RSM Resources

M&A Alert 2007-9

Background
A QSUB is an entitydisregarded from its S corporation owner. All of the assets and liabilities of a QSUB are considered owneddirectly by the S corporation.  However,the QSUB remains a separate legal entity with outstanding stock.  As such, difficult questions surrounded theappropriate treatment of a sale or other issuance of S corporation stock to anowner other than the S corporation that results in the termination of the QSUBelection.

Prior to the recentamendment, the result varied significantly depending on the specifics facts andcircumstances surrounding the termination of the QSUB election.  IRC § 1361(b)(3)(C) stated only that if theQSUB failed to remain eligible as a QSUB it is treated as a new corporationacquiring all of its assets (and assuming all of its liabilities) immediatelyprior to the termination.  Treasuryregulations filled in the details, providing that termination as a result ofthe sale of >20% of a QSUB stock by the S corporation results in a fullytaxable transfer of assets by the S corporation in exchange for stock in thenew corporation followed by the sale of the stock to the acquirer.  The result appears inappropriate since the Scorporation is required to recognize gain on 100% of the assets even though itretains as much as a 79% interest in the assets and liabilities of theQSUB.  The recent change to the statuteaddresses this result.  

Recent Guidance
The U.S. Troop Readiness,Veterans’ Care, Katrina Recovery, and Iraq Accountability Appropriations Act,2007 amended IRC §1361(b)(3)(C).  As aresult of the change, the sale of QSUB stock is now considered the sale of aproportionate amount of the QSUB’s assets followed by a tax deferred rolloverof the continuing ownership. 

However, the new law mayprovide additional opportunities when applied in conjunction with other QSUBprovisions  In general, when an Scorporation is acquired by another corporation and the old owners continue asminority owners, the transaction is either structured as a fully taxabletransaction with an IRC § 338(h)(10) providing step up in the basis of theassets, or as an IRC § 351 transfer providing deferral to the continuing ownersbut no step in the assets of the corporation. The change to the law potentially offers both step up in basis and a taxdeferred continuing interest.  Thefollowing example demonstrates one such potential opportunity.

Example: S corporationholding company structure
The S corporationshareholders transfer their S corporation stock to a newly formed holdingcompany (Newco). An immediate QSUB election is made by Newco on behalf of the Scorporation. This is generally treated as a non-event for federal tax purposes.  Newco then sells the S corporation stock, nowQSUB stock, to the acquirer.  The sale ofthe QSUB stock is treated as a sale of a proportionate share of the underlyingassets of the QSUB, followed by an IRC § 351 transfer of the assets by theacquirer and Newco to the QSUB (now a C corporation).  As a result, the shareholders of the Scorporation receive gain deferral on their continuing interest and the assetsof the C corporation receive step up in basis for the proportionate shareacquired via purchase of the QSUB stock.

In this example, the Scorporation shareholders hold their continuing interest through their ownershipin the S corporation; however, with the flow-through treatment of the Scorporation, the benefit of the deferral remains.  Issues do arise if the continuing interest isnot proportionate, as the income recognized on the deemed sale of the QSUBassets by the S corporation is apportioned ratably to the owners.  

Summary
The change to IRC § 1361(b)(3)(C)adds additional flexibility to S corporation owners and acquirers.  When contemplating a sale or restructuring ofan S corporation with a PEG or other acquirer, in which the currentshareholders intend to retain a minority interest, owners, acquirers, and taxadvisors should consider if pre-transaction restructuring could minimize sellertax costs and provide basis step up to acquirers.