LLC may limit choice of accounting method.

• Author: Kolk, J. Michael
• Position: Limited liability company

As more and more states enact limited liability company (LLC) statutes, the attention directed at these entities has become more focused. One aspect that seems to be ignored by both the tax professional community and the IRS is that LLCs in many states technically may be required to report income using the accrual method of accounting. Although the practical results seem to skirt this issue, there is a potential pitfall which, in theory, could be retroactively used against LLCs to force use of the accrual method. This could be particularly troublesome for service businesses traditionally using the cash method.

Sec. 448(a)(3) provides that a tax shelter shall not be allowed to compute taxable income under the cash-basis method of accounting. Sec. 448(d)(3) defines a tax shelter in part as a non-C corporation enterprise that at any time had been offered for sale in an offering "required to be registered" with any Federal or state agencies regulating the sale of securities. This definition is further expanded by Temp. Regs. Sec. 1.448-1T(b)(2), which provides that an offering is "required to be registered" with a Federal or state agency if, under the applicable Federal or state law, failure to file an exemption notice would result in a violation of the applicable law (regardless of whether the notice is in fact filed).

The potential trouble caused by this provision was recognized soon after its enactment. The Sec. 448(d)(3) definition of tax shelter was amended to provide that an S corporation would not be treated as a tax shelter merely by reason of being required to file an exemption notice from securities registration if all corporations formed in that state are also required to do so. The amendment did not apply to limited partnerships and arguably does not apply to LLCs (even though only two states had enacted such statutes by 1987).

As more and more states permit LLCs to exist...