SN 98(3)
Effect of Recent Federal Tax Law Changes on the Taxation of Limited Liability Companies and S Corporations and Their Shareholders
This publication has been superseded by SN 99(3)
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.
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.
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.
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.
SN 98(3) Various taxes Issued: 1/22/98
