By: Ted Sutton
What a Q-Sub is and How It Can Help Your Business
Diane has been obsessed with dogs from a very young age. She was very close with her childhood hound, and enjoyed spending time with other dogs she knew. After the hound’s passing, she vowed to make a career out of tending to our four-legged friends. She kept her word into adulthood. After graduating high school, she set up a dog store in town. Like a responsible business owner, she properly formed an LLC taxed as an S-Corp for the store.
After setting up shop, Diane soon discovered that there were very few dog grooming services in town. Given this business opportunity and her passion for dogs, Diane decided to capitalize. A few weeks later, she set up a dog grooming service in the dog store.
Over time, Diane began establishing a rapport with her clients. She noticed that many of them dropped off their dog for grooming before work and picked them up after the work day ended. What were the dogs to do after they had been groomed? Because the dogs spent all that time with her, Diane decided to provide a dog walking service.
Now Diane is in charge of three separate businesses operating under the same LLC. She has employees who work for all three and has separate obligations for each. Diane has a lot on her plate. She begins to worry about the direction of her businesses. What will she do with employee payroll? What if someone slips in the dog store? What happens if a dog bites someone while on a walk?
To address these fears, the IRS has a solution. Diane can set up Q-Subs for each of her businesses.
What are Q-Subs?
A Qualified Subchapter S Subsidiary (Q-Sub) is an S-Corp that is 100% owned by a parent S-Corp. Both the parent entity and the Q-Sub can be a corporation or an LLC. Parent S-Corps can own more than one Q-Sub, but they must make the election for each Q-Sub by filling out Form 8869 on the IRS website. This election must also be timely filed. If it is not, the Q-Sub will be taxed as a C-Corp.
Because the parent S-Corp files the tax return, the Q-Sub is not treated as a separate entity for tax purposes. However, Q-Subs are still responsible for a few things. Q-Subs must still obtain an EIN number from the IRS. Q-Subs are also separately responsible for some taxes, including employment taxes, some excise taxes, and certain other federal taxes. They should also follow all the corporate formalities (i.e. annual minutes) of a separate entity.
How they can help your business
There are a wide range of benefits that Q-Subs offer for business owners.
Q-Subs aid business owners when their S-Corp has more than one business activity. The S-Corp can limit its liability by separating its different business activities into different Q-Subs. Having this structure is certainly advantageous from an asset protection standpoint. Here, Diane only has one LLC set up for her dog store, dog grooming business, and dog walking business. Because Diane is concerned about liability, she sets up two separate Q-Subs for the dog grooming and dog walking businesses. In the event a dog bites someone on a walk, that person can only reach the assets inside the Q-Sub set up for the dog walking business. This business structure is diagrammed below:
Q-Subs come in handy when there are state and local transfer taxes that apply to sold property. In some states, transferring the property to a Q-Sub in exchange for 100% of the Q-Sub’s stock can avoid these types of transfer taxes. Let’s say that Diane lives in a state that allows these transfers without incurring tax. After setting up the Q-Sub for the dog grooming business, she wants to transfer title to the dog grooming tables into the new entity. If this transfer involves the dog store owning 100% of the dog grooming company’s stock, Diane will not have to pay any transfer taxes.
The IRS provides business owners with incentives when forming a Q-Sub. An S-Corp can deduct up to $5,000 in organizational costs the first year the Q-Sub is formed. After setting up the new dog grooming and dog walking businesses, Diane incurs $17,000 in such costs during the first year. Because the IRS offers these deductions, she can deduct $10,000 in organizational costs between the two new businesses, and deduct the remaining $7,000 in later years.
Businesses with two or more related entities use Q-Subs to minimize employee payroll taxes. When employees work for two related corporations, one corporation can set up a Q-Sub to employ the employee to avoid any double tax. Diane employs people who assist with the dog store, dog grooming, and dog walking. Instead of placing them on the payroll of all three entities, Diane sets up a third Q-Sub to employ everyone who helps with all three. This will prevent Diane from overpaying on payroll taxes. This business structure is diagrammed below:
Instead of filing separate tax returns for each entity, the parent S-Corp only needs to file one tax return for itself and its Q-Subs. At this point in time, Diane owns the dog store, dog grooming business, dog walking business, and a Q-Sub that employs everyone. With four entities, Diane thinks that tax season will be a nightmare. Fortunately, only the dog store will need to file a tax return on behalf of all four businesses. This certainly makes life easier for everyone during tax season.
Q-Sub elections are useful when S-Corps are bought and sold. If one S-Corp buys a second S-Corp, the first S-Corp could elect to treat the second as a Q-Sub.
Jack is a well-known figure and has the only doggy daycare in town. Many of the clients who buy products at Diane’s dog store give their dogs to Jack when they take a trip. At this point in time, Jack has run the daycare for over 30 years. While he also shares a passion for dogs, he decides that it is time to move on and calls it quits.
Diane views this as a perfect opportunity to add to her growing repertoire of dog businesses. Diane approaches Jack with an offer to buy the daycare. Jack is excited by this proposal. He can cash out, retire, and buy that coveted house in Hawaii to spend the rest of his days with his wife.
Both agree to the arrangement. After consultations from competent accountants and attorneys, Diane uses the dog store to buy the doggy daycare. The dog store now owns four Q-Subs, but both parties are happy. Diane has a near monopoly on dog products in town, and Jack can finally retire to Hawaii. This business structure is diagrammed below:
Lenders may want to create more lending protection by requiring S-Corp borrowers to hold loan collateral in a Q-Sub. After buying the doggy daycare from Jack, Diane realizes that she needs more kennels to house the growing number of dogs staying overnight. This will not be a cheap purchase.
Diane decides to buy the kennels on credit and approaches the bank seeking a loan. After reviewing her business credit, the bank tells Diane that they will need the kennels to be held as collateral in a Q-Sub. Fortunately, the doggy daycare business is already a Q-Sub. Both parties agree to the arrangement, and the kennels are held in the doggy daycare business as planned.
Given the numerous benefits that Q-Subs provide, business owners should consider forming them in the right circumstances. They helped Diane. And if you are faced with similar issues, they can certainly help you.