Preserving federal benefits of single-member LLCs in light of state tax concerns.

Now that final check-the-box regulations have been out for almost a year, it is interesting to see how the states have reacted. California has already announced that it will not follow the check-the-box regulations; the question is whether many other states will do likewise. If states refuse to follow the new regulations, it is highly probable that simplification and certainty in drafting partnership and limited liability company (LLC) agreements (the goals of the check-the-box regulations) will never really be achieved, because agreements would still need to be drafted to take the old four-factor entity classification test into account.

The heart of the states' objections to check-the-box, generally, is the treatment of single-member LLCs as nonentities for tax purposes. Some, state tax administrators fear that treating single-member LLCs as nonentities will lead to a disintegration of their corporate tax base. Merely announcing that they will not follow the check-the-box regulations, however, may not enable these states to treat single-member LLCs as corporations for tax purposes. Thus, practitioners should anticipate that various states might attempt to adopt rules that treat single-member LLCs as per se corporations for state tax purposes, notwithstanding their Federal classification as nonentities. (A number of states already treat all LLCs as corporations for state tax purposes.)

This would generally make the formation of single-member LLCs expensive from a state tax perspective (although some state tax planning opportunities may exist to take advantage of their "hybrid" status). Practitioners could deal with this problem by avoiding forming single-member LLCs in such states, opting instead to form "99:1 partnerships" between the "parent" and an affiliate. That would require giving up the simplicity (and perhaps some Federal tax planning advantages) of being a single-member LLC.

One alternative for taxpayers seeking nonentity treatment for their LLCs for Federal tax purposes (e.g., to avoid filing a separate tax return for the entity), but concerned about preserving flowthrough treatment, could involve setting up a two-member LLC--one member being the "parent" (owning 99% of the interests) and the other being a separate single-member LLC owned by the parent (owning a 1% interest).

If the taxing authority falls in line with the Federal treatment of single-member LLCs as nonentities, both the upper- and lower-tier LLCs are effectively consolidated with the parent (i.e., the LLCs are treated as a branch or division), because the parent would be considered to own 100% of each entity. In those states treating single-member LLCs as corporations, the "upper-tier" LLC would be treated as a corporation (because it has only one member), but the lower-tier LLC would now have two members (i.e., the parent and its wholly owned LLC subsidiary treated as a corporation). Thus, the lower-tier entity could be taxed as a partnership (assuming the four-factor test for partnership classification is met). In these states, 99% of the income would still flow directly to the parent, with only 1% trapped in a separately taxed entity. Thus, the preservation of flowthrough benefit would be maximized in those states that do not follow Federal law, and the simplified tax reporting advantages of a single-member LLC would be retained for Federal purposes and in states recognizing that status.

From Glenn E. Dance, CPA, and Monte A. Jackel, J.D., Washington, D.C.