State tax pitfalls for LLCs.

• Author: Burton, Elizabeth
• Position: Limited liability companies

Since January 1997, when the Federal "check-the-box" regulations went into effect, limited liability companies (LLCs) have proliferated, allowing newly formed LLCs to elect their Federal tax classification and clarifying the tax status of single-member LLCs (SMLLCs).

The old "four factor" test--continuity of life, centralized management, limited liability and free transferability of interests--has been discarded for Federal purposes. If the entity elects to have the LLC treated as a partnership (i.e., does not check the box), it is treated as if it were a flowthrough entity.

This choice has been viewed as very beneficial to companies. The LLC has become the solution to the business community's search for a way to combine the passthrough tax aspects of a partnership with the limited liability protection of a corporation. With a few exceptions (such as Texas and Michigan), the states have gradually conformed to the check-the-box regulations. The majority of the states will follow the Federal entity classification selected by the corporation for state income tax purposes.

The picture is not so clear, however, when other state taxes are involved. For instance, a number of states levy both income and franchise taxes on corporations. The franchise tax is based on net worth or capital values. It is not clear that the states will use the Federal entity classification for franchise tax purposes. Pennsylvania, for example, will follow the Federal check-the-box regulations for an LLC and will accept partnership treatment for corporate net income tax purposes, but will tax the LLC as a corporation for franchise tax purposes.

This raises a further complication. If a corporation is a multistate corporation, it must determine its Pennsylvania income by using an apportionment formula. For purposes of the income tax, the state will include the factors (property, payroll and sales) of the LLC in the parent company's apportionment formula. But how does the franchise tax fit into this formula? Will the states include an LLC's factors in the parent company's apportionment formula? They should not, because the LLC will be taxed separately, using its factors in its own apportionment formula. There are no rules or regulations that address this question; a company in this situation will have to make its own compliance decision.

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