Planning for a QSSS.

• Author: Huizenga, David L.
• Position: Qualified Internal Revenue Code Subchapter S subsidiaries

For tax years beginning before 1997, an S corporation was prohibited from owning 80% or more of another corporation's stock. In addition, an S corporation could not have a corporate shareholder. Section 1308 of the Small Business Job Protection Act of 1996 (SBJPA) liberalized these rules.

Sec. 1361(b)(3)(A) now allows an S corporation to own a qualified subchapter S subsidiary (QSSS). Sec. 1361(b)(3)(B) defines a QSSS as a domestic corporation that is not an "ineligible corporation" if an S corporation holds 100% of that corporation's stock and it elects to treat that subsidiary as a QSSS.

Ineligible corporations include:

* Financial institutions using the reserve method for bad debts described in Sec. 585;

* Insurance companies subject to tax under Subchapter L;

* Corporations subject to a Sec. 936 election; or

* Domestic international sales corporations (DISCs) or former DISCs.

By repealing former Sec. 1361(b)(2)(A), the SBJPA permits an S corporation to own 80% or more of a C corporation. At the same time, new Sec. 1504(b)(8) prevents an S corporation from joining in a consolidated return with its affiliated C corporations. However, the C corporation subsidiary may elect to join in the filing of a consolidated return with its affiliated C corporations.

Under prior law, the S election of a corporation with earnings and profits (E&P) accumulated as a C corporation terminated if the S corporation received passive investment income (including dividends) exceeding 25% of gross receipts for three consecutive years. Sec. 1362(d)(3)(E) modifies this rule by excluding dividends from an 80%-or-more-owned C corporation to the extent they are attributable to that C corporation's E&P derived from the active conduct of a trade or business.

However, neither the law nor its legislative history provides rules for determining the attribution of dividends to an active trade or business. It would seem that Sec. 316(a) would apply to require that a distribution be treated as having been made out of the most recently accumulated E&P, including current E&P when there is no accumulated E&P.

Election's Effect

The QSSS will not be treated as a separate corporation for Federal income tax purposes. Under Sec. 1361(b)(3)(A), its assets, liabilities, items of income, deduction and credit will be treated as belonging to the parent S corporation. However, the statute does not specify how the S corporation makes this election, its effective date, or how the commingling...