I. Introduction

This Directive discusses three fact patterns involving the sale of a business conducted through a structure where a Massachusetts Business Trust (MBT) [1] that has elected to be treated as an S corporation for federal income tax purposes [2] owns 100% of the stock of a Qualified Subchapter S Subsidiary (QSUB). In each case, the QSUB is the operating company, whereas the MBT is a holding company that holds the stock in the QSUB as its only asset. In each case, the business conducted by the operating company is effectively sold to an unrelated party.

Directive 1 describes the Massachusetts income tax and corporate excise consequences of a sale by an MBT of 100% of the stock of its QSUB to an unrelated party. In this case, the sale of 100% of the QSUB's stock is treated as a sale of the QSUB's assets for federal income tax purposes. See Treas. Reg. § 1.1361-5(b)(3), Ex. 9. [3] Directive 1 concludes that such sale is also treated as a sale of the QSUB's assets for Massachusetts income tax and corporate excise purposes.

Directive 2 describes the Massachusetts income tax and corporate excise consequences of a sale by the shareholders of an MBT of 100% of the MBT's stock to an unrelated party, where an IRC § 338(h)(10) election is made to treat the transaction as if the MBT sold its assets ( i.e., comprised of its stock in the QSUB). In Directive 2, this deemed sale of the QSUB's stock is then treated, as in the transaction in Directive 1, as a sale of the QSUB's assets for federal income tax purposes. Directive 2 concludes that such sale is also treated as a sale of the QSUB's assets for Massachusetts income tax and corporate excise purposes.

Directive 3 addresses the Massachusetts income tax and corporate excise consequences of an upstream merger or liquidation of a QSUB into its MBT parent and a subsequent sale or deemed sale by the MBT of the assets formerly owned by the QSUB. Directive 3 observes that, for Massachusetts tax purposes under G.L. c. 63, § 32D, the Commissioner may apply the sham and step transaction doctrines and treat the multi-step transaction as involving a taxable sale of assets by the QSUB if it is determined that the taxpayer has engaged in transactions the purpose of which is the avoidance of tax. See in particular G.L. c. 62C, § 3A. In those situations where a subsequent sale or deemed sale of assets by the MBT occurs within 2 years of an upstream merger or liquidation of a QSUB, treatment of the multi-step transaction as involving a taxable sale of assets by the QSUB will be presumed, unless the taxpayer can demonstrate, under the standards of G.L. c. 62C, § 3A, that the subsequent sale or deemed sale of former QSUB assets was independent of the prior merger or liquidation and was not part of a plan to avoid taxes.

II. Background

a. IRC amended to authorize QSUBs

Federal S corporations are governed by the provisions of IRC § 1361 et seq. The federal Small Business Job Protection Act of 1996 amended IRC § 1361 to allow federal S corporations to own QSUBs, for taxable years beginning after December 31, 1996. [4] For federal income tax purposes, a QSUB generally is not treated as a separate corporation. IRC § 1361(b)(3)(A)(i). Rather, upon the election of its federal S corporation parent to treat its subsidiary as a QSUB, the QSUB is deemed to have liquidated into the parent. See Treas. Reg. § 1361-4(a)(2). Thus, all of the income tax attributes ( e.g., the items of income, deduction, and credit) of the QSUB are treated as belonging to its federal S corporation parent. IRC § 1361(b)(3)(A)(ii).

b. TIR 97-6, addressing Massachusetts tax treatment of QSUBs

In TIR 97-6, the Massachusetts Department of Revenue (DOR) explained the state tax consequences that resulted when a federal S corporation elected QSUB treatment under IRC § 1361 for its subsidiary. In such cases, because Massachusetts law made no special provision for a QSUB, the income tax attributes of the QSUB would be considered those of its parent S corporation and therefore generally would pass through to the individual shareholders of the S corporation parent like the attributes of the S corporation itself, to become taxable under the personal income tax provisions of chapter 62. TIR 97-6 noted that this pass-through from the parent to the individual shareholders generally would not follow where the QSUB was owned by a federal S corporation that was an MBT ( see the discussion of the situation where an MBT owns a QSUB, infra). [5] However, TIR 97-6 indicated that, irrespective as to how the QSUB was owned, the QSUB would constitute a "corporation" within the meaning of chapter 63 that would be separately subject to the greater of: (1) the tangible property or net worth component of the corporate excise or (2) the minimum corporate excise. Also, TIR 97-6 stated that, in the situation where a corporate parent is treated as an S corporation and owns a QSUB, the entity-level income tax imposed upon certain S corporations under G.L. c. 63, § 32D, would continue to apply, and would be imposed upon the S corporation parent based upon the combined income attributes of the parent and the QSUB.

c. LR 99-17, addressing circumstances where MBT is treated as an S corporation for federal income tax purposes and owns a QSUB

TIR 97-6 noted that MBTs were not subject to chapter 63 and therefore raised the prospect that, in the case of a QSUB that was owned by an MBT, the c. 63, § 32D entity-level tax might not apply, as the income tax attributes of the QSUB would be considered those of its parent, and the QSUB parent - the MBT - would not be subject to chapter 63. This issue was evaluated in 1999, when DOR issued Letter Ruling (LR) 99-17. That ruling concluded that if a Massachusetts S corporation reorganized as a wholly-owned QSUB of a newly-formed MBT holding company, the QSUB would not be subject to the net income measure of the corporate excise imposed under section 32 or section 39, nor to the entity-level tax imposed under G.L. c. 63, § 32D (though the QSUB would be subject to the greater of the non-income measure of the corporate excise or the minimum corporate excise imposed under G.L. c. 63, §§ 32 and 39). Rather, all of the QSUB's income tax attributes would be treated as those of its MBT parent for purposes of Massachusetts tax under G.L. c. 62. LR 99-17 also concluded that the MBT parent would be subject to tax at the entity-level under G.L. c. 62, § 8 on the combined income of itself and the QSUB. Consequently, a number of Massachusetts S corporations that were subject to the entity-level tax imposed under G.L. c. 63, § 32D reorganized as a wholly-owned QSUB of a newly-formed MBT holding company in order to not be subject to the § 32D entity-level tax. See DD 04-1. [6]

d. 2003 Massachusetts legislation, subjecting QSUBs to entity-level S corporation tax irrespective of form of parent entity

In 2003, in order to remove the tax incentive for a business conducted through a federal S corporation to be structured with a QSUB owned by a parent entity not subject to tax under c. 63, including a parent MBT, the Massachusetts Legislature enacted St. 2003, c. 4, § 18, which revised G. L. c. 63, § 32D. See DD 04-1 (stating, inter alia, that "with the enactment of St. 2003, c. 4, § 18, the Massachusetts tax incentive to reorganize an S corporation as a QSUB of a corporate trust has been largely eliminated"). Pursuant to this statutory enactment, a QSUB became separately subject to the entity-level tax imposed under G.L. c. 63, § 32D, as applicable, effective March 5, 2003. Specifically, G.L. c. 63, § 32D(a) includes a QSUB as being subject to a net income measure of the corporate excise determined under said Section 32D, and Section 32D(b) states that "[f]or purposes of this section, in determining the net income of any [QSUB], its gross income shall be determined by computing its gross income as defined under the [IRC] as if it had been taxed as a separate corporation for federal income tax purposes." Consequently, when a federal S corporation makes an election to treat a subsidiary as a QSUB, the QSUB may be subjected to a tax on income pursuant to the terms of Section 32D, and for that limited purpose shall determine its gross income by reference to what would have been its gross income if taxed as a separate corporation federally. However, the new legislation did not alter the determination of the tax liability of a QSUB parent that is an MBT or other unincorporated entity. Therefore, the requirement that an MBT parent take into account its QSUB's income, loss, deduction, and credit in determining its net income subject to tax under G.L. c. 62, § 8, as stated in LR 99-17, remained intact. See TIR 03-20.

As a result of the 2003 legislation pertaining to QSUBs, many Massachusetts S corporations that had restructured pursuant to LR 99-17 reverted back to stand-alone Massachusetts S corporations, through mergers of the parent entity into the QSUB in transactions that qualified as F reorganizations under IRC § 368(a)(1)(F) and through other restructuring transactions. [7]

Issue 1: Saleby MBT of 100% of its QSUB stock. How should the sale by an MBT of 100% of its QSUB's stock to an unrelated party be treated for Massachusetts income tax and corporate excise purposes? If treated as a sale of the QSUB's assets, how should the tax consequences, including the entity-level tax under c. 63, § 32D, be reported by the parties?

Directive 1: (a) Treatment as asset sale taxable to QSUB and MBT. The sale by an MBT of 100% of its QSUB's stock to an unrelated party is properly treated as a sale of the QSUB's assets for Massachusetts income tax and corporate excise purposes, consistent with the federal characterization of such a sale as an asset sale, as set forth in Treas. Reg. § 1.1361-5(b)(3), Ex. 9, [8] and consistent with the objective embodied in G.L. c. 63, § 32D that any built-in gain ( i.e., appreciation in value over tax basis) reflected in corporate assets held within a QSUB be subject to G.L. c. 63, § 32D in the case of a sale of such assets. Both the QSUB and the MBT must recognize the gain from the deemed sale of the QSUB's assets, as applicable.

Specifically, in determining a QSUB's net income subject to the entity-level tax under G.L. c. 63, § 32D, the QSUB must include the gain or loss from the deemed asset sale. Additionally, the MBT must include the gain or loss in determining its net income subject to tax under G.L. c. 62, § 8.

(b)Treatment of MBT shareholders. For federal income tax purposes, the income of the MBT from the deemed asset sale is taxed to the shareholders of the MBT because the MBT itself is treated as an S corporation and thus as a pass-through entity. Accordingly, the MBT shareholders are accorded an increase in the federal tax basis in their shares on account of the passed-through income. [9] For Massachusetts income tax purposes however, the income of the MBT from the deemed asset sale is not taxed to the shareholders of the MBT. Thus, there is no corresponding adjustment to an MBT shareholder's basis. Rather, the MBT itself is subject to tax on the deemed asset sale at the entity level as provided in G.L. c. 62, § 8(a). Under G.L. c. 62, § 8(c), distributions from a corporate trust generally are not included in Massachusetts gross income of a shareholder unless they are made out of "tax-free earnings and profits", i.e., generally earnings that were not taxed to the corporate trust. In determining whether distributions are made out of tax-free earnings and profits as well as the characterization of other distributions from an MBT, the ordering rules of 830 CMR 62.8.2(5)(e)2.a. through d. will apply.

Discussion: (a) Treatment of transaction. A QSUB is generally disregarded as a separate entity for federal income tax purposes, having been deemed to have liquidated into its federal S corporation parent at the time the QSUB election is made. See IRC § 1361(b)(3)(A); Treas. Reg. § 1361-4(a). The sale by an MBT/federal S corporation of 100% of its QSUB's stock to an unrelated party is treated for federal income tax purposes as a sale of the QSUB's assets by the federal S corporation. See Treas. Reg. § 1.1361-5(b)(3), Ex. 9. [10] Accordingly, upon this deemed asset sale, for federal income tax purposes the buyer is generally allowed to claim a step-up in the basis of the QSUB's assets [11] just as if it had bought those assets directly.

The provisions of St. 2003, c. 4, § 18, which revised G.L. c. 63, § 32D to impose an entity-level S corporation tax on QSUBs in the circumstances described in Section 32D, were intended to eliminate the prospect of Massachusetts tax planning that was designed to use QSUBs owned by MBTs and other non-corporate entities to avoid the entity-level S corporation tax. As so revised, section 32D states that for purposes of "determining the net income of any [QSUB], [the QSUB's] gross income shall be determined by computing its gross income as defined under the [IRC] as if it had been taxed as a separate corporation for federal income tax purposes." G.L. c. 63, § 32D(a), (b). See also DD 04-1; TIR 03-20.

Section 32D does not directly address the situation where an MBT sells 100% of its QSUB's stock to an unrelated party. However, because the sale of QSUB stock is treated for federal tax purposes as an asset sale and because those assets are in fact held by the QSUB, the gain in those assets is properly subject to the Massachusetts entity-level S corporation tax imposed on the QSUB under G.L. c. 63, § 32D, where applicable. Section 32D provides that the QSUB's gross income is to be determined by computing its gross income "as if it had been taxed as a separate corporation for federal income tax purposes," and income from the deemed sale of the QSUB's assets would have been included in the QSUB's income if the QSUB were "taxed as a separate corporation" for federal income tax purposes rather than disregarded as an entity.

Inherent in the statutory revision of G.L. c. 63, § 32D was the intent that the gain in assets held by a QSUB that is taxable for federal income tax purposes also be subject to the entity-level tax in section 32D, in the case of an S corporation structure subject to that section. The Legislature's revision of section 32D effectively takes into account the federal gross income attributable to the assets and operations of the QSUB, but imposes the tax on that income on the QSUB by treating it "as if it had been taxed as a separate corporation" for federal tax purposes. The mechanic of imposing the tax on the QSUB as if it were a separate corporation for federal purposes reflected the Legislature's recognition that the QSUB was disregarded as an entity for federal tax purposes, and thus the "as if" determination of the QSUB's income was necessary in order to attribute to it the gain that for federal purposes was simply included in the parent's income.

DOR has been asked whether treating a sale of the QSUB stock as a sale of the QSUB's assets, subjecting the QSUB to entity-level tax under c. 63, § 32D on any gain on the deemed asset sale, is consistent with (i) the terms of § 32D, determining the QSUB's income by hypothesizing the QSUB as if it were taxed federally as a separate corporation (the suggestion being made that a sale of QSUB stock should, as a result, be viewed as a sale of corporate stock), and (ii) the fact that federal law disregards the QSUB and taxes the gain on the deemed asset sale as if realized by the S corporation parent (the suggestion being made that the assets should be viewed as sold not by the QSUB but by the MBT). DOR concludes that treatment as a sale by the QSUB of its assets is consistent with the precise terms of § 32D and with federal law (as modified in the manner expressly provided in § 32D), and fulfills both the terms and apparent objectives of the statutory regime for taxing income of S corporations and QSUBs. Specifically:

(i) the 2003 amendment to c. 63, § 32D, in subjecting QSUBs to the entity-level tax under such section, provides only that the QSUB's income shall be determined "as if it had been taxed as a separate corporation for federal income tax purposes" and only "for purposes of this section" (all italicized emphasis added). This rule does not prescribe treatment of the QSUB generally as a separate C corporation for other Massachusetts income tax purposes under c. 62 or c. 63. As noted in this Directive, for other income tax purposes the QSUB continues to be disregarded and its income is treated as the income of its federal S corporation parent (whether that parent is (i) an actual corporation treated as an S corporation for Massachusetts purposes, with its income passed through to the shareholders, or (ii) an unincorporated entity such as a corporate trust or partnership whose income is taxed to the trust or the partners).

The limited role of the § 32D tax as extended to certain QSUBs by the 2003 amendment is to ensure that income of the QSUB, which would include gain from the disposition or deemed disposition of assets held by the QSUB, is subject to corporate-level income tax. The hypothetical "as if" test used by §32D constructs what would have been the gross income of the QSUB, if it were taxed as a separate entity for federal tax purposes, thus recognizing that the QSUB is otherwise disregarded and its income treated as that of its parent.

(ii) While the federal tax rules, because they fully disregard the QSUB as a separate entity, treat the QSUB's owner (a federal S corporation) as the taxpayer that must include any gain on the QSUB's assets in taxable income, the actual language of the pertinent federal provisions makes it clear that federal law also recognizes that this transaction involves a sale of the assets of the QSUB, and does not view the assets as actually residing in the parent. Treas. Reg. § 1.1361-5(b)(3), Ex. 9.states that "the transaction is treated as a transfer of the assets of Y [the QSUB] to Z [the 3d party acquirer] . . . ." (emphasis added). And IRC § 1361(b)(3)(C)(ii) [12] provides that upon the "sale of stock of a corporation which is a qualified subchapter S subsidiary, the sale of such stock shall be treated as if . . . the sale were a sale of an undivided interest in the assets of such corporation [i.e., of the QSUB]. . . ." (emphasis added). Thus, while federal law would treat gain on the deemed asset sale as realized by the MBT (because the QSUB is disregarded), the federal rules in fact recognize that the deemed sale is a sale of assets of the QSUB. And since c. 63, § 32D states that for purposes of the entity-level tax the QSUB's gross income is determined as if the QSUB had been a separate corporation rather than wholly disregarded, the gain that is included in the parent's income federally is properly included in the QSUB's income for purposes of the § 32D tax.

Further, considering the broader tax policy reflected in the statutory scheme, in these circumstances when the MBT's sale of its QSUB's stock is treated as a sale of the QSUB's assets to an unrelated buyer, any gain on that deemed asset sale will normally give rise to a step-up in the tax basis of the assets for federal and Massachusetts income tax purposes. The DOR will similarly recognize a stepped-up basis on these facts under the analysis set out in this Directive. However, for Massachusetts tax purposes, in order for there to be a stepped-up basis in the assets in the hands of the buyer, the gain from the deemed asset sale must be taken into account in taxable income by the seller in the deemed asset sale. See generally General Mills, Inc. v. Commissioner, 440 Mass. 154 (2003), cert. denied 541 U.S. 973 (2004) (evaluating a fact pattern where a deemed sale of assets pursuant to an election made under IRC § 338(h)(10) resulted in both taxable gain and a corresponding "step up" in basis). As noted above, because of the revision to section 32D that requires the QSUB to determine its income as if it were a separate corporation for federal tax purposes, the gain that is reflected in the step-up in basis to the buyer must first be taken into account by the QSUB that actually held the assets.

Having concluded that the sale of QSUB stock is properly treated as a sale of the QSUB assets, gain from the deemed asset sale must be recognized and reported by both the QSUB and the MBT, as applicable -- i.e., to the QSUB under c. 63, § 32D, assuming the statutory conditions for the § 32D tax exist ( e.g., total receipts of at least $6 million), and to the MBT under the rules of c. 62, § 8. Specifically, in determining a QSUB's net income subject to tax under G.L. c. 63, § 32D, the QSUB must include the gain or loss from the asset sale. Additionally, the MBT must include the gain or loss in determining its net income subject to tax under G.L. c. 62, § 8. See TIR 03-20 (noting that subsequent to the statutory change effected by St. 2003, c. 4, § 18, "a QSUB parent that is a corporate trust … will continue to take into account its QSUB's income, loss, deduction, and credit in determining its net income subject to tax under G.L. c. 62…"). Although the QSUB and the MBT parent must both include the gain or loss from the sale of the QSUB's assets in determining their net income subject to tax, the combined tax burden is equivalent to the tax that would be imposed if the QSUB were a stand-alone S corporation taxed under section 32D and its shareholders were taxed under Chapter 62 at the individual level on the S corporation income passed through to them.

(b) Treatment of MBT shareholders. For federal income tax purposes, the income of the MBT from the deemed asset sale is taxed to the shareholders of the MBT because the MBT itself is treated as an S corporation and thus as a pass-through entity. Accordingly, the MBT shareholders are accorded an increase (or decrease) in the federal tax basis in their shares on account of the passed-through income, generally preventing a second shareholder-level tax on this income. For Massachusetts income tax purposes, however, the income of the MBT from the deemed asset sale is not taxed to the shareholders of the MBT. Thus, there is no corresponding adjustment to an MBT shareholder's basis. Rather, the MBT itself is subject to tax on the deemed asset sale at the entity level as provided in G.L. c. 62, § 8(a). Distributions of this income generally may be made to shareholders without a further Massachusetts personal income tax at the shareholder level because, under G.L. c. 62, § 8(c), distributions from a corporate trust generally are not included in Massachusetts gross income of a shareholder unless they are made out of "tax-free earnings and profits", i.e., generally earnings that were not taxed to the corporate trust. In determining whether distributions are made out of tax-free earnings and profits as well as the characterization of other distributions from an MBT, the ordering rules of 830 CMR 62.8.2(5)(e)2.a. through d. will apply.

Issue 2: Saleby MBT shareholders of stock of MBT, with IRC § 338(h)(10) election to treat as deemed sale by MBT of its assets (its QSUB stock). Where an IRC § 338(h)(10) election is made to treat a sale by the shareholders of an MBT parent of 100% of their shares in the MBT to an unrelated party as a deemed sale of the MBT's assets (namely, the stock of the QSUB owned by the MBT) for federal income tax purposes, how should the sale of the MBT's shares be treated for Massachusetts tax purposes and how should the tax consequences be reported by the respective parties?

Directive 2: (a) Treatment as sale of assets of MBT (the QSUB stock), and in turn as a sale of QSUB's assets taxable to QSUB and MBT. Consistent with the federal treatment of the sale of shares accompanied by the IRC § 338(h)(10) election, the sale by the shareholders of an MBT parent of 100% of the MBT's shares to an unrelated party is properly deemed to be a sale of the MBT's assets (the stock of the QSUB) for Massachusetts tax purposes. This deemed sale by the MBT of its stock in the QSUB is then treated as a deemed sale of the QSUB's assets for purposes of both taxation of the MBT under G.L. c. 62, § 8, and taxation of the QSUB under G.L. c. 63, § 32D, in accordance with Directive 1.

(b) Treatment of MBT Shareholders. For federal income tax purposes, the income of the MBT from the deemed sale of the QSUB's assets is taxed to the shareholders of the MBT because the MBT itself is treated as an S corporation and thus as a pass-through entity. Accordingly, the MBT shareholders are accorded an increase (or decrease) in the federal tax basis in their shares, and the MBT is then deemed to be liquidated for federal income tax purposes pursuant to the IRC § 338(h)(10) election, with the shareholders recognizing applicable gain or loss on the deemed exchange of their shares in this liquidation. For Massachusetts income tax purposes, however, the income of the MBT from the deemed asset sale is not taxed to the shareholders of the MBT. Thus, there is no corresponding adjustment to an MBT shareholder's basis. Rather, the MBT itself is subject to tax on the deemed asset sale at the entity level as provided in G.L. c. 62, § 8(a). The MBT is then deemed to distribute the proceeds in a liquidation pursuant to the IRC § 338(h)(10) election. Such deemed distributions from a corporate trust generally are not included in Massachusetts gross income of a shareholder unless they are made out of "tax-free earnings and profits", i.e., generally earnings that were not taxed to the corporate trust. G.L. c. 62, § 8(c). In determining whether distributions are made out of tax-free earnings and profits as well as the characterization of other distributions from an MBT, the ordering rules of 830 CMR 62.8.2(5)(e)2.a. through d. will apply.

Discussion: (a) Treatment of transaction. Section 8(a) of G.L. c. 62 provides generally that in the case of a corporate trust subject to Massachusetts income tax, its adjusted gross income shall be redetermined "as if it were a resident natural person." However, this general statement is then modified by the proviso that "for purposes of any determination involving sections 311, 312, 332 to 338, inclusive or 346 to 368, inclusive" of the IRC, "any corporate trust shall be taxable as a corporation." The reference to IRC § 338 was added by St. 2004, c. 262, § 12, effective for taxable years beginning on or after January 1, 2004. [13]

Consequently, where an IRC § 338(h)(10) election is made to treat a sale by the shareholders of an MBT parent of 100% of their shares in the MBT to an unrelated party as a deemed sale of the MBT's assets for purposes of federal income tax, the transaction is treated for Massachusetts tax purposes - for the MBT as well as the QSUB -- as a deemed sale of the MBT's assets, i.e., a deemed sale of the stock of the QSUB that is owned by the MBT. [14] As discussed in Directive 1, the deemed sale of the stock of the QSUB is, in turn, treated as the deemed sale of assets held by the QSUB. Therefore, for the reasons set forth in Directive 1, for purposes of determining the application of the entity-level income tax under G.L. c. 63, § 32D, this transaction is treated as the sale of assets by the QSUB to the unrelated party.

As noted above, an MBT/federal S corporation parent of a QSUB must also take into account the QSUB's income, loss, deduction, and credit in determining its net income subject to tax under G.L. c. 62, § 8. TIR 03-20. See also LR 99-17. Thus, as in Directive 1, the gain or loss from the deemed sale of the QSUB's assets in the fact situation described by this Directive 2 must also be recognized by the MBT.

(b) Treatment of MBT shareholders. For federal income tax purposes, the income of the MBT from the deemed sale of the QSUB's assets is taxed to the shareholders of the MBT because the MBT itself is treated as an S corporation and thus as a pass-through entity. Accordingly, the MBT shareholders are accorded an increase (or decrease) in the federal tax basis in their shares (generally preventing a second shareholder-level tax on this income), and the MBT is then deemed to liquidate for federal income tax purposes pursuant to the IRC § 338(h)(10) election, with the shareholders recognizing applicable gain or loss. For Massachusetts income tax purposes, however, the income of the MBT from the deemed asset sale is not taxed to the shareholders of the MBT and thus there is no corresponding adjustment to an MBT shareholder's basis on account of the deemed asset sale by itself. Rather, the MBT itself is subject to tax on the deemed asset sale at the entity level as provided in G.L. c. 62, § 8(a). However, for Massachusetts income tax purposes, the deemed liquidation pursuant to the IRC § 338(h)(10) election will similarly be treated as a liquidation of the MBT, and the shareholders will thus be considered to receive distributions from the MBT in liquidation. Distributions from a corporate trust generally are not included in Massachusetts gross income of a shareholder unless they are made out of "tax-free earnings and profits", i.e., generally earnings that were not taxed to the corporate trust. G.L. c. 62, § 8(c). In determining whether distributions are made out of tax-free earnings and profits as well as the characterization of other distributions from an MBT, the ordering rules of 830 CMR 62.8.2(5)(e)2.a. through d will apply.

Issue 3: Upstream merger or liquidation of QSUB into MBT, and subsequent sale of former QSUB assets by MBT. What is the appropriate tax characterization of an upstream merger or liquidation of the QSUB into its MBT parent and a subsequent sale or deemed sale of the former QSUB assets?

Directive 3: The Commissioner may apply the sham and/or step transaction doctrines in cases in which there is an upstream merger or liquidation of the QSUB into its MBT parent prior to a subsequent sale or deemed sale of the former QSUB assets, and may treat the multi-step transaction as involving a taxable sale of assets by the QSUB if it is determined that the taxpayer has engaged in transactions the purpose of which is the avoidance of tax. See in particular G.L. c. 62C, §3A. In those situations where a subsequent sale or deemed sale of assets by the MBT occurs within 2 years of an upstream merger or liquidation of a QSUB, treatment of the multi-step transaction as involving a taxable sale of assets by the QSUB will be presumed unless the taxpayer can demonstrate, under the standards of G.L. c. 62C, § 3A, that the subsequent sale or deemed sale of former QSUB assets was independent of the prior merger or liquidation and was not part of a plan to avoid taxes.

Discussion: Given the history in cases involving the generic fact pattern discussed by this Directive, the Commissioner may apply the sham and/or step transaction doctrines in cases in which there is an upstream merger or liquidation of the QSUB into its MBT parent prior to a subsequent sale or deemed sale of the former QSUB assets, and may treat the multi-step transaction as involving a taxable sale of assets by the QSUB if it is determined that the taxpayer has engaged in transactions the purpose of which is the avoidance of tax. See in particular G.L. c. 62C, § 3A. [15] In those situations where a subsequent sale or deemed sale of assets by the MBT occurs within 2 years of an upstream merger or liquidation of a QSUB, treatment of the multi-step transaction as involving a taxable sale of assets by the QSUB will be presumed unless the taxpayer can demonstrate, under the standards of G.L. c. 62C, § 3A, that the subsequent sale or deemed sale of former QSUB assets was independent of the prior merger or liquidation and was not part of a plan to avoid taxes.

/s/Navjeet K. Bal
Navjeet K. Bal
Commissioner of Revenue

NKB:MTF:pls

August 25, 2008

DD 08-4



[1]For purposes of this Directive, such MBT is treated as a "corporate trust" subject to tax under G.L. c. 62, § 8(a). See also G.L. c. 62, §1(j) (defining a "corporate trust" as "any partnership, association or trust, the beneficial interest of which is represented by transferable shares").

[2] See IRC § 1362. The term, "IRC," as used herein, refers to the federal Internal Revenue Code of 1986, as amended.

[3]For tax years beginning after December 31, 2006, see also IRC § 1361(b)(3)(C)(ii), added by the U.S. Troop Readiness, Veterans' Care, Katrina Recovery, and Iraq Accountability Appropriations Act, 2007 (P.L. 110-28).

[4] See IRC § 1361(b)(3), added by P.L. 104-88 § 1308(b).

[5]An MBT, though taxable at the personal income tax rate under G.L. c. 62, §8, is generally taxed at the entity-level, and therefore there is generally no pass-through of items of income, deduction, etc.

[6]Similar tax planning was also done using parent entities that were partnerships owned by individuals and that elected to be treated as S corporations federally. The income of these partnerships, like MBTs, is separately subject to the provisions of chapter 62 and not chapter 63. See, e.g., LRs 01-1 (reorganization where QSUB is owned by a general partnership), 02-3 (reorganization where QSUB is owned by a general partnership), 02-7 (reorganization where QSUB is owned by a limited liability partnership). See also LR 01-9 (reorganization where QSUB/financial institution is owned by an MBT).

[7]Directive 04-1 discussed the income tax ramifications of several of these restructuring transactions.

[8] See also footnote 3 supra.

[9]Conversely, the shareholders may have a reduction in basis in the case of a passed-through loss.

[10] See also footnote 3, supra.

[11]That is, the tax basis of the various assets as acquired by the buyer will reflect the current fair market value of those assets, as opposed to their historic tax basis. When assets have appreciated in value, this is commonly referred to as a "step-up" in basis.

[12]This codifying provision was added effective for 2007 ( see footnote 3 supra) and is consistent with Treas. Reg. § 1.1361-5(b)(3), Ex. 9 as it relates to the present issue.

[13]This Directive 2 does not address periods prior to the effective date of this statutory amendment. It is noted, however, that while the statutory language under G.L. c. 62, §8, regarding determinations under IRC § 338 was not adopted until 2004, imposition of the entity-level S corporation tax on a QSUB under G.L. c. 63, § 32D was effective March 5, 2003. See discussion of St. 2003, c. 4, § 18, supra.

[14]As noted in the introduction, this Directive assumes that the MBT owns only the shares in the QSUB and no other assets.

[15]In St. 2003, c. 4, § 10, the Massachusetts Legislature enacted G.L. c. 62C, § 3A, effective for tax years beginning on or after January 1, 2002. St. 2003, c. 4, § 87. That provision authorizes the Commissioner to apply, under terms described in that section, the sham transaction doctrine and other related tax doctrines such as the step transaction doctrine.