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The Basics of Qualified Subchapter S Subsidiaries

Sep 13, 2021

Qualified Subchapter S Subsidiary Defined

A Qualified Subchapter S Subsidiary (QSub) is an S Corporation, or a corporation that is eligible to be an S Corporation, that is 100% owned by another S Corporation. A QSub is elected by filing a Form 8869 with the IRS. Equivalent state forms are used in some states, like New Jersey and New York, that require their own separate election. There are late election provisions, but the effective date for the QSub election generally cannot be more than twelve months after the date the election is filed or two months and 15 days before the date the election is filed.

For the most part, a QSub is disregarded for income tax purposes, does not file a separate return, and is treated as a division of its S Corporation parent. However, there may be some instances in which the QSub does have some separate reporting responsibilities when it comes to federal employment taxes, information return filings and, in a few cases, state filings.

QSub Formation

There are some strategies to take into consideration when forming a QSub. If the QSub is formed by a dropdown of assets from the parent S Corporation, there are normally no tax issues since the basis of the assets of the parent will be the basis of assets in the QSub. However, if the QSub is formed by way of a stock transaction, the basis of assets in the QSub would retain their tax basis, while not being adjusted for by the premium that may have been paid for the stock. As a QSub, the premium paid for the stock in excess of the tax basis of the assets is lost. In this instance, it is best to purchase the assets instead of the stock.    

Bringing in potential future investors should also be considered when forming a QSub structure.      Additional investors into a QSub converts the entity into a C Corporation since a QSub cannot have more than one shareholder and would now have a corporation (the parent company) as one of its shareholders. Corporations are not eligible S Corporation shareholders. For most privately held companies, a C Corporation is not a desirable entity. As an alternative to the QSub, the parent company may want to form a single member limited liability company (SMLLC), which is also treated as a disregarded entity. If new investors are brought in, the SMLLC simply coverts to a multi-member LLC which would be taxed as a partnership and would, normally, be more conducive for a privately held business.

QSub Asset Sales

The sale of QSub stock is always treated as an asset sale, since the QSub, for income tax purposes, is disregarded and deemed a division of its parent. So, in the instance where the QSub was formed with a dropdown of assets, the tax consequences of a sale of a QSub would be as expected – sale price less the basis of the assets would equal the gain. If the QSub was formed by a stock purchase transaction and then sold subsequently, the tax results could be catastrophic.       

For example, a parent company purchased the stock of a QSub for $1 million and the basis of the assets within the QSub was $300,000. If the parent company turned around and sold the QSub stock the very next day for $1 million, you might think there is no gain. However, that would be incorrect as the sale of stock is deemed a sale of the underlying assets. So, the gain would be $1M (sale price) minus $300,000 (basis of the asset), or a gain of $700,000. After paying $1 million for the QSub stock and selling the very same stock the next day, the parent company would be subject to tax on the gain of $700,000.    

Alternatively, if the parent company purchases the very same assets for $1 million and then dropped the assets into a QSub, the assets would have a basis of $1M. In the event the parent company sells either the stock or the assets for $1 million the next day, the gain would be $1 million (sales price) minus $1 million (basis), or no gain. This is much different than the $700,000 gain described directly above.

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Daniel Gibson

Daniel Gibson provides accounting, tax planning and consulting services to real estate and services industries and is a member of the AICPA and New Jersey Society of Certified Public Accountants.

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