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Business planning with Qsubs.

The qualified Subchapter S Subsidiary (QSub) was introduced in the Small Business Job Protection Act of 1996 (SBJPA), marking the first time an S corporation could have a wholly owned subsidiary. In addition to allowing for the 100% ownership of an S subsidiary, the SBJPA also allowed for an S parent to own any percentage of the stock of a C corporation. Under new Sec. 1361(b)(3), a QSub is a domestic corporation 100% owned by an S parent. To qualify for QSub treatment, the S parent must make a QSub election with respect to the subsidiary. Once the election is made, the subsidiary is not treated as a separate entity for Federal income tax purposes; all of its assets, liabilities and items of income, deduction and credit are treated as those of the parent. The corporations do maintain separate legal status.

To qualify for QSub status, the subsidiary's stock must be 100% owned by an S corporation. The subsidiary must be a domestic corporation that is not an ineligible corporation. Ineligible corporations generally include financial institutions, insurance companies, domestic international sales corporations (DISCs) or former DISCs, or corporations operating under a Sec. 936 election. The parent must elect to treat the subsidiary as a QSub. The election is treated as a deemed liquidation of the subsidiary under Secs. 332 and 337, and, generally, will be a tax-free transaction. Notice 97-4 provides the current procedure for electing QSub status. The S corporation must file Form 966, Corporate Dissolution or Liquidation, indicating the subsidiary's employer identification number (EIN), the desired effective date of election and the parent's name and EIN. The phrase "Filed pursuant to Notice 97-4" should appear at the top of the form. The form must be signed by an authorized officer of the parent. This procedure should be followed until the final regulations are published. A QSub election will become effective for the date requested, as long as the effective date is not more than two months and 15 days before or 12 months after the filing date. Relief for a late election may be available under Rev. Proc. 98-55, if the parent can show reasonable cause for the late election and the election is filed by the due date for the S corporation's tax return (excluding extensions).

QSubs present interesting business and tax planning opportunities for S corporations. First, an S corporation may separate the business lines of a company by dropping the operations into wholly owned subsidiaries; each business line can be in its own corporation while maintaining S status for the overall group. For example, a company may manufacture and sell one product while distributing another. Under the QSub provisions, these separate business lines can be split between two separate corporations; one company can become the parent of the other company or have yet a third company, acting as a holding company, be the parent of the two operating companies. If a subsidiary were to be sued by creditors, they cannot reach the parent's or other subsidiary's assets.

A second benefit of the QSub structure arises when an individual owns several S corporations, some profitable and some struggling. When a struggling company continues to lose money, the losses may not be deductible by the shareholder, if he does not have sufficient basis in that company. Traditional solutions, such as shareholder or intercompany loans, are not as appealing as they once were, as these arrangements are often successfully challenged by the IRS. First, shareholder loans must be in writing, with a stated interest rate or with interest being imputed at the applicable Federal rate. Second, in Bergman (4/19/99), the Eighth Circuit disallowed a loan between related S corporations as an increase to a shareholder's outside basis in the struggling entity. The transactions were viewed by the court as a series of offsetting bank transactions among accounts that the taxpayer controlled. Because total indebtedness among all related entities did not change, the court ruled that no economic outlay actually occurred; therefore, no new basis was created. The QSub provisions offer a new alternative to this otherwise cumbersome recordkeeping and risk of IRS challenge.

For example, a profitable company makes a QSub election with respect to a nonprofitable company. The nonprofitable company's stock is contributed to capital by the shareholder as a tax-free exchange under Sec. 351 or 368(a)(1)(B). The deemed liquidation under Sec. 332 generates carryover basis, while the suspended Sec. 1366 losses of the new subsidiary are treated as a carryover with no result to the parent. Therefore, outside basis is looked at as a whole, rather than at the individual company level. This provides a tremendous opportunity to use the suspended losses of the struggling companies against the profits of the other companies, without the risk of IRS challenge.

A potential barrier to this structure will probably arise once final regulations are published. A nonprofitable company may have liabilities that exceed the basis of its assets. Under the step-transaction doctrine, the QSub reorganization outlined above would trigger gain to the subsidiary under Sec. 357(c) to the extent the QSub's liabilities exceed the basis in its assets. While, according to the proposed Sec. 1361 regulations, the step-transaction doctrine will apply to all QSub transactions, they provide transition relief to avoid the triggering of this gain. Prop. Regs. Sec. 1.1361-4(a) (5) states that the step-transaction doctrine will not apply to determine the tax consequences of any QSub elections effective before 60 days after the final regulations are published in the Federal Register. As of yet, the final regulations have not been published.

As previously mentioned, the subsidiary must be wholly owned by the S parent. If one share of stock of the subsidiary was sold, the QSub election is automatically terminated. Also, a QSub election may be revoked by the parent filing a revocation statement with the Service at the service center at which it normally files its tax returns. The statement must contain the names, addresses and EINs of both the parent and the QSub, and be signed by an authorized officer of the S corporation.

On termination or revocation, the subsidiary is deemed to become a newly formed C corporation acquiring its assets and assuming its liabilities from the S corporation in exchange for its stock. This termination will generally be governed by Sec. 351, which provides for nonrecognition treatment and carryover basis; however the step-transaction doctrine will apply in this situation once final regulations are published. If the subsidiary has liabilities in excess of the basis in its assets, Sec. 357(c) will trigger gain on termination. This newly formed corporation must generally wait five years to elect S status or reelect QSub status.

Many new planning opportunities are available to S corporations with the advent of QSubs. Caution should be exercised to ensure that the procedural aspects of the election are adhered to.

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Article Details
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Title Annotation:qualified Subchapter S subsidiary corporations
Author:Yerian, Alane L.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Aug 1, 1999
Previous Article:Partnership depreciation trap.
Next Article:Can an accrual-method S corporation elect under Sec. 170(a)(2)?

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