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Disregarded Entities Under 100% S Corporation Ownership

Worldview Consulting & Accounting, Inc., as a Portland CPA firm, provides tax advisory services to help its clients understand the tax code and intricacies of proper S corporation reporting.  For example, when a Small Business Corporation, otherwise known as an “S Corporation,” owns 100% of the stock in an LLC.  Presume the LLC has made no specific tax elections.

The issue, in this case, is how the Internal Revenue Service will treat the income, taxable or otherwise, coming from the LLC to its owners in the S Corporation.  The shareholders of the S Corporation will have earnings passed to them through the S Corporation and, therefore, the earnings coming to them from the wholly owned LLC need to be clarified.

Section 1361 defines S Corporation as a small business corporation, making a valid election per Section 1362(a) as to any tax year, and that has less than or equal to 100 shareholders, only one class of stock, and has no non-US-citizen owners.

1361(b)(3)(A) provides that a corporation where the S Corporation owns 100% of the stock of such corporation can be treated as a “qualified subchapter S subsidiary.”  Thus, per Section 1361(b), a “corporation which is a qualified subchapter S subsidiary shall not be treated as a separate corporation,” and “all assets, liabilities, and items of income, deduction, and credit of a qualified subchapter S subsidiary shall be treated as assets, liabilities, and such items (as the case may be) of the S Corporation.”

Under Reg. Sec. 301.7701-2(a), a business entity with two or more members is classified for federal tax purposes as either a corporation or partnership, and with only one member is classified as a corporation and is disregarded.  If it is a disregarded entity, then it is treated in the same manner as if a part of its owner.

Under Reg. Sec. 301.7701-2(b)(3), a corporation is also defined as a business entity organized under state law if that state jurisdiction describes such as a “joint-stock company.”

Under Reg. Sec. 301.7701-2(c)(1), a partnership exists if it has at least two members.  Under Reg. Sec. 301.7701-2(c)(2), a wholly owned business entity with only a single owner that is not a corporation is disregarded as an entity separate from its owner.

Here, we are given an LLC 100% owned by the S Corporation.  We can presume that the LLC is organized under a state statute since this is the only way such an entity is allowed for purposes of limited liability and is, thus, not per se a corporation under federal definitions.  We are also not told whether it is defined as a joint-stock company by the actual jurisdiction involved.  Given the fact that the LLC is a wholly owned business entity, if not a corporation, under Reg. Sec. 301.7701-2 it is “disregarded as an entity separate from its owner.”  Similarly, per Sections 1361 and 1362, the LLC could be a qualified subchapter S subsidiary of the S Corporation if elected to be as such by the S Corporation under Section 1363.

Since the subsidiary LLC will be disregarded as a separate entity for federal income tax purposes, all items of earnings and losses will be considered one and the same with the S Corporation as its owner.  This means the shareholders of the S Corporation will report the earnings and losses of the LLC as pass-through earnings and losses on their individual tax returns as reported by the S Corporation.

Thus, all of the LLC earnings and losses will be disregarded and considered one and the same with the S Corporation for tax purposes.

Worldview Consulting & Accounting, Inc. is an Oregon registered CPA accounting firm. William Burwell, CPA, CFF, MBA, CPIM, is a business consultant and financial forensic accounting services professional with over twenty years of high technology industry experience. Licensed in Oregon and Massachusetts.

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