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Important Developments for Limited Liability Companies

The Limited Liability Company (LLC) is an entity that has become very popular -- for good reason. The LLC offers a combination of very favorable business and tax attributes which previously were not available in a single entity. Because of this increasing popularity, there are several new pieces of legislation under consideration relating to LLCs right now. Here we'll take a look at some of them.

"Check the Box" Approach Under Study

Obtaining partnership classification for an LLC can be complex and impede the operations of the company. Moreover, an error in this area would have serious ramifications because the entity would be considered a corporation and subject to double taxation. It could even result in loss of an S election if an S corporation were a member owning more than 79% of an LLC. In March 1995, the Treasury Department issued Notice 95-14 proposing a check the box procedure to deal with these problems. Under the check the box approach, members of the LLC can elect whether they desire partnership or corporate status. This approach is currently under study, and we will let you know when any further developments happen.

Revenue Ruling Covers Conversion Process

In general, it is beneficial to convert an entity from partnership form to LLC form. The IRS, in recently issued Revenue Ruling 95-37, states that the conversion from a partnership to an LLC is tax free. Prior to this ruling, the only authority that existed specifically for LLCs were private letter rulings addressed to specific taxpayers.

You should note, however, that although conversion from a partnership to an LLC is tax free, under certain circumstances a conversion could result in shifting liabilities from one partner to the other under the partnership rules. Shifting liabilities is considered a distribution of cash and is taxable.

Revenue Ruling 95-37 further provides that conversion from partnership to LLC does not result in closing the entity's tax year or in termination of the entity. Furthermore, the LLC will continue to use the partnership's employer identification number. Essentially, for tax purposes everything continues as if nothing happened other than a change in the entity's nature. Converting a corporation's assets, including intangible assets, do not have value in excess of both book value and shareholder's basis in stock. Because of the adverse tax consequences, typically neither C corporations are converted to LLCs. However, in specialized circumstances (i.e., and "S" corporation owns real estate worth less than its carrying value) LLC conversion can create ordinary losses that the shareholders can deduct on their individual income tax returns.

Self Employment Tax

The IRS has recently issued regulations in proposed form providing guidance on applying the self employment tax to LLCs. Limited partners of a partnership, except for guaranteed payments for the performance of services, are not subject to self employment tax on their allocable share of partnership income. This is because it is assumed that general partners perform services while limited partners do not.

Confusion existed as to the application of the self employment tax to LLCs and its owners (members). The newly proposed regulations alleviate a great deal of this confusion. Under the proposed regulations, a member is subject to self employment tax with respect to his or her allocable share of income. However, if the LLC is manager-managed, the income allocable to the nonmanager member is not subject to self employment tax if two conditions are met:

1. The LLC could have been formed as a limited partnership in the same jurisdiction.
2. The member could have qualified as a limited partner had the entity been formed as a limited partnership.

Issue of Single-Member LLCs Unresolved

A number of states, such as New York, permit single-member LLCs.The IRS has not resolved whether or not a single-member LLC may be classified as a partnership for tax purposes. Because common thought holds that a partnership must have associates -- meaning more than one-- there is risk that a single-member LLC will be classified a corporation until this issue is resolved by the IRS.

A favorable resolution of this issue would add significant flexibility. For example, individuals operating a single owner business would be able to use an LLC without having to resort to bringing in a second owner. Furthermore, S corporation might be able to form wholly-owned LLCs which would provide liability protection but would be considered divisions for tax purposes. Currently, however, it is our belief that an individual may take on tremendous tax risk if an LLC is set up with a single member.

These are just a few of the developments currently being debated in the LLC arena. If you have any questions about these, or any other developments please call our office. We will be happy to explain how these proposals may affect your business.