[Federal Register Volume 65, Number 16 (Tuesday, January 25, 2000)]
[Rules and Regulations]
[Pages 3843-3856]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-1718]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1, 301, and 602

[TD 8869]
RIN 1545-AU77


Subchapter S Subsidiaries

AGENCY:  Internal Revenue Service (IRS), Treasury.

ACTION:  Final regulations.

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SUMMARY:  This document contains final regulations that relate to the 
treatment of corporate subsidiaries of S corporations and interpret the 
rules added to the Internal Revenue Code by section 1308 of the Small 
Business Job Protection Act of 1996. These regulations provide the 
public with guidance needed to comply with applicable law and will 
affect S corporations and their shareholders.

DATES:  Effective Date: These regulations are effective January 20, 
2000.
    Applicability Date: For dates of applicability, see Secs. 1.1361-
4(a)(3)(iii), 1.1361-4(a)(5)(i), 1.1361-5(c)(2), 1.1361-6, 1.1362-8(e), 
and 301.6109-1(i)(4).

FOR FURTHER INFORMATION CONTACT:  Jeanne M. Sullivan (202) 622-3050 
(not

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a toll-free number) or David J. Sotos (202) 622-3050 (Subchapter S); 
Michael N. Kaibni (202) 622-7550 (Subchapter C) (not toll-free 
numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in these final regulations 
have been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under 
control number 1545-1590. Responses to these collections of information 
are required to determine the manner in which a corporate subsidiary of 
an S corporation will be treated under the Internal Revenue Code.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    The estimated annual burden per respondent/recordkeeper varies from 
45 minutes to 1 hour, depending on individual circumstances, with an 
estimated average of 57 minutes.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, 
Washington, DC 20224, and to the Office of Management and Budget, Attn: 
Desk Officer for the Department of the Treasury, Office of Information 
and Regulatory Affairs, Washington, DC 20503.
    Books or records relating to this collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    On April 22, 1998, the IRS published in the Federal Register a 
notice of proposed rulemaking (REG-251698-96, 63 FR 19864) concerning 
the treatment of corporate subsidiaries of S corporations. The 
regulations interpreted rules added to the Internal Revenue Code (Code) 
by section 1308 of the Small Business Job Protection Act of 1996, 
Public Law 104-188, 110 Stat. 1755 (the Act), as amended by section 
1601 of the Taxpayer Relief Act of 1997, Public Law 105-34, 111 Stat. 
788 (the 1997 Act). The Act modified section 1361 of the Code to permit 
an S corporation: (1) To own 80 percent or more of the stock of a C 
corporation, and (2) to elect to treat a wholly owned subsidiary as a 
qualified subchapter S subsidiary (QSub). The 1997 Act made a technical 
correction to section 1361 to provide regulatory authority to make 
exceptions to the general tax treatment of an election to be a QSub.
    Written comments were received in response to the notice of 
proposed rulemaking, and a public hearing was held on October 14, 1998. 
After consideration of all the comments, the proposed regulations under 
sections 1361, 1362, and 1374 are adopted, as revised by this Treasury 
decision. The comments received and the revisions are discussed below. 
In addition, regulations under section 6109 are adopted to provide 
additional guidance consistent with the QSub provisions.
    On January 13, 1997, the IRS published Notice 97-4, 1997-1 C.B. 
351, to provide a temporary procedure for making a QSub (formerly QSSS) 
election. Taxpayers should continue to follow Notice 97-4 when making a 
QSub election until the QSub election form is published.

Explanation of Provisions

1. Step Transaction Doctrine

a. QSub Election
    The proposed regulations provide that, when an S corporation makes 
a valid QSub election with respect to a subsidiary, the subsidiary is 
deemed to have liquidated into the parent S corporation immediately 
before the QSub election is effective. The tax treatment of this 
liquidation, alone or in the context of any larger transaction (for 
example, a transaction that also includes the acquisition of the 
subsidiary's stock), generally is determined under all relevant 
provisions of the Code and general principles of tax law, including the 
step transaction doctrine. However, the proposed regulations include a 
special transition rule that applies to certain elections effective 
prior to the date that is 60 days after publication of final 
regulations in the Federal Register. The transition rule suspends the 
application of the step transaction doctrine with respect to the 
acquisition of stock followed by a QSub election in cases where the S 
corporation and the subsidiary are related (as described in section 
267(b)) prior to the acquisition of the subsidiary's stock.
    Commentators expressed concern over the application of the step 
transaction doctrine to transactions that include the deemed 
liquidation that occurs as the result of a QSub election. These 
commentators argued that applying step transaction to the acquisition 
of stock that precedes a QSub election can cause the transaction to be 
recast as an asset acquisition under section 368 with results that may 
be inconsistent with the expectations of some taxpayers. Under step 
transaction principles, for example, if, pursuant to a plan, a 
shareholder contributes the stock of one wholly owned S corporation 
(S2) to another wholly owned S corporation (S1), and makes a QSub 
election for S2, the transaction generally would be a reorganization 
under section 368(a)(1)(D), with the possibility of gain recognition 
under section 357(c). See generally, Rev. Rul. 67-274 (1967-2 C.B. 
141). In the opinion of these commentators, the legislative history of 
the QSub provisions indicates that the deemed liquidation that is 
incident to a QSub election should be respected as an independent, tax-
free liquidation under section 332, rather than recast under the 
principles of the step transaction doctrine.
    After consideration of all of the comments, Treasury and the IRS 
believe that the proposed regulations are consistent with the 
legislative history of the QSub provisions, conform the results of the 
deemed liquidation to the results that would obtain if an actual 
liquidation occurred, and follow the approach taken in other provisions 
of the tax law. (In regulations published on November 29, 1999 (64 FR 
66580), rules for elective changes in the classification of an entity 
for Federal tax purposes also provide that the tax treatment of a 
change in the classification of an entity by election is determined 
under all relevant provisions of the Internal Revenue Code and general 
principles of tax law, including the step transaction doctrine.) 
Accordingly, the final regulations provide that general principles of 
tax law, including step transaction, apply to determine the tax 
consequences of the transactions that include a QSub election. The 
final regulations provide examples illustrating the results of applying 
step transaction in the context of a QSub election.
    The final regulations also provide for an extended transition 
period during which step transaction will be suspended. During the 
extended transition period, it is anticipated that proposed regulations 
published in the Federal Register on June 14, 1999, relating to the tax 
treatment of partially controlled subsidiaries under section 
368(a)(1)(C) (64 FR 31770), will be finalized. These regulations 
generally reverse the IRS's position that the acquisition of assets of 
a partially controlled subsidiary does not qualify as

[[Page 3845]]

a tax-free reorganization under section 368(a)(1)(C). See Bausch & Lomb 
Optical Co. v. Commissioner, 30 T.C. 602 (1958), aff'd 267 F.2d 75 (2d 
Cir.), cert. denied, 361 U.S. 835 (1959); Rev. Rul. 54-396, 1954-2 C.B. 
147. The regulations provide that preexisting ownership of a portion of 
a target corporation's stock by an acquiring corporation generally will 
not prevent the solely for voting stock requirement in a ``C'' 
reorganization from being satisfied. See also Notice 2000-1, 2000-2 
I.R.B. 1, which provides that the proposed regulations, when finalized, 
will provide that the regulations generally will apply to transactions 
occurring after December 31, 1999, with an exception for transactions 
pursuant to binding agreements. The finalization of these regulations 
will provide additional certainty as to the tax consequences of making 
a QSUB election in situations where an S corporation acquires the 
remainder of a partially controlled subsidiary in exchange for stock of 
the S corporation and immediately thereafter elects QSUB status with 
respect to the subsidiary.
b. QSUB Termination
    Section 1361(b)(3)(C) provides that, if a QSUB election terminates, 
the corporation is treated as a new corporation acquiring all of its 
assets (and assuming all of its liabilities) from the S corporation in 
exchange for stock of the new corporation immediately before the 
termination. The proposed regulations provide that the tax treatment of 
this transaction or of a larger transaction that includes this 
transaction will be determined under the Code and general principles of 
tax law, including the step transaction doctrine. The proposed 
regulations include examples illustrating the application of the step 
transaction doctrine in the context of the termination of a QSUB 
election.
    Commentators recommended that step transaction not apply to the 
termination of a QSUB election. Those commentators argue that the 
application of the step transaction doctrine causes inappropriate tax 
results in some situations. One example cited is the sale of 21 percent 
of the stock of a QSUB, thereby terminating the QSUB election. Under 
step transaction principles, the deemed formation of a new corporation 
that occurs as a result of the QSub termination fails to qualify under 
section 351 because the S corporation parent is not in control of the 
new corporation as defined in section 368(c) after the disposition. As 
a result of the failure to qualify under section 351, gain would be 
recognized on all of the QSub's assets.
    Treasury and the IRS believe that it is appropriate to apply the 
step transaction doctrine to the termination of a QSub election. 
Applying the step transaction principles to the control requirement of 
section 351 after the disposition of QSub stock is completed is 
consistent with the legislative history of the QSub termination 
provisions. S. Rep. No. 104-281, 104th Cong., 2d Sess. 52 n.59 (1996). 
Moreover, in many cases, application of the step transaction doctrine 
will provide a more taxpayer favorable result than giving separate 
effect to each step. This may occur, for example, if 100 percent of the 
stock of a QSub is sold. In that case, applying step transaction 
principles would result in a fair market value basis for the former 
QSub's assets, rather than a lower carryover basis that would result 
(absent a section 338 election) from treating the deemed formation of 
the new corporation as an independent step qualifying under section 
351. In order to assist taxpayers to understand the effect of QSub 
terminations, the final regulations include two examples that 
illustrate the contrasting tax consequences of purchasing 21 percent of 
the stock of a QSub as opposed to the tax consequences of contributing 
property to the QSub in exchange for 21 percent of the former QSub's 
stock. The final regulations include additional examples illustrating 
the consequences of revoking the QSub election prior to sale of the 
QSub's stock and of merging a QSub into a disregarded entity prior to 
such sale.

2. ``F'' Reorganizations During the Transition Period

    As noted above, commentators generally oppose applying the step 
transaction doctrine to the acquisition of the stock of a corporation 
followed immediately by a QSub election. Some commentators, however, 
suggested that, for policy and other reasons, during the transition 
period, the formation of a new shell S corporation (Newco) by the 
shareholders of an existing S corporation, followed by the contribution 
of the stock of the existing S corporation to Newco, coupled with an 
immediate QSub election for the existing corporation, should be 
characterized as a reorganization under section 368(a)(1)(F) if all of 
the other requisites of that section are met. Treating the transaction 
as an ``F'' reorganization (as opposed to a stock acquisition followed 
by a section 332 liquidation) can be beneficial to taxpayers. For 
example, the existing S corporation's taxable year does not close if it 
undergoes an ``F'' reorganization.
    In light of the underlying purpose of the transition rule as a 
relief provision for the benefit of taxpayers, during the extended 
transition period provided in the final regulations, the IRS will not 
challenge taxpayers who, through application of the step transaction 
doctrine to an acquisition of stock followed by a QSub election, obtain 
tax treatment similar to that applied in a valid reorganization under 
section 368(a)(1)(F) if, without regard to the transition rule, the 
transaction would properly qualify as such a reorganization.

3. Timing of Adoption of Plan of Liquidation

    Under section 332(a), no gain or loss shall be recognized on the 
receipt by a corporation of property distributed in complete 
liquidation of another corporation if the requirements of section 
332(b) are satisfied. Those requirements include the adoption of a plan 
of liquidation at a time when the corporation receiving the 
distribution owns 80 percent or more of the stock of the liquidating 
corporation. A QSub election results in a constructive liquidation for 
Federal tax purposes. Formally adopting a plan of liquidation for the 
QSub, however, is potentially incompatible with the QSub provisions of 
the Code, which allow the state-law entity to continue to exist while 
liquidating only for Federal tax purposes. In order to provide tax 
treatment for the constructive liquidation incident to a QSub election 
that is compatible with the requirements of section 332, the proposed 
regulations include a provision that the making of a QSub election 
satisfies the requirement of adopting a plan of liquidation.
    One commentator asked that the regulations provide a safe harbor 
with respect to the timing of the adoption of the plan of liquidation 
for purposes of section 332. The commentator argued that, where the 
acquisition of stock followed by the deemed liquidation does not 
constitute a reorganization (after appropriate application of step-
transaction principles), the regulations should provide that, for 
purposes of applying section 332 to the liquidation incident to a QSub 
election, the S corporation will be deemed to adopt a plan of 
liquidation for its subsidiary as of the effective date of the 
election, which should not precede the acquisition by the S corporation 
of 100 percent of the stock of the subsidiary.
    The timing of the adoption of the plan of liquidation is important 
in the

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context of section 332 because only liquidating distributions to a 
corporation that owns 80 percent or more of the stock of the subsidiary 
when the plan is adopted qualify for tax-free treatment. A QSub 
election cannot be effective until the parent S corporation owns 100 
percent of the subsidiary. Thus, the constructive liquidation incident 
to a QSub election cannot commence before that level of ownership is 
attained. Furthermore, providing certainty with respect to the deemed 
timing of the adoption of the plan of liquidation facilitates the 
efficient administration and use of the QSub provisions. Accordingly, 
to provide tax treatment of a QSub election that is compatible with the 
requirements of section 332, the final regulations provide that, for 
purposes of satisfying the requirement of section 332(b) that the 
parent corporation own stock in the subsidiary meeting the requirements 
of section 1504(a)(2) on the date of adoption of the plan of 
liquidation of the subsidiary, the plan of liquidation is deemed 
adopted immediately before the deemed liquidation incident to a QSub 
election unless a formal plan of liquidation that contemplates the 
filing of the QSub election is adopted on an earlier date. (Although no 
similar rule is contained in the rules for elective changes in the 
classification of an entity for Federal tax purposes, Treasury and the 
IRS intend to amend those regulations to include such a rule.) However, 
if as a result of the application of general tax principles the 
transactions that include the QSub election are treated as an asset 
acquisition, section 332 is not applicable and this rule has no 
relevance.

4. Insolvent Subsidiaries

    In general, section 332 does not apply to the liquidation of an 
insolvent corporation, because the parent corporation does not receive 
at least partial payment for the stock of its subsidiary. See, e.g., 
Sec. 1.332-2(b) and Rev. Rul. 68-602 (1968-2 C.B. 135). One commentator 
recommended that a QSub election made for an insolvent subsidiary be 
eligible for tax-free treatment under section 332. The commentator 
argued that the legislative history of the QSub provisions makes it 
clear that a QSub election should qualify as a liquidation under 
section 332 unless regulations provide otherwise and that taxpayers may 
be unaware of the harsh results of making a QSub election for an 
insolvent corporation.
    Treasury and the IRS do not agree that the legislative history 
indicates that section 332 applies to the liquidation of an insolvent 
corporation. In order to assist taxpayers, an example illustrates the 
effect of a QSub election for an insolvent corporation.

5. Definition of Stock of the QSub

    Commentators recommended that, for purposes of determining whether 
a subsidiary is wholly owned by the parent S corporation, arrangements 
that are not considered to be stock under the one-class-of-stock rules 
of Sec. 1.1361-1(l) should be disregarded. The commentators noted that 
applying the principles of these regulations would provide certainty 
with respect to the subsidiary's eligibility to be a QSub and avoid 
difficult debt/equity determinations.
    The final regulations adopt the position recommended by the 
commentators. The final regulations provide that, for purposes of 
determining whether the deemed liquidation of the subsidiary qualifies 
under section 332, the deemed exercise of an option under Sec. 1.1504-4 
and any instrument, obligation, or arrangement that would not be 
considered stock under the one-class-of-stock rules of Sec. 1.1361-1(l) 
are disregarded in determining if the stock ownership requirements of 
section 332(b) are met. For example, an option that would not be 
treated as stock under Sec. 1.1361-1, but that would be treated as 
exercised under Sec. 1.1504-4, is disregarded. Similarly, if a QSub 
election terminates, in determining the applicability of section 351, 
the determination of whether stock ownership of the newly formed 
corporation satisfies the control requirement of section 368(c) is made 
without regard to instruments, obligations, or other arrangements that 
are not treated as stock for purposes of the 100 percent stock 
ownership requirement for the election.
    The rule regarding options under Sec. 1.1504-4 is included for 
purposes of applying section 332 because section 332 explicitly 
incorporates the affiliation rules of section 1504. See Sec. 1.1504-
4(a)(1) (the option rules apply to all provisions under the Code and 
the regulations to which affiliation within the meaning of section 
1504(a) is relevant). The affiliation rules are not relevant for 
purposes of applying the rules regarding the 100 percent stock 
ownership requirement in section 1361(b)(3)(B)(i). Accordingly, the 
rule concerning the treatment of stock in applying the 100 percent 
stock ownership requirement does not refer to the option rules under 
Sec. 1.1504-4.

6. Section 1374 and Excess Loss Accounts

    Commentary on the proposed regulations identified certain 
discrepancies in the treatment of tiered groups of corporations when 
QSub elections are made for some or all of the members of the group and 
certain unintended implications of the sentence added to Sec. 1.1374-
8(b) in the proposed regulations.
a. Section 1374
    Section 1374(d)(8) and Sec. 1.1374-8(a) generally provide that, if 
an S corporation acquires assets in a transaction in which the S 
corporation's basis in the assets is determined (in whole or in part) 
by reference to a C corporation's basis in the assets (or any other 
property) (a section 1374(d)(8) transaction), section 1374 applies to 
the net recognized built-in gain attributable to the assets acquired in 
such a transaction. Section 1.1374-8(b) provides that, for purposes of 
the tax imposed under section 1374(d)(8), a separate determination of 
tax is made with respect to the assets the S corporation acquires in 
one section 1374(d)(8) transaction from the assets the S corporation 
acquires in another section 1374(d)(8) transaction and from the assets 
the corporation held when it became an S corporation.
    A corporation's section 1374 attributes (loss carryforwards, 
credits, and credit carryforwards as provided in Sec. 1.1374-1(c)) may 
be used only to reduce the section 1374 tax imposed on the disposition 
of assets held by the S corporation at the time it converted from C 
status. Likewise, section 1374 attributes acquired in one section 
1374(d)(8) transaction may be used only to reduce tax on the 
disposition of assets acquired in that transaction. This results in 
separate section 1374 pools for purposes of calculating the tax imposed 
by section 1374.
    One commentator noted that Sec. 1.1374-8(b) of the proposed 
regulations implies that a QSub election for two or more corporations 
results in a section 1374(d)(8) transaction for each subsidiary and 
that this implication is contrary to the general timing rules of 
Sec. 1.1361-4(b)(1). Those general timing rules provide that the deemed 
liquidation of a tiered group of C corporations that elect S and QSub 
status effective on the same day occurs at the close of the day before 
the effective date of the elections, while the parent is a C 
corporation. As a result of the operation of the general timing rules, 
there is a single section 1374 pool when the parent corporation's S 
election

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is effective. Moreover, the commentator noted that a literal reading of 
Sec. 1.1374-8(b) of the proposed regulations may cause the assets of an 
S corporation that is acquired by a C corporation to become subject to 
section 1374 when the acquiring C corporation immediately makes an S 
election for itself and a QSub election for the acquired S corporation. 
Finally, the commentator requested that the final regulations provide 
that when an S corporation acquires a tiered group of corporations and 
makes QSub elections effective on the same date for some or all of the 
corporations, the assets deemed acquired by the S corporation will be 
treated as acquired in a single section 1374(d)(8) transaction, 
consistent with the apparent intent of the general timing rules of 
Sec. 1.1361-4(b)(1) of the proposed regulations.
b. Excess Loss Accounts
    Section 1.1502-19 of the Income Tax Regulations provides rules 
requiring, in certain instances, a member (X) of a consolidated group 
of corporations to include in income its excess loss account (ELA) in 
the stock of another member (Y) of the group. An ELA reflects X's 
negative adjustments with respect to Y's stock to the extent the 
negative adjustments exceed X's basis in the stock. An ELA must be 
included in X's income if X is treated as disposing of Y's stock. See 
Sec. 1.1502-19(b)(1). A merger or liquidation of X into an S 
corporation or an S election by X is treated as a disposition that 
triggers income recognition with respect to an ELA in Y stock. In 
contrast, X's income or gain in certain cases is subject to any 
nonrecognition or deferral rules applicable, including section 332. As 
a result, if Y liquidates into X in a transaction subject to section 
332, there is no income recognition with respect to an ELA in Y's 
stock. See Sec. 1.1502-19(b)(2)(i).
    Under the general timing rules of Sec. 1.1361-4(b)(1), if the 
common parent elects S status, the deemed liquidations of the 
subsidiary members of the consolidated group for which QSub elections 
are made (effective on the same date as the S election) occur as of the 
close of the day before the QSub elections are effective, while the S 
electing parent corporation is still a C corporation. As a result, 
there is no triggering of income with respect to ELAs in the stock of 
the subsidiary corporations if the liquidations qualify under section 
332. In contrast, if a consolidated group of corporations is acquired 
by an S corporation and the acquiring S corporation makes QSub 
elections for the parent and members of the consolidated group, a 
deemed liquidation of the parent prior to the deemed liquidation of 
other members of the consolidated group may be a disposition that 
triggers income recognition with respect to ELAs in the subsidiaries' 
stock.
c. Modifications Adopted in the Final Regulations
    The final regulations remove the proposed amendment to Sec. 1.1374-
8(b). Furthermore, an amendment to the general timing rules under 
Sec. 1.1361-4(b)(1) for acquired S corporations clarifies that an 
acquired S corporation liquidates into an acquiring corporation as of 
the beginning of the day of acquisition, after the parent's S election, 
if any, is effective. There is no section 1374(d)(8) transaction when 
an S corporation acquires assets from another S corporation, if the 
acquired S corporation has no C corporation history. The modification 
to the timing rule also clarifies that there is no period during which 
an acquired S corporation is a C corporation if the QSub election is 
made effective as of the time of the acquisition.
    As noted in the commentary, the order of the deemed liquidations 
for a tiered group of corporations for which QSub elections are made 
(effective on the same date) is significant for purposes of section 
1374 and under Sec. 1.1502-19. In many situations, it is preferable to 
have the deemed liquidations occur in order from the lowest tier 
subsidiary to the highest tier subsidiary, a bottom-up liquidation 
order. As a result of that ordering, the final liquidation of the 
highest tier subsidiary results in a single section 1374 pool for the 
group. In addition, in the case of a consolidated group of 
corporations, because the deemed liquidation of the common parent 
follows the deemed liquidation of its subsidiaries, there is no 
deconsolidation for purposes of Sec. 1.1502-19 and no triggering of 
ELAs. In other circumstances, however, a top to bottom liquidation of a 
tiered group of subsidiaries may be preferable. Therefore, the final 
regulations allow the S corporation to specify the order of the deemed 
liquidations when QSub elections are made (effective on the same day) 
for a tiered group of subsidiaries. In default of an election, the 
deemed liquidations occur in succession on the effective date of the 
election, beginning with the lowest tier subsidiary.

7. Timing

    One commentator noted a potential lack of coordination in the 
regulations that determine the timing of the termination of the S 
election of an acquired S corporation and the deemed liquidation 
incident to a QSub election for that S corporation. The commentator 
acknowledged that the intent of the proposed regulations is to provide 
that an acquired S corporation for which a QSub election is made 
effective immediately on acquisition should have no intervening C 
period.
    Other timing issues can arise with respect to the termination of a 
QSub election. The regulations provide rules that govern the timing of 
the deemed liquidation incident to a QSub election and of the 
termination of a QSub election. The regulations also provide examples 
illustrating those rules. The regulations generally are intended to 
provide that a corporation may move between S and QSub status without 
an intervening C period, if the appropriate election is made effective 
as of the termination of the previous S or QSub election. The 
regulations are coordinated with provisions under section 338 and 
Secs. 1.1362-2 and 1.1502-76 that have differing timing provisions.

8. Inadvertent QSub Election and Inadvertent Termination Relief

    One commentator requested that the regulations provide inadvertent 
invalid QSub election relief similar to the relief that is available 
under section 1362(f) for inadvertent invalid S elections and 
inadvertent S terminations. The proposed regulations include a 
provision indicating that inadvertent QSub termination relief may be 
available under standards established by the Commissioner for 
inadvertent termination of an S election under Sec. 1.1362-4.
    The QSub provisions include no section analogous to section 1362(f) 
that allows the IRS to determine that a corporation is a QSub during a 
period when the corporation does not satisfy the requirement of section 
1361(b)(3)(B)(i). For example, if the parent corporation inadvertently 
transfers one share of QSub stock to another person, the QSub election 
terminates. The subsidiary is not eligible to have a QSub election in 
effect for the period during which the parent does not own 100 percent 
of its stock. If the QSub election terminates because of the 
inadvertent termination of the parent's S election, however, relief may 
be available under section 1362(f). A favorable determination under 
that section causes the subsidiary to continue to satisfy the 
requirements of section 1361(b)(3)(B)(ii) during the period when the 
parent is accorded

[[Page 3848]]

relief for inadvertent termination of its S election. Moreover, if the 
parent fails to make a timely QSub election, relief may be available 
under the procedures applicable under Sec. 301.9100-1 and 
Sec. 301.9100-3.
    The final regulations do not include the provision relating to the 
inadvertent termination of a QSub election. The removal of that 
provision is not intended to suggest that relief under section 1362(f) 
is not available in appropriate circumstances (such as those discussed 
above), but is intended to avoid confusion with respect to the scope of 
the IRS's statutory authority under section 1362(f).

9. Ordering Rule for Termination of QSub Elections

    Commentators requested that the final regulations provide an 
ordering rule for the simultaneous termination of QSub elections as the 
result of the termination of an upper-tier subsidiary's QSub election. 
The final regulations provide that the terminations occur in 
succession, beginning with the upper-tier subsidiary, and include 
examples to illustrate the effect of simultaneous QSub terminations.

10. Banking Provisions

    Consistent with the proposed regulations, the final regulations 
provide that any special rules applicable to banks under the Code 
continue to apply separately to banks as if the deemed liquidation 
incident to a QSub election had not occurred (the banking provisions). 
Commentators requested that the banking provisions be retroactive to 
the effective date of the Act, by election. As authorized by section 
1601 of the 1997 Act, and as first announced in Notice 97-5 (1997-1 
C.B. 352), the final regulations provide that the banking provisions 
apply to taxable years beginning after December 31, 1996. This rule 
applies to all taxpayers and is not subject to an election. The banking 
provisions also include a reference to other published guidance for 
section 265(b); see Rev. Rul. 90-44 (1990-1 C.B. 54, 57).

11. Taxpayer Identifying Numbers

    The regulations provide clarification regarding employer 
identification numbers (EINs) for QSubs. The regulations restate the 
general rules that: (1) When an entity's classification changes as a 
result of an election, it retains its EIN; and (2) unless regulations 
or published guidance provide otherwise, a disregarded entity 
(including a QSub) must use its owner's EIN for Federal tax purposes.
    Notice 99-6 (1999-3 I.R.B. 12) provides guidance that, under 
limited circumstances, a disregarded entity may use its own EIN. If a 
QSub wishes to use its own EIN in accordance with Notice 99-6 but did 
not have an EIN prior to becoming a QSub, it must apply for a new EIN.
    If a subsidiary's QSub election terminates, the new corporation 
formed as a result of that termination must use its own EIN for Federal 
tax purposes. If the new corporation had an EIN before the effective 
date of its QSub election or during its QSub status, it should use that 
EIN. Otherwise, the new corporation must apply for a new EIN.

12. Effective Date and Transition Rules

    The regulations generally apply to taxable years that begin on or 
after January 20, 2000; however, taxpayers may elect to apply the 
regulations in whole, but not in part (aside from those sections with 
special dates of applicability), for taxable years beginning on or 
after January 1, 2000, provided the corporation and all affected 
taxpayers apply the regulations in a consistent manner. To make the 
election, the corporation and all affected taxpayers must file a return 
or an amended return that is consistent with these rules for the 
taxable year for which the election is made. For purposes of this 
section, affected taxpayers means all taxpayers whose returns are 
affected by the election to apply the regulations. The rules relating 
to the treatment of banks apply to all taxable years beginning after 
December 31, 1996; see Sec. 1.1361-4(a)(3)(iii). The provision relating 
to transitional relief from the step transaction applies to certain 
QSub elections effective on or before the end of calendar year 2000; 
see Sec. 1.1361-4(a)(5)(i). Section 1.1361-5(c)(2), relating to 
automatic consent for an S or QSub election made for a corporation 
whose QSub election has terminated within the five-year period 
described in section 1361(b)(3)(D), applies to certain QSub elections 
effective after December 31, 1996. Section 301.6109-1(i), relating to 
EINs, applies on or after January 20, 2000.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. It is hereby 
certified that the collection of information in these regulations will 
not have a significant impact on a substantial number of small 
businesses. This certification is based upon the fact that the economic 
burden imposed on taxpayers by the collection of information and 
recordkeeping requirements of these regulations is insignificant. For 
example, the estimated average annual burden per respondent is less 
than one hour. Furthermore, most taxpayers will only have to respond to 
the requests for information contained in Secs. 1.1361-3 and 1.1361-5 
one time in the life of the corporation. Therefore, a Regulatory 
Flexibility Analysis is not required under the Regulatory Flexibility 
Act (5 U.S.C. chapter 6). Pursuant to section 7805(f) of the Internal 
Revenue Code, the notice of proposed rulemaking preceding these 
regulations was submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Drafting Information

    The principal authors of these regulations are Jeanne M. Sullivan 
and David J. Sotos of the Office of the Assistant Chief Counsel 
(Passthroughs & Special Industries); and Michael N. Kaibni of the 
Office of the Assistant Chief Counsel (Corporate). However, other 
personnel from the IRS and Treasury Department participated in their 
development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 301

    Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income 
taxes, Penalties, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1, 301, and 602 are amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority:  26 U.S.C. 7805 *  *  


    Par. 2. Amend Sec. 1.1361-0 as follows:
    1. Revise the introductory text.
    2. Remove the entry for Sec. 1.1361-1(d)(3).

[[Page 3849]]

    3. Add entries for Secs. 1.1361-2, 1.1361-3, 1.1361-4, 1.1361-5, 
and 1.1361-6.
    The revisions and additions read as follows:


Sec. 1.1361-0  Table of contents.

    This section lists captions contained in Secs. 1.1361-1, 1.1361-2, 
1.1361-3, 1.1361-4, 1.1361-5, and 1.1361-6.
* * * * *

Sec. 1.1361-2  Definitions relating to S corporation subsidiaries.

    (a) In general.
    (b) Stock treated as held by S corporation.
    (c) Straight debt safe harbor.
    (d) Examples.

Sec. 1.1361-3  QSub election.

    (a) Time and manner of making election.
    (1) In general.
    (2) Manner of making election.
    (3) Time of making election.
    (4) Effective date of election.
    (5) Example.
    (6) Extension of time for making a QSub election.
    (b) Revocation of QSub election.
    (1) Manner of revoking QSub election.
    (2) Effective date of revocation.
    (3) Revocation after termination.
    (4) Revocation before QSub election effective.

Sec. 1.1361-4  Effect of QSub election.

    (a) Separate existence ignored.
    (1) In general.
    (2) Liquidation of subsidiary.
    (i) In general.
    (ii) Examples
    (iii) Adoption of plan of liquidation.
    (iv) Example.
    (v) Stock ownership requirements of section 332.
    (3) Treatment of banks.
    (i) In general.
    (ii) Examples.
    (iii)Effective date.
    (4) Treatment of stock of QSub.
    (5) Transitional relief.
    (i) General rule.
    (ii) Examples.
    (b) Timing of the liquidation.
    (1) In general.
    (2) Application to elections in tiered situations.
    (3) Acquisitions.
    (i) In general.
    (ii) Special rules for acquired S corporations.
    (4) Coordination with section 338 election.
    (c) Carryover of disallowed losses and deductions.
    (d) Examples.

Sec. 1.1361-5  Termination of QSub election.

    (a) In general.
    (1) Effective date.
    (2) Information to be provided upon termination of QSub election 
by failure to qualify as a QSub.
    (3) QSub joins a consolidated group.
    (4) Examples.
    (b) Effect of termination of QSub election.
    (1) Formation of new corporation.
    (i) In general.
    (ii) Termination for tiered QSubs.
    (2) Carryover of disallowed losses and deductions.
    (3) Examples.
    (c) Election after QSub termination.
    (1) In general.
    (2) Exception.
    (3) Examples.

Sec. 1.1361-6  Effective date.


    Par. 3. Amend Sec. 1.1361-1 as follows:
    1. Revise paragraph (b)(1)(i).
    2. Remove paragraph (d)(1)(i).
    3. Redesignate paragraphs (d)(1)(ii), (d)(1)(iii), (d)(1)(iv), and 
(d)(1)(v) as paragraphs (d)(1)(i), (d)(1)(ii), (d)(1)(iii), and 
(d)(1)(iv), respectively.
    4. Revise newly designated paragraph (d)(1)(i).
    5. Remove paragraph (d)(3).
    6. Revise the first sentence of paragraph (e)(1).
    The revisions read as follows:


Sec. 1.1361-1  S corporation defined.

* * * * *
    (b) * * *
    (1) * * *
    (i) More than 75 shareholders (35 for taxable years beginning 
before January 1, 1997);
* * * * *
    (d) * * *
    (1) * * *
    (i) For taxable years beginning on or after January 1, 1997, a 
financial institution that uses the reserve method of accounting for 
bad debts described in section 585 (for taxable years beginning prior 
to January 1, 1997, a financial institution to which section 585 
applies (or would apply but for section 585(c)) or to which section 593 
applies);
* * * * *
    (e) * * *
    (1) General rule. A corporation does not qualify as a small 
business corporation if it has more than 75 shareholders (35 for 
taxable years beginning prior to January 1, 1997). * * *
* * * * *

    Par. 4. Add Secs. 1.1361-2, 1.1361-3, 1.1361-4, 1.1361-5, and 
1.1361-6 to read as follows:


Sec. 1.1361-2  Definitions relating to S corporation subsidiaries.

    (a) In general. The term qualified subchapter S subsidiary (QSub) 
means any domestic corporation that is not an ineligible corporation 
(as defined in section 1361(b)(2) and the regulations thereunder), if--
    (1) 100 percent of the stock of such corporation is held by an S 
corporation; and
    (2) The S corporation properly elects to treat the subsidiary as a 
QSub under Sec. 1.1361-3.
    (b) Stock treated as held by S corporation. For purposes of 
satisfying the 100 percent stock ownership requirement in section 
1361(b)(3)(B)(i) and paragraph (a)(1) of this section--
    (1) Stock of a corporation is treated as held by an S corporation 
if the S corporation is the owner of that stock for Federal income tax 
purposes; and
    (2) Any outstanding instruments, obligations, or arrangements of 
the corporation which would not be considered stock for purposes of 
section 1361(b)(1)(D) if the corporation were an S corporation are not 
treated as outstanding stock of the QSub.
    (c) Straight debt safe harbor. Section 1.1361-1(l)(5)(iv) and (v) 
apply to an obligation of a corporation for which a QSub election is 
made if that obligation would satisfy the definition of straight debt 
in Sec. 1.1361-1(l)(5) if issued by the S corporation.
    (d) Examples. The following examples illustrate the application of 
this section:

    Example 1. X, an S corporation, owns 100 percent of Y, a 
corporation for which a valid QSub election is in effect for the 
taxable year. Y owns 100 percent of Z, a corporation otherwise 
eligible for QSub status. X may elect to treat Z as a QSub under 
section 1361(b)(3)(B)(ii).
    Example 2. Assume the same facts as in Example 1, except that Y 
is a business entity that is disregarded as an entity separate from 
its owner under Sec. 301.7701-2(c)(2) of this chapter. X may elect 
to treat Z as a QSub.
    Example 3. Assume the same facts as in Example 1, except that Y 
owns 50 percent of Z, and X owns the other 50 percent. X may elect 
to treat Z as a QSub.
    Example 4. Assume the same facts as in Example 1, except that Y 
is a C corporation. Although Y is a domestic corporation that is 
otherwise eligible to be a QSub, no QSub election has been made for 
Y. Thus, X is not treated as holding the stock of Z. Consequently, X 
may not elect to treat Z as a QSub.
    Example 5. Individuals A and B own 100 percent of the stock of 
corporation X, an S corporation, and, except for C's interest 
(described below), X owns 100 percent of corporation Y, a C 
corporation. Individual C holds an instrument issued by Y that is 
considered to be equity under general principles of tax law but 
would satisfy the definition of straight debt under Sec. 1.1361-
1(l)(5) if Y were an S corporation. In determining whether X owns 
100 percent of Y for purposes of making the QSub election, the 
instrument held by C is not considered outstanding stock. In 
addition, under Sec. 1.1361-1(l)(5)(v), the QSub election is not 
treated as an exchange of debt for stock with respect to such 
instrument, and Sec. 1.1361-1(l)(5)(iv) applies to determine the tax 
treatment of payments on the instrument while Y's QSub election is 
in effect.


[[Page 3850]]




Sec. 1.1361-3  QSub election.

    (a) Time and manner of making election--(1) In general. The 
corporation for which the QSub election is made must meet all the 
requirements of section 1361(b)(3)(B) at the time the election is made 
and for all periods for which the election is to be effective.
    (2) Manner of making election. Except as provided in section 
1361(b)(3)(D) and Sec. 1.1361-5(c) (five-year prohibition on re-
election), an S corporation may elect to treat an eligible subsidiary 
as a QSub by filing a completed form to be prescribed by the IRS. The 
election form must be signed by a person authorized to sign the S 
corporation's return required to be filed under section 6037. Unless 
the election form provides otherwise, the election must be submitted to 
the service center where the subsidiary filed its most recent tax 
return (if applicable), and, if an S corporation forms a subsidiary and 
makes a valid QSub election (effective upon the date of the 
subsidiary's formation) for the subsidiary, the election should be 
submitted to the service center where the S corporation filed its most 
recent return.
    (3) Time of making election. A QSub election may be made by the S 
corporation parent at any time during the taxable year.
    (4) Effective date of election. A QSub election will be effective 
on the date specified on the election form or on the date the election 
form is filed if no date is specified. The effective date specified on 
the form cannot be more than two months and 15 days prior to the date 
of filing and cannot be more than 12 months after the date of filing. 
For this purpose, the definition of the term month found in 
Sec. 1.1362-6(a)(2)(ii)(C) applies. If an election form specifies an 
effective date more than two months and 15 days prior to the date on 
which the election form is filed, it will be effective two months and 
15 days prior to the date it is filed. If an election form specifies an 
effective date more than 12 months after the date on which the election 
is filed, it will be effective 12 months after the date it is filed.
    (5) Example. The following example illustrates the application of 
paragraph (a)(4) of this section:

    Example. X has been a calendar year S corporation engaged in a 
trade or business for several years. X acquires the stock of Y, a 
calendar year C corporation, on April 1, 2002. On August 10, 2002, X 
makes an election to treat Y as a QSub. Unless otherwise specified on 
the election form, the election will be effective as of August 10, 
2002. If specified on the election form, the election may be effective 
on some other date that is not more than two months and 15 days prior 
to August 10, 2002, and not more than 12 months after August 10, 2002.

    (6) Extension of time for making a QSub election. An extension of 
time to make a QSub election may be available under the procedures 
applicable under Secs. 301.9100-1 and 301.9100-3 of this chapter.
    (b) Revocation of QSub election--(1) Manner of revoking QSub 
election. An S corporation may revoke a QSub election under section 
1361 by filing a statement with the service center where the S 
corporation's most recent tax return was properly filed. The revocation 
statement must include the names, addresses, and taxpayer 
identification numbers of both the parent S corporation and the QSub, 
if any. The statement must be signed by a person authorized to sign the 
S corporation's return required to be filed under section 6037.
    (2) Effective date of revocation. The revocation of a QSub election 
is effective on the date specified on the revocation statement or on 
the date the revocation statement is filed if no date is specified. The 
effective date specified on the revocation statement cannot be more 
than two months and 15 days prior to the date on which the revocation 
statement is filed and cannot be more than 12 months after the date on 
which the revocation statement is filed. If a revocation statement 
specifies an effective date more than two months and 15 days prior to 
the date on which the statement is filed, it will be effective two 
months and 15 days prior to the date it is filed. If a revocation 
statement specifies an effective date more than 12 months after the 
date on which the statement is filed, it will be effective 12 months 
after the date it is filed.
    (3) Revocation after termination. A revocation may not be made 
after the occurrence of an event that renders the subsidiary ineligible 
for QSub status under section 1361(b)(3)(B).
    (4) Revocation before QSub election effective. For purposes of 
Section 1361(b)(3)(D) and Sec. 1.1361-5(c) (five-year prohibition on 
re-election), a revocation effective on the first day the QSub election 
was to be effective will not be treated as a termination of a QSub 
election.


Sec. 1.1361-4  Effect of QSub election.

    (a) Separate existence ignored--(1) In general. Except as otherwise 
provided in paragraph (a)(3) of this section, for Federal tax 
purposes--
    (i) A corporation which is a QSub shall not be treated as a 
separate corporation; and
    (ii) All assets, liabilities, and items of income, deduction, and 
credit of a QSub shall be treated as assets, liabilities, and items of 
income, deduction, and credit of the S corporation.
    (2) Liquidation of subsidiary--(i) In general. If an S corporation 
makes a valid QSub election with respect to a subsidiary, the 
subsidiary is deemed to have liquidated into the S corporation. Except 
as provided in paragraph (a)(5) of this section, the tax treatment of 
the liquidation or of a larger transaction that includes the 
liquidation will be determined under the Internal Revenue Code and 
general principles of tax law, including the step transaction doctrine. 
Thus, for example, if an S corporation forms a subsidiary and makes a 
valid QSub election (effective upon the date of the subsidiary's 
formation) for the subsidiary, the transfer of assets to the subsidiary 
and the deemed liquidation are disregarded, and the corporation will be 
deemed to be a QSub from its inception.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (a)(2)(i) of this section:

    Example 1. Corporation X acquires all of the outstanding stock 
of solvent corporation Y from an unrelated individual for cash and 
short-term notes. Thereafter, as part of the same plan, X 
immediately makes an S election and a QSub election for Y. Because X 
acquired all of the stock of Y in a qualified stock purchase within 
the meaning of section 338(d)(3), the liquidation described in 
paragraph (a)(2) of this section is respected as an independent step 
separate from the stock acquisition, and the tax consequences of the 
liquidation are determined under sections 332 and 337.
    Example 2. Corporation X, pursuant to a plan, acquires all of 
the outstanding stock of corporation Y from the shareholders of Y 
solely in exchange for 10 percent of the voting stock of X. Prior to 
the transaction, Y and its shareholders are unrelated to X. 
Thereafter, as part of the same plan, X immediately makes an S 
election and a QSub election for Y. The transaction is a 
reorganization described in section 368(a)(1)(C), assuming the other 
conditions for reorganization treatment (e.g., continuity of 
business enterprise) are satisfied.
    Example 3. After the expiration of the transition period 
provided in paragraph (a)(5)(i) of this section, individual A, 
pursuant to a plan, contributes all of the outstanding stock of Y to 
his wholly owned S corporation, X, and immediately causes X to make 
a QSub election for Y. The transaction is a reorganization under 
section 368(a)(1)(D), assuming the other conditions for 
reorganization treatment (e.g., continuity of business enterprise) 
are satisfied. If the sum of the amount of liabilities of Y treated 
as assumed by X exceeds the total of the

[[Page 3851]]

adjusted basis of the property of Y, then section 357(c) applies and 
such excess is considered as gain from the sale or exchange of a 
capital asset or of property which is not a capital asset, as the 
case may be.

    (iii) Adoption of plan of liquidation. For purposes of satisfying 
the requirement of adoption of a plan of liquidation under section 332, 
unless a formal plan of liquidation that contemplates the QSub election 
is adopted on an earlier date, the making of the QSub election is 
considered to be the adoption of a plan of liquidation immediately 
before the deemed liquidation described in paragraph (a)(2)(i) of this 
section.
    (iv) Example. The following example illustrates the application of 
paragraph (a)(2)(iii) of this section:

     Example. Corporation X owns 75 percent of a solvent corporation 
Y, and individual A owns the remaining 25 percent of Y. As part of a 
plan to make a QSub election for Y, X causes Y to redeem A's 25 
percent interest on June 1 for cash and makes a QSub election for Y 
effective on June 3. The making of the QSub election is considered 
to be the adoption of a plan of liquidation immediately before the 
deemed liquidation. The deemed liquidation satisfies the 
requirements of section 332.

    (v) Stock ownership requirements of section 332. The deemed 
exercise of an option under Sec. 1.1504-4 and any instruments, 
obligations, or arrangements that are not considered stock under 
Sec. 1.1361-2(b)(2) are disregarded in determining if the stock 
ownership requirements of section 332(b) are met with respect to the 
deemed liquidation provided in paragraph (a)(2)(i) of this section.
    (3) Treatment of banks--(i) In general. If an S corporation is a 
bank, or if an S corporation makes a valid QSub election for a 
subsidiary that is a bank, any special rules applicable to banks under 
the Internal Revenue Code continue to apply separately to the bank 
parent or bank subsidiary as if the deemed liquidation of any QSub 
under paragraph (a)(2) of this section had not occurred (except as 
other published guidance may apply section 265(b) and section 291(a)(3) 
and (e)(1)(B) not only to the bank parent or bank subsidiary but also 
to any QSub deemed to have liquidated under paragraph (a)(2) of this 
section). For any QSub that is a bank, however, all assets, 
liabilities, and items of income, deduction, and credit of the QSub, as 
determined in accordance with the special bank rules, are treated as 
assets, liabilities, and items of income, deduction, and credit of the 
S corporation. For purposes of this paragraph (a)(3)(i), the term bank 
has the same meaning as in section 581.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (a)(3):

    Example 1.  X, an S corporation, is a bank as defined in section 
581. X owns 100 percent of Y and Z, corporations for which valid 
QSub elections are in effect. Y is a bank as defined in section 581, 
and Z is not a financial institution. Pursuant to paragraph 
(a)(3)(i) of this section, any special rules applicable to banks 
under the Internal Revenue Code continue to apply separately to X 
and Y and do not apply to Z. Thus, for example, section 265(b), 
which provides special rules for interest expense deductions of 
banks, applies separately to X and Y. That is, X and Y each must 
make a separate determination under section 265(b) of interest 
expense allocable to tax-exempt interest, and no deduction is 
allowed for that interest expense. Section 265(b) does not apply to 
Z except as published guidance may provide otherwise.
    Example 2. X, an S corporation, is a bank holding company and 
thus is not a bank as defined in section 581. X owns 100 percent of 
Y, a corporation for which a valid QSub election is in effect. Y is 
a bank as defined in section 581. Pursuant to paragraph (a)(3)(i) of 
this section, any special rules applicable to banks under the 
Internal Revenue Code continue to apply to Y and do not apply to X. 
However, all of Y's assets, liabilities, and items of income, 
deduction, and credit, as determined in accordance with the special 
bank rules, are treated as those of X. Thus, for example, section 
582(c), which provides special rules for sales and exchanges of debt 
by banks, applies only to sales and exchanges by Y. However, any 
gain or loss on such a transaction by Y that is considered ordinary 
income or ordinary loss pursuant to section 582(c) is treated as 
ordinary income or ordinary loss of X.

    (iii) Effective date. This paragraph (a)(3) applies to taxable 
years beginning after December 31, 1996.
    (4) Treatment of stock of QSub. Except for purposes of section 
1361(b)(3)(B)(i) and Sec. 1.1361-2(a)(1), the stock of a QSub shall be 
disregarded for all Federal tax purposes.
    (5) Transitional relief--(i) General rule. If an S corporation and 
another corporation (the related corporation) are persons specified in 
section 267(b) prior to an acquisition by the S corporation of some or 
all of the stock of the related corporation followed by a QSub election 
for the related corporation, the step transaction doctrine will not 
apply to determine the tax consequences of the acquisition. This 
paragraph (a)(5) shall apply to QSub elections effective before January 
1, 2001.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (a)(5):

    Example 1. Individual A owns 100 percent of the stock of X, an S 
corporation. X owns 79 percent of the stock of Y, a solvent 
corporation, and A owns the remaining 21 percent. On May 4, 1998, A 
contributes its Y stock to X in exchange for X stock. X makes a QSub 
election with respect to Y effective immediately following the 
transfer. The liquidation described in paragraph (a)(2) of this 
section is respected as an independent step separate from the stock 
acquisition, and the tax consequences of the liquidation are 
determined under sections 332 and 337. The contribution by A of the 
Y stock qualifies under section 351, and no gain or loss is 
recognized by A, X, or Y.
    Example 2. Individual A owns 100 percent of the stock of two 
solvent S corporations, X and Y. On May 4, 1998, A contributes the 
stock of Y to X. X makes a QSub election with respect to Y 
immediately following the transfer. The liquidation described in 
paragraph (a)(2) of this section is respected as an independent step 
separate from the stock acquisition, and the tax consequences of the 
liquidation are determined under sections 332 and 337. The 
contribution by A of the Y stock to X qualifies under section 351, 
and no gain or loss is recognized by A, X, or Y. Y is not treated as 
a C corporation for any period solely because of the transfer of its 
stock to X, an ineligible shareholder. Compare Example 3 of 
Sec. 1.1361-4(a)(2)(ii).

    (b) Timing of the liquidation--(1) In general. Except as otherwise 
provided in paragraph (b)(3) or (4) of this section, the liquidation 
described in paragraph (a)(2) of this section occurs at the close of 
the day before the QSub election is effective. Thus, for example, if a 
C corporation elects to be treated as an S corporation and makes a QSub 
election (effective the same date as the S election) with respect to a 
subsidiary, the liquidation occurs immediately before the S election 
becomes effective, while the S electing parent is still a C 
corporation.
    (2) Application to elections in tiered situations. When QSub 
elections for a tiered group of subsidiaries are effective on the same 
date, the S corporation may specify the order of the liquidations. If 
no order is specified, the liquidations that are deemed to occur as a 
result of the QSub elections will be treated as occurring first for the 
lowest tier entity and proceed successively upward until all of the 
liquidations under paragraph (a)(2) of this section have occurred. For 
example, S, an S corporation, owns 100 percent of C, the common parent 
of an affiliated group of corporations that includes X and Y. C owns 
all of the stock of X and X owns all of the stock of Y. S elects under 
Sec. 1.1361-3 to treat C, X and Y as QSubs effective on the same date. 
If no order is specified for the elections, the following liquidations 
are deemed to occur as a result of the elections, with each successive 
liquidation occuring on the same day immediately after the preceding 
liquidation: Y is treated as liquidating into X, then X is treated as 
liquidating

[[Page 3852]]

into C, and finally C is treated as liquidating into S.
    (3) Acquisitions. (i) In general. If an S corporation does not own 
100 percent of the stock of the subsidiary on the day before the QSub 
election is effective, the liquidation described in paragraph (a)(2) of 
this section occurs immediately after the time at which the S 
corporation first owns 100 percent of the stock.
    (ii) Special rules for acquired S corporations. Except as provided 
in paragraph (b)(4) of this section, if a corporation (Y) for which an 
election under section 1362(a) was in effect is acquired, and a QSub 
election is made effective on the day Y is acquired, Y is deemed to 
liquidate into the S corporation at the beginning of the day the 
termination of its S election is effective. As a result, if corporation 
X acquires Y, an S corporation, and makes an S election for itself and 
a QSub election for Y effective on the day of acquisition, Y liquidates 
into X at the beginning of the day when X's S election is effective, 
and there is no period between the termination of Y's S election and 
the deemed liquidation of Y during which Y is a C corporation. Y's 
taxable year ends for all Federal income tax purposes at the close of 
the preceding day. Furthermore, if Y owns Z, a corporation for which a 
QSub election was in effect prior to the acquisition of Y by X, and X 
makes QSub elections for Y and Z, effective on the day of acquisition, 
the transfer of assets to Z and the deemed liquidation of Z are 
disregarded. See Secs. 1.1361-4(a)(2) and 1.1361-5(b)(1)(i).
    (4) Coordination with section 338 election. An S corporation that 
makes a qualified stock purchase of a target may make an election under 
section 338 with respect to the acquisition if it meets the 
requirements for the election, and may make a QSub election with 
respect to the target. If an S corporation makes an election under 
section 338 with respect to a subsidiary acquired in a qualified stock 
purchase, a QSub election made with respect to that subsidiary is not 
effective before the day after the acquisition date (within the meaning 
of section 338(h)(2)). If the QSub election is effective on the day 
after the acquisition date, the liquidation under paragraph (a)(2) of 
this section occurs immediately after the deemed asset purchase by the 
new target corporation under section 338. If an S corporation makes an 
election under section 338 (without a section 338(h)(10) election) with 
respect to a target, the target must file a final or deemed sale return 
as a C corporation reflecting the deemed sale. See Sec. 1.338-10T(a).
    (c) Carryover of disallowed losses and deductions. If an S 
corporation (S1) acquires the stock of another S corporation (S2), and 
S1 makes a QSub election with respect to S2 effective on the day of the 
acquisition, see Sec. 1.1366-2(c)(1) for provisions relating to the 
carryover of losses and deductions with respect to a former shareholder 
of S2 that may be available to that shareholder as a shareholder of S1.
    (d) Examples. The following examples illustrate the application of 
this section:

    Example 1. X, an S corporation, owns 100 percent of the stock of 
Y, a C corporation. On June 2, 2002, X makes a valid QSub election 
for Y, effective June 2, 2002. Assume that, under general principles 
of tax law, including the step transaction doctrine, X's acquisition 
of the Y stock and the subsequent QSub election would not be treated 
as related. The liquidation described in paragraph (a)(2) of this 
section occurs at the close of the day on June 1, 2002, the day 
before the QSub election is effective, and the plan of liquidation 
is considered adopted on that date. Y's taxable year and separate 
existence for Federal tax purposes end at the close of June 1, 2002.
    Example 2. X, a C corporation, owns 100 percent of the stock of 
Y, another C corporation. On December 31, 2002, X makes an election 
under section 1362 to be treated as an S corporation and a valid 
QSub election for Y, both effective January 1, 2003. Assume that, 
under general principles of tax law, including the step transaction 
doctrine, X's acquisition of the Y stock and the subsequent QSub 
election would not be treated as related. The liquidation described 
in paragraph (a)(2) of this section occurs at the close of December 
31, 2002, the day before the QSub election is effective. The QSub 
election for Y is effective on the same day that X's S election is 
effective, and the deemed liquidation is treated as occurring before 
the S election is effective, when X is still a C corporation. Y's 
taxable year ends at the close of December 31, 2002. See 
Sec. 1.381(b)-1.
    Example 3. On June 1, 2002, X, an S corporation, acquires 100 
percent of the stock of Y, an existing S corporation, for cash in a 
transaction meeting the requirements of a qualified stock purchase 
(QSP) under section 338. X immediately makes a QSub election for Y 
effective June 2, 2002, and also makes a joint election under 
section 338(h)(10) with the shareholder of Y. Under section 338(a) 
and Sec. 1.338(h)(10)-1T(d)(3), Y is treated as having sold all of 
its assets at the close of the acquisition date, June 1, 2002. Y is 
treated as a new corporation which purchased all of those assets as 
of the beginning of June 2, 2000, the day after the acquisition 
date. Section 338(a)(2). The QSub election is effective on June 2, 
2002, and the liquidation under paragraph (a)(2) of this section 
occurs immediately after the deemed asset purchase by the new 
corporation.
    Example 4. X, an S corporation, owns 100 percent of Y, a 
corporation for which a QSub election is in effect. On May 12, 2002, 
a date on which the QSub election is in effect, X issues Y a $10,000 
note under state law that matures in ten years with a market rate of 
interest. Y is not treated as a separate corporation, and X's 
issuance of the note to Y on May 12, 2002, is disregarded for 
Federal tax purposes.
    Example 5. X, an S corporation, owns 100 percent of the stock of 
Y, a C corporation. At a time when Y is indebted to X in an amount 
that exceeds the fair market value of Y's assets, X makes a QSub 
election effective on the date it is filed with respect to Y. The 
liquidation described in paragraph (a)(2) of this section does not 
qualify under sections 332 and 337 and, thus, Y recognizes gain or 
loss on the assets distributed, subject to the limitations of 
section 267.

Sec. 1.1361-5  Termination of QSub election.

    (a) In general--(1) Effective date. The termination of a QSub 
election is effective--
    (i) On the effective date contained in the revocation statement if 
a QSub election is revoked under Sec. 1.1361-3(b);
    (ii) At the close of the last day of the parent's last taxable year 
as an S corporation if the parent's S election terminates under 
Sec. 1.1362-2; or
    (iii) At the close of the day on which an event (other than an 
event described in paragraph (a)(1)(ii) of this section) occurs that 
renders the subsidiary ineligible for QSub status under section 
1361(b)(3)(B).
    (2) Information to be provided upon termination of QSub election by 
failure to qualify as a QSub. If a QSub election terminates because an 
event renders the subsidiary ineligible for QSub status, the S 
corporation must attach to its return for the taxable year in which the 
termination occurs a notification that a QSub election has terminated, 
the date of the termination, and the names, addresses, and employer 
identification numbers of both the parent corporation and the QSub.
    (3) QSub joins a consolidated group. If a QSub election terminates 
because the S corporation becomes a member of a consolidated group (and 
no election under section 338(g) is made) the principles of 
Sec. 1.1502-76(b)(1)(ii)(A)(2) (relating to a special rule for S 
corporations that join a consolidated group) apply to any QSub of the S 
corporation that also becomes a member of the consolidated group at the 
same time as the S corporation. See Example 4 of paragraph (a)(4) of 
this section.
    (4) Examples. The following examples illustrate the application of 
this paragraph (a):

    Example 1.Termination because parent's S election terminates. X, 
an S corporation, owns 100 percent of Y. A QSub election is in 
effect with respect to Y for 2001. Effective on January 1, 2002, X 
revokes its S election. Because X is no longer an S corporation, Y

[[Page 3853]]

no longer qualifies as a QSub at the close of December 31, 2001.
    Example 2.Termination due to transfer of QSub stock. X, an S 
corporation, owns 100 percent of Y. A QSub election is in effect 
with respect to Y. On December 10, 2002, X sells one share of Y 
stock to A, an individual. Because X no longer owns 100 percent of 
the stock of Y, Y no longer qualifies as a QSub. Accordingly, the 
QSub election made with respect to Y terminates at the close of 
December 10, 2002.
    Example 3. No termination on stock transfer between QSub and 
parent. X, an S corporation, owns 100 percent of the stock of Y, and 
Y owns 100 percent of the stock of Z. QSub elections are in effect 
with respect to both Y and Z. Y transfers all of its Z stock to X. 
Because X is treated as owning the stock of Z both before and after 
the transfer of stock solely for purposes of determining whether the 
requirements of section 1361(b)(3)(B)(i) and Sec. 1.1361-2(a)(1) 
have been satisfied, the transfer of Z stock does not terminate Z's 
QSub election. Because the stock of Z is disregarded for all other 
Federal tax purposes, no gain is recognized under section 311.
    Example 4. Termination due to acquisition of S parent by a 
consolidated group. X, an S corporation, owns 100 percent of Y, a 
corporation for which a QSub election is in effect. Z, the common 
parent of a consolidated group of corporations, acquires 80 percent 
of the stock of X on June 1, 2002. Z does not make an election under 
section 338(g) with respect to the purchase of X stock. X's S 
election terminates as of the close of the preceding day, May 31, 
2002. Y's QSub election also terminates at the close of May 31, 
2002. Under Sec. 1.1502-76(b)(1)(ii)(A)(2) and paragraph (a)(3) of 
this section, X and Y become members of Z's consolidated group of 
corporations as of the beginning of the day June 1, 2002.
    Example 5. Termination due to acquisition of QSub by a 
consolidated group. The facts are the same as in Example 4, except 
that Z acquires 80 percent of the stock of Y (instead of X) on June 
1, 2002. In this case, Y's QSub election terminates as of the close 
of June 1, 2002, and, under Sec. 1.1502-76(b)(1)(ii)(A)(1), Y 
becomes a member of the consolidated group at that time.

    (b) Effect of termination of QSub election--(1) Formation of new 
corporation--(i) In general. If a QSub election terminates under 
paragraph (a) of this section, the former QSub is treated as a new 
corporation acquiring all of its assets (and assuming all of its 
liabilities) immediately before the termination from the S corporation 
parent in exchange for stock of the new corporation. he tax treatment 
of this transaction or of a larger transaction that includes this 
transaction will be determined under the Internal Revenue Code and 
general principles of tax law, including the step transaction doctrine. 
For purposes of determining the application of section 351 with respect 
to this transaction, instruments, obligations, or other arrangements 
that are not treated as stock of the QSub under Sec. 1.1361-2(b) are 
disregarded in determining control for purposes of section 368(c) even 
if they are equity under general principles of tax law.
    (ii) Termination for tiered QSubs. If QSub elections terminate for 
tiered QSubs on the same day, the formation of any higher tier 
subsidiary precedes the formation of its lower tier subsidiary. See 
Example 6 in paragraph (b)(3) of this section.
    (2) Carryover of disallowed losses and deductions. If a QSub 
terminates because the S corporation distributes the QSub stock to some 
or all of the S corporation's shareholders in a transaction to which 
section 368(a)(1)(D) applies by reason of section 355 (or so much of 
section 356 as relates to section 355), see Sec. 1.1366-2(c)(2) for 
provisions relating to the carryover of disallowed losses and 
deductions that may be available.
    (3) Examples. The following examples illustrate the application of 
this paragraph (b):

    Example 1. X, an S corporation, owns 100 percent of the stock of 
Y, a corporation for which a QSub election is in effect. X sells 21 
percent of the Y stock to Z, an unrelated corporation, for cash, 
thereby terminating the QSub election. Y is treated as a new 
corporation acquiring all of its assets (and assuming all of its 
liabilities) in exchange for Y stock immediately before the 
termination from the S corporation. The deemed exchange by X of 
assets for Y stock does not qualify under section 351 because X is 
not in control of Y within the meaning of section 368(c) immediately 
after the transfer as a result of the sale of stock to Z. Therefore, 
X must recognize gain, if any, on the assets transferred to Y in 
exchange for its stock. X's losses, if any, on the assets 
transferred are subject to the limitations of section 267.
    Example 2. (i) X, an S corporation, owns 100 percent of the 
stock of Y, a corporation for which a QSub election is in effect. As 
part of a plan to sell a portion of Y, X causes Y to merge into T, a 
limited liability company wholly owned by X that is disregarded as 
an entity separate from its owner for Federal tax purposes. X then 
sells 21 percent of T to Z, an unrelated corporation, for cash. 
Following the sale, no entity classification election is made under 
Sec. 301.7701-3(c) of this chapter to treat the limited liability 
company as an association for Federal tax purposes.
    (ii) The merger of Y into T causes a termination of Y's QSub 
election. The new corporation (Newco) that is formed as a result of the 
termination is immediately merged into T, an entity that is disregarded 
for Federal tax purposes. Because, at the end of the series of 
transactions, the assets continue to be held by X for Federal tax 
purposes, under step transaction principles, the formation of Newco and 
the transfer of assets pursuant to the merger of Newco into T are 
disregarded. The sale of 21 percent of T is treated as a sale of a 21 
percent undivided interest in each of T's assets. Immediately 
thereafter, X and Z are treated as contributing their respective 
interests in those assets to a partnership in exchange for ownership 
interests in the partnership.
    (iii) Under section 1001, X recognizes gain or loss from the deemed 
sale of the 21 percent interest in each asset of the limited liability 
company to Z. Under section 721(a), no gain or loss is recognized by X 
and Z as a result of the deemed contribution of their respective 
interests in the assets to the partnership in exchange for ownership 
interests in the partnership.
    Example 3. Assume the same facts as in Example 1, except that, 
instead of purchasing Y stock, Z contributes to Y an operating asset 
in exchange for 21 percent of the Y stock. Y is treated as a new 
corporation acquiring all of its assets (and assuming all of its 
liabilities) in exchange for Y stock immediately before the 
termination. Because X and Z are co-transferors that control the 
transferee immediately after the transfer, the transaction qualifies 
under section 351.
    Example 4. X, an S corporation, owns 100 percent of the stock of 
Y, a corporation for which a QSub election is in effect. X 
distributes all of the Y stock pro rata to its shareholders, and the 
distribution terminates the QSub election. The transaction can 
qualify as a distribution to which sections 368(a)(1)(D) and 355 
apply if the transaction otherwise satisfies the requirements of 
those sections.
    Example 5. X, an S corporation, owns 100 percent of the stock of 
Y, a corporation for which a QSub election is in effect. X 
subsequently revokes the QSub election. Y is treated as a new 
corporation acquiring all of its assets (and assuming all of its 
liabilities) immediately before the revocation from its S 
corporation parent in a deemed exchange for Y stock. On a subsequent 
date, X sells 21 percent of the stock of Y to Z, an unrelated 
corporation, for cash. Assume that under general principles of tax 
law including the step transaction doctrine, the sale is not taken 
into account in determining whether X is in control of Y immediately 
after the deemed exchange of assets for stock. The deemed exchange 
by X of assets for Y stock and the deemed assumption by Y of its 
liabilities qualify under section 351 because, for purposes of that 
section, X is in control of Y within the meaning of section 368(c) 
immediately after the transfer.
    Example 6. (i) X, an S corporation, owns 100 percent of the 
stock of Y, and Y owns 100 percent of the stock of Z. Y and Z are 
corporations for which QSub elections are in effect. X subsequently 
revokes the QSub elections and the effective date specified on each 
revocation statement is June 26, 2002, a date that is less than 12 
months after the date on which the revocation statements are filed.
    (ii) Immediately before the QSub elections terminate, Y is treated 
as a

[[Page 3854]]

new corporation acquiring all of its assets (and assuming all of its 
liabilities) directly from X in exchange for the stock of Y. Z is 
treated as a new corporation acquiring all of its assets (and assuming 
all of its liabilities) directly from Y in exchange for the stock of Z.
    Example 7. (i) The facts are the same as in Example 6, except 
that, prior to June 26, 2002 (the effective date of the 
revocations), Y distributes the Z stock to X under state law.
    (ii) Immediately before the QSub elections terminate, Y is 
treated as a new corporation acquiring all of its assets (and 
assuming all of its liabilities) directly from X in exchange for the 
stock of Y. Z is also treated as a new corporation acquiring all of 
its assets (and assuming all of its liabilities) directly from X in 
exchange for the stock of Z.
    Example 8. Merger of parent into QSub. X, an S corporation, owns 
100 percent of the stock of Y, a corporation for which a QSub 
election is in effect. X merges into Y under state law, causing the 
QSub election for Y to terminate, and Y survives the merger. The 
formation of the new corporation, Y, and the merger of X into Y can 
qualify as a reorganization described in section 368(a)(1)(F) if the 
transaction otherwise satisfies the requirements of that section.
    Example 9. Transfer of 100 percent of QSub. X, an S corporation, 
owns 100 percent of the stock of Y, a corporation for which a QSub 
election is in effect. Z, an unrelated C corporation, acquires 100 
percent of the stock of Y. The deemed formation of Y by X (as a 
consequence of the termination of Y's QSub election) is disregarded 
for Federal income tax purposes. The transaction is treated as a 
transfer of the assets of Y to Z, followed by Z's transfer of these 
assets to the capital of Y in exchange for Y stock. Furthermore, if 
Z is an S corporation and makes a QSub election for Y effective as 
of the acquisition, Z's transfer of the assets of Y in exchange for 
Y stock, followed by the immediate liquidation of Y as a consequence 
of the QSub election are disregarded for Federal income tax 
purposes.

    (c) Election after QSub termination--(1) In general. Absent the 
Commissioner's consent, and except as provided in paragraph (c)(2) of 
this section, a corporation whose QSub election has terminated under 
paragraph (a) of this section (or a successor corporation as defined in 
paragraph (b) of this section) may not make an S election under section 
1362 or have a QSub election under section 1361(b)(3)(B)(ii) made with 
respect to it for five taxable years (as described in section 
1361(b)(3)(D)). The Commissioner may permit an S election by the 
corporation or a new QSub election with respect to the corporation 
before the five-year period expires. The corporation requesting consent 
to make the election has the burden of establishing that, under the 
relevant facts and circumstances, the Commissioner should consent to a 
new election.
    (2) Exception. In the case of S and QSub elections effective after 
December 31, 1996, if a corporation's QSub election terminates, the 
corporation may, without requesting the Commissioner's consent, make an 
S election or have a QSub election made with respect to it before the 
expiration of the five-year period described in section 1361(b)(3)(D) 
and paragraph (c)(1) of this section, provided that--
    (i) Immediately following the termination, the corporation (or its 
successor corporation) is otherwise eligible to make an S election or 
have a QSub election made for it; and
    (ii) The relevant election is made effective immediately following 
the termination of the QSub election.
    (3) Examples. The following examples illustrate the application of 
this paragraph (c):

    Example 1. Termination upon distribution of QSub stock to 
shareholders of parent. X, an S corporation, owns Y, a QSub. X 
distributes all of its Y stock to X's shareholders. The distribution 
terminates the QSub election because Y no longer satisfies the 
requirements of a QSub. Assuming Y is otherwise eligible to be 
treated as an S corporation, Y's shareholders may elect to treat Y 
as an S corporation effective on the date of the stock distribution 
without requesting the Commissioner's consent.
    Example 2. Sale of 100 percent of QSub stock. X, an S 
corporation, owns Y, a QSub. X sells 100 percent of the stock of Y 
to Z, an unrelated S corporation. Z may elect to treat Y as a QSub 
effective on the date of purchase without requesting the 
Commissioner's consent.

Sec. 1.1361-6  Effective date.

    Except as provided in Secs. 1.1361-4(a)(3)(iii), 1.1361-4(a)(5)(i), 
and 1.1361-5(c)(2), the provisions of Secs. 1.1361-2 through 1.1361-5 
apply to taxable years beginning on or after January 20, 2000; however, 
taxpayers may elect to apply the regulations in whole, but not in part 
(aside from those sections with special dates of applicability), for 
taxable years beginning on or after January 1, 2000, provided all 
affected taxpayers apply the regulations in a consistent manner. To 
make this election, the corporation and all affected taxpayers must 
file a return or an amended return that is consistent with these rules 
for the taxable year for which the election is made. For purposes of 
this section, affected taxpayers means all taxpayers whose returns are 
affected by the election to apply the regulations.

    Par. 5. Amend Sec. 1.1362-0 by adding an entry for Sec. 1.1362-8 to 
read as follows:

Sec. 1.1362-0  Table of contents.

* * * * *

Sec. .1362-8   Dividends received from affiliated subsidiaries.

    (a) In general.
    (b) Determination of active or passive earnings and profits.
    (1) In general.
    (2) Lower tier subsidiaries.
    (3) De minimis exception.
    (4) Special rules for earnings and profits accumulated by a C 
corporation prior to 80 percent acquisition.
    (5) Gross receipts safe harbor.
    (c) Allocating distributions to active or passive earnings and 
profits.
    (1) Distributions from current earnings and profits.
    (2) Distributions from accumulated earnings and profits.
    (3) Adjustments to active earnings and profits.
    (4) Special rules for consolidated groups.
    (d) Examples.
    (e) Effective date.

    Par. 6. Section 1.1362-2 is amended by adding a sentence to the end 
of the paragraph (c)(5)(ii)(C) to read as follows:


Sec. 1.1362-2  Termination of election.

* * * * *
    (c) *  *  *
    (5) *  *  *
    (ii) *  *  *
    (C) *  *  * See Sec. 1.1362-8 for special rules regarding the 
treatment of dividends received by an S corporation from a C 
corporation in which the S corporation holds stock meeting the 
requirements of section 1504(a)(2).
* * * * *

    Par. 7. Section 1.1362-8 is added to read as follows:


Sec. 1.1362-8  Dividends received from affiliated subsidiaries.

    (a) In general. For purposes of section 1362(d)(3), if an S 
corporation holds stock in a C corporation meeting the requirements of 
section 1504(a)(2), the term passive investment income does not include 
dividends from the C corporation to the extent those dividends are 
attributable to the earnings and profits of the C corporation derived 
from the active conduct of a trade or business (active earnings and 
profits). For purposes of applying section 1362(d)(3), earnings and 
profits of a C corporation are active earnings and profits to the 
extent that the earnings and profits are derived from activities that 
would not produce passive investment income (as defined in section 
1362(d)(3)) if the C corporation were an S corporation.
    (b) Determination of active or passive earnings and profits--(1) In 
general. An S corporation may use any reasonable method to determine 
the amount of

[[Page 3855]]

dividends that are not treated as passive investment income under 
section 1362(d)(3)(E). Paragraph (b)(5) of this section describes a 
method of determining the amount of dividends that are not treated as 
passive investment income under section 1362(d)(3)(E) that is deemed to 
be reasonable under all circumstances.
    (2) Lower tier subsidiaries. If a C corporation subsidiary (upper 
tier corporation) holds stock in another C corporation (lower tier 
subsidiary) meeting the requirements of section 1504(a)(2), the upper 
tier corporation's gross receipts attributable to a dividend from the 
lower tier subsidiary are considered to be derived from the active 
conduct of a trade or business to the extent the lower tier 
subsidiary's earnings and profits are attributable to the active 
conduct of a trade or business by the subsidiary under paragraph (b) 
(1), (3), (4), or (5) of this section. For purposes of this section, 
distributions by the lower tier subsidiary will be considered 
attributable to active earnings and profits according to the rule in 
paragraph (c) of this section. This paragraph (b)(2) does not apply to 
any member of a consolidated group (as defined in Sec. 1.1502-1(h)).
    (3) De minimis exception. If less than 10 percent of a C 
corporation's earnings and profits for a taxable year are derived from 
activities that would produce passive investment income if the C 
corporation were an S corporation, all earnings and profits produced by 
the corporation during that taxable year are considered active earnings 
and profits.
    (4) Special rules for earnings and profits accumulated by a C 
corporation prior to 80 percent acquisition. A C corporation may treat 
all earnings and profits accumulated by the corporation in all taxable 
years ending before the S corporation held stock meeting the 
requirements of section 1504(a)(2) as active earnings and profits in 
the same proportion as the C corporation's active earnings and profits 
for the three taxable years ending prior to the time when the S 
corporation acquired 80 percent of the C corporation bears to the C 
corporation's total earnings and profits for those three taxable years.
    (5) Gross receipts safe harbor. A corporation may treat its 
earnings and profits for a year as active earnings and profits in the 
same proportion as the corporation's gross receipts (as defined in 
Sec. 1.1362-2(c)(4)) derived from activities that would not produce 
passive investment income (if the C corporation were an S corporation), 
including those that do not produce passive investment income under 
paragraphs (b)(2) through (b)(4) of this section, bear to the 
corporation's total gross receipts for the year in which the earnings 
and profits are produced.
    (c) Allocating distributions to active or passive earnings and 
profits--(1) Distributions from current earnings and profits. Dividends 
distributed by a C corporation from current earnings and profits are 
attributable to active earnings and profits in the same proportion as 
current active earnings and profits bear to total current earnings and 
profits of the C corporation.
    (2) Distributions from accumulated earnings and profits. Dividends 
distributed by a C corporation out of accumulated earnings and profits 
for a taxable year are attributable to active earnings and profits in 
the same proportion as accumulated active earnings and profits for that 
taxable year bear to total accumulated earnings and profits for that 
taxable year immediately prior to the distribution.
    (3) Adjustments to active earnings and profits. For purposes of 
applying paragraph (c) (1) or (2) of this section to a distribution, 
the active earnings and profits of a corporation shall be reduced by 
the amount of any prior distribution properly treated as attributable 
to active earnings and profits from the same taxable year.
    (4) Special rules for consolidated groups. For purposes of applying 
section 1362(d)(3) and this section to dividends received by an S 
corporation from the common parent of a consolidated group (as defined 
in Sec. 1.1502-1(h)), the following rules apply--
    (i) The current earnings and profits, accumulated earnings and 
profits, and active earnings and profits of the common parent shall be 
determined under the principles of Sec. 1.1502-33 (relating to earnings 
and profits of any member of a consolidated group owning stock of 
another member); and
    (ii) The gross receipts of the common parent shall be the sum of 
the gross receipts of each member of the consolidated group (including 
the common parent), adjusted to eliminate gross receipts from 
intercompany transactions (as defined in Sec. 1.1502-13(b)(1)(i)).
    (d) Examples. The following examples illustrate the principles of 
this section:

    Example 1.  (i) X, an S corporation, owns 85 percent of the one 
class of stock of Y. On December 31, 2002, Y declares a dividend of 
$100 ($85 to X), which is equal to Y's current earnings and profits. 
In 2002, Y has total gross receipts of $1,000, $200 of which would 
be passive investment income if Y were an S corporation.

    (ii) One-fifth ($200/$1,000) of Y's gross receipts for 2002 is 
attributable to activities that would produce passive investment 
income. Accordingly, one-fifth of the $100 of earnings and profits is 
passive, and $17 (\1/5\ of $85) of the dividend from Y to X is passive 
investment income.

    Example 2.  (i) The facts are the same as in Example 1, except 
that Y owns 90 percent of the stock of Z. Y and Z do not join in the 
filing of a consolidated return. In 2002, Z has gross receipts of 
$15,000, $12,000 of which are derived from activities that would 
produce passive investment income. On December 31, 2002, Z declares 
a dividend of $1,000 ($900 to Y) from current earnings and profits.

    (ii) Four-fifths ($12,000/15,000) of the dividend from Z to Y are 
attributable to passive earnings and profits. Accordingly, $720 (\4/5\ 
of $900) of the dividend from Z to Y is considered gross receipts from 
an activity that would produce passive investment income. The $900 
dividend to Y gives Y a total of $1,900 ($1,000 + $900) in gross 
receipts, $920 ($200 + $720) of which is attributable to passive 
investment income-producing activities. Under these facts, $41 ($920/
1,900 of $85) of Y's distribution to X is passive investment income to 
X.

    (e) Effective date. This section applies to dividends received in 
taxable years beginning on or after January 20, 2000; however, 
taxpayers may elect to apply the regulations in whole, but not in part, 
for taxable years beginning on or after January 1, 2000, provided all 
affected taxpayers apply the regulations in a consistent manner. To 
make this election, the corporation and all affected taxpayers must 
file a return or an amended return that is consistent with these rules 
for the taxable year for which the election is made. For purposes of 
this section, affected taxpayers means all taxpayers whose returns are 
affected by the election to apply the regulations.


Sec. 1.1368-0  [Amended]

    Par. 8. 
    Amend Sec. 1.1368-0 in the entry for Sec. 1.1368-2(d)(2) by 
revising ``Reorganizations'' to read ``Liquidations and 
reorganizations''.


Sec. 1.1368-2  [Amended]

    Par. 9. Amend Sec. 1.1368-2 in paragraph (d)(2) by revising 
``Reorganizations'' to read ``Liquidations and reorganizations'' in the 
heading and by revising ``section 381(a)(2)'' to read ``section 
381(a)'' in the first sentence.
    Par. 10. Amend Sec. 1.1374-8 by adding one sentence to the end of 
paragraph (b) to read as follows:

[[Page 3856]]

Sec. 1.1374-8  Section 1374(d)(8) transactions.

* * * * *
    (b) Separate determination of tax. * * * If an S corporation makes 
QSub elections under section 1361(b)(3) for a tiered group of 
subsidiaries effective on the same day, see Sec. 1.1361-4(b)(2).

PART 301--PROCEDURE AND ADMINISTRATION

    Par. 11. The authority citation for part 301 continues to read in 
part as follows:

    Authority:  26 U.S.C. 7805 * * *

    Par. 12. Section 301.6109-1 is amended as follows:
    1. Paragraph (i) is redesignated as paragraph (j) and the first 
sentence of newly designated paragraph (j)(1) is amended by removing 
the language ``paragraph (i)'' and adding ``paragraph (j)'' in its 
place.
    2. A new paragraph (i) is added.
    The addition reads as follows:


Sec. 301.6109-1  Identifying numbers.

* * * * *
    (i) Special rule for qualified subchapter S subsidiaries (QSubs)--
(1) General rule. Any entity that has an employer identification number 
(EIN) will retain that EIN if a QSub election is made for the entity 
under Sec. 1.1361-3 or if a QSub election that was in effect for the 
entity terminates under Sec. 1.1361-5.
    (2) EIN while QSub election in effect. Except as otherwise provided 
in regulations or other published guidance, a QSub must use the parent 
S corporation's EIN for Federal tax purposes.
    (3) EIN when QSub election terminates. If an entity's QSub election 
terminates, it may not use the EIN of the parent S corporation after 
the termination. If the entity had an EIN prior to becoming a QSub or 
obtained an EIN while it was a QSub in accordance with regulations or 
other published guidance, the entity must use that EIN. If the entity 
had no EIN, it must obtain an EIN upon termination of the QSub 
election.
    (4) Effective date. The rules of this paragraph (i) apply on 
January 20, 2000.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 13. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 14. In Sec. 602.101, paragraph (b) is amended by adding 
entries for Secs. 1.1361-3, 1.1361-5, and 1.1362-8 to the table in 
numerical order to read as follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                             Current OMB
     CFR part of section where identified and described      control No.
------------------------------------------------------------------------
* * * * *
1.1361-3...................................................    1545-1590
1.1361-5...................................................    1545-1590
* * * * *
1.1362-8...................................................    1545-1590
* * * * *
------------------------------------------------------------------------


Robert E. Wenzel,
Deputy Commissioner, Internal Revenue Service.
    Approved: January 19, 2000.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 00-1718 Filed 1-20-00; 1:19 pm]
BILLING CODE 4830-01-U