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TAX CLINIC

determined that Reserve’s risk had not Facts was ineffective because Sub was not a
been distributed among unrelated par- On date 1, a parent company (X) corporation as defined by Regs. Sec.
ties and, therefore, was not sufficiently formed a subsidiary (Sub) as a limited 301.7701-2(b). Therefore, X had failed
distributed (id. at 46). liability company in state 1, and Sub because it did not meet all the require-
elected to be treated as a partnership ments of Sec. 1361(b)(3)(B). On date
Takeaways from Reserve for federal income tax purposes. Sub’s 5, X sold some of its interest in Sub to
The taxpayer in Reserve was unsuc- operating agreement included partner- a third party.
cessful in satisfying the distribution- ship provisions that applied regardless From date 2 to date 4, all distribu-
of-risk criteria primarily because of whether X was a partnership. On tions and liquidation proceeds were
its stop-loss insurer, PoolRe, was date 2, Sub made an S corporation elec- identical, and the shareholders and Sub
deemed to not be a bona fide insur- tion; however, due to Sub’s operating had consistently filed tax returns as an
ance company. In Reserve, the court agreement having allowed dispropor- S corporation. Moreover, Sub did not
used the nine factors as a guideline tionate distribution and liquidation change the agreement’s provisions de-
and found that PoolRe failed to oper- proceeds, the election became inef- spite not being an S corporation. Fur-
ate as a proper insurance company fective under Sec. 1362(b)(1)(D). Sub ther, X stated that the circumstances
and, thus, was not a bona fide insur- requested relief from a termination of that led to both the S corporation and
ance company. its S election under Sec. 1362(f) due to QSub elections’ becoming ineffective
The holding in Reserve illustrates having more than one class of stock. were inadvertent, not the result of tax
the importance the court has placed On date 3, Sub’s shareholders avoidance or retroactive tax planning.
on the nine factors in determining formed X in state 2, and on date 4, Sub In the ruling request, the shareholders
whether a reinsurer, when used as made X a wholly owned subsidiary of and Sub agreed to any required adjust-
a vehicle for distributing risk, is a Sub by contributing all the stock in ments by the IRS under Sec. 1362(f)
bona fide insurance company. In light Sub to X in a purported reorganization consistent with the treatment of Sub on
of this, it is recommended that tax under Sec. 368(a)(1)(F). This would date 2 as an S corporation and on date
professionals’ clients that have captive have resulted in X’s being treated as 4 as a QSub.
insurance companies take great care to the successor S corporation to Sub for
distribute risk properly. If a taxpayer federal tax purposes without having Legal principles
wishes to distribute risk by insuring to make a new S election, pursuant to Sec. 1361(b)(2) provides that financial
other, unrelated parties, the taxpayer Rev. Rul. 2008-18. Since Sub’s original institutions that use the reserve method
should make certain the insurance S election was ineffective, Sub became for bad debts, taxable insurance com-
vehicle used meets most, if not all, the a disregarded entity for federal income panies, or domestic international sales
above factors to ensure it is a bona fide tax purposes. X therefore made an S corporations (DISCs) or former DISCs
insurance company. corporation election, effective on date 3. are ineligible to be a small business cor-
From Terrance J. Pak, J.D., MBA, On date 4, X filed an election to poration under Subchapter S. Under Sec.
Irvine, Calif. treat Sub as a QSub, but the election 1361(b)(1), a small business corporation

S Corporations

IRS applies Sec. 1362(f)
to relieve inadvertent
terminations of S and QSub
elections

In IRS Letter Ruling 202219005,
released May 13, 2022, the Service
addressed a consolidated corpora-
tion’s request to apply Sec. 1362(f) PHOTO BY SIMON MCGILL/GETTY IMAGES
to provide relief from termination of
the corporation’s subsidiary’s S cor-
poration and qualified Subchapter S
subsidiary (QSub) elections.

20 November 2022 The Tax Adviser