Tax Provisions in LLC Agreements
The tax provisions governing an LLC are typically found in its operating agreement. The extent and nature of the provisions will depend on whether the LLC is to be classified as a partnership, S corporation, or C corporation.
Assuming an operating agreement is adopted, it would not really need anything in the way of tax provisions. However, it may nonetheless be useful to set forth the intention to be classified as disregarded, and the manner in which employment and excise tax compliance will be handled (see discussion below).
LLC as C Corporation
In the case of an LLC classified as a C corporation, the operating agreement would likely not need much more in the way of tax provisions than is found in the typical certificate of incorporation and by-laws of a C corporation. In particular, there is no need for an article governing allocations of income among the members. Given the potential for confusion, however, it would be useful to make clear that the LLC will be classified as a C corporation for tax purposes and that the corporate tax laws will be complied with.
LLC as S Corporation
If the LLC is to be classified as an S corporation, the operating agreement would be expected to contain a provision expressing the intent to be an S corporation and the terms and provisions common to S corporations.
Initially, the LLC must satisfy all the requirements for being a "small business corporation" under IRC õ1361, including the single-class-of-stock requirement. Thus, the distribution rights (currently and on liquidation) of all membership interests must be identical. In this regard, both Delaware and Illinois LLC statutes provide, in the absence of a different scheme in the operating agreement, for property on liquidation to be distributed first to members in repayment of their capital contributions, and thereafter pro rata. 6 Del. C. õ18-804; 805 ILCS 180/35-10. Hence, unless all members contributed capital equally, the statutory liquidation scheme would not permit an S election. Thus, if an S election is to be made, the operating agreement should expressly provide that all distributions, including on liquidation, be pro rata. In addition, typical S corporation restrictions on transferring stock to ineligible shareholders (generally, any person other than a U.S. citizen or resident) may be included as well.
Since it is a flow-through entity, additional tax provisions related thereto are common, such as a requirement that the LLC provide K-1s to the members (possibly after input and feedback from members). As some states impose withholding taxes on S corporations in respect of nonresident stockholders, it may also be advisable to include a provision concerning compliance with any state withholding tax requirements.
LLC as Partnership
For an LLC classified as a partnership, it will typically have more extensive tax provisions, such as the following:
A partnership agreement typically contains one article specifying distributions to be made to the partners, and another article specifying the allocation of items of income, gain, loss, deduction, and credit to the partners for income tax purposes. It is important to grasp that these articles are separate and distinct in purpose and effect: one allocates distributions, the other only taxable income. Broadly speaking, the distribution article is the more important, as it represents the parties' "economic deal."
Unlike S corporations, partnerships afford a great deal of flexibility in allocating tax items among the partners, although that flexibility is not unlimited. IRC õ704 sets forth standards that must be met in order for an allocation of tax items among partners to be respected for tax purposes. It provides that a partner's share of tax items is determined by the partnership agreement, unless the allocation under the agreement does not have "substantial economic effect," in which case the partner's share is determined in accordance with the "partner's interest in the partnership." For example, these principles preclude allocating 99% of the taxable income to a tax-exempt partner that has only a 1% interest in the economic capital and profits of an enterprise. Nor could all losses be allocated to one partner and income to another while distributions are to be made equally.
Treas. Reg. õõ1.704-1 and -2 flesh out the IRC õ704 standards. Under the regulations, an allocation generally has "substantial economic effect" if it (i) has "economic effect" and (ii) such economic effect is "substantial." In general, "economic effect" means that the partner receiving a tax allocation of an item bears the corresponding economic benefit or burden of the item, and requires that the partnership agreement provide (i) for maintenance of capital accounts, (ii) that liquidating distributions be made in accordance with positive capital account balances, and (iii) that partners have deficit capital account restoration obligations. In general, economic effect is considered substantial if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences (thus, "shifting" and "transitory" allocations will not be respected). An LLC agreement adopting this approach must contain provisions for maintaining capital accounts in accordance with the regulations, as well as requiring liquidating distributions to be made in accordance with positive capital accounts.
Under the "partner's interest in the partnership" standard, a tax item will be allocated in accordance with the manner in which the partners have agreed to share the corresponding economic benefit or burden of the item, determined from all the facts and circumstances. Relevant factors include the partners' relative contributions to the partnership; the interests of the partners in economic profits and losses; the interests of the partners in cash flow and other non-liquidating distributions; and the rights of the partners on liquidation.
Special rules apply to items attributable to nonrecourse financing. If the financing is provided by a partner, then the items attributable thereto (e.g., depreciation) are allocated to that partner.
Otherwise, because risk of loss on property financed by nonrecourse debt is borne only by the unrelated creditor, allocations of deductions from the property among the partners cannot have economic effect. Such allocations must therefore be made in accordance with the partners' interest in the partnership. If the partnership otherwise complies with the substantial economic effect requirements, an allocation of nonrecourse deductions will be deemed to be in accordance with the partners' interest in the partnership if (i) it is reasonably consistent with the allocation of some other item from the property that has substantial economic effect, and (ii) gain from disposing of the property for an amount equal to the nonrecourse debt will be charged back to the partners in the same manner in which the nonrecourse deductions were allocated.
Substantial Economic Effect v. Independent Distribution and Tax Allocation Articles
Since the distributions article specifies the amounts actually distributed to the partners, it represents the "economic deal" between the partners. It is essential that the distribution article properly implement the partners' economic deal.
The substantial economic effect approach requires distributions to be made in accordance with capital accounts. The capital accounts are in turn determined by the tax allocations, which can be exceedingly complex. Under the substantial economic effect approach, then, an error in the tax allocations article goes beyond a misallocation of income among the partners for tax purposes, and could corrupt the actual distributions. Although the economic deal itself may be complex and difficult to encapsulate, tax allocations typically incorporate an additional layer of even greater complexity. Moreover, if distributions are determined with reference to tax-based capital accounts, those endeavoring to understand the economics of the operating agreement need to understand the tax allocations, which may not be possible for non-tax experts.
To reduce the risk that the economic deal will be skewed, as well as to enable non-tax people to understand the economic distribution scheme, one may consider divorcing the distribution scheme from the tax allocation scheme, and have each operate independently. On the other hand, this approach may increase the risk of an IRS reallocation of tax items, since it is outside the substantial economic effect safe harbor. In the end, the choice of approach may require a balancing, with some opting to "just make sure the cash comes out right." Note however that in some deals, special rules may mandate compliance with the substantial economic effect requirements. See, e.g., IRC õ514(c)(9)(E) ("fractions rule" applicable to certain deals between taxable and tax-exempt investors).
LLCs in M&A Transactions
Single Entity LLCs
A transfer of assets between a disregarded SMLLC and its owner is generally disregarded for income tax purposes. Where the owner of a disregarded SMLLC sells his or her entire interest in the SMLLC to another party, the transaction would be treated for federal income tax purposes as a sale and purchase of the underlying assets of the SMLLC.
If the owner of a disregarded SMLLC sells only a portion of his or her interest in the LLC to one or more buyers, the LLC converts to a partnership (assuming a corporation election is not made) since it would then have at least two owners. In that case, the original owner is treated as selling an undivided interest in the underlying assets to the buyer(s), immediately followed by a contribution by the parties of their respective shares in the underlying assets to the new partnership LLC under IRC õ721. See Rev. Rul. 99-5, 1999-1 C.B. 434. If a corporate classification election is made for the LLC, presumably the same deemed structural format would apply except that the contribution of assets to the new LLC corporation would be governed by IRC õ351.
If an existing disregarded SMLLC issues new interests to new members for consideration delivered to the LLC, then once again a partnership (or corporation) springs into existence since it then has multiple owners. Here, the original member is treated as contributing the LLC's pre-existing assets and the new members the new consideration to the new LLC partnership under IRC õ721 (or to the new LLC corporation under IRC õ351 if a corporate election is made). Id.
If one member of an existing LLC partnership buys all the other members' interest therein, the LLC partnership converts to a disregarded SMLLC since it then has only one member (unless it elects corporate status). In this case, a hybrid tax treatment is applied. The sellers are deemed to sell their interests in the LLC under IRC õõ741 and 751. However, on the buyer's side, the LLC is deemed to have liquidated, with the buyer receiving the share of assets attributable to its previously owned interest in liquidation of that interest and as purchasing the remaining shares of the assets from the sellers. Rev. Rul. 99-6, 1999-1 C.B. 432. If the buyer owned no interest in the LLC beforehand, the buyer would be treated as purchasing the entirety of the assets. Id.
A partnership (including an LLC) may combine by merger or other transaction with another partnership (including LLC), with the resulting entity continuing as a partnership (including LLC). In that case, the partnership merger regulations, Treas. Reg. õ1.708-1(c) would govern the tax treatment. A partnership (including an LLC) could also spin-off or split-up into two or more entities classified as partnerships (including LLCs), in which case the transaction would be governed by the partnership division regulations, Treas. Reg. õ1.708-1(d).
An LLC classified as a corporation can be organized, or merge or otherwise combine with another entity classified as a corporation, or split up into two or more corporate entities, or liquidate, under Subchapter C of the Internal Revenue Code just like a regular corporation formed under the corporation laws.
In addition, recent regulations under IRC õ368 have created a place for disregarded SMLLCs in corporate reorganizations as well. Under IRC õ368(a)(1)(A), a target corporation can merge directly into an acquiring corporation in a tax-free "statutory merger" reorganization. Under IRC õ368(a)(2)(D), the target corporation could also merge into a corporate subsidiary of the acquiring corporation in a tax-free forward triangular "statutory merger" reorganization. However, the IRC õ368(a)(2)(D) forward triangular merger has additional requirements beyond IRC õ368(a)(1)(A), in particular a requirement that substantially all the assets of the target be acquired.
Now, under Treas. Reg. õ1.368-2T(b)(1), a target corporation can be merged into a disregarded SMLLC owned by the acquiring corporation, which is treated as a direct IRC õ368(a)(1)(A) merger of the target into the acquiring corporation. Since this straight IRC õ368(a)(1)(A) merger format has fewer requirements than a forward triangular merger into a corporate subsidiary under IRC õ368(a)(2)(D), this can be a useful structure. For example, if the target has recently made or is concurrently making a substantial distribution of assets, such that it is questionable whether the substantially all requirement of IRC õ368(a)(2)(D) can be met, but a direct merger into the acquiring corporation is not desired as it will expose the acquiring corporation directly to target's liabilities or require a vote by the shareholders of the acquiring corporation, then a merger of the target into a disregarded SMLLC of the acquiring corporation may work beautifully.
FICA Employment Taxes
Chapter 21, Federal Insurance Contributions Act, of Subtitle C, Employment Taxes, of the Internal Revenue Code, imposes FICA employment taxes with respect to wages paid in an employment context. An employee is required to pay old-age, survivors, and disability insurance (Social Security) taxes equal to 6.2% of wages received up to a maximum base amount of wages ($94,200 for the 2006 tax year), and hospital insurance (Medicare) taxes equal to 1.45% of all wages received. These taxes are collected through withholding. The employer must also pay Social Security taxes of 6.2% on wages paid to the employee up to the base amount, and Medicare taxes of 1.45% on all wages paid. On a combined basis, the Social Security tax is 12.4% on the first $94,200 of an employee's wages, and the Medicare tax is 2.9% of all wages.
Chapter 2, Tax on Self-Employment Income, of Subtitle A, Income Taxes, of the Internal Revenue Code imposes as part of the income tax a tax on the self-employment income of self-employed individuals. This tax parallels the FICA taxes imposed in the employment context, and funds Social Security and Medicare for self-employed individuals. Under Chapter 2, an individual is subject to a 12.40% Social Security tax on self-employment income up to the same base amount as applies for FICA Social Security tax purposes ($94,200 in 2006), and a 2.9% Medicare tax on all self-employment income.
Self-employment income is generally defined as "net earnings from self-employment," which in turn is generally defined as-
the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member.
IRC õ1402(a). The term "trade or business" as used above has the same meaning as when used in IRC õ162 (relating to the deduction of ordinary and necessary business expenses), except that it generally does not include the performance of services by an individual as an employee. IRC õ1402(c). Rentals from real property, dividends, interest on corporate bonds, gains and losses from sales of property other than inventory, are generally excluded from self-employment income. IRC õ1402(a). Pensions and annuities are also generally not considered self-employment income. Rev. Rul. 58-359, 1958-2 C.B. 422.
Self-Employment Taxation of Partners
As noted above, a partner must generally include in self-employment income his or her distributive share under IRC õ702(a)(8) of income or loss from a partnership engaged in a trade or business. IRC õ702(a)(8) is the partnership's taxable income or loss, exclusive of items required to be separately stated (capital and IRC õ1231 gains and losses, charitable contributions, dividends, foreign taxes, and other items specified in Treas. Reg. õ1.702-1). Payments received by a partner for services rendered to the partnership or for the use of capital by the partnership that are determined without regard to the income of the partnership (i.e., guaranteed payments) are generally considered self-employment income. Treas. Reg. õ1.1402(a)-1(b). See also Rev. Rul. 69-184, 1969-1 C.B. 256 (bona fide partner in partnership is not an employee and remuneration received is not "wages" with respect to "employment" so FICA and FUTA taxes and withholding provisions do not apply). For purposes of the self-employment tax rules, a partnership is any entity, joint venture, or other arrangement classified as a partnership for federal income tax purposes. Treas. Reg. õ1.1402(a)-2(f).
A general partner's entire distributive share of a partnership's ordinary income may be much greater than the partner could expect to receive as salary in an employment relationship. For example, a general partner in a large and successful carpet cleaning business, which operates through a large staff of cleaning employees, might have a distributive profit share as a general partner of $1 million due to the entrepreneurial success of the business (including a return on invested capital) and the partner's status as an owner. In that case, the entire $1 million would be subject to the 2.9% Medicare tax even though the value of the general partner's actual personal services to the partnership for the year is only $100,000. But this would also be true if the individual conducted the business directly as an entrepreneur as well.
IRC õ1402(a)(13) excludes from self-employment income -
the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.
IRC õ1402(a)(13). Under this provision, a partner's distributive share attributable to a limited partnership interest is exempt from self-employment tax, and this is so even if the partner also has a general partnership interest or receives guaranteed payments for services. In addition, under a separate exemption, certain retirement annuity payments received by a partner are excluded from self-employment income if the partner rendered no services during the year and the partner's capital has been paid to him before the end of the year. IRC õ1402(a)(10); Treas. Reg. õ1.1402(a)-17.
It should be noted that if a business generates a loss, then its treatment as self-employment income can beneficially reduce self-employment income from other sources. In particular, if an individual has a loss from a partnership, he or she may prefer to be treated as a general rather than limited partner in respect thereof so as to be able to offset that loss against self-employment income from other sources.
Self-Employment Taxation of LLC Members
If an LLC engaged in a trade or business is classified as a partnership for federal income tax purposes, the members therein are regarded as partners for tax purposes and subject to self-employment tax on their shares of its ordinary income, unless one or more can come within the limited partner exemption in IRC õ1402(a)(13). LTR 9432018 (May 16, 1994).
In 1997, the Service issued Prop. Reg. õ1.1402(a)-2(h) to define "limited partner" for purposes of the IRC õ1402(a)(3) exemption. Under the proposed regulation, an individual may be considered a limited partner in respect of all or part of his or her interest in an entity classified as a partnership (including an LLC), and the distributive share with respect thereto is not self-employment income, in one of three circumstances:
According to the Service, these rules exclude from self-employment income "amounts that are demonstrably returns on capital invested in the partnership." Preamble to Prop. Reg. õ1.1402(a)-2(h), 62 Fed. Reg. p. 1702 (Jan. 13, 1997). Service partners in service partnerships are excluded from limited partner treatment under the proposed regulation.
Although Prop. Reg. õ1.1402(a)-2(h) has not been finalized, it seems reasonable to rely on it. See, e.g., Business Entities, IRS to Follow 1997 Proposed Regs in Applying Self Employment Tax Rules to LLC Members (September/October 2003). However, the proposed regulations are not binding on the Service and do not afford absolute protection against challenge.
Under the proposed regulations, an LLC member is generally not going to have personal liability, and so would be considered a limited partner unless he or she is a manager (or otherwise has authority to contract on behalf of the LLC) or spends more than 500 hours working for the LLC. In such cases, one strategy to reduce self-employment tax would be to own separate classes of interests, with the bulk of the income allocable to a class of limited interests owned substantially by pure limited partners.
An alternative strategy that does not rely on Prop. Reg. õ1.1402(a)-2(h) is for the LLC to elect to be classified as an S corporation, as S corporation shareholders are not subject to self-employment tax on their shares of the S corporation's income. Rev. Rul. 59-221, 1959-1 C.B. 225. However, the LLC/S corporation should pay an appropriate level of salary subject to FICA and FUTA wage taxation, as otherwise the Service can recharacterize distributions as taxable wages, and penalties can result. Rev. Rul. 74-44, 1974-1 C.B. 287. However, this strategy may not be available if the rigid S corporation requirements cannot be met, or may be undesirable based on disadvantageous tax treatment of S corporations in other respects as discussed herein.
Another strategy is to instead use a limited partnership, and still achieve limited liability by holding the general partnership interest through a C or S corporation. The individuals could render services as employees of the corporate general partner. Although there would be FICA and FUTA wage taxation on their compensation from the C or S corporation for such services, they could rely on their status as limited partners under traditional law to escape self-employment taxation on the income allocated to them as such. Again, the general partner's share of income and the salaries paid to the individual service providers should be reasonable in relation to the services provided.
As a means of helping close the tax gap, improving compliance, and promoting tax neutrality among choice of entities, the Joint Committee has proposed reforming the self-employment tax regime. See Additional Options to Improve Tax Compliance, J.Ct. Report (Aug. 3, 2006). One proposed approach would be to extend the current treatment of general partners to the owners of any type of pass-through entity, including limited partners, S corporation stockholders, and LLC members. Under that approach, S corporation stockholders would be subject to self-employment tax on their distributive shares of S corporation income to the same extent they would be as a general partner under the current rules. Another, more-targeted approach would limit such general partner treatment to owners of pass-through entities engaged in service businesses.
Business owners should consider the possibility of such legislation in structuring their affairs. In particular, an S corporation's ability to shelter income from self-employment tax may be short-lived.
Unemployment taxes are also assessed at both the Federal and state levels on wages paid to employees. Unemployment taxes should generally not be assessed with respect to partners in a partnership, including members in an LLC classified as such. However, wages paid to employees (including officers) of a C or S corporation, including an LLC classified as such, generally would be subject to unemployment taxes.
Disregarded SMLLC Employment and Excise Taxes
In Notice 99-6, 1999-1 C.B. 321, the Service announced that until additional guidance is issued, employment tax compliance for employees of a disregarded SMLLC could be handled by the SMLCC's owner as though they were employees of the owner and using the owner's name and EIN, or by the SMLLC under its own name and EIN.
However, because of administrative difficulties that have arisen in applying the disregarded entity approach for Federal employment and excise tax purposes, the Service has proposed regulations under which SMLLCs that are generally disregarded for income tax purposes will nonetheless be treated as separate taxable entities for purposes of the Federal employment and excise taxes. See Prop. Reg. õõ301.7701-2(c)(2)(iv) and (v). As proposed, the regulations would be effective for wages paid or excise taxes incurred on or after January 1 following the date the regulations are finalized.
A number of income and non-income tax considerations need to be weighed in deciding what type of state law entity to use to operate a business, and in determining its income tax classification. Although the set-up that will work best in a given situation depends on the particular facts and circumstances, in general LLCs classified as disregarded entities or partnerships will be the most tax-efficient.
George R. Goodman, firstname.lastname@example.org, is of counsel in Foley's Tax & Employee Benefits Practice. He is also a member of the firm's Tax, Valuation & Fiduciary Litigation and Insurance Practices, as well as the Life Sciences and International Business Industry Teams. He principally advises clients on the structure and tax aspects of transactions, investments, and business organizations. His broad experience includes mergers and acquisitions, consolidated returns, tax-free spin-offs and other tax-efficient asset dispositions, partnerships, real estate, international transactions, financial products, venture capital investments, tax-sharing arrangements, and insolvency work-outs. His clients include business enterprises, investment funds, exempt organizations, and individuals. Mr. Goodman is vice-chair of the Corporate Taxation Division of the Chicago Bar Association and is a member of the American Bar Association. He speaks and writes frequently on tax-related topics, and has served as an editorial advisor to the AICPA's The Tax Advisor magazine.
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