QSub election does not create an item of income

BY KARYN BYBEE FRISKE, CPA, PH.D. AND DARLENE PULLIAM, CPA, PH.D.

The Third Circuit affirmed the Tax Court’s opinion that an S corporation’s election to treat its wholly owned subsidiary as a qualified subchapter S subsidiary (QSub) did not create an item of income or tax-exempt income under Sec. 1366(a)(1)(A). It also determined that an increase in stock bases and declared losses from a subsequent sale were improper.

A parent S corporation may elect to treat a wholly owned domestic corporation as a QSub under Sec. 1361(b)(3). The QSub is then no longer treated as a separate corporation, and all its assets, liabilities, items of income, deductions, and credits are treated as the corresponding items of the parent S corporation. The QSub is deemed to have liquidated into the parent S corporation (Regs. Sec. 1.1361-4(a)(2)). The QSub election is considered an adoption of a plan of liquidation immediately before the deemed liquidation, which qualifies the deemed liquidation for tax-free treatment under Sec. 332.

Under Sec. 1367(a), a shareholder’s tax basis in the stock of an S corporation is adjusted to reflect the shareholder’s pro rata share of income, losses, deductions, and credits of the S corporation, as calculated under Sec. 1366(a)(1).

In 1997, the Ball family formed several trusts to acquire all the shares of American Insurance Service Inc. (AIS), a C corporation. Two years later, the trusts formed Wind River Investment Corp. (WRIC), a Delaware corporation, and contributed the AIS shares in exchange for all the WRIC stock, making AIS a wholly owned subsidiary. WRIC then elected to be taxed as an S corporation under Sec. 1361. In 2003, WRIC elected to treat AIS as a QSub under Sec. 1361(b)(3), resulting in a deemed liquidation. The trusts increased their bases in the WRIC stock from $15 million to $242 million to reflect the gain under Sec. 331 purportedly resulting from the deemed liquidation of AIS. Later in 2003, the trusts sold their WRIC stock to a third party for a net $230 million. The trusts claimed a combined loss on the sale of $12 million using the new adjusted bases of the WRIC stock.

The IRS denied the losses and issued deficiency notices totaling more than $33 million, stating that the QSub election did not create an item of income and that the trusts improperly increased their bases in the WRIC stock. The trusts filed petitions with the Tax Court, and the cases were consolidated.

The trusts argued that the deemed liquidation of AIS was a sale or exchange of property under Sec. 331, creating a realized gain to WRIC under Sec. 61(a). They contended that this item of income under Sec. 1366(a)(1)(A) passed through to them and increased their bases in WRIC stock under Sec. 1367(a)(1)(A), despite the nonrecognition of that gain under Sec. 332.

The Tax Court considered the difference between “realization” and “recognition” of income and held that gain from a QSub election is realized and calculated under Sec. 1001 but is not recognized under Sec. 332. The court concluded that an unrecognized gain “does not rise to the level of income” and is not an “item of income for tax purposes” under Sec. 1366. The Tax Court found the increase in stock bases and claimed tax losses to be improper.

In affirming the Tax Court decision, the Third Circuit first considered the meaning of the undefined term “item of income” as it is used in Sec. 1366. Sec. 61(a) provides a broad definition of gross income unless excepted by other Code sections. The Supreme Court has previously concluded that income requires an “accession to wealth.” The Third Circuit reasoned that the QSub election did not increase wealth for WRIC and therefore did not create income for the trusts. Next, the court addressed realization and recognition of gains and whether a gain must be recognized to create an item of income under Sec. 1366. The underlying question is whether Sec. 331 or 332 applies to the deemed liquidation of AIS as a result of the QSub election. The Tax Court had been correct in concluding that a QSub election results in a Sec. 332 liquidation and the nonrecognized gain does not create an item of income, the Third Circuit held.

The Third Circuit examined the trusts’ contention that an item of income may be defined as income under one section of the Code and not recognized under another but still be considered an item of income under Sec. 1366. The trusts based their arguments on the Supreme Court’s decision in Gitlitz, 531 U.S. 206 (2001), and the Third Circuit’s decision in Farley, 202 F.3d 198 (3d Cir. 2000), which both allowed a cancellation of debt (COD) to pass through to shareholders as an item of income, increasing shareholder basis to allow recognition of suspended losses, even though the income was excluded under Sec. 108. According to the Third Circuit, an important distinction between those cases and the current case was that those payments were explicitly included in gross income under Sec. 61(a) (before the Sec. 108 exclusion), while the unrecognized gain from a QSub election is not. (After Gitlitz, Congress amended Sec. 108(d)(7)(A) to disallow S corporation passthrough of COD income exclusion (Section 402 of the Job Creation and Worker Assistance Act of 2002, P.L. 107-147).)

The Third Circuit concluded that the gain from the QSub election was not recognized and, under the Supreme Court definition, was not income. Consequently, it could not be an item of income under Sec. 1366, and shareholders could not increase their bases under Sec. 1367.

  Ball, No. 13-2247 (3d Cir. 2/12/14), aff’g T.C. Memo. 2013-39

By Karyn Bybee Friske, CPA, Ph.D., Schaeffer Professor of Business Ethics and professor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Business, both of the College of Business, West Texas A&M University, Canyon, Texas.

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