There are several business entities that are essentially disregarded as separate from their owners for the purposes of federal taxation. When analyzing the formation of or conversion to such entities, it is necessary to deem the transaction to allow an end result. When a disregarded entity is involved, the deemed transaction is a liquidation. Typically, this is referred to as a “deemed liquidation.”
Qualified Subchapter S Subsidiaries
An S corporation may have a qualified subchapter S subsidiary (QSub) for tax years after 1996, which would be any domestic corporation that is not an ineligible corporation (basically, a corporation that would be eligible to be an S corporation if the stock of the corporation were held directly by the shareholders of its parent corporation), if: all of the stock of such corporation is held by the S corporation and the S corporation elects to treat the subsidiary as a QSub. The corporation of which a QSub election is made, is generally not treated as a separate corporation from the S corporation parent. The QSub’s income, deductions, credits, assets and liabilities are treated as items of the parent. See Internal Revenue Code Section 1361(b)(3)(A). If an S corporation elects to treat an existing corporation as a QSub, the subsidiary is deemed to have liquidated Internal Revenue Code Sections 332 and 337. This deemed liquidation may trigger built in gain (BIG) tax under IRC 1374 as well as LIFO recapture under IRC 1363(d) if the subsidiary was a C Corporation. It is also important to note that if the subsidiary held an interest in a partnership, the partnership may be terminated (deemed liquidated) under Internal Revenue Code Section 708(b)(1)(B). The deemed liquidation occurs on the close of the day before the QSub election is effective.
Disregarded Entities & Entity Classification
Deemed liquidations may occur under IRC 331 or 332 when an eligible entity makes an election to change its classification under the check the box regulations. An eligible entity is defined in the regulations as an entity that is not a trust, nor a corporation. See the regulations under 301 regarding further definitions. The check the box regulations provide than an eligible entity with 2 or more members may elect to be classified as an association taxed as a corporation or to be disregarded as an entity separate from its owner, which would be a disregarded entity. Assets and liabilities of disregarded entities are treated as owned, and the activities treated as performed by its owner. Therefore, if the owner is a corporation, the activities of the disregarded entity are treated as though performed by a division or branch of the corporation.
There are default rules in place. A multi-member entity will be classified as a partnership unless it makes the election to be taxed as a corporation. A single member entity will be disregarded unless it elects to be taxed as a corporation. An entity can accomplish a classification change by one of three ways: an election is made (see Form 8832), an automatic classification change occurs due to the number of owners or a conversion occurs whereby the entity merges into or liquidates and forms a new entity.
Treatment of Classification Changes
An eligible entity classified as an association that elects to be classified as a partnership, is deemed to have distributed all of its assets and liabilities to the shareholders in liquidation, and then the shareholders are deemed to have contributed all assets and liabilities to a newly formed partnership. Thus, the entity is deemed to have liquidated under IRC 331 or 332. The same result occurs if an entity classified as an association elects to be a disregarded entity. For tax purposes, the deemed liquidation is treated as an actual liquidation
When or if a corporation merges into a partnership (or a limited liability company classified as a partnership) the IRS treats the transaction as a transfer by the corporation to the partnership for partnership interests. This is followed by the distribution of the partnership interests to the corporate shareholders in liquidation of the corporation. The transfer of assets to the partnership is generally considered tax free under IRC 721. The liquidation is tax-free under IRC 332 if the 332 requirements are met, otherwise the transaction is likely taxable under IRC 331.
If you have questions regarding business liquidation, business classification or classification change, contact The McGuire Law Firm to speak with a Denver business attorney. Mr. McGuire has an LL.M. in taxation which helps him analyze the tax implications of certain business decisions. All potential clients receive a free consultation.
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