11.29.11

Hum, the Case of Disappearing Basis?

by Darren J. Mills

Introduction

Did the IRS get it wrong or is it just addressing the question at hand?  On April 8, 2011, the Chief Counsel’s Office issued CCA 201114017 (“the CCA”) addressing the income tax implications whereby the shareholders of a C corporation contributed the stock of that C corporation to an S corporation (“Parent”) owned by those same shareholders and a retroactive QSUB election was filed for the C corporation (“QSUB”).  The shareholders then took the position that for purposes of determining their basis in the stock of Parent, the deemed liquidation under Code Sec. 332 gave rise to “an item of income”; therefore, the shareholders could increase their basis in the stock of Parent under Code Sec. 1366(a)(1)(A).  The IRS concluded that the deemed liquidation under Code Sec. 332 did not give rise to an item income and the shareholders could not increase their basis in the stock of Parent.

Background

According to the redacted facts of the CCA, the shareholders of Parent were electing small business trusts (“the Taxpayers”) created for the benefit of various family members.  The basis of the shares of stock in Parent was negligible.  The Taxpayers also owned a C corporation.  The Taxpayers contributed the stock of the C corporation to Parent and a QSUB election was filed for the C corporation.  A day after filing the QSUB election, Parent and Taxpayers signed a letter of intent to sell Parent’s stock to presumably a third party.

The Taxpayers took the position that the deemed liquidation was an item of income under Code Sec. 1366(a) (1) and the regulations thereunder even though under Code Sec. 332, no gain or loss is recognized.  The taxpayers analogized the application of Code Sec. 331 and 332 regarding the deemed liquidation to Code Sec. 61 and 108 respectively.  As a general matter, Code Sec. 331 provides that a liquidation of a corporation results in the recognition of gain or loss by the shareholder.  Code Sec. 332 is nonrecognition provision where if certain requirements are satisfied such as an ownership test and a solvency test, no gain or loss is recognized by a corporate shareholder.  Code Sec. 61(a) (12) states that cancellation of indebtedness income is gross income and Code Sec. 108 provides for an exclusion from gross income for cancellation of indebtedness income if the taxpayer is, for example, in bankruptcy or insolvent.

The Taxpayers based their argument on the Supreme Court’s holding in D.A. Gitlitz.¹  In Gitlitz, the Court held that cancellation of debt income, excludable from gross income under Code Sec. 108, is an item of income for purposes of Code Sec. 1366(a)(1), therefore enabling the taxpayers in Gitlitz to increase their basis in the stock of the S corporation.

The IRS analyzed the policy behind Subchapter S and Subchapter C to determine whether the deemed liquidation as a result of the QSUB election gives rise to an item of income for purposes of Code Sec. 1366.  The analysis of the policy is sound.  It is where the IRS “goes” after the policy analysis that may not be sound if it is not just focusing on the specific question at hand (i.e., that the deemed liquidation gives rise to an “item of income”).  One of the benefits of making an S election is the potential to have a single level of tax.²   The IRS notes in the CCA that Code Secs. 1366 and 1367 operate to preserve the policy regarding the single level of tax for an S corporation.  The IRS then notes that the policy behind Code Sec. 332 is to preserve the nonrecognition of gain.  The IRS states in the CCA:

In order to effect such a simplification of corporate structures in a tax neutral manner, Congress created a statutory framework which provides that (i) under §332, no gain or loss is recognized by the parent on property distributed to it in liquidation, (ii) under [Redacted Text] §334(b) the parent takes the subsidiary’s assets with a carryover basis, and (iii) under §381 the parent succeeds to the subsidiary’s tax attributes.  The subsidiary stock is canceled and, as a necessary corollary, the basis in that stock also disappears.  The net effect of these provisions is to eliminate from the tax system the subsidiary stock and its basis, and thus any potential gain or loss in the stock, because such gain or loss can never result in economic gain that enriches the parent corporation.  Because the parent receives the assets with a carryover basis, not a fair market value basis, the appreciation in the assets will be recognized by the parent when the assets are sold.

The IRS then goes through three arguments of why the taxpayer’s position is wrong.  The taxpayer’s argument is certainly suspect; however, the end result was correct albeit for a different reason.

What the Taxpayer Should Have Argued

Code Sec. 1371 states that Subchapter C, as a general matter, shall apply to an S corporation and its shareholders.  In determining the effect of a QSUB election Reg. §1.1361.-4(a)(2)(i) provides, in part, “the tax treatment of the liquidation or of a larger transaction that includes the liquidation will be determined under the Internal Revenue Code and general principles of tax law, including the step transaction doctrine.”  The starting point for determining shareholder basis in an S corporation is generally Code Sec. 358.  The basis is then subsequently adjusted under the principles of Code Sec. 1367.  Again, Code Sec. 1366 and 1367 operate to preserve the single level of tax policy objective.

The assets of the C corporation, as a result of the transaction undertaken by the Taxpayers, now reside in the S corporation.³   Based on the facts in the CCA, it would appear that the Taxpayers had basis in the stock of the C corporation.  But where did this basis go?  It is true that Code Sec. 332 liquidation results in a disappearance of the subsidiary’s basis because the basis is deemed to be replicated in the assets that are transferred to the acquiring parent.⁴  We cannot tell from the facts in the CCA, but somehow the C corporation acquired its assets.  If the Taxpayers funded the acquisition of those assets through capital contributions, their basis in the stock of the C corporation should be preserved; otherwise, the policy objective of a single level of taxation is adverted.

Code Sec. 358 is to Subchapter C what Code Sec. 1367 is to Subchapter S, at least philosophically.  Code Sec. 358 provides basis adjustments so that essentially after tax dollars are not taxed again and Code Sec. 358 further operates to defer any built-in gain in a nonrecognition transaction.⁵

When the Taxpayers contributed their stock the S corporation and subsequently elected QSUB status for the former C corporation, something had to have happened with their stock basis in the C corporation.  There does not appear to be any built-in loss issues under Code Sec. 362(e) based on the scant and redacted facts of the CCA; therefore, presumably the election under Code Sec. 362(e)(2)(C) was not made.

Similar to Rev. Rul. 76-123,6 the transfer by the Taxpayers of the C corporation stock and the filing of the QSUB election are interdependent steps and part of an overall plan.   The result is the shifting of property from one corporate entity to another and, from what can be gleamed from the CCA, no boot is issued.  Applying the meaningless gesture doctrine arguably results in a tax-free reorganization under Code Sec. 368.  Because of the redacted text, we cannot be certain of whether the transaction should be viewed, for example, as Type D or Type F reorganization.  However, a tax-free reorganization under Code Sec. 368 would invoke Code Sec. 358; therefore, the Taxpayers should be able to increase their stock basis in the S corporation by the basis of their stock in the C corporation.

Conclusion

The only logical answer when analyzing the CCA is that the IRS was narrowly focused and only dealing with the specific question at hand: Does a deemed liquidation qualifying for nonrecognition under Code Sec. 332 give rise to an item of income?  From a policy perspective, it just does not seem right that the Taxpayers should not be able to increase the basis of the stock of Parent as a result of the “contribution” of the C corporation to Parent.  This is the certainly the result intended by the Taxpayers in the CCA, but it appears that they accidentally got on the wrong train.

ENDNOTES

* This publication does not constitute tax, legal, or other advice from Argy, Wiltse, & Robinson, P.C., which assumes no responsibility with respect to assessing or advising the reader as to tax, legal, accounting or other consequences arising from the reader’s particular facts and circumstances.  IRS Circular 230 Disclosure:  Please be advised that the tax advice contained herein (including any attachments) is not intended or written by the practitioner to be used and cannot be used by the taxpayer for the purpose of avoiding any U.S. tax-related penalties that may be imposed on the taxpayer.  All references are to the Internal Revenue Code of 1986 as amended and the regulations thereunder unless otherwise noted.

¹ D.A. Gitlitz, SCt, 2001-1 USTC 50,147, 531 US 206 (2001).  Subsequent to Gitlitz, the Treasury issued Reg. §1.1366-1(a)(2)(viii), which yields a different result than that reached by the Court in Gitlitz.

² See Code Sec. 1374 providing for a corporate-level tax with respect to certain built-in gain items existing immediately before the S election and recognized during the recognition period.

³ See Reg. §1.1361-4(a)(2) providing that the separate existence of the QSUB corporation is ignored and its assets and liabilities are deemed to be those of the S corporation.

⁴ Code Sec. 334(b).

⁵ “A recurring theme of fundamental importance in the income tax is that when gain or loss goes unrecognized at the time of an exchange of property for property, the transferor’s basis of the property given up is ordinarily preserved and applied to the property received.” Bittker & Eustice, FEDERAL INCOME TAXATION OF CORPORATIONS AND SHAREHOLDERS (7th ed. 2000), at 3.10[1].  6 Rev. Rul. 76-123, 1976-1 CB 94.

This article is reprinted with the publisher’s permission from the TAXES–THE TAX MAGAZINE, a monthly journal published by CCH, a Wolters Kluwer business.  Copying or distribution without the publisher’s per mission is prohibited.  To subscribe to the TAXES–THE TAX MAGAZINE® or other CCH Journals please call 800-449-8114 or visit www.CCHGroup.com.  All views expressed in the articles and columns are those of the author and not necessarily those of CCH.
 

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