Are You Exposed? Considerations When Funding a Single-Member LLC Published July 26, 2016
Lenders frequently ask about the differences between a limited liability company’s (LLC’s) tax consequences and its exposure to liability. The question usually takes the following form: “I have a client that operates as an LLC. My client has personal 1040 liability stemming from income generated by the LLC that passed through to my client (on a 1040 schedule C for a sole proprietorship or through the 1065 partnership return to the K-1 to the 1040 return for a partnership). Can the IRS levy the LLC’s receivables when pursuing collection of the personal liability?”
Even though a single-member LLC or multi-member LLC may be taxed as a sole proprietorship or partnership, respectively, it is not treated as a sole proprietorship or partnership for IRS collection purposes. The IRS generally cannot levy the LLC’s receivables to collect against the individual’s personal 1040 income tax liability.
When forming a business, the choice of entity (e.g., sole proprietorship, partnership, corporation, limited liability company, etc.) has significant implications for the business. This decision affects the owners or shareholders relative to filing requirements, tax consequences, and exposure to liability – and can impact the lender as well.
Specifically, the choice of entity will impact how the IRS can collect personal 1040 liabilities (and what assets are exposed). Generally, owners should avoid operating as a sole proprietorship or partnership. There is no distinction between the individual(s) and business. Since the assets and liabilities associated with the business are also the personal assets and liabilities of the owner(s), the IRS can pursue the accounts receivable to collect on the individual’s personal liability.
The LLC provides for additional protection, but exemplifies the complexities surrounding the choice of entity. The single-member LLC can be taxed as a sole proprietorship on a 1040 return or as a corporation on a 1120 or 1120S return. The multi-member LLC can be taxed as a partnership on a 1065 return or as a corporation on a 1120 or 1120S return. The confusion, at least for IRS collection purposes, stems from the fact that sole proprietorships and partnerships are considered “disregarded” or “pass-through” entities. Disregarded entities are distinct from their owners for some purposes, but not when it comes to taxes.
Even though the single- or multi-member LLC can be taxed as a sole proprietorship or partnership, the rule is different for collection. The IRS cannot pursue an LLC’s assets (or a corporation’s, for that matter) to collect an individual shareholder or owner’s personal 1040 federal tax liability. In short, the LLC (or corporation) has a separate and distinct taxpayer identification number from that of the individual (EIN vs SSN). Even though an LLC may be taxed as a sole proprietorship or partnership, state law indicates the taxpayer/LLC owner has no interest in the LLC’s property. The LLC is treated differently for taxation than for liability and collection.
The IRS’s chief counsel addressed the question of whether the IRS could satisfy the single-member owner’s tax liability from the disregarded LLC’s assets in a 2003 memo (Chief Counsel Advice 200338012, Jan. 1, 2003). Chief counsel reviewed the Supreme Court’s 1999 Drye decision, 528 U.S. 49 (1999), in which the Court articulated a two-prong test to determine a taxpayer’s property and rights to property.
Under the first prong of the Drye test, one looks to state law to determine a taxpayer’s interest. Generally, states conclude the taxpayer/single member owner has no interest in the LLC’s property. As such, the second prong of the test is irrelevant. “If under the first prong, a taxpayer has no interest in or rights to particular property under state law, it follows that the IRS has no right to levy the particular property under the Internal Revenue Code.” Thus, as a general rule, even though an LLC can be taxed as an entity disregarded as separate from the single- or multi-member owner, “for federal tax liability purposes, the IRS cannot satisfy the single member owner’s tax liability from the disregarded LLC’s assets.”
As with any general rule, there are exceptions. Depending on the facts and circumstances of the case, the IRS could determine that the LLC is an alter ego of the individual and/or assets were fraudulently conveyed to the LLC by the individual. Although the IRS’s use of an alter ego assessment is rare, the likelihood increases dramatically when there is commingling of assets.
Practice pointer: When funding an entity, verify that the LLC (or corporation) paperwork with the Secretary of State’s office is in good standing. If the Secretary of State requirements have not been met (e.g., annual reports filed or fees/taxes paid), the LLC’s charter or status could be revoked. If the LLC’s status is revoked by the Secretary of State, the business is operating as a sole proprietorship or partnership and the IRS can levy the business’s receivables to collect the personal 1040 taxes.
Please note: There are exceptions to all scenarios presented above and this should not be interpreted as legal advice. Should you have specific questions about your situation please feel free to contact us for a consultation.