How does a Texas S corporation and its chain of Qualified Subchapter S Subsidiaries (QSSSs) compute taxable earned surplus, and can a parent exclude cash distributions from its subsidiary?

Plain-English summary

A Texas S corporation sat atop a chain of Qualified Subchapter S Subsidiaries (QSSSs) - Company A owns A1, which owns A2, which owns A3, which owns A4, all Texas corporations treated as QSSSs federally. In the example, each corporation directly earns $100 of taxable earned surplus and distributes $60 plus whatever cash it received from its own subsidiary. The taxpayer asked how each computes taxable earned surplus for the Texas franchise tax.

• Each corporation reports its own $100. For franchise-tax purposes, each corporation reports $100 of taxable earned surplus, with parent and subsidiary treated under Franchise Tax Rule 3.556(g)(3).
• A parent can exclude the cash it received from its subsidiary. A parent QSSS is not required to include the cash distributions from its subsidiary in computing its own taxable earned surplus if it meets the requirements of Rule 3.556(g)(4). This prevents the same earnings from being counted again as they move up the chain.
• The rest of the rule still applies. The computation must also comply with the remaining provisions of Rule 3.556(g), and the answer is based on the stated facts and current law.

Currency note: This 2001 letter applies the pre-2008 franchise tax and its taxable earned surplus base (replaced by the margin tax effective January 1, 2008 under House Bills 3 and 3928). The margin tax computes the base differently and treats S corporations and QSSSs under its own rules; confirm current law.

What this means for you

S corporations with QSSS structures in Texas

Under the old franchise tax, each entity in the chain was its own taxpayer reporting its own earned surplus - the QSSS "disregarded" treatment used federally did not collapse them for Texas. But the rule protected against double-counting: a parent could leave out the cash distributions passed up from a subsidiary if it satisfied Rule 3.556(g)(4).

Tax professionals

The letter turns entirely on Rule 3.556(g): subsection (g)(3) fixes each corporation's own earned surplus, and (g)(4) governs the exclusion of upstream cash distributions. Because the modern margin tax computes the base differently and can require combined reporting, re-verify any QSSS-chain computation under current law rather than this pre-2008 guidance.

Common questions

Q: Does each QSSS report its own earned surplus for Texas franchise tax?
A: Yes. Each corporation reports its own $100 of taxable earned surplus, with parent and subsidiary treated under Rule 3.556(g)(3).

Q: Must a parent include the cash distributions it receives from its subsidiary?
A: No, provided it meets the requirements of Rule 3.556(g)(4); then those upstream cash distributions are excluded from the parent's earned surplus.

Q: Is this still how Texas taxes S corporations and QSSSs?
A: Not necessarily. The pre-2008 franchise tax analyzed here was replaced by the margin tax effective January 1, 2008, which computes the base differently. Confirm current law.

Citations and references

Rules:

• 34 Tex. Admin. Code Sec. 3.556(g)(3) (Franchise Tax Rule 3.556) - each corporation reports its own taxable earned surplus
• 34 Tex. Admin. Code Sec. 3.556(g)(4) - a parent may exclude cash distributions received from its subsidiary if the requirements are met

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200103523L

Original ruling text

March 28, 2001

Dear **:

In his letter of February 14, PERSON A asked about the computation of earned
surplus for an S corporation and its related Qualified Subchapter S
Subsidiaries (QSSSs). PERSON A asked that I direct my reply to you.

In his letter, PERSON A indicated that Company A, a Texas corporation, is
treated as an S corporation for federal income tax purposes. Company A owns
100% of the stock of Company A1 which owns all of the stock of Company A2.
Company A2 owns 100% of the stock of Company A3. Company A3 owns all the stock
of Company A4. Company A1, Company A2, Company A3, and Company A4 are Texas
corporations that are treated as QSSSs for federal income tax purposes. In the
situation described, each corporation directly earns $100 of taxable earned
surplus for the taxable year ended December 31, 200X. Each corporation
distributes $60 plus the cash distributions received from its subsidiary.

My responses to each ruling that you requested are as follows:

1. Each corporation would report $100 of taxable earned surplus for franchise
   tax purposes. Each parent corporation and its subsidiary would be treated in
   accordance with the provisions of Rule 3.556(g)(3).

2. The parent corporation of each QSSS would not be required to include the
   cash distributions from their subsidiary in computing the parent's taxable
   earned surplus if they meet the requirements of Rule 3.556(g)(4).

Of course, the computation of earned surplus must also comply with the
remaining provisions of Rule 3.556(g).

This response is based on the facts presented and current law. If there are
different or additional facts, the response may change.

If you have any questions, contact Tax Policy Division. You may call me toll
free 1-800-531-5441, or our regular number is 512/463-4600. My extension is
3-4662.

Sincerely,

Bob Jeffcoat
Tax Policy Division