C corporations as S corporation subsidiaries.

• Author: Ellentuck, Albert B.

AN S CORPORATION CAN ELECT TO TREAT A 100% owned subsidiary as a qualified subchapter S subsidiary (QSub) (Sec. 1361(b)(3)). A QSub election causes the subsidiary to be disregarded for most federal tax purposes. Accordingly, the QSub's items of income, deduction, and credit, as well as its assets and liabilities, are normally treated as those of its parent. As a prerequisite for the election, the subsidiary must be a corporation that would be eligible to be an S corporation if the shareholders of its parent S corporation held its stock directly.

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Observation: Before the creation of the QSub alternative, an individual who owned multiple activities conducted as S corporations was required to hold them in a "brother-sister" format (the individual owner holds the stock of several S corporations). Under this arrangement, the individual owner had to ensure that there was adequate stock basis to receive a passthrough loss from any S corporation that may have a loss year. Conversely, in QSub format, all income and losses are combined at the S level, and the owner's tax basis in stock needs to be monitored for only one entity.

As a practical matter, the biggest benefit of establishing one or more QSubs is to limit the parent company's legal liability (i.e., to prevent problems in one business or location from affecting other businesses or locations).

Example 1: E, Inc., is an S corporation that operates a vegetarian restaurant. The owners are interested in expanding but are worried about the liability of opening new restaurants. To prevent problems in one restaurant from spilling over into other restaurants, [pounds sterling] forms three new corporations, each operating a new restaurant in a different location, and elects to treat them as QSubs. The assets and liabilities of each restaurant are treated as if they are owned by E. Only one S corporation return is filed, the three subsidiaries are disregarded for federal tax purposes, and each provides limited liability protection for [pounds sterling] and its shareholder(s). Operating a Subsidiary as a C Corporation

S corporations are permitted to hold up to 100% of the stock of a corporation. Ownership of more than 50% of a corporation's stock gives the owner the right to control the subsidiary corporation. Ownership of 80% or more establishes an affiliated group relationship (Sec. 1504(a) (1)). However, the S corporation parent cannot be included as a member of the affiliated...