What is a Disregarded Entity?

A separate existence of a business entity generally does not eliminate its requirement to pay taxes and the requirement to file a tax return.

In our March 2016 edition of Tax News, All About Business article Disregarded Entities, SMLLC – Credit Limitations we focused on one tax consequence, credit limitation, of a single owner eligible entity classified as a disregarded entity for federal tax purposes, the single member limited liability company (SMLLC). We stated a business may organize under any number of legal forms, but that decision on how the business entity is organized is important, as you may face different tax consequences. When considering certain business entities whose separate existence is commonly referred to as “disregarded,” it is very important to consider the various state tax ramifications. When it comes to California, the separate existence of a business entity generally does not eliminate its requirement to pay taxes and in some cases, the requirement to file a tax return.

While we cannot cover all issues, in this article we will give you an example of various entities commonly referred to as disregarded entities and what California law requires.

A disregarded entity is a term commonly used to refer to an entity that is separate from its owner but has activities attributed to its owner. If a disregarded entity is owned by an individual, it is treated as a sole proprietorship. If the disregarded entity is owned by any other entity, it is treated as a branch or division of its owner. In some cases, the entity is disregarded based on the application of law, while in other cases an election is required.

When an election is required, it is generally made with the IRS. California law requires the election or classification of the entity to be the same as federal. Examples of entities that will be disregarded for federal income tax purposes include a:

  • SMLLC that has not filed a federal election to be taxed as a corporation.
  • Qualified subsidiary of an S corporation (QSub)[1] that has filed a federal election.
  • Qualified REIT subsidiary (QREITS or QRS)[2] that has not filed a federal election to be a taxable REIT subsidiary.
  • Grantor trust.

Although a disregarded entity may be a common term, it is not a term defined in the tax code. What you find are references to entities whose separate existence is to be disregarded for federal income tax purposes. While California law always requires the same treatment to be for California franchise and income tax purposes, often, but not always, California law may have specific language that would still require the entity to pay an annual tax or file a tax return. For example:

  • SMLLC – An SMLLC that is disregarded for federal income tax purposes, shall also be disregarded for California franchise and income tax purposes (R&TC Section 23038) other than that it must file Form 568 (R&TC Section 18633.5), pay the annual tax (R&TC Section 17941), and pay the LLC fee (R&TC Section 17942). In addition, California law (R&TC Sections 17039 and 23036) specifically limits the amount of credits the owner can claim.

    An SMLLC is therefore required to file a tax return (Form 568), pay the annual tax, and potentially the LLC fee[3].

  • QSub – R&TC Section 23800.5 specifically modifies the treatment of certain wholly-owned subsidiaries that are treated as a qualified subchapter S subsidiary (QSub) (IRC Section 1361(b)(3)) by imposing an annual tax of $800 on the QSub. In addition, unlike the corporate (parent),[4] California law (R&TC Section 23153 (f)(2)) does not allow the 1st year annual tax imposed on the QSub to be waived.

    The parent S corporation in this case would have the requirement to file a return and pay the franchise or income tax on the income that includes the activities of the QSub. The S corporation parent must complete Schedule QS, Qualified Subchapter S Subsidiary (QSub) Information, and attach it to Form 100S, California S Corporation Franchise or Income Tax Return, for each taxable year in which a QSub election is in effect. This schedule notifies us that the QSub’s items of income, deduction, and credit will be included in the parent’s return and the QSub will not be filing a separate California franchise or income tax return. The S corporation parent is required to pay the $800 annual tax for each QSub it owns that is incorporated, qualified, or doing business in California. The QSub annual tax is due and payable when the S corporation’s first estimated tax payment is due. If the QSub is acquired during the taxable year, the QSub annual tax is due with the S corporation’s next estimated tax installment.

  • QRS –Under R&TC Section 24870, which California conforms to IRC Section 856(i), a QRS is not treated as a separate corporation and all income, deductions, and credits of the QRS are treated as those of its parent REIT. Therefore, a QRS and its parent REIT are treated as a single tax entity for California tax purposes. Since the QRS is not treated as a separate tax entity from its parent, a QRS is not subject to the minimum franchise tax.

    The parent REIT is required to file a return (Form 100), and may be subject to the corporate franchise or income tax (R&TC Section 24872(b)(2)), which may include the income from the activities of the QRS.

  • Grantor trust – pursuant to R&TC Section 17731, California law conforms to IRC Sections 671-679, commonly known as the Grantor Trust Rules. If a trust is considered a grantor trust under the Grantor Trust Rules, all items of income, deduction, and credit attributable to that portion of the trust will be included in the taxable income of the grantor or other person treated as the grantor. Any remaining portions would be taxable to the trust on Form 541, Fiduciary Income Tax Return.

So, remember when it comes to California, although we often follow the federal elections for classification of an entity, it always important to check for California’s specific requirement for an entity commonly thought of as a disregarded entity.

[1] Qualified subchapter S subsidiary.
[2] Qualified Real Estate Investment Trust (QREIT) subsidiary. Both acronyms are commonly used for this entity.
[3] California law (R&TC Section 23153 (f)(2)) does not allow the 1st year annual tax imposed on LLCs to be waived.
[4] R&TC Section 23153(f)(1) allows corporations that are incorporated or qualified to do business in California on or after January 1, 2000, to pay a franchise tax based on income for its 1st taxable year without imposing a minimum franchise tax.