You correctly identified an error in my writing. the members of LLC B are individuals (husband and wife in fact) and file their 1040 together. Do not bring up the fact that, therefore, filing a 1065 is unneccesary, they said they wanted to do it anyway even though not required as CA is a community property state. more fee for me so whatever.

Anyway, when I wrote "it should be obvious they do not" I meant it should be obvious that LLC B does not file a 1040 because a business would never file a 1040. thats all.

Scenario 1 is correct. LLC B owns LLC A. I wrote incorrectly above because I rushed, since I am getting tired of writing the same thing over and over and I feel the conversation meandered into another area that was not relevant to the question of filing in CA. 

Be that as it may, yes LLC B reports the income and all other data from LLC A on its 1065. now the real question about Cali that I have yet to solve....