The benefits and burdens of QSubs.

• Author: Lindholm, Nancy S.
• Position: Taxation regarding qualified Subchapter S subsidiaries

EXECUTIVE SUMMARY

* The QSub election is effective when filed, if another appropriate date has not been specified.

* When a QSub election is made, the subsidiary is deemed to have liquidated into the parent.

* The IRS has provided transitional relief from the step-transaction doctrine for QSub elections made until 60 days after the final regulations are issued.

Tax planning via the use of S corporation subsidiaries became a reality after the Small Business Job Protection Act of 1996, which created the "qualified subchapter S subsidiary" (QSub) for tax years beginning after 1996. Despite the availability of this type of entity, comprehensive guidance was not available until proposed regulations were issued. This article explains these rules and the planning potential stemming therefrom.

The Small Business Job Protection Act of 1996 (SBJPA) enacted significant changes for S corporations, resulting in new tax planning opportunities. One of the major changes, SBJPA Section 1308, repealed Sec. 1361(b)(2)(A), allowing S corporations to own (1) 80% or more of a domestic or foreign C corporation and (2) domestic qualified subchapter S subsidiaries (QSubs) for tax years beginning after 1996. QSubs are treated as disregarded entities; they have a separate legal existence for liability purposes, but exist only as a division of the parent S corporation (parent) for tax purposes. New Sec. 1361(b)(3)(B) defines a QSub as any domestic corporation that is not an ineligible corporation(1) if an S corporation (1) holds 100% of its stock and (2) elects to treat the subsidiary as a QSub.

The Service released proposed regulations on QSubs.(2) This article will review the mechanics of electing and working with QSubs, the consequences of terminating QSub status, the tax opportunities and pitfalls of using QSubs and the tax advantages of using a QSub versus a single-member limited liability company (SMLLC), another type of disregarded entity.

Election Procedure

Notice 97-4(3) prescribed how to elect QSub status. The parent must file Form 966, Corporate Dissolution or Liquidation, printing at the top "FILED UNDER NOTICE 97-4" to make a QSub election. Form 966 should be filed with the Service Center where the subsidiary fried its most recent tax return. If a new corporation is formed, Prop. Regs. Sec. 1.1361-3(a)(1) prescribes that Form 966 should be fried with the parent's Service Center. The parent can provide that QSub status will be effective up to two months and 15 days before (or up to 12 months after) the date the QSub election is actually made. This procedure applies even if the QSub is a new entity.

Although the proposed regulations changed many of the prescriptions of Notice 97-4, the preamble states that taxpayers must follow the notice until the regulations are finalized. Prop. Regs. Sec. 1.1361-3(a)(1) indicates that an S corporation making a QSub election will file a new form that the IRS will develop. The form will be signed by a person authorized to sign the S corporation's return.

Prop. Regs. Sec. 1.1361-3(a)(3) presents several possible effective dates for the QSub election. The election may be made at any time during the year. In general, QSub status is effective the day the election is filed. However, the parent may specify a different effective date, which may be as early as two months and 15 days before or 12 months after the actual filing.

Example 1: A calendar-year S corporation acquired 100% of a domestic C corporation on May 1, 1999. On July 1, 1999, a QSub election was made. If not specified, the election was effective on July 1, 1999; however, it could have been effective as early as May 1, 1999 or as late as July 1, 2000.

Rev. Proc. 98-55(4) permits inadvertent late elections to be rectified. Basically, a late QSub election may be made within 12 months from the original due date of the S election, but not later than the unextended due date of the return for the first S year. The QSub election should be filed with the applicable Service Center, with "FILED UNDER REV. PROC. 98-55" printed at the top of Form 2553, Election by a Small Business Corporation. A reason for the failure to file a timely S election must be provided. Because this is not a letter ruling request, no filing fee is required.

Deemed Liquidation

Prop. Regs. Sec. 1.1361-4(a)(2) provides that on a QSub election, the subsidiary is deemed to have liquidated into the parent, generally tax-free under Secs. 332 and 337(5); if it is tax-free, the parent will take the QSub's carryover basis in its assets. Under Sec. 381 (a), the QSub's other tax attributes will also carry over to the parent. The parent's investment in the subsidiary's stock will disappear on the Sec. 332 liquidation. If the QSub was formerly a C corporation, exposure to Sec. 1374 built-in gains tax, Sec. 1375 excess passive investment income (PII) tax and Sec. 1363(d) LIFO recapture tax may occur. If a potential QSub is insolvent (i.e., the fair market value (FMV) of its assets is less than its liabilities), the liquidation would be a taxable transaction.

After the election and deemed liquidation, the QSub becomes a disregarded entity. Under Sec. 1361 (b) (3) (a) (ii), the parent is treated as owning all of the QSub's assets, liabilities and similar tax items, and must report them on its own return. In effect, the QSub is treated as a division of its parent; thus, any transfer of property within the parent S and QSub group is nontaxable. Loans to the QSub by a shareholder will increase the adjusted basis for loss in the parent company. A consolidated return is not allowed for a parent and a QSub subsidiary; instead, only one Form 1120S is filed, which should reflect the income, losses and separately stated items of both the parent and the QSub. Thus, nonseparately reported profits and losses could offset each other before flowing to the shareholders.

When Liquidation Occurs

Under Prop. Regs. Sec. 1.1361-4(b)(1), the liquidation occurs at the close of the day before the QSub election is effective. Thus, if the parent...