The rising popularity of SMLLCs in tax and business planning.

• Author: Pace, Ryan H.
• Position: Single-member limited liability companies

Single-member limited liability companies (SMLLCs) have become popular in the past decade as taxpayers take advantage of opportunities presented by the check-the-box regulations. This article examines common situations in which SMLLCs are useful and identifies some potential pitfalls with their use.

A decade has now passed since the check-the-box (CTB) regulations became effective. (1) Tax and business planners have taken advantage of the flexibility provided by the regulations to structure a wide variety of transactions. Perhaps the most beneficial tax and business planning opportunity encouraged by the CTB regulations is the use of the single-member limited liability company (SMLLC). This article provides a brief overview of the law in this area, then discusses some common situations in which the SMLLC has become an entity of choice. It concludes by identifying some potential pitfalls regarding the use of SMLLCs.

State LLC Law

If an LLC is properly organized and operated, state laws afford liability protection to the LLC's owners. (2) State LLC laws also generally provide significant operational flexibility for LLCs that is not generally available to corporations. For instance, LLCs may be managed by one or more managers or by the members. In addition, state LLC laws are often not as stringent compared with corporate laws on shareholder and board meetings, etc., which may appeal especially to LLCs with few owners. (3) State laws also allow an LLC to have only one owner, a benefit not available to partnerships. (4)

With the favorable Federal income tax treatment and the flexibility afforded LLCs under state law, it is not surprising that the number being formed has increased significantly in recent years. For example, new LLC filings in Arizona increased from 32,662 in 2004 to 57,017 in 2006--a 75% increase over that period. (5) Other states have also experienced dramatic increases in LLC filings. (6)

CTB Regs.

The emergence of LLCs as a popular choice in the late 1980s and early 1990s was undoubtedly an important factor causing the IRS to closely examine how various entities should be taxed for Federal income tax purposes. The law on the tax treatment of entities at that time had evolved primarily from the Morrissey (7) case in 1935. In that case, the Supreme Court held that, if a business entity had at least three of the following four characteristics, it was taxed as a corporation for Federal income tax purposes: continuity of life, free transferability of interest, centralized management and limited liability for owners.

The CTB regulations changed the entity-classification system dramatically. Under Regs. Sec. 301.7701-3(a), by default, an entity incorporated under state law is taxed as a corporation. Further, an entity not incorporated under state law is generally taxed as a partnership if it has more than one owner and as a "disregarded entity" (DE) if it has only one owner. The alternative to the default classification for unincorporated entities is to "check the box" on Form 8832, Entity Classification Election, to notify the IRS that the entity elects to be taxed as a corporation. Under Regs. Sec. 301.7701-2(a), the consequence of being classified as a DE is that the entity is treated as if it does not exist separately from its owner for Federal income tax purposes; the DE's sole owner reports all the entity's income, gain, loss, expense, etc., directly on the owner's tax return. As a result, an SMLLC is considered a "tax nothing" under the Federal income tax regulations if the LLC does not check the box to be treated as a corporation. Not surprisingly, taxpayers and their advisers have found many creative ways to use SMLLCs.

Real Estate

Investing

Real estate investors usually desire personal liability protection from their real estate activities. Moreover, investors that own more than one property usually want to isolate potential liability exposure for each property. Before the advent of LLCs, a real estate investor would generally have to form a corporation or limited partnership (LP) to gain personal liability protection. Of course, the disadvantage of a corporation is the double taxation of its income. Even an S corporation provides bruits that real estate investors may find prohibitive (e.g., the limit on eligible shareholders, one-class-of-stock requirement, gain recognition on the corporation's distribution of appreciated property and tax on excess net passive income). (8)

Partnerships also pose some potential problems. An LP must have at least two partners, with at least one serving as general partner. With an SMLLC, the investor not only gets liability protection but can also be the entity's sole owner. Unlike an S corporation, there is no limit on who can own an interest in an SMLLC.

Example 1: R, a real estate investor, wants to acquire two rental properties. R would also like to be protected from personal liability as to the properties and would like each property to be isolated from the other's liabilities. R forms two SMLLCs and places one property in each. R does not elect to check the box to have the SMLLCs treated as corporations for Federal income tax purposes. As a result of these transactions, R reports the SMLLCs' activities directly on his income tax return.

Like-Kind Exchanges

SMLLCs have evolved into an important part of Sec. 1031 deferred-exchange transactions. Under Sec. 1031(a)(3), once the taxpayer has disposed of the relinquished property, the taxpayer has 45 days to identify a replacement property and 180 days to acquire it. If the taxpayer receives property (including cash) in an exchange that is not of like kind, the Sec. 1031 gain-deferral provisions do not apply, according to Sec. 1031(b).Thus,"qualified intermediaries" (QIs) typically become involved, so the taxpayer does not directly receive nonqualified property from the buyer. (9) These QIs often accommodate the exchange by creating SMLLCs to receive cash and/or properties held as part of the deferred like-kind exchanges until the exchange is complete. The IRS has ruled that a like-kind exchange accommodator's use of a DE as titleholder to exchange properties will not disqualify the transaction. (10) At the...