Much ado about "nothings".

• Author: Hamill, James R.
• Position: Tax nothings - form of business enterprise

EXECUTIVE SUMMARY

* SMLLCs offer simplified Federal income tax reporting and a liability shield under state law.

* QSubs allow S corporations to isolate assets and liabilities of various businesses without complicating Federal tax reporting.

* The type of member determines how the SMLLC's operations will be reported for Federal income tax purposes.

Need an entity to segregate business lines, hold assets or alleviate risk? One that will be a disregarded "nothing" for Federal tax purposes? Then consider using either of these two relatively new types of entities--the single-member limited liability company or the qualified subchapter S subsidiary. This article explains how to create these entities, their various structures and uses and related issues.

Effective for tax years beginning after 1996, taxpayers can create entities having legal significance for state law purposes, but disregarded for Federal income tax purposes. These "disregarded entities" (DEs) include the single-member limited liability company(1) (SMLLC) and the qualified subchapter S subsidiary (QSub) under Sec. 1361(b)(3)(A)(i).

The SMLLC is a creation of state law. The number of states permitting such entities has dramatically increased following the 1996 issuance of the final "check-the-box" regulations,(2) which confirmed the Federal income tax treatment of the SMLLC as a DE. The QSub is a creation of Federal income tax laws; Sec. 1361 (b) (3) (B) requires 100% ownership by an S corporation and an affirmative election to treat the entity as a QSub.

The owner of an SMLLC may be any type of taxpayer; the owner of a QSub must be an S corporation. Tax advisers are just beginning to explore the uses of DEs. This article reviews the distinctions between the SMLLC and the QSub, including the ownership structure under state law, nontax advantages of DEs, and the planning opportunities and pitfalls for both state and Federal income tax purposes.

Development of the DE

SMLLC

The final "check-the-box" regulations streamlined the rules for classifying an unincorporated business entity, facilitating the use of the limited liability company (LLC) as an alternative to a corporate or partnership structure. The SMLLC offers simplified Federal income tax reporting and a liability shield under state law. State income or franchise tax treatment of the SMLLC need not follow the Federal income tax treatment.

QSub

The Small Business Job Protection Act of 1996 (SBJPA), Section 1308, made significant changes to S corporations to increase the attractiveness of such entities. One such change was the creation of the QSub, effective for post-1996 tax years. For pre-1997 tax years, an S corporation was prohibited from Sec. 1504 affiliated group membership, thereby limiting S corporation ownership of multiple business activities. The SBJPA removed some of the ownership constraints by allowing S corporations to own any amount of the stock of another corporation (the restriction on the type of S shareholders means that a subsidiary will be a C corporation). A QSub, however, is disregarded as an entity separate from its S corporation owner, preserving single-entity tax treatment for the QSub and its parent. QSubs allow S corporations to isolate assets and liabilities of various businesses without complicating Federal tax reporting. Recently proposed regulations under Sec. 1361 clarify many of the tax issues affecting QSubs.(3)

Payroll Taxes

The DE status of an SMLLC or a QSub will be respected for payroll tax purposes. However, taxpayers can obtain separate taxpayer identification numbers (TINs) and make payroll filings in the DE's name. The IRS has announced that,(4) until further guidance is issued, taxpayers may make payroll filings using the DE owner's or the DE's name and TIN. If an owner has multiple DEs, different reporting methods (owner or entity) may be selected for each. The owner remains liable for payroll tax liabilities regardless of the reporting method selected.

Creating a DE

SMLLC

An SMLLC is created under a state LLC statute that permits one-member entities. Such an entity generally confers liability protection on the member similar to that offered by the corporate form. State law may require fewer formalities to establish and maintain an SMLLC vis-a-vis a corporation. For Federal income tax purposes, a domestic eligible entity with a single member can elect to be classified as a corporation; otherwise, it will be disregarded as an entity separate from its owner under the default classification of Regs. Sec. 301.7701-3(b)(1)(ii). No election is necessary if default classification is desired.

According to Rev. Rul. 99-6,(5) an SMLLC may also be created when one owner acquires all of the interests in an LLC classified as a partnership under Regs. Sec. 301.7701-3(b)(1)(i) because it has two or more owners. If an LLC member purchases all of the other member interests, the seller(s) report(s) a sale of a partnership interest under Regs. Sec. 1.741-1(b). The LLC is deemed to have made a liquidating distribution of all assets to all LLC members; the purchaser is treated as having acquired the assets deemed distributed to the other members in liquidation of their LLC interests. If an unrelated person purchases all of the LLC interests held by existing members, the LLC is deemed to terminate under Sec. 708(b)(1)(A) and distribute its assets to the existing members, who then sell them to the single LLC member.

The type of member determines how the SMLLC's operations will be reported for Federal income tax purposes. If the owner is an individual, the type of business in which the DE is engaged will determine its treatment. For instance, if the DE is involved in a trade or business, its operations will be reflected on Schedule C; if in the business of farming, on Schedule F; if in a rental activity, on Schedule E. A partnership or corporate owner will treat the DE as a branch or division of the owner. It is possible to create multiple SMLLCs under a common owner, as discussed below.

QSub

A QSub is a corporation under state law; it must be created and maintained under a state corporate statute. Although both SMLLCs and QSubs offer liability protection, attorneys may feel that state court decisions applicable to corporations offer shareholders greater assurances of the protections offered in conflict situations. Any such concerns with the use of LLCs should dissipate as advisers become more comfortable with these relatively new entities.

An election must be made for QSub treatment. Under Sec. 1361(b)(3)(B), an S corporation must own 100% of the entity's stock and elect to treat it as a QSub.(6) Under Sec. 1361(b)(3)(A), a QSub is not treated as a separate corporation; its assets, liabilities and items of income, deduction and credit are treated as the parent's.

Under Prop. Regs. Sec. 1.1361-2(b), the S corporation may consider both "direct" and certain "indirect" ownership in meeting the 100% ownership requirement. QSub eligibility applies to directly owned subsidiaries and wholly owned subsidiaries lower in the ownership chain. Stock held by a DE is deemed held by its parent.

Example 1: S corporation X owns 100% of QSub Y. Y owns 80% of Z; X owns the remaining 20%. Because Y is a DE, X is deemed to own all of the g stock. X can elect QSub status for Z (see Exhibit 1 (a)).

[Exhibit 1(a) ILLUSTRATION OMITTED]

X can elect QSub status for Z, regardless of whether Y is a QSUB or an SMLLC. If, however, Y is not a DE, X cannot make a QSub election for Z (see Exhibit 1 (b)). An S corporation may elect QSub status for a chain of eligible subsidiaries, if the line of ownership is not interrupted by an entity or individual other than the parent or its DE subsidiaries.

[Exhibit 1(b) ILLUSTRATION OMITTED]

Under Prop. Regs. Sec. 1.1361-4(a)(2) and (b)(1), the subsidiary for which a QSub election is made is deemed to have liquidated under Secs. 332 and 337 at the close of the day before the election is effective. This rule allows a parent C corporation to make S and QSub elections on the same day, with the subsidiary Sec. 332 liquidation occurring while both entities are C...