United States

Unintended consequences of QSub elections for insolvent subsidiaries


When an S corporation makes a qualified subchapter S subsidiary (QSub) election with respect to a subsidiary, the subsidiary is deemed to liquidate into the parent S corporation as of the effective date of the election.

The deemed liquidation resulting from a QSub election is generally tax-free to both the parent S corporation and the subsidiary with which the QSub election is being made. However, if an insolvent subsidiary is liquidated, the provisions governing tax-free liquidations will generally not apply. 

Thus, the liquidating subsidiary will recognize gain or loss on the distribution of its assets and the subsidiary’s tax attributes will not carry over to the parent. While gain on liquidation will be taxable, a recognized loss on liquidation may be disallowed under related party rules.

Following a taxable liquidation, the parent S corporation will take a basis in the subsidiary’s assets equal to their fair market value, which could result in a step-up or step-down in asset tax basis. In addition, tax accounting methods and elections of the pre-liquidated subsidiary will cease following the QSub election and will generally conform to those of the parent S corporation.

As a result, unintended tax consequences could result if a QSub election is made for an insolvent subsidiary.

Richard Wehrheim