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The consolidated return and limited liability companies after the check-the-box regulations.

The recently finalized check-the-box regulations enable certain taxpayers filing separate returns to obtain benefits similar to those afforded a consolidated return group of corporations without being subject to the requirements of the consolidated return regulations. Effective January 1, 1997, certain eligible business entities may now choose to be classified as either a corporation or a partnership or alternatively be disregarded as an entity separate from its owner. If the entity is disregarded, its activities are treated in the same manner as a sole proprietor, branch, or division of the owner. It is this area of the regulations that provides an alternative to the consolidated return. A commonly owned group of business entities can now be structured as limited liability companies (LLCs) and treated as disregarded entities (divisions) of a single owner. Under this structure, a group of business entities filing a separate tax return can obtain results similar to those that would have been obtained by filing a consolidated tax return.

Limited Liability Companies

An LLC is an unincorporated entity organized trader state statute whose tax treatment, prior to January 1, 1997, had been determined by examining the LLCs' operating agreement. If a multi-member LLC lacked two or more of the corporate characteristics of limited liability, continuity of life, centralized management, or free transferability of interest, it was treated as a partnership. The classification of a single member LLC was somewhat unclear. Under the new check-the-box regulations the presence or absence of these characteristics is not determinative of whether an LLC will be classified as a corporation or a partnership.

Check-the-box regulations. The regulations provide classification rules for eligible entities that are not automatically classified as corporations for Federal tax purposes. A business entity with two or more members can elect to be classified as either a corporation or a partnership. A business entity with only one owner can elect to be classified as a corporation or to be disregarded as an entity separate from its owner. Multi-member entities are not eligible to elect to be disregarded and single owner entities cannot elect to be classified as partnerships. Since the regulations provide default classifications, an election is necessary only when an eligible entity chooses to be classified initially by other than the default classification or chooses to change its classification. The default classification for a domestic eligible entity with two or more members is a partnership; a single member entity is disregarded as an entity separate from its owner.

Advantages of LLCs. By electing to be treated as a disregarded entity, a single member LLC can have the benefits of corporate characteristics yet not be taxed as a corporation for Federal tax purposes. Corporations can now isolate the liabilities of a new or existing division without incurring a Federal corporate-level tax since the disregarded LLC will not be recognized as a separate entity. A commonly owned group of business entities can now take advantage of some tax planning that had not been available prior to the check-the-box regulations.

* Under the consolidated return regulations, either all the subsidiaries of a common parent are included in a consolidated return or none. In a situation where P has multiple subsidiaries each filing separate returns, P could selectively choose which subsidiaries it wanted to integrate into its Federal return by converting those subsidiaries into LLCs. The subsidiaries it wanted to exclude could remain as C corporations. P would not be encumbered with the "all or none" requirements of the consolidated return regulations yet it would obtain the same benefits as if a consolidated return had been filed with those entities it selected to integrate. Converting from a C corporation to an LLC could be a taxable transaction so the benefits of conversion would have to be weighed against any possible tax generated on the conversion.

* Use of LLCs as disregarded entities should eliminate the need to track intercompany transactions since the group would be treated as a single taxable entity for Federal tax purposes.

* The use of LLCs as disregarded entities should also eliminate the need for any recordkeeping related to a subsidiary's stock basis (and excess loss) and earnings and profits accounts since there is no stock investment in a subsidiary for a disregarded LLC.

* The separate return limitation year (SRLY) rules could be avoided by the use of entities classified as disregarded LLCs - for example, when a loss company target is merged into a disregarded LLC owned by a profitable group member.

* The check-the-box regulations provide alternatives to a consolidated group for state tax purposes. In states which follow the Federal check-the-box rules but do not permit consolidated/combined reporting, or permit it only for selected group members, the use of disregarded LLCs offers the benefits of consolidated/combined reporting automatically without the need to request state permission or meet other state requirements.

The use of disregarded LLCs is not without disadvantages. For one thing, the regulations are new so the ultimate consequences of transactions involving disregarded LLCs have not been fully analyzed. Transactions between disregarded entities and their owners, or between commonly owned disregarded entities, are interdivisional transactions that should be ignored and thus have minimal tax consequence. Likewise, there should be minimal tax consequence in creating a new LLC and electing to treat it as a disregarded entity. But in the absence of clear guidance, taxpayers must be very careful in evaluating the effects of transactions utilizing LLCs as a way around the consolidated return regulations. Situations where some or all of the subsidiaries of a consolidated group are converted into disregarded entities should be carefully analyzed since any potential tax generated on the conversion may outweigh the benefits obtained.
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Author:McLaughlin, Mary
Publication:The CPA Journal
Date:Apr 1, 1998
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