Qsub Election Does Not Create an Item of Income

The Third Circuit affirmed the Tax Court's opinion that an S corporation's election to treat its wholly owned subsidiary as a qualified subchapter S subsidiary (QSub) did not create an item of income or tax-exempt income under Sec. 1366(a)(l)(A). It also determined that an increase in stock bases and declared losses from a subsequent sale were improper. A parent S corporation may elect to treat a wholly owned domestic corporation as a QSub under Sec. 1361(b)(3). The QSub is then no longer treated as a separate corporation, and all its assets, liabilities, items of income, deductions, and credits are treated as the corresponding items of the parent S corporation. The QSub is deemed to have liquidated into the parent S corporation (Regs. Sec. 1.1361-4(a)(2)). The QSub election is considered an adoption of a plan of liquidation immediately before the deemed liquidation, which qualifies the deemed liquidation for tax-free treatment under Sec. 332. Under Sec. 1367(a), a shareholder's tax basis in the stock of an S corporation is adjusted to reflect the shareholder's pro rata share of income, losses, deductions, and credits of the S corporation, as calculated under Sec. 1366(a)(l). In 1997, the Ball family formed several trusts to acquire all the shares of American Insurance Service Inc. (AIS), a C corporation. Two years later, the trusts formed Wind River Investment Corp. (WRIC), a Delaware corporation, and contributed the AIS shares in exchange for all the WRIC stock, making AIS a wholly owned subsidiary. WRIC then elected to be taxed as an S corporation under Sec. 1361. In 2003, WRIC elected to treat AIS as a QSub under Sec. 1361(b)(3), resulting in a deemed liquidation. The trusts increased their bases in the WRIC stock from $15 million to $242 million to reflect the gain under Sec. 331 purportedly resulting from the deemed liquidation of AIS. Later in 2003, the trusts sold their WRIC stock to a third party for a net $230 million. The trusts claimed a combined loss on the sale of $12 million using the new adjusted bases of the WRIC stock. The IRS denied the losses and issued deficiency notices totaling more than $33 million, stating that the QSub election did not create an item of income and that the trusts improperly increased their bases in the WRIC stock. The trusts filed petitions with the Tax Court, and the cases were consolidated. The trusts argued that the deemed liquidation of AIS was a sale or exchange of property under Sec. 331, creating a realized gain to WRIC under Sec. 61(a). They contended that this item of income under Sec. 1366(a)(l)(A) passed through to them and increased their bases in WRIC stock under Sec. 1367(a)(l)(A), despite the nonrecognition of that gain under Sec. 332. The Tax Court considered the difference between realization and recognition of income and held that gain from a QSub election is realized and calculated under Sec. …