Td 8869

REV. RUL. 2000–9 TABLE 3
Rates Under Section 382 for February 2000
Adjusted federal long-term rate for the current month

5.73%

Long-term tax-exempt rate for ownership changes during the current month (the highest of the adjusted
federal long-term rates for the current month and the prior two months.)
5.73%

REV. RUL. 2000–9 TABLE 4
Appropriate Percentages Under Section 42(b)(2)
for February 2000
Appropriate percentage for the 70% presentvalue low-income housing credit

8.57%

Appropriate percentage for the 30% presentvalue low-income housing credit

3.67%

REV. RUL. 2000–9 TABLE 5
Rate Under Section 7520 for February 2000
Applicable federal rate for determining the present value of an annuity, an interest for life or a term
of years, or a remainder or reversionary interest

Section 1288.—Treatment of
Original Issue Discounts on Tax
Exempt Obligations
The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month
of February 2000. See Rev. Rul. 2000–9, page 497.

Section 1361.—S Corporation
Defined
26 CFR 1.351–2: Definitions relating to S
corporation subsidiaries.

T.D. 8869
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1, 301, and 602
Subchapter S Subsidiaries
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.

February 7, 2000

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 §§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)6223050 (not 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

498

8.0%

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 15451590. 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

2000–6 I.R.B.

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
REG–251698–96, 1998–20 I.R.B. 14 (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

2000–6 I.R.B.

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, taxfree 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

499

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 T.D. 8844, (1999–50 I.R.B.
661) 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 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. 288, 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 con-

February 7, 2000

trolled 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,
104 th 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

February 7, 2000

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 Liquida-

500

tion
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 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

2000–6 I.R.B.

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.,
§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

2000–6 I.R.B.

corporation, arrangements that are not
considered to be stock under the oneclass-of-stock rules of §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 §1.1504–4 and any instrument,
obligation, or arrangement that would not
be considered stock under the one-classof-stock rules of §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 §1.1361–1,
but that would be treated as exercised
under §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
§1.1504–4 is included for purposes of applying section 332 because section 332
explicitly incorporates the affiliation rules
of section 1504. See §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 §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

501

some or all of the members of the group
and certain unintended implications of the
sentence added to §1.1374–8(b) in the
proposed regulations.
a. Section 1374
Section 1374(d)(8) and §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
§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
§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 §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 is effective.
Moreover, the commentator noted that a

February 7, 2000

literal reading of §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 §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 §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 §1.1502–19(b)(2)(i).
Under the general timing rules of
§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

February 7, 2000

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 §1.1374–8(b). Furthermore, an amendment to the general
timing rules under §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 §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
§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.

502

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
§§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
§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

2000–6 I.R.B.

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 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 §301.9100–1 and §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

2000–6 I.R.B.

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
§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 §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

503

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 §§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.
* * * * *
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:

February 7, 2000

Authority: 26 U.S.C. 7805 * * *
Par. 2. Amend §1.1361–0 as follows:
1.Revise the introductory text.
2.Remove
the
entry
for
§1.1361–1(d)(3).
3.Add entries for §§1.1361–2,
1.1361–3, 1.1361–4, 1.1361–5, and
1.1361–6.
The revisions and additions read as follows:
§1.1361–0 Table of contents.
This section lists captions contained in
§§1.1361–1, 1.1361–2, 1.1361–3,
1.1361–4, 1.1361–5, and 1.1361–6.
*****
§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.
§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.
§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.

February 7, 2000

(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.
§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.
§1.1361–6 Effective date.
Par. 3. Amend §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:
§1.1361–1 S corporation defined.
*****
(b) * * *
(1) * * *
(i) More than 75 shareholders (35 for
taxable years beginning before January 1,
1997);
*****

504

(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 §§1.1361–2, 1.1361–3,
1.1361–4, 1.1361–5, and 1.1361–6 to
read as follows:
§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
§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 §1.1361–1(l)(5) if issued by the S

2000–6 I.R.B.

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
§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
§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 §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 §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.

§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
§1.1361–5(c) (five-year prohibition on reelection), 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 cor-

2000–6 I.R.B.

poration 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
§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
§§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

505

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 §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.
§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

February 7, 2000

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 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

February 7, 2000

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 §1.1504–4 and any instruments, obligations, or arrangements that
are not considered stock under
§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 determi-

506

nation 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 §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 de-

2000–6 I.R.B.

scribed 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 §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
§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 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 corpo-

2000–6 I.R.B.

rations. 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 §§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 §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

507

respect to S2 effective on the day of the
acquisition, see §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
§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
§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

February 7, 2000

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.

§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 §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 §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
§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 no longer qualifies as a
QSub at the close of December 31, 2001.
Example 2. Termination due to transfer of

February 7, 2000

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 §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
§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
§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. The 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 §1.1361–2(b) are
disregarded in determining control for purposes of section 368(c) even if they are eq-

508

uity 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
§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 an as 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 §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 inter-

2000–6 I.R.B.

ests 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 cotransferors 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 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

2000–6 I.R.B.

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 ef-

509

fective 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.

§1.1361–6 Effective date.
Except
as
provided
in
§§1.1361–4(a)(3)(iii), 1.1361–4(a)(5)(i),
and 1.1361–5(c)(2), the provisions of
§§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 §1.1362–0 by adding an
entry for §1.1362–8 to read as follows:
§1.1362–0 Table of contents.
*****
§1.1362–8 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.

February 7, 2000

(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:
§1.1362–2 Termination of election.
*****
(c) * * *
(5) * * *
(ii) * * *
(C) * * * See §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:
§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 dividends that are not treated as passive investment income under section 1362(d)(3)(E).
Paragraph (b)(5) of this section describes a

February 7, 2000

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
§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 §1.13622(c)(4)) derived from activities that would
not produce passive investment income
(if the C corporation were an S corpora-

510

tion), 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 §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 §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
§1.1502–13(b)(1)(i)).
(d) Examples. The following examples illustrate the principles of this section:

2000–6 I.R.B.

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, onefifth 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.
§1.1368–0 [Amended]
Par. 8. Amend §1.1368–0 in the entry
for §1.1368–2(d)(2) by revising “Reorganizations” to read “Liquidations and reor-

ganizations”.
§1.1368–2 [Amended]
Par. 9. Amend §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 §1.1374–8 by adding
one sentence to the end of paragraph (b)
to read as follows:
§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 §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:
§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 §1.1361–3 or if a QSub

CFR part or section where
identified and described

election that was in effect for the entity
terminates under §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 §602.101, paragraph (b) is
amended by adding entries for §§1.1361–3,
1.1361–5, and 1.1362–8 to the table in numerical order to read as follows:
§602.101 OMB Control numbers.
*****
(b) * * *
Robert E. Wenzel,
Deputy Commissioner
of Internal Revenue Service.
Approved January 14, 2000.
Jonathan Talisman,
Acting Assistant Secretary of the
Treasury.
(Filed by the Office of the Federal Register on January 20, 2000, 1:19 p.m., and published in the issue of
the Federal Register for January 25, 2000, 65 F.R.
3843)

Current OMB
control No.

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1.1361–3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1590
1.1361–5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1590 * * *
1.1361–8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1590
*****

2000–6 I.R.B.

511

February 7, 2000