STATE AND LOCAL TAXATION

February 2000

CHALLENGES OF DEALING WITH THE S CORPORATION AND QSSS IN NEW YORK

By Peter C. Leonardis

In 1996 Congress enacted the Small Business Job Protection Act, which included provisions that allow subchapter S corporations to have wholly owned S corporation subsidiaries, referred to as qualified subchapter S subsidiaries (QSSSs) [IRC section 1361(b)(3)(B)].

The creation of QSSSs is significant in that, upon election by an S corporation parent, a QSSS is not treated as a separate corporation for Federal income tax purposes [IRC section 1361(b)(3)(A)(i)]. Furthermore, all assets; liabilities; items of income, deduction, and credit; and the tax history of a QSSS are treated as belonging to the S corporation parent. The shareholders of the S corporation parent have the ability to isolate its activities into separate entities for the purpose of limiting liability without compromising the flow-through benefits provided by S corporation status.

As is often the case with IRC changes that, at first glance, appear simple at the Federal income tax level, the QSSS provisions create a myriad of complications at the state and local tax level.

New York State Corporate Franchise Tax

Federal S corporations are permitted to elect S corporation status for New York State tax purposes [N.Y. Tax Law sections 208(1-A) and 660]. The election is made by filing New York State Form CT-6, Election by a Federal S Corporation to Be Treated as a New York S Corporation. However, New York S corporations are not afforded the total exemption from tax that applies at the Federal level. New York S corporations are subject to tax at a reduced rate equal to the difference between the regular corporate rate under Article 9-A and the equivalent rate under Article 22 for personal income tax [N.Y. Tax Law section 210(g)(1)]. The equivalent rate is currently being reduced on a sliding scale: for tax years beginning before July 1, 1999, 1.125%; for tax years beginning after June 30, 1999, and before July 1, 2000, .975%; for tax years beginning after June 30, 2000, and before July 1, 2001, .825%; and for tax years beginning after June 30, 2001, .65% [TSB-M-98(7)C (Nov. 23, 1998)]. Federal S corporations that do not elect to be treated as S corporations for New York State tax purposes will be treated as C corporations.

In 1997, New York State amended its tax law to generally conform to the Federal treatment of QSSSs, adopting the definition of QSSS as provided in IRC section 1361 [N.Y. Tax Law section 208(1-B)]. Unlike Federal S corporations, however, QSSSs are not required to make an election to be treated as an S corporation.

Differences in State and Federal Income Taxation Create Complexity

In the most basic case, where the S corporation parent has elected New York S corporation status, the S corporation parent and the QSSS will be taxed as a single New York S corporation. This treatment will be followed whether or not the QSSS, on a separate basis, is a New York taxpayer [N.Y. Tax Law section 208(9)(k)(1); TSB-M-97(6)C (Sept. 9, 1997)]. Similar to the Federal treatment, the "assets, liabilities, income and deductions of the QSSS" will be deemed to be those of the New York S corporation parent. In addition, the "property, payroll, receipts, capital, credits, and all other tax attributes and elements of economic activity" will be deemed to be those of the S corporation parent [N.Y. Tax Law section 208(1-B)(a)]. Accordingly, for purposes of determining the New York State business allocation percentage, the property, payroll, and receipts of the QSSS will flow up into its S corporation parent.

Where the S corporation parent does not make the election for New York S corporation status, depending on whether the QSSS is a New York taxpayer, New York may follow Federal QSSS treatment. If the QSSS is a New York taxpayer, the S corporation parent and the QSSS will be taxed as a single New York C corporation. If the QSSS is not a New York taxpayer, the S corporation parent will be taxed separately and apart from the QSSS as a C corporation. However, the S corporation parent may make an "inclusion election" whereby the S corporation parent and the QSSS will be taxed as a single New York C corporation.

In this situation, a planning opportunity is available where inclusion of a non­New York QSSS's attributes would result in a reduced tax liability (i.e., where the S corporation parent has significant income and the QSSS is in a loss position or where inclusion of the QSSS would result in a lower business allocation percentage). An additional benefit of making the inclusion election is that the non­New York QSSS is eliminated from the subsidiary capital tax which is an additional component of the New York State corporate franchise tax.

If the QSSS is a New York taxpayer and the S corporation parent is not, the QSSS will be treated as a C corporation for New York purposes; however, a planning opportunity is also available. The shareholders of the non­New York S corporation parent can elect to be treated as a single New York S corporation. It should be noted that if the election is made, the shareholders of the S corporation parent will be subject to New York State personal income tax [TSB-M-97(6)C].

Furthermore, if either the S corporation parent or the QSSS is an excluded corporation, the entities are viewed on a separate basis. For New York State corporate franchise tax purposes (Article 9-A), an excluded corporation is defined as any corporation subject to tax under Articles 9, 32, or 33. Accordingly, QSSS treatment is not followed for New York corporate franchise tax purposes unless both the S corporation parent and the QSSS are Article 9-A taxpayers.

The above analysis merely scratches the surface with respect to the myriad of issues that arise when dealing with QSSSs. Examples of other issues that warrant consideration include combined reporting, tracking each shareholder's pro rata share of credits and depreciation, and considering the tax ramifications of disposing of an interest in a QSSS.

New York City General Corporation Tax

New York City does not recognize a Federal S election for general corporation tax (GCT) purposes. The operative New York City Administrative Code section 11-602(8)(ii) defines "entire net income" as total net income from all sources, which shall presumably be the same as the entire net income that the taxpayer would have been required to report to the U.S. Treasury if it had not made an election under subchapter S of the IRC.

Accordingly, a corporation treated as an S corporation for Federal purposes is treated as a C corporation under the GCT. New York City recently addressed its treatment of corporations that have elected under Federal law to be treated as S corporations and QSSSs [Finance Memorandum 99-3 (October 21, 1999)]. New York City specifically states that "a corporation that has made a Federal S election and has a QSSS should treat the QSSS as a separate corporation for New York City tax purposes." Clearly, New York City's treatment is entirely different from the treatment of S corporations and QSSSs under Federal and New York State tax law.

As separate C corporations under the GCT, both S corporation parents and their QSSSs may be subject to all taxes (e.g., utility taxes, sales and use taxes, and real property transfer tax) imposed by New York City on an individual basis.

Another consideration must be made with respect to combined reporting. Under the GCT, related corporations that meet certain criteria (stock ownership, existence of a unitary business and distortion of the business, income or capital of the corporations' activities in New York City) may be permitted or required to file on a combined basis. An S corporation parent and a QSSS, under the IRC definition, will meet the stock ownership requirement. Whenever dealing with related corporations, the results of filing on a combined or separate basis should be examined.

However, due to the fact that a QSSS is treated as a separate entity for GCT purposes, the subsidiary capital rules with respect to QSSSs should also be reviewed. New York City, similar to New York State, has a subsidiary capital tax that is imposed as an additional component of the GCT. In addition, as subsidiary capital, any income, gains, or losses related to a QSSS will not be included in income, and any amounts attributable to carrying subsidiary capital or to income, gains, or losses from subsidiary capital shall be added back to entire net income [N.Y. City Admin. Code sections 11-602(8)(b)(1) and (6); N.Y. City Reg. Rule section 11-45(a)].

Therefore, any gains or losses that result from the sale or disposition of QSSS stock should be excluded from the S corporation parent's income in computing GCT liability.

Another consideration is how New York City's treatment affects an S corporation parent's shareholders that are residents of New York City. Since any income from an S corporation parent and its QSSSs will flow up to the shareholders, it would seem logical from a tax perspective that the shareholders would be allowed a credit for GCT taxes paid with respect to their ownership interest in the S corporation for New York City personal income tax purposes. However, this is not the case. There is no provision for such a credit.

Legislation has recently been introduced that would authorize a credit for New York City personal income tax purposes with respect to a New York City resident's share of GCT taxes paid by S corporations (1999 S. 5670 and 1999 A. 8519). If passed, New York City resident shareholders will be entitled to a credit for tax years beginning on or after January 1, 1999.

Example

A theoretical scenario shows the complexities: An S corporation parent is a New York City and State taxpayer that does not elect New York S corporation status; the S corporation parent has a QSSS that is a non­New York City and State taxpayer and makes an "inclusion election." In such a scenario, three widely varying results are possible:

* For Federal purposes, the QSSS will be disregarded and all of its attributes will flow up to the S corporation parent.
* For New York State purposes, the S corporation parent and the QSSS will be taxed as a single C corporation.
* For New York City purposes, the S corporation parent will be taxed as a C corporation on a stand-alone basis, assuming that the combined reporting requirements are not satisfied.

While the differences in the laws present challenges, they also present planning opportunities to those practitioners that have the stamina to evaluate the results under various scenarios. *