LLC Taxation
Limited liability companies (LLCs) can be taxed in various ways based on default treatment rules and LLC elections. There are two default taxation treatments for LLCs (disregarded entity and partnership) and two elections (S-Corp and C-Corp).
§ 9.1Default Taxation Treatments
§ 9.1:1Disregarded-Entity Treatment
When an LLC is owned by a single person or a married couple, it is treated as a disregarded entity by default (similar to a sole proprietorship that does not operate under any legal entity structure). This means that revenues and expenses are reported on the owner’s personal 1040 tax return. This is the least cumbersome and easiest form of taxation because it does not require the LLC to file any tax information with the IRS.
When two or more nonmarried persons own an LLC, it is treated as a partnership by default, which is a pass-through entity for taxation purposes (meaning profits and losses flow through to the owners just like with disregarded entities). The IRS does not recognize the LLC structure as a business entity like it does partnerships and corporations. When taxed as a partnership, the LLC must file IRS Form 1065 showing the company’s profits or losses and, in accordance with the company agreement, must issue a schedule K-1 to every member reporting that member’s portion of the LLC’s reported profits and losses. This form of taxation is the standard for multimember LLCs that do not want to deal with the additional reporting and filing requirements of the two available taxation elections.
§ 9.2Taxation Treatment Elections
The following LLC taxation treatments are applied solely upon election by an LLC to be taxed as a corporation. Note that S-Corps and C-Corps are not legal entity types; they are merely tax elections available to both LLCs and corporations.
To be eligible for S corporation taxation treatment, an LLC must have no more than one hundred members that are, with a few exceptions, human beings (no corporate, LLC, or partnership members are allowed). No member may be a “nonresident alien,” and the LLC can have only one class of LLC units (cannot use preferred units, but different voting classes are allowed). An LLC desiring to elect S corporation treatment must file IRS Form 2553 within seventy-five days of formation or seventy-five days from the first day of the year in which it desires to be taxed as an S corporation. LLCs that make this election are opting to be taxed as a corporation under subchapter S of the Internal Revenue Code, but the taxes still flow through to the owner(s) of the LLC. This structure is popular for single-owner-employee LLCs that do not want to be treated as disregarded entities and that do not want to be subject to self-employment taxes on the entirety of the LLCs’ profits.
Owners of LLCs may choose to be taxed as a C corporation primarily for certain tax advantages, access to fringe benefits, greater flexibility for the carrying of profits and losses forward and backward, and certain corporation-only business financing. To be taxed as a C corporation, the LLC must file IRS Form 8836. While there are several advantages to the C corporation election, there are also several disadvantages, such as double taxation at the corporate and individual levels, more complex taxation reporting requirements, and restrictions on certain deductions.
Determining an entity’s taxation scheme is generally just as important as determining what entity structure works best for the client’s goals and potential liability exposure. It is always a good idea to advise your clients to seek competent tax advice in conjunction with working with you in their corporate development.
§ 9.3New Partnership Representative for LLC Taxed as Partnership
In the past, LLCs that were taxed as partnerships appointed a tax matters partner (TMP). Beginning in 2018, following the passage of the Bipartisan Budget Act of 2015, the IRS implemented new rules to, in theory, ease the burden on the IRS for auditing partnership tax returns. These new rules require the LLC to designate a partnership representative (PR), who is given extreme authority for taxation issues on behalf of the LLC. The PR may be an individual (such as a member of the LLC or the LLC’s attorney, accountant, or other advisor) or an entity; however, if an entity is listed, a designated individual (DI) of that entity must also be identified. The PR acts solely on behalf of the LLC for all issues regarding IRS tax audits (including litigation) and the elections made on form 1065.
Form 1065 requires the PR to choose whether to elect out of the centralized partnership audit scheme. A “yes” election means that any audit adjustments get pushed to the members of the LLC, which requires the members to amend their personal returns to account for the adjustment.
A “no” election means that the LLC pays any audit adjustments (this is not available for trusts and disregarded entities, including single-member LLCs). A “no” election is generally typical since the members of the LLC during the period covered in an audit must account for any adjustments.
The naming of a PR seems like a nonissue when forming an LLC and its associated internal structures, but the new role of the PR can be damning on an LLC and its members if that individual or entity becomes adversarial or even a nonmember. Unlike the TMP of old, a PR does not have to be a member of the LLC, so even if a member is removed or withdrawn, if that member is listed as the PR, it still retains power over its former LLC. It is imperative that careful thought is given to PR designations, and if a member listed as the PR is removed, the LLC’s company agreement should be immediately amended to reassign the PR position.
Entities taxed as partnerships, including multimember LLCs that make such an election, are subject to the Bipartisan Budget Act of 2015 (BBA, amended 2018) § 1101, 26 U.S.C. §§ 6221–6241, which drastically changes audit and collection procedures for tax years beginning after December 31, 2017.
The BBA creates a new centralized regime, wherein the IRS audits and collects underpayments due from a partnership at the entity level instead of the partner (personal) level. This change shifts audit-driven liabilities for underpaid taxes, interest, and penalties from the partners in place during the underpaid tax year (the audited or “reviewed year”) to the partners in the tax year in which the adjustments become final (the “adjustment year”). See 26 U.S.C. § 6225(a), (d). It is possible that the partners in the adjustment year are not the same as, or do not have the same percentage interests as, the partners in the reviewed year. This shift in liability may result in potential conflicts between partners, including a desire by adjustment-year partners to seek reimbursement from reviewed-year partners.
The BBA replaces the tax matters partner (TMP), a position formed by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), with a partnership representative (PR). See 26 U.S.C. § 6223(a). It is not at all clear yet whether the IRS or courts will find that a partnership’s TMP can function as its PR. Thus, entities in existence before January 1, 2018, should (1) retain or include language designating a TMP in their operating agreements until the statute of limitations for audits expires for those tax years governed by TEFRA, limiting the TMP’s authority to tax years ending before January 1, 2018, and (2) appoint a PR for tax years beginning on or after January 1, 2018. Unlike a TMP, a PR can be anyone, including a sole individual or entity, and does not have to be a partner or member of the company. See 26 U.S.C. § 6223(a).
§ 9.5Opting Out of New Audit Regime
Partnerships and multimember LLCs taxed as partnerships may opt out of the new audit regime and elect to be governed by the previous audit rules in a number of ways, including the following.
Partnerships that furnish no more than one hundred schedule K-1s for their partners are eligible to opt out of the new default audit rules if all the partners are eligible partners at all times during the taxable year and are individuals, domestic C corporations, certain foreign entities, deceased partners’ estates, or S corporations. 26 U.S.C. § 6221(b)(1). A partnership is not eligible to elect out under section 6221 if any of its partners is a partnership, disregarded LLC, trust, foreign entity that would not be treated as a C corporation if it were domestic, estate of a nonpartner deceased individual, or person holding the partnership interest on behalf of another person. Treas. Reg. § 301.6221(b)–1(b)(3)(ii). Schedule K-1s issued by a partner that is an S corporation to its shareholders are counted for purposes of determining whether a partnership has furnished no more than one hundred schedule K-1s. 26 U.S.C. § 6221(b)(2). The partnership must make the election on a timely filed return each taxable year and notify the partners of the election. The return must also include information about the partners, such as names and taxpayer identification numbers. 26 U.S.C. § 6221(b)(1), (b)(2).
The partnership agreement may contain provisions that (1) make this election mandatory, if qualified under the statute, and (2) prohibit the partnership or partners from allowing the transfer of partnership interests or taking any other actions that would disqualify the partnership from making the election.
When a partnership receives a notice of final partnership adjustment, the partnership has forty-five days from the issuance of the notice to elect to push out the imputed underpayment to the reviewed-year partners by furnishing them an adjustment statement, similar to a schedule K-5. This election generally benefits partners in the adjustment year at the expense of partners from the reviewed year. The IRS may not permit the push-out election for tiered partnerships. 26 U.S.C. § 6226(a).
Again, the partnership agreement may include provisions that (1) require the partnership to make this election on a timely basis and in all audit situations and (2) prohibit the partnership or partners from taking any actions that would disqualify the partnership from making the election.
§ 9.5:3Tax Indemnification Provisions
Partnership agreements, partnership share purchase agreements, or other internal agreements can include tax indemnification provisions that allocate any liabilities arising from imputed underpayments according to the partners’ interests in the reviewed year. Indemnification provisions should also provide that the indemnification is mandatory, rather than being subject to a partnership election or other decision. Agreements for the purchase of partnership interests by new partners from existing partners should include tax indemnity provisions to cover adjustments under the Bipartisan Budget Act of 2015 audit regime. Note that any allocations resulting from these tax indemnity provisions must have substantial economic effect for the IRS to allow the agreement to ultimately control in the determination of the partners’ distributive shares. See 26 U.S.C. § 704(b); Treas. Reg. § 1.704–1(b)(2).
See form 9-1 in this manual for optional provisions relating to partnership representatives and audit procedures to include in LLC agreements.