QSSSs and state issues.

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 California, for example, allow Federal S corporations an election to be treated as a C corporation for state income tax purposes. These states present an interesting planning opportunity; it appears that in some instances, either the parent or the QSSS can be treated as a C corporation for state purposes, while the other is treated as an S. On the other hand, certain rules of the "separate election" states create potential pitfalls. For instance, New Jersey not only requires a separate election for the parent, but also for the QSSS. A qualifying QSSS must also file a separate New Jersey return and pay the minimum tax, even though its net income and apportionment factors are included in the parent's return. In Pennsylvania, if the parent has elected S status in the state, its QSSS will automatically be an S corporation. The Wisconsin election to be treated as a C corporation for state purposes is not available to corporations with QSSSs. The subsequent acquisition of a QSSS by an S corporation electing C status in Wisconsin will revoke the election. The California election allowing an S corporation to file the state's franchise (income) tax return as a C corporation is not available to QSSSs.

New York's QSSS rules merit their own category. When the parent is a New York S corporation, the state will tax the parent and the QSSS as one S corporation. If the parent is a New York C corporation and the QSSS is a New York taxpayer or the QSSS is not a New York taxpayer but the parent makes a New York QSSS inclusion election, the parent and QSSS will be taxed as one C corporation. If the parent does not make an inclusion election for the "non-New York" QSSS, it will file as a New York C corporation on a stand-alone basis. If the parent is not a New York taxpayer, it can make a New York election to follow the Federal treatment, treating the parent and the QSSS as one S corporation. If the parent does not make this election, the QSSS will file as a C corporation on a stand-alone basis. In all instances in which the parent and QSSS file as one corporation, the QSSS is exempt from the income-based franchise tax, the fixed-dollar minimum tax, the capital tax and the alternative tax based on assets.

In determining nexus, many of the states ignore that an S and its QSSS(s) are separately incorporated. States that do not require a separate state S election tend to treat the parent and its QSSS as one corporation for determining nexus. States such as Utah, Massachusetts and California consider the operations of a QSSS within their borders in determining if the parent S corporation has a tax obligation to the state.

Although a parent S and its QSSS are treated as one corporation for Federal and many state income taxes, they are separately incorporated entities. Accordingly, a QSSS may be liable for a number of "nonincome" taxes, such as franchise taxes based on net worth, equity or a fixed fee basis. California, which views its $800 minimum tax as a franchise tax for corporations qualified to do business in the state, imposes this tax on a QSSS, even if its income is included in its S parent's California return. New Jersey also requires a QSSS to pay the state's minimum income tax which (like California) is viewed as a franchise fee. Massachusetts requires a QSSS to pay any corporate excise tax based on its taxable tangible property, taxable net worth or the minimum tax (the QSSS does not pay Massachusetts tax based on its net income, which is included in its parent's return). Other states, such as West Virginia, have franchise taxes filed separately from the state's income tax, and filed separately for both the parent S and its QSSS.

There are differences among the states on the treatment of sales/use and payroll taxes. For example, Illinois requires a QSSS to register separately for sales/use taxes. In Wisconsin, if a QSSS is disregarded as a separate entity for income tax, the QSSS's information is included on the owner's Wisconsin sales/use tax return. For payroll taxes, many states require a QSSS to file separately from its parent if the QSSS has a separate Federal identification number; many QSSSs are obtaining them solely for state payroll tax-reporting purposes; see Notice 99-6.

There are numerous QSSS issues that many states have not yet addressed; undoubtedly, more state QSSS rules can be expected in the future.

FROM LARRY EWING, CPA, CHICAGO, IL