DRS: SN 98(3), Effect of Recent Federal Tax Law Changes on the Taxation of Limited Liability Companies and S Corporations and Their Shareholders

 

STATE OF CONNECTICUT
DEPARTMENT OF REVENUE SERVICES

450 Columbus Blvd
Hartford CT 06103
 
 
 
 
 
 

 
 

This Special Notice has been modified and superseded by SN 99(3)

SN 98(3)

Effect of Recent Federal Tax Law Changes on the
Taxation of Limited Liability Companies
and S Corporations and Their Shareholders


PURPOSE: The purpose of this Special Notice is to explain the effect of the federal check-the-box regulations and changes to the federal income tax laws affecting S corporations on the treatment of certain limited liability companies and S corporations for purposes of the Connecticut personal income tax, corporation business tax, additional tax on capital and minimum tax, sales and use taxes, real estate conveyance tax and controlling interest transfer tax.


STATUTORY AUTHORITY: Conn. Gen. Stat. §§34-101(9); 34-113; 12-407(1), §12-701(a)(33) and (34), 12-494, et seq. and 12-638a, et seq.


EFFECTIVE DATE: Effective for taxable years beginning on or after January 1, 1997.


INTRODUCTION: Recent changes in federal income tax law have introduced two new business entities referred to as see-through entities. This Special Notice explains the Department of Revenue Services’ treatment of these see-through entities for purposes of the personal income tax, corporation business tax, additional tax on capital and minimum tax, sales and use taxes, real estate conveyance tax and controlling interest transfer tax. Part I addresses the federal check-the-box regulations. Part II addresses S corporation law reform.


Part I.

FEDERAL CHECK-THE-BOX REGULATIONS

BACKGROUND: In December 1996, the IRS issued check-the-box entity classification regulations in an attempt to simplify the entity classification process. The new check-the-box regulations, which entail an elective classification scheme, allow every unincorporated business entity that is not properly classified as a trust or expressly taxed as a corporation under the Internal Revenue Code to elect how it is to be classified and taxed for federal income tax purposes.

These check-the-box rules in Treasury Regulation §301.7701-2(a) provide, in part, that:

[a] business entity with only one owner is classified as a corporation or is disregarded; if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner.

Thus, under the check-the-box rules, single-member unincorporated business entities may elect either to be taxed as corporations or to be disregarded as entities separate from their owners, in which case they will be treated as a sole proprietorship, branch, or division of the owner. Unincorporated business entities with two members or more may elect to be taxed as partnerships or as corporations.

Prior to the revision of Treasury Regulation §301.7701, all unincorporated business entities (other than sole proprietorships) were treated for federal income tax purposes either as partnerships or as corporations. The federal entity classification rules then in effect listed six corporate attributes which were used to determine whether an unincorporated business entity was to be classified as a partnership or as a corporation. Entities possessing a preponderance of the six attributes were classified as corporations. Adoption of the check-the-box rules render such an analysis unnecessary. In addition, the check-the-box rules, effective January 1, 1997, recognize single-member limited liability companies (LLCs) for the first time. Prior to January 1, 1997, single-member LLCs (SMLLCs) were not formally recognized by the IRS.


CURRENT CONNECTICUT LAW: Many states, including Connecticut, now allow the formation of SMLLCs. Conn. Gen. Stat. §34-101(9), as amended by 1997 Conn. Pub. Acts 70, §2, changes the definition of a limited liability company from an organization having two or more members to an organization having one or more members.

Additionally, Conn. Gen. Stat. §34-113 (as amended by 1997 Conn. Pub. Acts 70) provides that:

[a] limited liability company formed under sections 34-100 to 34-242, inclusive, as amended by this act, or a foreign limited liability company transacting business in this state pursuant to the provisions of said sections shall be treated, for purposes of taxes imposed by the laws of the state or any political subdivision thereof, in accordance with the classification for federal tax purposes.

  1. Income Tax Treatment Generally. In determining the Connecticut income tax treatment of both an SMLLC and an LLC with two members or more, the Department of Revenue Services will adopt the entity’s federal income tax classification, as determined under the check-the-box rules. Thus, for taxable years beginning on or after January 1, 1997, an SMLLC will be disregarded as an entity separate from its owner for Connecticut income tax purposes if it is so disregarded for federal income tax purposes. Otherwise, an SMLLC will be treated as a corporation for Connecticut income tax purposes if it is classified as such for federal income tax purposes.

Similarly, effective for taxable years beginning on or after January 1, 1997, an LLC with two members or more will be treated as a partnership for Connecticut  income tax purposes if it is classified as such for federal income tax purposes. Otherwise, an LLC with two members or more will be treated as a corporation for Connecticut income tax purposes if it is classified as such for federal income tax purposes.

In contrast to LLCs, the Connecticut income tax treatment of all other unincorporated business entities is unaffected by the recent federal changes discussed above.

  1. Treatment of Individual-Owned SMLLCs. SMLLCs that elect to be treated as sole proprietorships are not required to file Form CT-1065, Connecticut Partnership Income Tax Return. LLCs that are treated as partnerships for federal income tax purposes and that have income, gain, loss or deductions derived from or connected with Connecticut sources during the year continue to be required to file a Form CT-1065. See Conn. Gen. Stat. §§12-701(a)(33) and (34), as amended by 1997 Conn. Pub. Acts 286, §3, which incorporate LLCs treated as partnerships for federal income tax purposes, and their members, in the definitions of partnership and partner, respectively.

  2. Corporation Business Tax Treatment of Corporation-Owned SMLLCs. Where an SMLLC that elects to be disregarded as a separate entity is owned by a corporation, the SMLLC will be treated as a branch or division of the owner. Accordingly, the corporation owner must take into account the activities of its SMLLC in determining whether the owner is doing business in Connecticut. For purposes of this determination, all of the SMLLC’s activities will be attributed to the owner. Additionally, the corporation owner must take the SMLLC’s items of income, loss and deduction into account in determining the owner’s net income and must include the SMLLC’s property, payroll and sales in determining the owner’s apportionment factors.

  3. Sales and Use Tax Treatment. For purposes of the sales and use tax, the separate existence of an SMLLC will be recognized. See Conn. Gen. Stat. §12-407(1) (definition of person) and SFA Folio Collections, Inc. v. Timothy F. Bannon, Commissioner of Revenue Services, 217 Conn. 220, 585 A.2d 666 (1991). In general, therefore, the sales and use tax laws apply to SMLLCs as they would to any other person as that term is defined in Conn. Gen. Stat. §12-407(1).

    Sales and use taxes apply to transfers of tangible personal property and enumerated services, for consideration, between an individual and an SMLLC, unless expressly exempted. Where the member/owner of an SMLLC renders a service to the SMLLC, the transaction is subject to tax if the member/owner of the SMLLC is compensated for the rendition of such services other than through a distribution of SMLLC profits.

    Sales and Use Tax Nexus Consequences of Agency Relationships. Although SMLLCs generally are not accorded see-through status for sales and use tax purposes, if the entities are acting as agents or representatives of one another, the non-Connecticut entity could be found to have nexus with Connecticut.

    Sales and Use Tax Exemption for Services Rendered. SMLLCs and their owners do not qualify for the exemption allowed under Conn. Gen. Stat. §12-412(62) (for services rendered between parent companies and wholly-owned subsidiaries), because both entities must be stock corporations.

    Registration Requirements. SMLLCs that are doing business in Connecticut must register for sales and use tax purposes.    

  4. Real Estate Conveyance Tax Treatment. For purposes of the real estate conveyance tax, the separate existence of an SMLLC will be recognized. See Bjurback v. Commissioner of Revenue Services, 44 Conn. Sup. 354, 690 A.2d 902 (1996).

    Where an individual who owns Connecticut real estate in his or her individual capacity forms a limited liability company of which the individual is the single member and transfers the property to the limited liability company in exchange for his or her limited liability company membership interest, and where the value of the real property is at least $2,000, the deed contributing the property to the limited liability company is subject to the real estate conveyance tax. This situation is distinguishable from the situation in PS 93(5.1), Real Estate Conveyance Tax Implications for Conversions of Partnerships to Limited Liability Companies, where the new deed merely records the proper ownership of real property in the case of a continuing partnership within the meaning of 26 U.S.C. §708.

  5. Controlling Interest Transfer Tax Treatment. The separate existence of an SMLLC will be recognized for purposes of the controlling interest transfer tax because it is the complement to the real estate conveyance tax. See Bjurback v. Commissioner of Revenue Services, 44 Conn. Sup. 354, 690 A.2d 902 (1996).

Part II.

S CORPORATION REFORM AND QSSSs

BACKGROUND: Recent changes to S corporation law in the Small Business Job Protection Act of 1996 (the Act) have eliminated or eased several restrictions on federal S corporation eligibility. Starting with 1997 taxable years, the Act makes it easier for corporations to qualify as federal S corporations and to remain eligible for federal S corporation treatment. Specifically, S corporations may now have 75 shareholders whereas only 35 shareholders were permitted under prior law. See 26 U.S.C. §§1361(b)(1)(A), as amended by P.L. 104-88 §1301. In addition, certain entities that were previously ineligible to be S corporation shareholders may now own S corporation shares. See 26 U.S.C. §1361(c)(2), as amended by P.L. 104-88, §§1302 and 1303 (expanding the eligibility of trusts to own corporate shares); 26 U.S.C. §1361(c)(7), as amended by P.L. 104-88 §1316(a)(2) (permitting certain tax exempt organizations to own S corporation shares).

Also among the changes to S corporation law is one that permits S corporations to own subsidiary corporations that, for federal income tax purposes, will not be considered to be separate corporations. 26 U.S.C. §1361(b)(3)(A) now provides that

(I) [a] corporation which is a qualified subchapter S subsidiary shall not be treated as a separate corporation, and

(ii) 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.

The Act allows S corporations to own qualified S corporation subsidiaries (QSSS) starting with 1997 taxable years. See 26 U.S.C. §1361(b)(3). A corporation is a qualified subchapter S subsidiary if it is 100 percent owned by an S corporation and that S corporation elects to treat the subsidiary as a QSSS. 26 U.S.C. §§1361(b)(3)(B)(i) and (ii). For federal tax purposes, the qualified S corporation subsidiary is not treated as a separate corporation. Rather, all of the subsidiary’s assets, liabilities, and items of income, deduction and credit are treated as those of the S corporation parent. 26 U.S.C. §1361(b)(3)(A). These items then flow through to the shareholders as provided in 26 U.S.C. §1366.


CURRENT CONNECTICUT LAW: Connecticut relies on the current Internal Revenue Code for purposes of defining S corporations under both the personal income tax and the corporation business tax. Conn. Gen. Stat. §12-213(a), Corporation Business Tax Definitions, and Conn. Gen. Stat. §12-701(a)(17), Definitions, both define S corporation as any corporation that is an S corporation for federal income tax purposes.

  1. Income Tax Treatment Generally. Because the personal income tax and the corporation business tax both incorporate the federal income tax definition of S corporations, a corporation that meets the expanded definition of an S corporation for federal tax purposes will be treated as an S corporation in Connecticut. In addition, where an S corporation has a QSSS, the subsidiary’s items of income, loss and deduction pass through to the parent’s shareholders.

  2. Personal Income Tax Treatment. An S corporation must pass its items of income, loss and deductions through to its shareholders. No provision of Connecticut law changes these results where the S corporation owns a qualified S corporation subsidiary. Where an S corporation elects see-through treatment for a QSSS, only one Form CT-1120SI, S Corporation Information and Composite Income Tax Return, is required to be filed. Where an S corporation does not elect see-through treatment for a QSSS, two Forms CT-1120SI are required to be filed: one for the S corporation parent and one for the S corporation subsidiary.

  3. Corporation Business Tax Treatment. In the case of an S corporation, the corporation business tax is determined under Conn. Gen. Stat. §12-214, et seq. An S corporation parent must take into account the activities of its QSSSs in determining whether the parent is doing business in Connecticut. Likewise, a QSSS must take into account the activities of its parent in determining whether the QSSS is doing business in Connecticut.

    For purposes of this determination, all of the QSSSs activities will be attributed to the parent. Additionally, the S corporation parent must take the subsidiary’s items of income, loss and deduction into account in determining the parent’s net income and must include the subsidiary’s property, payroll and sales in determining the parent’s apportionment factors.

    A QSSS is not, itself, subject to the net income measure of the corporation business tax since all of its income is treated as that of the parent. However, a QSSS doing business in Connecticut must file a corporation business tax return to report the minimum corporation business tax .

    Combined Returns. While an S corporation parent and its S corporation subsidiary (regardless of whether it is a QSSS) may not file a combined return as provided by Conn. Gen. Stat. §12-223a(1) because they may not be included in a consolidated return for federal income tax purposes, such S corporations may petition the Commissioner of Revenue Services to file a combined return under Conn. Gen. Stat. §12-223a(2). Such petitions will be considered on a case-by-case basis.

    Additional Tax on Capital and Minimum Tax. No provision of the tax imposed by Conn. Gen. Stat. §12-219 allows the Commissioner to disregard the existence of a QSSS. Therefore, both qualified S corporation subsidiaries and their S corporation parents are subject to the tax imposed by Conn. Gen. Stat. §12-219.

    For purposes of the additional tax on capital and the minimum tax, the parent and the subsidiary each determine and report their tax based on their own separate attributes. The assets, liabilities, income, deductions and credits of the parent and the QSSS are not combined and intercompany transactions are not eliminated for these purposes.

  4. Sales and Use Tax Treatment. For purposes of the sales and use tax, the separate existence of a QSSS and its S corporation parent will be recognized. See Conn. Gen. Stat. §12-407(1) (definition of person) and SFA Folio Collections, Inc. v. Timothy F. Bannon, Commissioner of Revenue Services, 217 Conn. 220, 585 A.2d 666 (1991).

    Sales and Use Tax Nexus Consequences of Agency Relationships. Even though QSSSs generally are not accorded see-through status for sales and use tax purposes, if the QSSS or its parent are found to be acting as agents or representatives of one another, the non-Connecticut entity could be found to have nexus with Connecticut.

    Sales and Use Tax Exemption for Services Rendered. S corporations and their QSSSs or other corporate subsidiaries may qualify for the exemption allowed under Conn. Gen. Stat. §12-412(62) (for services rendered between parent companies and wholly-owned subsidiaries).

    Registration Requirements. QSSSs and their S corporation parents that do business in Connecticut must register for sales and use tax purposes.

  5. Real Estate Conveyance Tax Treatment. For purposes of the real estate conveyance tax, the separate existence of a QSSS will be recognized. See Bjurback v. Commissioner of Revenue Services, 44 Conn. Sup. 354, 690 A.2d 902 (1996).

    Where an existing S corporation forms a QSSS, any deed transferring real property from the S corporation to its QSSS (in a tax-free exchange under 26 U.S.C. §351) would be subject to real estate conveyance tax if the value of the real property were at least $2,000.

  6. Controlling Interest Transfer Tax Treatment. The separate existence of a QSSS will be recognized for purposes of the controlling interest transfer tax, since it is the complement to the real estate conveyance tax. See Bjurback v. Commissioner of Revenue Services, 44 Conn. Sup. 354, 690 A.2d 902 (1996).

EFFECT ON OTHER DOCUMENTS: This document modifies and supersedes PS 93(5.1), Real Estate Conveyance Tax Implications for Conversions of Partnerships to Limited Liability Companies.


EFFECT OF THIS DOCUMENT: A Special Notice (SN) is a document that, in response to newly enacted or amended Connecticut or federal laws or in response to newly released judicial decisions, announces a new Department position, policy or practice affecting the tax liability of taxpayers.


FOR FURTHER INFORMATION: If you have questions about Connecticut taxes, please call the Department of Revenue Services during business hours, Monday through Friday:

  • 860-297-5962 (Hartford calling area or from out-of-state); or
  • 1-800-382-9463 (toll-free from within Connecticut)

Telecommunications Device for the Deaf (TDD/TT) users only, please call 860-297-4911 during business hours.


FORMS AND PUBLICATIONS:

You may obtain forms and publications at any hour, seven days a week:

  • Telephone: use the phone numbers listed above and select Option 3 from a touch-tone phone;
  • Internet: preview and download forms from the DRS Web site: http://www.ct.gov/drs.

SN 98(3)
Various taxes
Issued: 1/22/98