State and Local Tax Implications of 'See-Through' Entities under the Federal 'Check-the-Box' Regulations and QSSS Legislation
In 1996 two significant developments in the federal income tax law gave rise to broad new categories of business entities that will be "disregarded" for federal income tax purposes. The Small Business Jobs Protection Act, enacted last August, introduced the qualified subchapter S subsidiary, or "QSSS," a corporate subsidiary that, upon an election by its S corporation parent, will be disregarded for federal income tax purposes. In addition, the "Check-the-Box" regulations finalized in December include provisions under which certain wholly owned, noncorporate entities, such as a single-member LLC, also can be disregarded for federal income tax purposes.
The introduction of these "see-through" entities is revolutionary, and will provide myriad tax planning opportunities under federal tax law. The possibility of ignoring the separate existence of a QSSS or single-member LLC also opens doors to alternative ways of structuring multi-state business activities. However, while the federal tax law ignores the separate existence of these see-through entities, they are nonetheless very much alive under local law. One cannot assume that the federal treatment of these entities will obtain at the state and local level as well. Moreover, state and local taxation presents many important issues, such as nexus, or the appliction of sales taxes, that are irrelevant under the federal income tax. For these reasons, the state and local tax ramifications of using see-through entities require careful consideration.
The enclosed article by Carolyn Lee, which appeared recently in State Tax Notes, poses a variety of fundamental questions that arise with respect to the state tax treatment of these new entities. Because state and local tax rules are so diverse and complex, it will take years for all of the issues to surface. And because the tax regimes of different states, and even the various taxes within a state, can be premised on fundamentally divergent policies, answers developed in one jurisdiction or under one tax may not be readily exportable to another.
Among the state and local tax issues that need to be considered by users of the new see-through entities are the following:
- Whether, or to what extent, the income tax laws of the states and localities in which such entities do business conform to the federal income tax classification rules.
- The consequences and uses of nonconformity. When a see-through entity conducts business in more than one jurisdiction, or operates in jurisdictions different from its owner, there may be opportunities to avoid state tax, and risks of incurring multiple state taxes.
- The degree to which the use of see-through entities creates "automatic" combination. This can be useful, but also might attract income to different jurisdictions, blend or dilute losses, or change the character of income.
- How "nexus" standards may be applied to a see-through entity and its owners, both for income tax purposes and for sales tax purposes.
- The availability of the protections of Public Law 86-272 to see-through entities and their owners.
- Excise tax issues, including whether federal conformity extends to such taxes, and the classification of what one owns as tangible or intangible property.
- Enforcement issues which may arise when tax liability is attributed to an owner who has no contacts with the taxing jurisdiction.
See-through entities clearly provide tremendous planning opportunities, but the tax treatment of these entities at the state and local level can be considerably more complex than the "nothingness" ascribed to them under the federal income tax. We trust the enclosed article will assist you in identifying areas of potential significance, and in considering planning alternatives.