Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
On the Difficulties of Taxing Disregarded Single Member
Limited Liability Companies as Corporations for Employment Taxes
As part of the so-called “check-the-box” regulations that became effective in 1996, Treasury provided that a single member limited liability company (LLC) would be treated as a disregarded tax entity unless the LLC elected to be taxed as a corporation. Many states have adopted a similar rule. However, newly adopted regulations have changed this rule for federal employment taxes, treating LLCs that are disregarded for all other tax purposes as corporations for the purpose of employment taxes. This Comment argues that the new employment tax regulation not only creates a hardship for many taxpayers, but also ensures a conflict between federal and state tax law in some states.
All states and the District of Columbia now recognize LLCs. LLCs, like corporations, provide limited liability protection to their owners. However, unlike “C” corporations, which are subject to double taxation (first at the corporate level, then at the shareholder level), LLCs, unless they elect otherwise, are taxed only on the shareholder level.
LLCs are created by state law; the first such law was passed in Wyoming in 1977. The LLC business form grew in popularity because of the flexibility it provided. Because of the hybrid nature of the LLC model, however, there has been controversy over how it should be treated for federal tax purposes. Since 1996, Treasury has disregarded single member LLCs by default, but permitted taxpayers to elect (“check-the-box”) that a single member LLC be taxed as a corporation. However, Treasury recently adopted regulations requiring treatment of single member LLCs as corporations for purposes of certain tax obligations, including unemployment taxes, Social Security and Medicare taxes, and withheld employee income (“employment taxes”). Consequently, while single member LLCs can elect to be taxed as corporations, those that are disregarded for most tax purposes will still be taxed as corporations when assessing employment-related taxes.
These new regulations were highlighted in a recent Second Circuit decision, McNamee v. Department of Treasury. In McNamee, the taxpayer was the sole owner of a disregarded Connecticut LLC that had employment tax deficiencies for the years 2000 and 2001. The LLC had gone out of business, and the Service assessed the deficiencies against the taxpayer directly. The taxpayer challenged the validity of the check-the-box regulations that permitted him to elect to have the LLC disregarded for tax purposes, arguing that under both Connecticut law and the Code, LLCs should be classified as corporations, whereby he would not have personal liability for the LLC’s tax deficiencies. The Second Circuit rejected both of these arguments, and upheld the validity of Treasury’s check-the-box regulations.
McNamee also challenged the regulations on the grounds that Treasury had proposed new regulations that would treat single member LLCs as corporations for the purpose of employment taxes, even if the LLCs were disregarded entities for other tax purposes. The court rejected this argument. These were merely proposed regulations, and proposed regulations that would reverse existing policy are not evidence that the current policy is unreasonable, if there is a reason for the change in policy. The court noted that McNamee could have elected for corporate treatment of his LLC, but did not.
The proposed regulations at issue in McNamee have since become final. Under the final employment tax regulations, McNamee would have had limited liability protection for the employment taxes owed by his LLC regardless of whether he elected corporate status for other tax purposes. The McNamee court did not address whether the Service might find McNamee liable for those taxes due to his role as a corporate officer, but such liability would require a showing that the taxes were “willfully” withheld.Part I of this Comment reviews the history of LLCs and their tax treatment. Part II examines the recently adopted employment tax regulations and Treasury’s reasons for making those changes. Part III examines the negative effects created by the new regulations. Finally, Part IV proposes a way to revise the regulations to resolve those negative effects.