In CCA 201114017, the IRS addressed the question as to whether a qualified subchapter S subsidiary (“ QSub”) election and subsequent deemed liquidation results in an increase in the shareholder’s basis in the parent corporation’s stock.
Putting some numbers to the situation, assume P Co. is owned 100% by A, who has a basis in the P stock of $200. P owns 100% of S Co., a C corporation. P elects to treat S Co. as a QSub when S has assets with a basis of $10 and a FMV of $100. Can A increase his basis in P stock from $200 to $290 for the $90 gain inherent in S’s assets at the time of the QSub election?
To understand how the IRS approached this issue, and why it’s an important analysis, we have to understand some concepts that span Subchapters C and S:
1. In general, S corporations do not pay entity level tax. Instead, under Section 1366(a)(1), each shareholder reports their pro rata share of income or loss on their individual income tax return. To prevent double taxation (product placement!), shareholders are required to increase their basis in the S corporation stock by income and decrease it by losses, distributions, and nondeductible expenses.
3. Included in the positive adjustment to stock basis is an increase for tax-exempt income realized by the S corporation. Why is this? To preserve the tax-exempt nature of the income. Assume you put $100 into S Co. which S Co. invested in muni bonds, generating $2o of tax-exempt interest under Section 103. If someone wanted to buy your stock, they would likely pay $120 for it. If you did not increase your stock basis from $100 to $120 upon pass-through of the $20 of tax-exempt income, the $20 of tax-exempt interest would effectively be taxed upon the sale of the stock.
4. Under Section 1361(b)(3), an S corporation may elect to treat a 100% owned subsidiary meeting certain requirements as a QSub, in which case the subsidiary’s tax existence is disregarded and the assets and liabilities of the subsidiary are deemed to be owned by the parent.
5. The regulations provide that when a QSub election is made, it results in a deemed liquidation of the subsidiary under Sections 332 and 337.
6. Under these two code sections, the liquidation of a 100% subsidiary is not a taxable event. The parent corporation merely takes a basis in the assets of the subsidiary equal to the subsidiary’s basis prior to liquidation. The subsidiary does not recognize gain on the distribution of any appreciated assets to the parent, which is an exclusion to the general rule of Section 311(b) that treats a corporate distribution of appreciated assets as a sale. Likewise, the parent recognizes no gain upon receipt of the subsidiary’s assets.
Got all that? Good.
In CCA 201114017, the taxpayer argued that when the parent made the QSub election (#4 above) and liquidated the subsidiary (#5), since the subsidiary did not recognize gain on the appreciation inherent in its assets under Section 337 (#6), the unrecognized gain should be treated as tax-exempt income earned by the subsidiary, passed through to the parent corporation, and in turn passed through to the shareholders. As a result, the shareholders should increase their basis in the parent corporation’s stock (#3).
The IRS disagreed. It reasoned that Section 337 is not an exemption from income, but rather a nonrecognition provision that simply effects a change in the form of a taxpayer’s property. In this case, the parent S corporation continued its investment in the subsidiary corporation, but in a different form by holding the assets directly rather than through stock ownership.
The IRS differentiates this situation from one in which an S corporation recognizes cancellation of indebtedness income that is excluded under Section 108, which was held by the Supreme Court in Gitlitz to increase the shareholder’s basis in the S corporation. In the COD context, the taxpayer has realized a clear accession of wealth by being relieved of a debt that is then being excluded under a statutory provision.
When a corporation liquidates its subsidiary, however, the combined companies are no wealthier than they were before. The IRS concluded that “tax-exempt income” for purposes of increasing a shareholder’s basis should be reserved for those items that provide a formal exclusion from an economic benefit.
So going back to our number example, A is not entitled to increase its stock basis in P from $200 to $290, because the nonrecognitoin of S’s $90 gain under Section 337 does not constitute tax-exempt income.
This ruling has important planning implications as well, as it confirms that S corporations may want to think twice before buying the stock of a corporation and then making a QSub election. In purchasing the stock, you will be paying for the net FMV of the underlying assets. If you then make the QSub election, the deemed liquidation of the newly purchased subsidiary will require the parent to take a basis in the subsidiary’s assets equal to their historical cost. With this CCA, it is clear that the Service’s position is that no step-up will be afforded to parent’s shareholders for the unrecognized gain on the subsidiary’s liquidation.
To illustrate, if a corporation acquires the stock of a company with assets having a basis of $100 and a FMV of $1,000 by paying $1,000 and then immediately makes a QSub election, all the parent corporation will have to show for its $1,000 payment is assets with a depreciable basis of $100. The $1,000 it paid for the stock “disappears.”