S Corporations: Can They Have Subsidiaries?

An entrepreneur who wants to organize a small business can use one of several business entities to establish her organization. Sole proprietorships, partnerships, limited partnerships, corporations, limited liability companies and S corporations are a few of the types of business entities available. The tax savings a small-business owner realizes from passing income from a subsidiary to its corporate parent to the shareholder makes an S corporation an attractive business entity.

An S corporation is a type of business entity that has no taxable income, losses, deductions or credits. An S corporation passes all of its income and losses through to its shareholders. A shareholder, in turn, must report the flow of revenue and loss as personal income on his personal tax return. The corporation only pays taxes on passive income and certain types of gains, thus avoiding double taxation on its ordinary income.

Up until 1997, an S corporation could not own more than an 80 percent interest in an active subsidiary. In 1996, however, Congress removed this restriction. Therefore, an S corporation can own an interest in a domestic subsidiary and can flow its taxable income from the subsidiary through the S corporation to the shareholders. The tax savings is significant. If the subsidiary earned $100,000 in 2010, instead of paying $39,000 in federal income tax, a shareholder paid just $21,709, based on personal tax rates for single taxpayers. The shareholder, or shareholders, of the S corporation must own 100 percent of the subsidiary's stock to make the subsidiary eligible for Qualified Subchapter S, or "QSub" treatment.

The tax advantages that apply to ownership of a domestic subsidiary do not extend to ownership of foreign subsidiaries. An S corporation can legally own a foreign subsidiary, but the foreign subsidiary cannot achieve QSub status. An S corporation must hold a foreign subsidiary as a C corporation, and a C corporation must pay tax at the corporate rate on its earnings.

Shareholders can form an S corporation by having all shareholders sign IRS Form 2553, Election by a Small Business Corporation. An S corporation must be a domestic corporation, it can have no more than 100 shareholders, and no partnerships, corporations or nonresident alien shareholders can hold stock. It can only issue one class of stock, and it cannot be a bank, insurance company or international sales corporation.