Key LLC issues and answers.

• Author: Cochran, Carol Mayo
• Position: Limited liability companies

EXECUTIVE SUMMARY

While the use of limited liability companies has become more widespread, as evidenced by the enactment of LLC legislation in almost every state, the Federal tax treatment of such entities and their members has been defined only in very limited ways. Questions such as the ability of LLC members to use passive activity losses, the computation of at-risk basis and the taxability of single-member LLCs remain unanswered. This article analyzes the law in these and other heretofore unexplored areas and proffers guidance.

With the recent adoption of limited liability company (LLC) legislation in Massachusetts, 49 jurisdictions (including the District of Columbia and excluding Hawaii and Vermont) now legally recognize LLCs. In comparison with the use of an S corporation, although the proposed S Corporation Reform Act(1) (SCRA) recommends liberalization of the S requirements, LLCs continue to offer members the advantages of (1) increased basis for entity-level debt, (2) a step-up in the basis of LLC assets on the taxable transfer of an interest and (3) multiple levels of participation. The SCRA does not contemplate such benefits; thus, when combined with the feature of limited liability, the LLC becomes an attractive option for many business ventures.

Although the IRS has published some guidance regarding LLCs in the form of revenue rulings and proposed regulations, most ruling requests ask whether the LLC is a partnership for tax purposes(2); seldom are the tax aspects of practical and operational issues addressed. Even when much-needed direction is provided (e.g., whether LLC income is earnings for self-employment (SE) tax purposes), many unanswered questions remain.

This article addresses some of the key operational tax issues pertaining to LLCs, focusing on areas for which specific guidance is not yet available: passive activities, at-risk basis calculations, taxability of single-member LLCs and other matters; state tax considerations are also discussed.

Background

The LLC concept originated in Germany in 1892. Although the U.S. did not pass LLC legislation until 1977, many foreign countries based their LLC laws on a common-law provision enacted by Pennsylvania in 1824. Germany's law served as the model for businesses in Europe and Latin Amrican that adopted the LLC form of entity ownership.(3) Foreign LLCs share the basic characteristics of limited liability, dissolution on a member's death, controlled admission of new members and recognition as a separate legal entity.

In 1977, Wyoming passed the first LLC legislation,(4) followed by Florida in 1982.(5) However, LLCs were not considered viable entities until the IRS ruled that they would be taxed as partnerships rather than corporations.(6) Accordingly, LLCs combine the unique benefits of limited liability with flowthrough taxation to members.

Comparison With Other Types of Entities

LLCs are an attractive alternative to partnerships and corporations, because they provide limited personal liability to members with a single level of tax; in contrast, general partners have personal liability for partnership debts, while limited partners cannot participate in partnership management without jeopardizing their limited liability. Unlike partners, LLC members can participate in the entity's management without risking loss of limited liability. While S corporations limit the number and type of shareholders, LLCs have no such limits. Additionally, because LLCs are treated as partnerships for tax purposes, LLC members receive various tax advantages not available to S corporation shareholders, such as: a basis increase for their share of certain LLC liabilities, special allocations of income and expenses, and the ability to elect to step up the basis in LLC property to reflect the outside basis in membership interests. Finally, while C corporations impose a double tax on corporate earnings distributed to shareholders, LLCs pass through to members items of income, gain, loss, deduction and credit.

LLCs are flexible in that they permit any economic or management-sharing relationship desired; LLC operating agreements can establish preferred interests, special allocations or other forms of ownership. All LLC statutes characterize a member's interest in the LLC as personal property and permit the assignment of an economic interest in the LLC to third parties; however, third-party transferees cannot become LLC members without the consent of other members, under either the LLC's operating agreement or state statute.

In ruling on whether an LLC is treated as a partnership for tax purposes, the IRS applies the entity classification criteria of Regs. Sec. 301.7701-2. Under that regulation, an unincorporated business is a partnership for Federal tax purposes only if it lacks at least two of the four major corporate characteristics--limited liability, continuity of life, centralization of management and free transferability of interests. By definition, all LLCs have limited liability; a given LLC must lack two of the remaining three criteria to achieve partnership status and tax treatment.

SE Tax Considerations

Sec. 1401 imposes Social Security and Medicare taxes on SE income; Sec. 1402(a) provides that net earnings from SE include the gross income derived by an individual or partner from any trade or business. Sec. 1402(a) (13) excludes a limited partner's distributive share of any item of income or loss from SE income, although guaranteed payments to limited partners are included in such income under Regs. Sec. 1.1402(a)-1 (b); this rule was originally intended to prevent passive investors in limited partnerships from including investment income in Social Security earnings.

Recently issued Prop. Regs. Sec. 1.1402(a)-18(7) addresses the determination of SE earnings for certain LLC members and clarifies whether an LLC member will be treated as a limited or general partner; the latter is helpful in that the Code, regulations and rulings do not define those terms. An LLC member is treated as a limited partner whose distributive share of partnership income is excluded from SE earnings if (1) the member is not a manager and (2) the entity could have been formed as a limited partnership rather than an LLC in the same jurisdiction and the member could have qualified as a limited partner (the exclusion test). Prop. Regs. Sec. 1.1402(a)-18(c) (3) defines a "manager" as one who (alone or together with others) is vested with the continuing exclusive authority to make the management decisions necessary to conduct the business for which the LLC was formed. According to the preamble to the proposed regulations, the exclusion test is intended to ensure that a business operating through an LLC cannot obtain a better result for SE tax purposes than would be available by operating as a limited partnership, because some states prohibit the conduct of certain activities through limited partnerships.

The proposed regulations are helpful in addressing the classification of SE earnings for LLC members, but numerous questions remain. Are members managers if they have the power to elect managers? Can management authority be waived without jeopardizing an LLC member's treatment as a limited partner? Will management authority be imputed to LLC members who do not use it? If a partnership recently converted to an...