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S Corporations as Shareholders, LLC Members, and Partners, Part 2

Posted on Sep. 20, 2021
[Editor's Note:

This article originally appeared in the September 20, 2021, issue of Tax Notes Federal.

]

Herbert N. Beller is a professor of practice at Northwestern Pritzker School of Law and of counsel with Eversheds-Sutherland (US) LLP. He thanks Elizabeth Dengler, Daniela Estrada, and Despena Saramadis for helpful research and editorial assistance.

In this final installment of a two-part report, Beller examines the tax consequences of various scenarios involving the disposition of corporate or noncorporate affiliate interests held by an S corporation.

Copyright 2021 Herbert N. Beller.
All rights reserved.

Table of Contents
  1. IV. Disposition of Affiliate Interests
    1. A. Taxable Dispositions
      1. 1. C corporation stock/assets.
      2. Case 15. Stock sale without section 338 election.
      3. Case 16. Stock sale with section 338(h)(10) election.
      4. Case 17. Stock sale with section 336(e) election.
      5. Case 18. Sale of subsidiary assets/liquidation.
      6. 2. QSub stock/assets.
      7. Case 19. Sale of all QSub stock.
      8. Case 20. Sale of some QSub stock.
      9. Case 21. Sale of QSub parent stock.
      10. Case 22. Sale of S corporation and QSub assets.
      11. Case 23. Sale of QSub assets.
      12. Case 24. Sale of C corporation stock to related S corporation.
      13. Case 25. Sale of S corporation stock to related S corporation.
      14. Case 26. Sale of S corporation loss stock to related corporation.
      15. 3. Sale of partnership/LLC interests.
      16. Case 27. Sale of SMLLC interest.
      17. Case 28. Sale by S corporation of partnership/LLC interest.
      18. Case 29. Sale of assets by partnership/LLC.
      19. Case 30. Private equity acquisition.
    2. B. Nontaxable Transactions
      1. 1. Acquisitive reorganizations.
      2. Case 31. Merger of S corporation (with QSub) into C corporation.
      3. Case 32. Merger of S corporation (with QSub) into S corporation (with QSub).
      4. Case 33. Merger of QSub into C corporation.
      5. Case 34. S corporation (with QSub) stock exchanged for C corporation stock.
      6. Case 35. S corporation (with QSub) stock exchanged for S corporation (with QSub) stock.
      7. Case 36. All-cash acquisitive D reorganization.
      8. 2. Section 355 transactions.
      9. Case 37. Spinoff of C corporation subsidiary.
      10. Case 38. Split-off of QSub.
      11. Case 39. ATB in partnership/LLC.
      12. Case 40. Cash-rich split-off.
      13. Case 41. Successive spins.
  2. V. Conclusion

Part 1 of this report outlined the fundamentals of how subchapter S operates and began an examination of numerous scenarios, with particular focus on the federal income tax treatment of transactions through which the S corporation comes into existence, other entities become affiliated with the S corporation group, and cash or other property is transferred from an affiliate to the S corporation or between affiliates.1 This final installment examines scenarios in which a complete or partial interest in an affiliate is sold or otherwise disposed of by the S corporation, including through a taxable stock or assets transaction, a tax-free reorganization under section 368, or a tax-free corporate separation under section 355.

IV. Disposition of Affiliate Interests

Two threshold questions inform the tax consequences of a disposition of corporate or noncorporate affiliate interests held by an S corporation. First, will the interest be disposed of directly by the S corporation, or indirectly through a disposition of S corporation stock by its shareholders? Second, will the entire interest be disposed of, or only a partial interest? Affected transactions can include taxable or nontaxable dispositions of stock, partnership/limited liability company interests, interests in disregarded entities (qualified subchapter S subsidiaries or single-member LLCs (SMLLCs)), or assets of the affiliate entity, and the chosen transactional structure may result in the loss of S corporation or disregarded entity status.

A. Taxable Dispositions

Cases 15-26, below, address various taxable disposition scenarios involving corporate affiliates of an S corporation.

1. C corporation stock/assets.

Case 15. Stock sale without section 338 election.

Esco, an S corporation owned 50-50 by Jim and John, directly conducts Business A. Subco, a wholly owned C corporation subsidiary of Esco, conducts Business B. On December 31, 2020, (1) Jim and John each have an adjusted basis of $250,000 in their Esco stock; (2) Esco’s Business A assets are worth $1 million (with a basis of $600,000); (3) Subco’s Business B assets are worth $2 million (with a basis of $1.5 million); and (4) Esco’s basis in the Subco stock is $750,000. On the same date, Esco and Subco have outstanding liabilities of $400,000 and $500,000, respectively. On July 1, 2021, Esco sells all the Subco stock to P, a public company, for $1.5 million and retains the proceeds for expansion and working capital needs of Business A. Subco becomes a wholly owned subsidiary of P and a member of the P consolidated return group. A section 338 election to step up the basis of the Subco assets is not made.

This transaction is simply a straight section 1001(a) sale of stock, resulting in $750,000 of long-term capital gain to Esco ($1.5 million sale price less $750,000 basis). The gain passes through to Jim and John ($375,000 each) and, combined with any other capital gain or loss items they may have, is taxed to them individually at a 20 percent rate (plus the 3.8 percent surtax on net investment income). The passthrough gain correspondingly increases their Esco stock basis. P has a cost basis of $1.5 million in the Subco stock, and the basis of the Subco assets remains the same as it was when Subco was a subsidiary of Esco ($1.5 million). The sale does not affect the S status of Esco. Subco cannot become a QSub because P, as a public company, is not and cannot be an S corporation. The same tax treatment would result if Esco were to instead sell 50 percent, 25 percent, or any other less-than-80-percent portion of Subco stock.2

Case 16. Stock sale with section 338(h)(10) election.

The facts are the same as in Case 15, except that the parties jointly agree to treat the transaction as an asset sale under a section 338(h)(10) election.

If 80 percent or more of the Subco stock (in terms of voting power and value) is acquired by another corporation during the 12-month period preceding the sale, and the acquisition otherwise meets the definitional requirements of a qualified stock purchase (QSP),3 the parties can agree to make a section 338(h)(10) election in order to obtain a stepped-up basis in the Subco assets. Under the election, Subco is treated as having engaged in two deemed transactions: (1) a deemed sale of the Subco (Old Subco) assets to a new corporation (New Subco) for a deemed selling price essentially equal to the fair market value of the Old Subco assets plus the amount of Old Subco liabilities assumed in the transaction by New Subco (now a P subsidiary); followed by (2) a deemed complete liquidation of Old Subco into Esco. The deemed asset sale will result in taxable gain or loss to Old Subco, computed on an asset-by-asset basis under the residual method prescribed by section 1060,4 and the deemed liquidation will generally be tax free to Esco and Old Subco under sections 332 and 337. The actual stock sale by Esco is ignored for tax purposes. Because the taxpayer for the deemed asset sale is a C corporation (Old Subco) and the deemed liquidation into Esco is tax free, the transaction has no tax consequences for the Esco shareholders.5

Assume that P would agree to pay $1.5 million for the Subco stock, the net asset value of Subco ($2 million gross asset value less liabilities of $500,000). Absent a section 338(h)(10) election, Esco’s taxable gain on a sale of the Subco stock would be $1.25 million (all capital gain). That gain would flow through and be taxed to the shareholders at 23.8 percent (including the section 1411 surtax), resulting in a total tax of $297,500. By contrast, if a section 338(h)(10) election were made, and assuming P was treated as buying the Subco assets for $1 million cash plus assumption of the $500,000 liabilities (that is, $1.5 million), the taxable gain to Subco (a C corporation) would be $500,000 (that is, $1.5 million less $1 million basis). Subco, a C corporation, would owe $105,000 tax on that gain (at the flat 21 percent corporate rate), none of which would flow through to Jim or John. The deemed liquidation of Subco into Esco would be tax free under section 332.

Case 17. Stock sale with section 336(e) election.

The facts are the same as in Case 16, except that P is a partnership or other noncorporate purchaser.

A section 338(h)(10) election is unavailable in this situation because P is not a corporate purchaser. However, Esco’s sale of all the Subco stock to P is a qualified stock disposition,6 which permits a different election, under section 336(e), yielding tax consequences similar to those resulting from a section 338(h)(10) election.

If a section 336(e) election is made, (1) no gain or loss is recognized to Esco on the sale of the Subco stock to P; (2) Subco is deemed to sell its assets to P for consideration equal to the amount paid for the Subco stock ($1.5 million) plus the assumed Subco liabilities ($500,000) (that is, $2 million); (3) the deemed sale price is allocated to the various Subco assets under the section 1060 residual method used in section 338 transactions, with gain or loss calculated on an asset-by-asset basis; (4) Old Subco is deemed to liquidate into Esco tax free under section 332; and (5) New Subco takes a stepped-up basis in the assets deemed acquired from Old Subco.7

So when the smoke clears, Subco becomes a P subsidiary (still a C corporation) and Esco continues as an S corporation, inheriting any accumulated E&P that Old Subco may have (including earnings and profits generated by its deemed sale of assets). There is no passthrough or stock basis impact to the Esco shareholders.

Case 18. Sale of subsidiary assets/liquidation.

The facts are the same as in Case 17, except that instead of Esco selling the Subco stock to P, Subco sells all its Business B assets to P for cash and P assumes all the Business B liabilities. Subco thereafter completely liquidates, distributing the net proceeds from the sale to Esco and then dissolving under state law.

If a section 338 or 336(e) election could not or would not be made in connection with a stock sale, the buyer could obtain a stepped-up basis in the target company’s assets only through an actual purchase of the assets.8 Whereas stock sales effectively transfer the seller’s interest in all the corporation’s assets and liabilities, asset acquisitions can be tailored to eliminate particular assets that the buyer does not want, as well as particular liabilities that it is unwilling to assume. In the instant case, when all the Subco assets and liabilities are acquired and Subco then liquidates, the tax consequences are the same as would result from a stock sale coupled with a deemed sale of assets under a section 338(h)(10) election — a corporate-level tax to Subco (gain/loss calculated asset by asset and allocated under section 1060), and no tax to Esco or its shareholders on the complete liquidation of Subco (under sections 332 and 337).9

If instead of liquidating, Subco were to stay in existence and use the sale proceeds to acquire or develop another business, Esco could make a QSub election for Subco, thus turning it into a disregarded entity. As a result of that election, Subco (as a C corporation) would be treated as liquidating tax free into Esco under section 332. Assuming all the Subco assets were sold for cash, there would be no built-in gain (BIG)/section 1374 implications from the deemed liquidation because Esco would receive only the sale proceeds from Subco. However, Esco would inherit any accumulated E&P that Subco might have (under section 381(a)), and that could trigger adverse consequences down the road under the section 1375 passive income rules or the section 1368 accumulated adjustments account (AAA) rules (that is, dividend treatment to the shareholders).

2. QSub stock/assets.

Transactional contexts involving taxable dispositions of QSub interests may include (1) a sale of all or some of the QSub stock; (2) a sale of some or all of the QSub assets; or (3) a sale of the stock of an S corporation that has a QSub. Those transactions will normally cause a termination of QSub status, which in turn will result for tax purposes in deemed transactions designed to remove the QSub from disregarded entity status. In some instances, however, it may be possible to preserve QSub status if the acquiring party is or can become an S corporation.

Case 19. Sale of all QSub stock.

Esco, an S corporation since its inception in 2005, is owned 50-50 by Jim and John and conducts Business A. A wholly owned subsidiary of Esco, for which a valid QSub election was made (QSub), conducts Business B. On June 30, 2021, Esco sells all the QSub stock to Pubco, a public company, for $1.5 million. On that date, the QSub assets are worth $2.25 million and have an aggregate basis of $500,000, and QSub has outstanding liabilities of $750,000. Esco retains $750,000 of the QSub sale proceeds for use in Business A and distributes $375,000 each to Jim and John.

The sale of the QSub stock to Pubco terminates the QSub election because QSub is no longer wholly owned by an S corporation. Under section 1361(b)(3)(C)(ii) (enacted in 2007),10 a termination of QSub status because of a stock sale is treated for tax purposes as (1) a sale by Esco of all the QSub assets and liabilities (already housed in Esco for tax purposes because QSub was a disregarded entity), followed by (2) Pubco’s transfer of the assets and liabilities to a new C corporation (Newco) in a section 351 transaction. The deemed sale of assets would result in recognized gain or loss to Esco on an asset-by-asset basis (allocated under section 1060), all of which would pass through with the same character to John and Jim for reporting on their personal returns. The total passthrough gain would be $1.75 million — the cash purchase price ($1.5 million) plus assumed liabilities ($750,000) less asset basis ($500,000). Thus, Jim and John would each have taxable passthrough gain of $875,000.

Pubco would take a section 1012 cost basis of $2.25 million in the QSub assets deemed purchased (that is, cash paid plus liabilities assumed), allocated on an asset-by-asset basis under the section 1060 residual method. In the following deemed section 351 transfer by Pubco to Newco, no gain or loss would be recognized by Pubco, and Newco would take a transferred basis in the old QSub assets that Pubco was just deemed to have acquired with a cost/stepped-up basis. As a result, no section 357(c) gain would be triggered to Pubco because the $750,000 of liabilities deemed assumed by Newco would not exceed the basis of the assets deemed transferred. Pubco’s basis in the Newco stock would be a substituted basis of $1.5 million, under section 358(a) and (d), representing the recently acquired stepped-up basis in the old QSub assets ($2.25 million) less the $750,000 liabilities assumed in the transaction.

Case 20. Sale of some QSub stock.

The facts are the same as in Case 19, except that Esco sells 40 percent of the QSub stock to Pubco for $600,000 and distributes all the sale proceeds 50-50 to Jim and John. After the transaction, Esco continues to own 60 percent of the QSub stock.

If only part of the QSub stock is sold, Esco will be treated as having sold to Pubco a 40 percent undivided interest in the QSub assets and liabilities, followed by a deemed section 351 transfer by Esco (60 percent of QSub assets retained) and Pubco (40 percent of QSub’s assets deemed purchased) to a new C corporation (Newco) in exchange for 60 percent and 40 percent, respectively, of the Newco stock plus Newco’s assumption of the former QSub liabilities.11 The deemed assets sale would result in recognized passthrough gain to Esco’s shareholders ($700,000)12 and a stepped-up basis in the assets deemed purchased by Pubco. The deemed section 351 transfer to Newco would be tax free because co-transferors Esco and Pubco would together hold 100 percent control of the Newco stock, but Esco would have a section 357(c) gain because its 60 percent share of the liabilities deemed assumed by Newco would exceed its basis in the assets deemed transferred.13

An example in the regulations (Example 1), which predates the 2007 amendment of section 1361(b) (regarding sales of QSub stock), delineates a different set of deemed transactions and, therefore, different tax consequences.14 Under Example 1, Esco would be treated as contributing all the QSub assets and liabilities to a new C corporation in exchange for 100 percent of the Newco stock, followed by a sale of 40 percent of the Newco stock to Pubco. Example 1 concludes that the initial deemed transfer into Newco flunks the section 351 “control immediately after” requirement because of Esco’s planned disposition of more than 20 percent of the Newco stock to Pubco. As a result, instead of the partial recognized gain now mandated by section 1361(b)(3)(C)(ii), Example 1 would trigger full gain recognition on the initial deemed asset transfer into Newco. Taxpayers contemplating partial QSub stock sales should consider seeking advance confirmation by the IRS that Example 1 is no longer valid.

Case 21. Sale of QSub parent stock.

Instead of Esco selling all or part of QSub to Pubco (as in cases 19 and 20), Jim and John sell all their Esco stock to Pubco for $5.25 million (that is, $2,625,000 each). Immediately before the sale, (1) Jim and John each have a basis of $1 million in their Esco stock; (2) the aggregate value and basis of the Esco assets other than those attributable to QSub are $4.25 million and $2.5 million, respectively; and (3) QSub and Esco each have outstanding liabilities of $750,000.

Assuming that a section 338 election is not made, the sale of the Esco stock (part of the value of which is represented by the assets/liabilities of disregarded entity QSub) is a section 1001(a) transaction and triggers capital gain to Jim and John equal to the excess of their 50 percent share of the sale proceeds less the adjusted basis of their Esco stock at the time of the sale. Because Pubco is not an eligible S corporation shareholder, Esco’s S corporation status terminates, as does the disregarded entity status of QSub (the stock of which will no longer be owned by an S corporation). Under section 1361(b)(3)(C)(ii), Esco is deemed to have transferred the QSub assets/liabilities to a new C corporation (Newco) in a section 351 transaction, with Esco then becoming a wholly owned C corporation subsidiary of Pubco, and Newco (that is, Old QSub) becoming a wholly owned C corporation subsidiary of Esco. These deemed transactions will not cause the section 351 “control immediately after” requirement to be violated because Esco will continue to directly own 100 percent of the Newco stock. However, the deemed section 351 transfer of the QSub assets/liabilities would trigger a section 357(c) gain for the $250,000 excess of the Old QSub liabilities over the basis of the Old QSub assets.15 That gain would pass through 50-50 to Jim and John on Esco’s final S corporation return and correspondingly increase their adjusted Esco stock basis by $125,000 for purposes of calculating their gain from the sale of the Esco stock to Pubco.16

Absent a section 338(h)(10) election, the adjusted basis of the QSub assets would remain the same in the hands of Newco after the sale to Pubco of the Esco stock. However, the regulations permit a section 338(h)(10) election to be jointly made for an acquired S corporation notwithstanding that it has noncorporate shareholders.17 If the parties agree to an (h)(10) election, the S corporation is deemed to have sold its assets to a Newco for consideration consisting essentially of the amount paid for the S corporation stock plus liabilities assumed, thus triggering a corporate-level gain (or loss) that passes through to and increases the stock basis of the S corporation’s shareholders. The deemed sale is followed by a deemed complete liquidation of the S corporation under section 331, typically triggering little or no additional taxable gain (but possibly a loss) to the shareholders (because of the stock basis step-up from the deemed asset sale).18

Applying section 338(h)(10) on the Case 21 facts is more complicated because Esco has a QSub whose special tax status as a disregarded entity will terminate as a result of the Pubco transaction (along with the termination of Esco’s S corporation status). If an (h)(10) election is made, the deemed taxable sale of the Esco assets and liabilities to a New Esco (C corporation) should include the QSub assets and liabilities, which are considered held directly by Esco for tax purposes. However, the actual transaction results in Pubco acquiring QSub as a second-tier C corporation subsidiary, so the QSub assets and liabilities deemed transferred to Pubco (as part of the overall assets and liabilities of Esco) must be deemed transferred into New Esco through a section 351 transaction.

When the smoke clears, Newco will be a second-tier subsidiary of Pubco, and the assets of both New Esco (a first-tier subsidiary) and Newco should have a stepped-up basis. If the termination of the QSub status is governed by section 1361(b)(3)(C)(i) because it was caused not by a direct sale of the QSub stock but rather by a sale of the Esco stock (which caused QSub to no longer be owned by an S corporation), Esco would be treated as transferring — immediately before the sale of the Esco stock to Pubco — the QSub assets and liabilities to a new C corporation in exchange for the Newco stock. That deemed exchange would generally be tax free under section 351, except for the $250,000 section 357(c) gain that would pass through to Jim and John and increase their Esco stock basis. This construct would appear to require section 338(h)(10) elections for both Esco (target) and Newco (target affiliate) under the consistency rules of section 338.19

But if the QSub termination is instead governed by section 1361(b)(3)(C)(ii) because the statute is read as covering both direct and indirect “sales” of QSub stock (that is, through a sale of the parent S corporation stock), the deemed section 351 transfer of the QSub assets/liabilities into a Newco C corporation would occur immediately after the sale of the Esco stock, and the deemed taxable asset sale by Esco under the section 338(h)(10) election would include the assets/liabilities of QSub (still a disregarded entity of Esco). Because the section 338(h)(10) regulations provide that the acquired S corporation and any of its QSubs retain their S and QSub status through the date of the acquisition, this construct should obviate the need for a separate (h)(10) election for Newco.20

Case 22. Sale of S corporation and QSub assets.

The facts are the same as in Case 21, except that instead of Jim and John selling their Esco stock to Pubco, Esco sells all its assets (including the QSub stock) to Pubco for cash consideration of $5.75 million, pays off its outstanding liabilities ($750,000), and distributes the remaining cash ($5 million) to Jim and John in complete liquidation of their Esco stock interests.

This is a taxable section 1001(a) sale of the assets of a going business, with gain or loss calculated on an asset-by-asset basis, including the QSub assets (which Esco is deemed to own for tax purposes). The total sale price is allocated to the various assets based on their FMVs under the section 1060 residual method used in section 338 transactions. The gains or losses from the asset sales pass through as taxable income pro rata to Jim and John and correspondingly increase/decrease their respective Esco stock bases. Any excess of the liquidating distributions to Jim and John over their adjusted Esco stock basis results in an additional taxable capital gain under section 331(a).

Esco will have no tax liability from the transaction unless the assets sold include BIG assets. When Esco goes out of existence, its S corporation status will terminate,21 as will the disregarded entity status of QSub (which will become a C corporation subsidiary of Pubco). Pubco will take a section 1012 cost basis in the various assets acquired (including the QSub C corporation stock).22

Case 23. Sale of QSub assets.

Assume that instead of Esco selling the QSub stock, or Jim and John selling the Esco stock, on June 30, 2020, (1) QSub sells all its Business B assets to Pubco for $2.25 million ($500,000 adjusted basis), (2) uses $500,000 of the sale proceeds to pay off its liabilities, and (3) then completely liquidates into Esco, which in turn distributes $750,000 to each of Jim and John. During 2020 Esco generates $1 million of operating income from Business A and distributes an additional $350,000 each to Jim and John. At the beginning of 2020, Jim and John each had a basis of $400,000 in their Esco stock.

Because QSub is a disregarded entity, its sale of assets is treated as a sale by Esco. The taxable gain or loss is computed on an FMV asset-by-asset basis (under a section 1060 allocation) and passes through 50-50 to Jim and John. The QSub’s payment of its liabilities is likewise treated as if Esco paid off its own liabilities, and the liquidating distribution of the sale proceeds by QSub to Esco is a non-event for tax purposes, as if Esco had made the distribution to itself. Pubco takes a cost (that is, FMV) basis in the purchased assets. Because no liabilities are assumed, the amount of the cash purchase price is the aggregate asset basis in Pubco’s hands (or in the hands of a new subsidiary or SMLLC to which Pubco might immediately transfer the Business B assets).

The tax treatment of the 2020 transactions to Jim and John involves three components.23 First, Esco’s asset-by-asset gain/loss from the sale by QSub of its assets would pass through as capital gain/loss or ordinary income/loss depending on the character of the particular asset. The gain items would increase their Esco stock basis, and any loss items would decrease stock basis.24 Second, the Business A operating income passes through (as ordinary income) and correspondingly increases stock basis. And third, under section 1368, the distributions to Jim and John are taxable to them only to the extent they exceed their then-adjusted Esco stock basis. Jim and John would each receive distributions of $1,100,000 against an adjusted Esco stock basis of $1,775,000.25 Thus, no part of the distributions would be taxable to Jim or John because they were fully absorbed by the available stock basis.

Finally, these transactions would not affect the S status of Esco, and QSub would cease to exist as a result of its liquidation into Esco (a non-event for tax purposes). Had QSub instead used the sale proceeds to acquire or develop a new business, it would continue to be a disregarded entity of Esco.

Case 24. Sale of C corporation stock to related S corporation.

In addition to each owning 50 percent of the Esco stock, Jim and John also own 50-50 stock interests in Seeco, a C corporation. Esco conducts Business A directly, and Seeco conducts Business B directly. Neither corporation has any lower-tier affiliates. Esco has been an S corporation since its inception and has no accumulated E&P. At the beginning of 2019, Seeco had accumulated E&P of $750,000, and Jim and John each had a basis of $400,000 in their Esco stock and $750,000 in their Seeco stock. To combine the operations of Esco and Seeco into a single corporate group, on December 31, 2019, Jim and John sold all their Seeco stock to Esco for total cash consideration of $2 million (that is, $1 million each). At the time of the sale, the Seeco assets had an aggregate value of $2.5 million and an aggregate basis of $750,000 and were encumbered by liabilities of $500,000. During 2019 (1) Seeco generated current E&P of $1.5 million from Business B operations and distributed $700,000 each to Jim and John; and (2) Esco generated $1.2 million of net income from Business A operations and distributed $500,000 each to Jim and John. As a result of the transaction, Seeco became a wholly owned subsidiary of Esco, which thereafter made a valid QSub election for Seeco effective as of January 1, 2020.

This situation is fraught with tax complexity and is not without uncertainty. In form, the transaction is simply a straight section 1001(a) sale of stock. However, because of the at-least-50-percent common control (section 304(c) control) of Esco and Seeco (Jim and John together own 100 percent of each corporation),26 section 304 requires that the transaction be tested for dividend equivalency under the stock redemption rules of section 302. More specifically, under section 304(a)(1), Jim and John are each treated as having transferred their Seeco stock to Esco through a tax-free section 351 transaction in exchange for additional Esco stock, which is then hypothetically redeemed for $1 million (that is, 50 percent of the sale consideration). The hypothetical redemption is then tested under the rules of section 302(b) by comparing the shareholders’ percentage interests in Seeco before and after the sale transaction. Jim and John each directly owned 50 percent of the Seeco stock before the sale and continued to each own 50 percent after the sale under the section 318 stock attribution rules — as 50 percent owners of Esco, Jim and John are each deemed to own 50 percent of Seeco, which became a wholly owned subsidiary of Esco.27 With no reduction in interest, none of the section 302(b) gateways to exchange/capital gain treatment under section 302(a) can be satisfied.28

Thus, section 304(a)(1) treats the deemed redemption as a section 301 distribution by the acquiring corporation (Esco), taxable as a dividend first to the extent of any Esco E&P and then to the extent of any E&P of Seeco (the issuing corporation).29 However, because Esco is an S corporation, its distributions that would otherwise constitute section 301 distributions by C corporations are governed by section 1368. Further, under section 1371(a), the provisions of subchapter S overrule any conflicting provisions of subchapter C.30 Because Esco has no E&P, under section 1368(b) Jim and John can each offset their $1 million distributions with their $1.15 million basis ($400,000 Esco basis plus $750,000 Seeco basis).31 Thus, neither should have taxable dividend income, and each should hold their Esco stock after the transaction with a $150,000 basis.32

Apart from the section 304 consequences of the transaction, Esco will retain its status as an S corporation. By reason of the QSub election for Seeco (now a wholly owned Esco subsidiary), Seeco will be treated as having liquidated tax free into Esco under section 332 and will thereafter be considered a disregarded entity of Esco (for tax purposes only). Seeco’s then-adjusted basis for each of its appreciated assets will carry over to Esco under section 334(a)(1) and potentially be subject to corporate-level tax under section 1374 if disposed of by Esco during the succeeding five-year period. There will be AAA implications under section 1368(c) because Seeco’s E&P of $850,000 will be inherited by Esco.33 The gain inherent in the Seeco assets deemed liquidated will not be triggered to Seeco on its final C corporation return because section 337 calls off General Utilities repeal for distributions of appreciated property in a section 332 liquidation.

Case 25. Sale of S corporation stock to related S corporation.

Assume instead that (1) Esco and Seeco have both been S corporations since their inception; (2) neither has any accumulated E&P; and (3) each has a QSub (QEsco and QSeeco). On December 31, 2020, Jim and John sell all their Seeco stock to Esco for total consideration of $2 million (that is, $1 million each). On that date, Jim and John each have an adjusted basis in their Seeco stock of $750,000 and an adjusted basis in their Esco stock of $500,000. On March 1, 2021, Esco makes a QSub election for Seeco effective January 1, 2021.

This situation is also subject to section 304 treatment, but again there should be no dividend income because even though the hypothetical redemption does not qualify for exchange treatment under section 302, neither S corporation had any E&P (that is, neither was previously a C corporation, and neither had inherited E&P from a C corporation in a section 381(a) nonrecognition transaction). Under section 1368(b), the $1 million deemed section 301 distribution to John and Jim (under section 304) is offset against their $1.25 million basis ($500,000 Esco basis plus $750,000 Seeco basis). Neither shareholder will have taxable dividend income, and each will hold their Esco stock with a $250,000 basis. Because the transaction is governed by section 304, the “sold” Seeco stock is deemed transferred to Esco in a section 351 transaction, and under section 362(a), Esco thus takes an aggregate transferred basis of $1.5 million in that stock (that is, Jim’s and John’s basis of $750,000 each in the Seeco stock deemed transferred).

As a result of the Seeco stock sale to Esco, Seeco would lose its S corporation status because it would now have an ineligible corporate shareholder. QSeeco would lose its QSub status because it would no longer be owned by an S corporation. At that point, Seeco and QSeeco would momentarily become lower-tier C corporation subsidiaries of Esco (Seeco a first tier, and QSeeco a second tier), but the subsequent QSub election should retroactively restore QSub status for both subsidiaries effective January 1, 2021 (because the election is made within the 75-day grace period).34 Consequently, both Seeco and QSeeco will on January 1, 2021, become disregarded entities of Esco. Seeco would file a final S corporation return for 2020 (including QSeeco), and neither Seeco nor QSeeco would have to file C corporation returns for 2021.

The section 304 consequences would become more complicated and less clear if either or both of Esco or Seeco had any E&P. Under section 1368, section 301-type distributions by an S corporation that exceed the adjusted balance of the AAA are treated as coming out of E&P and are thus taxable as dividend income. Distributions that exceed both the AAA balance and available E&P offset any unrecovered stock basis and, if basis is exhausted, give rise to capital gain for any excess (as if the stock had been sold). In the section 304 context, distributions that exceed the AAA and E&P of the acquiring corporation (Esco) will presumably be treated under section 1368(c) as dividends out of the issuing corporation’s (Seeco’s) E&P. However, Seeco’s AAA apparently would not be available to protect the shareholders from dividend treatment because Esco (not Seeco) is deemed to make the distributions.35

Case 26. Sale of S corporation loss stock to related corporation.

Jim and John each own 50 percent (50 shares) of the stock of Esco and Seeco, both of which are S corporations without any E&P. Jim sells all his Seeco shares (adjusted basis of $750,000) to Esco for $600,000 (Esco’s net asset value). The sale leaves Jim and John as 50-50 owners of Esco, and Esco and John as 50-50 owners of Seeco.

This transaction also enters the section 304 gateway because Jim has the requisite section 304(c) control of both Esco and Seeco at the time of the sale. Nonetheless, the hypothetical redemption of the Seeco stock would not be treated as a section 301 distribution because it is a substantially disproportionate distribution under section 302(b)(2) and therefore qualifies for exchange treatment under section 302(a). In this regard, section 304(a)(1) requires that the hypothetical redemption of the Esco stock be tested with reference to Jim’s before-and-after percentage interests in Seeco. Before the transaction, Jim directly owned 50 shares, or 50 percent, of the Seeco stock. After the transaction, he owned no Seeco shares directly but indirectly owned 25 shares under the section 318 constructive stock ownership rules because of his continuing 50 percent stock ownership in Esco (that is, 50 percent of the 50 shares of Seeco stock now owned by Esco). The deemed redemption distribution therefore should not be treated under section 302 as a dividend-type section 301 distribution (with the attendant section 1368 consequences) because Jim (1) owns less than 50 percent of Seeco after the deemed redemption; and (2) has reduced his percentage interest in Seeco by 50 percent (that is, from 50 percent to 25 percent), thus easily satisfying the 20 percent reduction threshold for “substantially disproportionate” treatment under section 302(b)(2).36 As a result, the transaction should be treated as a sale of Jim’s Seeco stock for $600,000 with full basis recovery (that is, a capital loss of $150,000). Loss recognition is not foreclosed in this situation by the related-party loss disallowance rules of section 267 because (under section 267(b)(2)) Jim’s exact 50 percent stock ownership in Esco falls below the “more than 50 percent” threshold for proscribed relationships between individuals and their corporations.

The sale of Jim’s 50 percent Seeco stock interest to Esco does not affect Esco’s S corporation status but does terminate Seeco’s S status because Seeco now has a corporate shareholder. Moreover, because Seeco is not wholly owned by an S corporation, it cannot qualify as a QSub and thus must be separately taxed as a C corporation. If John were to contribute his directly held Seeco stock to Esco in exchange for additional Esco stock in order to increase his percentage interest in Esco to at least 80 percent, that exchange would qualify for nonrecognition treatment under section 351, and Esco could then make a QSub election for Seeco (which it would then wholly own).

3. Sale of partnership/LLC interests.

When an S corporation sells an interest in an LLC or a partnership, the tax consequences will depend on whether the LLC is an SMLLC/disregarded entity, or the sale of a multimember LLC or partnership interest triggers ordinary income (under section 751) or causes a termination of the partnership for tax purposes (under section 708). Other scenarios may involve (1) asset sales by the LLC or partnership, followed by distributions (non-liquidating or liquidating) to the partners/members (including the S corporation); or (2) dispositions of S corporation stock to private equity funds. Cases 27-30, below, address these types of transactions.

Case 27. Sale of SMLLC interest.

Esco, an S corporation owned 50-50 by Jim and John, directly conducts Business A and also conducts Business B through an SMLLC that is treated as a disregarded entity for tax purposes. On June 30, 2020, Esco sells its entire interest in the SMLLC to Buyco, an unrelated C corporation, for cash consideration of $1.5 million. Buyco has several wholly owned corporate subsidiaries, which are members of the Buyco consolidated return group. At the time of the sale, the aggregate value and adjusted basis of the SMLLC assets are, respectively, $1.8 million and $1 million, and its outstanding liabilities are $300,000. After the sale, Buyco continues to conduct Business B through the SMLLC.

The tax treatment of this transaction is similar to a sale by an S corporation of all its stock in a QSub37: Esco is treated as selling all the SMLLC assets to Buyco in exchange for cash plus assumption of the SMLLC liabilities, and Buyco is treated as transferring the SMLLC assets and liabilities to New SMLLC which, absent a check-the-box election, is considered a disregarded entity of Buyco. The amount and character of gain or loss on the deemed asset sale is determined on an asset-by-asset basis (under section 1060) and passes through pro rata to the Esco shareholders. Buyco/New SMLLC takes a corresponding cost basis in the assets deemed purchased, which will now be treated for tax purposes as disregarded entity assets owned by Buyco.

Buyco could instead make a check-the-box election for New SMLLC, so that it would become a wholly owned C corporation subsidiary of the existing Buyco consolidated return group. Under that scenario, Buyco would be treated as having transferred the purchased assets and liabilities to the new subsidiary tax free in a section 351 transaction.38 Moreover, if Buyco were (or eligible to be) an S corporation, simultaneous check-the-box and QSub elections could be made for New SMLLC.39 In all these scenarios, New SMLLC’s momentary status as a C corporation (as a result of the check-the-box election) would be disregarded.40

If Esco instead sold only a portion of its SMLLC interest to Buyco, say 40 percent, the transaction would be treated as if (1) Esco sold an undivided 40 percent interest in the SMLLC assets to Buyco, and (2) Buyco and Esco then simultaneously transferred their respective 40 percent and 60 percent interests in the SMLLC assets to a new partnership in exchange for partnership interests.41 Esco would recognize gain or loss on the deemed sale of partial interests in the assets (ordinary or capital depending on the character of the assets), and the subsequent deemed asset transfers by Esco and Buyco would be tax free under section 721(a).42 Alternatively, Buyco could contribute cash to the SMLLC in exchange for a 40 percent interest. In this case, Esco is treated as contributing all the SMLLC assets to a new partnership in exchange for a 60 percent interest, with Buyco treated as contributing cash in exchange for a 40 percent interest. Under this structure, Esco would be protected by section 721(a) from recognizing any gain or loss.43

Case 28. Sale by S corporation of partnership/LLC interest.

Esco, an S corporation owned 50-50 by Jim and John, directly conducts Business A and has long owned a 40 percent interest in an LLC that conducts Business B (BLLC). An unrelated individual, Jack, owns 60 percent of the BLLC interests. On September 30, 2020, Esco sells its 40 percent member interest in BLLC, with a then-adjusted basis of $250,000, to Buyco for $750,000. Buyco and Jack thereafter continue to own and operate BLLC. Esco uses the entire sale proceeds for expansion of Business A.

Under section 741, the sale or exchange of a partnership interest results in a recognized capital gain or loss, except that a portion of the overall gain will be treated as ordinary when the partnership assets include specified hot assets (that is, inventory and unrealized receivables) described in section 751(a).44 Thus, Esco has a $500,000 gain from the sale of its BLLC interest, some of which may be treated as gain from the sale of a non-capital asset. This gain (including its character as capital or non-capital) will pass through separately to Jim and John, and will increase their Esco stock basis, irrespective of whether any portion of the sale proceeds is distributed by Esco to the shareholders.

If Esco instead owned and sold to Buyco a 60 percent interest in BLLC, with Jack continuing as a 40 percent partner, under prior law the sale would cause a termination of the LLC/partnership under section 708(b)(1)(B). However, the Tax Cuts and Jobs Act eliminated the termination rule in section 708(b)(1)(B), which now provides that a partnership terminates “only if no part of any business . . . of the partnerships continues to be carried on by any of its partners in a partnership.”45 Thus, because Buyco and Jack continue to own and operate BLLC, there will be no termination of the BLLC partnership.46

Assume that Esco instead sold its entire 40 percent BLLC interest to Jack. With only one remaining owner (Jack), the partnership status of BLLC for tax purposes would terminate because BLLC is no longer a partnership entity.47 Under a 1999 published revenue ruling,48 and consistent with a 1966 Tax Court decision,49 Esco would recognize a $500,000 passthrough gain from the sale of its partnership interest under section 741 (some possibly ordinary under section 751(a)), but Jack would be treated as having purchased 40 percent of the BLLC assets with a cost basis ($500,000). As a result of the termination of the partnership, BLLC would become an SMLLC/disregarded entity owned solely by Jack.

Case 29. Sale of assets by partnership/LLC.

The facts are the same as in Case 28, except that BLLC (1) sells all its assets (aggregate basis of $1.2 million) to Buyco for $2 million; (2) pays off outstanding liabilities of $400,000; and (3) distributes $640,000 to Esco and $960,000 to Jack in liquidation of their respective BLLC member interests. Esco uses $340,000 of the BLLC distribution to expand Business A and distributes the rest to Jim and John ($150,000 each). At the time of the BLLC assets sale, Esco had a $250,000 basis in its 40 percent BLLC interest, and Jim and John each had a basis of $250,000 in their respective Esco stock interests.

This fact pattern illustrates the interface between the subchapter S and subchapter K passthrough regimes when the lower-tier entity (an LLC) is completely liquidated. The $800,000 aggregate gain on the BLLC assets sale passes through 40 percent to Esco ($320,000) and 60 percent to Jack ($480,000)50 and correspondingly increases the basis of their respective BLLC member interests (under section 705(a)(1)(A)). Those basis amounts would be further adjusted downward by the member’s share of the paid-off BLLC liabilities — that is, by $160,000 for Esco and $290,000 for Jack (under section 752(b)). Taking these basis adjustments into account, Esco would recognize a gain on the liquidating distribution of $230,000 (under section 731(a)).51 That gain would correspondingly increase Jim’s and John’s respective Esco stock basis by their $115,000 share (from $250,000 to $365,000), and the stock basis would then be reduced (to $215,000) by the $150,000 distributions by Esco to each shareholder.

Case 30. Private equity acquisition.

Esco, an S corporation owned 50-50 by Jim and John, directly conducts Business A. A private equity fund (PEF) wants to purchase a controlling interest in Business A, with Jim and John retaining an equity interest. Before the PEF acquisition, the following restructuring transactions occur, all effective as of July 1, 2020: (1) Jim and John form a new corporation (Newco) to which they transfer their Esco stock in exchange for all the outstanding Newco stock; (2) an S election is made for Newco, and a QSub election is made for Esco (EscoQ); (3) on August 15, 2020, EscoQ converts into an SMLLC under a state law conversion procedure; and (4) SMLLC issues a 2 percent LLC interest to X, a key employee of Business A, thereby converting the SMLLC into a multi-member LLC/partnership (EscoLLC). After the restructuring, (1) Jim and John own 100 percent of Newco, an S corporation; (2) Newco and X own, respectively, 98 percent and 2 percent of the EscoLLC member interests; and (3) EscoLLC owns and operates Business A. On September 30, 2020, a newly formed C corporation subsidiary of PEF (Buyer) purchases 60 percent of the EscoLLC interests from Newco for cash.

This fact pattern reflects a transactional structure used in some taxable acquisitions of S corporations by private equity firms, under which the S corporation shareholders maintain a continuing (rollover) equity interest in the acquired business through a new passthrough entity, and the buyer gets a stepped-up basis in the acquired business assets. In a 2008 revenue ruling,52 the IRS concluded that these transactions should be viewed on an integrated basis as a tax-free reorganization under section 368(a)(1)(F), which accords nonrecognition treatment to “a mere change in identity, form, or place of organization of one corporation, however effected.”

The hallmark requirements of an F reorganization are that the reorganized corporation has the same shareholders and conducts the same business activities as the original corporation.53 These requirements are clearly met by creating a holding company structure for Esco.54 As a result, Newco succeeds to the tax attributes of Esco, including its status as an S corporation (which continues without need for a new election).55 The conversion of EscoQ into an SMLLC, both disregarded entities of Newco, is treated as a transaction by Newco with itself and therefore is a non-event for tax purposes.56 When X acquires his 2 percent interest in the SMLLC, that entity (now EscoLLC) becomes a partnership for tax purposes between Newco (98 percent) and X (2 percent), and that sets the stage for the PEF acquisition of a 60 percent interest in Esco LLC.57 As discussed in Case 27, PEF’s purchase of a 60 percent interest from Newco will be treated as a sale by Newco of a partial interest in a partnership.

B. Nontaxable Transactions

S corporations and their affiliated entities may also be involved in various types of nontaxable transactions. As previously discussed, these transactions often occur when nonrecognition treatment is accorded under section 351, 721, or 332 in connection with the formation and liquidation of affiliates, or the conversion of affiliates to or from disregarded entity status. Two other important nontaxable transactions involve (1) corporate reorganizations that qualify for nonrecognition treatment under section 368 and related subchapter C provisions and (2) corporate separations or divisions that qualify for nonrecognition treatment under section 355.

1. Acquisitive reorganizations.

When one corporation (Acquiring or P) acquires another corporation (Target or T) in a transaction that meets the definitional requirements of specific types of reorganization transactions described in section 368(a): (1) the T shareholders can receive P stock in exchange for their T stock tax free (under section 354(a)); (2) the basis of P stock received by the T shareholders will generally be same as the basis of the T stock exchanged (under section 358(a)); (3) the basis of T assets acquired by P in the transaction will generally be the same as their basis in the hands of T (under section 362); and (4) T and P will generally recognize no gain or loss from their participation in the transaction (under sections 361 and 1032, respectively). If the T shareholders also receive permitted non-stock consideration (boot) in the particular type of reorganization involved, some or all of the boot may be taxable as capital gain and/or ordinary income at the T and/or T shareholder levels (under the special rules in sections 361(c) and 356(a)). In addition to meeting the applicable statutory definitional requirements, acquisitive reorganizations must also satisfy some nonstatutory requirements articulated in the regulations, namely business purpose, continuity of proprietary interest (COI), and continuity of business enterprise (COBE).58

S corporations and their affiliates can be involved in either or both of the P or T sides of a qualifying acquisitive reorganization, with varying tax consequences. Cases 31–36 illustrate several transactional scenarios in this regard.

Case 31. Merger of S corporation (with QSub) into C corporation.

Esco, an S corporation owned 50-50 by Jim and John, has long operated Business A directly and Business B through a QSub (TQSub). On June 30, 2020, Esco merges into P, a publicly held company, through a state law statutory merger. Under the merger: (1) all the Esco assets and liabilities (including the TQSub stock) are transferred to P by operation of law; (2) Jim and John each surrender their Esco stock (with an adjusted basis of $300,000) in exchange for P stock (with an aggregate value of $1 million); and (3) Esco goes out of existence. After the merger, P operates Business A through a separate division and continues to own all the stock of TQSub, which continues to operate Business B and becomes a member of the P consolidated return group. At the time of the merger, Esco has no accumulated E&P, and P has accumulated E&P of $5 million.

This is a classic two-party statutory merger, which qualifies as a type A reorganization under section 368(a)(1)(A). No gain or loss is recognized by Jim or John on their receipt of P shares (under section 354(a)) or by Esco on its transfer of appreciated or depreciated assets to P incident to the merger (under section 361(a)).59 Thus, there is no passthrough gain from the merger to Jim and John. However, as a result of the merger, Esco’s existence and S corporation status end, as does the QSub status of TQSub, which no longer has an S corporation sole shareholder. The QSub termination is treated as a transfer of the QSub assets and liabilities by Esco to P, with P then contributing those assets without tax to a new wholly owned C corporation subsidiary through a deemed section 351 transaction.60

If Esco instead merged into a newly formed P subsidiary (PSub), with Jim and John receiving P stock, the transaction would still qualify for A reorganization treatment under section 368(a)(2)(D) (a forward triangular merger).61 PSub and TQSub would then survive as first-tier and second-tier wholly owned C corporation subsidiaries of P. Alternatively, if Esco merged into an SMLLC/disregarded entity of P, that too would be treated as a good two-party A reorganization as a statutory merger into P, the corporation in which the disregarded entity’s assets and liabilities are lodged for tax purposes.62

As a result of its S status being terminated in the merger, Esco would file a final Form 1120S return and issue Schedules K-1 to Jim and John for the short tax year that ended on June 30, 2020.63 This return would include income/loss generated by TQSub as a disregarded entity during the first six months of 2020. Jim and John’s adjusted basis in their Esco stock as of that date (taking into account the requisite section 1367 adjustments for income, gain, or loss items and distributions) would become their initial basis in the P stock received in the merger (under section 358(a)(1)). If Esco had any accumulated E&P from a prior C corporation existence or transactions with C corporations, P would inherit that E&P under section 381(a). Any AAA balance that Esco might have at the time of the merger would disappear,64 as would the need for tracking any BIG assets (because P would take a transferred basis in the assets, and section 1374 would not apply to assets sold by a C corporation subsidiary).

If instead of receiving solely P stock in the merger (worth $1 million) Jim and John received P stock worth $750,000 plus cash of $250,000 (that is, boot), the stock portion would still be nontaxable.65 However, under section 356(a)(1), the cash portion would be taxable to each shareholder to the extent of the lesser of the overall gain realized on the transaction ($700,000)66 or the boot received ($250,000). The character of the boot gain will be capital except to the extent, if any, that the exchange of Esco stock for P stock is treated as having “the effect of the distribution of a dividend” within the meaning of section 356(a)(2).

This “dividend within gain” boot determination is made applying the approach articulated in Clark,67 a 1989 Supreme Court decision. Specifically, P is treated as having hypothetically redeemed, for the amount of the boot (that is, $250,000), the additional shares of P that would have been received by the Esco shareholders had the merger consideration been solely P shares. The hypothetical redemption is then tested for dividend equivalency under the rules of section 302 by comparing the shareholder’s percentage interest in P before and after the hypothetical redemption. If there is a decrease in percentage interest that qualifies as substantially disproportionate (under section 302(b)(2)) or as not essentially equivalent to a dividend (under section 302(b)(1)), the entire boot gain will be taxed as capital gain. That is typically the result when, as here, T is much smaller than P (that is, a “whale swallows a minnow” scenario), even though the T shareholders receive only a very small minority stock interest in P.68

If the hypothetical redemption under the Clark construct does not pass muster under section 302, any dividend treatment is limited under section 356(a)(2) to the shareholder’s ratable share of any undistributed E&P of “the corporation.” There is conflicting authority whether this refers only to the target/acquired corporation or to the acquiring corporation as well.69 This issue takes on an added dimension when T is an S corporation that, as is often the case, has no accumulated E&P.70 In that situation, P’s E&P may also support dividend characterization.71

Case 32. Merger of S corporation (with QSub) into S corporation (with QSub).

The facts are the same as in Case 31, except P is also an S corporation that directly conducts Business A and indirectly conducts Business C through PQSub. On June 30, 2021, Esco merges into P, after which P continues to directly conduct Business A and own all the stock of PQSub (Business C) and TQSub (Business B). The values of businesses A, B, and C are approximately the same. Esco and P each have accumulated E&P and BIG assets. On October 1, 2021, P sells the stock of TQSub to an unrelated corporation.

This also is a good A reorganization, with no tax consequences to Esco, Jim, or John. Although Esco’s existence, and therefore its S status, terminates, the Esco assets and liabilities are transferred to another S corporation, which continues in existence, as do TQSub and PQSub. However, unless a new QSub election is made for TQSub, effective immediately after the merger, TQSub will become a C corporation subsidiary of P and cannot elect to restore QSub status for five years.72 Moreover, any AAA balance, accumulated E&P, or BIG assets that Esco has at the time of the merger would carry over and be combined with any of those items that P might have.73

If Esco instead merged into PQSub (a disregarded entity of P), the merger would be treated as a good two-party A reorganization between Esco and P.74 A new QSub election would have to be made for TQSub in that situation as well.75 This result would be consistent with the treatment of a T merger into an SMLLC/disregarded entity of P.76

The post-merger sale of TQSub should not jeopardize tax-free qualification of the transaction by reason of the COBE requirement. That requirement comes into play when, after the acquisition transaction, P does not continue a significant historic business of T or continue to use a significant portion of the historic business assets of T in a P business. COBE should not be a problem here if the sale was not planned or contemplated at the time of the merger. In any event, the continued T businesses (Business A and Business C) are, separately or together, surely significant.77

Likewise, if soon after the merger P were to liquidate TQSub or PQSub, or merge either QSub into the other, those transactions would be deemed to occur solely at the P level and thus be considered non-events for tax purposes. The same would hold if P were to contribute stock of either QSub to the other, thus creating a tiered QSub structure. For tax purposes, P would be treated as transferring disregarded entity assets to itself, and going forward, income, loss and other tax items generated by both QSubs would be attributed to P. In either instance, COBE would not be a concern because P would continue to own and operate both of Esco’s historic businesses.

Case 33. Merger of QSub into C corporation.

The facts are the same as in Case 31, except that Esco’s TQSub merges directly into P, with Esco receiving solely P stock and then distributing the P shares 50-50 to Jim and John in complete liquidation of their Esco stock interests. At the time of the merger, the respective gross asset values of Business A (Esco) and Business B (TQSub) are $1 million and $3 million, and Esco and TQSub have respective outstanding liabilities of $500,000 and $1 million.

This merger does not qualify as a good A reorganization because, as a disregarded entity, TQSub represents only part of Esco’s total assets, and the TQSub stock does not exist for tax purposes. A statutory merger cannot qualify as an A reorganization unless all of T’s assets and liabilities are transferred to the acquiring corporation. In some instances, however, a “flunked” A reorganization may still qualify for nonrecognition treatment as a type C reorganization under section 368(a)(1)(C). That provision requires that T transfer substantially all its assets to P for P voting stock and then completely liquidate.78 A limited amount of boot is permitted (20 percent), but if any actual boot is paid, any assumed liabilities (normally not boot under sections 357(a) and 368(a)(1)(C)) will count as tainted boot for purposes of the special 20 percent limitation.79

As noted earlier, the IRS considers the “substantially all” requirement to be met for advance ruling purposes if P acquires T assets representing at least 90 percent of T’s net asset value and 70 percent of gross asset value. However, published revenue rulings and case law support a more liberal interpretation focusing mainly on the nature of the assets transferred/retained (for example, operating assets versus cash/other liquid assets).80 In this case, 75 percent of the gross assets are transferred ($3 million of Esco’s total $4 million), and 80 percent of the net assets are transferred ($2 million out of Esco’s total $2.5 million). While these percentages only narrowly miss the advance ruling thresholds and are certainly substantial in an absolute sense, the fact that none of the operating assets of an entire, albeit considerably smaller, business are being transferred (Business A) could prove troublesome.81

If the “substantially all” requirement is met, the liquidation of Esco should qualify the transaction as a C reorganization and bestow nonrecognition treatment at both the corporate (Esco/TQSub) and shareholder (Jim and John) levels. But if the transaction is not a good C reorganization, onerous tax consequences would result: The transaction would be treated as a taxable sale by Esco of the TQSub assets, followed by a taxable liquidating distribution of the sale proceeds and the retained Business A assets.82 Both steps would trigger substantial passthrough gain to Jim and John. In either case, the S corporation status of Esco and the QSub status of TQSub would terminate.83

Case 34. S corporation (with QSub) stock exchanged for C corporation stock.

Instead of doing a statutory merger transaction with public company P, Jim and John exchange all their Esco stock for shares of P voting stock representing 5 percent of the total outstanding P stock. As a result of the transaction, Esco becomes a wholly owned subsidiary of P, and TQSub becomes a second-tier subsidiary of P (that is, a direct subsidiary of Esco).

Because the sole consideration for the exchange is voting stock of P, and P has more than the requisite section 368(c) control of Esco immediately after the exchange, the transaction qualifies as a good type B reorganization (under section 368(a)(1)(B)).84 As a result, (1) no gain or loss is recognized by Jim or John on the receipt of P shares; (2) Esco loses its S status and becomes a wholly owned first-tier C corporation subsidiary of P; and (3) TQSub becomes a new wholly owned C corporation subsidiary of Esco (New Sub) through a deemed section 351 transfer by Esco of TQSub’s disregarded entity assets. As wholly owned domestic subsidiaries, TQSub and Esco become members of an existing P consolidated return group.

A stock-for-stock exchange can also be carried out through a reverse triangular merger under section 368(a)(2)(E). In that type of reorganization, a transitory subsidiary of P (typically holding the stock or other merger consideration) merges into T under a statutory merger in which the T shareholders exchange T shares representing section 368(c) control of T for P voting stock. Unlike a B reorganization (which only permits consideration comprising solely P voting stock), up to 20 percent of the consideration in a section 368(a)(2)(E) merger can be cash or other boot property.85 As a result of the merger, the transitory subsidiary goes out of existence, and T becomes a wholly owned subsidiary of P, and after the merger T must continue to hold substantially all its assets for some unspecified period.86

In this case, like a straight B reorganization, a reverse merger of a P subsidiary into Esco would leave Esco as a P subsidiary, thus terminating its S status. It also would terminate the QSub status of TQSub, which would become a wholly owned second-tier C corporation subsidiary of P through a deemed section 351 transfer of the TQSub disregarded entity assets by Esco to New Sub.87 A post-merger disposition of Business B assets by New Sub could raise a “substantially all” issue under section 368(a)(2)(E), or possibly a COBE issue, particularly if done fairly soon after the merger and under a plan existing at the time of the merger.88

Under either the straight B reorganization or a section 368(a)(2)(E) construct, step transaction principles could come into play if P were to liquidate Esco upstream relatively soon after the transaction and under a preexisting plan (as opposed to unforeseen circumstances arising after the transaction).89 If respected as separate transactions, the stock-for-stock exchange would be a tax-free B reorganization, and the liquidation would also qualify for nonrecognition treatment under section 332, with the Esco assets (including the stock of New Sub/former TQSub) becoming housed in P with a transferred/carryover basis. However, under the rationale of Rev. Rul. 67-274, 1967-2 C.B. 141, the transaction might be recharacterized as a good C reorganization — that is, as a direct transfer by Esco of substantially all its assets and liabilities to P for P voting stock, followed by Esco distributing the P stock to Jim and John in complete liquidation of their Esco stock.90 But if for any reason the recharacterized transaction did not pass muster under section 368(a)(1)(C), the transaction would be taxable to Jim and John, and possibly Esco as well if any BIG assets were deemed transferred.

Case 35. S corporation (with QSub) stock exchanged for S corporation (with QSub) stock.

The facts are the same as in Case 34, except that P is an S corporation and has its own QSub (PQSub), which (like TQSub) conducts Business B. Jim and John exchange all their Esco stock for P voting stock, leaving Esco as a wholly owned P subsidiary and TQSub as a wholly owned Esco subsidiary. After the transaction, TQSub merges into PQSub, which continues as a wholly owned QSub of P.

This scenario also results in a good reorganization under both the straight B reorganization and section 368(a)(2)(E) constructs. As a wholly owned subsidiary of P (an ineligible corporate shareholder), Esco loses its S status, and TQSub loses its QSub status (because it no longer has a sole S corporation shareholder). However, if P immediately elects QSub status for Esco and TQSub, the momentary C corporation status of Esco and TQSub will be disregarded for tax purposes.91 Moreover, when TQSub merges into PQSub, TQSub will go out of existence, and that transaction will also be disregarded because it occurred between two disregarded entities of P. So when the smoke clears: (1) P continues as an S corporation with new eligible shareholders, Jim and John; (2) Esco becomes a QSub of P; (3) TQSub goes out of existence; and (4) the Business B assets, liabilities, and operations are combined into a single entity (PQSub) but treated for tax purposes as assets, liabilities, and operations of P. While a B reorganization is not a transaction described in section 381(a), the QSub elections for Esco and TQsub result in deemed section 332 liquidations (which are covered by section 381).92 Thus, any accumulated E&P, AAA balance, or BIG assets will be attributed to P.93

Case 36. All-cash acquisitive D reorganization.

Esco and P are both S corporations owned 50-50 by John and Jim. Esco transfers all its assets (including the stock of TQSub) to P in exchange for $1.5 million cash plus P’s assumption of all of Esco’s outstanding liabilities ($300,000). Esco then liquidates, distributing $750,000 each to John and Jim, who surrender their stock in Esco. At the time of the transaction: (1) the aggregate value and adjusted basis of the Esco assets (including the TQSub assets) was $1.8 million; (2) the TQSub assets included BIG assets acquired from a C corporation in a prior merger transaction, with an aggregate BIG of $300,000; (3) Esco had accumulated E&P of $900,000 and an AAA balance of $300,000; and (4) Jim and John each had an adjusted basis of $150,000 in their Esco stock. After the transaction, TQSub continued in existence as a wholly owned subsidiary of P.

On its face, this transaction appears to be simply a taxable sale of assets followed by a taxable liquidation of the selling corporation. However, under the rationale of a long-standing published revenue ruling94 and Treasury regulations finalized in 2009,95 the transaction qualifies as an all-cash type D reorganization under the definitional boundaries of section 368(a)(1)(D). Under that provision, an acquisitive D reorganization results when T transfers substantially all its assets to P and, under the plan of reorganization, liquidates, distributing P stock received in the transaction and any other T assets to the T shareholders in cancellation of their T shares. Further, immediately after the transaction, the former T shareholders must be in section 304(c) control of P.96 When the shareholders of T hold identical percentage interests in P, an actual issuance of additional P shares in exchange for the T assets would be a “meaningless gesture” and therefore is not required.97 Under section 361(c), the cash paid by P to T for the transferred assets constitutes “other property” but is not taxable boot to T because it is distributed to the T shareholders under the plan of reorganization. Under section 356(a), the cash is taxable as boot to the T shareholders to the extent of their realized gain on the overall transaction, and the recognized boot gain may be taxed as capital gain or dividend income (under the dividend-within-gain boot rule of section 356(a)(2)), determined under the hypothetical redemption approach adopted by the Supreme Court in Clark.98

On the Case 36 facts, all the Esco assets and liabilities (including those attributable to TQSub) are transferred to P (thus satisfying the “substantially all” requirement),99 and there would be no need to issue additional P shares because Jim and John already owned, and continue to own, 50 percent of P after the transaction. Jim and John each have a realized gain of $600,000 from the transaction — the excess of the $750,000 cash received from Esco over their $150,000 adjusted stock basis in Esco. Because the realized gain ($600,000) is less than the amount of boot distributed ($750,000), the taxable amount of boot for each shareholder is limited to $600,000. Under the Clark analysis (which involved C corporations), that amount would likely be taxed as a dividend to the extent of Esco’s accumulated E&P (and, at least under some case law, any accumulated E&P that P might have as well).100

So when the smoke clears: (1) Esco will go out of existence; (2) the transfer of the Esco assets to P in exchange for cash will not trigger a corporate-level taxable gain that passes through to Jim and John; (3) Jim and John will each be taxed on receipt of the cash boot at the 20 percent uniform rate (plus the 3.8 percent surtax on NII), whether characterized as capital gain or dividend income; (4) P will take a transferred or carryover basis in the Esco assets (under section 362);101 (5) P will retain its status as an S corporation; and (6) TQSub will become a QSub of P.102

Finally, it should be noted that the Case 36 transaction is literally described as well by section 304(a)(1), because Jim and John together own 100 percent of Esco and P and will transfer the Esco shares to P in exchange for property (that is, cash). If section 304 were to apply, the hypothetical redemption of P stock would not qualify for exchange/capital gain treatment under section 302 because Jim and John would continue to own 100 percent of Esco (constructively) after the transaction. Thus, the entire $750,000 “sale” consideration received by each would be taxed as a dividend first to the extent of Esco accumulated E&P and then to the extent of any P E&P.103 This is a worse result than the $600,000 dividend that would result if the transaction were instead taxed as an all-cash D reorganization.104 A 2004 revenue ruling105 instructs that D reorganization boot treatment trumps section 304 treatment in those circumstances.

2. Section 355 transactions.

If all the statutory and nonstatutory requirements of section 355 are satisfied, a corporation (Distributing) can distribute the stock of an 80-percent-or-more-controlled subsidiary (Controlled) without tax at either the shareholder or corporate level. A qualifying section 355 distribution can take the form of (1) a pro rata distribution to all Distributing shareholders, without any surrender of their Distributing shares (commonly known as a spinoff); (2) a distribution to some Distributing shareholders in redemption of some or all of their Distributing shares (a split-off); or (3) a distribution to all Distributing shareholders in complete liquidation of their stock interests in Distributing (a split-up). Absent section 355, these distributions would be taxable to the shareholders as dividends (to the extent of E&P), redemption exchanges (under section 302), or complete liquidations (under section 331 or 332), and they also would trigger a taxable gain to Distributing (under section 311 or 336) for the excess of the then value of the distributed Controlled stock over Distributing’s basis in that stock. Thus, section 355 provides a major exception to General Utilities repeal in that Distributing can distribute appreciated property (the Controlled stock) without triggering a corporate-level gain.

In some instances, Distributing has an existing subsidiary that can be separated tax free under section 355 without the need for any preliminary transactions. Many section 355 distributions, however, are preceded by a transfer of cash or other property by Distributing to Controlled and are considered part of a divisive D reorganization under section 368(a)(1)(D). As a result, under section 361(a), no gain or loss is recognized to Distributing on the pre-distribution transfer of property having a value in excess of basis. In contrast to an acquisitive D reorganization (which requires a transfer of substantially all the transferor corporation’s assets),106 any quantum of assets can be transferred tax free in a divisive D reorganization (that is, ranging from isolated assets to a collection of assets comprising an entire active trade or business (ATB)).

The core statutory requirements for section 355 qualification are that (1) Distributing must distribute stock of Controlled constituting section 368(c) control;107 (2) Distributing and Controlled must each be engaged, immediately after the distribution, in an ATB that has the requisite five-year history;108 and (3) the distribution cannot be used as a device to avoid the taxation of dividend income.109 Nonstatutory requirements include a demonstrated non-federal-tax corporate business purpose for separating Controlled on a stand-alone basis,110 as well as satisfying the somewhat ambiguous COI111 and continuity of business (COB) conditions.112 In addition, under section 355(d) and (e), a change of 50 percent or more in the stock ownership of Distributing or Controlled during the five-year period before, or the four-year period starting two years before and ending two years after, an otherwise qualifying section 355 distribution can trigger a corporate-level tax to Distributing.113

S corporations can, and often do, engage in section 355 transactions that involve corporate and noncorporate affiliates. Cases 37-41, below, explore some of these scenarios.

Case 37. Spinoff of C corporation subsidiary.

Esco, owned 50-50 by Jim and John, has been an S corporation since its inception in 2010, directly conducting a chain of golf driving ranges at various locations in Illinois. On March 1, 2018, Esco purchased for cash all the stock of Driveco, a C corporation that had for many years owned and operated driving ranges in Colorado, where Jim had a second home that he frequently visited. A section 338(h)(10) election was not made in connection with the Driveco acquisition, nor did Esco make a QSub election for Driveco. The Driveco operations were managed by Tom, a long-time employee who informed Jim and John that he was willing to keep working for Driveco only if he could obtain a stock interest in that company. On July 1, 2018, Esco distributed the Driveco stock 50-50 to Jim and John. The next day Tom purchased from Driveco for cash newly issued stock representing 10 percent of the total outstanding shares of Driveco (that is, reducing the percentage interest of John and Jim in Driveco to 45 percent each). A valid S election was thereafter made for Driveco effective January 1, 2019. Driveco had substantial accumulated E&P at the beginning of, and substantial current E&P during, 2018.

The Driveco spinoff should be viewed as meeting all the qualification requirements for nonrecognition treatment under section 355. Because 100 percent of the Driveco stock was distributed, the “distribution of control” requirement (that is, section 368(c) control) is clearly satisfied. Providing a meaningful equity interest to a key employee of Distributing or Controlled is often recognized by the IRS as an acceptable section 355 business purpose regardless of whether the employee threatens to leave.114 Here, although Tom’s 10 percent stock interest in Driveco is a relatively small minority position, it is still meaningful, not only because of his significant personal economic outlay for the interest, but also because he essentially holds a tiebreaker interest if the remaining equal shareholders, Jim and John, should disagree on an important corporate decision.115 Tom would not hold that leverage if he were to instead acquire the 10 percent interest in Driveco without a spinoff, because Esco would then own the remaining 90 percent and Tom would have no real say in any corporate decision. Moreover, although the post-spin S election for Driveco may be viewed as a federal tax purpose, examples in the section 355 business purpose regulations make clear that the more dominant nontax key employee purpose should carry the day, especially when Esco, the distributing corporation, is an S corporation.116

Pro rata spinoff distributions that would otherwise constitute taxable section 301 dividend distributions are generally viewed suspiciously from a device perspective. The fact that Esco has no E&P to support dividend treatment is not helpful because Driveco did have substantial E&P.117 In any case, the section 355 device regulations provide that a strong corporate business purpose can override evidence of device.118 Further, most device scenarios involve post-distribution sales of Distributing or Controlled stock by one or more of their shareholders, thus facilitating a conversion or “bailout” of potential dividend income into capital gain.119 Apart from the fact that, as a technical matter, S corporations generally do not have E&P and therefore do not pay dividends,120 a capital gain bailout clearly was not achieved by Esco’s nontaxable issuance of new shares to Tom.121

The ATB requirement should also be satisfied here, although the technical analysis is somewhat more complicated because Esco acquired the Driveco stock in a taxable transaction during the five-year period preceding the spin, and that transaction is specially treated under the so-called separate affiliated group rules of section 355(b)(3). Both Esco and Driveco have to be engaged in a five-year ATB immediately after the spinoff distribution. That clearly was so for Esco, which had continuously conducted its driving range business for more than five years. Although Driveco had also conducted the Colorado driving ranges for more than five years, section 355(b)(2)(D) appears to present a serious roadblock. Under that provision, the ATB requirement cannot be satisfied when, during the five-year pre-distribution period, Distributing acquires an 80 percent or more controlling stock interest in Controlled in a taxable (or partially taxable) transaction. While Esco’s acquisition of the Driveco stock was such a transaction, it is not necessarily fatal from an ATB perspective because of the “separate affiliated group” rules of section 355(b)(3), which ignore intercompany stock ownership and treat a group of affiliated corporations (for example, Esco and Driveco) as a single entity and pool of assets in determining whether a qualifying five-year ATB exists somewhere within the group. Consistent with this fictional treatment, proposed ATB regulations (issued in 2007) call off the application of section 355(b)(2)(D) in situations involving taxable stock acquisitions during the five-year pre-distribution period.122 Instead, they require that the transaction be tested as an asset acquisition under section 355(b)(2)(C), which similarly taints taxable acquisitions of the assets of an ATB within the five-year pre-distribution period unless the acquisition merely expands an existing five-year ATB (rather than adding a new line of business).123 This business expansion exception should clearly apply here because the acquisition of Driveco served simply to add additional locations to Esco’s existing (for more than five years) driving range business.124

Because this is a qualifying section 355 distribution, Jim and John will not be taxed on their receipt of Driveco stock, and each will allocate part of his existing Esco stock basis to his Driveco shares based on relative FMVs.125 However, the corporate-level nonrecognition treatment usually available in section 355 transactions presumably would not be available here because Esco’s “purchase” of more than 50 percent of the Driveco stock during the five-year pre-distribution period would trigger a corporate-level gain under section 355(d).126 The regulations provide several exceptions to section 355(d), including for transactions that do not violate the purposes of section 355(d) and for scenarios in which any purchased basis is eliminated such that the distribution does not involve disqualified stock.127 The transaction in Case 37 does not fall within any of these exceptions.

The spinoff will not affect the S corporation status of Esco. Driveco will file as a C corporation for all of 2018 and will begin filing as an S corporation in 2019. Driveco’s conversion from C to S corporation status will not be a taxable event but will result in the new S corporation inheriting Driveco’s accumulated E&P and any BIG assets having potential section 1374 exposure.

Case 38. Split-off of QSub.

The facts are the same as in Case 37, except that Esco instead acquired the Driveco stock on March 1, 2014, and then made a valid QSub election for Driveco effective as of that same date. Tom continues to work for Driveco at an enhanced salary, but without receiving an equity interest in either Driveco or Esco. In the fall of 2019 Jim tells John that he plans to soon move permanently to Colorado and would like, with Tom’s help, to now concentrate his work solely on the management, operation, and expansion of the Colorado driving range business. John is amenable to taking over full ownership and responsibility for the Esco (Illinois) driving ranges and having no continuing ownership interest in the Colorado ranges. The parties agree that the total value of Esco is $3.5 million, of which $1.5 million is attributable to Driveco. On December 1, 2019, to equalize the values of Driveco and Esco, Esco contributes $250,000 cash to Driveco, and on December 31, 2019, distributes the Driveco stock to Jim in redemption of his 50 percent stock interest in Esco. On January 31, 2020, Jim makes an S election for Driveco.

This is a classic section 355 split-off situation, in which shareholders of a closely held corporation decide, whether amicably or not, to go their separate ways with one or more of the distributing corporation’s active businesses. The IRS generally views these transactions as embodying a valid corporate business purpose, despite the existence of personal motivations on the part of the shareholders as well.128 Under a safe harbor provision in the section 355 regulations, there is ordinarily no device concern in these transactions if, absent section 355, the redemption would have qualified for exchange/capital gain treatment as a redemption under section 302(a) and therefore does not facilitate dividend avoidance.129 Moreover, because the Driveco stock was acquired more than five years before the split-off distribution, the ATB restrictions of section 355(b)(2)(C) or (D) do not apply, and there is no need to invoke the business expansion exception or the separate affiliated group rules. Thus, the ATB requirement should be satisfied so long as Esco and Driveco each continue to independently operate their respective driving range businesses with their own employees.

There are some technical wrinkles concerning Driveco’s pre-split status as a QSub. The threshold statutory requirement under section 355 is that Distributing have and distribute an 80 percent or more controlling stock interest in another “corporation” (which refers to a C corporation). As a QSub, Driveco was a disregarded entity of Esco and for tax purposes, Driveco’s stock was ignored and all the Driveco assets and liabilities were treated as residing in Esco. The distribution of the Driveco stock to Jim terminated Driveco’s QSub status because it was no longer wholly owned by an S corporation. As a result of the termination, the Driveco disregarded entity assets and liabilities deemed held by Esco were all deemed to be transferred into to new C corporation (New Driveco) as part of a divisive D reorganization that culminated in the section 355 distribution of the New Driveco stock (that is, stock of a C corporation) to Jim. The deemed transfer of assets and liabilities to New Driveco did not cause Esco to recognize gain or loss (under sections 361(a) and 357(a)). Moreover, Esco’s momentary ownership of the New Driveco stock (that is, immediately after the first leg of the divisive D reorganization) should not prevent Jim from electing S status for New Driveco as of its inception, even though it momentarily had an ineligible corporate shareholder (Esco) just before the section 355 distribution.130

Finally, it should be noted that when Esco originally elected QSub status for Driveco (then a C corporation) in 2014, that triggered a deemed section 332 liquidation of Driveco into Esco, resulting in Esco’s inheritance (under section 381(a)(1)) of any BIG assets or accumulated E&P that Driveco might then have had. By the time of the split-off, the five-year period for triggering section 1374 tax on the disposition of any such BIG assets would have expired.131 However, part of any inherited E&P that Esco may still have at the time of the split-off would be allocated between Esco and New Driveco in the divisive D reorganization.132 Accordingly, at the beginning of its life as an S corporation, New Driveco would have accumulated E&P and therefore potential exposure to passive income taxation under section 1375 or to dividend taxation under the AAA rules of section 1368.

Case 39. ATB in partnership/LLC.

Esco, an S corporation owned 50-50 by Jim and John, has directly conducted Business A since 2017. Esco also owns (1) since 2013, 90 percent of the outstanding stock of Subco, a C corporation engaged in Business B; and (2) since 2010, a 40 percent interest in XYZ, an LLC engaged in Business C. The remaining Subco stock (10 percent) is owned by Bill, and 60 percent of the XYZ member interests are owned by numerous individuals. The Business C operations are carried out by XYZ employees. Jim and John sit on the XYZ governing board. On June 30, 2019, for valid corporate business reasons, Esco distributed its Subco stock to Jim and John, leaving each with a 45 percent interest and Bill with a 10 percent interest. On July 1, 2019, Jim, John, and Bill consented to a valid S election for Subco.

This situation relates to the ability of Distributing or Controlled to satisfy the section 355 ATB requirement by relying on its interest in a partnership or LLC that owns and operates an active business. Long-standing published rulings set forth specific administrative benchmarks in this regard that later were incorporated in the 2007 proposed ATB regulations.133 In short, a 20 percent partnership interest will suffice if the corporate partner (through its officers and/or employees) performs “active and substantial management functions” for the partnership business, and a one-third interest will pass muster even though no such management functions are performed by the corporate partner.

On the Case 39 facts, Esco distributed all the Subco stock to Jim and John, and Subco (Controlled) conducted a qualifying five-year ATB (Business B) immediately after the distribution. Esco (Distributing) must also conduct a qualifying ATB immediately after the spin. It cannot rely on Business A for that purpose because that business is less than five years old. It can, however, rely on the XYZ business because its 40 percent LLC interest meets the one-third administrative benchmark with room to spare. Even if Esco’s XYZ interest were below one-third, say 25 percent, it might also meet the 20 percent administrative test based on Jim’s and John’s XYZ board participation. However, if Business C had a history of less than five years in XYZ’s hands, Esco’s percentage interest, no matter how high, would not satisfy the ATB requirement, and the spinoff would therefore be taxable at both the shareholder and Esco levels. That same double-whammy result would hold if any of the other statutory or nonstatutory requirements for section 355 treatment were not met.

As a result of the spinoff, Subco would become a separate S corporation. Its final C corporation return would be filed for the short tax year ended June 30, 2019, and 90 percent of any dividends paid by Subco to Esco on or before that date would pass through as taxable dividend income to Jim and John. The conversion of Subco from C to S corporation status would not be a taxable event, but Subco would inherit any accumulated E&P or BIG assets that Subco might have.

Case 40. Cash-rich split-off.

Esco, an S corporation owned 40 percent by each of Jim and John, and 20 percent by Tom, has directly conducted Business A since 2005. Business A now has assets worth $1.5 million and liabilities of $300,000. A QSub of Esco has owned and operated Business B since 2010. Business B now has assets worth $300,000 and liabilities of $50,000. Esco’s remaining assets include (1) excess cash of $150,000; (2) a portfolio of investment securities with an aggregate current value of $500,000; (3) a 40 percent stock interest in Vendco, a supplier to businesses A and B, worth $600,000; and (4) a 10 percent limited partner interest in a partnership (RE LP) that develops and owns rental real estate properties, worth $250,000. To permit Tom to go his separate way with Business B (leaving Business A in Esco), Esco proposes to buy out Tom by distributing the QSub stock to him in redemption of his 20 percent Esco stock interest, which the parties agree is worth $650,000. Before the distribution, Esco will contribute to QSub (1) $130,000 cash; (2) an 8 percent stock interest in Vendco (worth $120,000); (3) a 2 percent interest in RE LP (worth $50,000); and (4) portfolio securities worth $100,000. After the redemption distribution of the QSub stock, Jim and John will each own 50 percent of the Esco stock, and Tom will be the sole shareholder of, and make an S election for, QSub.

This fact pattern implicates section 355(g), enacted in 2005 to thwart so-called cash-rich split-off transactions. It was prompted by high-profile public company transactions involving pre-split transfers into Controlled of substantial amounts of cash and/or investment-type assets having an aggregate value much higher than the value of Controlled’s qualifying ATB.134 The IRS National Office initially ruled favorably on these transactions. In doing so, it presumably was comfortable that there was no device to bail out E&P because, absent section 355, the redemption would have been taxed under section 302 as capital gain, and further, because the IRS had historically blessed section 355 transactions in which a qualifying ATB represented 5 percent or less of the value of Distributing’s or Controlled’s total assets.135 Section 355(g) sets forth objective statutory hurdles that, if not cleared, prevent the transaction from qualifying under section 355, even though the device, active business, and all other qualification requirements are satisfied. It can apply in both public company and closely held contexts, including split-offs by S corporations.

Section 355(g) prevents section 355 nonrecognition treatment when, immediately after the distribution of the Controlled stock, (1) either Distributing or Controlled is a disqualified investment corporation and (2) any person who held a less-than-50-percent stock interest (by vote or value) in the disqualified investment corporation immediately before the transaction holds a 50-percent-or-greater interest immediately after.136 Distributing or Controlled will constitute a disqualified investment corporation if “investment assets” (as defined by section 355(g)(2)(B)(i)) represent at least two-thirds of the aggregate FMV of all its assets. The section 318 constructive stock ownership rules apply in determining the relevant before-and-after stock ownership percentages.137 Moreover, in determining whether investment assets breach the two-thirds threshold, special look-through rules apply for some corporate stock and partnership interests. If Distributing or Controlled owns a 20 percent or greater stock interest in another corporation, or a partnership interest that would permit reliance on the partnership’s business for purposes of the ATB requirement (as discussed in Case 39, above), it is treated as directly owning its ratable portion of the assets (including any investment assets) owned by the corporate or partnership affiliate. If the look-through rule does not apply, the full value of the corporate stock interest or partnership interest is considered a single tainted investment asset in applying the section 355(g) percentage tests.138

On the Case 40 facts, QSub becomes a C corporation (QSubC) because, after the distribution, it is no longer wholly owned by an S corporation. Thus, under section 1361(b)(3)(C)(i), QSubC is treated as receiving its Business B assets and liabilities from Esco (the holder of those disregarded entity assets and liabilities). Further, Esco actually transfers cash, portfolio securities, and the Vendco and RE LP interests to QSubC. As part of a divisive D reorganization/section 355 transaction, these deemed and actual downstream transfers by Esco are accorded nonrecognition treatment under section 361(a).

QSubC is not a disqualified investment corporation. In that regard, the aggregate value of its investment assets is $400,000 — including $130,000 cash, $100,000 portfolio securities, $120,000 Vendco stock (no look through because it has a less than 20 percent interest), and $50,000 RE LP interest (no look through because it does not meet 20 percent or one-third administrative benchmarks). QSubC’s total asset value (including Business B) is $700,000. Thus, the investment assets represent approximately 57 percent of its total asset value (that is, the two-thirds threshold is not breached).139 Accordingly, section 355(g) should not preclude the transaction from qualifying under section 355.

Even though QSubC should escape the reach of section 355(g), its substantial complement of investment assets could carry exposure under the passive income rules of section 1375. Thus, if (1) in any tax year more than 25 percent of an S corporation’s gross receipts are attributable to passive investment income (for example, dividends, interest, or gains from the sale of stock or securities) and (2) the S corporation has any accumulated E&P at the end of that year (even only $1), the excess above the 25 percent threshold will be taxed at the corporate level.140 More drastically, if this situation continues for three consecutive years, the S status will be terminated.141 If Esco had any accumulated E&P at the time of the split-off (for example, from a prior C corporation existence or inherited in a merger with a C corporation) and any part of that E&P were allocable to QSubC under applicable Treasury regulations,142 QSubC would have potential section 1375 exposure from its inception. Likewise, corporate-level tax exposure could arise under section 1374 if Esco transferred any BIG assets to QSubC in the divisive D reorganization or BIG assets were later acquired by QSubC from a C corporation in a transferred-basis nonrecognition transaction (under section 1374(d)(8)).

Case 41. Successive spins.

Esco, an S corporation with 10 equal shareholders, conducts Business 1 directly and Business 2 through Sub 1. Esco owns 90 percent of the sole class of outstanding Sub 1 stock. U, an unrelated investor, owns 10 percent of the Sub 1 stock. Sub 1 conducts Business 2 in several East Coast states and owns all the outstanding stock of Sub 2, which conducts Business 2 at East Coast locations. Sub 1 and Sub 2 file a consolidated return. On June 30, 2021, Sub 1 distributes Sub 2 to Esco (internal spin), and two weeks later, Esco distributes Sub 2 pro rata to the Esco shareholders (external spin). On March 1, 2022, Esco merges into a publicly traded corporation (Pubco), with the Esco shareholders receiving Pubco stock representing 10 percent of the total outstanding Pubco shares (the Pubco merger). At the time of the internal spin and external spin, the value of the distributed Sub 2 stock was $3.5 million. At the time of the internal spin, Sub 1’s basis in the S2 stock was $1.5 million, Esco’s basis in the Sub 1 stock was $1.5 million, and the Sub 1 stock was worth $4 million.

Viewed separately, each of the internal spin and external spin can qualify for nonrecognition treatment under section 355, even though carried out under an overall plan, provided they meet all the section 355 statutory and nonstatutory qualification requirements.143 However, the ultimate tax treatment of the spins will depend on whether the Pubco acquisition is part of a plan that included the external spin, thus bringing section 355(e) and (f) into play.

If a section 355(e) plan did not exist — for example, because Pubco and Esco had had no pre-spin discussions or other communications regarding an acquisition144 — then, under section 355, both spins would result in (1) tax-free treatment to Esco and the Esco shareholders on their receipt of the Sub 2 stock under the internal spin and external spin; and (2) tax-free treatment to Sub 1 and Esco on their distributions of the Sub 2 stock in both spins. Esco’s basis in the Sub 2 shares received in the internal spin would be determined under section 358 by allocating the existing basis of its Sub 1 shares between the Sub 1 and Sub 2 shares in accordance with the relative FMVs of those shares. This would leave Esco with a Sub 2 stock basis of $700,000 immediately after the internal spin.145 When the Sub 2 stock was then distributed to the Esco shareholders (under the external spin), the shareholders would similarly allocate the existing basis of their Esco shares. The Sub 2 asset basis would not change as a result of either spin.

The results would be significantly different, however, if the Pubco merger triggered the application of section 355(e) and (f). Section 355(e) comes into play in the first instance only if (1) all section 355 requirements are met; and (2) during the four-year period spanning two years before and two years after the spinoff, stock representing 50 percent or more (in vote or value) of the Distributing or Controlled stock was acquired through an acquisition or series of related acquisitions (taxable or nontaxable) that are part of a plan including the distribution.146

Under section 355(e)(3)(B), the Pubco merger would be treated as an acquisition by the Pubco shareholders of 90 percent of the Esco stock, thus clearly surpassing the 50 percent change-in-ownership threshold. Whether a proscribed plan exists is determined under the regulations, which contain several safe harbors and otherwise require an overall facts and circumstances evaluation.147

When section 355(e) applies, the otherwise qualifying spinoff is still tax free to the Distributing shareholders, but nonrecognition treatment is not available to Distributing — it will recognize taxable gain as if it had sold the distributed Controlled stock for its FMV. Distributing normally will have a lower historic tax basis in the distributed Controlled stock, but not when, as in this case, the external spin is preceded by an intragroup spin, which triggers section 355(f).148 Under that provision, section 355 nonrecognition treatment is not available for the internal spin (by Sub 1 of Sub 2 to Esco). Instead, the value of the Sub 2 stock distributed to Esco is treated as a section 301 dividend distribution (assuming adequate E&P in Sub 1), which passes through as taxable income to the Esco shareholders.149 Moreover, the distribution of Sub 2 to Esco generates section 311(b) gain to Sub 1 in an amount equal to the excess of the value of the distributed Sub 2 stock over Sub 1’s basis in that stock.150 Esco will take an FMV basis in the distributed Sub 2 stock, with the result that the immediate redistribution of that stock to the Esco shareholders under the external spin should not generate any further corporate-level gain despite the application of section 355(e).

V. Conclusion

S corporations are certainly familiar creatures in the business world. Despite the TCJA’s substantial reduction of the tax rate on C corporation income, they remain a popular entity choice for tax purposes because of their passthrough single-tax nature, the section 199A deduction, and their having generally less complexity than the subchapter K passthrough regime for partnerships and LLCs. Future changes to the code could, of course, enhance or reduce the appeal of S corporations as an entity choice. In any event, S corporations can take on a chameleon-like quality and become more complicated tax animals when, as is often the case, they conduct some or all of their activities through corporate and/or noncorporate affiliated entities.

As illustrated by the numerous fact patterns discussed in this report, transactions between S corporation affiliates and their S corporation equity owners or outside parties often have collateral tax implications governed by provisions of subchapter C or K, or by the rules regarding disregarded entities. Some of these potential tax implications may be identifiable early on when the choice of entity decision is being made and particular affiliate structures are being considered. Others, however, will come to light only when particular transactions involving affiliates first appear on the radar screen. In either context, tax advisers must carefully analyze all tax consequences that could arise from proposed affiliate transactions or activities — especially their effect on stock basis and the triggering of corporate-level tax on BIGs or excess passive income under section 1374 or 1375. If necessary and feasible, alternative transactional structures should be considered to eliminate or significantly reduce possible tax exposures while still enabling the client to accomplish the desired business objectives in an acceptable manner.

FOOTNOTES

1 Herbert N. Beller, “S Corporations as Shareholders, LLC Members, and Partners,” Tax Notes Federal, Sept. 13, p. 1713.

2 If an S corporation sells stock in a C corporation that has been held since original issuance for more than five years and otherwise meets the definitional requirements of qualified small business stock under section 1202, the gain on the sale can be excluded from gross income (up to $10 million), and the exclusion can, subject to some conditions, pass through pro rata to the S corporation shareholders. Any possibility of using this extremely favorable provision should, of course, be carefully explored in connection with any planned sale of C corporation stock by an S corporation. See Emily L. Foster, “Lucrative Capital Gains Exclusion Rule Is a Hot Topic Again,”  Tax Notes Federal, Sept. 13, 2021, p.  1814.

3 Stock acquisitions through nonrecognition transactions or from specified related parties do not qualify as QSPs. See section 338(d)(3) and (h)(3). The section 338(h)(10) election is available only when both parties to the transaction are corporations. See section 338(h)(10); reg. section 1.338(h)(10)-1(c)(1); and infra Case 17.

4 The residual method applies to taxable acquisitions of assets that comprise a trade or business of the seller (as described in reg. section 1.1060-1(b)(2)). As detailed in reg. section 1.338-6(b), it delineates seven classes of assets, including cash, marketable securities, inventories, depreciable and non-depreciable assets, section 197 intangibles, and goodwill/going concern value. The sale consideration (including assumed liabilities) is allocated first, to any acquired cash (Class I); second, to the FMV of the acquired Class II through Class VI assets; and third, if there is any remaining consideration (including any premium), to goodwill and going concern value (Class VII).

5 By contrast, a sale of S corporation stock with a section 338(h)(10) election will trigger passthrough gain or loss to the shareholders on the deemed asset sales and possibly on the deemed section 331 liquidation of the S corporation as well. See infra Case 21. A sale of S corporation stock with a “regular” section 338 election (under section 338(a) and (g)) would shift the tax liability on the deemed asset sale to the buyer but is generally not economically feasible because the present value of the down-the-road tax savings from the stepped-up asset basis (i.e., higher depreciation and/or lower gain on sale) normally will be less than the upfront tax liability from the deemed asset sale.

6 A qualified stock disposition has the same 80 percent control, 12-month period, and related-party definitional elements as a QSP, but it also includes any combination of sales, exchanges, or distributions of T stock to multiple and/or noncorporate purchasers or distributees. See reg. section 1.336-1(b)(5)(i), (6), and (7).

7 See reg. section 1.336-2(b)(1) and (k), examples 1 and 5.

8 See H.R. Rep. No. 97-760, at 536 (Aug. 17, 1982) (Conf. Rep.). Section 338 was enacted to replace the judicial Kimbell-Diamond doctrine, under which a purchase of stock followed by liquidation of the purchased corporation could be treated as a purchase of assets, and the subsequent codification of that doctrine in specific circumstances described in old section 334(b)(2). See Kimbell-Diamond Milling Co. v. Commissioner, 14 T.C. 74 (1950), aff’d, 187 F.2d 718 (5th Cir. 1951); and former section 334(b)(2) (1954 code).

9 If the consideration for the Subco assets consisted entirely or partly of notes or other obligations eligible for installment sale treatment under section 453, the distribution of the installment obligations to Esco in the section 332 liquidation would not constitute a taxable disposition of the unpaid obligations (because section 337(a) accords nonrecognition treatment to the liquidated corporation in a section 332 liquidation). See section 453B(d). When and as Esco receives payments on the installment obligations, the remaining installment sale gain will be triggered and pass through to Jim and John.

11 Section 1361(b)(3)(C)(ii).

12 (40 percent * $2.25 million) - (40 percent * $500,000) = $700,000.

13 Section 357(c) gain is calculated transferor by transferor. See Rev. Rul. 66-142, 1966-1 C.B. 66. In the deemed section 351 transaction, Esco transfers assets with an aggregate basis of $300,000 (60 percent * $500,000) and liabilities of $450,000 (60 percent * $750,000), thus triggering a $150,000 section 357(c) passthrough gain to the Esco shareholders. Pubco transfers assets with an aggregate basis of $900,000 ($600,000 stock purchase price + 40 percent * $750,000 share of assumed liabilities) and is only transferring liabilities of $300,000 (40 percent * $750,000). Section 357(c) gain will not result from that leg of the transaction.

14 See reg. section 1.1361-5(b)(3), Example 1.

15 Esco is deemed to transfer Old QSub assets with an aggregate basis of $500,000 and a liability of $750,000, thus resulting in $250,000 of section 357(c) gain.

16 Thus, Jim and John both have an adjusted Esco stock basis at the time of sale of $1,125,000 ($1 million plus $125,000 section 357(c) gain) and a long-term capital gain of $1.5 million ($2,625,000 sale proceeds less $1,125,000 basis).

17 Reg. section 1.338(h)(10)-1(c).

18 See reg. section 1.338(h)(10)-1(d)(4) and (5). This is an exception to the typical section 338(h)(10) circumstances in which the target company is a subsidiary of a corporate affiliated group, and the deemed asset sale is followed by a deemed section 332 liquidation of the target. In any (h)(10) transaction, the actual sale of the target stock is ignored for tax purposes, i.e., only the deemed asset sale is taxed.

19 Section 338(f); reg. section 1.338(h)(10)-1(d)(3)(ii); and reg. section 1.338(h)(10)-3(b)(4) (acquisition of tiered target corporations).

20 Reg. section 1.338(h)(10)-1(d)(3)(i).

21 A final Form 1120S return would be filed for the portion of the tax year ending on the date of the liquidation. See section 1362(d) and (e) and reg. section 1.1362-3(a). Instead of liquidating, Esco could remain in existence as an S corporation and acquire or develop a new business.

22 Assume that Esco instead received part of the sale consideration through a non-tradable Pubco promissory note payable in equal annual installments over five years. In that scenario, part of the gains from the asset sales would be deferred under the installment sale rules of section 453 (unless Esco chose to elect out of that provision). The liquidating distribution of the note would not trigger the unrealized installment gain to Esco (or Jim and John) by reason of section 453B(h), and shareholder-level recognition of any section 331 gain attributable to the value of the distributed note would be postponed until payments on the note were received. See section 453(h). Because the distribution of the note will not be a recognition event for Esco (assuming no section 1374 or 1375 implications), there will be no passthrough gain to the shareholders regarding the note and thus no basis increase for them. See section 453B(h) (flush language).

23 See reg. section 1.1367-1(f) (ordering rules for basis adjustments under section 1367).

24 Note that losses decrease basis after all income items and distributions are taken into account. Reg. section 1.1367-1(f)(4).

25 Each had a beginning-of-year stock basis of $400,000 that during 2020 was increased by (1) an $875,000 share of QSub sale gain and (2) a $500,000 share of Business A operating income, and decreased by (3) $1.1 million ($750,000 + $350,000) total cash distributions, leaving each with an Esco stock basis of $675,000 going into 2021.

26 Section 304(c) control requires actual or constructive (under a modified version of the section 318 attribution rules) ownership of stock having at least 50 percent of the voting power or at least 50 percent of the value of all outstanding shares.

27 Under section 318(a)(2)(C), a shareholder who owns 50 percent or more in value of the stock of another corporation is treated as constructively owning an equal percentage of stock owned by the other corporation. In applying section 302 to a hypothetical redemption of stock under section 304, the 50 percent threshold for attributing stock ownership from a corporation is called off — i.e., even a 1 percent shareholder of Corp. X would be attributed 1 percent of the stock of another corporation owned by Corp. X. See section 304(b)(1) (last sentence).

28 Because of their constructive ownership of Seeco, they would not have (1) a complete termination of interest under section 302(b)(3) (section 302(c) waiver of constructive stock ownership through a corporation is not permitted); (2) a substantially disproportionate redemption under section 302(b)(2); or (3) a meaningful reduction in proportionate interest required to satisfy the “not essentially equivalent to a dividend” test under section 302(b)(1).

29 See section 304(b)(2).

30 See Beller, supra note 1, at Section II.D.

31 See section 304(a)(1) (in a hypothetical section 351 transaction deemed to occur before the hypothetical redemption, Jim and John take section 358(a) substituted basis in Esco stock deemed received in deemed section 351 exchange); and Martin J. McMahon Jr. and Daniel L. Simmons, “When Subchapter S Meets Subchapter C,” 67 Tax Law. 231, 268-269 and 272-273 (2014).

32 Seeco’s E&P is not taken into account because the shareholders have sufficient basis to cover the distribution under section 1368(b). Further, the $700,000 distribution in 2019 to each of Jim and John will not reduce basis because Seeco had sufficient E&P ($1.5 million current E&P + $750,000 accumulated E&P = $1.25 million) for the entire distribution to be characterized as a dividend under section 301(c)(1). Although section 304 consequences are generally adverse to the taxpayer, the statute’s literal application here operates to avoid dividend treatment under the “basis recovery first” rule of section 1368(b).

33 $750,000 accumulated E&P + $1.5 million current E&P - $1.4 million 2019 distributions = $850,000.

34 Section 1362(b)(1)(B); see also reg. section 1.1361-4(b)(3)(ii), reg. section 1.1361-5(c)(2); and LTR 200229025.

35 For additional discussion of the interaction between sections 304 and 1368, see McMahon and Simmons, supra note 31, at 269-273 (providing several examples); and James S. Eustice, Joel D. Kuntz, and John A. Bodganski, Federal Income Taxation of S Corporations, para. 13.06[8][d][i] and [ii] (2021).

36 Section 302(b)(2) is satisfied if the redeemed shareholder’s post-redemption percentage ownership of the corporation’s voting and common stock is less than 80 percent of the pre-redemption percentage and its post-redemption ownership of the corporation’s voting power is less than 50 percent.

37 See supra Case 19.

38 See reg. section 301.7701-3(g)(1)(iv) and (2)(i).

39 See reg. section 301.7701-3(a) and (b)(1); and reg. section 1.1361-2(d), Example 2.

40 See reg. section 1.1361-4(b)(3)(ii).

41 See Rev. Rul. 99-5, 1999-1 C.B. 434, Situation 1.

42 See id. There will be no section 704(c) consequences here because Esco recognized gain or loss on the deemed sale, thus eliminating any built-in gain or loss on Esco’s share of the assets it is deemed to contribute to the new partnership. The deemed sale would be for $720,000 ($600,000 + $120,000 liability assumption by Buyco). Esco’s gain recognition would be $320,000 ($720,000 - ($1 million basis * 40 percent)) under section 1001(a). Esco would hold its 60 percent interest in the new partnership with a $600,000 basis and $900,000 net value ($1,080,000 less $180,000 share of liabilities).

43 There would, however, be section 704(c) consequences, because built-in gain or loss on the SMLLC assets would need to be allocated to Esco, the contributing partner. See Rev. Rul. 99-5, Situation 2. Esco’s reduction in its share of the $300,000 liability would also decrease basis. See section 752(b). And if the SMLLC held a QSub as an asset, the addition of Buyco as a member/partner would cause the QSub status to terminate and cause the formation of a new C corporation. See ILM 201326014.

44 Under a 1997 amendment to section 751(a), all inventory items are now considered hot assets (not just “substantially appreciated” inventory items). See Taxpayer Relief Act of 1997, section 1062(a).

45 Section 708(b)(1), as amended by TCJA section 13504(a).

46 Under prior law, BLLC would be treated as having terminated and contributed all its assets and liabilities to a new partnership (New BLLC) in exchange for New BLLC partnership member interests, which would be deemed distributed to Jack and Buyco.

47 See reg. section 1.708-1(b)(1).

48 Rev. Rul. 99-6, 1999-1 C.B. 432, Situation 1; and reg. section 1.741-1(b).

49 McCaulsen v. Commissioner, 45 T.C. 588 (1966).

50 The passthrough is on an asset-by-asset basis, with each passthrough item (gain or loss) retaining the same character (capital or ordinary). See sections 702, 703(a), 705, and 1060; and reg. section 1.1060-1(a)(1) and (b)(1).

51 $640,000 distribution less adjusted stock basis of $410,000 (i.e., $250,000 + $320,000 - $160,000). The gain would be considered a liquidating distribution governed by sections 731(a), 732(b), and 751(b) (although sections 732(b) and 751(b) would not come into play here because BLLC is distributing only cash).

52 Rev. Rul. 2008-18, 2008-1 C.B. 674, at 674–676.

53 See reg. section 1.368-2(m) (requirements for F reorganization); see also Rev. Rul. 66-284 (nonparticipation in merger of shareholders owning less than 1 percent stock interest considered de minimis and not fatal to qualification as F reorganization).

54 The legislative history indicates that the “of one corporation” limitation in section 368(a)(1)(F) “does not preclude the use of more than one entity to consummate the transaction provided only one operating company is involved.” H.R. Rep. No. 97-760, at 541; see also reg. section 1.368-2(m)(1) and (3).

55 See Rev. Rul. 2008-18, 2008-1 C.B. at 675-676; and Rev. Rul. 64-250, 1964-2 C.B. 333.

56 Depending on how soon the LLC conversion takes place after the stock transfer to Newco, it may be integrated into the overall F reorganization, thereby making a QSub election unnecessary. See Kevin Anderson and Randy Schwartzman, “’F’ Reorganization Under Rev. Rul. 2008-18: Timing of QSub Election Is Key,” BDO, at 4 (Oct. 2017). However, if significant time passes between the two transactions, it is critical that a valid QSub election be timely made for EscoQ. See id. and LTR 201724013.

57 See Anderson and Schwartzman, supra note 56, at 3-5. The TCJA targeted PEF interests by extending the holding period for some “applicable partnership interest[s]” to three years for long-term capital gain treatment. TCJA section 13309(a) (adding new section 1061).

58 See reg. section 1.368-1(b), (d), and (e).

59 Because all the merger consideration is P stock and T’s historic business will be continued by P, the non-statutory COI and COBE requirements are both satisfied. See reg. section 1.368-1(d)-(e).

60 Section 1361(b)(3)(C); reg. section 1.1361-5(b)(3), Example 9; and reg. section 1.368-2(b)(1)(iii), Example 3. See also Joint Committee on Taxation, “Technical Explanation of the ‘Small Business and Work Opportunity Tax Act of 2007’ and Pension Related Provisions Contained in H.R. 2206 as Considered by the House of Representatives on May 24, 2007,” JCX-29-07, at 24-25 (2007) (new section 1361(b)(3)(C)(ii) “not intended to change the present-law treatment of the disposition of stock of a [QSub] by an S corporation in connection with an otherwise non-taxable transaction”); and Robert M. Kane Jr., “QSub Dispositions: Example 9 and Nonrecognition Transactions,” Tax Notes Federal, Jan. 27, 2020, p. 567.

61 In a section 368(a)(2)(D) merger, the P subsidiary must acquire substantially all the T assets, and the merger consideration cannot include stock of the acquiring P subsidiary. Prior dispositions of T assets as part of the plan of reorganization will count against the applicable “substantially all” threshold (90 percent of net asset/70 percent gross asset value for advance ruling purposes). Rev. Proc. 77-37, 1977-2 C.B. 568, section 3.01, as amplified by Rev. Proc. 86-42, 1986-2 C.B. 722, section 7.05(3). However, published rulings and case law endorse lower/more flexible thresholds. See, e.g., Rev. Rul. 57-518, 1957-2 C.B. 253 (focus on “the nature of the properties retained by the transferor, the purpose of the retention, and the amount thereof”); and Pillar Rock Packing Co. v. Commissioner, 90 F.2d 949 (9th Cir. 1937) (retained assets to pay creditors instead of distributing to shareholders).

62 Reg. section 1.368-2(b)(1)(iii), examples 2 and 3.

63 Section 1362(d)(2) and (e).

64 The post-termination transition period (PTTP) rules will apply here such that distributions during the PTTP are tax free to Jim and John to the extent of the AAA, and Jim and John can use their previously suspended losses to the extent of basis. See sections 1366(d)(3), 1371(e), and 1377(b)(1); and reg. sections 1.1366-2(b)(1) and 1.1377-2(b). The extended PTTP rules, as amended by the TCJA, do not apply here because Esco is not an eligible terminated S corporation, as defined in section 481(d). See TCJA section 13543 (amending sections 481(d) and 1371(f)); and reg. section 1.481-5(b).

65 In a two-party A reorganization, boot constituting up to as much as 60 percent of the merger consideration is generally acceptable by the IRS for COI purposes. See reg. section 1.368-1(e)(2)(v), Example 1. The same boot maximum applies to forward triangular mergers under section 368(a)(2)(D).

66 $750,000 value of P stock + $250,000 boot - $300,000 Esco stock basis = $700,000.

67 Clark v. Commissioner, 489 U.S. 726 (1989); see also Rev. Rul. 93-61, 1993-2 C.B. 118, revoking Rev. Rul. 75-83, 1975-1 C.B. 112 (IRS adopting post-reorganization redemption test). All the taxable boot is taxed to the T shareholders. Boot received (or deemed received) by T avoids corporate-level tax if distributed to T shareholders or used to pay off T creditors. Section 361(a) and (c).

68 See, e.g., Rev. Rul. 76-385, 1976-2 C.B. 92 (reduction of shareholder’s interest from 0.0001118 percent to 0.0001081 percent, or a 3.3 percent reduction, qualified as a good section 302(b)(1) redemption under the “meaningful reduction” in interest standard announced by the Supreme Court in United States v. Davis, 397 U.S. 301 (1970)).

69 Compare Davant v. Commissioner, 366 F.2d 874, 889-890 (5th Cir. 1966) (P E&P available to extent of purchase price), with Atlas Tool Co. v. Commissioner, 614 F.2d 860, 867-868 (3d Cir. 1980) (T E&P only), and American Manufacturing Co. v. Commissioner, 55 T.C. 204, 229-231 (1970) (T E&P only).

70 The interface between sections 356(a)(2) (“dividend within gain” rule for reorganization boot) and 1368 (S corporation distributions) is unclear. See William M. Richardson and Samuel P. Starr, “Task Force Report on Taxable and Tax-Free Acquisitions Involving S Corporations,” 45 Tax Law. 435, 458-460 (1992).

71 It follows logically and economically that under a post-reorganization test, both Target and Acquiring E&P should be available, but Clark left open the question of whose E&P may support the deemed dividend under section 356(a)(2). See Francis A. Muracca, “Boot Distributions and Assumption of Liabilities,” 782 Tax Mgmt. Port. (BNA), at IV.C.6.

72 Reg. section 1.1361-5(c)(2) and (3), Example 2 (commissioner consent not required if the QSub election is made effective immediately); see also Rev. Rul. 2004-85, 2004-2 C.B. 189, Situation 2; and section 1361(b)(3)(D).

73 Reg. sections 1.381(c)(2)-1(a) (combination of E&P in transaction to which section 381(a) applies), 1.1368-2(d)(2) (Target’s and Acquirer’s AAAs will merge), and 1.1374-8(c) (BIG assets will be in separate pools); see also Announcement 86-128, 1986-51 IRB 22 (transferee S corporation recognition period for BIG assets acquired in nonrecognition transaction from other S corporation was reduced by the portion of the recognition period of the transferor S corporation that had expired before transfer). Jim and John will also carry over any suspended losses they may have and can use them in the first tax year in which they have sufficient stock basis. Reg. section 1.1366-2(c)(1) (any disallowed loss is treated as incurred by acquiring S corporation for the shareholder with the suspended loss). The PTTP rules will not apply here because Esco’s assets are acquired by another S corporation; thus, no PTTP arises. See reg. section 1.1377-2(b).

74 See reg. section 1.368-2(b)(1)(i),(ii), and (iii), Example 3.

75 See reg. section 1.1361-5(b)(3), Example 9, and (c)(2).

76 See supra Case 31. Further, because P is an S corporation and PQSub is a disregarded entity of P, the same suspended loss and PTTP rules discussed above will apply. See supra note 73.

77 See reg. section 1.368-1(d)(1) and (5), Example 1 (sale of two of three equally valued former T businesses six months after acquisitions does not violate COBE).

78 Section 368(a)(2)(G) (liquidation requirement; permitted waiver authority by Treasury rarely exercised).

79 See section 368(a)(2)(B). In Case 33 there is no actual boot, so the assumed Esco/TQSub liabilities ($1.5 million total) do not affect C reorganization qualification. But even one penny of cash boot would cause a breach of the 20 percent limitation. Here P would be assuming $1 million in liabilities, which constitutes one-third of the FMV of the property transferred. Thus, the assumed liabilities far exceed the 20 percent threshold, and any amount of actual boot would preclude qualification under section 368(a)(1)(C).

80 See supra note 61.

81 Authorities analyzing the substantially all requirement often focus on the type of assets retained, distinguishing operating assets (which need to be transferred) from liquid or surplus cash (which can be retained, depending on the facts of the case). See, e.g., Smothers v. United States, 642 F.2d 894, 896, 900-901 (5th Cir. 1981) (necessary operating assets transferred met test, even though transfer did not involve tangible assets and represented only 15 percent of net value); Pillar Rock, 90 F.2d at 950-951 (retaining assets in the form of receivable fails substantially all requirement); Rev. Rul. 88-48, 1988-1 C.B. 117 (sale of assets followed by C reorganization involving the transfer of a distinct business is sufficient); and Rev. Rul. 57-518 (nature of assets transferred is critical).

82 See Rev. Rul. 69-6, 1969-1 C.B. 104 (failed acquisitive reorganization recharacterized as taxable section 1001 disposition of T assets for P stock distributed to T shareholders in taxable section 331 liquidation); cf. Rev. Rul. 67-274, 1967-2 C.B. 141 (acquisition of T stock through purported B reorganization, followed by upstream section 332 liquidation of T into P, is tested as a C reorganization).

83 The same tax consequences described for Case 32 should attach if Business B were conducted by an Esco SMLLC that merged into P.

84 Absolutely no boot is permitted in a B reorganization. The acquisition consideration must be solely P voting stock. There is no minimum percentage of the outstanding P stock that must be received by the T shareholders in the exchange.

85 See section 368(a)(2)(E)(ii) (requiring former shareholders to exchange an amount of stock in T constituting section 368(c) control, thus permitting up to 20 percent boot).

86 Also, if the merger subsidiary of P held any assets before the transaction, T must continue to hold substantially all “the properties of the merged corporation” as well. Section 368(a)(2)(E)(i). See also Rev. Proc. 86-42, 1986-2 C.B. at 724.

87 See Rev. Rul. 67-448, 1967-2 C.B. 144 (reverse triangular merger characterized as B reorganization (before enactment of section 368(a)(2)(E))).

88 The hold element of the section 368(a)(2)(E) substantially all requirement implies that even without a plan at the time of the reorganization, most of the former Esco (and any QSub) assets should be retained for some indefinite period. But see Rev. Rul. 2001-25, 2001-1 C.B. 1291 (use of term “hold” instead of “acquire” reflects awkwardness of requiring T to acquire its own property; section 368(a)(2)(E) does not impose any additional requirement before or after merger that would not apply had the transaction been a C reorganization or forward triangular merger).

89 See reg. section 1.368-2(k)(1)(ii)(C).

90 However, if the transaction takes the form of a reverse triangular merger followed by a liquidation of T into P, this may be characterized as a taxable QSP under section 338(d)(3) followed by a section 332 liquidation and will be taxable to the parties. Compare Rev. Rul. 2008-25, 2008-1 C.B. 986 (liquidation of T into P following wholly owned P subsidiary merger into T treated as QSP), and Rev. Rul. 90-95, 1990-2 C.B. 67 (cash merger of T into P following P wholly owned subsidiary merger into T treated as QSP and section 332 liquidation regardless of whether section 338 election made), with Rev. Rul. 2001-46, 2001-2 C.B. 321 (merger of wholly owned P subsidiary into T, flunked section 368(a)(2)(E) (more than 20 percent cash), followed by T merger into P; treated as two-party A reorganization of T into P).

91 See reg. section 1.1361-4(b)(3)(ii) and -5(c)(2); see also supra cases 27 and 31.

92 See reg. section 1.1361-4(b)(2) (order of liquidations for QSub elections of tiered subsidiary group).

93 See supra Case 32; and notes 73 and 76.

94 Rev. Rul. 70-240, 1970-1 C.B. 81.

95 Reg. section 1.368-2(l)(2)(i) and (3), Example 1, finalized in T.D. 9475; see also reg. section 1.1361-4(a)(2)(ii), Example 3.

96 See section 368(a)(2)(H)(i).

97 See reg. section 1.368-2(l)(2)(i); Wilson v. Commissioner, 46 T.C. 334, 344 (1966); and James Armour Inc. v. Commissioner, 43 T.C. 295, 307 (1964) (interpreting 1939 code predecessor of section 368(a)(1)(D)).

98 See supra notes 67-71.

99 See section 354(b)(1).

100 See supra notes 69-71. Because Esco and P are S corporations, the rules of section 1368 should govern the treatment of the distribution, although there is uncertainty in this area. See supra note 70; and McMahon and Simmons, supra note 31, at 296-298. Also, because Esco’s assets are “acquired” by an S corporation, no PTTP will arise and suspended losses will carry over. See supra Case 32 and notes 73 and 76.

101 Note that P will not increase its basis in the Esco assets under section 362(a) by gain recognized by Jim and John because Esco was the transferor, not Jim or John.

102 P will need to make a new QSub election for TQSub. See reg. section 1.1361-4(b)(3)(ii).

103 Esco and P are S corporations, so section 1368 will govern the treatment of the deemed dividend. The first $300,000 will be protected by Esco’s AAA, resulting in $150,000 basis recovery for Jim and John and $150,000 capital gain under section 1368(b) and (c)(1). The remaining $450,000 is a dividend under section 1368(c)(2), depleting Esco’s $900,000 accumulated E&P.

104 In which case, the shareholders would only have a $300,000 dividend under section 1368(c)(2).

105 Rev. Rul. 2004-83, 2004-2 C.B. 157. Thus, the critical differences in tax consequences are that (1) the amount of the deemed dividend is $150,000 more ($450,000 versus $300,000), and (2) the tax attribute inheritance rules of section 381(a) would not apply to the transaction if section 304(a) controlled. See supra cases 24 and 25.

106 See section 354(b)(1)(A) (substantially all requirement for acquisitive D reorganizations and bankruptcy reorganizations under section 368(a)(1)(G)).

107 Section 355(a)(1)(A) and (D); section 368(c); and Rev. Rul. 59-259, 1959-2 C.B. 115, at 116.

108 Section 355(b). The active business does not have to have been owned by Distributing or Controlled throughout the five-year pre-distribution period; but it cannot have been acquired by Distributing or Controlled during that period in a taxable or partially taxable transaction. See section 355(b)(2)(C) and (D).

109 Section 355(a)(1)(B). Device issues are most commonly triggered by sales of significant blocks of Distributing or Controlled stock fairly soon after the distribution. The original concern in this regard was using section 355 to facilitate a capital gain bailout for distributions that otherwise would have been taxed as dividends (before 2003, at usually much higher ordinary rates and without any basis offset). Despite the current uniform rate for qualified dividends and capital gains, the IRS still views the device concern to be justified by the ability to achieve basis recovery and the potential use of capital losses to offset capital gains from a post-section-355 distribution stock sale. See reg. section 1.355-2(d)(1) and (2)(iii).

110 See reg. section 1.355-2(b). The key element of the business purpose requirement is that the asserted purpose could not otherwise be feasibly accomplished on a nontaxable basis without separating Controlled as a stand-alone corporation. A non-exhaustive list of several corporate business purposes that the IRS has found acceptable for advance ruling purposes is set forth in Appendix A to Rev. Proc. 96-30, 1996-1 C.B. 696.

111 See reg. section 1.355-2(c)(1). Under the section 355 COI requirement, historic shareholders of Distributing must continue collectively, and for some indefinite period, to directly or indirectly own a substantial stock interest in Distributing and Controlled. Examples in the regulations indicate that a 50 percent continuing interest is sufficient, whereas a 20 percent interest is not. Reg. section 1.355-2(c)(2), examples 2 and 4. In contrast, the COI requirement for acquisitive reorganization purposes will generally be satisfied by the target shareholders’ receipt of at least 40 percent stock consideration in the transaction, but with no requirement of post-acquisition continuity. See reg. section 1.368-1(e)(1)(i) and (v), Example 1.

112 The section 355 COB requirement is articulated by the regulations as follows: “Section 355 contemplates the continued operation of the business or businesses existing prior to the separation.” Reg. section 1.355-1(b). The relevance for section 355 COB purposes of the “historic business,” “historic business assets,” and other concepts of the section 368 COBE regulations is uncertain, as is the precise relationship between the COB requirement and the section 355 ATB requirement (which requires conduct of a qualifying active business “immediately after” the section 355 distribution). See Beller, “Section 355 Revisited: Time for a Major Overhaul?” 72 Tax Law. 131, 177-179 (2018).

113 Section 355(d) and (e) come into play only if all qualification requirements for section 355 nonrecognition treatment at the shareholder level are met. Corporate-level tax is triggered by section 355(d) if 50 percent or more of the stock of Distributing or Controlled is acquired by purchase during the five-year pre-distribution period. Section 355(e) triggers corporate-level tax by the acquisition of 50 percent or more of the stock of Distributing or Controlled during the four-year period spanning the distribution (two years before to two years after), but only if those acquisitions (whether taxable or nontaxable) are linked to the spinoff as part of a plan. See reg. section 1.355-7 (plan and non-plan factors and safe harbors). There is no plan requirement under section 355(d); thus, if both section 355(d) and (e) apply, section 355(d) controls. Section 355(e)(2)(D).

114 See reg. section 1.355-2(b)(5), Example 8; and Rev. Proc. 96-30, section 2.01(1), App. A.

115 Rev. Rul. 69-460, 1969-2 C.B. 51, situations 2 and 3 (5 percent interests to key employees meets business purpose requirement); LTR 199940013 (valid business purpose to increase key employee ownership to 16.5 percent); LTR 9311022 (valid business purpose when providing key employee with 20 percent interest and remaining 80 percent is held equally by four other shareholders); and LTR 9011033 (valid business purpose when four key employees acquire 5 percent equity interests in a transaction involving S corporations).

116 Reg. section 1.355-2(b)(5), examples 6 and 7; see also Rev. Proc. 96-30, at App. C.

117 Any E&P of either Distributing or Controlled is relevant to the device inquiry. See reg. section 1.355-2(d)(2)(ii) and (5)(ii).

118 Reg. section 1.355-3(d)(3)(ii).

119 See reg. section 1.355-2(d)(2)(iii) (subsequent sale or exchange of stock is evidence of device; substantial evidence if prearranged or negotiated).

120 An S corporation can have E&P from a prior life as a C corporation or inheritance from a C corporation through a merger, section 332 liquidation, or other nonrecognition transaction described in section 381(a).

121 Section 1032(a) (no gain or loss recognized to corporation from issuance of its own stock); cf. reg. section 1.355-2(d)(4), Example 1 (key employee purpose did not override device when Distributing could have issued shares to key employee instead of Distributing shareholders selling some of their shares to key employee).

122 Prop. reg. section 1.355-3(b)(4)(iv)(F).

123 Reg. section 1.355-3(b)(3)(ii) (acquisition of another business in the same line of business is ordinarily treated as an expansion of the original business, all of which is treated as having been actively conducted during the five-year period, unless the acquisition “effects a change of such a character as to constitute a new or different business”); and prop. reg. section 1.355-3(b)(3)(ii) (same in the separate affiliated group context).

124 See reg. section 1.355-3(c), Example 8 (ATB requirement met when hardware store expands to new state and spins off business in new state); Rev. Rul. 2003-18, 2003-1 C.B. 467 (ATB requirement met when new automobile brand added to existing car dealership business); and Rev. Rul. 2003-38, 2003-1 C.B. 811 (ATB requirement met when online sales component added to existing brick-and-mortar business).

125 See section 358(b) and (c); and reg. section 1.358-2(a)(2)(iv).

126 The taxable gain would equal the excess of the value of the distributed Driveco shares over Esco’s basis in those shares and would pass through to Jim and John and increase their Esco stock basis. No gain would pass through to Tom because he is not an Esco shareholder. The basis of the Driveco assets would not be affected by the section 355(d) gain. Although the regulations provide some exceptions for avoiding the internal application of section 355(d), postponing the section 355 distribution for at least five years after the disqualifying stock purchase(s) (if feasible) is surely the safest course.

127 See reg. section 1.355-6(b)(2)(iii) and (3). A distribution does not violate the purposes of section 355(d) when the effect of the distribution is neither to increase the ownership of a disqualified person nor to give a disqualified person a purchased basis in the stock of Controlled. Reg. section 1.355-6(b)(3).

128 See reg. section 1.355-2(b)(5), Example 2; and Rev. Rul. 2003-52, 2003-1 C.B. 960 (split-off by closely held family corporation permitted shareholders to pursue their own “business direction” vision, in addition to promoting family harmony and furthering estate planning objectives for the older generation).

129 Reg. section 1.355-2(d)(5)(iv). The safe harbor does not require filing of a section 302(c) stock attribution waiver in complete termination of interest contexts. It extends as well to split-off redemptions that are made to fund “death” taxes and estate administration expenses and would have qualified for section 302(a) exchange treatment under the special rules of section 303. See reg. section 1.355-2(d)(5)(iii).

130 See, e.g., LTR 201949013 and LTR 201851004. See also Rev. Rul. 72-320, 1972-1 C.B. 270 (Distributing’s momentary ownership of Controlled stock did not terminate Distributing’s S election under prior-law prohibition against S corporation controlling stock ownership of a C corporation).

131 The 10-year section 1374 waiting period was permanently reduced to five years in 2015. See Protecting Americans From Tax Hikes Act of 2015, Division Q of the Consolidated Appropriations Act, 2016, Title I, pt. 3, section 127(a).

132 See reg. section 1.312-10(a). If neither Esco nor Driveco has any C corporation E&P, that circumstance would ordinarily preclude any device concern (even if for some reason the section 302 safe harbor were unavailable). See reg. section 1.355-2(d)(5)(ii).

133 See Rev. Rul. 92-17, 1992-1 C.B. 142; Rev. Rul. 2002-49, 2002-2 C.B. 288; Rev. Rul. 2007-42, 2007-2 C.B. 44; and prop. reg. section 1.355-3(b)(2)(v) and (d)(2), examples 22 and 23.

134 See, e.g., Jasper L. Cummings, Jr., “Spinning, Acquiring, and Disposing,” Tax Notes, Jan. 1, 2018, p. 101 (citing examples of high-profile public company transactions that prompted section 355(g)).

135 See Rev. Proc. 96-43, 1996-2 C.B. 330 (permitted an even less than 5 percent ATB if overall facts and circumstances warranted). Proposed regulations dictate 5 percent as the absolute minimum threshold, with no possibility of exceptions. Prop. reg. section 1.355-9(b); REG-134016-15, 81 F.R. 46004 (July 15, 2016).

136 Section 355(g)(1).

137 Section 355(g)(3)(B).

138 The statutory list of investment assets includes “any interest in a partnership.” Section 355(g)(2)(B)(i)(III). The IRS has issued proposed regulations on the device requirement that use a similar two-thirds threshold calculation based on nonbusiness assets compared with business assets to determine if there is a per se device. See prop. reg. section 1.355-2(d)(2). The IRS has indicated that the term “nonbusiness assets” has a different meaning from investment assets, as defined in section 355(g); however, the interaction between the proposed regulations and section 355(g) is unclear. See preamble to REG-134016-15, 81 F.R. at 46009-46010; see also Beller, supra note 112, at 154–156.

139 $400,000/$700,000 = 57 percent.

140 Section 1375(a).

141 Section 1362(b)(3).

142 See reg. section 1.312-10(a).

143 See Rev. Rul. 62-138, 1962-2 C.B. 95.

144 See reg. section 1.355-7(b)(2) (so-called super safe harbor).

145 equation Thus, Esco would have a basis of $800,000 in its Sub 1 stock ($1,500,000 - $700,000).

146 Section 355(e)(2).

147 See reg. section 1.355-7. On the instant facts, for example, a plan would certainly exist if, at the time of the external spin, the parties had already agreed to or undertaken substantial negotiations toward the Pubco merger or another proposed acquisition transaction with Pubco on different terms (e.g., a cash purchase of the Esco stock). See reg. section 1.355-7(b)(3)(i). On the other hand, if Pubco, and Esco had had no pre-spin discussions or other communications regarding a possible acquisition transaction, the Pubco merger likely would not be included in the internal spin or external spin as part of a plan. See reg. section 1.355-7(b)(2) and (j), Example 3 (no plan even if Esco had reason to expect that Pubco or some other company might seek to acquire it soon after the external spin).

148 Although Esco is not part of the Sub 1/Sub 2 affiliated group for consolidated return purposes, it is the parent company of that group for section 355(f) purposes. See sections 355(f) and 1504(a).

149 No dividends received deduction or consolidated return elimination is available. See Beller, supra note 1, at cases 1 and 4.

150 Sub 1 will have $2 million gain realized and recognized ($3.5 million FMV less $1.5 million basis). This is not a deferred intercompany gain under the consolidated return regulations because Esco, as an S corporation, is not a member of the consolidated return group.

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