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QSubs revisited

20 years running and still not widely understood

Mark Sellner, CPA, JD, LLM (taxation) | June/July 2018 Footnote

More than 20 years ago, S Corporations were first allowed, without forfeiting their S Corporation status, to own 80 percent or more of another corporation and to elect to treat a 100-percent owned domestic corporation as a disregarded entity, namely a qualified S Corporation subsidiary (QSub).1

With a fair amount of information out there about QSubs, including two articles in the past five years in this very magazine, QSubs remain the most common area on which I receive consulting inquiries.2

Reason for QSubs

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.3

Uses, requirements, elections, tax treatments and reporting of QSubs

When there is a business reason to maintain certain S Corporation operations in a separate subsidiary, the use of a QSub may provide a tax planning opportunity.

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.4 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. A QSub may be the solution to the problem.

A QSub is a domestic corporation that itself would be eligible to make an S Corporation election, if it had only eligible shareholders, and is 100-percent owned by an S Corporation that makes the QSub election for its subsidiary.5

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.

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.6

There is no separate federal income tax return for a QSub. Its operations are reported in the S Corporation’s Form 1120S U.S. Income Tax Return for an S Corporation, thus providing a de facto consolidated return for the S Corporation and its QSub.

Common misunderstandings with QSubs

Forming a QSub versus buying and electing

Because a 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.7

If the QSub had been formed by a dropdown of assets from the parent S Corporation, there would be no particular tax issue upon sale of the QSub because the basis of the assets in the QSub would be the same as it had been in the parent S Corporation. A sale of the QSub would have the same tax effect as the sale of the QSub assets by the parent S Corporation had they never been transferred to the QSub.

However, if the QSub arose because of a stock purchase by the parent S Corporation of another corporation, followed by a QSub election for the acquired corporation, the QSub assets would retain their carryover tax basis from the acquired corporation and would not be adjusted for any premium paid for the acquired corporation stock. The premium paid for acquired corporation stock in excess of the carryover tax basis of the assets is forfeited in a QSub election.8

This pitfall can be avoided by acquiring assets instead of stock in the acquired corporation.

Sale of part of a QSub

If a part, but not all, of a QSub may be sold in the future, an initial structure using a single-member limited liability company may be preferable to a QSub.

A new investor in part of a QSub will convert the entity into a C Corporation, while a new investor in part of a single member LLC will convert the entity in to a multi-member LLC taxed as a partnership.9

Restructuring S Corporation operations

Assume that instead of either forming or buying a separate subsidiary of the S Corporation, a brother-sister organization structure already is 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.10 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 carryforwards 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 carryforwards survive the contributions to capital and the QSub elections.11

Potential new tax law benefit

Under the Tax Cuts and Jobs Act of 2017, a taxpayer other than a corporation generally is allowed a deduction of 20 percent of its qualified business income.12 This clearly applies to S Corporations.
The deduction is reduced for high-income taxpayers in a qualified trade or business, and completely eliminated for such taxpayers in a specified service trade or business.

Segregating qualified trade or business activities from specified service trade or business activities has been suggested as a way for high-income professionals to avoid a total phase out of the deduction on at least part of their income.13

There are a couple significant risks in restructuring an S Corporation in the hope of obtaining a larger qualified business income deduction.

First, the new provision has no related party rules, which could be added by forthcoming regulations to potentially nullify the separation of a qualified trade or business from a specified trade or business.

Second, and perhaps more devastating, is a purported “spin-off” of assets, such as real estate from an S Corporation into a separate entity claiming qualified trade or business status separate from the S Corporation’s specified trade or business. A spin-off of real estate, and perhaps other assets as well, generally would fail the active trade or business requirement for a tax-free distribution of assets out of either a C or S Corporation, resulting in current taxation of the appreciation inherent in the distributed assets.14

A lower risk structure might be to segregate qualified trade or business income in a QSub owned by a specified trade or business S Corporation, and then claim the qualified business income deduction, since it is determined for each qualified trade or business carried on by a taxpayer.15

Use of a QSub would not trigger taxation of the appreciation inherent in qualified trade or business assets, because the assets held in a separate QSub legal entity are treated as continuously held by the parent S Corporation for federal income tax purposes, and not treated as distributed out of the S Corporation.

There may be an opportunity to be had with the old QSub law as an advantage under the new federal tax law. Don’t miss out on it.

Mark Sellner, CPA, JD, LLM (taxation), provides tax consulting and CPE programs through Sellner Tax Consulting, LLC. He is a member of the Minnesota Society of CPAs, where he received the R. Glen Berryman Excellence in Teaching award and the Distinguished Service award, and the Florida Institute of CPAs. You may reach Mark at 612-508-4107 or mark@sellnertaxconsulting.com