S Corporation • Qualified Subchapter S Subsidiary • “Item of Income”

Ball v. Comm’r. of Int. Rev., PICS Case No. 14-0293 (3d Cir. Feb. 12, 2014) Van Antwerpen, J. (25 pages).

The parties disagreed as to whether Qsub election and subsequent sale of the S corporation parent creates an “item of income” under §1366(a)(1)(A) thereby requiring the parties who held stock in the parent S corporation to adjust their bases in stock under §1367(a)(1)(A). The Tax Court properly found an increase in stock bases and declared the losses to be improper. Affirmed.

In 1997, 10 trusts acquired direct ownership of all shares of American Insurance Service, Inc., with an aggregate basis in AIS stock totaling $5,612,555. In 1999, the trusts formed Wind River Investment Corp. and contributed their shares in AIS in exchange for all of the shares of Wind River. Wind River subsequently designated itself a subchapter S Corporation. In 2003, Wind River elected to treat AIS as a Qsub under §1361(b)(3). Prior to the Qsub election, the trusts’ aggregate adjusted basis in the Wind River stock was $15,246,099 and after the election it was increased to $242,482,544. Later that year, the trusts sold their interests in Wind River to Fox Paine for $230,111,857 in cash and securities and claimed a loss of $12,247,229.

The IRS determined that the trusts should not have increased their bases in the Wind River stock following the Qsub election and that the sale of Wind River to Fox Paine resulted in a capital gain of approximately $214,000,000. This resulted in a tax deficiency of $33,747,858 for the trusts. The trusts appealed.

The trusts argued that the Qsub election resulted in a gain derived from their dealings in property and created an “item of income” under §61(a).The deemed liquidation of AIS was under §331, sale or exchange of property creating a realized gain to Wind River, and that gains from property were expressly included in gross income under §61(a). Although §332 provides for non-recognition of that gain, it was still an item of income which passed through to the trusts and increased their bases in Wind River stock.

The Tax Court rejected the argument relying on the differences between “realization” and “recognition” of income in determining what constitutes an “item of income” under §1366. A gain from a Qsub election is “realized” and calculated under §1001 but it is not “recognized” due to the non-recognition provision of §332. Additionally, the Tax Court found that under §1366, when a gain is unrecognized it “does not rise to the level of income” and is not an “item of income” for tax purposes.

The trusts’ dismissal of the effect of non-recognition on whether a gain is income was undermined by regulations corresponding to §61(a). Under the Treasury regulations gains from sale or exchange of property, including those derived under §331 are not “recognized” and thus “not included in or deducted from gross income at the time the transaction occurs.” The Supreme Court has held that “income” requires an “accession to wealth.” The Qsub election did not add wealth, it merely changed the tax treatment of the income flowing from the Qsub. This did not provide an “accession to wealth” for the corporation and could not create “income” for the trusts.

A liquidation is either governed by the general rule in §331 or by the exception in §332, it cannot be governed by both. Section 332 by its plain language applies to a special set of liquidations that are treated under a different statutory scheme. Under the Internal Revenue Code a Qsub election results in a §332 liquidation.