsidiary are related (as defined in Sec. 267(b)) immediately before acquisition of the subsidiary's stock. Under the proposed regulations, this transitional rule would have applied to certain elections effective before the 60th day after publication of final regulations.

Trap for the Unwary

Many tax practitioners expressed concern over application of the step-transaction doctrine to transactions...