Massachusetts Business Trusts - Final Guidance

The Massachusetts Department of Revenue recently provided final guidance in connection with unwinding corporate structures designed to avoid entity level income taxes imposed on certain S corporations. This tax, otherwise known as the sting tax, is imposed on S corporations and their Qualified Subchapter S Subsidiaries ("Q Subs"). 

By way of background, prior to March 5, 2003, shareholders of many S corporations that were otherwise subject to the sting tax transferred their stock into a newly created Massachusetts Business Trust ("MBT") and caused the MBT to elect Q Sub status for the transferred S corporation. From the federal tax perspective, nothing changed and the Q Sub's taxable income, losses etc. continued to pass through and taxed to the shareholder. However, from the State perspective, such income passed to the MBT and was taxed at that level. As neither the Q Sub nor the MBT was subject to the sting tax, the sting tax was avoided. In fact, the DOR blessed this structure in Letter Ruling 99-17. 

All of this ended on March 5, 2003, as a result of a change in the Massachusetts tax law. Under the new law, Q Subs are subject to the sting tax. As a result, the MBT/Q Sub structure will result in a sting tax on taxable income at the Q Sub level at 3% (where gross receipts are at least $6 million but less than $9 million) or 4.5% (where gross receipts are $9 million or more). This taxable income will also be taxed at 5.3% at the MBT for a combined rate of up to 9.8%. 

In view of the new law, many taxpayers are considering unwinding their MBT/Q Sub structures mostly to avoid the filing complexities of such structures. Although many agreed that unwinding the MBT/Q Sub structure could be accomplished on a tax-free basis under existing tax law, there was sufficient concern that caused many taxpayers to wait for guidance from the DOR. 

The DOR recently issued a final directive, Directive 04-1, after reviewing comments to a draft directive issued in March, including comments submitted by Feeley & Driscoll. The final directive addresses two approaches to unwinding the MBT/Q Sub structure. 

The first and likely more common approach is to merge the MBT into the Q Sub (otherwise known as a down stream merger) resulting in the individual shareholders of the MBT becoming the shareholders of the former Q Sub that, in turn, becomes an S corporation. The second approach is to merge the Q Sub into the MBT (otherwise known as an upstream merger) resulting in the MBT surviving. In both cases, the Directive concludes that the restructuring is tax free to the entities and shareholders. 

As an observation, the upstream merger of the Q Sub into its MBT parent will avoid subsequent sting tax. However, consideration must be given as to the level of liability protection provided through the MBT compared to the S corporation in the case of the downstream merger. In addition, in some cases, losses that are otherwise deductible at the shareholder level in the case of an S corporation are trapped and unused in an MBT. 

The Directive provides guidance in connection with the various tax return filing requirements. A full discussion of this guidance is beyond the scope of this article due to its length and complexity. In general, however, in the case where the MBT mergers into the Q Sub, the Q Sub goes out of existence on the date of merger and a new S corporation is deemed to come into existence. Although the new S corporation is literally a continuance of the Q Sub, they are treated as separate entities. The Q Sub files a final return (form 355S) and the new S corporation files a separate return (also form 355S). Both entities are subject to both the sting tax and the non-income excise tax. The MBT does not file a return (form 3F) in the year in which the merger occurs. 

Importantly, in completing the Schedule SK-1 (income, loss, deductions and credits reportable by the shareholders) for the taxable year in which the reorganization takes place, the new Massachusetts S corporation includes not only its own items of income, loss, deductions and credits for the taxable year, but those of the Q Sub and MBT before they ceased to exist for Massachusetts income tax purposes. As the resulting tax is incurred at the shareholder level (and not at the historical MBT level), guidance is provided in transferring estimated tax payments from the MBT's account to the shareholders' account. 

As for the sting tax in the year of merger, the Q Sub reports its taxable income for the period from the beginning of its tax year (or from March 1 or 5 in the case of mergers occurring in 2003) to the date it goes out of existence and the new S corporation reports its taxable income for the period beginning when it is deemed to come into existence (i.e., the MBT/Q Sub merger date) to the end of its tax year. 

Although Directive 04-1 is helpful in providing guidance once the decision is made to terminate the MBT/Q Sub structure, careful thought must be given in terminating the structure in the first place. For example, the MBT/Q Sub structure can reduce the alternative minimum tax at the shareholder level. 

Once the decision is made to terminate the structure, alternative structures that may be more tax efficient should be considered. Feeley & Driscoll, P.C. continues to explore alternative tax structures that may retain some of the efficiency of the MBT/Q Sub structure. 

Please contact Feeley & Driscoll's Accountants and Consultants by Email or call 1 (888) 875-9770 to learn more.

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