A Disregarded Entity can be Regarded for Various Tax Purposes
By Bonnie Wassall, Senior Manager, Tax & Business
A taxpayer may conduct business operations, hold property, or participate in financial or business transactions through an entity wholly owned by the taxpayer that is classified as a “disregarded entity” under United States federal tax law. As a general rule, such an entity is not regarded as being separate from its owner for federal income tax purposes. However, there are exceptions to the general rule. In addition, such an entity may be recognized as a separate entity under applicable state, local, and foreign tax laws. A business entity’s classification under tax laws can significantly affect the tax consequences of its activities and transactions and the attendant reporting and payment obligations of both the entity and its owner. Accordingly, when the tax consequences of planned or completed transactions are assessed, operations or activities of an entity classified as a disregarded entity under federal tax law should identify and consider the impact of any other relevant tax law under which the entity is treated as being separate from its owner.
The Internal Revenue Code (IRC) prescribes the classification of organizations that are recognized as entities separate from their owners for federal tax purposes. Whether an organization is generally classified under the IRC as a business entity that is separate from its owner is determined under federal tax law and does not depend on whether the organization is recognized, or what form of entity classification is assigned to the organization, under other laws.
With few exceptions, every business organization or business entity that is capable of being recognized as a separate entity under federal tax law is classified as a corporation, partnership, or disregarded entity (DRE) pursuant to Treasury regulations. Pursuant to regulations, certain business organizations and entities are required to be classified as corporations. Any business organization or entity that is not required to be treated as a corporation is an “eligible entity” that may choose its classification, subject to certain limitations. An eligible entity that has more than one owner is classified as a partnership, unless it elects to be classified as a corporation.
As a general rule, a DRE’s activities are treated as though they were performed directly by the entity’s owner, and all assets, liabilities, and items of income, deduction and credit of the DRE are treated as those of its owner. If the owner is an individual, the DRE is treated as the owner’s sole proprietorship; otherwise, the DRE is treated as an unincorporated branch or division of its owner.
Some of the exceptions to this rule include the following:
- For federal employment tax purposes, a business entity that is otherwise classified as a DRE is treated as a separate entity. Thus, a DRE is generally required to calculate, report and pay federal employment taxes and file W-2 forms with respect to its employees under its own name and federal employer identification number. However, such an entity is not regarded as being separate from its owner for the purpose of employing its owner. Thus, a DRE that is owned by an individual is not recognized as the owner’s employer. In a similar vein, and consistent with federal tax law under which a partner of a partnership who performs services for the partnership is not considered an employee of the partnership, a DRE that is owned by a partnership is not treated as an entity separate from the partnership for purposes of employing a partner.
- Under final regulations issued in June 2016, if the debt of a DRE is discharged in a Title 11 bankruptcy case, any cancellation of indebtedness income realized upon such discharge is not eligible for exclusion from the gross income of the DRE’s owner under the bankruptcy exclusion of the Internal Revenue Code, unless the owner is a Title 11 debtor and the debt is cancelled under the owner’s bankruptcy petition.
- The tax basis of a partner’s interest in a partnership includes the partner’s share of partnership liabilities. Under a complex set of regulations that govern allocations of partnership liabilities to partners, to the extent that a partner bears the “economic risk of loss” with respect to a partnership liability, the liability must be allocated to that partner. A partner is considered to bear the economic risk of loss for a partnership liability only to the extent that the partner, or a person related to the partner, would have an obligation to make a payment to the creditor or a contribution to the partnership (a “payment obligation”) upon a constructive liquidation of the partnership under certain hypothetical circumstances. As a general rule, for purposes of determining the extent to which a partner or related person has a payment obligation and the economic risk of loss with respect to a partnership liability, it is assumed that all partners and related persons who have obligations to make payments actually perform those obligations, irrespective of their actual net worth, unless the facts and circumstances indicate a plan to circumvent the payment obligations. Where this general rule applies, no inquiry is made as to the financial ability of a person to make a payment or satisfy a financial obligation. However, in determining the extent to which a partner bears the economic risk of loss for a partnership liability, payment obligations of a business entity that is a DRE are taken into account only to the extent of such disregarded entity’s “net value” on the date as of which the partnership determines a partner’s share of partnership liabilities. For the purposes of this rule, a DRE’s net value is determined as the excess of the fair market value of its assets that may be subject to creditors’ claims, reduced by all obligations of the DRE that do not constitute payment obligations to the partnership for which the DRE’s net value is being determined. However, in computing the net value of the DRE’s assets, the calculation must exclude the fair market value of any interest the DRE owns in the partnership for which the DRE’s net value is being determined and the net fair market value of any property pledged to secure a partnership liability which has already been taken into account under a different portion of the rules under which economic risk of loss for a partnership liability is determined.
- Certain IRC provisions and provisions in some tax treaties between the United States and foreign countries limit the availability of treaty benefits with respect to income that treaty country residents derive from “fiscally transparent entities.” For purposes of applying those provisions, an entity that is otherwise a DRE is not disregarded as an entity separate from its owner but is, instead, considered an entity that is fiscally transparent in the United States. In general, an entity is fiscally transparent if its current year income and profits are currently taxable to the owners of the entity, regardless of whether or not the entity makes a distribution to its owners during that year.
- A business entity that is otherwise classified as a DRE is treated as a separate entity with respect to certain excise tax purposes that are set forth in Treasury Regulation § 301.7701-2(c)(2)(v).
- A business entity that is otherwise classified as DRE is treated as an entity separate from its owner for purposes of (a) federal tax liabilities of the entity with respect to any taxable period for which the entity was not a DRE, (b) refunds or credits of tax with respect to any such period, and (c) federal tax liabilities of any other entity for which the entity is liable.
Under the tax laws of a state, local or foreign government, an entity that is generally disregarded as an entity separate from its owner under federal tax law is considered an a separate entity (i.e., not a disregarded entity), except to the extent (if any) that those laws provide otherwise. Such an entity is also generally regarded as an entity separate from its owner under non-tax laws except to the extent, if any, that those laws expressly otherwise provide. Several areas that illustrate these points are as follows:
- An entity classified as a DRE under federal tax law is regarded as an entity separate from its owner under the Bank Secrecy Act, pursuant to which a United States person is obligated to file a Report of Foreign Bank and Financial Accounts for any calendar year in which such person has a financial interest in or signature authority over one or more financial accounts maintained with financial institutions located outside of the United States, if the aggregate maximum values of such accounts exceed $10,000 at any time during that year.
- Some states do not conform to the federal tax treatment of an entity that is classified as a DRE under federal tax law. Where federal-state differences in the tax treatment of a DRE exist, the state tax consequences of the DRE’s activities, operations and transactions may differ, perhaps substantially, for the DRE and its owner.
- Some states impose an annual entity-level tax or fee on a DRE and impose on DRE’s an obligation to file an annual return with respect to such tax or fee, regardless of whether for state income tax purposes the DRE is disregarded as an entity that is separate from its owner.
- Many states that impose employment taxes treat an entity classified as a DRE under federal tax law as a separate taxpayer for employment tax purposes. A DRE that has one or more employees may be required to register as a separate taxpayer for state employment tax purposes and to determine, report, and pay state employment taxes as a separate entity.
- Under some states’ sales and use tax laws, a DRE is treated as an entity that is separate from its owner. A DRE may be required to register as a separate taxpayer for state sales and use taxes and to determine, report, and pay state sales and use taxes as a separate entity.
If you wish to receive additional information about any of the foregoing matters or professional counsel regarding other tax matters, please contact us at Marcum LLP.