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Letter Ruling 9825008, March 16, 1998

Uniform Issue List Information:
UIL No. 1362.02-03
UIL No. 1374.00-00
Tax imposed on built-in gains

Code Secs. 1362 and 1374

This responds to your letter dated September 9, 1997, submitted on behalf of X and requesting rulings under §§1362 and 1374 of the Internal Revenue Code.

FACTS

Taxpayer represents the relevant facts as follows. X is the common parent of an affiliated group of corporations involved in the coal business. X has nine wholly owned subsidiaries, one of which owns two other subsidiaries. X and its subsidiaries file consolidated federal income tax returns for fiscal years ending on Date 1.

X's income and that of certain of its subsidiaries primarily consists of (i) coal royalties received from independent third parties from coal reserves owned in fee and leased to such parties, and (ii) overriding royalties from coal reserves which have been leased by X or its subsidiaries and then subleased to independent third parties. Taxpayer represents that the income realized from the receipt of such coal royalties qualifies under the provisions of §631(c) of the Code.

X plans to liquidate three of its subsidiaries by means of an upstream merger with and into X pursuant to separate plans of merger. After the merger, X will make an election to be treated as an S corporation. In addition, X will file elections to treat its remaining subsidiaries as qualified subchapter S subsidiaries (QSSSs). The S election will result in a change of the parent's taxable year to the calendar year.

Based on these representations, X requests the following rulings:

1) The royalties that qualify for gain treatment under §631(c) received by X (directly and indirectly through its QSSSs) will not be treated as passive investment income within the meaning of §1362(d)(3)(C) ; and

2) The gains of X (received directly and indirectly through its QSSSs) under §631(c) with respect to the receipt of coal royalties will not be subject to the built-in gains tax under §1374 .

LAW AND ANALYSIS

Section 631(c) provides that if an owner of coal disposes of coal held for more than a requisite period under any form of contract under which the owner retains an economic interest in the coal, the difference between the amount realized from the disposal and the adjusted depletion basis plus the deductions disallowed for the taxable year under §272 shall be considered as though it were a gain or loss on the sale of the coal. Section 631(c) does not apply to income realized by any owner as a co-adventurer, partner, or principal in the mining of coal, and the word "owner" means any person who owns an economic interest in coal in place, including a sublessor. The date of disposal of the coal is deemed to be the date the coal is mined. Section 631(c) also does not apply to any disposal of coal to a person whose relationship to the person disposing of the coal would result in the disallowance of losses under §267 or §707(b) , or to a person owned or controlled directly or indirectly by the same interests which own or control the person disposing of the coal. Under §1231(b)(2) , coal to which §631(c) applies is "property used in the trade or business" for §1231 purposes.

Section 1362(a) permits a small business corporation, as defined in §1361(b) to elect to be treated as an S corporation. Such an election terminates under the provisions of §1363(d) if the corporation's passive investment income exceeds 25 percent of its gross receipts for three consecutive years if, for each of those years, the corporation has subchapter C earnings and profits.

Section 1362(d)(3)(D)(i) provides that the term "passive investment income" includes royalties. Under §1.1362-2(c)(5) (ii)(A)(1), the term "royalties" generally means all royalties, including mineral oil, and gas royalties, and amounts received for the privilege of using patents, copyrights, secret processes and formulas, good will, trademarks, tradebrands, franchises, and other like property. Under §1.1362-2(c)(5) (ii)(A)(3), however, royalties does not include amounts received upon disposal of timber, coal, or domestic iron ore with respect to which the special rules of §§631(b) and (c) apply.

Section 1361(b)(3)(A)(ii) generally provides that, for all purposes of the Internal Revenue Code, all assets, liabilities, and items of income, deduction, and credit of a qualified subchapter S subsidiary are treated as assets, liabilities, and such items (as the case may be) of the parent S corporation.

Section 1374 imposes a corporate-level tax on an S corporation's net recognized built-in gain during the recognition period (generally 10 years) following (a) a C corporation's conversion to S corporation status (§1374(a) ), or (b) an S corporation's acquisition of C corporation assets in a carryover basis transaction (§1374(d)(8) ).

Section 1374(d)(2) provides that an S corporation's net recognized built-in gain for any taxable year is generally its taxable income for the year computed as if it were a C corporation, but taking into account only items treated as recognized built-in gain or recognized built-in loss.

Section 1374(d)(3) provides that recognized built-in gain includes any gain recognized during the recognition period on the disposition of an asset, except to the extent the S corporation shows that (a) it did not hold the asset as of the beginning of the first taxable year for which it was an S corporation (the "Conversion Date"), or (b) the gain recognized was greater than the excess of the asset's fair market value over its adjusted basis on the Conversion Date.

Section 1.1374-4(a) of the Income Tax Regulations provides that §1374(d)(3) applies to any gain or loss recognized during the recognition period in a transaction treated as a sale or exchange for federal income tax purposes.

Section 1374(d)(6) provides that if the adjusted basis of any asset is determined (in whole or in part) by reference to the adjusted basis of any other asset held by the S corporation on the Conversion Date, the asset is treated as held by the S corporation on the Conversion Date, and any determination under §1374(d)(3) with respect to that asset is made by reference to the fair market value and adjusted basis of the other asset on the Conversion Date.

In Example 1 of §1.1374-4(a)(3) , X is a C corporation that elects to become an S corporation effective January 1, 1996. On the Conversion Date, X owns a working interest in an oil and gas property on which production of oil has not yet begun, and the fair market value of the working interest exceeds X's adjusted basis in the working interest by $200,000. During the recognition period, X produces and sells oil from the working interest and includes $75,000 in income on the sale. X's $75,000 of income is not recognized built-in gain because on the Conversion Date X held only a working interest in the oil and gas property and not the oil it sold.

In Example 2 of §1.1374-4(a)(3) , Y is a C corporation that elects to become an S corporation effective January 1, 1996. On the Conversion Date, Y owns a royalty interest in an oil and gas property, and the fair market value of the royalty interest exceeds Y's adjusted basis in the royalty interest by $100,000. During the recognition period, Y sells the royalty interest and recognizes a gain of $75,000 on the sale. Y's $75,000 gain is recognized built-in gain because Y held the royalty interest on the Conversion Date.

X represents that valid QSSS elections will be made with respect to its surviving subsidiaries. Accordingly, for federal tax purposes, the assets, liabilities, and items of income, deduction, and credit of the subsidiaries will be treated as assets, liabilities, and items of income, deduction, and credit of X. X represents that income realized from the receipt of coal royalties received by X will qualify under §631(c) . Based on this representation, we conclude that the royalties that qualify for treatment under §631(c) received by X will not be treated as passive investment income within the meaning of §1362(d)(3)(C) . Furthermore, X's income from coal royalties that qualify for gain treatment under §631(c) will not be subject to tax under §1374 .

CONCLUSIONS

Based solely on the facts submitted and the representations made, we conclude that:

1) Royalties that qualify for gain treatment under §631(c) received by X will not treated as passive investment income under §1362(d)(3)(C) ; and

2) X's income realized from royalties that qualify for gain treatment under §631(c) received by X during the recognition period will not be subject to the built in gains tax under §1374 .

Except for the specific ruling above, no opinion is expressed or implied concerning the federal income tax treatment of the transaction described above under any other provision of the Code or regulations or the tax treatment of any conditions existing at the time of, or effects resulting from, the transaction not specifically covered by the above ruling. In particular, we express no opinion as to (a) the qualification of Taxpayer as an S corporation under §1361(a) ; (b) the qualification of the subsidiaries as QSSS under §1361(b)(3) ; (c) the treatment of any subsidiaries that qualify as QSSS; (d) the treatment of any disposition of coal mined before, rather than during, the recognition period; (e) the §1374 treatment of income of Taxpayer or the subsidiaries other than the income described in the above ruling; (f) the character of royalty income; (g) the effect of the subchapter S or QSSS elections on items of income, gain, loss, deduction, or credit subject to the applicable intercompany transaction regulations (§§1.1502-13 and 14 as in effect before the publication of T.D. 8597 , 1995-2 C.B. 147, and as currently in effect; §1.1502-13 as published by T.D. 8597 ); (h) the effect of the subchapter S or QSSS elections on any excess loss account under §1.1502-19 ; or (i) the treatment of the liquidations of the three subsidiaries.

The rulings in this letter are based on the facts and representations submitted under penalties of perjury in support of the request for rulings. Verification of that information may be required as part of the audit process.

This letter is sent to you, Company's authorized representative, pursuant to a power of attorney on file with this office.

This ruling is directed only to the taxpayer on whose behalf it was requested. Section 6110(j)(3) provides that it may not be used or cited as precedent.

Sincerely yours, Brian M. Blum, Senior Technician Reviewer, Branch 1, Office of the Assistant Chief Counsel (Passthroughs and Special Industries).