Updated November 11, 2020:

An S corp subsidiary is a situation in which an S corporation owns more than 80 percent interest in another corporation. An S corporation is considered a pass-through tax entity, which means that shareholders report all income, losses, credits, and deductions on their individual tax returns. This allows them to avoid double taxation since corporate income taxes are charged only on passive income.

To form an S corporation, all shareholders must agree in writing by signing and submitting IRS Form 2553. This option is only available to corporations that:

  • Are domestic
  • Have 100 or fewer shareholders
  • Do not have corporations, partnerships, or nonresident aliens as stockholders
  • Issue only one class of stock
  • Are not an insurance company, bank, or international sales corporation

Can S Corporations Own Subsidiaries?

Before 1997, an S corporation was not allowed to own more than 80 percent of the shares of an active subsidiary. This restriction was removed to allow taxpayers to create different corporate entities for different types of business. Congress thus allowed for both parent-subsidiary and brother-sister corporate arrangements. An S corporation can purchase stock in a domestic subsidiary and flow income through this subsidiary to shareholders, creating substantial tax savings. That's because the income will be taxed at the lower individual taxpayer rate rather than at the corporate rate.

An S corporation can create a subsidiary as either a limited liability company (LLC), a C corporation, or a qualified subchapter S subsidiary (QSub). An S corporation can be 80 percent or more owned by C corporations that act as subsidiaries. These subsidiaries can file a single tax return, but the parent S corporation must file a separate return.

When the S corporation receives dividends from these subsidiaries, they are not taxed as passive investment income. This allows the S corp to avoid the scenario where its beneficial tax status is revoked because of accumulated earnings and profits. 

Because an S corporation cannot have another corporation as a shareholder, most subsidiaries cannot be treated as S corporations. The exception is a QSub, also called a QSSS. In this case, the S corporation owns the entire subsidiary and elects S taxation for the company in question. This subsidiary must be an eligible S corporation. With the QSSS election, the subsidiary is treated as a disregarded tax entity, not as a separate corporation. 

This means that the subsidiary's income, assets, deductions, and liabilities pass through to the parent corporations, as do accumulated earnings and profits, built-in gains, and passive income. A QSub is not required to file a separate federal income tax return since its financials are consolidated on the S corp return. 

Establishing a QSub provides each separate business entity with limited liability protection from financial issues that affect related entities. The taxation of this type of structure is complex. However, it allows S corporations to establish discrete legal entities without affecting pass-through taxation. When an existing corporation transforms into a QSub, it is typically considered a tax-free subsidiary liquidation. 

Take caution when selling a QSSS if its stock was purchased at a premium by the S corporation. This can create a tax pitfall that can be avoided by replacing a stock purchase with asset negotiation or adjusting the purchase price of the stock. The best course of action is to consult a tax attorney or CPA.

Alternative Structures

Instead of creating a subsidiary to hold a valuable asset, the asset in question could be distributed to shareholders. However, they would have to pay tax on its appreciation as well as the built-in gain tax if applicable.

The S corp could also create a subsidiary to hold the asset, but this subsidiary could be liable for claims against the parent company, putting the asset at risk. The exception is when the subsidiary is a limited liability company (LLC).

Another option is to transfer the main business to a subsidiary and hold the asset in the parent company. This is a common solution if art or something else that wouldn't generate liabilities is the asset in question. Finally, a new holding company could be created with the original corporation and a new subsidiary as its two subsidiaries.

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