As many of you now know, the Internal Revenue Service has passed regulations
effective January 1, 1997 which simplify the tax classification of limited
liability companies ("LLCs"). Generally stated, most US-created
LLCs may avoid corporate income tax unless they specifically elect to be
treated as a corporation. This will result in tax treatment as a sole proprietorship
in the case of one-person LLCs and as a partnership for all other qualifying
LLCs. The old "four factor" test, previously used by the IRS
for determining how it would tax an LLC is no longer valid. This means
that many LLC operating agreements should be amended. You should see your
legal advisor for that purpose.
The new regulations are referred to as "Check-the-Box" ones
because business entities are permitted to simply check a box on a tax
form indicating their election to be treated as either a "Corporation"
or as a "partnership" (or sole proprietorship). The IRS, however,
has made it even easier than checking the box. It anticipates that most
LLCs will not even file the "Check-the-Box" tax form. If they
do not, the LLC will be assigned the tax category it would have chosen
for itself had it filed the form. This means that even if it fails
to submit the "Check-the-Box" form that it will generally be
considered as a partnership for IRS tax purposes.
Please note, however, that state tax laws do not necessarily follow
federal tax regulations. Thus, an LLC advisor should check state tax law
irrespective of the new federal regulations. For example, California has
formally said it will not follow the new federal classification of entity
regulations. (See California Franchise Tax Board, Release 96-5,
How will your LLC be classified should it not check the box? It will
automatically be assigned to a "default" classification. New
LLCs with two or more members will automatically be classified as partnerships
unless they elect corporate tax status. New one-member LLCs will automatically
be "disregarded" unless they elect corporate tax treatment. By
being disregarded they will be effectively be treated as sole proprietorships
for tax purposes. This means that the intent of almost all LLC owners to
achieve non-corporate tax treatment will be met with IRS regulations facilitating
Non-US LLCs or "foreign" entities are automatically treated
as corporations should the foreign entity be found on a list set forth
in the IRS regulations. They are referred to as "per se"
corporations. As an example, "public limited companies" of the
United Kingdom are on that list. Thus, non-US operating companies may well
consider converting to US-based LLCs. All fifty states have LLC statutes.
Delaware appears to be the most popular state for LLC formation.
What about existing LLCs? An LLC that asserted partnership tax status
prior to 1997 will be classified as a partnership in 1997 and thereafter
unless it elects otherwise. Where the entity filed partnership returns,
for example, it is almost certain that it will be found to have claimed
partnership status. There is one exception, however, to this general default
rule. That is where the pre-1997 LLC had but one member and claimed, nevertheless,
partnership status prior to January 1, 1997. This claim will be disregarded
unless it elects otherwise. The good news, however, is that a pre-1997
existing LLC will not be "defaulted" into corporate tax treatment
unless it makes a demand for corporate tax treatment.
What are the means by which an election can be made? Assuming the LLC
does not wish the automatic partnership default, Form 8832 should be completed.
It is called Entity Classification Election. The election must be signed
by all LLC members, or by a person authorized to make the election, such
as an officer, manager or member. Additionally, the authority to make such
an election should be present in the organizational agreement of the LLC.
The LLC may specify an effective date for its tax election. It may be up
to 75 days before the form has been filed and as long as twelve months
What action may be anticipated by the states? State LLC laws were drafted
in all fifty states prior to the passage of the IRS Check-the-Box regulations.
Accordingly, many statutes, especially those characterized as "bullet
proof" will almost certainly be amended. This will help those state-specific
LLCs to avail themselves of the final IRS regulations. One-member LLCs
should become more prevalent. In addition, those state statutes which had
no meaning other than to assist the LLC in meeting the old "four factor"
test will likely be eliminated. Thus, limitations on continuity of existence
and on free transferability of member interests should be eliminated by
new state statutes.
The end result will be a marked increase in the significant attractiveness
of LLCs in general and of one-member LLCs in particular. LLCs will likely
become the entity of choice by which business can insulate its owners from
liability attacks and still provide those owners with the benefits of federal
partnership income tax treatment.