The use of QSubs in S corporation tax planning: Understand the opportunity and know the potential pitfalls
Note: This article originally appeared in the October 2012 Footnote. Due to popularity of the topic, it has been reviewed by Mark Sellner and re-posted in October 2015.
When there is a business reason to maintain certain S corporation operations in a separate subsidiary, the use of a qualified S corporation subsidiary (“QSub”) may provide a tax planning opportunity. But when the QSub operations are sold, a tax pitfall may loom.
Read on to learn more about QSubs, when and why it's advantageous to establish a QSub, and how to avoid potential tax traps associated with their sale.
QSub elections became available because Congress understood that there were situations in which taxpayers wished to separate different trades or businesses into different corporate entities. Congress believed that, in such situations, shareholders should be allowed to arrange these separate corporate entities under parent-subsidiary arrangements as well as under brother-sister arrangements.1
For a business reason such as segregation of assets and liabilities or maintenance of contractual obligations, it may be prudent to establish certain S corporation operations in a separate subsidiary. However, an S corporation may not have another corporation as a shareholder.2 If it did, the S corporation's subsidiary would be a C corporation, which is not the pass-through entity treatment desired by S corporation clients. Also, an S corporation is not eligible to join in a federal consolidated return.3 So, losses in a C corporation cannot be offset by profits in an S corporation.
Tax planning opportunity
If all tax requirements are met, the S corporation may make a QSub election for its subsidiary, thus avoiding the C corporation treatment of its lower-tier operations.
A QSub is a domestic corporation that itself would be eligible to make an S corporation election and is 100 percent owned by an S corporation that makes the QSub election for its subsidiary.4
For federal income tax purposes, the QSub is not treated as a separate corporation. All assets, liabilities and items of income, deduction and credit of the QSub are treated as assets, liabilities and such items of the S corporation.5 There is no separate federal income tax return for a QSub. Its operations are reported in the S corporation's federal income tax return, thus providing a de facto consolidated return for the S corporation and its QSub. While this treatment is favorable for operating results, it may create a pitfall if the QSub is sold.
Buy versus build tax pitfall
Because the QSub is treated as a division of the S corporation for federal income tax purposes, a sale of the stock of a QSub is actually an asset sale for federal income tax purposes.6 Care should be taken to properly report an asset sale on the S corporation return versus passing through a stock sale as a separately stated item on the shareholders' individual returns, even though the sale contract is labeled a Stock Purchase Agreement.
This asset sale treatment could have unintended tax consequences if the QSub were bought by the S corporation rather than built by the S corporation.
Case in point
Assume that an S corporation plans to expand its operations into another state. The company's lawyers recommend the use of a separate legal entity. The S corporation transfers assets with a fair market value of $1 million and a tax basis of $100,000 to the new corporation in exchange for all of the subsidiary's stock.
Formation of the new subsidiary is a tax-free incorporation.7 The basis of the stock of the subsidiary is the $100,000 substituted from the basis of the assets.8 The basis of the assets transferred to the subsidiary is the $100,000 carried over from the S corporation.9
The S corporation's QSub election results in the newly-formed subsidiary being treated as a QSub from its inception.10 The $100,000 asset basis is retained. A subsequent sale of the QSub for $1 million would result in a $900,000 gain, which is the same result as if the assets had never been transferred to the subsidiary. The S corporation would have had the benefit of the pass-through treatment of operations, and no detriment upon a subsequent sale of the subsidiary business.
Instead, assume that the S corporation acquires the stock of an existing corporation for $1 million. The acquired corporation retains a tax basis of $100,000 in its assets. The basis of the stock of the subsidiary is the $1 million cost.11 A QSub election accomplishes the goal of maintaining pass-through treatment of the subsidiary's operations, but forfeits the difference between the $1 million stock purchase price and the $100,000 tax basis in the assets.12
If the QSub is sold for $1 million, there is a $900,000 tax gain, even though the economics of the deal indicate a breakeven transaction because of the original $1 million stock purchase price.
This pitfall arises because the stock was purchased, but the assets were sold. The carryover asset basis is substituted for the purchase price of the stock in a QSub election, and no tax deductible loss may be recognized. The difference between the $1 million stock purchase price and the $100,000 carryover asset basis is not tax goodwill, because the acquisition of the existing corporation was a stock rather than an asset purchase.13
While this result seems counterintuitive and even unfair, it makes sense from a tax perspective. Had the S corporation acquired the assets rather than the stock of the existing corporation for $1 million, the existing corporation would have recognized the $900,000 gain, the same amount triggered upon the subsequent sale of the QSub. However, the tax burden has been shifted from the selling shareholders of the existing corporation to the buyers of the QSub.
This pitfall can be avoided by acquiring assets instead of stock in the existing corporation. If the acquired corporation were an S corporation, an asset step up would be available in conjunction with the QSub election by making a joint Section 338(h)(10) election with the selling shareholders.14 In that case, the asset basis would have been increased from the $100,000 carryover basis to the $1 million purchase price, and the existing corporation would have recognized the $900,000 gain on the deemed asset sale to the S corporation.
Restructuring S corporation operations
Assume that instead of either buying or building a separate subsidiary of the S corporation, a brother-sister organization structure is already in place. This structure may exist for long-standing S corporation clients that established additional new brother-sister S corporations as their businesses grew before QSubs were available.
Unlike an S corporation and its QSub, brother-sister S corporations may not offset profits and losses on their S corporation income tax returns. The profits and losses are passed through to the S corporation shareholders, who may have basis limitations that prevent netting on their individual returns.15 Restructuring the brother-sister S corporations into a parent-subsidiary group of an S corporation and its QSubs may ameliorate this problem, while still maintaining separate legal entities for business purposes.
This restructuring could be accomplished by way of shareholder contributions to capital, whereby the stock of the brother-sister corporations would be contributed to an S corporation in exchange for stock, in proportion to the fair market values of the shares contributed.
Because any suspended loss carry-forwards are tax attributes held personally by the shareholders and are not tax attributes attached to the S corporation stock that is eliminated in the QSub election, suspended loss carry-forwards survive the contributions to capital and the QSub elections.16
QSub elections are made on Form 8869 Qualified Subchapter S Subsidiary Election. The parent S corporation may make the QSub election at any time during the tax year. However, the requested effective date of the QSub election generally cannot be more than 12 months after the date the election is filed, or two months and 15 days before the date the election is filed.
Tax return reporting
Because a QSub is a disregarded entity, for purposes of Schedule M-3, Schedule L, and the Form 1120S tax return in general, the subsidiary is deemed to have liquidated into the parent S corporation. As such, all QSubs are treated as divisions of the S corporation parent.
Understand the opportunity, beware the pitfall
The use of a qualified S corporation subsidiary (“QSub”) may provide a tax planning opportunity for conducting S corporation operations in separate legal entities, while still preserving the pass-through tax treatment of profits and losses. But when the QSub operations are sold, a tax pitfall may loom if the stock of the QSub had been purchased by the S corporation at a premium to the tax basis of the assets. Recognizing this pitfall upfront will allow S corporation clients to either negotiate an asset instead of a stock purchase, or adjust the stock purchase price accordingly.
Mark Sellner, CPA, JD, LLM (taxation), is an adjunct professor of business taxation at the University of St. Thomas Law School and has served as director of graduate studies in taxation at the University of Minnesota's Carlson School of Management. He is a CPA, and a member of the Minnesota Society of CPAs and the Minnesota Board of Accountancy. You can reach Mark at 612-508-4107 or firstname.lastname@example.org.
1 Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 104th Congress (JCS-12-96),
Part Four: Revenue Provisions of the Small Business Job Protection Act of 1996 (H.R. 3448)
2 IRC Section 1361(b)(1)(B) 3 IRC Section 1504(b)(8)
4 IRC Section 1361(b)(3)(B)
5 IRC Section 1361(b)(3)(A)
6 IRC Section 1361(b)(3)(C)(ii)(I)
7 IRC Section 351(a)
8 IRC Section 358(a)(1)
9 IRC Section 362(a)
10 Reg. §1.1361-4(a)(2)(i)
11 IRC Section 1012(a)
12 Reg. §1.1361-4(a)(2)(ii) Example (1), Reg. §1.332-1, and IRC Section 334(b)(1)
13 IRC Section 1060(a), IRC Section 1060(c)(2)
14 Reg. §1.1361-4(b)(4), Reg. §1.1361-4(d) Example (3)
15 IRC Section 1366(d)(1)
16 Reg. Sec. 1.1366-2(c)(1)