LLCs and QSubs Are Not Always Disregarded for Tax Purposes
When establishing an entity in the form of a single member Limited Liability Company (LLC) or a Qualified S Corporation Subsidiary (QSub), the expectation would be that these disregarded entities for federal purposes would not be subject to tax. Normally, these types of entities would have their results of operations reported by the owner of the entity. Their income and expenses would be considered belonging to the owner of the entity and reported as if the lower level entity was nonexistent.
However, there are exceptions to the disregarded entity rules. In the past, the Internal Revenue Service has determined that a disregarded entity could satisfy its employment tax obligation either by reporting a payment made by the owner of the disregarded entity under its tax ID number, or by separate calculation and reporting under its own name and tax ID number. Effective for wages paid in 2009, only one method of reporting is allowed. Disregarded entities will now be treated as a corporation for employment tax purposes and related reporting requirements. The formerly disregarded entity will be liable for employment taxes, Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes and responsible for issuing W-2 forms, as well as making timely employment tax deposits. Quarterly and annual employment tax returns are also required by the separate entity.
In addition to employment taxes, some excise taxes are also required to be filed separately on behalf of the disregarded entity. For liabilities imposed and actions first required or allowed in periods beginning on or after January 1, 2008, single member LLCs and QSubs must pay and report excise taxes, register for excise tax activities and claim any refunds, credits and payments under their own tax ID number. They are treated as separate entities for purposes of filing Forms 720, 730, 2290 and 11-C, as well as for excise tax refunds or payments claimed on Form 8849 and excise tax registration on Form 637.
State Tax Exceptions
Although generally disregarded for federal tax purposes, single member LLCs may be required to file separate income tax returns in many states. Often they are subject to the minimum tax in a manner similar to the treatment of S Corporations. Annual reports are also commonly required by single member LLCs. For the most part, states recognize the federal QSub election and follow the federal treatment for purposes of income tax reporting and liability. The following are some of the exceptions.
In the imposition of the Business Profits Tax, New Hampshire makes no distinction between C Corporations and S Corporations. Both are taxed at the entity level, disregarding any passthrough to shareholders. A Qualified S Subsidiary is treated as a separate corporation and must file its own tax return unless it is included as part of a combined return of a unitary business. Adjustments can be made to taxable income for expenses that are allowed for a C Corporation.
Similarly, New York imposes a corporate level minimum tax on S Corporations. In order to be treated as an S Corporation, a separate state election must be filed with the shareholders’ consent to a New York S Election. The parent corporation of a QSub may elect to treat the subsidiary as a QSub for New York franchise tax purposes. Under this election, the parent computes its entire net income by including the assets, liabilities, income and deductions of the QSub as its own. Thus, the QSub will be exempt from a separate tax. In the case where the subsidiary is a New York taxpayer but the parent is not, the parent may elect for the parent and subsidiary to be taxed as a single New York S Corporation. Without the election, the subsidiary will file as a New York C Corporation on a stand-alone basis.
Under New York’s new combined reporting rules, it is unclear if QSubs will be treated any differently than under prior rules.
Pennsylvania imposes both a net income tax and a capital stock/franchise tax. For years beginning after December 31, 2005, all entities treated as S Corporations for federal purposes, will be treated as such for Pennsylvania purposes. With 100 percent shareholder approval, an S Corporation can “elect out” in order to be considered a C Corporation. A QSub will be automatically treated as a Pennsylvania S Corporation. All assets, liabilities, income and deductions of the QSub will be treated as belonging to the parent, for income tax purposes. The QSub, however, will still be subject to the capital stock/franchise tax on a separate company basis.
Any taxpayer doing business in Tennessee is subject to an excise tax. An S Corporation must compute its tax liability as if it were a C Corporation. A QSub is not disregarded for purposes of the Tennessee excise tax and must file a separate entity excise tax return without regard to its federal classification.
Like Pennsylvania, Georgia imposes two types of corporate tax. For purposes of the income tax, Georgia recognizes the passthrough status of both an S Corporation and a QSub. Shareholders pay income tax in Georgia on their share of the passthrough income. Any S Corporation subject to tax on a federal level for net passive investment income or built in gains, for instance, may be subject to the income tax portion of the tax imposed in Georgia. The net-worth tax, however, is imposed on both the S Corporation and the QSub, on a separate company basis.
Prior to January 1, 2009, Massachusetts treats QSubs as an entity completely separate from the parent entity for reporting purposes. Each QSub and parent files its own tax return. For calculation of the income tax, however, all income is combined in order to determine if the entity level tax applies, where combined net income exceeds $6 million. If the threshold is exceeded, all entities are subject to this so-called “sting tax,” but it is applied at the separate company level. The excise tax or minimum tax is also imposed at the separate company level, based on each entity’s own property measure.
Effective January 1, 2009, however, Massachusetts will recognize the disregarded entity status of the QSub, with only one return required to include all QSub operations on the parent return, following federal tax treatment.
These are just some of the states that do not treat disregarded entities according to their federal level status. In filing state income tax returns, it has always been important to determine the correct state tax interpretations of disregarded entities. Now it looks like state employment tax treatment warrants close attention also.
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