July 16, 2012 The Tax Lawyer

Now You See It, Now You Don’t: The Comings and Goings of Disregarded Entities

Vol. 65, No. 2 - Winter 2012

Martin J. McMahon, Jr.

Abstract

A. Limited Liability Companies

    A business may be conducted through a limited liability company (LLC), organized under state law, rather than through a partnership, corporation, or through direct ownership by an individual as a sole proprietor. While state law recognizes an LLC as a distinct type of entity, the Code does not recognize an LLC as a distinct entity. Rather, for federal income tax purposes, an LLC that is regarded as an entity separate and distinct from its owners will be treated as either a corporation or a partnership, and it will be taxed accordingly. In some circumstances, however, an LLC will simply be disregarded for purposes of federal income taxation.

    Under the rules governing the classification of unincorporated business entities for income tax purposes, an LLC with two or more members (owners) is treated as an entity separate and distinct from its members and is taxed either as a corporation or a partnership. It is taxed as a corporation only if it affirmatively elects to be treated as a corporation for federal tax purposes. Otherwise, it will be treated as a partnership for purposes of federal income taxation.

    An LLC with a single owner—whether the owner is an individual, corporation, or partnership—may affirmatively elect to be taxed as a corporation, but if it does not so elect, it will be disregarded as an entity separate from its owner. When an LLC is disregarded as an entity, its assets, liabilities, income items, and deduction items will be treated as owned, owed, received, and incurred directly by its owner. Thus, for example, if an individual is the sole owner of a domestic LLC that has not elected to be taxed as a corporation, the business conducted by the LLC will be treated as a sole proprietorship, the income of which is reportable directly on the individual taxpayer’s income tax return. In practice, LLCs rarely elect to be taxed as corporations unless they also elect S corporation status to operate under a pass-through tax regime. Virtually every LLC that does not make these two elections is either treated as a partnership or is disregarded for federal tax purposes.

B. Corporations

    Unlike partnerships, which are not taxpaying entities but generally are treated as an aggregate of the partners who pay tax on their shares of the partnership’s income, corporations are taxpaying entities that are separate and distinct from their shareholders. However, certain corporations are eligible to elect under Subchapter S to treat the corporation as a pass-through entity with gains and losses being reported on the shareholders’ individual returns. Corporations that do not make an election under Subchapter S are called “C corporations”; corporations that make the election are called “S corporations.” Approximately 60% of corporations elect to be treated as S corporations.

C. Qualified Subchapter S Subsidiaries

    An S corporation may own the stock of a subsidiary that is a C corporation. Such a C corporation subsidiary may elect to join in the filing of a consolidated return with its affiliated C corporations—chains of controlled corporations of which the subsidiary is the common parent—but the S corporation parent is not allowed to join in the consolidated return. On the other hand, a subsidiary of another corporation may not be an S corporation, because a corporation that has another corporation as a shareholder is not eligible to make an S election. However, section 1361(b)(3) provides a special rule for “qualified Subchapter S subsidiaries” (QSubs).

    A qualified Subchapter S subsidiary (QSub) is any domestic corporation that (1) is not an ineligible corporation, (2) is wholly owned by an S corporation, and (3) is one that the parent S corporation elects to treat as a QSub. A corporation for which a QSub election is made is not treated as a separate corporation. The existence of the stock of a QSub is ignored for tax purposes. All assets, liabilities, and items of income, deduction, and credit of the QSub are treated as assets, liabilities, and items of income, deduction, and credit of the parent S corporation. Transactions between the S corporation parent and the QSub are not taken into account for tax purposes.

D. The Comings and Goings of Disregarded Entities

    Both single-member LLCs and QSubs are “disregarded entities” for income tax purposes. This Article discusses the income tax consequences of a number of events in the life of a domestic disregarded entity, focusing principally on transitions between disregarded entity status and regarded entity status, as well as acquisitions and dispositions. Part II discusses LLCs, and Part III discusses QSubs.

    Because the transition of an LLC from a disregarded entity to a partnership and the transition of an LLC from a partnership to a disregarded entity involve all of the issues that arise with respect to the formation and liquidation of partnerships, including the complex rules for allocating built-in gains and losses with respect to contributed property after the formation of a partnership and the complex rules governing distributions from partnerships, this Article does not attempt to provide a detailed description of the answers to all the questions. It merely identifies the issues and highlights the governing provisions of the Code and Treasury Regulations that must be applied to the transactions discussed in this Article. An attempt to answer all of the questions would require a treatise on partnership taxation.

    Likewise, elections and revocations of QSub status involve all of the provisions dealing with the formation and liquidation of corporations, as well as many other provisions of Subchapter C of the Code that generally govern corporate taxation along with provisions of Subchapter S. Again, this Article does not attempt to provide a detailed description of the answers to all the questions but merely identifies the issues and highlights the governing provisions of the Code and Treasury Regulations that must be applied to the transactions discussed in this Article.

Read the full article or download the complete issue.