Single Owner LLC, Analytical comparison between Saudi System and US system.
Citation: Susan Kalinka, Should an S Corporation Form a Single-Member LLC or Make a QSSS Election , 76 Taxes 7, 9 (1998) Provided by: <br>SMU Underwood Law Library
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TAXES/JULY 1998
BUSINESS TAX ADVISOR v lBY SUSAN KALINKA
Should an S Corporation Form a Single-Member LLC or Make a QSSS Election? Since January 1, 1997, an S corporation has been per- mitted to own either of two entities that may be dis- regarded for federal tax purposes (sometimes referred to as "disregarded entities"), the single-member LLC 1
or the qualified subchapter S subsidiary ("QSSS"). 2
In either case, the S corporation must be the sole owner 3 or the sole shareholder' of the entity. For fed- eral tax purposes, a disregarded entity is treated as a branch or division of its S corporation owner.5 All assets, liabilities, and items of income, deduction, and credit of a disregarded entity are treated as assets, li- abilities and items of in- come, deduction, and credit of the S corpora- tion. Transactions be- [R]ECENTLY IS tween an S corporation REGULATIONS and a disregarded entity also are disregarded for PLANNING OPP federal tax purposes. RESPECT TO TH
While a single-mem- THAT ARE NOT J ber LLC or a QSSS may be disregarded for fed- OWNER OF A SifN eral tax purposes, the entity is not disregarded for state law purposes. Thus, an S corporation may place all of the assets and liabilities of each of its divi- sions in a single-member LLC or a QSSS, thereby shielding the assets of one division from the claims of creditors of another division. It may be easier for an S corporation to obtain credit by operating its divisions in separate disregarded entities that have lim- ited liability. For federal tax purposes, however, the losses of one of the divisions may offset income from another division, notwithstanding the liability shield under state law.
In many cases, the use of a single-member LLC may have better tax consequences than the use of a QSSS. However, recently issued proposed regulations con- cerning the formation and operation of a QSSS 6 pro-
vide some planning opportunities with respect to the use of a QSSS that are not available to the owner of a single-member LLC. This column discusses some of the considerations that should be taken into account in determining whether an S corporation should use the LLC or the QSSS form of business organization now that the proposed regulations have been issued.
FORMATION OF A NEW ENTITY
In many cases, the formation of a single-member LLC or a QSSS will be tax-free. However, gain can be trig-
SUED PROPOSED
. . PROVIDE SOME
'ORTUNITIES WITH
E USE OF A QSSS
AVAILABLE TO THE
IGLE-MEMBER LLC.
the S corporation or the
gered in some cases. An S corporation is less likely to recognize gain if it forms a single-mem- ber LLC rather than a new corporation for which a QSSS election is to be made.
In most cases the transfer of assets to a single-member LLC should not cause gain recognition, either to
LLC, even if the transferred assets are encumbered by liabilities. Because the LLC is disregarded as a separate entity from its inception, the transaction should be treated as a transfer by the S corporation to a branch or division. However, if the LLC assumes liabilities in a transaction in which the S corporation is relieved of the liabilities, the S corporation should recognize gain 7 or discharge of indebtedness income.8
Susan Kalinka, J D., is the Harriet S. Daggett-Frances Leggio Landry Professor ofLaw at the PaulM Hebert Law Center,
Louisiana State University, in Baton Rouge.
Fw
BUSINESS TAX ADVISOR
Like the formation of a single-member LLC, the formation of a new subsidiary followed by a QSSS election in many cases will not trigger gain recogni- tion.9 However, an S corporation must recognize gain on the formation of a new subsidiary if and to the extent that liabilities transferred to the subsidiary exceed the aggregate adjusted basis of the transferred property transferred to the subsidiary.'0 Thus, the transfer of encumbered property to a subsidiary may cause the S corporation to recognize gain.
An S corporation may be able to avoid gain recog- nition in such a case by contributing enough prop- erty to the subsidiary to ensure that the liabilities do not exceed the adjusted basis of the contributed prop- erty."1 However, such a contribution exposes more of the S corporation's property to the demands of the subsidiary's creditors. Thus, in some cases, better tax results can be achieved if an S corporation forms a single-member LLC rather than a QSSS.
EXISTING CORPORATION
If an S corporation owns or acquires all of the stock of another corporation, there may a question as to whether the S corporation should make a QSSS elec- tion for the existing subsidiary or liquidate the sub- sidiary and contribute its assets and liabilities to a single-member LLC. The tax consequences will be the same regardless of which option is chosen.
When an S corporation makes a QSSS election for an existing subsidiary, the transaction is treated as if the subsidiary liquidated into the S corporation. 2
Thus, the QSSS election may be tax-free13 unless the subsidiary is insolvent,1 4 is indebted to the S corpora- tion parent, 5 or has liabilities in excess of the adjusted basis of its assets.16 While the tax consequences are the same regardless of whether the S corporation forms a single-member LLC or makes a QSSS elec- tion for an existing subsidiary, it may be preferable to form a single-member LLC because of the tax con- sequences that may result on a later termination of the QSSS election. However, it may be better to make a QSSS election for the existing subsidiary if the S corporation plans to distribute interests in the entity to its shareholders.
ADMISSION OF AN ADDITIONAL MEMBER
A single-member LLC or a QSSS will cease to be treated as a disregarded entity if an additional person acquires an interest in the entity. 7 When disregarded entity status terminates on the admission of an additional owner in the entity, the tax consequences will differ,
01998 CCH]
depending on whether the entity was a single-member LLC or a QSSS. If a QSSS election terminates on the admission of an additional shareholder, the former QSSS is taxed as a C corporation, and its items of in- come and loss no longer pass through to any of its shareholders. 8 In contrast, pass-through taxation may continue after the admission of an additional mem- ber to a single-member LLC because an LLC with two or more members may be classified as a partnership for federal tax purposes. 19
The termination of disregarded entity status also may trigger gain recognition. In most cases, how- ever, the termination of a QSSS election is likely to trigger more gain than the termination of disre- garded entity status for a single-member LLC.2 °
When a QSSS election terminates, the QSSS is treated as a new corporation acquiring all of its as- sets (and assuming all of its liabilities) from the S corporation parent in exchange for its stock imme- diately before the election terminates. 21 While the deemed incorporation of the former QSSS generally is tax-free under Code Sec. 351,22 gain can be triggered if the liabilities of the former QSSS exceed the ad- justed basis of its assets. 23
The proposed QSSS regulations also would apply the step transaction doctrine to require gain recogni- tion if an S corporation parent transfers more than 20% of the stock in the former QSSS to another per- son by sale or exchange. In the case of a termination of a QSSS election, the S corporation is the transf- eror of property. Thus, the deemed incorporation of the subsidiary will not qualify as a tax-free incor- poration under Code Sec. 35124 if the S corporation parent does meet the stock-ownership requirement because it has transferred more than 20% of the subsidiary's stock to another person. In such a case, the S corporation must recognize gain with respect to all of the subsidiary's appreciated property.
Under the proposed QSSS regulations, an S corpo- ration may avoid gain recognition on the sale or ex- change of more than 20% of the stock of a QSSS to another person if the S corporation revokes the QSSS election before transferring the stock and the step transaction doctrine does not apply.25 The proposed regulations, however, provide no guidance with re- spect to the circumstances under which the step trans- action doctrine will not apply to the revocation of a QSSS election followed by a sale or exchange of more than 20% of the stock in a former QSSS.
In contrast, the sale or exchange of an interest in a single-member LLC should be treated as a sale or ex-
INCORPORATED
TAXES/JULY 1998
change of a portion of the LLC's assets. Thus, the termination of disregarded entity status on the trans- fer of an interest in the entity is likely to trigger less gain recognition if the disregarded entity is an LLC rather than a QSSS.
In many cases, gain recognition can be avoided on the admission of a new owner, regardless of whether the entity is a single-member LLC or a QSSS, if the new owner acquires an interest in the entity by mak- ing a capital contribution. 6 In the case of a single- member LLC, however, gain will be recognized by the initial member if and to the extent that the amount of the LLC's liabilities that are allocated to the new member exceeds the adjusted basis of the ini- tial member's interest in the LLC.
2 7
TAX-FREE TRANSACTIONS INVOLVING
INTERESTS IN THE ENTITY
The ability to engage in certain tax-free transactions involving interests in the entity will vary, depending on whether the disregarded entity is a single-member LLC or a QSSS. Depending upon the circumstances, both a single-member LLC and a QSSS offer benefi- cial tax results.
For example, an S corporation that owns a single- member LLC should be able to take advantage of Code
Sec. 1031 to avoid gain recognition on the transfer of its LLC interest in exchange for like kind property or for an interest in another single-member LLC that owns such like kind property.28 In contrast, a trans- fer of stock in a QSSS in exchange for property should not qualify under Code Sec. 103 1.29
On the other hand, an S corporation may distrib- ute the stock of a QSSS tax-free to its shareholders as long as the requirements of Code Secs. 355 and 368(a)(1)(D) are met. 30 In fact, the proposed QSSS regulations would permit the former QSSS to make an S election immediately after the distribution with- out the Commissioner's consent, 31 notwithstanding the general rule requiring a five-year waiting period before a former QSSS may make an S election. 32 In contrast, a distribution by an S corporation of an interest in an LLC is a taxable event and may trigger gain. 33 Thus, the tax benefits with respect to transac- tions involving an interest in a disregarded entity may differ, depending on the type of transaction that is contemplated.
CAVEAT
The practitioner should examine state law to determine whether a QSSS election or a single-member LLC will provide state tax benefits and liability protection.
ENDNOTES
1 See Reg. §301.7701 -2(b), -3(a). For convenience, this column assumes that a single-member LLC is eligible to be a disregarded entity.
2 See Code Sec. 1361 (b)(3)(B). 3 Reg. §301.7701-3(a). 'Code Sec. 1361 (b)(3)(B)(i). 5 Code Sec. 1361 (b)(3)(A); Reg. §301.7701-2(a). 6 REG-251 698-96, 63 Fed. Reg. 19,864 (April 22, 1998). 7 See Reg. §1.1001-3(b); -3(c)(2)(i); and -3(e)(5)(ii). 8 Code Sec. 61 (a)(1 2). 9 Code Sec. 351 (a). '0 Code Sec. 357(c)(1). 1 An S corporation also may be able to avoid gain recognition by
contributing its own promissory note to the subsidiary. See, e.g., Peracchi v. Com., 98-1 USTC 50,374 (CA-9) Lessinger v. Com., 872 F2d 519 (CA-2 1989). But see Alderman v. Com., 55 T.C. 662 (1971) (taxpayer has a zero basis in the taxpayer's own note); Rev. Rul. 68-629, 1968-2 C.B. 154 (same).
12 Prop. Reg. §1.1361-4(a)(2); S. REP. No. 281, 104th Cong., 2d Sess. 53 (1996).
13 Code Secs. 332, 337. 4 See, e.g., Rev. Rul. 68-602, 1968-2 C.B. 135; Rev. Rul. 59-296, 1959-2 C.B. 87.
15 Any gain or loss realized by the parent on cancellation of the subsidiary's debt is recognized by the parent. Reg. §1 .332-7.
16 It is not certain whether gain will be recognized on the liquidation of a wholly-owned subsidiary if the subsidiary's liabilities exceed the adjusted basis of its assets. However, the Service could apply the step transaction doctrine to treat the liquidation as a reorgani- zation under Code Sec. 368(a)(1)(D). In that case, gain will be triggered under Code Sec. 357(c)(1).
17 See Code Sec. 1361 (b)(3)(B)(i); Reg. §301.7701 -2(a). 18 A QSSS or a former QSSS cannot be an S corporation if an S corporation owns any of its stock because an S corporation may not have a corporation as a shareholder. Code Sec. 1361 (b)(1)(B). If a QSSS election terminates on the admission of an additional shareholder, the former QSSS may not make an S election or have a QSSS election made for before its fifth taxable year after the taxable year in which the QSSS election terminated unless the IRS consents. Code Sec. 1361 (b)(3)(D).
'9 Reg. §§301.7701-2(a), -3(a). 20 Code Secs. 1361 (b)(3)(C), 351 (a), 357(c)(1). 21 Code Sec. 1361 (b)(3)(C). 22 Code Sec. 351 (a). 23 Code Sec. 357(c)(1). 24 Code Secs. 351 (a), 368(c). The transferor must own at least 80%
of both voting stock and of total number of shares of all other classes of stock immediately after the exchange.
25 Prop. Reg. §1.1361 -5(b)(3), Ex. 4. 26 Code Sec. 721 (a) (LLC); Prop. Reg. § 1361 -5(b)(3), Ex. 2. 21 Code Secs. 731 (a), 752(b). 28 See, e.g., LTR 9807013 (Nov. 13, 1997); LTR 9751012 (Sept.
15,1997). 29 The exchange of the QSSS's stock will be treated as an exchange
of stock for other property rather than as an exchange of property for property. See Code Sec. 1361 (b)(3)(C) and Prop. Reg. §1.1362- 2(b)(4). Code Sec. 1031 does not apply to the transfer of stock in a corporation. Code Sec. 1031 (a)(2)(B).
30 Prop. Reg. § 1.1361 -5(b)(3), Ex. 3. 31 Prop. Reg. § 1.1361-5(d)(2), (d)(3), Ex. 1. 32 Code Sec. 1361 (b)(3)(D)(ii). 3 2See Code Secs. 311 (b), 1366(a)(1), 1367(a)(1), 1368(b), 1368(c).