An “S” corporation can acquire and own the stock of a “C” corporation.  But having an “S” corporation own a “C” corporation may not make the most sense tax-wise.  The “C” corporation would be a taxable entity and would pay tax on all of its income at the “C” corporation rates.  The “C” corporation would then pay dividends to the “S” corporation.  This dividend would be received by the “S” corporation and taxed to the “S” corporation shareholders as a dividend (whether or not the shareholders received any cash).

This double tax phenomenon could be avoided by making a Qsub election.  Under IRC section 1361(b)(3), an “S” corporation can elect to treat a wholly-owned domestic corporation as a Qsub.  When the Qsub election is made, the subsidiary is deemed to have liquidated into the “S” corporation.  The Qsub is not treated as a separate corporation for federal income tax purposes.  All of the Qsub assets, liabilities, and items of income, deduction and credit are treated as items of the “S” corporation.  The Qsub continues its separate legal existence for state law liability purposes however.
If a Qsub election is made, the former “C” corporation (now a Qsub) does not pay tax on its income.  Rather, the Qsub income is included with the “S” corporation’s other income, allocated among the “S” corporation shareholders and taxed just once at the shareholder level.

Operating as an “S” corporation is often the way to go.  Putting separate divisions in subsidiaries is also a good move.  If you acquire a corporation and want to hold it as a subsidiary of your “S” corporation for liability reasons, consider making a Qsub election.  Give me a call or email if you have any questions about making a Qsub election at 937-223-1130 or Jsenney@pselaw.com.

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The S corporation’s structure is simple.  There is generally no tax at the entity level.  By making an S election, the shareholders have elected to report and pay tax on all of the corporation’s income on their personal income tax returns.  But while this seems easy enough, it can be somewhat complex. What happens when a shareholder is bought out during a year?   What happens if new shareholders buy-in?  What happens if a shareholder dies? What happens if the S election terminates during a year?  What happens if a shareholder goes bankrupt?
Under the general rule, the income of an S corporation must be allocated among the shareholders pro-rata on a per-share, per-day basis.   For example, if you owned 50% of the stock of an S corporation, and the corporation’s year-end is December 31^st, and you sold your stock to another shareholder as of June 30^th, your share of the corporation’s income for the entire year would be 25% (50% ownership interest for half a year).   Under general rule, it makes no difference if the corporation had a great first half of the year and a terrible second half of the year.  Under the general rule, the shareholder is allocated a share of the entire year’s income or loss.
However, the S corporation allocation rules also permit the shareholders to elect a “closing of the books” allocation methodology.  Under this special rule, if a shareholder disposes of his or her entire interest during a year, or disposes of more than 20% of his or her ownership interest, the shareholders may elect to actually close the books as of the date of that disposition. To do this, however, every person who was a shareholder on any day during that year must consent.  In this case, if you owned 50% of the stock, and you sold your stock to another shareholder as of June 30^th, you would be allocated 50% of the corporation’s income only for that portion of the year during which you owned stock (January 1^st to June 30^th).  If the corporation had a great first half and a terrible second half, you would be allocated a lot of income based on the first half results.
Whether this would be a better or worse result for you would depend on your personal tax situation and whether the corporation distributed cash in accordance with income allocations.  The point is, if you are contemplating the sale of your S corporation stock, you need to consult with your tax advisor and consider whether doing a special “closing of the books” election is in your best interests.  If so, you must make such an election a condition to close on the stock sale.

And remember, you will need to get everyone who was a shareholder at any time during the year to sign a consent to make the “closing of the books” election.  This consent should include language whereby the corporation and all of the shareholders agree to attach the election to the corporation’s tax return for that year and compute the tax allocation accordingly. stock
Although you are closing the book as of the disposition date, the corporation will not file two (2) tax returns for the year.  Rather, the corporation will file one return for the year, and such return will be due at the same time as the return is normally due.  Yet the corporation will need to be able to allocate the amount of income and loss between the pre and post-stock disposition periods so as to issue accurate Schedule K-1s to the shareholders.
Further, some complications may arise in allocating income and expenses between the pre and post-disposition periods.  For example, an amount that is accrued but unpaid by the corporation to a shareholder may not be deducted by the corporation until the year actually paid (even if the corporation is an accrual-basis taxpayer).   Under the Treasury Regulations, the disposition date is treated as if it were the corporation’s year-end for this purpose. Therefore, if there are any amounts owed to shareholders that accrued but are unpaid on the date of disposition, those expenses are treated as falling in the part of the year in which they are actually paid.  This would also be true of accruals to family and affiliates of the shareholders (unless the affiliates were also accrual-basis taxpayers).
If you are considering selling or transferring all or a significant portion of your S corporation stock, you need to be aware of these rules and should discuss them with your tax advisor.  Please give me a call or email at 937-223-1130 or Jsenney@pselaw.com if you would like to discuss this or any tax matter further.

AND ONE MORE THING.  At this time of year, some taxpayers wish they had planned better to reduce income.   It is too late to utilize this strategy for 2013, but it is certainly worth considering for next year.  So if you hate to pay taxes and are charitably minded, but don’t have the cash to make a sizable charitable donation, you might want to consider contributing stock of your closely-held company to a charity as a way to generate a tax deduction.   If you don’t really want to add the charity as a shareholder permanently, you can make the tax-deductible contribution of stock this year and then buy back the stock next year in a lump sum or in an installment sale.  Note, however, that the contribution and subsequent purchase or redemption must occur without any prearrangement between you and the charity. That is, the transaction must be accomplished without any preexisting binding obligation on the part of the charity to offer the stock for sale or on the part of you or the company to buy or redeem the stock.  But charities do not want to hold illiquid closely-held stock of companies they do not control.  So getting the charity to sell the stock should not be a problem.  If you want to discuss this more, please call or email me at Jsenney@pselaw.com or 937-223-1130.

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