United States: Tax Court Rules Unrecognized Gain From QSUB Election Does Not Adjust Shareholder Basis

The Tax Court has ruled in R. Ball for R Ball III by Appt. v. Commissioner (T.C. Memo. 2013-39) that shareholders in an S corporation improperly adjusted the basis of their S corporation stock upon an election to treat the S corporation's wholly owned subsidiary as a qualified subchapter S subsidiary (QSUB). The Tax Court rejected the argument that the QSUB election for the subsidiary corporation resulted in an item of income for the parent S corporation, and it denied the shareholders' claim to an increase in S corporation stock basis.

The shareholders owned stock in American Insurance Service Inc. (AIS), a C corporation. In 1999, the shareholders of AIS contributed 100% of the AIS stock to a newly formed holding company, Wind River Investment Corporation (WRIC), in exchange for 100% of WRIC's stock. WRIC then elected to be taxed as an S corporation for U.S. federal income tax purposes. In 2003, WRIC elected to treat AIS as a QSUB for U.S. federal income tax purposes. Later in 2003, the shareholders sold their WRIC stock for approximately $230 million and reported an aggregate tax loss of approximately $12 million.

The IRS challenged the reported loss and instead asserted that the shareholders should have reported an aggregate taxable gain of approximately $202 million. The Tax Court agreed with the IRS and ruled that the shareholders inappropriately increased their tax basis in the stock of the S corporation, WRIC, upon the QSUB election for AIS.

In general, Section 1366(a)(1)(A) provides that a shareholder in an S corporation must take into account a shareholder's pro rata share of an S corporation's items of income, including tax-exempt income. Section 1367(a)(1)(A) provides that the basis of each shareholder's stock in an S corporation must be increased for items of income determined under Section 1366(a)(1)(A).

The shareholders in R. Ball for R Ball III by Appt. v. Commissioner argued that the deemed liquidation of AIS upon the QSUB election should be treated as an item of gross income to WRIC from "[g]ains derived from dealings in property" under Section 61(a)(3) and that such income should then be treated as exempted by Section 332. A valid QSUB election is generally treated as a liquidation that is tax free to the parent S corporation under Section 332. Consequently, the shareholders took the position that as an item of income, the gain from the QSUB election should result in an increase in basis pursuant to sections 1366(a)(1)(A) and 1367(a)(1)(A) even though such income is not recognized under Section 332. The shareholders analogized their facts to those in Gitlitz v. Commissioner (531 U.S. 206, 2001) where the Supreme Court held that gross income includes income from the discharge of indebtedness under Section 61(a)(12) even when the income was exempted by the insolvency provision of Section 108(a)(1)(B).

The Tax Court disagreed with the shareholders' position and noted that under the principles of Treas. Reg. Sec. 1.61-6(b), certain realized gains are not "recognized" and are therefore not included in gross income at the time the relevant transaction occurs. The Tax Court found that Section 332 is a nonrecognition provision that causes the parent corporation to ignore any gain or loss realized in the deemed liquidation. Thus, the Tax Court reasoned that gain exempted by Section 332 does not create an item of income pursuant to Section 61(a)(3).

In addition, the Tax Court found the analogy to Gitlitz to be misguided. The Tax Court noted that Gitlitz (subsequently overturned by congressional statute) addressed payments that are explicitly included in Section 61(a) gross income and then explicitly excluded by Section 108(a)(1)(B). In the current case, the Tax Court reasoned that realized gain from the QSUB election was never explicitly included in gross income. Instead, nonrecognition under Section 332 is not an exclusion provision, but merely prevents "realized" gain from rising to the level of income.

Thus, in summary, the Tax Court held that WRIC's election to treat AIS as a QSUB did not result in an item of income. Consequently, the WRIC shareholders improperly increased their adjusted tax basis in their WRIC stock and failed to report the proper amount of gain.

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