This is a series based on questions from
the AICPA tax certificate of educational achievement (CEA) courses.
Small Business Tax Solutions
Q. What recent legislative developments in the Congress and changes at the Internal Revenue Service have allowed S corporations to diversify their means of holding investments in subsidiary businesses?
A. There are several ways in which S corporations can hold investments in other businesses. The possibilities have broadened largely as a result of passage of the Small Business Job Protection Act of 1996 and some significant changes in its positions by the IRS.
SMALL BUSINESS JOB PROTECTION ACT
Before 1997, S corporations were not permitted to own 80% or more of the stock in another corporation. An S corporation could own less than 80% of the stock of a subsidiary corporation, but the subsidiary could not be an S corporation. The Small Business Job Protection Act repealed Internal Revenue Code section 1361(b)(2)(A), which prohibited S corporations from being members of an affiliated group of corporations.
The 1996 act also includes a provision that allows an S corporation to own a so-called qualified subchapter S subsidiary (QSSS). A QSSS is a separate corporation from the parent company under local law and thus offers the tax advantages of splitting assets for liability purposes and regulatory compliance. For federal tax purposes, however, a QSSS is disregarded as a separate entity.
CHANGES AT THE IRS
In 1994, the IRS reversed a 1977 ruling (revenue ruling 77-220, 1977-1 CB 263) that said an S corporation with an interest in a partnership could lose its S corporation status unless there was a valid nontax business purpose for the arrangement. This change (revenue ruling 94-43, 1994-2 CB 308) means S corporations are now free to be partners in partnerships.
In the early 1990s, the IRS issued several revenue rulings on the tax status of limited liability companies (LLCs). In states that permitted LLCs to choose attributes normally found in corporations, problems arose about how certain entities were classified. The combination of LLC classification problems and the affiliated group prohibition discussed above could be deadly for an S corporation. In one situation, an S corporation owned more than 80% of an LLC. The IRS classified the LLC as an association. Thus, the parent company was a member of an affiliated group and lost its eligibility for S status (private letter ruling 9433008).
Adoption of final regulations-Treasury regulations section 301.7701-3, known as the check-the-box regulation-eliminated the uncertainty about LLC classification. An unincorporated entity can now choose its tax classification. Default classification rules also now exist. Under regulations section 301.7701-3(b)(1)(i), a domestic entity with two or more members is treated as a partnership. Under regulations section 301.7701-3(b)(1)(ii), a domestic organization with only one member is disregarded for tax purposes. Thus, a one-owner LLC (established in a state that allows such an arrangement) would be a proprietorship if owned by an individual or would be a branch or division if owned by an entity such as an S corporation (regulations section 301.7701-3(b)(4)).
Taking into account all of these developments, an S corporation may now be
- A partner in a partnership.
- A part or sole owner of an LLC, with the LLC classified as a flow-through entity.
- A part or sole owner of a C corporation.
- The owner of a QSSS.
Either of these options might be the optimal tax arrangement depending on the circumstances, such as compensation needs or the divisibility of the subsidiary business. If an S corporation owns all of the stock of another corporation, the second corporation may be a C corporation. In that case, the shareholder-employees of the parent company might be able to participate in employee benefits offered by the lower tier company and receive the tax advantages that only a C corporation can provide its employees. Alternatively, the lower tier company may be a QSSS, an arrangement that preserves the pass-through nature of the business entity. The parent company can achieve the same result by structuring the lower tier subsidiary as an LLC, provided it is chartered in a state that permits one-member companies.
If the parent S corporation wants to sell part of the equity in the subsidiary operation to another person, the distinction between an LLC and a QSSS becomes important. The sale of part of the stock in a wholly owned company would cause that company to lose its eligibility as a QSSS. The sale of part of the equity in an LLC, however, would allow the LLC to continue to be a pass-through entity.
The changes that have taken place from 1994 through 1996 have allowed businesses organized as S corporations much greater flexibility in conducting their operations than was available in prior years. The comparative ease of restructuring ownership arrangements allows an S corporation to achieve its best tax structure at little or no tax cost.
ROBERT W. JAMISON , CPA, PhD, is professor of accounting at
Ohio University, Athens. He is an author in the AICPA tax CEA series.