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