THE CONSOLIDATED RETURN AND LIMITED LIABILITY COMPANIES AFTER THE CHECK-THE-BOX REGULATIONS
By Mary McLaughlin, CPA, Siemens Corporation
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 under 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.
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.
A TAXPAYER "WINN"--DISCHARGE-OF-INDEBTEDNESS INCOME INCREASES BASIS
By Albert De Rosa, CPA, Charles Hecht & Company LLP
Gross income generally includes income from the discharge of indebtedness (DOI). IRC section 108 provides an exception to this general rule. Under that section, DOI is excluded from gross income if the discharge occurs in a Title 11 case or when the taxpayer is insolvent; the discharged indebtedness constitutes qualified farm indebtedness; or, in the case of a taxpayer other than a C Corporation, the discharged indebtedness is qualified real property business indebtedness. When DOI is excluded from income under the above rules, corresponding reductions must be made to the taxpayer's attributes in the following order: NOLs, general business credits, minimum tax credits, net capital losses and carryovers, basis of property, passive activity loss or credit carryovers, and foreign tax credit carryovers. In the case of partnerships, debt discharge exclusions, and attribute reductions are applied at the partner level. In the case of S corporations, debt discharge exclusions, and attribute reductions are applied at the corporate level.
The IRS stated in TAM 9739002 that Babin v. Commissioner, 23 F.3d 1032 (6th Cir. 1994) predates the amendments to section 108 by the Bankruptcy Tax Act of 1980 and therefore does not apply to partnership transactions commencing after December 31, 1980. The IRS ruled that a partner may increase the basis in his partnership interest by the share of the partnership's income from DOI that is excluded from the partner's income under the insolvency exclusion. The allocation of the amount of DOI income to a partner results in that partner's basis in the partnership being increased by such amount (section 705). At the same time the reduction in the partner's share of partnership liabilities caused by a debt discharge results in a deemed distribution under section 752, in turn resulting in a reduction under section 733 of the partner's basis in the partnership. The basis reduction which offsets the basis increase is separate from any basis reduction pursuant to the attribute reduction rules.
Section 1366(a)(1) provides that, in determining a shareholder's tax for a shareholder's year in which the S corporation's year ends, the shareholder shall take into account his or her pro rata share of (a) "items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the tax liability of the shareholder" and (b) "nonseparately computed income or loss." Although the term tax-exempt income is not defined for this section, it seems to include DOI income. Under section 1367(a)(1)(A), a shareholder's basis of stock in an S corporation must be increased by the items of income described in section 1366(a)(1)(A). Under the literal terms of section 1367(a)(1)(A), an S corporation shareholder would be entitled to increase his S corporation stock basis by his pro rata portion of the corporation's DOI. The literal reading of the statutory language, the interaction of the S corporation basis adjustment rules, the provision governing the determination of a shareholders' tax liability, and the ordering rules applicable to the reduction of tax attributes under the DOI income provisions seem to result in the creation of basis against which an S corporation shareholder can offset his pro rata share of items of loss and deductions and any suspended losses.
In TAM 9541001, the national office advised that the "taxable year of the discharge" refers to the S corporation's taxable year and that, because the reduction of tax attributes occurs at the corporate level, the amount excluded from gross income is neither allocated to nor passed through to the shareholders. Similarly, the National Office advised in TAM 9423003, that the DOI income that is excluded from gross income under section 108(a) does not pass through under section 1366(a)(I) as tax-exempt income for which S corporation shareholders may increase their stock basis under section 1367. The national office reasoned that section 108 operates as an exception to the general pass-through scheme applicable to S corporations and their shareholders. Consequently, to the extent that an S corporation is insolvent there is no DOI income passed through to a shareholder because the exclusion from income and the reductions in tax attributes apply at the corporate level. The national office reasoned, further, that the DOI income excluded from gross income is tax deferred and not tax exempt.
In Winn v. Comr., T.C. Memo, 1997-286 the Commissioner of Internal Revenue abandoned prior arguments. The commissioner argued that excluded DOI income is not an item of income and never flows through to taxpayers. This position was based on Regulations section 1.61-12(b) which states in part, that "income is not realized by a taxpayer ... by virtue of an agreement among his creditors...." The Tax Court noted that section 108 codified the insolvency exception of the pre-section 108 regulations. The court reasoned that section 108, and not regulations section 1.61-12 (b), controls in these situations, and DOI income is an item of income for purposes of determining a shareholders basis in S corporation's stock. Since the court rejected the IRS's only argument, summary judgment was granted to the taxpayer.
The practitioner should note that DOI income does not increase the corporation's AAA and, if the corporation has any subchapter C earnings and profits, the section 108 income could get "locked in" behind the subchapter C earnings and profits, i.e., subchapter C earnings and profits would need to be distributed before the section 109 income.
The Winn decision provides judicial support for the argument that DOI, though excluded by an S corporation, results in a basis increase for shareholders. Substantial authority may now exist for taxpayers who adequately disclose the relevant facts.
Kevin Leifer, JD, CPA
Louis A. Lepore, CPA
©2009 The New York State Society of CPAs. Legal Notices
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