Operating a QSub
S Corporation Income Taxation
Qualifications & Considerations
Editor: Albert B. Ellentuck, Esq.
A qualified subchapter S subsidiary (QSub) is a subsidiary corporation 100% owned by an S corporation that has made a valid QSub election for the subsidiary (Sec. 1361(b)(3)(B)). Because a QSub's separate existence is ignored, transactions between the S corporation parent and QSub are not taken into account, and items of the subsidiary (including accumulated earnings and profits, passive investment income, and built-in gains) are considered items of the parent. The QSub election terminates the QSub's former identity as a separate entity for federal tax purposes. Thus, a final income tax return must be filed. This final return generally includes the deemed liquidation transaction.
A QSub is normally treated as a disregarded entity for all purposes of the Code (Secs. 1361(b)(3)(A)(i) and (ii)). However, the IRS is authorized to treat it as a separate entity for certain purposes (Sec. 1361(b)(3)(A)).
Under this authority, the IRS has issued regulations that treat QSubs as separate entities for the following purposes: (1) employment taxes; (2) certain federal liabilities, refunds, and credits of federal tax; and (3) certain excise taxes.
QSub Treated Separately for Employment Taxes
For wages paid after 2008, a QSub is treated as a separate entity for federal employment taxes (Regs. Sec. 1.1361-4(a)(7)). Accordingly, the QSub is liable for employment taxes on wages paid to its employees and is responsible for satisfying its other employment tax obligations (e.g., backup withholding, making timely deposits of employment taxes, filing returns, and providing wage statements to its employees on Forms W-2, Wage and Tax Statement ). The parent S corporation is separately responsible for employment taxes on wages paid to its employees and is separately responsible for satisfying its other employment tax obligations.
Related corporations may avoid the overpayment of employment taxes for common employees by implementing a common paymaster system. If two or more related corporations concurrently employ the same worker and pay him or her through a common paymaster that is one of the related corporations, only the common paymaster corporation must withhold and pay employer FICA and FUTA taxes (Secs. 3121(s) and 3306(p)). If all wages of the concurrently employed worker are disbursed by the common paymaster, the group of corporations pays no more employer tax than would a single employer.
To implement a common paymaster system, the corporations must (1) be appropriately related, (2) concurrently employ workers, and (3) authorize one of the corporations to be the common paymaster (Regs. Secs. 31.3121(s)-1 and 31.3306(p)-1(a)). While there is no direct authority on point, it would appear that an S corporation parent and its QSub would meet the relationship requirement, which requires that either a stock ownership test, 50% common director test, 50% common officer test, or 30% common employee test (one of these four tests) be met at any time during the quarter (Regs. Sec. 31.3121(s)-1(b)(1)). Presumably, the relationship test is met (if not one of the other tests) because a QSub is a subsidiary corporation that is 100% owned by an S corporation that has made a QSub election for the subsidiary.
Planning tip: Because these rules apply only to concurrently employed workers, each corporation remains responsible for the wages of its remaining employees. Thus, a common paymaster designation usually does not completely relieve the participating corporations from payroll tax responsibility. Each business remains separately responsible for employees who are not concurrently employed by another related business entity.
QSub Treated Separately for Other Purposes
Although a QSub generally is treated as a disregarded entity for federal tax purposes, it will be treated separately from its S corporation parent for purposes of the following (Regs. Sec. 1.1361-4(a)(6)):
The QSub's federal tax liabilities for any tax year in which it is not treated as a QSub;
The federal tax liabilities of any other entity for which the QSub is liable; and
Refunds or credits of federal tax.
Example 1: A Co., an S corporation, has owned all the stock of B Co. for the past six years. Both corporations are calendar-year corporations but have never reported their taxes on a consolidated basis. A Co. elects to treat B Co. as a QSub effective Jan. 1, 2012. In August 2012, following an IRS audit of B Co.'s 2009 tax return, the IRS seeks an extension of the statute of limitation on assessment of B Co.'s taxes. Because B Co. was treated as a separate corporation for its 2009 tax year, B Co.'s
officers must sign the extension on behalf of B Co. Similarly, if B Co. fails to pay its audit assessment, the IRS will attach a general tax lien against B Co.'s property.
A QSub is generally treated as a separate entity for purposes of federal excise taxes (Regs. Sec. 1.1361-4(a)(8)). Furthermore, an S corporation and a QSub are recognized as separate entities for making information returns, except as otherwise required by the IRS (Sec. 1361(b)(3)(E); Regs. Sec. 1.1361-4(a)(9)).
Organizational Expenditures of the QSub
Expenditures paid to facilitate (i.e., an amount paid in the process of investigating or otherwise pursuing) the formation or organization of a disregarded entity, such as a QSub, must be capitalized under Sec. 263 (see Regs. Secs. 1.263(a)-5(a)(6) and (b)). A de minimis exception is provided when, in the aggregate, such expenditures do not exceed $5,000 (Regs. Sec. 1.263(a)-5(d)(3)). However, regardless of whether the de minimis exception applies, it appears that the traditional organizational expenditures incurred in the process of forming or organizing a QSub continue to qualify for amortization under Sec. 248 (Regs. Sec. 1.263(a)-5(j)).
An organizational cost is any expense incurred by a corporation or partnership that is (1) incident to the creation of the company; (2) chargeable to the capital account of the company; and (3) of a character that, if expended incident to the creation of a company having a limited life, would be amortizable over such life. Organizational costs include (1) legal services incurred in drafting the initial documents; (2) accounting services required when organizing the company; (3) organizational meetings of directors or shareholders; and (4) fees paid to the state of incorporation (Regs. Sec. 1.248-1(b)(2)).
Example 2: D Co. is an S corporation that provides airframe and powerplant repair and maintenance services for aircraft. Early in the year, D Co. pays $7,000 to investigate whether to form a QSub for the purpose of expanding its business to include a retail business. The investigation makes a strong business case for organizing a QSub to conduct a retail business. Accordingly, D Co. forms a corporation ( E Co.) and immediately makes a QSub election for it. E Co. then establishes a new retail store to sell a complete line of pilot supplies. E Co. pays $16,000 to recruit and train employees for the new retail store and to advertise the new store. E Co. also pays $9,000 to acquire a 10-year lease agreement for the new store.
The $7,000 paid to investigate whether to establish a QSub must be capitalized under Sec. 263 (Regs. Sec. 1.263(a)-5(a)(6)). However, traditional organizational expenditures (such as attorneys' fees and fees paid to the state of incorporation) incurred in the process of organizing E Co. evidently qualify for amortization under Sec. 248 (Regs. Sec. 1.263(a)-5(j)). The $16,000 paid for employee recruitment and training, and the expenditures for advertising qualify as startup expenditures and are amortizable under Sec. 195 (Regs. Sec. 1.263(a)-4(b)(4)).
The $9,000 paid to acquire the lease must be capitalized under Sec. 263 because it is a payment to another party to enter into an agreement for the right to use tangible property and the payment amount is not de minimis . E Co. can amortize the payment over the 10-year life of the lease (Regs. Secs. 1.263(a)-4(d)(6)(i)(A), (6)(v), and 6(vii), Example (1)).
Organizational costs are not deductible when paid or incurred, but the corporation can elect to deduct up to $5,000 of the costs in the tax year in which business begins, with the remainder of the costs amortized over a 180-month period beginning with the month it begins business. The $5,000 amount is reduced (but not below zero) by the amount by which the cumulative cost of organizational expenditures exceeds $50,000 (Sec. 248(a); Regs. Sec. 1.248-1(a)). Once cumulative organizational expenditures reach $55,000, none of the costs can be deducted in the tax year in which business begins, but all of the costs can still be amortized over 180 months.
Startup Expenses of the QSub
Expenditures that would be deductible (under Sec. 162) as ordinary and necessary business expenses if the corporation were actively engaged in a trade or business must be capitalized if they are incurred during the startup period. However, taxpayers can deduct up to $5,000 of startup costs in the tax year in which active conduct of the trade or business begins. The $5,000 amount is reduced, but not below zero, by the amount by which the cumulative cost of the startup expenditures exceeds $50,000 (Sec. 195(b); Regs. Sec. 1.195-1(a)). Accordingly, after incurring $55,000 of startup costs, no amounts are currently deductible (but can still be amortized over 180 months).
The types of costs affected by this rule commonly include amounts paid or incurred in connection with (1) investigating the creation or acquisition of an active trade or business; (2) creating a new active trade or business; or (3) any "preopening" activity of an investment activity that occurs in anticipation of the commencement of an active trade or business.
For purposes of Sec. 195, a corporation is considered to be in the startup period with respect to a particular activity until the active conduct of the associated trade or business begins. Active conduct of a trade or business occurs when the business has begun to function as a going concern and perform the activities for which it is organized.
An existing taxpayer operating in a particular industry or segment, such as manufacturing, will be considered to be entering a new trade or business, requiring a Sec. 195 election, if it expands into a different industry or segment, such as wholesaling or retailing. Expenses associated with opening additional stores in new locations, which conduct the same activity or same line of business, do not constitute startup expenditures subject to capitalization and amortization. However, when the expansion is accomplished by setting up a separate taxable entity, such as a corporate subsidiary, startup expenses must be capitalized and may be deducted and amortized under Sec. 195, regardless of whether the expansion is within the same line of business or into a new line of business. Amortization begins with the month each new business begins.
Planning tip: An S corporation expanding an existing line of business can set up one or more QSubs to own the new same-line-of-business operations. Since the QSubs are disregarded for federal tax purposes, a current deduction should be allowed for expansion costs of each QSub because they are treated as incurred by the existing S corporation rather than the QSub.
Accounting Methods of Parent and QSub
When a subsidiary of an S corporation becomes a QSub, the QSub is deemed to be liquidated into the parent S corporation, and the former wholly owned subsidiary's assets and liabilities are treated as those of the parent S corporation (Regs. Sec. 1.1361-4(a)(1)). The wholly owned subsidiary's separate existence terminates for federal tax purposes. Therefore, the parent S corporation's overall method of accounting does not change, and the QSub apparently uses the same method of accounting as the parent. (Only one Form 1120S, U.S. Income Tax Return for an S Corporation , is filed, and the accounting method is indicated on the form.)
If, however, the parent has been using the cash method and the subsidiary carries inventory, the transfer of the QSub's merchandise would evidently trigger the parent S corporation's requirement to maintain inventory and use the accrual method of accounting (at least for the inventory), assuming that none of the exceptions to the accrual-method requirement apply.
This case study has been adapted from PPC's Tax Planning Guide—S Corporations, 26th Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, and James A. Keller, published by Practitioners Publishing Co., Fort Worth, Texas, 2011 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.