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BUSINESS LAW U P D A T E A Publication of the Los Angeles County Bar Association Business & Corporations Law Section Fall 2006 [Article reprint] CHOICE OF ENTITY FOR A NEW SUBSIDIARY OF AN S CORPORATION By William C. Staley Law Office of William C. Staley1 When an S corporation wants to create a wholly-owned subsidiary, it has three choices: a C corporation, a qualified subchapter S subsidiary (a “QSub”) or a limited liability com- pany (“LLC”). This article explains why an LLC is usually the best choice. Alternative Structures. An existing S corporation might operate a busi- ness and also own a valuable asset (examples: real estate, art or another business operated as a division). Management will want to insulate the valuable asset from catastrophic claims that might arise in the opera- tion of the corporation’s primary business.2 There are various ways to accomplish this: 1 Mr. Staley practices law in Woodland Hills, advising businesses and nonprofit organiza- tions. www.staleylaw.com 2 This would be a judgment that exceeded the value of the corporation’s assets less its (footnote continued…) • The valuable asset could be distributed to the shareholders. This would insulate it, but the sharehold- ers would pay tax on the apprecia- tion in the asset.3 If the built-in gain tax applied, the corporation would also pay a tax.4 Also, it might not be convenient for the shareholders to hold the assets as tenants in com- mon. • The S corporation could form a subsidiary and transfer the valuable asset to the new subsidiary. How- ever, a claim against the parent corporation could be satisfied with the stock of a corporate subsidiary holding the valuable asset. If the subsidiary holding the valuable asset is an LLC, the result might be differ- ent. Although a judgment creditor of an LLC member (in this case, the parent corporation) is generally lim- ited to a charging order or becom- ing a holder of an economic interest – not a voting membership interest – in the LLC, many doubt that a judg- ment creditor of a single-member (footnote continued) other liabilities and also its insurance cover- age. 3 I.R.C. § 311. 4 I.R.C. § 1374. BUSINESS LAW U P D A T E 2 LLC would be prevented from ob- taining the LLC’s assets.5 • The primary business could be transferred to a subsidiary and the valuable asset could be held in the parent corporation.6 This would be satisfactory if the valuable asset was art or another asset that would not generate liabilities, because the sub- sidiary stock would be subject to claims against the parent corpora- tion. To preserve the benefits of S corporation status7 the parent must 5 Cal. Corp. Code § 17302 (no charging or- der exception for single-member LLCs); but see In re A-Z Electronics, 2006 Bankr. LEXIS 2105 (Bankr. D. Idaho, February 23, 2006) (bankruptcy trustee of sole member and not member-manager entitled to file bank- ruptcy petition on behalf of the LLC); In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003) (allowing a bankruptcy trustee to reach the assets in the debtor’s single-member LLC). See also J. Stein, Building Stumbling Blocks, BUSINESS ENTITIES (September/October 2006) 28, 34-36. 6 This could be accomplished by creating a new corporation and issuing its shares to the existing shareholders in exchange for their shares of the existing corporation. The old corporation would become a subsidiary of the new corporation. The subsidiary would distribute its valuable asset to the parent corporation. 7 The principal benefit of S corporation status is the ability to sell the business assets and to pay one level of tax, with the goodwill taxed as capital gain so that the favorable tax rates for long-term capital gain can apply. An S corporation that is not subject to the built-in gain tax can accommodate the buyer’s wish to buy assets (not stock) without creating a double tax for the selling share- (footnote continued…) elect to be an S corporation and must elect to treat the old corpora- tion/new subsidiary as a QSub.8 A QSub is disregarded for tax purposes and its assets are treated as assets of its S corporation parent.9 Because the QSub is “disregarded’ for tax (but not liability) purposes, it could be merged into a limited liability company wholly-owned by the par- ent corporation. A single-member LLC is also disregarded for federal tax purposes.10 Consequently, this merger would have no effect for federal tax purposes – the assets and liabilities of the parties to the merger would be the assets and liabilities of the parent (for tax purposes) before and after the merger. • A new holding company could be organized with two sub- (footnote continued) holders. For a mature business with substan- tial cash flow, S corporation status allows the business to distribute profits to shareholders with one level of tax. 8 I.R.C. § 1361(b)(3)(B); Treas. Reg. § 1.1361- 3. 9 I.R.C. § 1361(b)(3)(A); Treas. Reg. § 1.1361- 4(a). Because the separate existence of the QSub is disregarded, the transfer of assets between the parent and subsidiary has no effect for tax purposes. To avoid piercing the corporate veil, the transfers must be properly documented and properly re- flected on the accounting records of both entities. 10 Treas. Reg. § 301.7701-3(b)(1) (the “check-the-box” rules for entity classification for federal tax purposes). BUSINESS LAW U P D A T E 3 sidiaries: the existing corporation and a new subsidiary. The existing corporation would transfer its valu- able asset to the new subsidiary. The holding company would own only the stock or other ownership interests in the subsidiaries. A claim against one subsidiary could not be satisfied with the stock or assets of the other subsidiary or with the stock or assets of the holding company.11 C Corporation. In these examples the subsidiaries hold valuable assets and businesses. If the value of the asset or business exceeds its tax basis – or is likely to exceed its tax basis in the future – it generally should not be held in a C corporation. When the asset is sold by a C corporation, the corporation will pay tax on the gain and the shareholders will pay tax again when the after-tax sale pro- ceeds are distributed to them. This rules out a C corporation as a sub- sidiary in many situations.12 So the 11 In this article we assume that the entities would be organized and operated in way that would prevent a creditor from piercing the corporate veil of any entity. 12 If the parent corporation is a C corpora- tion – not what we assume in this article – it might make sense for its subsidiary to be a C corporation and to use the consolidated return rules and the dividends-received de- duction to minimize taxes on transfers within the consolidated group. I.R.C. §§ 1501- 1564. However, using a “disregarded” sin- gle-member LLC will often involve less com- plication than the consolidation rules. For example, there is no deferred inter- company gain and no excess loss account (footnote continued…) choice is between a QSub or a sin- gle-member LLC. QSub. For a subsidiary to be a QSub, the parent must (1) be an S corpora- tion, (2) own 100% of the outstanding shares of the QSub and (3) file an election.13 If the election is not filed or shares are acquired by anyone other than the S corporation parent, the subsidiary ceases to be a QSub and becomes a C corporation – sub- ject to a double tax when it sells its assets. When the subsidiary ceases to be QSub, a special tax fiction ap- plies to the “transformation.” The as- sets of the subsidiary are treated as if the parent contributed them to the subsidiary on the transformation date in exchange for stock of the subsidiary. The liabilities of the sub- sidiary are treated as if the subsidiary assumed them from the parent on the transformation date.14 Gener- ally, the deemed exchange of assets for subsidiary stock will be tax-free under Section 351 of the Internal Revenue Code (the “IRC”). How- ever, to the extent that liabilities of the subsidiary exceed the tax basis of its assets, gain will be recognized by the parent on the “transforma- (footnote continued) for subsidiaries structured as “disregarded” single-member LLCs. 13 I.R.C. § 1361(b)(3)(B); Treas. Reg. § 1.1361- 2. 14 I.R.C. § 1361(b)(3)(C); Treas. Reg. § 1.1361-5(b)(1)(i). BUSINESS LAW U P D A T E 4 tion” of the subsidiary.15 It is also pos- sible that the transformation will not satisfy the requirements of a Section 351 tax-free exchange and therefore will be taxable.16 Single-Member LLC. In contrast, an LLC will never become a C corporation unless it files a C cor- poration tax return. If the number of members exceeds one, it will “trans- form” into a partnership for tax pur- poses. Consequently, the transfor- mation of a single-member LLC into a multi-member LLC will not result in a double tax when the LLC sells its assets. Section 721 of the IRC pro- vides for the tax-free exchange of assets for partnership interests and is less restrictive than Section 351. It is possible for a partner to recognize gain if the liabilities that the partner- ship assumes from the partner ex- ceed the basis of the assets contrib- uted by the partner, but it is less likely than with a QSub transformation.17 15 I.R.C. § 357(c). 16 For these three reasons, it is a good idea to issue only one share of a QSub and leg- end the stock certificate that “This corpora- tion is a qualified subchapter S subsidiary. Special tax rules apply to it. Tax advice should be obtained before issuing or trans- ferring any shares of this corporation.” A better idea: use a single-member LLC in- stead. 17 See McKee, Nelson & Whitmire, FEDERAL TAXATION OF PARTNERSHIPS AND PARTNERS, ¶4.03[1][c]. The “disguised sale” rules can also apply. Id. At ¶ 13.02[3][b]. State taxes can also be a factor in choosing the LLC. (footnote continued…) Liability Protection. The reason to use a subsidiary is to isolate liabilities, so it is necessary to go beyond tax is- sues and consider the liability protec- tion that the entities provide. Courts have respected the limited liability of shareholders for many years in doz- ens of alter ego cases. The Califor- nia LLC statute provides that a member of an LLC will have limited liability to the extent that sharehold- ers of corporations have limited li- ability in similar circumstances.18 To some extent, the statutory liability protection of members is stronger than for shareholders.19 However, for very risky enterprises, a corporation might provide more certain liability protection until we have California appellate cases respecting the lim- ited liability of members of LLCs. (footnote continued) The minimum tax in California and the possi- ble resurrection of the gross receipts tax are concerns, are the new margin tax in Texas and the Pennsylvania tax on LLCs. 18 Cal. Corp. Code § 17101. 19 I did not find in the General Corporation Law a provision corresponding to Sec- tion 17101(a) of the Limited Liability Com- pany Act, explicitly limiting the liability of a member.
