Jeffrey Glickman
  Andy Immerman
Jeffrey Glickman   Andy Immerman
Unexpected Pitfalls in Using LLCs

How state tax treatment can complicate tariff consequences of M&As and business restructurings involving LLCs operating in multiple states.

August 12, 2010
by Jeffrey Glickman, JD and Andy Immerman, JD

The advent of the limited liability company (LLC) has in some ways simplified numerous transactions, both domestically and abroad. The LLC can combine liability protection to all owners, with passthrough tax treatment (if passthrough tax treatment is what the owner wants), even if the LLC does not qualify as an “S” corporation. However, LLC's continue to present pitfalls, a few of which are described here.

The Partnership/LLC Becomes a Disregarded Entity

Rev. Rul. 99-6, 1999-1 C.B. 423, is one of those rulings that is actually relevant to most tax practitioners' work on a regular basis: What happens when one person purchases all of the interests in an LLC that has been classified as a partnership? It ruled:

  • If one member sells its interests to the other member, which becomes the sole member:

    1. The partnership terminates;
    2. The seller is treated as selling their interest in the partnership to the buyer;
    3. The buyer is treated as if they received their share of the partnership property in a partnership liquidation and bought the rest of the property from the seller.

This gives the buyer split treatment of the assets — part carryover and part purchased. However, the seller’s treatment does not correspond to the buyer’s. The seller is treated as if they sold their membership interest even though the buyer is not treated as acquiring a partnership interest.

  • Similarly, if all members sell their interests to a third party, the members are treated as selling partnership interests while the third party is treated as buying assets.

When a partner receives a distribution from a partnership it must report as gain any cash (and sometimes marketable securities) received in excess of its basis in its partnership interest. In the deemed liquidation in the first case above, the buyer will receive an undivided interest in all the LLC assets deemed distributed, including cash. If the buyer has low or no basis it could recognize income. Perhaps this could be avoided by having the LLC distribute all of the cash to the selling member prior to the sale, but the problem needs to be considered.

Shifts in Classification

If an eligible entity (such as an LLC) that has been treated as a partnership elects under the federal tax rules to be treated as an association, the partnership is deemed to contribute its assets for the stock of a new corporation and is deemed to distribute the stock to its partners in liquidation (of the partnership). Reg. 301.7701-3(g)(1)(i). Many states now permit partnerships or LLCs to convert directly into corporations by means of a simple filing with the Secretary of State. The IRS treats such a state law conversion the same as an entity electing tax treatment as a corporation. Rev. Rul. 2004-59, 2004-1 C.B. 1050. But if the entity wants to do the transaction "longhand," it has three choices: actually contribute the assets for stock and then liquidate (the same as on an election); liquidate first and have the partners create the new corporation; or contribute the partnership interests to a new corporation and then liquidate. Rev. Rul. 84-111, 1984-2 C.B. 88. One downside of liquidating first and then incorporating is that the liquidation could expose the partners to personal liability for obligations they are deemed “assumed” on the liquidation. An advantage of the elective approach is that the LLC can stay in place for state law purposes.

Late Election

Under Reg. 301.7701-3(c) the change of status treatment can be made retroactive to 75 days before the day the election is filed. The date of mailing seems to count as the date of filing, but that is not entirely clear. Assuming an election is timely, the old entity is deemed to terminate at the end of the day before the effective date — which is the date of filing if an earlier date is not selected — and the new entity is deemed to start at the beginning of the effective date. Proof of mailing date is important. Many taxpayers miss filing on the date they need the election to be effective or within 75 days thereafter. Procedures are available, however, for recognition of certain late elections. See Rev. Proc. 2009-41, 2009-39 IRB 439.

Foreign Eligible Entities

Remember that the default classification for foreign eligible entities (i.e. those that are not corporations per se) depends on whether the owners all have limited liability and if so, then it is an association; if not it is a partnership or a disregarded entity — in contrast to the default classification for domestic entities as partnerships or disregarded entities. Reg. 301.7701-3(b).

State Tax Issues

The use of LLCs can give rise to varying — and sometimes unexpected — state tax treatment and can often complicate the state tax consequences of mergers, acquisitions and business restructurings involving LLCs operating in multiple states:

  1. With regard to the federal classification rules, almost all states conform for income tax purposes. Some states, however, have enacted a business activity tax that is not based on net income (e.g., Ohio's Commercial Activity Tax and Texas' Franchise Tax). In these states, an LLC may be considered a taxable entity regardless of its classification for federal income tax purposes. See e.g., Ohio Rev. Code Ann. § 5751.01(A), (D); Tex. Tax Code Ann. § 171.0002. In addition, while states generally do not apply the federal classification rules for taxes other than income taxes, there are a few states that, for purposes of non-income taxes, conform to the federal classification rules or provide a specific classification rule. See e.g., Ala. Code § 10-12-8(b); N.Y. Tax Law § 2(5); S.C. Code Ann. § 12-2-25(B).
  2. Some states treat LLCs differently from other business entities, for no apparent reason. For example, New York provides a safe-harbor exclusion from sales tax for transfers of tangible personal property pursuant to corporate mergers; however, the rules are silent regarding LLC mergers. See N.Y. Tax Law § 1101(b)(4)(iv). This inequality is particularly troublesome in states, like New York, whose LLC statutes don't permit an LLC to re-domesticate (i.e., change its state of formation) via a simple re-domestication or conversion statute where the re-domesticated LLC would be treated as a continuation of itself. Typically no sales or other transfer taxes would apply in that case since no transfer of assets has taken place. Instead, a taxpayer may be forced to merge LLCs in order to effect the re-domestication, giving rise to potential New York sales tax liabilities. Therefore, taxpayers should be thoughtful about forming an LLC in a state, like Delaware, that provides flexibility to effect a variety of potential transactions.

Imposition of Unlimited Sales-and-Use Tax Liability

Finally, while almost all states have responsible person/officer statutes for unpaid sales and use taxes, beware that New York's statute seems to impose unlimited sales-and-use tax liability on each member of an LLC, regardless of whether that member is an active or passive investor. See N.Y. Tax Law §§ 1131(1), 1133(a).

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Jeff Glickman, JD is a partner in the State & Local Tax Group. His practice focuses on multistate tax planning and business transactions. Glickman advises clients on the state tax issues associated with sophisticated information technology sourcing arrangements. L. Andrew Immerman, JD is a partner in Alston & Bird’s Federal Income Tax and International Tax Groups. Immerman is a frequent author and speaker on domestic and international income tax topics.