How an S-Corp Subsidiary (QSub) Works for Small Businesses

Hopefully you already know the answer to, “What is an S-Corporation?” Now, you may be wondering about some of those more complex topics surrounding S-Corps. If you haven’t already, check out “Can an S-Corp have Subsidiaries and Partnerships?” for a refresher on some of the requirements and options when an S-Corp wishes to own interest in another business or enter a partnership.

One of those options is a QSub, which is what we’ll be talking about today. Have specific questions for your small business accounting and taxes? Give us a call and let our S-Corp-dedicated CPA Firm find the best strategy for you.

What Is a Qualified S-Corp Subsidiary (QSub or QSSS)

An S-Corp would usually be an ineligible shareholder in another S-Corp because as we talked about in “How to Keep the S-Corp Filing Status,” S-Corps may only have certain “allowable shareholders.” The caveat to this rule is our topic today. If an S corporation owns 100 percent of another business entity, it may elect under IRC §1361(b)(3) to have the second business considered a subsidiary of the parent S corporation.

A QSub, also known as a QSSS, can be a particularly good strategy for small business owners who may want to have two connected businesses under a single S-Corp. Just remember, the parent S-Corp must own 100 percent of the second business to be considered a QSub.

Example of an Existing S-Corp Using a QSub Strategy

Laura owns a retail store where she sells reclaimed furniture. Her current small business is an S-Corp, and she recently decided to open a new business that specializes in refinishing and upholstery service. Using a QSub structure, Laura could protect her successful retail business, while still branching out into the furniture services market under the same S-Corp entity.

Benefits of a QSub Under a Parent S-Corp

Income, deduction, credit, and assets are treated as those of its parent S-Corp.
Limits the parent company’s legal liability and prevents problems in one business from affecting the other.
Allows owner to manage only one entity for small business tax purposes.

Requirements of a QSub Under a Parent S-Corp

1. 100 percent of the subsidiary must be owned by the parent S-Corp.

2. The subsidiary must be a domestic (U.S.) corporation — a company organized outside the United States can never be a QSub. Note that the QSub itself does not have to re-satisfy the shareholder-level S-Corp eligibility rules, since its only shareholder is the parent S-Corp, but the parent must keep its own S-Corp status intact. Be sure to read “Who Can Make the S-Corp Election?” for a refresher on S-Corp eligibility.

3. Must NOT be one of the following ineligible corporations.

A bank or thrift institution that uses the reserve method of accounting for bad debts under section 585.
An insurance company subject to tax under subchapter L of the Internal Revenue Code.
A domestic international sales corporation (DISC) or former DISC.

How to Create a QSub under a Parent S-Corp

Ensure the desired subsidiary meets all requirements for eligibility.
The parent S-Corp must file Form 8869 and elect to treat the corporation as a QSub.
Per the Form 8869 instructions, the requested QSub effective date generally must not be more than 12 months after the date of filing or more than 2 months and 15 days before the date of filing (late-election relief may be available for reasonable cause).

After an S-Corp Files a QSub Election

The IRS service center will notify the S-Corp of whether the election was accepted and assuming it is, when it will go into effect.
The subsidiary will undergo a deemed liquidation into the parent S-Corp.
If the election is later revoked or terminated, the QSub is treated as a new corporation that immediately assumed all of its liabilities and acquired its assets, and it generally cannot make a new S-Corp or QSub election for five tax years without IRS consent.

Can an S-Corp have Multiple QSubs?

Yes! As long as each subsidiary meets all of the eligibility requirements above and separate elections are made for each desired subsidiary, an S-Corp may have multiple QSubs. Let’s take the example of Laura above. Her furniture repair business has really taken off along with her already successful retail store. She may decide it’s time to open an interior decorating business. Using the QSub structure the same way she did before, Laura can open her third small business, protect her other businesses from liability or other effects, and keep her small business taxes nice and tidy under the umbrella of her parent S-Corp.