Can an S Corporation Own Another S Corporation?
Explore the IRS rules and exceptions that allow an S corp to own a subsidiary, enabling specific business structures while preserving pass-through tax status.
An S corporation cannot own another S corporation. The Internal Revenue Code’s regulations are designed to keep the ownership of S corporations simple by limiting who can be a shareholder. If a corporation acquires shares in an S corporation, it violates these eligibility rules, which has immediate tax consequences for the company whose shares were acquired.
Understanding S Corporation Shareholder Restrictions
The Internal Revenue Service (IRS) limits S corporation shareholders to individuals who are U.S. citizens or residents, certain trusts, and estates. The rules prohibit other corporations, including C corporations or other S corporations, from owning stock.
If an ineligible shareholder, such as a corporation, acquires even a single share of stock in an S corporation, the target company’s S status is immediately terminated. Upon termination, the company automatically reverts to being a C corporation for tax purposes. This change means the business’s profits would be subject to double taxation, taxed first at the corporate level and again when distributed to shareholders as dividends.
With this change, the company loses the benefit of pass-through taxation, where profits and losses are passed directly to shareholders. Once an S election is terminated, the corporation is generally barred from re-electing S status for five years, making compliance with shareholder rules an ongoing responsibility.
The Qualified Subchapter S Subsidiary (QSub) Exception
A provision in the tax code allows an S corporation to own another corporation through a structure called a Qualified Subchapter S Subsidiary (QSub). For this to be valid, the parent S corporation must own 100% of the subsidiary’s stock. Selling even one share of the subsidiary to another party breaks this ownership requirement and disqualifies its QSub status.
To qualify as a QSub, the subsidiary must be a domestic corporation that would otherwise be eligible to be an S corporation. The parent S corporation must then make a formal election to treat the subsidiary as a QSub, which allows the parent to operate different business lines in separate legal entities.
For federal tax purposes, a QSub is a disregarded entity, so its financial activities like income and losses are treated as belonging to the parent S corporation. These items are reported on the parent’s tax return, preserving pass-through taxation. The QSub remains a separate legal entity under state law, which provides liability protection by isolating the parent from the subsidiary’s debts.
Making the QSub Election
The process to designate a subsidiary as a QSub is initiated by filing Form 8869, Qualified Subchapter S Subsidiary Election, with the IRS. The form requires information for both the parent and subsidiary, including names, addresses, Employer Identification Numbers (EINs), and the subsidiary’s incorporation date.
A key part of Form 8869 is the effective date of the QSub election. This date cannot be more than two months and 15 days before the date the form is filed, nor can it be more than 12 months after the filing date. The form must be signed by a person authorized to sign the parent S corporation’s tax return.
The completed form is mailed to the IRS service center corresponding to the parent S corporation’s business location. After the IRS processes the election, it will send a notification to the parent corporation confirming its acceptance.
Alternative Business Structures
An S corporation can also own a Limited Liability Company (LLC). If the S corporation is the sole owner, the LLC is treated as a disregarded entity for tax purposes. This functions much like a QSub, with the LLC’s income and losses passing through to the parent S corporation’s tax return.
An S corporation is permitted to own stock in a C corporation, but this can create tax inefficiencies. The C corporation pays corporate income tax on its earnings. When these earnings are distributed as dividends to the parent S corporation, they are considered passive investment income, which can risk the termination of the parent’s S status if it becomes excessive.
A “brother-sister” corporate structure is another alternative. In this arrangement, the same group of shareholders owns two or more separate S corporations directly, with no parent-subsidiary relationship. This structure avoids QSub complexities and maintains separate legal entities for different ventures, with each qualifying for pass-through taxation.