LLC IRS Regulations

LLC IRS Regulations

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 The old “four factor” test, previously used by the IRS for determining how it would tax an LLC is no longer valid.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, issued 12/6/96)

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 that intent.

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 thereafter.

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.