2007_05_29_outline_final

ALI-ABA Course of Study Partnerships, LLC, and LLPs: Uniform Acts, Taxation, Drafting, Securities, and Bankruptcy May 31–June 2, 2007 Baltimore, Maryland LLCS–THE SWISS ARMY KNIFE OF BUSINESS ORGANIZATIONS BY STUART LEVINE BALTIMORE, MARYLAND Copyright © 2007, The American Law Institute. All rights reserved. STUART L EVINE STUART LEVINE is an attorney in private practice in Baltimore, Maryland. He received a B.A. from the University of Maryland (College Park) in 1972; a J.D. from the University of Baltimore in 1975; and an LL.M. (Taxation) from the Georgetown University Law Center in 1979. He was the Chairman of the Special Committee on Limited Liability Companies established by the Sections of Taxation and Business Law of the Maryland State Bar Association, which drafted the Maryland Limited Liability Company Act and subsequent amendments thereto, and was the co-chair of the Prototype Drafting Project of the Limited Liability Subcommittee of the Committee on Partnerships and Unincorporated Businesses of the A.B.A. Section of Business Law which drafted the Prototype Limited Liability Company Act. He was a member of the Task Force on Limited Liability Companies established by the A.B.A. Section of Taxation and is the past chair of the Subcommittee on Limited Liability Companies and Entity Classification of the Committee on Partnership Taxation of the ABA Section of Taxation. He had principal drafting responsibility for the comments submitted by the ABA Section of Taxation to the Internal Revenue Service on the entity classification (“Check-the-Box”) regulations. Mr. Levine is an adjunct professor at the University of Baltimore School of Law and in the Graduate Tax Program at the University of Baltimore and is a past chair of the Section of Taxation of the Maryland State Bar Association. Mr. Levine has authored or co-authored numerous professional articles, including: “Is There a Right of Contribution Among Responsible Persons?”, 78 Journal of Taxation 30 (January, 1993); “Amortization of Intangibles: The End of Transactional Tax Planning?”, Tax Talk, Vol. III, No. 1 (Fall, 1993); “One-Member LLCs Pose Often-Overlooked State Law Issues”, 1 Journal of Limited Liability Companies 162 (Spring, 1995); “Proposed Regulations Use ‘Management Rights’ Litmus Test for LLC Members’ SE Tax Liability”, 82 Journal of Taxation 196 (April, 1995); “When Forming a Firm--Should You Prepare for Its Demise?” 29 The Maryland Bar Journal No. 3, 24 (May/June 1996); “How Much Is That LLC in the Window?” XI PUBOGRAM No. 1, 6 (December, 1996); “The New Right of Contribution From Other Responsible Persons--How Far Does It Go?”, 86 Journal of Taxation 76 (February, 1997); “New Regulations Introduce a New Paradigm,” Aspen Law & Business, (March 3, 1997); “Righting the Wrong Approach to Wrongful Distributions in Limited Liability Entities,” 3 Journal of Limited Liability Companies 164 (Spring, 1997); “IRS Shifts Focus with Controversial New SE Tax Proposed Regulations,” 86 Journal of Taxation 325 (June, 1997); and “Rehearsal for Retirement: Drafting Provisions to Consider,” 14 The Practical Tax Lawyer No. 1, 55 (Fall 1999). Mr. Levine is also one of the co-authors of the Maryland Limited Liability Company Forms and Practice Manual, published in 1993 by Data Trace Legal Publishers, Inc. and is one of the co-reporters for Maryland in State Limited Liability Company Laws (Prentice Hall Law & Business). Mr. Levine comments on developments in the area of tax and business law issues on his weblog, Tax and Business Law Commentary, http://taxbiz.blogspot.com. He is also one of the editors of The Maryland Courts Watcher Blog, http://marylandcourts.blogspot.com/ that provides daily synopses of all Maryland cases posted online. TABLE OF CONTENTS Page 1. 2. INTRODUCTION ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 SOLE MEMBER LLCS AND THEIR USE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2.1. What Is a Sole Member LLC?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2.2. Does a Sole Member LLC Need an Operating Agreement?. . . . . . . . . . . . . . 2 2.3. Some Uses for Sole Member LLCs.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2.3.1. FIREWALLS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2.3.2. CREATION OF SINGLE PURPOSE BANKRUPTCY REMOTE ENTITIES.. 5 2.3.3. AVOIDANCE OF TRANSFER TAXES.. . . . . . . . . . . . . . . . . . . . . . . . . . 11 2.3.4. AVOIDANCE OF ANCILLARY PROBATE (AND , PERHAPS, INHERITANCE TAXES). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 2.3.5. LIKE KIND EXCHANGES... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 2.3.6. USE AS ENTITY OF CHOICE FOR CORPORATE SUBSIDIARIES... . . . . 14 CONVERTING ONE INTO MANY AND MANY INTO ONE: CONVERSION ISSUES... . . 15 3.1. Conversion of a One Member LLC Into a Multi-Member LLC.. . . . . . . . . 16 3.2. Conversion of a Multi-Member LLC Into a One-Member LLC.. . . . . . . . . 16 PAYMENT OF EMPLOYMENT TAXES WITH RESPECT TO DISREGARDED ENTITIES.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 LIMITED LIABILITY AND ITS DISCONTENTS .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 INSOLVENCY AND THE PROBLEM OF “WRONGFUL” DISTRIBUTIONS.. . . . . . . . . . . 24 6.1. The Issue.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 6.2. The Historical Roots of the Problem... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 6.3. Sanitizing Payments to Members.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 SELF-EMPLOYMENT TAX ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 7.1. Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 7.2. Self-Employment Tax Act (“SECA”) Taxes.. . . . . . . . . . . . . . . . . . . . . . . . . 28 7.3. Unanswered Questions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 7.4. The New Proposed Regulations... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 7.5. Stop in the Name of Congress.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 7.6. Inconsistent Treatment of LLCs v. S Corporations.. . . . . . . . . . . . . . . . . . . 30 THE AT-RISK RULES, IRC §465.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 8.1. General Principles.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 8.2. Applicability to One Member LLCs... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 3. 4. 5. 6. 7. 8. LLCS–THE SWISS ARMY KNIFE OF BUSINESS ORGANIZATIONS STUART LEVINE, ESQUIRE 1. INTRODUCTION . 1.1. LLCs are now the vehicle of choice for most closely-held business start-up companies. Except in Texas and, to a limited extent in Pennsylvania, they are virtually completely transparent for tax purposes, yet offer a complete limited liability shield comparable to that of a corporation. One member LLCs represent an even more recent development. While one member LLCs had been allowed under various state LLC statutes prior to January 1, 1997, their classification for Federal, and generally state, income tax purposes was so uncertain that they were virtually never used. With the finalization of the check-the-box regulations, however, the federal tax treatment of one member LLCs is clear--they are ignored as separate taxable entities and taxed as transparent “divisions” of the sole member. Notwithstanding their current popularity, the mechanics of LLCs are often misunderstood by clients, lawyers, and accountants. The check-the-box regulations have removed the structural straightjacket that had formerly been imposed on LLCs by the Kintner regulations. The old distinction between “flexible” and “bulletproof” LLC statutes has disappeared--all LLC statutes are flexible now. Although the previous tax classification rules were a hindrance to planners, they also provided them with some psychological security. After all, rules, even overly restrictive ones, do offer the succor of relatively clearly demarcated guideposts. In the post-check-the-box vacuum, planners are often experiencing a sort of vertigo. If LLCs are a lump of clay, what should we fashion them into. There are, however, issues that fall through the cracks of other presentations but which are necessary with respect to drafting and working with LLCs. 1.2. 1.3. 1.4. 1.5. 1.6. 2. SOLE MEMBER LLCS AND THEIR USE. 2.1. What Is a Sole Member LLC?--Once one gets beyond the tautological (e.g., a sole member LLC is an LLC with only one member), there is a surprising amount of misunderstanding about the metaphysics of a sole member LLC. The best definition is that a sole member LLC is an entity (i) which is governed by an LLC statute (as opposed to a corporate statute), (ii) which offers the sole owner the Page 1 ability to limit his/her/its responsibility for debts and obligations to the amount of equity committed to the entity, and (iii) which, in most (but not all) cases, is ignored as a separate entity for federal income tax purposes. 2.2. Does a Sole Member LLC Need an Operating Agreement? 2.2.1. This is a debate that has generated more heat than light. The “con” camp points to the fact that an “operating agreement” cannot really be an “agreement” since there is only one party to it. (“What is the sound of one hand clapping?”) 2.2.2. The “cons” seem to miss the fact that under most statutes, the term “operating agreement” is a term of art rather than a description of some subclass of a larger class. Certainly, in the colloquial parlance of LLCs, the term has taken on the character of a term of art. 2.2.3. Furthermore, an agreement between an LLC and its sole member would certainly be enforceable. By way of example, if the sole member had agreed to contribute a certain amount of money to the LLC, but failed to do so, the LLC’s creditors could likely step into the shoes of the LLC via an insolvency proceeding and enforce the obligation. 2.2.4. Of course, merely because one can “enter into” a one party agreement is not, of itself, a sufficient reason to do so. There are, however, at least three reasons to enter into an operating agreement in a sole member LLC. 2.2.4.1. The agreement segregates and identifies the precise assets which belong to the LLC and, thus, carefully distinguishes those assets which are subject to the claims of the creditors of the business from those which are not. Often, when challenged by creditors, the question of whether a court should honor the limited liability shield may become whether the “corporate” formalities of treating the LLC as a separate entity were properly observed. Of prime importance to this inquiry is the question of whether the sole member treated the assets of the LLC as being the property of a separate entity. Closely related to the factor noted above is the ability to pay reasonable compensation to the sole member for services rendered to the LLC and not have creditors treat the payments as “wrongful” distributions if the payments are made when the LLC is technically insolvent. Thus, it is helpful if the operating agreement describes the duties Page 2 2.2.4.2. to be performed by the sole member and then describes the compensation (including any fringe benefits) to be paid for those services. 2.2.4.3. Finally, many LLC statutes provide that an LLC will dissolve if it does not have a member for a certain period of time, say ninety (90) days. This provision can be overridden by a provision in a sole member operating agreement to the effect that any successor in interest automatically becomes a member of the LLC. Such a provision is important in many LLCs to avoid inadvertent dissolution, especially if dissolution will either trigger a breach in a contract or lease or make it difficult to transfer the contract or lease. However, when drafting the operating agreement keep it simple. There is no reason to impose requirements on the sole member that could be fashioned into a tool by a creditor. By way of example, a requirement that the LLC have annual meetings of the members will not likely be complied with and the fact of non-compliance might latter be used to argue that the “corporate veil” should be pierced. 2.2.4.4. 2.3. Some Uses for Sole Member LLCs. 2.3.1. FIREWALLS--Perhaps the simplest and, yet, most neglected area in which sole member LLC’s can be of importance is in the creation of “firewalls.” That is, the compartmentalization of various discrete economic activities in separate LLC “boxes” to limit the exposure that each type of activity has to liabilities that might arise in other areas of the business. 2.3.1.1. Every new economic venture, no matter how small, entails some degree of risk. LLCs can be used to encapsulate those risks. Creative use of financing between related entities reinforces the walls. Example: A print broker will purchase printing on special order for a variety of customers. With respect to the various suppliers of the products, the broker is the actual contract purchaser and is completely liable for the purchase price. Because the broker’s markup is relatively small, often the failure of even one customer to pay an Page 3 outstanding bill can force the broker’s entire venture into insolvency. To a large degree, this result can be avoided by structuring the print broker as one LLC, with a number of sole member LLC subsidiaries, with larger contracts being channeled through custom-made LLC subsidiaries. The subsidiaries are thinly capitalized and are funded through a private line of credit from the parent LLC that is secured by a security interest in accounts receivable of the subsidiaries. So long as the lines of credit are extended on reasonable terms, the actual assets at risk to the claims of general creditors at any time can be minimized. 2.3.1.2. Certain activities may inherently be more risky than others. The potential of LLCs to encapsulate these risks are perhaps greater than one might anticipate. 2.3.1.2.1. For instance, in U.S. v. Bestfoods, 524 U.S. 51 (1998), the Supreme Court addressed the question of a corporate parent’s liability for the liability of its subsidiary under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (“CERCLA”). CERCLA holds the “operator” of a polluting facility liable for the clean-up costs in certain circumstances. The Court held that “[a]ctivities that involve the facility but which are consistent with the parent’s investor status, such as monitoring of the subsidiary’s performance, supervision of the subsidiary’s finance and capital budget decisions, and articulation of general policies and procedures” are insufficient to make the parent the operator of the facility. Although Bestfoods dealt with CERCLA liability in the context of inter-corporate relationships, the principles enunciated in the opinion should be equally applicable to situations involving LLC subsidiaries. Thus, if a “facility” represents merely an investment by a corporate parent, the parent may be able to insulate itself from potential CERCLA liability by placing the facility in a wholly-owned LLC subsidiary designed as a stand Page 4 2.3.1.2.2. 2.3.1.2.3. alone operation, with its own employees and management structure. 2.3.1.3. The availability of sophisticated off the shelf computer software has removed the most significant impediment to the proliferation of related party LLCs, namely the costs and complexity of performing the accounting function for multiple entities. It is now easy to establish any number of separate accounting systems to clearly delineate the boundaries between these related parties and to maintain separate financial books and records. However, be aware that traditional veil piercing may still apply. While not an LLC or partnership case, the recent opinion in Fontana v. TLC Builders, Inc., 362 Ill. App. 3d 491 (2005) is instructive. There, a non-shareholder was held to be liable via a piercing the veil theory. 2.3.1.4. 2.3.2. CREATION OF SINGLE PURPOSE BANKRUPTCY REMOTE ENTITIES. 2.3.2.1. In the real estate downturn of the late 1980’s, lenders were frequently hindered in their efforts to foreclose on collateral when borrowers declared bankruptcy. In reaction, lenders are frequently requiring that borrowers form “single purpose bankruptcy remote entities” to borrow the funds and hold the collateral. These entities are generally restricted in their ability to borrow additional funds, add any assets to their asset base other than the collateral, declare voluntary bankruptcy, or take various other actions not in the ordinary course of business. Most significantly, perhaps, is that the lender will require that its nominee be placed on the governing board of the entity and that the entity be prohibited from taking any of the types of actions set forth above without the approval of that nominee. Thus, even if the parent of the entity were to declare bankruptcy, the entity itself would not be in the bankruptcy estate. A problem frequently arises if the property that is to be placed in the entity is property that is acquired in a like-kind exchange under I.R.C. §1031. Page 5 2.3.2.2. 2.3.2.3. 2.3.2.3.1. In Rev. Rul. 75-292, 1975-2 C.B. 333, a like-kind exchange was followed immediately by a Section 351 transfer of the property to a controlled corporation. The Service ruled that the like-kind transfer could not reap the benefits of Section 1031 because the property was intended to be transferred to the corporation, not used in the trade or business of the taxpayer. Similarly, in Rev. Rul. 77-337, 1977-2 C.B. 305, the relinquished property was held not to be used by the taxpayer in his trade or business, since it was distributed to him by a corporation in liquidation. I have encountered a similar problem. H and W own property as tenants by the entirety. Under local law, there was a significant transfer and recordation tax due if the property was swapped for like-kind property. The parties desired to transfer the property to a controlled LLC and then to “upstream” the LLC interest, with the result that they would own, as tenants by the entirety, an LLC which had as its sole asset a 100% interest in the LLC that owned the real property. In discussing this issue with the National Office of the IRS, the Service stated that a swap of the LLC interest would not be a like-kind exchange because it was not being held by the parent LLC for use in a business. In Rev. Proc. 2002-69, 2002-2 C.B. 760, the Service addressed the issue of an LLC that is owned by both husband and wife as community property in a community property jurisdiction. The revenue procedure holds that the Service will honor the classification choice of the taxpayers. That is, if the taxpayers treat the LLC as being owned by only one spouse and a disregarded entity, then it will be treated as a disregarded entity owned by that spouse. Similarly, if the parties treat the LLC as being jointly owned and classified as a partnership, the Service will abide Page 6 2.3.2.3.2. 2.3.2.3.3. 2.3.2.3.4. by their choice. A change in reporting position will be treated as a conversion of the entity for federal tax purposes. Although there is no written guidance, in informal conversations with Service personnel, practitioners have been informed that the flexibility afforded taxpayers in community property states will not be extended to taxpayers in common law states. There, if an LLC is owned by both spouses, it will be deemed to be a partnership for tax purposes. 2.3.2.3.5. H.R.2206 (U.S. Troop Readiness, Veterans’ Care, Katrina Recovery, and Iraq Accountability Appropriations Act, 2007) has a section, Section 8215, entitled “Family Business Tax Simplification.” It provides that a “qualified joint venture” conducted by a husband and a wife is outside of Subchapter K under certain circumstances (the only co-joint venturers are the two spouses, both materially participate in the joint venture, and both spouse agree to, in essence, elect out of Subchapter K). Sadly, the statute does not define the term “joint venture.” Query: Is an LLC a joint venture? 2.3.2.4. In PLR 199911033, the Service ruled that an LLC that has two members, one of which has no economic interest in the LLC, is a single-member LLC, and is thus disregarded as a taxable entity. This opens the door for the use of LLCs in this context. 2.3.2.4.1. Under the facts of the ruling, the taxpayer was the grantor of a grantor trust. The taxpayer desired to exchange real property held by the trust for other real property in accordance with the deferred exchange rules of I.R.C. 1031(a)(3). Pursuant to an exchange agreement, the trustees assigned all of their rights in a contract to sell real estate (the “relinquished property”) to a qualified intermediary (QI) (as defined in Reg. 1.1031-1(g)(4)). Title to the relinquished property was subsequently deeded directly by the trust to the buyer, pursuant to, and in satisfaction of, the trust’s obligations in the exchange agreement. Page 7 As contemplated by the exchange agreement, the QI was to acquire (as defined in Reg. 1.1031(k)-1(g)(4)(iv)) like-kind property (“the replacement property”) and transfer it to the trust. The replacement property was to be financed by a lender, who insisted that legal title to the property be held by a bankruptcy-remote entity. The trust proposed to use a single-member LLC as the bankruptcy-remote entity, but the lender objected because it did not give the bankruptcy-remote protection desired. As an alternative, the trust formed a Delaware LLC, with the trust and “Member 2,” a corporation wholly owned by the trust, as the members of the LLC. One of the members of the board of directors of Member 2 would be a representative of the lender. The trust would have a 100% interest in the profits, losses, and capital of the LLC, while correspondingly, Member 2 would have no interest in the LLC’s profits, losses, or capital. Member 2 was designated a “manager” in the LLC agreement, and the approval of such manager (via a unanimous vote of its board of directors), together with that of the trust, was required for the LLC to: i. File or consent to the filing of a bankruptcy or insolvency petition or otherwise institute insolvency proceedings. ii. Dissolve, liquidate, merge, consolidate, or sell substantially all its assets (with the prior written consent of the lender). iii. Engage in any business activity other than as specified in its Certificate of Formation. iv. Borrow money or incur indebtedness other than the normal trade accounts payable and any other indebtedness expressly permitted by the documents evidencing and securing the loan from the lender. Page 8 v. Take or permit any action that would violate any provision of any of the documents evidencing or securing the loan from the lender. vi. Amend the Certificate of Formation or any provision of the operating agreement concerning any of the aforesaid items (without the permission of the lender). All other decisions of the LLC would be made solely by the trust. The replacement property was transferred directly to the LLC. 2.3.2.4.2. Furthermore, the operating agreement provided that all distributions of net cash flow and capital proceeds would be made entirely to the trust. On the dissolution of the LLC, the trust would wind up the affairs of the LLC in any manner permitted or required by law, provided that the payment of any outstanding obligations owed to the lender would have priority over all other expenses or liabilities. In analyzing the issue, the Service stated that: “The primary inquiry is whether the parties had the intent to join together to operate a business and share in its profits and losses. The inquiry is essentially factual and all relevant facts and circumstances must be examined. Furthermore, it is federal, not state, law that controls for income tax purposes, regardless of how the parties are treated under state law.” The Service then applied the analysis developed in Herbert M. Luna, 42 T.C. 1067, 1077 (1964), the court stated that the following factors should be considered in determining whether the parties intended to be a partnership: (1) the agreement of the parties and their conduct in executing its terms; (2) whether business was conducted in the joint names of the parties; (3) whether the parties filed Federal partnership returns or otherwise represented to the Service or to persons with whom they dealt that they were joint venturers; (4) Page 9 2.3.2.4.3. 2.3.2.4.4. whether separate books of account were maintained for the venture; (5) the contributions, if any, which each party has made to the venture; (6) whether each party was a principal and co-proprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; (7) the parties’ control over income and capital and the right of each to make withdrawals; and (8) whether the parties exercised mutual control over and assumed mutual responsibility for the enterprise. 2.3.2.4.5. The Service then concluded that the members of the LLC did not come together to form a partnership for federal tax purposes because, as evidenced by the operating agreement, the parties did not enter into the agreement to operate a business and share profits and losses. Member2 was a member of LLC for the sole limited purpose of preventing Trust from placing LLC into bankruptcy on its own volition. Member 2 had has no interest in LLC’s profits or losses and neither managed the enterprise nor had any management rights other than those limited rights described above. In Rev. Rul. 2004-77, 2004-2 C.B. 119 a single member LLC and its single member owner were the two partners in a state law partnership. The Service ruled that the state law partnership was either a disregarded entity or, if it had elected to be classified as a corporation, a corporation. It was not a partnership for income tax purposes. Rev. Rul. 2004-77 and PLR 199911033 likely presage the use of one member LLCs in a host of new situations to protect lenders and for other purposes. 2.3.2.4.6. 2.3.2.4.7. Page 10 2.3.3. AVOIDANCE OF TRANSFER TAXES. 2.3.3.1. In many states, transfer taxes, such as sales tax, will be imposed upon the sale of a business via an asset sale. Since asset sales are preferred by purchasers because they get a step-up in basis for the assets being purchased and they avoid acquiring any unwanted and unexpected hidden liabilities of the seller, these taxes effectively impose a toll-charge on this fairly common planning tool. Sole member LLCs can often be used to avoid the transfer taxes involved. 2.3.3.2.1. Sales Tax--The contract of sale is structured to provide that the seller will, immediately before closing, transfer all of the assets which are the subject of the sale, to a one member LLC, subject only to any liabilities which the purchaser has explicitly agreed to purchase. This transfer is typically exempt from the imposition of these transfer taxes, since sales tax statutes typically contain exemptions for transfers of assets to LLCs in exchange for interests in the LLCs or as capital contributions to the LLCs. The purchaser then purchases, not the assets themselves, but all of the outstanding interests in the LLC. The purchaser can, in most cases, continue to hold and operate the business within the same LLC shell, since the LLC is ignored for tax purposes. Because the LLC is not dissolved and is not merely a brief intermediary step, the transaction is likely immunized from attack as step transaction. Real Estate Transfer and Recordation Tax. In some states, such as Maryland and Virginia, the conversion of a partnership or a sole proprietorship to an LLC is not subject to transfer or recordation tax so long as there is perfect congruence between the owners of the LLC after the transaction and the owners of the sole proprietorship or partnership prior to the conversion. Page 11 2.3.3.2. 2.3.3.2.2. (i) (ii) If real property is being used for commercial purposes (i.e., the rental of land for farming purposes), it can be converted to an LLC and the interests in the LLC thereafter sold. Note: The transfer of real estate to the LLC may or may not be subject to transfer or recordation taxes. Compare Crescent Miami Center, LLC v. Florida Department of Revenue, (Fla. Sup. Ct. No. SC03-2063, May 19, 2005) (no documentary tax imposed on transfer to a wholly-owned entity), with Dean v. Pinder, 312 Md. 154 (1988) (absent a statutory exception, transfer tax imposed.) Also, the LLC will likely not be an insured party under the individual owners’ title policy, thus a new policy ought to be considered. See Gebhardt Family L.L.C. v. Nations Title Ins. of N.Y., Inc., 132 Md.App. 457 (2000). Sharing a taxpayer identification number. Treas. Reg. § 301.6109-1(a)(2)(iii) specifically provides that “A new partnership that is formed as a result of the termination of a partnership under I.R.C. § 708(b)(1)(B) will retain the employer identification number of the terminated partnership. This paragraph . . . applies to terminations of partnerships under I.R.C. § 708(b)(1)(B) occurring on or after May 9, 1997.” Query: Do you really want to share the same TIN as the party to whom you sold a property or from whom you purchased one? The question can be entirely avoided if the Selling Partnership had placed the title to the property in a one-member LLC (call it “Title, LLC”) that was entirely owned by the Selling Partnership. Thereafter, the buyers would form their own partnership which would then purchase all of the interests in Title, LLC, from the Selling Partnership. For state transfer and recordation tax Page 12 (iii) 2.3.3.2.3. (i) (ii) (iii) purposes, the sale would still be cast as a sale of an interest in an LLC, thus avoiding imposition of state transfer and recordation taxes. However, since the separate existence of a one-member LLC is ignored for federal tax purposes, the sale is treated for income tax purposes as a sale of the underlying asset. The purchasers and the sellers do not need to use the same employer identification. 2.3.4. AVOIDANCE OF ANCILLARY PROBATE (AND , PERHAPS, INHERITANCE TAXES) 2.3.4.1. An interest in an LLC is personal property. The “domicile” of personal property is deemed to be the domicile of the owner. If real estate is held in the name of a sole individual and the owner dies, there must generally be an ancillary probate in the state in which the realty is located. Assuming, however, the realty is held by an LLC and the LLC is structure in a way to avoid dissolution upon death of the owner, there should be no need for ancillary probate. Since the federal estate tax credit for state inheritance taxes has been repealed, some, but not all, states have “de-coupled” their estate tax regimes and imposed an inheritance or estate tax that may be actually higher than the federal tax. If a decedent lives in a “no tax” state, but has property in a state that imposes a tax, holding property in the state that imposes a tax should avoid the imposition of the tax for the same reason: No property in that state is changing hands due to the death of the owner, since the owner is an LLC. 2.3.4.2. 2.3.5. LIKE KIND EXCHANGES. 2.3.5.1. Sole member LLCs are generally “tax nothings.” That is, their separate existence is ignored for tax purposes unless they have elected to be classified as corporations for tax purposes. Assume that the property held by an LLC is property that could be used in a tax free like-kind exchange under IRC 2.3.5.2. Page 13 §1031 (“property held either for productive use in a trade or business or for investment”). 2.3.5.3. In two private letter rulings, PLR 9751012 and PLR 9807013, the IRS ignored the existence of a one-member LLC in the context of IRC §1031. In both cases, the various properties were transferred, not to the taxpayers directly, but to various one-member LLCs that they had formed. In both cases, the Service agreed to disregard the LLCs as entities separate from their owners and treated the replacement properties as being received directly by the owners in an otherwise qualifying Section 1031 exchange. This result would point to the ability to swap interests in one member LLCs for Section 1031 property or for interests in other one member LLCs, so long as the underlying assets held by the various LLCs otherwise qualify under Section 1031. In PLR 199945038, a taxpayer owned property that was condemned. The taxpayer placed the proceeds of the sale into two one-member LLCs. The LLCs then purchased the replacement properties. For purposes of Section 1033, this was held to be a direct purchase of the replacement properties by the subject taxpayer, since the separate existences of the LLCs were ignored for all tax purposes. 2.3.5.4. 2.3.5.5. 2.3.6. USE AS ENTITY OF CHOICE FOR CORPORATE SUBSIDIARIES. There are several applications for single member LLCs as subsidiaries of corporations. 2.3.6.1. By using LLC subsidiaries, a corporation could have the benefits of compartmentalizing its business activities, but could avoid the necessity of filing consolidated federal income tax returns. There are additional planning opportunities in corporate reorganization transactions. See, e.g., PLR 9739014 (transfer of S corporation stock to several one member LLCs, each of which was owned by the respective shareholders of the corporation did not terminate S 2.3.6.2. Page 14 election because LLCs were disregarded as taxable entities). 2.3.6.3. There are several potential benefits with respect to state income taxation. First, a state cannot impose a tax on all of the income of a multi-state corporation unless its activities in that state are part of the corporation’s unitary activities. See generally, Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992). By using LLC subsidiaries, a corporation can clearly denominate the business activities conducted in particular states with a view to isolating those activities and avoiding aggregation of all of its income for state income taxation purposes. This might be of particular significance if it is likely that the various subsidiaries will, even in the indefinite future, be sold. The second use might, at first examination, seem to be a contradiction of the first. That is, some states do not allow the filing of consolidated returns for certain state income tax purposes. However, the use of LLC subsidiaries effectively overrides the prohibition against consolidated returns since the separate existence of an LLC may be ignored for income tax purposes. Although there is no case law in this area as yet, LLCs present interesting questions with respect to the question of nexus for state sales tax purposes. Specifically, if an LLC is doing business in State X, are sales made to citizens of State X by that LLC’s parent or a brother LLC subject to sales tax? 2.3.6.3.1. 2.3.6.3.2. 2.3.6.3.3. 3. CONVERTING ONE INTO MANY AND MANY INTO ONE: CONVERSION ISSUES. Early in 1999, the IRS addressed the tax effects of the conversion of a one member LLC to a partnership and the conversion of a partnership to a one member LLC. Page 15 3.1. Conversion of a One Member LLC Into a Multi-Member LLC. In Rev. Rul. 99-5, 1999-1 C.B. 434, the Service addressed the tax effects of the conversion of a one member LLC to a partnership. Two hypothetical situations were presented. 3.1.1. In the first situation, B purchases a 50% interest in a sole member LLC from A for $5,000.00. In this case, A is considered to have made a sale of 50% of each of the assets in the LLC and A and B are each deemed to have subsequently transferred their respective 50% interest in the assets to the newly formed partnership. Thus, to the extent that the assets have a fair market value in excess of their basis, A will have taxable income and the new partnership will have a stepped-up basis in one-half of the assets, which step-up needs to be specially allocated to B in accordance with I.R.C. §704. 3.1.2. Under the facts in the second hypothetical, B contributes $10,000.00 in cash to the LLC for a 50% interest, none of which is distributed to A. A is deemed to have contributed all of the assets to a partnership in exchange for a 50% interest. B is deemed to have contributed the $10,000.00 cash to the LLC in exchange for his interest. The assets contributed by A do not get a step-up basis in whole or in part in the hands of the LLC/partnership. Of course, however, there will likely have to be §704 special allocations because the basis of B’s interest in the LLC will likely be different than that of A. 3.2. Conversion of a Multi-Member LLC Into a One-Member LLC. In a companion revenue ruling, Rev. Rul. 99-6, 1999-1 C.B. 432, the I.R.S. addressed the tax effects of a conversion from a partnership to a one member LLC. As in Rev. Rul. 99-5, two hypotheticals were presented. 3.2.1. In the first hypothetical, A and B are equal partners in AB, LLC. A sells her entire interest in the LLC to B for $10,000.00 in cash. Thereafter, B continues the business as an LLC. The ruling holds that A treats the sale as a sale of her entire interest in the LLC and reports gain or loss under I.R.C. §741. In dealing with the results to B, the ruling applied the analysis used in the case of Edwin E. McCauslen, 45 T.C. 588 (1966) and Rev. Rul.67-65, 1967-1 C.B. 168. Using that analysis, AB, LLC is deemed to have made a liquidating distribution to A and B and B is deemed to have purchased A’s 50% interest in the LLC assets that were distributed to her in consideration of the $10,000.00 payment. B therefore has a total basis in one-half of the assets equal to $10,000.00 (the amount paid to A), and in the other half of the assets, a carry-over basis equal to the basis of the assets in the hands of AB, LLC. There is also a divided holding period, Page 16 with a new holding period for one-half of the assets beginning on the day of sale and a carryover holding period for the other one-half of the assets. 3.2.2. In the second hypothetical, CD, LLC, is owned equally by C and D. They sell all of their interests in the LLC to E for $10,000.00 each. E continues the business without dissolving the LLC under state law. In this case, the CD partnership is deemed to have terminated under I.R.C. §708(b)(1)(a) when E purchases the interests of C and D. C and D report gain or loss under I.R.C. §741. E is deemed to have acquired by purchase all of the former partnership’s assets. E’s basis in the assets is $20,000.00 and her holding period begins on the date she purchases the interests in the LLC from C and D. 4. PAYMENT OF EMPLOYMENT TAXES WITH RESPECT TO DISREGARDED ENTITIES. In Notice 99-6, 1999-1 C.B. 321, the Service requested taxpayer comments concerning employment tax and various reporting issues relating to disregarded entities that should be addressed in future guidance. Additionally, Notice 99-6 set forth temporary procedures that the Service will follow until additional guidance is issued. 4.1. The areas in which comments were solicited include: 4.1.1. Any increase or decrease in the administrative burden on taxpayers created by a system of filing employment tax returns under the owner’s name and taxpayer identification number where employees are actually employed by a state law entity that is disregarded as an entity separate from its owner for federal tax purposes. 4.1.2. Whether different rules should apply to newly formed disregarded entities with no previous employment tax history as opposed to entities in existence prior to the time when they became disregarded. 4.1.3. Different results (both in amount of tax, type of tax, and time and method of deposits) that arise from filing as one employer as compared to filing as separate employers. 4.1.4. Appropriate methods for notifying the service center about changes in employment tax obligations when an entity’s status as a disregarded entity changes. 4.1.5. Possible issues arising in situations where the owner or the disregarded entity is formed or domiciled in a country other than the United States. Page 17 4.1.6. Additional issues relating to employment taxes and disregarded entities including, but not limited to, confusion for employees, employers, and state and federal agencies resulting from a single entity reporting structure for employment tax purposes. 4.1.7. Whether any guidance issued should also apply to qualified REIT subsidiaries (as defined in section 856(i)). 4.1.8. Information reporting on IRS Form 1099s issued by, or with respect to, disregarded entities and their owners. 4.1.9. Issues related to qualified or nonqualified deferred compensation plans, fringe benefit and welfare plans, and other compensation arrangements. 4.2. Until additional guidance is issued, the Service will accept either one of two possible methods with respect to reporting and payment of employment obligations. 4.2.1. Specifically, the reporting can be completed either under the name and taxpayer identification number of the owner of the disregarded entity or under the name and taxpayer identification number of the disregarded entity. Owners of multiple disregarded entities may choose to use one method with some of the disregarded entities and the other method with the remainder of the disregarded entities. 4.2.2. Notice 99-6 warns that if the owner chooses to file using the name and taxpayer identification number of the disregarded entity, the owner would nonetheless remain ultimately responsible for the employment tax obligations with respect to the employees of the disregarded entity. Presumably, then, if the obligations were not paid, the Service believes that it has the authority to move directly against an owner who is an individual without the necessity of invoking the penalty provisions of I.R.C. §6672. Moreover, an owner that is not an individual cannot encapsulate unpaid employment tax obligations in a wholly-owned LLC or S-corporation subsidiary and thus insulate itself from liability. 4.2.3. In that regard, see PLR 199936003. There, a taxpayer operated a business as a sole proprietorship. He then split the business between two trusts which formed one LLC. For reasons not pertinent here, the business enterprise generated significant withholding tax liabilities. 4.2.3.1. The Service held that if the trusts were shams, the LLC would be a one member LLC and the sole owner/creator would be liable for all unpaid withholding taxes. Page 18 4.2.3.2. However, if the trusts and the LLC were not shams, the liability of the trusts would be determined under state law. Presumably IRC § 6672 would also operate to impose liability on the actual responsible persons. 4.2.4. In F.S.A. 200105045, the Service held that employment tax assessments under the name and EIN of a single member LLC were valid against the single member. In part, the result seemed to be dictated by the fact that the sole member did not dispute receipt of the notices or knowledge of their contents. “Thus, even if the assessments may have been erroneous in a technical sense, [the single member] was not misled or prejudiced by the errors.” 4.3. In Rev. Rul. 2001-61, 2001-2 C.B. 573, the Service provided guidance with respect to the retention of an entity's employer identification number upon changing under Treas. Regs. § 301.7701-3 from a partnership to a disregarded entity or from a disregarded entity to a partnership. The ruling holds that: 4.3.1. If an entity classified as a partnership becomes a disregarded entity for federal tax purposes and if the disregarded entity chooses to calculate, report, and pay its employment tax obligations under its own name and EIN pursuant to Notice 99-6, the disregarded entity must retain the same EIN for employment tax purposes it used as a partnership. For all federal tax purposes other than employment obligations or except as otherwise provided in regulations or other guidance, a disregarded entity must use the TIN of its owner. 4.3.2. If an entity classified as a disregarded entity for federal tax purposes calculates, reports, and pays its employment tax obligations under its own name and EIN pursuant to Notice 99-6 and if the federal tax classification of that entity changes to a partnership, the partnership must retain the same EIN it used as a disregarded entity. 4.4. A New Day Dawning? 4.4.1. The Treasury has proposed regulations that “would would eliminate disregarded entity status for purposes of federal employment taxes. A disregarded entity would be regarded for employment tax purposes, and, accordingly, become liable for employment taxes on wages paid to employees of the disregarded entity, and be responsible for satisfying other employment tax obligations (e.g., backup withholding under section 3406, making timely deposits of employment taxes, filing returns, and providing wage statements to employees on Forms W-2). The owner of Page 19 the disregarded entity would no longer be liable for employment taxes or satisfying other employment tax obligations with respect to the employees of the disregarded entity. The disregarded entity would continue to be disregarded for other Federal tax purposes.” See 70 Fed. Reg. 60475 (October 18, 2005). 4.4.2. Well, not yet. In two cases, McNamee v. U.S., Docket No. 05-6151-cv (2nd Cir. May 23, 2007) and Littriello v. U.S., 2007 Fed. App. 0136P (6th Cir., April 13, 2007), appellate courts held that (i) proposed means proposed and that the check-the-box regulations were valid. Hence, one member LLCs that have not elected to be classified as corporations for tax purposes are disregarded for all tax purposes, including liability for employment and withholding taxes. Thus, the Service need not (i) rely on the provisions of I.R.C. § 6672 to tag an owner with personal liability and (ii) the owner will be liable for both the employer and the employee portions of F.I.C.A. and F.U.TA. 5. LIMITED LIABILITY AND ITS DISCONTENTS . 5.1. Obviously, the raison d’etre of LLCs are in their name–limited liability. However, creditors are not always comfortable with this result. 5.1.1. In PLR 200235023, the IRS began to address various issues pertaining to limited liability. Specifically, the ruling addresses the following questions: (i) Who is liable for the tax resulting from the operation of a multi-member LLC?; (ii) Who is liable for the tax resulting from the operation of a single member LLC?; (iii) If the Service makes an assessment against an LLC that is a disregarded entity, is that a valid assessment against the single member owner?, (iv) If the Service files a Notice of Federal Tax Lien (“NFTL”) naming the disregarded LLC as the taxpayer, is that a valid NFTL against the single member owner?; and (v) Are there state law theories that the Service could use to collect the single member owner's liability from the disregarded LLC? 5.1.2. The first question was answered quite easily. If a multi-member LLC has elected to be classified as a corporation for income tax purposes, the LLC will be liable for the tax, except to the extent that IRC § 6672 is applicable. Significantly, however, even if an LLC is classified as a partnership, members are not liable for federal taxes except to the extent that the members are either liable for the LLC’s obligations under state law or IRC § 6672 is applicable. Thus, in a multi-member business, a multi-member LLC has liability advantages, even for income tax liabilities, over a plain vanilla general partnership. Page 20 5.1.3. In a single member LLC, as is the case with a multi-member LLC, a single member LLC that has elected to be classified as a corporation is liable for the tax and the sole member is only liable to the extent that IRC § 6672 is applicable. Not surprisingly, the Service takes the position that in a single member LLC that is a disregarded entity, the assessment is against the single member. Thus, the single member’s assets may be attached, but the assets of the LLC may not be. 5.1.4. Surprisingly, however, the Service stated that it will honor the division between the LLC, as an entity, and its sole member, when it comes to collecting the tax obligation of the member. Thus, the Service will not, automatically, move to use the assets of the LLC to satisfy the obligations of the sole member. However, collection action can be taken against the single member’s ownership interest in the LLC. This may result in a foreclosure action which ultimately exposes the LLC’s assets to the IRS’s claims. 5.1.5. However, note that it is the member who is the taxpayer of a single member LLC that is a disregarded entity. Thus, as noted above, all income, loss, etc., as well as obligations for withholding taxes, flows directly to the owner. 5.1.6. With respect to notice of federal tax liens, a notice inadvertently naming as the taxpayer an LLC that is a disregarded entity for the obligations of the member may sometimes be valid. To determine whether the notice of lien is valid, the so-called “substantial compliance” test is used. As stated in the ruling, “The guiding legal principle is that the name on the NFTL must be sufficient to put a third party on notice of a lien outstanding against the taxpayer. . .Such a determination will depend on the facts and circumstances in each particular case. . . .[T]he substantial compliance test is met when the third party examining the public record is alerted to the possibility of the federal tax lien.” In cases where the notice of lien has been filed incorrectly and there is no substantial compliance (e.g., the lien is filed in the name of Eagle, LLC, a single member LLC owned by John Jones), the Service can withdraw the notice of lien and refile under the name of John Jones. 5.1.7. Finally, PLR 200235023 discusses various state law theories that the Service could use to collect the single member’s liability from his or her disregarded LLC. It is in this area that the ruling becomes troubling. 5.1.7.1. For instance, in its discussion of the “piercing the corporate veil” or “alter ego” doctrine, the Service Page 21 described the doctrine as follows: “The alter ego theory has been asserted in the corporate context when facts show that there is such a unity of interest and ownership between the subject taxpayer and corporation that the individuality or separateness of the taxpayer and the corporation has ceased. Generally there are facts that show that adhering to the fiction of a separate existence of the corporation would, under the particular circumstances, sanction a fraud or promote an injustice.” 5.1.7.2. In a sense, this is a correct, black-letter statement of the law. However, the formula that leads to this conclusion is not necessarily composed of the same factors in every state. The Service listed some of these factors as “occurrences of fraud; inadequate capitalization of the corporate entity; failure to adhere to corporate formalities (such as commingling of funds); and abuse of the corporate entity so as to amount to complete dominance by the shareholder or shareholders.” In one particularly chilling remark, the ruling stated that “the fact that the LLC is disregarded under the ‘check-the-box’ regulations for purposes of computing the taxpayer’s tax liability may make the courts amenable to applying the alter ego/piercing the corporate veil concepts to the LLC. Arguably, where due to the ‘check-the-box’ regulations the individual taxpayer is responsible for reporting and paying all income earned by the LLC, and the individual arranges his business affairs so that the LLC, rather than the individual taxpayer, has the assets to pay the tax liability, this could be significant factor supporting piercing the LLC veil.” In other words, a single member LLC is more at risk for veil piercing than a multi-member LLC. This idea runs counter to the basic predicate of an LLC--that the assets of the LLC and its business are the assets and business of an entity that has an identity that is separate from the owner. It should not matter that the LLC has one member or one hundred members. Finally, the ruling also states that liability may also be founded on a theory that the LLC is a mere nominee, that transferee liability is applicable, or that the LLC may be Page 22 5.1.7.3. 5.1.7.4. 5.1.7.5. liable as a transferee under IRC § 6901. With respect to transferee liability, the ruling notes that “many of the factors which tend to support piercing the LLC veil--such as pervasive control by the individual taxpayer over the LLC--also tend to support transferee liability.” 5.1.8. While PLR 200235023 ostensibly gives guidance only to the employees of the IRS, bad news travels fast. To the extent that the Service misstates the law (as in the veil piercing context with respect to the law in a number of states) or undermines the efficacy of the limited liability shield in single member situations, the theories espoused in PLR 200235023 might be adopted by non-governmental creditors with devastating effect. Going one step further, to the extent that the law is not settled, PLR 200235023 is even more troublesome, since the Service may take litigating positions that are more extreme than those a private creditor might take. And, going even one further step, courts might be less reluctant to rule in the creditor’s favor in breaking down limited liability shields when the creditor is the government. 5.2. Another case that has attracted a good deal of national attention is In Re Allbright. (Bankr. D. Col. 2003) (http://www.cob.uscourts.gov/opinions/Albright%2001-11367.pdf). 5.2.1. Allbright was the sole owner and member of an LLC that owns real estate in Colorado. The trustee in Allbright’s bankruptcy asserted the ability to take over the LLC, liquidate its property, and then distribute the proceeds pursuant to the bankruptcy proceeding. Allbright contended that "at best, the Trustee is entitled to a charging order and cannot assume management of the LLC or cause the LLC to sell" its assets. 5.2.2. The court noted that, under Colorado law, an interest in an LLC is personal property. By virtue of the bankruptcy filing, all of Allbright's personal property, including her interest in the LLC, was transferred to the bankruptcy trustee. Brushing aside Allbright's attempt to parse the difference between the right to manage the property and the right of a member to distributions from the LLC, the court went to the nub of the matter and said: "[T]he charging order, as set forth in [the Colorado LLC Act] exists to protect other members of an LLC from having involuntarily to share governance responsibilities with someone they did not choose, or from having to accept a creditor of another member as a comanager. A charging order protects the autonomy of the original members, and their ability to manage their own enterprise. In a single-member entity, there are no non-debtor members to protect. The charging order limitation Page 23 serves no purpose in a single member limited liability company, because there are no other parties’ interests affected." 5.2.3. In a footnote, the court provided a common sense guide to future cases involving multi-member LLCs, when it stated: “The harder question would involve an LLC where one member effectively controls and dominates the membership and management of an LLC that also involves a passive member with a minimal interest. If the dominant member files bankruptcy, would a trustee obtain the right to govern the LLC? Pursuant to [the Colorado LLC Act], if the non-debtor member did not consent, even if she held only an infinitesimal interest, the answer would be no. The Trustee would only be entitled to a share of distributions, and would have no role in the voting or governance of the company. Notwithstanding this limitation, [the provision of the Colorado LLC Act dealing with charging orders] does not create an asset shelter for clever debtors. To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with ‘peppercorn’ co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse. 11 U.S.C. Sections 544(b)(1) and 548(a).” 5.2.4. There are numerous charlatans who contend that there is some secret hocus-pocus inherent in charging orders. Somehow, against common sense, they argue that if one puts assets in an LLC, the setup will has the same effect on the creditors of the members of the LLC as garlic does to vampires. They contend that not only are the assets themselves beyond the reach of the creditors, but the creditors can get allocated taxable income without the benefit of receiving cash to pay the resulting tax. (If you don’t believe me, punch the term “charging order” into any search engine.) 5.2.5. By contrast, Allbright is short, clear, and well-reasoned. It's message is surprisingly simple: What a debtor controls, belongs to his or her creditors, unless there are others who hold legitimate interests with legitimate expectancies that, unless they gave their consent, they would not have to deal with third-parties. 6. INSOLVENCY AND THE PROBLEM OF “WRONGFUL” DISTRIBUTIONS. 6.1. The Issue. 6.1.1. Members who perform services for an LLC typically receive either a guaranteed payment or an LLC “distribution” for their services. Page 24 6.1.2. Distributions are problematic in the LLC arena because many LLC statutes specifically give creditors remedies against both members who receive and members who authorize distributions from the LLC at a time when the LLC is either insolvent or will be rendered insolvent by the payment. Under some statutes, even guaranteed payments may be problematical. 6.1.3. The problem can best be illustrated by examining a hypothetical comparing the treatment of members in an LLC with similarly situated stockholders in a corporation. Both the LLC and the corporation have there are two owners. In all cases, the owners receive payments bi-weekly for the services they render to the business, but the LLC owners receive the payments as guaranteed payments while the corporate shareholders receive the payments as salary. The payments are in all cases reasonable for the services rendered. On January 1, 1997, both the LLC and the corporation become technically insolvent. However, in both cases, the owners determine to press on with their respective businesses. Unfortunately, by December it is apparent that neither business is viable. Accordingly, both business file for bankruptcy on December 31, 1997. Because the LLC act under which the LLC was formed had a “wrongful distribution” provision the two members will likely have to disgorge all of the monies paid to them during the year, while the stockholder’s in the corporation will not have to do so. Furthermore, under some statutes members who approve “wrongful distributions” may be liable to creditors for the amounts paid. Thus, if the facts given in the hypothetical change slightly and the LLC has as members the spouses of the two members, the spouses may be liable for the wrongful payments as well. 6.2. The Historical Roots of the Problem. 6.2.1. LLC statutes are often a blend of corporate and partnership statutes. Typically, corporate statutes had “wrongful distribution” provisions designed to protect creditors from corporations draining their assets through dividend distributions. 6.2.2. When LLC statutes were initially drafted, these creditor protective mechanisms were borrowed wholesale from various corporate statutes. Drafters (including this author) failed to recognize the difference in the Page 25 relationship between an owner performing services for a corporation and an owner performing services for an LLC. 6.2.3. In the corporate context, the owner will likely be an employee, with taxes being withheld from wages paid on a regular basis. 6.2.4. As noted in 3.1.2., payments to LLC members are likely not to be as clearly denominated as being compensation payments. Moreover, LLC statutes may take the position that distributions are distributions regardless of how the payments are denominated. 6.2.5. LLP’s typically do not present similar problems. The reason is that statutory provisions which allow the creation of LLPs have been engrafted onto either the Uniform Partnership Act or an earlier iteration of the Revised Uniform Partnership Act. Since general partners had historically been jointly and severally liable for partnership debts, these statutes did not need and did not contain wrongful distribution provisions. 6.3. Sanitizing Payments to Members. 6.3.1. In states which have broad-brush wrongful distribution provisions, the LLC should provide, either by a separate agreement or by explicit provisions contained in the operating agreement, that the member will receive a “salary” that the LLC and the member will treat as a guaranteed payment under IRC §707(c). Ideally, the agreement or written provisions should recite that payments are being made for specifically denominated services and not to the member in the member’s capacity as a member. 6.3.2. Even if an LLC payment to a member for services has to be disgorged, the recipient of the payment may still have a quantum meruit claim for compensation equal to the distribution. In such a case, the member should be able to assert a third-tier priority claim under Bankruptcy Code section 507(a)(3) for compensation to the extent of the value of the services rendered within the 90 day period preceding the earlier of the filing of the bankruptcy petition or the cessation of the debtor’s business. There is, however, a cap of $4,000.00. 6.3.3. A better solution might be to form the LLC under a state statute which does not have a wrongful distribution provision. Page 26 7. SELF-EMPLOYMENT TAX . 7.1. Background. 7.1.1. PLR 9432018. In August of 1994, the Service addressed the selfemployment issue for the first time in the context of LLCs. PLR 9432018 discussed a partnership which was converting to LLC status. The LLC in question was to be engaged in the performance of professional services. The LLC’s state of organization (known to be Colorado) required the business and affairs of an LLC to be managed by managers. The ruling noted, however, that all of the members would be actively engaged in the LLC’s business. After concluding that the LLC qualified as a partnership, the ruling made short-shrift of any argument that § 1402(a)(13) would apply to a member’s distributive shares of the LLC’s income. It found: The language at the beginning of § 7701(a) of the Code provides that the definitions of “partnership” and “partner” contained in § 7701 apply when used in Title 26 . . . where not otherwise distinctly expressed or manifestly incompatible with the intent thereof. Section 1.1402(a)-2(f) of the regulations provides that for the purposes of determining net earnings from self-employment, a partnership is one which is recognized as such for income tax purposes. Therefore, the classification of the LLC as a partnership under § 7701 means that the members of the LLC will be partners for SECA tax purposes. Also, the members’ distributive shares of income are not excepted from net earnings from self-employment by § 1402(a)(13). Therefore, [the member’s] distributive share of the income and loss described in § 702(a)(8) from any trade or business carried on by LLC shall be includible in computing the [member’s] net earnings from self-employment . . . .” 7.1.1.1. PLR 9432018 provided comfort at the time it was issued to those who feared that the Service might routinely classify LLC members as limited partners regardless of their role in the operation of the LLC. However, the ruling actually may have swung too far in the other direction with its unqualified statement that “classification of the LLC as a partnership under § 7701 means that the members of the LLC will be partners for SECA purposes.” 7.1.2. PLR 9452024. In PLR 9452024, the Service analyzed the applicability of SECA in the context of an LLC which was to provide medical Page 27 services. In concluding that the distributive shares of the members of the LLC were subject to self-employment tax, the Service emphasized that the members would “engage in the daily activities” of the LLC and perform substantial services for the LLC. Thus, the Service focused on the nature of the economic relationship between the members and the LLC rather than relying on an analysis of whether the members were managers or had limited liability. 7.2. Self-Employment Tax Act (“SECA”) Taxes. 7.2.1. Currently, IRC § 1402(a) provides that an individual’s net earnings from self-employment for purposes of calculating the self-employment tax means “the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in § 702(a)(8) from any trade or business carried on by a partnership of which he is a member.” IRC § 1402(a)(13) excludes from this definition “the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in § 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.” 7.2.2. The problem currently presented for the Service (and taxpayers) is what is an LLC. Is a member of an LLC a general partner because he or she manages the operations of the company, like a general partner, or a limited partner because he or she has limited liability like a limited partner in a limited partnership. 7.2.3. In December, 1994, the I.R.S. issued Prop. Reg. § 1.1402(a)-18 (the “First Shot”) which attempted to answer this question and provides, as a general rule, that an individual’s net earnings from self-employment include the individual’s distributive share (whether or not distributed) of income or loss from any trade or business carried on by an LLC of which the individual is a member. Nonetheless, this proposed regulation would have a member of an LLC to be treated as a limited partner for the purpose of IRC § 1402(a)(13) if (i) the member was not a manager of the LLC, (ii) the LLC could have been formed as a limited partnership rather than an LLC in the same jurisdiction, and (iii) the member could have qualified as a limited partner in that limited partnership under applicable law. Page 28 7.3. Unanswered Questions--The First Shot left numerous questions unanswered. 7.3.1. It did not define the term “management decisions.” Are management decisions day-to-day decisions; are they board of director-like decisions; or does this term include both types of decisions? Under the Revised Uniform Limited Partnership Act, adopted in most states, even limited partners may participate in major decisions without jeopardizing their status as limited partners. Thus, there does not seem to be any reason why a member who does not take part in day-to-day operations should not be able to vote on major decisions without becoming a manager and, thus, liable for self-employment taxes. 7.3.2. Second, the First Shot did not address the status of a member who holds membership interests in different capacities. For example, assume that a member has both a voting interest, which gives the member exclusive continuing authority to make all decisions concerning the LLC, and also a non-voting interest. May that person treat the distributive share with respect to his or her voting interest as self-employment income but avoid self-employment taxes on his or her non-voting interest? As noted above, it appears that, in a limited partnership, one could achieve this result by being both a general partner and a limited partner. Members of an LLC should be able to achieve the same result. 7.3.3. Finally, the First Shot did not deal at all with the fact that a member’s distributive share may be derived both from the member’s performance of services and from the member’s investment of capital. Rather, the bedrock of the First Shot appeared to be that if the member has the right to make management decisions, then his or her distributive share will be self-employment income, and that if he or she does not have the right to make management decisions, then his or her share will not be selfemployment income. 7.3.4. This last issue highlighted the fundamental weakness in the First Shot. It focused on voting rights as the indicia of whether a person is active or passive and thus, subject or not subject to self-employment taxes, rather than focusing on the performance of services by the member. However, this focus could have potentially lead to illogical results. For example, a member who works full time for the LLC but who has no right to make “management decisions” presumably would not have to had paid selfemployment taxes on his or her distributive share, while a member who does not actually work for the LLC but makes all of the decisions would be subject to self-employment tax. Page 29 7.4. The New Proposed Regulations. On January 13, 1997, the I.R.S. withdrew the First Shot and issued new proposed regulations. These proposed regulations (which are attached as Appendix B) are broader in scope. Rather than address merely the application of the SECA tax issues in the context of LLCs, the proposed regulations would modify Treas. Reg. §1.1402(a)-2 with respect to the definition of the term “limited partner.” In essence, a partner’s income would be subject to SECA tax if: 7.4.1. He or she has personal liability for the debts of or claims against the partnership because he or she is a partner; 7.4.2. He or she has authority to contract on behalf of the partnership; or 7.4.3. He or she participates in the partnership’s trade or business for more than 500 hours each year. 7.4.4. All income to partners in service businesses (i.e., law, accounting, medicine, architecture, etc.) would be subject to SECA tax. 7.4.5. If an individual had two classes of interest, his or her income could be bifurcated if, for instance, once class was clearly akin to a traditional limited partnership interest. 7.4.6. Finally, if a partnership has only one class of interest, but one or more of the partners have SECA income due to the application of the 500 hour test, income which is not attributable to services rendered (i.e., income that does not constitute a guaranteed payment under I.R.C. §707(c)) will not be subject to SECA. 7.5. Stop in the Name of Congress. As part of the Taxpayer Relief Act of 1997, the IRS was forbidden to issue any regulations relating to the definition of a limited partner for self-employment tax purposes until July 1, 1998. This has cast a giant shadow over whether the second iteration of the regulations will ever be finalized in their current form. The proposed regulations had been the target of Congressional Republicans who referred to the regulations as a “stealth tax” which would impose de facto tax increases on small businesses. Inconsistent Treatment of LLCs v. S Corporations. Neither the First Shot or the Second Shot addressed the potential inconsistent treatment of one-member LLCs and S corporations. 7.6.1. For instance, both sets of proposed regulations would have made all income from LLCs subject to SECA tax, unless the income from the activity that generated the tax was itself exempt from SECA. Page 30 7.6. 7.6.2. In the context of one shareholder S corporations, the approach is markedly different. First, there can be a bifurcation of the income of the business into salary, which is subject to FICA, and dividends, which are not subject to either FICA or SECA. Second, while the Service may show that what the taxpayer has categorized as dividends are really payments compensating the taxpayer for services rendered, thus subject to FICA, the question is inherently factual, thus giving one a good deal of planning flexibility. 7.6.3. Recently, the Staff of the Joint Committee on Taxation prepared a report entitled Options to Improve Tax Compliance and Reform Tax Expenditures. (A link to the report and my comments to the FICA/SECA tax proposal can be found at: http://snipurl.com/dgo4.) The Report proposed a three-part reform package. 7.6.3.1. First, all partners of any type of partnership, general, limited, or LLC, would be subject to self-employment tax on their share of self-employment income. This general rule would be subject to a carve-out for certain specified types of income or loss, such as certain rental income, dividends and interest, certain gains, and other items. However, income from service partnerships, described by the report as being partnerships substantially all of whose activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, would be entirely subject to SECA. Second, the general rule would be further blunted in the case of a partner who did not materially participate in the business of the partnership. In such a case, only that portion of that partner's income that represented reasonable compensation for the services the partner actually rendered to the partnership would be subject to SECA. Finally, in the most radical departure from current law, S corporation shareholders would be treated for all employment tax purposes as partners. That is, instead of being subject to FICA, they would be subject to SECA. More importantly, unless they did not materially participate in the business of the corporation, all of their income from the corporation (subject to the source Page 31 7.6.3.2. 7.6.3.3. limitations noted above) would be subject to SECA. Thus, S corporation shareholders could no longer engage in audit roulette by taking an aggressive position and hoping that the Service would either not challenge the position or that they could compromise with the Service if it did raise a challenge. The change to the manner in which employment taxes are imposed on S corporation shareholders would be coupled with an end to all income tax withholding for these individuals. In other words, they would not be treated in any way as employees for federal tax purposes. 7.6.4. A good review of the current state of the law and proposals to reform the law can be found in Self-Employment Taxes and Passthrough Entities: Where Are We Now?, by David C. Culpepper, et al. The article can be found and downloaded at http://ssrn.com/abstract=823045. 8. THE AT-RISK RULES, IRC §465. 8.1. General Principles. 8.1.1. Under IRC §465(a) an individual’s loss from any activity is limited to the amount that he or she has “at risk” with respect to the activity. 8.1.2. Under IRC §465(b), an individual is only at risk with respect to any activity to the extent that the individual has contributed money or property to the activity and the amounts borrowed with respect to the activity. 8.1.3. IRC §465(b)(2)(A) provides that an individual is considered at risk with to the extent that he or she “is personally liable for repayment of amounts” borrowed to finance the activity. 8.2. Applicability to One Member LLCs. 8.2.1. Treas. Reg. §1.456-27(b)(5), which deals with qualified recourse financing, states that the principles “similar” to those regarding non-recourse financing to partnerships will be applicable to one-member LLCs. The regulation then gives an example of a one-member LLC that holds real property and property that is incidental to the holding of real property, but no other assets. The LLC then borrows money with respect to which the sole member is not liable. The illustration concludes that the Page 32 liability is “qualified non-recourse financing” to the extent that the other requirement pertinent to non-recourse financing are met. 8.2.2. This raises a potentially troublesome problem. Assume that, instead of being engaged in real estate, the LLC were involved in the manufacture and sale of widgets. In such a case, the sole member of the LLC would not be at risk with respect to accounts payable, except to the extent that his or her cash and other property was at risk. Presumably, if the LLC were on the accrual basis, the sole member would be at risk with respect to accounts receivable taken into income, but he or she would not be at risk with respect to the fair market value of the widgets manufactured and held in inventory. In a mature business, the at-risk rules would not present a problem. However, that might not be the case when a company is in the start-up phase and the ratio of accounts payable to other assets is higher. Page 33