Over the past year there have been significant changes to the federal income tax treatment of partnerships and limited liability companies ("LLCs"), and to S corporations. Recently, California enacted changes to its tax laws to conform to these recent federal tax changes, including the "Check-the-Box" regulations. For example:
- a single-member LLC may now elect under the Check-the-Box regulations to be disregarded for federal and California income tax purposes; and
- S Corporations can have seventy-five shareholders, can own S corporation subsidiaries, and can elect to disregard qualified subchapter S subsidiaries.
Background to the California Check-the-Box Regulations
Prior to the Check-the-Box regulations, there was a complicated fact-based test to determine whether entities were treated as corporations or partnerships for tax purposes. The Check-the Box regulations eliminated this test. Instead, entities with two or more members may simply elect to be treated as a partnership or a corporation for federal income tax purposes. Moreover, many domestic entities (e.g., LLCs) are now deemed to be partnerships for tax purposes, unless the entity elects otherwise. Other entities, by contrast, are automatically treated as corporations and no election is allowed (the "per se" corporations); these include state-law formed corporations and enumerated foreign entities (i.e., those which are generally the equivalent of a U.S. corporation).
The Check-the-Box regulations also create a new concept -- an entity that is a "tax transparency." Specifically, the Check-the-Box regulations allow a business entity with a single member to elect to be disregarded for federal income tax purposes and to be treated as a branch or division of a corporate or partnership owner, or a sole proprietorship of an individual owner. Assets held by such entities will be treated as held directly by the member. For U.S. purposes, such an entity will commonly be a single-member LLC. For foreign purposes, a variety of entities may be treated as a "tax transparency" depending on the country involved.
California Conformity Legislation Check-the-Box Regulations
Under the conformity legislation, entity classification for California income tax purposes is determined similarly to federal law; it is elective, except for the per se corporations. Also, an entity must be classified for California purposes the same as it is classified for federal purposes. Proposed regulations have already been issued in contemplation of the enactment of this legislation.
The primary exception from conformity under California law is that a single member LLC cannot be created under the California Corporations Code. However, California will respect the status of a single-member entity that is formed under another state's laws. Thus, this problem can be addressed by creating a single-member LLC in another state (such as Delaware) and qualifying it to do business in California. The cost of such an arrangement is that the LLC may then incur annual fees and taxes in both states.
S Corporation Legislation
On August 20, 1996, Congress enacted the Small Business Job Protection Act ("SBJPA"), which significantly changed the present rules which govern S Corporations. Under the SBJPA, S corporations may now have 75 shareholders (instead of only 35), can own more than 80% of a C corporation, and can elect to disregard wholly-owned qualified subchapter S subsidiaries. California has also adopted these rules, to apply to all taxable years after December 31, 1996. Note, however, that -- unlike the federal rules -- California imposes a 12% tax on the taxable income of an S Corporation.
Planning Opportunities for Single-Member Entities
The single-member entity creates many planning opportunities by allowing individuals and corporations to isolate the liabilities of a new or existing sole proprietorship, division, or branch without incurring a U.S. corporate-level tax (or significant nontax costs). It also provides an alternative to the S Corporation, which previously has been the only way to achieve limited liability with no corporate-level tax but which requires complicated return filings and tax accounting. Foreign law is another factor to consider in deciding whether to use a single-member entity.
The advantage of a single-member LLC for an individual is generally the combined benefit of limited liability with tax treatment like a sole proprietorship (i.e., a single layer of tax). Also, in California, an LLC may be subject to lower taxes than a wholly owned S corporation. Although both are generally subject to an $800 annual fee, LLCs are subject to a maximum California tax of $4500, based on income. In contrast, S corporations are subject to 12% tax on income, without a limit. Thus, LLCs may have lower state tax liabilities, depending on their income.
Numerous benefits may be obtained by using a single-member LLC in a corporate context. Some of them are described briefly below.
A corporation may use a single-member LLC to separate a business for liability purposes, while aggregating income and losses for tax purposes. Also, assets and liabilities may be aggregated for tax purposes, which may be important, for instance, in meeting debt-equity ratios.
Single-member LLCs can be used to effectively consolidate a group of entities, without becoming subject to the consolidated return rules. Such effective consolidation allows the offsetting of one entity's income with another entity's losses, while avoiding the loss disallowance rules and the separate-return limitation year ("SRLY") rules. Also, by treating a parent entity with a group of single-member LLCs as one entity, cash and property can be transferred among the entities without dividend or capital contribution treatment under the corporate provisions, or without concern for guaranteed payment issues under the partnership provisions. Similarly, Section 482 transfer pricing issues can be avoided.
A single-member LLC may be used in a tax-free reorganization to own the target or its assets. For example, consider the case where target will be acquired in a tax-free reorganization, but acquiror wants to hold target's assets in a separate entity for liability purposes. To achieve these goals, acquiror may form a separate LLC and merge target into the LLC, with the LLC surviving. Similarly, it should be possible to merge a target corporation into a single-member LLC, in exchange for "grandparent" stock, which is generally not allowed under the triangular reorganization provisions.
Section 332 Liquidation (of an 80% Controlled Sub)
A single-member LLC may also be used to liquidate an 80% or more controlled subsidiary pursuant to Section 332, while still maintaining a separate entity for corporate purposes (including liability protection). If the consolidated subsidiary is merged into a sister single-member LLC formed by the subsidiary's parent, the subsidiary is deemed to have liquidated into the parent pursuant to Section 332.
General Foreign Tax Advantages of Transparent Entities
The tax benefits of a transparent entity in the foreign context will vary, depending on whether the U.S. taxpayer is the direct owner of a transparent entity, or an owner of a foreign subsidiary, which in turn owns transparent entities. In the former case, transparency benefits are offset by an inability to defer U.S. taxation of the entity's income. In the latter case, the use of lower-tier transparent entities allows U.S. tax deferral, along with a number of other benefits, while preserving limited liability in the local jurisdiction (e.g. Germany in our example below), allowing the lower entities to be recognized as corporations for various local tax purposes (such as local foreign tax credits and participation exemptions). Additional benefits provided by lower transparent entities include an ease of cash movement within the foreign structure with no U.S. tax consequences and the ability to offset the active business losses of various entities against each other (and thus reduce subpart F income).
U.S. Acquisitions of Foreign Entities
If a U.S. corporation acquires all the stock of a foreign entity which was previously a branch or partnership for U.S. tax purposes, such a purchase would cause an automatic step-up in the basis of F's assets for U.S. tax purposes. However, if the foreign target was previously a corporation for U.S. purposes and continued as such after the acquisition without a Section 338 election, the existing asset basis and earnings and profits would be unaffected.
Even without a Section 338 election, it may be possible to achieve the benefits of a stepped-up basis, even if the foreign target is a corporation, if the foreign target elects to be disregarded prior to the purchase, which election would result in a deemed liquidation followed by a deemed recontribution of assets to a new branch. In addition, the U.S. acquiror would get a cost basis in such assets. Such a step- up in basis could allow a U.S. acquiror to amortize goodwill and other intangible assets in the U.S. pursuant to Section 197.
Entity / Tax Nothing Hybrid
In another useful example, a U.S. person may form an entity which will be recognized as such in the country of formation, while the owner may elect to disregard the entity for U.S. federal income tax purposes. If such an entity makes interest, royalty, or similar payments to its owner, such payments will be disregarded as interbranch transactions for U.S. tax purposes. For local tax purposes, however, this hybrid entity will be recognized as a separate entity and will receive local tax deductions upon its payment of interest, royalties, and the like, although foreign withholding may also apply.