Much ado about "nothings".
* 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
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.
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)
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
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.
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 corporations. This deemed timing would avoid triggering gain from an excess loss account under Regs. Sec. 1.1502-19(b)(2). However, if the parent S corporation did not own 100% of the subsidiary's stock on the day before the QSub election, the liquidation will be deemed to occur under Prop. Regs. Sec. 1.1361-4(b)(2) immediately after the parent first owns 100% of the stock. In general, the deemed Sec. 332 liquidation will result in gain or loss nonrecognition, a carryover of the subsidiary's basis in its assets, a carryover of other tax attributes to the parent and the elimination of the parent's basis in the subsidiary's stock.(7)
When final Sec. 1361 regulations are issued, they will contain QSub election instructions; until then, Notice 97-4(8) provides temporary guidance. A corporation liquidating under Sec. 332 must file Form 966, Corporate Dissolution or Liquidation, to notify the IRS of a deemed election. The top of the form should state, "FILED PURSUANT TO NOTICE 97-4."
Uses for DEs
The uses for DEs (SMLLCs or QSubs) are still developing, as tax advisers become more familiar with them. Some of the more common uses for DEs are examined below.
Isolate Assets and Business Risk
The most obvious benefit of the DE is the owner's ability to isolate the business risk of one or more divisions in a separate legal entity, thereby shielding the assets of one division from the liabilities of another, while maintaining single-entity tax treatment.
For state law purposes, DEs are separate entities that offer certain statutorily specified liability protection. On the other hand, DEs are not entities separate from their owners for Federal income tax purposes, avoiding the complications of the consolidated return regulations and the need to file multiple returns for tiered flowthrough entities. Exhibits 2 and 3 illustrate the distinction between the state law and Federal income tax views of a DE.
[Exhibits 2-3 ILLUSTRATION OMITTED]
Alleviate Need for a Consolidated Group
Many C corporations are forming SMLLCs as alternatives to affiliated subsidiaries. As was discussed, the SMLLC allows single-entity tax treatment without the need to file a consolidated return. A C corporation with an existing subsidiary may choose to convert it to an SMLLC to simplify its tax filings (and, perhaps, to allow state tax combined reporting that might otherwise be unavailable).
There are two ways to convert a corporate subsidiary into an SMLLC. Many state statutes allow for a merger of a corporation into an LLC. A merger of a subsidiary into an SMLLC would terminate the affiliated group, but continue to allow for single-entity taxation (see Exhibit 4).
[Exhibit 4 ILLUSTRATION OMITTED]
Because the SMLLC is disregarded, the merger should be treated as a Sec. 332 liquidation of the subsidiary into its parent.
A possible concern with the merger of a subsidiary into an SMLLC is the risk that the subsidiary could be treated as an owner of the LLC for a moment before its liquidation. The LLC would then have two owners and would be a partnership for tax purposes.
An alternative structure would be for the subsidiary to form the SMLLC by a transfer of all of its assets. The subsidiary would then liquidate into its parent by distributing its only asset, the SMLLC interest (see Exhibit 5). This approach avoids the risk of momentary ownership of the LLC by two parties.
[Exhibit 5 ILLUSTRATION OMITTED]
Segregate S Corp. Business Lines
The DE alleviates problems for S shareholders who want to segregate assets into separate corporations without (1) triggering gain from the transfers or (2) creating a C corporation (and double taxation). Before 1997, an S corporation could have distributed assets to its shareholders, who could then have contributed them to another S corporation. For assets with a fair market value (FMV) in excess of adjusted basis, the distribution would have triggered gain under Sec. 311(b). The assets could also have been contributed to an LLC in which one or more shareholders was a member, but such a structure would create a separate entity and new owners separate from the S corporation.
An S corporation may now drop assets into a DE (QSub or SMLLC) subsidiary, isolating the business risk associated with the assets, without creating a second level of tax or a need for separate filing.
Example 2: A, an S corporation, has a portfolio of investment assets and a risky retail business. To protect the investment assets from the retail business, A could drop the retail assets into B, a DE (QSub) subsidiary. If B's creditors sued B, they could not generally access A's investment assets unless the transfer was a fraudulent conveyance (see Exhibit 6).
[Exhibit 6 ILLUSTRATION OMITTED]
It is important that the risky assets be placed in the subsidiary DE and not retained at the parent's level. Had A dropped the investment assets into B, leaving the risky assets in A and A's creditors sued, they could go after B's stock (and hence, the investment assets). The investment assets would not be protected from the risks associated with the retail business (see Exhibit 7).
[Exhibit 7 ILLUSTRATION OMITTED]
The isolation of risk could also be achieved using a C subsidiary, but this would cause two levels of tax. From a Federal tax standpoint, the advantages of using a DE outweigh the use of another structure.
Assist in Obtaining Credit
Isolating business risk in separate entities creates other benefits. For instance, it may assist the parent or one of the DEs in obtaining credit, because the lender will not be concerned about the liabilities and operating risk of the parent's other DEs. It may also help when a lender will not allow the parent to take title to an asset, because it may be subject to other creditors or risks associated with the parent's business. A DE could be set up as a single-purpose, bankruptcy-remote entity to take title to the asset securing the debt, and otters the added advantage of maintaining a single tax reporting entity.
Single-Entity Tax Treatment
DEs make it easier for a business to receive single-entity treatment while isolating risk. The SMLLC DE can be used by C corporations, S corporations and individuals to receive single-entity treatment. In the past, C corporations with lower-tiered entities had to use consolidated groups (and consolidated returns) to obtain single-entity treatment. Today, a C corporation parent can use SMLLCs to achieve the same result, without worrying about the ever-growing complexity of the consolidated return regulations. Similarly, an S corporation can use either a QSub or SMLLC to segregate business assets and liabilities and still receive single-entity treatment. Finally, an individual who creates an SMLLC DE will avoid having to file a separate Federal income tax return for the investment or business assets held therein. Regardless of the type of owner, entire chains of DEs may be created without increasing the number of returns.
Although the risks associated with different businesses may be segregated by the proper use of DEs, the income, gain, deductions, losses and credits are not. Single-entity reporting can be beneficial for owners who have both a profitable and an unprofitable business. The losses from the unprofitable business can offset the income from the profitable business, possibly eliminating any tax the latter otherwise might have incurred. Acquiring a target with net operating losses (NOLs) in an SMLLC rather than a subsidiary can also avoid the separate return limitation year (SRLY) limits, because the target will become a division of the acquirer.
Example 3: A Corp. proposes to acquire the assets of T Corp. in a nontaxable exchange that will result in an NOL carryover under Sec. 381(a)(2). A wants T assets to be held in a separate legal entity. If T assets are acquired in a forward triangular merger under Sec. 368(a)(2)(D), T's NOLs will be subject to SILLY limits under Regs. Sec. 1.1502-1(f)(4). If T assets are acquired by an SMLLC owned by A, the transfer of assets will be deemed to be directly to A; the SRLY rules will not apply. Sec. 382 will apply in any case.
Avoid PII Tax
The use of a DE may enable an S corporation to avoid the Sec. 1375 passive investment income (PII) tax. The tax on excess net PII applies when an S corporation has accumulated earnings and profits (E&P) and PII exceeds 25% of the entity's gross receipts. When a taxpayer owns an S corporation with significant PII and also owns a separate business with significant gross receipts, a DE could allow the businesses to be segregated for state law (and liability) purposes, but allow the income to be commingled for Federal tax purposes. By combining the gross receipts of one business with the PII of the other, the percentage of PII may be reduced or eliminated.
Example 4: Individual R owns A, an S corporation, and B, a C corporation. A was formerly a C corporation and has accumulated E&P. A owns rental properties and has sufficient PII to be subject to Sec. 1375. B is a retail business with significant gross receipts.
R could transfer her stock in B to A and immediately elect QSub status for B; the transaction should qualify under Sec. 351. A and B will be treated as a single entity for Federal tax purposes, allowing B's gross receipts to be combined with A's to avoid excess PII (see Exhibit 8).
[Exhibit 8 ILLUSTRATION OMITTED]
Before considering this strategy, the effect of the Sec. 1363(d) LIFO recapture tax on the retail business should be evaluated. The Sec. 1374 tax on built-in gains would also apply, but it is deferred until the gains are recognized.
Because of the ability to segregate business risk, a DE is ideal for holding real estate and may also offer planning opportunities in Sec. 1031 exchanges. The taxpayer who surrenders relinquished property in a Sec. 1031 exchange must also acquire title to replacement property. An individual taxpayer who holds title to relinquished property must also take title to replacement property. If the taxpayer desires a liability shield from the risks of direct ownership of replacement property, that property would need to be transferred to a corporation or an LLC in which the taxpayer is a member. There are two problems with such a strategy.
First, taking title in the individual's name, even for a short time, may create environmental liability. Second, a transfer to an entity may cause the IRS to argue that the taxpayer held the replacement property for the purpose of contribution to the entity, not for investment or trade or business use. The IRS so ruled in Rev. Rul. 75-292,(9) which involved a transfer to a corporation. The IRS lost a similar argument on the transfer to a partnership.(10) A transfer to an SMLLC would avoid both problems. The DE could directly acquire title to replacement property; the transfer would be treated as if it were made directly to the SMLLC owner.
In Letter Ruling 9807013,(11) a limited partnership owned land and an office building, which it leased to a single lessee under a long-term lease. The taxpayer wanted to exchange the land and building for replacement properties subject to debt (replacement debt). The terms of the replacement debt required that, for it to be taken subject to as part of an exchange, the replacement property had to be acquired by a single-asset entity. To achieve this result and meet the Sec. 1031 requirements, the taxpayer proposed to transfer the relinquished land and building to a qualified intermediary (QI) and then form an SMLLC for each of the replacement properties. The SMLLCs would each receive tide to a replacement property from the intermediary as part of the overall exchange, and would either elect to be disregarded as a separate entity pursuant to Regs. Sec. 301.7701-3 or rely on the default classification under Regs. Sec. 301.7701-3(b)(1)(ii).
The IRS ruled that because each SMLLC would be disregarded, the taxpayer would be treated as having directly received the replacement property in its own name for Sec. 1031 purposes (see Exhibit 9). This result could not have been attained prior to the enactment of SMLLC statutes and the DE status accorded such entities under the Sec. 7701 final regulations.
[Exhibit 9 ILLUSTRATION OMITTED]
The use of the DE in a Sec. 1031 exchange provides liability protection for the taxpayer without disqualifying the exchange. It may be wise for property owners to form a separate DE for each property owned. There is great liability exposure in the real estate market, especially relating to environmental damage from toxic and hazardous materials. Allowing a DE to take title directly prevents the owner from entering the chain of title for such property, insulating his personal and business assets from such risk.
Like-Kind Exchange of DE Interests
Sec. 1031(a)(2) prohibits exchanges of stock or partnership interests for Sec. 1031 purposes. However, because a DE is not a separate entity, the transfer of a DE interest in a Sec. 1031 exchange should be deemed to be a transfer of the assets held therein.
Example 5: A Corp. wants to transfer a group of properties to B Corp. for like-kind property. A holds such assets in D, an SMLLC; B holds its exchange assets in E, an SMLLC. A transfers its interest in D to B in exchange for the interest in E. For Federal tax purposes, E and D are disregarded. The exchange should qualify as a Sec. 1031 exchange if all other requirements are met. A and B reap the liability protection benefits of holding replacement property in a DE.
The transfer of an interest in an SMLLC could reduce costs otherwise associated with the direct transfer of title to assets. It would not be necessary to make a deed transfer of all of the assets involved in the exchange. This technique could achieve cost savings in states that impose real property transfer taxes.
Avoid Sec. 357(c) Gain
A corporate property transfer qualifying for nonrecognition treatment under Sec. 351 may still be subject to Sec. 357(c) gain to the extent the liabilities transferred exceed the basis of the property transferred. If a DE is created to receive the property transfer instead of a corporation, Sec. 357(c) gain can be avoided while still creating a liability shield for the owner.
Example 6: R owns an apartment building with an adjusted basis of $1,000,000 and an FMV of $4,000,000. The building secures a $3,200,000 liability. R wants to transfer title to the building to a separate entity to insulate his personal assets from the risks of operating the apartment building. Because R is the sole owner, he considers a transfer to a newly formed S corporation, which would result in $2,200,000 of gain under Sec. 357(c).A transfer to an SMLLC would result in no gain, as there is no debt relief on a transfer to a DE.
State Tax Savings and Issues
The Federal income tax savings techniques outlined above can be applied at the state level for states that "piggyback" the Federal system. However, presently, a few states do not follow the Federal regulations for classification of DEs. Certain states determine the treatment of a DE according to the member's characteristics. New Hampshire, New Jersey and Texas all treat SMLLCs owned by an individual as sole proprietorships, consistent with the Federal classification. However, SMLLCs deriving income from Delaware must file a partnership income tax information return. On the other hand, Delaware, New Hampshire and Texas provide that a corporate member of an SMLLC must file a state corporate income tax return.(12)
State income tax treatment of DEs can be complex for taxpayers with multistate operations. A handful of states, including Massachusetts, Tennessee and California, do not allow domestic SMLLCs; however, they do allow foreign DEs to operate in the state. Tennessee and California disregard a foreign DE.(13) State tax ramifications should be taken into consideration before deciding if a DE is advantageous.
For states that do not allow affiliated corporations to file combined returns, the group may lose the ability to offset one member's losses against another's income. If the state disregards an SMLLC, replacing subsidiaries with SMLLCs will allow combined reporting that might otherwise be unavailable. (See Exhibits 4 and 5 on p. 509 for methods to convert a wholly owned subsidiary into an SMLLC.)
An SMLLC may also affect state apportionment factors. If a state deems an SMLLC a DE, shifting ownership of an SMLLC without significant operations in a state to a tax reporting entity in that state may inflate the denominator of the state's apportionment factor without a corresponding increase in the numerator. An ownership group's overall state tax liability may thus be reduced.
Alternative to Single-Owner Title-Holding Company
Many tax-exempt entities, such as pension plans, set up tax-exempt "title-holding companies" to hold real estate under Sec. 501(c)(2) or (25). The objective is to limit the parent's liability; however, the parent must file with the IRS for recognition of the title-holding company's tax exemption and file annual returns for it. In addition, Sec. 501(c)(25)(G)(ii) and (c)(2) restrict the unrelated taxable income the title-holding company can generate. The use of an SMLLC achieves the same limited liability for the parent, without increasing filings or restrictions.
Terminating a DE
An SMLLC can lose its DE stares in seven ways. First, it can elect to be treated as a corporation by filing Form 8832, Entity Classification Election. In such a case, the SMLLC owner is deemed to have contributed the assets of the DE (subject to its liabilities) to a new corporation. The transaction should qualify under Sec. 351, unless Sec. 357(c) applies. Alternatively, the DE could liquidate into its owner. The transfer of assets under state law should not give rise to tax consequences, because they are deemed held by the owner.
A third alternative is for the SMLLC to convert to a partnership. One way would be for the SMLLC to issue ownership interests to other parties in exchange for a contribution of money or property, thereby converting the entity to a partnership under the default rules for LLCs. Rev. Rul. 99-5(14) provides that the issuance of membership interests by an SMLLC for property is a tax-free formation of a partnership under Sec. 721. Any future tax allocations attributable to inherent gain at the time the additional members are admitted would be subject to Sec. 704(c). Alternatively, the owner could sell an interest in the DE to another party. This transaction would be treated by Rev. Rul. 99-5 as a taxable asset sale by the owner. If the seller and purchaser continue to operate a business or investment within the LLC, each owner would be deemed to have contributed an undivided share of the assets to a new partnership; Secs. 721 and 704(c) would again apply to the transfer. In both cases, the conversion of the SMLLC from a DE to a recognized entity (i.e., a partnership) will not create a second level of tax.
Under Sec. 1361(b)(3)(C), a QSub election terminates when the entity ceases to meet the requirements.(15) The most common cause for termination will occur when the parent S corporation transfers some or all of the QSub stock to another party, thereby severing 100% ownership. When a QSub ceases to satisfy the eligibility requirements, it is treated under Sec. 1361(b)(3)(C) as a new corporation that has acquired all of its assets and liabilities from its parent immediately before such termination in exchange for its stock. Under Prop. Regs. Sec. 1.1361-5(b)(1), the tax treatment of the deemed re-contribution is determined under the Code and general principles of tax law, including the step-transaction doctrine. If the parent S corporation owns at least 80% of the subsidiary after the termination,(16) the deemed asset transfer would be tax-free under Sec. 351. There may be Sec. 357(c) gain if the subsidiary's liabilities exceed the adjusted basis of its assets.
On termination, under Sec. 1361(b)(3)(D), the former QSub cannot make either a QSub or an S election before the fifth tax year after the first tax year for which the termination is effective, without the IRS's consent. Thus, even if no gain is triggered by the termination, the entity thereby created will be a C corporation with a carryover asset basis under Sec. 362. Any inherent gain in the QSub's assets as of the termination date will be subject to two levels of tax. An exception to the five-year rule is provided by Prop. Regs. Sec. 1.1361-5(d)(2) for QSub terminations caused by a disposition of the subsidiary stock. Thus, for example, an S corporation that purchases 100% of the stock of a QSub may immediately make a QSub election for the subsidiary.
Choosing Between SMLLCs and QSubs
The benefits of a DE may be achieved by use of either the SMLLC or the QSub, although the QSub is available only for S corporation owners. Tax advisers must evaluate the advantages and disadvantages of each according to the S corporation owner's needs.
Subsequent Equity Transfers
As was discussed, the transfer of an equity interest in a DE will cause it to be a recognized entity. In the case of a QSub, the tax consequences could be detrimental. If a QSub sells sufficient stock, or otherwise causes its election to terminate, the entity is deemed to be a new corporation acquiring all of its assets and liabilities from the former QSub; the new corporation will be a C corporation. While the deemed transfer may qualify as tax-free under Sec. 351, the entity will lose its single level of tax and the Sec. 362 carryover basis will create two levels of tax for any inherent gain. Also, if the parent S corporation transferred more than 20% of the stock in the QSub, the deemed asset transfer will fail to qualify for Sec. 351, because the parent lacks control of the new corporation, causing the transfer to be fully taxable.(17) When the QSub has assets with FMVs well in excess of the adjusted bases, a transfer of interest could be devastating. Finally, despite the general tax-free treatment under Sec. 351, the incorporation may trigger gain under Sec. 357(c).
On the other hand, a transfer of an equity interest in an SMLLC to a new member is less likely to cause adverse tax consequences. When an SMLLC gains another member(s), it will be considered a partnership under Regs. Sec. 301.7701-2(a).A sale or exchange of an ownership interest in an SMLLC should be treated as a sale or exchange of a portion of the entity's assets. However, the admission of a new member to an SMLLC (whether by contribution or purchase) will not cause the entity to lose its single level of tax. In addition, the new partnership will not be subject to Sec. 357(c).
As long as the requirements of Secs. 355 and 368(a)(1)(D) are met, an S corporation can spin-off the stock of a QSub tax-free. The spinoff will terminate QSub status, because the parent will no longer own 100% of the QSub after the distribution. The termination will cause the QSub to be treated as a separate corporation immediately before the termination, under Sec. 1361(b)(3)(C); thus, the S corporation may then distribute the QSub stock to its shareholders in a Sec. 355 transaction. According to Prop. Regs. Sec. 1.1361-4(a)(4), the timing of the termination precludes the stock from being disregarded for purposes of Secs. 355 and 368(a)(1)(D). If the QSub stock were to be disregarded, the stock distribution would instead be treated as a distribution of assets and liabilities, possibly subjecting the S corporation and its shareholders to gain recognition.(18)
Example 7: A owns 100% of B, a QSub. B is a retail business operated by A for the last six years; it became a QSub one year ago. A distributes all of the B stock pro rata to its shareholders in a transaction that meets Sec. 355. B is deemed to have received all of its assets and liabilities from A in exchange for B stock immediately before the distribution. B continues in the retail business after the distribution. The transaction qualifies for nonrecognition treatment. B should immediately make an S election if its shareholders want to maintain one level of tax (see Exhibit 10).
[Exhibit 10 ILLUSTRATION OMITTED]
A QSub spinoff is subject to the corporate-level taxes imposed by Sec. 355(d) and (e). Thus, for example, if the distribution is pursuant to a plan in which one or more persons acquire (directly or indirectly) 50% or more of the QSub or S stock, gain must be recognized by the distributing S corporation under Sec. 355(e)(2).A plan is presumed to exist if one or more persons acquire 50% or more of the stock in the period starting two years before, and ending two years after, the distribution date.
Under Sec. 311(b), an S corporation's distribution of an SMLLC interest will cause it to recognize gain to the extent that the FMV of the distributed property represented by the SMLLC interest exceeds the S corporation's basis in the property. However, the SMLLC may still be an appropriate choice for the initial structure of the entity. If a distribution qualifying as a spinoff is later desired, elections could be made to convert the SMLLC to a corporation and for QSub status.
Application of Step-Transaction Doctrine
There is some concern over the application of the step-transaction doctrine to the deemed liquidation of a subsidiary for which a QSub election is made. Under Prop. Regs. Sec. 1.1361-4(a)(5), the step-transaction doctrine will not apply to a QSub election made within 60 days of the effective date of the final regulations. While the moratorium is somewhat beneficial, tax advisers have serious concerns as to how the step-transaction doctrine may be applied to QSub elections made thereafter.
Example 8: S owns 100% of the stock of S corporations A and B. To simplify her tax filings while maintaining two entities for state law purposes, S transfers the B stock to A and makes a QSub election for B. S's stock transfer should be tax-free under Sec. 351 and the QSub election should create a Sec. 332/337 liquidation of B. (Prop. Regs. Sec. 1.1361-4(a)(5)(ii), Example 2, so concludes under the step-transaction moratorium.) Because A has acquired all of the assets of B (a commonly controlled corporation), the transfer of stock followed by the deemed liquidation could be recast as a D reorganization. If B's liabilities exceed the basis of its assets, gain would be recognized under Sec. 357(c)(1)(B). This result seems inconsistent with the legislative purpose of the QSub provisions.
The LLC is a relatively new entity and therefore lacks case law. The SMLLC suffers from the same defect, including the risk that a liability shield may be pierced because the single owner disregards the entity's separate legal existence. Corporate law is much more well established than LLC law.
Another drawback of the SMLLC is the lack of uniform treatment among the states. As mentioned earlier, some states do not allow SMLLCs. Not all of the states will disregard the entity for income tax purposes.
The SMLLC and the QSub are both accepted as DEs for post-1996 tax years. Both entities allow a taxpayer to achieve nontax objectives of segregation of business and financial risk for different investment or business activities. The QSub is available only to S corporation owners and requires an affirmative election. The SMLLC is available to any type of taxpayer and is, by default, disregarded as an entity separate from its owners.
This article explores how tax advisers may recommend the use of a QSub or an SMLLC. It also examines important differences between the two types of DEs for transfers of interests and state income tax purposes.
(1) See Heller and Carnevale, "Check-the-Box Final Regs. Simplify Entity Classification," 28 The Tax adviser 296 (May 1997).
(2) Regs. Secs. 301.7701-1, -2 and -3 (TD 8697, 12/17/96).
(4) Notice 99-6, IRB 1999-3, 12.
(5) Rev. Rul. 99-6, IRB 1999-5, 6; for a discussion, see Schlueter, Tax Clinic, "Conversions of SMLLCs and LLCs to Single-Member Entities," 30 The Tax Adviser 232 (April 1999) and Noles, Tax Clinic, "Parntership/Disregarded Entity Conversions," p. 481, this issue.
(6) A QSub may not be an ineligible corporation; Sec. 1361(b)(2) defines an ineligible corporation as one that is (1) a financial institution that uses the Sec. 585 reserve method of accounting for bad debts, (2) an insurance company subject to tax under subchapter L, (3) a corporation to which a Sec. 936 election applies or (4) a domestic international sales corporation (DISC) or former DISC.
(7) See Secs. 332, 334, 337 and 381 for the tax treatment of a liquidation of a subsidiary into its parent.
(8) Notice 97-4, 1997-1 CB 351.
(9) Rev. Rul. 75-292, 1975-2 CB 333.
(10) Norman J. Magneson, 81 TC 767 (1983), aff'd, 753 F2d 1490 (9th Cir. 1985)(55 AFTR2d 85-911, 85-1 USTC [paragraph] 9205); for a discussion of these issues, see Hamill, "Avoiding Traps in Deferred Like-Kind Exchanges," 28 The Tax Adviser 716 (November 1997).
(11) IRS Letter Ruling 9807013 (11/13/97).
(12) See Boucher, "State Conformity to the Check-the-Box Regs.," (29) The Tax Adviser 166 (March 1998).
(14) Rev. Rul. 99-5, IRB 1999-5, 8; for a discussion, see Schlueter, note 5.
(15) See Prop. Regs. Sec. 1.1361-5(a)(2) for information reporting requirements when a QSub election terminates because the subsidiary is no longer eligible.
(16) Sec. 368(c) requires ownership of 80% of the voting power and 80% of all the classes of nonvoting stock.
(17) See Prop. Regs. Sec. 1.1361-5(b)(3), Example 1.
(18) See Secs. 311(b) and 1368(c).
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|Title Annotation:||tax nothings - form of business enterprise|
|Author:||Olson, Jennifer L.|
|Publication:||The Tax Adviser|
|Date:||Jul 1, 1999|
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