What are they and why should you care?
May 28, 2009
It has been 13 years since SBA ’96 introduced the concept of “qualified Subchapter S subsidiaries” (QSub). At the time, some experts questioned the usefulness of a QSub. Others rejoiced in the planning opportunities now possible. Practically speaking, let’s review the situation.
What Is a QSub?
A qualified Subchapter S subsidiary must:
A domestic corporation is defined as a corporation organized and created in the U.S. and District of Columbia (DC). This would exclude all foreign corporations. The ineligible corporations include insurance companies, financial institutions using the reserve method of accounting for bad debts Domestic International Sales Corporations (DISCs) or former DISCs and entities treated as taxable mortgage pools. The QSub election must be filed by the parent and approved by the QSub during the year the election is effective.
The effect of a QSub election is that once made, the QSub stock is disregarded for all federal tax purposes. The QSub is no longer treated as a separate corporation, with all assets, liabilities and items of income, deduction and credits treated as belonging to the parent corporation.
If an S corporation acquires a C corporation subsidiary and makes a QSub election, the built-in gains rules of section 1374 might apply. If any assets of the acquired subsidiary have a fair market value in excess of its tax basis, built in gains could be triggered if the asset is sold within ten years of the QSub election. One alternative to this exposure would be to purchase the assets of the entity, rather than the stock, and contribute the assets to a newly formed QSub. The built-in gains rules would not apply in this scenario.
If a C corporation using the LIFO method (assumes that the last unit making its way into inventory is sold first) of inventory accounting converts to an S corporation, it must include the LIFO recapture in the in the four-year period following the S election. This increased tax liability may be sufficient to question this business structure.
When an S corporation acquires a C corporation and elects QSub status for it, the subsidiary’s tax attributes — such as net operating losses and unused passive losses — will be trapped within the subsidiary and cannot be used in the S corporation structure. Planning may involve delaying the acquisition until such time as the tax benefits have been fully realized by the proposed target.
When dealing with multi-state corporations, the state tax implications of operating as a QSub can be overwhelming. Although most states follow the federal tax treatment of QSubs for purposes of imposing income taxes, the situation differs when dealing with taxes such as franchise, excise, capital stock, net worth and other taxes not based directly on income. Many states imposing these types of taxes will require each legal entity, or QSub, to file separately, regardless of the fact that all of its income is reported federally on the parent’s tax return.
Even if the state treats the QSub as a disregarded entity, the state filing requirements can become difficult to be in compliance. If a QSub is an operating entity requiring a business license, employing personnel and filing sales tax returns within a state, the normal consequence would be a requirement to file income tax returns. Due to the business structure of the QSub relationship, however, the entity filing tax returns would normally be the parent. Few states can make the connection between a QSub and a parent, especially with the onset of electronically filed tax returns. It becomes impossible to include statements of explanations that will be subsequently ignored by a computer. The result can be a flurry of notices, penalties, liens and license revocations, requiring many man-hours of time spent to correct.
In this age of technology, it’s hard to imagine, but some tax preparation software has not properly evolved to accommodate all the nuances of an S corporation with QSubs. At least one major software program cannot properly combine the state tax apportionment data for an S corporation and its QSubs. This combination of data is very easily accomplished in a similar consolidation of C corporations.
During the relatively brief period of existence of the QSub concept, some serious issues have yet to be resolved. The area of greatest inconsistency still remaining is the state tax arena. With all the state taxing jurisdictions in the country, operating as a QSub remains a risky undertaking. Being in compliance as a multistate entity can require an inordinate amount of time and expense. Do the benefits outweigh the burdens?
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Mary F. Bernard, CPA, MST is a Tax Principal and Director of State and Local TaxServices at Kahn, Litwin, Renza & Co., Ltd. in Providence, RI.