A business organized as a Subchapter S corporation has a distinct advantage over traditional corporations: It doesn't pay corporate income taxes. When it created the "S corp" structure, Congress intended that it be used only by smaller businesses -- indeed, the law refers to S corps as "small business corporations." To that end, the law tightly restricts their ownership. A multiple-shareholder S corp can own shares in another S corp, but only under very specific circumstances.
Under Title 26, Section 1361 of the U.S. Code, an S corporation can't have more than 100 shareholders. Those shareholders must all be U.S. citizens, legal permanent residents, estates or certain kinds of trusts. Corporations of any kind generally aren't allowed as shareholders -- with one exception, when one S corp owns another as a qualified Subchapter S subsidiary, or QSSS.
Qualified Subchapter S Subsidiary
For an "owned" S corporation to be a QSSS, 100 percent of its shares must be held by a single S corp. For example, say you own a landscaping business as an S corp with a dozen shareholders. Call it "Mow Money Inc." You and the other shareholders decide you want to expand into a new line of business, such as a plant nursery (call it "Baby Seeds"). To protect the original business from liability in case the nursery ends up failing or being sued, you form the nursery as an S corp. Mow Money can own shares in Baby Seeds, but it must own all the shares.
Legal and Tax Treatment
Legally, a QSSS operates like a regular S corporation. It is a legally distinct entity from its owners. In the previous example, Mow Money is not liable for the debts or contractual obligations of Baby Seeds, and it can't lose more than it has invested in the company. For tax purposes, though, the Internal Revenue Service essentially acts as if the QSSS doesn't exist. All of Baby Seeds' assets, liabilities, income and expenses are treated as if they belong to the parent company. That owner, Mow Money, is itself an S corp, so it doesn't pay corporate income taxes on any profits, from itself or Baby Seeds. It passes those profits to its owners -- you and your fellow shareholders. You then pay personal income taxes on the money.
The IRS isn't kidding around when it says that the QSSS must be a 100 percent, wholly owned subsidiary. If the parent S corp sells so much as a single share of the QSSS to anyone else, then the subsidiary loses its status as a QSSS. More important, the QSSS loses its status as an S corporation, as well, since its ownership no longer meets the legal criteria. That means the now-former QSSS will have to pay corporate taxes. Once a corporation loses S corp status, tax law bars it from regaining that status for five years.