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Court Rejects Attempt to Use QSub Election to Increase S Corp Stock Basis
(Parker's Federal Tax Bulletin: February 14, 2013)

In a recent Tax Court case, a group of S corporation shareholders used a novel argument in attempting to justify an increase in the basis of their S stock before selling it. The shareholders in R Ball for R Ball III By Appt., Et Al v. Comm'r, T.C. Memo. 2013-39 (2/6/13), argued that they were entitled to increase the adjusted bases in their S stock after the S corporation made a qualified subchapter S subsidiary (QSub) election for a subsidiary. Where a parent S corporation elects to treat a wholly owned domestic corporation as a QSub, the subsidiary is no longer treated as a separate corporation. Instead, Code Sec. 1361(b)(3)(A) treats all assets, liabilities, items of income, deductions, and credits of the QSub as the assets, liabilities, items of income, deductions, and credits of the parent S corporation. The subsidiary for which the election is made is deemed to have liquidated into the parent S corporation.

According to the shareholders, the QSub election resulted in a gain derived from dealings in property and, therefore, created an item of income that justified their increasing the basis of their S stock. Unfortunately for the shareholders, the IRS and the Tax Court rejected this argument. As the Tax Court noted, the shareholders overlooked the role of realization and recognition of income in determining what constitutes gain from the sale or disposition of property.


In June 1997, nine members of the Ball family and another person directly owned 100 percent of American Insurance Service, Inc. (AIS). The S shareholders had an aggregate adjusted basis of approximately $5.6 million in their shares of AIS.

In 1999, the S shareholders organized Wind River Investment Corp. (WRIC). They contributed 100 percent of their shares of AIS to WRIC in exchange for 100 percent of the stock in WRIC. After completing the transaction, the shareholders directly owned 100 percent of WRIC, and WRIC directly owned 100 percent of AIS. In 2003, the nine Ball family members owned 99.01 percent of WRIC.

Effective June 4, 1999, WRIC elected to be taxed as an S corporation. From June 4, 1999, through September 4, 2003, WRIC continued to own 100 percent of AIS. During WRIC's tax year ended September 4, 2003, WRIC made a QSub election under Code Sec. 1361(b)(3)(B) with respect to AIS, effective February 28, 2003.

About five months later, all the S shareholders sold their WRIC shares to an unaffiliated third party. Before transaction costs, they received over $230 million. The Ball family members claimed losses on the transaction as a result of having increased their S stock basis after the QSub election.

The IRS disallowed the claimed bases adjustments following the QSub election and assessed a deficiency.

Adjusting S Corporation Stock Basis

Under Code Sec. 1367(a)(1), the basis of each S shareholder's stock in an S corporation is increased for any period by the sum of certain items. Code Sec. 1367(a)(1)(A) provides that those items include items of income described in Code Sec. 1366(a)(1)(A). Code Sec. 1366(a)(1)(A) provides that, in determining an S shareholder's tax for the year, there is taken into account the shareholder's pro rata share of the corporation's items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder.

Taxpayers' Position

The S shareholders argued that they properly adjusted their bases in the WRIC shares after the QSub election pursuant to Code Sec. 1367(a)(1)(A) and that they properly claimed losses from the sale of WRIC on their 2003 income tax returns. According to the shareholders, the QSub election resulted in a gain derived from dealings in property and, therefore, created an item of income under Code Sec. 61(a). Code Sec. 61(a) defines gross income as all income from whatever source derived, which includes gains derived from dealings in property. The family members claimed that the exchange of the S corporation's shares of stock in the subsidiary for the subsidiary's assets resulted in gains derived from dealings in property.

Tax Court's Decision

The Tax Court held that the unrecognized gain resulting from the QSub election did not create an item of income or tax-exempt income pursuant to Code Sec. 1366(a)(1)(A). As a result, the court concluded that the shareholders improperly adjusted their bases in their WRIC stock following the QSub election.

According to the Tax Court, the shareholders' position would create noneconomic basis adjustments that would reduce or eliminate tax at the shareholder level. This would not only convert the single-level taxation of S corporations into a zero-level taxation of S corporations; it would also undermine the double-level taxation of C corporations, as preserved in Code Sec. 1374 (relating to the built-in gains tax), and circumvent the repeal of the General Utilities doctrine.

Observation: Before 1986, the General Utilities doctrine so named for the Supreme Court's decision in General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935) permitted a C corporation to escape corporate-level tax on certain distributions of appreciated property to its shareholders. Congress repealed the General Utilities doctrine in the Tax Reform Act of 1986, thus ensuring a corporate-level tax on the distribution of appreciated property. Congress noted that the General Utilities doctrine undermined the corporate income tax. Congress further cemented the repeal of the General Utilities doctrine by enacting Code Sec. 1374 in the Tax Reform Act of 1986. Code Sec. 1374 prevents a C corporation from avoiding corporate-level taxation on the sale of appreciated assets by converting to an S corporation.

The court noted that the shareholders' position would produce absurd results and would open the door to a myriad of abusive transactions. Using these noneconomic basis adjustments, the court noted that the shareholders attempted to turn what should have been a $202 million aggregate taxable gain into a $12 million aggregate loss. Had WRIC sold any of AIS' appreciated assets at a gain after the QSub election, the shareholders would have increased their adjusted bases in WRIC a second time, thus reducing or eliminating more tax.

(Staff Editor at Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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