71 The Alabama Lawyer 122 (2010). Disharmony in Alabama's Conformity to the Federal Tax Classification of Business Entities.

• Author: By James E. Long, Jr., James D. Bryce and Joe W. Garrett, Jr.

Alabama Lawyer

2010.

71 The Alabama Lawyer 122 (2010).

Disharmony in Alabama's Conformity to the Federal Tax Classification of Business Entities

Disharmony in Alabama's Conformity to the Federal Tax Classification of Business EntitiesBy James E. Long, Jr., James D. Bryce and Joe W. Garrett, Jr.Joe, the owner of a successful plumbing business operating as a sole proprietorship, is concerned that an accident or other job-related calamity may subject his personal assets to liability claims. Joe talks to his accountant, who advises him to consider operating his business through a limited liability company ("LLC"). Joe complains that he does not want to file separate income tax returns for his business. Joe's accountant assures him, however, that because he will be the single owner of his LLC, the LLC will be a disregarded entity ("DRE") for federal income tax purposes. Joe's income tax return preparation will remain the same as when he was conducting his business as a sole proprietor. Satisfied with his accountant's advice, Joe now comes to you, his lawyer, to help him transfer his plumbing business to an LLC. After the appropriate documents are drafted and executed, Joe asks you whether he needs to file his Alabama and local sales and use tax returns in his name (as he did before as a sole proprietor), or in the name of his new LLC. Instinctively, you advise Joe that his LLC should now make all filings, including sales and use, payroll withholding, personal property tax returns and business licenses, in the name of the LLC. You, of course, caution Joe that in order for his liability shield to be effective, he should observe all required formalities of conducting his business in the new LLC, such as preparing all non-income state and local tax filings in the name of the LLC.

Sound familiar? Many readers of this publication have undoubtedly counseled a Joe or Jane who needed guidance with respect to operating their business in an LLC, or perhaps a limited partnership or S corporation. Many will be surprised to learn, however, that for most (but not all) Alabama and local non-income tax purposes, your advice above was incorrect: a single-member LLC that is disregarded for federal income tax purposes is also generally disregarded for all Alabama and local tax purposes, including sales, use, payroll withholding and rental taxes.(fn1) Technically, Joe should complete his Alabama sales and use tax returns using his individual name and Social Security number because his LLC does not exist for Alabama sales and use tax purposes. In practice, however, many practitioners and taxpayers believe that a single-member LLC, or any other entity that is disregarded for federal tax purposes, is only treated as a DRE for Alabama income tax purposes. That understanding is indeed consistent with the general rule for most other states that impose a net income-based tax.(fn2)

While corporations are generally treated as separate entities for all federal and Alabama tax purposes,(fn3) what about other business entities that may be DREs, such as qualified subchapter S subsidiaries ("Q Subs"), which are wholly-owned subsidiaries of S corporations? How are these entities classified for Alabama tax purposes? Does it depend on the tax? This article summarizes the various classification rules applicable to pass-through business entities with respect to Alabama taxes, including income, sales and use, rental, property, payroll withholding, and business license taxes. This article also provides recommendations on legislative changes that would conform the classification rules to common practice and the general rule prevailing in other states, while preserving certain exemptions that exist under Alabama's current classification regime.

The central question in evaluating Alabama's classification regime is to determine which entities should be treated as separate taxpayers for purposes of the various Alabama taxes. This question arises primarily because the Internal Revenue Service ("IRS") in 1997 simplified the classification rules for business entities. The IRS did so by promulgating the so-called "check-the-box" ("CTB") regulations, which provide that for federal tax purposes, except in the case of per se corporations, an entity with two or more owners is classified as either a partnership or a corporation, and an entity with only one owner is taxed as either a DRE or a corporation.(fn4) Many practitioners assume that treating a single-member LLC as a DRE applies just to Alabama income taxes-to conform Alabama income tax rules with their federal counterpart, but that the same "disregarded" treatment does not apply to other state and local taxes, such as sales and use taxes and...