Effect of Installment Method on QSubs and Other Ignored Entities

Recently, practitioners have been making use of qualified subchapter S subsidiaries (QSubs) or other ignored entities to reduce clients' administrative filing burdens for separate entities. Although this may not be the primary and only reason to use a QSub (or other ignored entity), it is one that may offer a great deal of savings through reduced compliance costs. For many years, taxpayers with separate lines of business or divisions sought to isolate or separate their activities for legal protection. Keeping separate lines of businesses in separate legal entities has generally limited the liability and exposure to that separate activity. Taxpayers have formed separate legal companies to hold or conduct a specific trade or business. Although the result is what the taxpayer intended, most did not contemplate the additional administrative time and compliance costs associated with the newly formed entities.

Criticisms of this compliance-driven system aided in the enactment of legislation to ease the administrative costs of filing. In response to these criticisms, Congress has responded with the introduction of QSubs, and the IRS with the ignored-entities concept (such as the single-member limited liability company).

Despite the rule that an S corporation cannot normally have a corporate shareholder, an S parent may have a QSub. A QSub is a domestic corporation not otherwise ineligible to be an S corporation and 100% owned by an S parent that the S corporation elects to treat as a QSub (see Tax Clinic, "Final QSub Regs," TTA, May 2000, p. 326, for further explanation and other QSub tax issues). The collapsing of brother-sister S corporations into an S parent with QSubs may seem to be relatively inconsequential from a tax standpoint. However, prior to advising a client to contribute stock of a cash-basis, stand-alone S corporation to a sister holding company, an adviser should consider that the QSub structure might create an unexpected result when considering the sale of the cash-basis QSub in the future.

With the recent change in law under Sec. 453(a)(2), the installment method can no longer be used by accrual-method taxpayers for sales of property after Dec. 16, 1999, with few exceptions. The change has created much controversy and outcry from practitioners and other organizations. As a result, the Service has responded with Rev. Proc. 2000-22, which exempts certain taxpayers with annual gross receipts of $1 million or less from the requirements, to account for inventories and to use an accrual method of accounting for purchases and sales of merchandise.

Many believe Rev. Proc 2000-22 does not offer the relief to small businesses they readily deserve, as its scope is very narrow. QSubs contemplating the sale of assets or stock may fall into an unexpected trap. Consider a trade or business that is a separate and distinct legal entity for state tax purposes, but elects to be treated as a QSub for Federal tax purposes. The QSub elects to account for its income on the cash-method basis. Under Sec. 446(d), a taxpayer engaged in more than one trade or business might, in computing taxable income, use a different accounting method for each trade or business. The QSub may retain its cash method, even though its S parent uses an overall accrual method. On the surface, it may appear that the use of the installment method would be applicable if the QSub were to sell all of its assets, because it uses the cash method of accounting. The problem arises when the parent uses the accrual method, because it may be considered the seller of the subsidiary assets, even though under Sec. 446(d), the QSub is permitted to use the cash method and therefore falls under the installment sale rules in Sec. 453.

The IRS may take a contrary position. Because a QSub is considered to have liquidated tax-free under Sec. 332, the once stand-alone entity does not exist for Federal income tax purposes; its accounting and tax attributes are treated as if they are the S parent's. As a result, the Service may treat the sale of the wholly owned subsidiary's assets as a sale by the S parent and not by the QSub, resulting in disallowance of the installment method and recognition of the entire gain on sale.

Practitioners may try to make use of Rev. Proc. 2000-22 to obtain installment-sale treatment for a cash-basis QSub. When a QSub is maintained as a separate line of business and has gross receipts less than $1 million, it may appear to qualify for the cash method of accounting and use of the installment method. This argument is supported by the separate-trade-or-business provision under Sec. 446(d). However, this argument does not address the treatment of the QSub as an ignored entity for Federal income tax purposes and the requirement to aggregate gross receipts of related entities. Once again, the IRS would take the position that the S parent's accounting method and the current QSub regulations control the treatment of the accounting for the subsidiary (as well as any asset or stock sales).

Due to the limited guidance in Rev. Proc. 2000-22, as well as the final QSub regulations for the interplay between various Code sections, taxpayers contemplating the sale of an S corporation trade or business (assets or stock) should be aware of a potential detriment in forming a QSub before finalizing any transaction.

From Brian G. DeRespiris, CPA, Cohen & Company, LLC, Cleveland, OH