In an IRS internal legal memorandum (ILM 201433014) released on Aug. 15, the IRS Office of Chief Counsel addressed whether an S corporation (Corp X) and its wholly owned qualified subchapter S subsidiary (QSUB, known as Corp Y) must prorate annual income after the S corporation voluntarily revoked its Subchapter S election midyear.
The revocation caused Corp X to lose its status as an S corporation and convert to a C corporation and correspondingly caused Corp Y to lose its status as a QSUB and become a newly formed C corporation. The IRS stated that Corp X must prorate its annual income between its short year S corporation tax year and short C corporation tax year unless Corp X voluntarily elects an optional closing-of-the-books method. Corp Y is not permitted to allocate between its short QSUB tax year and its short C corporation tax year because Corp Y was deemed to have become an entirely new corporation when its QSUB status terminated. Thus, Corp Y must close its books when its QSUB status is terminated, and all of Corp Y's post-termination income (or loss) must be reported on Corp Y's short year C corporation tax return.
The facts of the ILM stated that Corp Y had sustained substantial losses after the termination date of its QSUB status. If a proration method had been permitted, a portion of those losses would have been allocated to the pretermination period and used to offset Corp X's income on its short year S corporation tax return or would have passed through to Corp X's shareholders, who apparently had sufficient tax basis in their Corp X stock to absorb the losses.
As a result of the IRS position in the ILM, however, Corp Y must close its books as of the end of the day before its QSUB termination, and all post-termination losses must be reported on Corp Y's short year C corporation tax return. Thus, the only way for Corp X to offset its income against Corp Y's post-termination losses would have been for Corp X and Corp Y to join in filing a consolidated tax return for the tax period beginning with the termination date.
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