QSSSs and state issues.

• Author: Ewing, Larry
• Position: Qualified Subchapter S subsidiary corporations

Sec. 1361 (b)(3) was enacted by the Tax Reform Act of 1996. This provision, which allows an S corporation to have a wholly owned subsidiary, provides an incentive for corporations that need to separately incorporate segments of their business (due to product liability or other reasons) to elect S status. Under Sec. 1361 (b)(3), the qualified subchapter S subsidiary (QSSS) is considered a division of the parent corporation; all of its assets, liabilities, income, expenses and credits are treated as belonging to the parent. As such, one Form 1120S is filed for both corporations.

When Sec. 1361(b)(3) became effective, many state departments of revenue announced that they would follow the Federal tax treatment of requiring one return for both entities; other states adopted alternative or additional rules for taxing QSSSs. Many of these rules are still being refined by the states. To a large extent, how states tax QSSSs is determined by their general rules for taxing S corporations. For instance, states such as Michigan, New Hampshire, Tennessee and Texas tax S corporations as they would C corporations. Although an argument could be made that both a parent S corporation and its QSSS should be combined and taxed as one C corporation, it appears that these states will treat these corporations as separate C corporations, requiring not only separate income tax returns, but a separate nexus analysis to determine if both companies have a filing requirement in the state. Additional analysis is required for New Hampshire, which requires combined unitary returns; thus, even though the parent and the QSSS are treated as separate C corporations, they are likely to be combined in a New Hampshire unitary income tax return.

Many states, including Illinois, Idaho, Kansas and Kentucky, automatically accept a Federal S election. Essentially, these states follow the Federal income tax method of treating QSSSs as divisions. There are some unusual filling requirements even among this group of states. For instance, Alabama, while recognizing Federal S status, requires a QSSS and its parent to file separate income tax returns. Utah requires the parent's return to include a schedule that lists each of its QSSSs that do business (or are qualified to do business) in that state.

States such as Arkansas, New Jersey, New York and Pennsylvania have adopted many of the Federal S and QSSS rules, or their equivalent, but require a separate state S election. Wisconsin and...