The Third Circuit Court of Appeals has affirmed the Tax Court on an appeal arising out of nine consolidated cases regarding the tax implications of an S Corporation’s election to treat its subsidiary as a qualified subchapter S subsidiary, or Qsub, under Section 1361 of the Tax Code.
Specifically, the parties disagreed as to whether the Qsub election and subsequent sale of the S Corporation parent created an item of income under Section 1366(a)(1)(A).
The Third Circuit, in Ball v. Commissioner, affirmed the Tax Court. It found that an increase in stock bases and declared losses were improper.
In 1997, 10 family-owned trusts acquired direct ownership of American Insurance Service Inc. with an aggregate basis over $5.6 million. In 1999, they formed Wind River Investment Corporation and contributed their shares in AIS in exchange for all of the shares of Wind River, resulting in Wind River owning all of the shares of AIS. In June 1999, Wind River designated itself a subchapter S Corporation.
In February 2003, Wind River elected to treat AIS as a Qsub under Section 1361(b)(3). Prior to the Qsub election, the trusts’ aggregate adjusted basis in the Wind River stock was $15.2 million. Following the Qsub election, the trusts increased their bases in the Wind River stock from $15,246,099 to a new basis of $242,481,544.
In September 2003 the trusts sold their interests in Wind River to an unrelated third party. Although the sale netted $230,111,857, the trusts claimed a loss in the amount of $12,247,229, calculated as the difference between the amount received and the new basis in the Wind River stock.
The main issue was whether or not a Qsub election creates an “item of income” for the parent corporation.
The Third Circuit held that the trusts failed to address the fact that Section 332, by its plain text, applies to a special set of liquidations that are treated under a different statutory scheme and do not create “items of income.” Therefore, the increases in stock bases and declared losses were improper.