Classification of single-member LLCs to be clarified under final "check-the-box" regulations.

Pending finalization of the "check-the-box" regulations under Sec. 7701, the classification of single-member limited liability corporations (LLCs) is highway uncertain. Under the current rules, the IRS could treat a single-member LLC as a sole proprietorship, an association taxable as a corporation or some type of trust (e.g., a grantor trust). The major risk of structuring a single-member LLC under the current rules is that the Service may, under examination, attempt to treat the single-member LLC as an association taxable as a corporation.

Once the "check-the-box" regulations are finalized, however, an eligible single-member LLC will be able to elect to be classified as a corporation or a branch. If no election is made, under the default files of the proposed regulations, a domestic, single-member LLC will be disregarded as an entity separate from its owner, thus, its activities will be treated in die same manner as a sole proprietorship, branch or division of the owner. A foreign single-member eligible entity may elect branch treatment, and, in the absence of an election, the entity will be treated as a corporation if it has limited liability.

Generally, the transition rules under the proposed regulations are favorable to taxpayers. Under these rules, an eligible entity existing prior to the effective date of the regulations that chooses to retain its current classification would not be required to file an election. It is unclear whether this rule would apply to a single-member LLC that takes the position under current law that it is a branch. The transition rules specifically provide that if an eligible single-member LLC claimed to be a partnership under the current regulations, the entity would be disregarded as an entity separate from its owner under the proposed regulations. Although this might be read to sanction current formation of single-member LLCS, it is unclear how a taxpayer can justify treating an entity with one owner as a partnership. Therefore, taxpayers should be cautious in considering whether to form a single-member LLC.

When the "check-the-box,, rules are finalized, single-member LLCs will serve as important tax planning tool. A single-member LLC provides liability protection, while remaining transparent for Federal tax purposes. Many LLCs have been formed in recent years with a 99% interest and a 1% interest controlled directly or indirectly by the same owner. This results in the need to prepare a tax-effective partnership agreement for the LLC and to annually file tax returns. In addition, if a special-purpose entity has been formed to hold the 1% interest (e.g., an S corporation), its tax returns need to be filed as well. The single-member LLC will allow these structures to be formed without a 1% holder and without any additional tax returns. In effect, a type of consolidated group can be formed for state law purposes that will be wholly transparent for Federal tax purposes. It may also be possible to clean up existing structures, although the tax implications of doing so will need to be evaluated.

The proposed regulations provide for greater simplicity and certainty in the classification of single-member LLCs. Until they are final, however, the current classification rules apply. Although there is only a slim chance that the proposed regulations win not become effective, taxpayers currently contemplating a restructuring of their businesses should be cautious about forming single-member LLCs until the regulations are finalized. Adverse tax consequences could result if the Service classifies a single-member LLC as an association taxable as a corporation. Further, a number of states have submitted comments advocating the position that single-member LLCs should be taxed as corporations under the proposed regulations. As a result, uncertainty exists as to whether the provisions under the proposed regulations regarding single-member LLCs will remain intact. However, once the "check-the-box" regulations become effective, single-member LLCs could provide an alternative structuring technique that will materially simplify structures that include a variety of entities.