LLCs: entry-level tax considerations.
The major employment tax issue is whether in a managermanaged LLC, a nonmanaging member will be subject to self-employment tax on his income from the LLC. The IRS has recently proposed Regs. Sec. 1.1402(a)-18, which would provide that, when it can be shown that the LLC could have been organized in its jurisdiction as a limited partnership and the nonmanaging member has not acted as a manager, he will be treated as a limited partner and not subjected to self-employment tax on earnings allocated under the operating agreement.
The major estate tax question is the amount of the discount from underlying asset value that may be applicable to the valuation of a decedent's share of an LLC. Given what may be the relative ease of triggering the dissolution of an LLC, careful drafting may be key in maximizing such a discount. The Service is expressing increasing concern over the use of such discounts in the context of interests in several kinds of closely held entities, so there may be many more developments in this area in the upcoming months.
Finally, there are some major income tax questions affecting LLCs being discussed among practitioners.
* Will the LLC be able to use the cash method of accounting if it has a corporate member? Sec. 448(a) seems to provide three safe harbors for such a corporate member: (1) it can be a farmer, (2) it may be a personal service corporation or (3) it may have gross receipts of less than $5 million per year.
* Any other caveats about an LLC's use of the cash method of accounting? The operating agreement should allocate at least 65% of all losses to active members (e.g., manager-members in a manager-managed LLC).
* In applying the passive loss rules of Sec. 469, are there any special concerns? Member-managers who intend to participate more than 100 hours a year in the activities of the LLC, but less than 500 hours, may not be able to demonstrate material participation. Until the Service issues new or modifies existing regulations, such participants should probably consider organizing as an S corporation rather than as an LLC, to ensure compatibility with the passive loss rules.
* How do the controlled group rules apply to LLCs? An LLC may be a subsidiary, or a parent, or have a nonparent corporate member, and in general not worry about the controlled group problems of S corporations.
* What are the major partnership tax rules applying to LLCs?
1. Member contributions of appreciated property are accounted for under Sec. 704(c).
2. Distributions of noncash property other than marketable securities will generally carry out basis to the receiving member rather than triggering income.
3. The partnership rules under Sec. 752 generally apply to allocate entity-level debt payable to third parties to the individual members to use as additional outside basis in their LLC interests.
4. An LLC may make a Sec. 754 election on the transfer of a member's interest or the withdrawal of a member.
* What partnership rules do not quite apply to LLCs?
1. In considering cancellation of indebtedness issues under Sec. 108, insolvency is measured at theentity level rather than the member level.
2. A retiring LLC member probably will not enjoy the advantages of Sec. 736(b).
* What are some corporate tax considerations LLCs should watch?
1. LLCs are not corporations and cannot issue incentive stock options.
2. An LLC cannot engage in a tax-free reorganization under Sec. 368.
3. An LLC cannot issue Sec. 1244 stock.
* What might the major questions be in considering transforming an existing business entity into an LLC?
1. Absent debt-in-excess-of-basis considerations, an existing partnership may feasibly become an LLC. (See Cochran, et al., "The Costs of Converting a Partnership to an LLC," p. 455, this issue.)
2. An existing C corporation or S corporation will trigger a very taxable event in becoming an LLC. It will be taxed as if it had liquidated and sold its assets, and then reorganized as an LLC.
Most practitioners expect LLCs to become more prevalent over the next several years. Hopefully, there will also be much more clarification regarding these and other tax considerations affecting them.
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|Title Annotation:||limited liability companies|
|Author:||McKinney, Hal, Jr.|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 1995|
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