Question 272: We have a situation that appears to be a ASG. My question concerns the FSO, which is an LLC (a title company) wholly owned by another LLC (a home builder) in which capital is a material income-producing factor. For tax purposes, the FSO is treated as a "disregarded entity"; its operations are included in the tax return of the parent.
Because the FSO is treated like a division of the parent for tax purposes, can we so treat it in determining ASG status? If this service organization actually were a division of a manufacturing or other unincorporated company where capital is a major income-producing factor, should we look at that division on its own to determine whether we have an ASG (or can we assume we don't since it is just a small part of the parent's operations)?
Answer: The second paragraph of your question makes your point eloquently. I concur. Let me elaborate with references to my book, Who's the Employer?. (Subscribers can click to view online the text of references to sections in the book.)
LLCs and similar entities are treated for tax purposes in one of 3 ways. The LLC can choose to be taxed as a corporation. If it does not, then it is taxed as a partnership if it has more than one member/owner. If it does not elect to be taxed as a corporation and it has just one owner, then it is disregarded. (See WTE 1:07.) If the sole owner is an individual, then the LLC is a Schedule C sole proprietorship. If the sole owner is a business, then the LLC is taxed as a division of the business.
This status applies for all purposes, including qualified plans. For an in-depth discussion of this issue, see Q&A 154.
With that background, let's turn to the affiliated service group rules and the definition of a First Service Organization (FSO). An FSO is a service organization. (See WTE 13:07.) IRC 414(m)(3) defines a service organization as an organization that primarily performs services. Isn't it wonderful to have such helpful definitions? Fortunately, the proposed regulations are more detailed. (See WTE 13:05.) Those proposed regulations state: "The term 'organization' includes a sole proprietorship, partnership, corporation, or any other type of entity, regardless of its ownership format."
So an organization must be an "entity." But, going back to the facts at hand, the LLC has the tax status of being "disregarded as an entity separate from its owner." Reg. 301.7701-3(b)(1)(ii). If it isn't an entity, it isn't an organization, a service organization, or an FSO.
The potential FSO in this case is the home builder, which is not a service organization. Accordingly it cannot be an FSO. In a traditional ASG, the only possible status for an entity that is not a service organization is as a B-Org. See WTE 13:30.)
As you point out, if this logic were untrue, then all the builder would need to do to avoid having the LLC treated as an FSO is to dissolve the LLC and take the assets into its own business. That event would not change any tax attributes. So it would be senseless to treat the disregarded LLC as a separate entity for ASG purposes but disregard it for all other purposes.