Corporations Owning Corporations
As your business grows, it may make sense to create a subsidiary for operating efficiency. The Internal Revenue Service has created the qualified Subchapter S subsidiary (QSub) rules to address this situation. (Remember that there is no limit on earnings for S-Corporation status, only a limit of 100 shareholders and one class of shares.) This rule allows a growing company the ability to open a subsidiary without losing its S status.
A subsidiary also qualifies as an S-corporation if:
- 100 percent of the stock is owned by the parent corporation;
- The parent corporation's shareholders hold the subsidiary's shares directly; and
- The parent corporation files for qualified subchapter S (QSub) status for the subsidiary.
The election to be treated as a Qsub is done by filing Form 8869, Qualified Subchapter S subsidiary Election and is effective on the date specified on the election form.
For tax purposes, the QSub doesn't exist. All of its income, deductions, profit or loss is considered to be the parent corporations. It is as if the subsidiary were liquidated and all the assets merged into the parent. This gives you the tax advantages of the S-corporation, while having the flexibility to manage your business needs.
Tax Treatments
As mentioned previously, an S-corporation is a flow-through entity (or passthrough entity). The income or loss 'flows' down to be paid by the shareholders. One of the things that you should know is that income/deductions are passed down in like form. For instance, ordinary income/loss is added/subtracted from the ordinary income on the shareholders tax return. Dividend interest is passed down to the shareholders Schedule D and combined with other investment income, which may be subject to the $3,000 a year loss limit. Charitable deductions are passed through to the shareholders Schedule A and added to other charitable contributions. This is why it is important to consider the type of income your business will be receiving when deciding whether to file for the S election.
There are additional considerations when switching a C-corporation that has been in existence for several years. If the C-corporation has a carry-over loss, it cannot be carried over to the S- corporation. The loss would be retained until such time as the S-election was cancelled and the business became a C-corporation again. So if the C-corporation has a sizable carry-over loss, it may be better to wait until that is used before making the switch.
A shareholder who sells their stock at a loss may claim that as a capital loss on their Schedule D, subject to the $3,000 a year capital loss limitation.
Each year, the S-corporation must timely issue to each shareholder a Form 1120S, Schedule K-1, which details what to include on the shareholders personal tax return.
S-corporation federal tax returns are due on 15th day of the third month after the end of the fiscal year. For calendar year S-corporations, that would be March 15th, unless a six month extension is filed.