Determining Eligibility to
Elect QSub Status

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 20th Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, James A. Keller and Diana L. Stephens, published by Practitioners Publishing Company, Ft. Worth, TX, 2006 ((800) 323-8724; ppc.thomson.com).

A qualified subchapter S subsidiary (QSub) is a subsidiary corporation 100% owned by an S corporation that has made a valid QSub election for that subsidiary; see Sec. 1361(b)(3)(B). (For example, an S corporation can own 100% of the stock of two subsidiaries and make a QSub election for either, neither or both of them.) For purposes of the 100%-stock-ownership requirement, a subsidiary’s stock is deemed owned by an S corporation if the latter is treated as the stock’s owner for Federal tax purposes; see Regs. Sec. 1.1361-2(b).

Eligibility

In addition to being 100% owned by an S corporation, a QSub must be a domestic corporation that otherwise meets the basic S corporation requirements; i.e., the QSub must:

1. Be a domestic corporation;

2. Have only one class of stock; and

3. Not be an ineligible corporation by definition (such as certain insurance companies).

Thus, certain financial institutions that use the reserve method of accounting for bad debts, insurance companies, domestic international sales corporations (DISCs) and former DISCs, are not eligible for QSub status.

Technically, a QSub is neither a C nor an S corporation and generally is not treated as a separate corporation for Federal tax purposes (although it is still treated as a separate corporation for other purposes). A QSub’s assets, liabilities and items of income, deduction and credit are treated as owned by the parent S corporation; see Sec. 1361(b)(3) and Regs. Sec. 1.1361-4(a).

Example 1

Essco, an S corporation, is the sole member of Lucky, a limited liability company. Lucky owns all the stock of Zeno, a corporation otherwise eligible for QSub status. Under Regs. Sec. 301.7701-2(c)(2), Lucky is a business entity that is disregarded as an entity separate from its owner. Essco is treated as owning all the stock of Zeno and can elect to treat Zeno as a QSub.

Example 2

Essco, an S corporation, owns 100% of Quiggley, a corporation for which a valid QSub election is in effect. Quiggley owns 100% of Zeno, a corporation otherwise eligible for QSub status. For purposes of the 100%-stock-ownership requirement, Quiggley is disregarded as an entity separate from Essco; thus, all of Quiggley’s assets (including its Zeno stock) are deemed owned by Essco. Essco can elect to treat Zeno as a QSub.

Observation: If Quiggley owns 50% of Zeno, and Essco owns the other 50%, Essco is deemed the owner of all the Zeno stock and can elect to treat Zeno as a QSub.

Example 3

The facts are the same as in Example 2, except that Quiggley is a C corporation. Although Quiggley is a domestic corporation otherwise eligible to be a QSub, no QSub election has been made for it. Quiggley is deemed to be the owner of the Zeno stock. Consequently, Essco cannot elect to treat Zeno as a QSub. Further, because Quiggley is not an S corporation, it cannot make a QSub election for Zeno.

Special Rules

Banks and bank holding companies should see Notice 97-5 for additional information on making a QSub election.