State tax pitfalls for LLCs.

Since January 1997, when the Federal "check-the-box" regulations went into effect, limited liability companies (LLCs) have proliferated, allowing newly formed LLCs to elect their Federal tax classification and clarifying the tax status of single-member LLCs (SMLLCs).

The old "four factor" test--continuity of life, centralized management, limited liability and free transferability of interests--has been discarded for Federal purposes. If the entity elects to have the LLC treated as a partnership (i.e., does not check the box), it is treated as if it were a flowthrough entity.

This choice has been viewed as very beneficial to companies. The LLC has become the solution to the business community's search for a way to combine the passthrough tax aspects of a partnership with the limited liability protection of a corporation. With a few exceptions (such as Texas and Michigan), the states have gradually conformed to the check-the-box regulations. The majority of the states will follow the Federal entity classification selected by the corporation for state income tax purposes.

The picture is not so clear, however, when other state taxes are involved. For instance, a number of states levy both income and franchise taxes on corporations. The franchise tax is based on net worth or capital values. It is not clear that the states will use the Federal entity classification for franchise tax purposes. Pennsylvania, for example, will follow the Federal check-the-box regulations for an LLC and will accept partnership treatment for corporate net income tax purposes, but will tax the LLC as a corporation for franchise tax purposes.

This raises a further complication. If a corporation is a multistate corporation, it must determine its Pennsylvania income by using an apportionment formula. For purposes of the income tax, the state will include the factors (property, payroll and sales) of the LLC in the parent company's apportionment formula. But how does the franchise tax fit into this formula? Will the states include an LLC's factors in the parent company's apportionment formula? They should not, because the LLC will be taxed separately, using its factors in its own apportionment formula. There are no rules or regulations that address this question; a company in this situation will have to make its own compliance decision.

Sales and Use Taxes 

What about sales and use taxes? Under the Federal check-the-box regulations, an SMLLC is treated as a "disregarded entity" (i.e., as an unincorporated division of the parent corporation) for Federal and state income tax purposes, but not necessarily for other tax purposes. Sales between two entities are subject to a sales tax in most states, even when the two entities are related; this is not true, however, for sales between two divisions of one corporation. Thus, if a parent spins off a division and forms an LLC, any intercompany sales that may have been tax-flee lose that status.

Another uncertainty exists when a parent sells part or all of its interest in a passthrough entity. If an intangible interest is being sold, the parent may not be subject to sales tax. On the other hand, if assets are being sold, the parent may be subject to tax.

Property Taxes

Property taxes are another consideration. Some states will grant exemptions from personal property taxes to corporations, but not to other entity forms. If the LLC is treated as a partnership, it may lose its exemption. A company may find that the benefits of being an LLC are of less value than the state's personal property tax exemption. In that case, the parent company may be able to timely reverse its LLC formation and qualify for the exemption.

Real property transfer taxes also pose questions. Although some jurisdictions have not yet extended their transfer taxes to include transfers of interests in-property-owning entities held by a common parent, others have. Are the transfers of real property between the passthrough entities and their owners disregarded or can they attract tax?

Many good reasons exist for companies to take advantage of electing passthrough treatment for LLCs, but there are disadvantages. Before leaping into the fray, companies should carefully examine the state tax pitfalls that loom to catch the unwary.

FROM ELIZABETH BURTON, CPA, CHICAGO, IL