In a recent Tax Court case, a taxpayer learned a fundamental lesson about single-member limited liability companies the hard way. The had carried out a transaction intended to create a tax benefit making use of a limited liability company (an “LLC”) that he thought was taxable as a partnership. As it turned out, however, the LLC, which the taxpayer thought was a two-member LLC, was treated as a single-member LLC for federal income tax purposes and none of the partnership tax benefits that the taxpayer had planned for were available. This story, described in detail below, is just one of many that illustrate the potential pitfalls of using disregarded entities without paying attention to the tax issues. And for New Hampshire taxpayers, there are even more potential pitfalls because most entities that are disregarded for federal tax purposes are not disregarded for New Hampshire tax purposes.
The details of the taxpayer’s story are instructive. The taxpayer formed an LLC, which we will call LLC 1, thinking that it would be taxed as a partnership. He knew that for an LLC to be treated as a partnership for federal tax purposes, it must have at least two members. So in addition to owning some of the interests personally, he had LLC 1 issue additional interests to another LLC, which we will call LLC 2. His problem arose because he owned all of the interests in LLC 2. An LLC with a single member is disregarded for federal income tax purposes unless it elects to be taxed as a corporation. When a single-member LLC is disregarded, all of the assets, liabilities and economic activity of the LLC are treated as belonging to the owner of the LLC. In this case, the taxpayer was treated as owning the LLC 1 interests that were issued to LLC 2. As a result, the taxpayer owned all of the interests in LLC 1—the interests he owned directly and the interest owned by LLC 2—and, thus, LLC 1 was also a single-member LLC treated as a disregarded entity rather than a partnership. Because partnership tax law did not apply, the taxpayer received none of the partnership tax benefits that he had planned for.
This case acts as a reminder that it can be very easy to make mistakes when dealing with a disregarded entity, such as a single-member LLC. This article is intended to alert you to some additional potential pitfalls.
What Is a Disregarded Entity?
Certain business entities can be treated as nonexistent for federal income tax purposes. They are referred to as disregarded entities and they include single-member LLCs, qualified subchapter S subsidiaries, qualified real estate investment trust subsidiaries, grantor trusts and certain foreign entities used for international business arrangements. A disregarded entity is most often used to obtain limited liability for its owner without any federal income tax consequences. In domestic business arrangements, the single-member LLC is used more often than other entities and that is what we will focus on in this article.
A single-member LLC formed in the United States is treated as a disregarded entity unless it files an IRS form electing to be taxed as a corporation. Because federal income tax law disregards a single-member LLC unless the taxpayer does something to change that treatment, disregarded entity treatment can become a trap for the unwary. Further, because a single-member LLC is treated as disregarded for federal income tax purposes but not necessarily all federal tax purposes and is never treated as disregarded for New Hampshire tax purposes, the traps can become even more difficult to avoid. Therefore the tax ramifications of using a single-member LLC, especially in New Hampshire, should be carefully considered.
Federal Taxation of Disregarded Entities
In general, a single-member LLC is disregarded for federal income tax purposes. Being disregarded essentially means that it is not treated as a separate entity; rather its assets, liabilities and activities are treated as those of its owner. Purchases, sales, loans and other transactions between owner and entity are simply treated as though they never happened and transactions between a single-member LLC and a third party are treated as a transactions between the third parties and the single-member LLC’s owner.
For some federal tax purposes, however, disregarded entities are not disregarded.
Employment Taxes. A single-member LLC that has employees must obtain its own employer identification number, file its own employment tax forms, pay all related withholding taxes and is liable, apart from its owner, for non-payment of those employment taxes. In addition, the IRS takes the position that the owner of a single-member LLC has no interest in the LLC’s property under state law and therefore has no “property or rights to property” in the LLC’s assets. As a result, the IRS cannot look to a single-member LLC’s assets to satisfy a tax liability of its owner. The IRS has indicated, however, that in such cases, it may attempt to pierce the “corporate” veil of the LLC or file nominee liens under state law against the assets of the LLC, under an “alter ego” theory or by establishing that there was a fraudulent conveyance between the owner and the LLC.
Sharing Partnership Liabilities. Complex income tax regulations deal with the allocation of basis associated with partnership debt among partners. Under these rules, partnership debt is generally allocated to any partner that bears the ultimate “economic risk of loss” for the debt. A common example of this arises where a partner guarantees partnership debt. In such a case, the partnership allocates the tax basis associated with the debt to that partner. In determining which partner bears the economic risk of loss, the rules generally assume that a partner is financially able to perform under any guarantee regardless of the partner’s actual ability to do so. Taking advantage of this general assumption, in the past tax advisors recommended that partners own their interests in a partnership through a single-member LLC that guaranteed partnership debt. The virtually valueless LLC protected its single member from having to ever make good on the guarantee, but the basis associated with the partnership debt that was allocated to the single-member LLC was actually treated as belonging to the single member. IRS regulations put an end to this planning technique in 2006 by establishing that a guarantee provided by a disregarded entity will be taken into account when determining a partner’s economic risk of loss only to the extent of the disregarded entity’s net value. Apart from being unusual enough to catch even some seasoned practitioners off guard, the regulations implementing this treatment are quite complicated.
Partnership Audit Rules. Another situation in which a single-member LLC will not be disregarded arises under the “small partnership” exception to the special audit rules for partnerships. Under this exception, any partnership with ten or fewer partners, each of which is a U.S. individual, a C corporation, or an estate of a deceased partner is not subject to the special audit rules. The IRS takes the position that if a corporation owns its interest in a partnership through a single-member LLC, the single-member LLC, not the corporation, is treated as the partner for purposes of the partnership audit rules and, therefore, the small partnership exception does not apply.
State Taxation of Disregarded Entities
A few states, New Hampshire in particular, do not disregard single-member LLCs. Most states that treat disregarded entities as separate entities only do so for purposes of imposing fees. New Hampshire, however, treats all disregarded entities (other than grantor trusts) as separate entities for purposes of all state taxes and, in the case of the Business Profits and Business Enterprise Tax look to the nature of the single member to determine the tax rules that are applied. For example, if a corporation owns a single-member LLC, the single-member LLC is taxed as a corporation.
One peculiar result of the New Hampshire treatment of single-member LLCs affects tax-exempt organizations in particular. In many states, the single-member LLC is regarded as the most efficient way for a tax-exempt organization to hold real estate. For federal and most state tax purposes, barring “corporate” veil piercing type arguments, using this structure generally protects the tax-exempt organization from liabilities associated with the real estate (apart from some environmental liabilities) but allows the property to still be treated as owned by the tax-exempt organization. Using this planning technique in New Hampshire, however, has the effect of transferring the real property to a taxable entity. While this may have little or no effect while the operations do not exceed the filing thresholds for the Business Profits and Business Enterprise taxes, disposition of the property could easily generate enough gain to require payment of New Hampshire tax on a disposition that would have been nontaxable had the property not been transferred to the single-member LLC.
In most states, single-member LLCs also are generally not disregarded for purposes of state property taxes and sales and use taxes. In New Hampshire, single-member LLCs are not disregarded for purposes of real estate transfer tax, local property tax and the Meals and Rentals tax. They are subject to reporting, payment and penalty provisions at the entity level just like any other business entity. It’s easy to miss the fact that transactions between disregarded entities and their owners, while disregarded for federal income tax purposes, can be subject to these types of taxes.
International Taxation of Disregarded Entities
While it is beyond the scope of this article, it is important to note that the use of single-member LLCs in international tax planning can be very complex and deserves serious professional attention.
The single-member LLC can be a very useful planning tool, especially in creating limited liability with respect to separate business properties or activities. Where the tax effects of single-member LLCs are not fully understood, however, nasty surprises can arise, even more so in New Hampshire than in other states. It is easy to mishandle single-member LLCs in part because they are so simple to form that they can be made part of a transaction without consulting legal counsel, let alone a qualified tax advisor.