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AMBRECHT & BRITTAIN, LLP

A Single Member LLC May Present Issues for Liability Protection, Bankruptcy, Gift and Estate Taxes, and Employment and Excise Taxes

By Dibby Allan Green, ACP

A "Single Member LLC" is a LLC whose entire membership interests are either owned by one individual, or are owned by a husband and wife as community property (but does not include any separate property interests).

Single Member LLCs initially appeared attractive with the possibility of obtaining similar liability protection as a corporation affords yet avoiding the double-tax at the corporate level with the pass-through taxation that a LLC affords. There are additional benefits of the Single Member LLC in that it may own stock in an S corporation or may engage in a 1031 real estate exchange.

However, there are possible issues on the horizon which we are beginning to see reflected in some court cases, although a clear body of law has not yet been developed.

A. Gift and Estate Tax Issues?

For federal income tax purposes the Single Member LLC is typically disregarded and all income is reported on the member's Schedule C to the 1040 return. (Under the "check the box" regulations, it may also be reported as a corporation. Although not anticipated in the "check the box" regulations, it may also be that some accountants may still report the LLC as a partnership and issue K-1's regardless of the regulations.)

The question arises in the context of federal gift and estate tax purposes inasmuch as the Treasury Regulation section 301.7701-1 states that the "check the box" classifications are for "federal tax purposes" and does not specify which tax. The author of the Regulation has indicated that it intended to apply to estate and gift taxes as well as income taxes, but most commentators and practitioners do believe the Regulation should be applied this broadly, and there appears to be no other law, ruling or any guidance as to how Single Member LLCs should be treated for federal estate and gift tax purposes. (Klompares & Youmans, "Single Member LLCs and Estate & Gift Tax Treatment," California Tax Lawyer, Spring 2006.)

The issues, then, include the following:

(1) What is reported in the donor's gift tax return or a decedent's estate tax return – the LLC membership interest or the underlying asset? Hence, is the full value of the asset reported or is the market value of the LLC interest reported (which is typically a discounted value)? In other words, will valuation discounts be lost in a Single Member LLC?

(2) In California there is no longer any estate tax or inheritance tax. If a California resident dies with an LLC membership interest, the interest (as personal property) would be administered on death under California law (whether in trust or probate, unless the trust provided for a different jurisdiction) and no California death tax applies. However, if the LLC owns land in another state, and if the federal rules apply to disregarding the LLC structure, then would either the administration of the real property (if the LLC is ignored) on death be under the other jurisdiction? This answer could be arguably "No" from the perspective of state law. However, from the perspective of estate or inheritance taxes levied by the other state, would their tax on the real estate apply if the LLC structure is to be ignored for estate, inheritance or gift tax purposes (if the other state incorporates federal rules and practice)?

Given these issues, some question the constitutionality of the "check-the-box" regulations from the standpoint of the estate and gift tax law, and have asked the Service to give clear guidance as to estate and gift tax applicability (e.g., Klompares & Youmans, supra).

Remedy. The clearest remedy is change the LLC so that it is no longer a Single Member LLC. For spouses, this can be done by transmuting all the community property into 50% separate property of one spouse and 50% separate property of the other spouse. One downside to this plan is loss of a step-up in basis upon death (as the property will no longer be community property) and so is not an ideal solution. Another option is to gift or sell some interest to another person, even if it is a 0.1% interest given to a child. As long as there is another member it will then be taxed as a partnership and the Single Member LLC rules no longer apply. The downside to this plan is the loss of the benefits of the single member status, such as the ability to make a 1031 exchange with LLC real property.

B. Charging Order Protection?

Generally a LLC will have the same liability protection as a corporation in regards to claims or litigation against the LLC.

The question comes when the member (owner) of the LLC is sued and the claimant tries to protect. Typically the claimant's only remedy is to get a charging order against the LLC membership interest (it is the same for a limited partnership interest). The charging order operates similar to a wage garnishment – the claimant only gets paid if the LLC decides to distribute profits (the profits allocable to the member who has the charging order against him get paid to the claimant). Generally, therefore, the assets of the LLC will not be seized to pay the debt, but only a charging order issued. The member or manager has control over when profits are distributed. (However, in California, although not in Delaware, a judge also has discretion in certain instances to go beyond the charging order and foreclose on LLC assets to pay the debt.)

The issue for the Single Member LLC is whether a claimant would be limited to the sole remedy of a charging order, or whether a claimant could instead obtain a writ of execution directly against the LLC assets.

The question arises because the purpose in the law for the charging order remedy is to protect non-debtor members & management. In the LLC or limited partnership with other members or partners, this is a valid protection. But with a Single Member LLC there are no non-debtors, i.e., the single member is the debtor. Even where the members are husband and wife, the community property is subject to the community debts. Therefore, the basis in law for the charging order being the only available remedy can be questioned. The claimant's argument is to ask why the claimant should be limited to a charging order when there is no one else's interest to protect? Why shouldn't the claimant be able to obtain a writ of execution directly on the LLC assets.

However, also see discussion from the Bankruptcy Appellate Panel of the Ninth Circuit in In re KRSM Properties, LLC, 318 B.R. 712 (9th Cir. Bank App. 2004), discussed below, which upheld the separate entity status of the single member LLC in a situation where the member himself argued that it should be ignored. In KRSM Properties, LLC, the LLC paid the tax liability of the member to the IRS, and the Court ordered the IRS to refund the tax payment to the LLC's bankruptcy estate based on the bankruptcy trustee's argument that the tax payment was a debt of the member and not of the LLC.

Remedy. The solution here is that as soon as the member of the Single Member LLC is served with a lawsuit, the member sells some percentage of interest for bona fide consideration to an outside third party so there is another non-debtor member. This transfer should not be done after a judgment is issued or it runs the risk of being deemed a fraudulent transfer. The question may arise: shouldn't the transfer be done prior to the events giving rise to the claim, rather than once one is served with the lawsuit? Certainly if one has the foresight a prior transfer helps. On the other hand, it more logically would be that the court will look to whether there are non-debtor members at the time the application for the charging order is made (which is after the judgment has been rendered). In such case, respected authorities believe that a sale well ahead of the date of application for the charging order will be sufficient.

Another remedy may be in having the management of the LLC separate from the membership (ownership) interest. This may be done by having the LLC managed by a manager who is not a member, and/or by providing for officers of the LLC (similar to officers of a corporation) who have management responsibilities.

C. Bankruptcy Issues?

First, as to all LLCs and limited partnerships, bankruptcy law distinguishes between non-executory contracts (where the bankruptcy trustee completely steps in the place of the debtor, i.e., become the LLC member) and executory contracts (where the debtor had additional duties and responsibilities with the bankruptcy trustee will not take on, so the bankruptcy trustee will only have an economic interest, i.e., not become the member). There are numerous cases holding that certain LLC Operating Agreements (or limited partnership agreements) were non-executory, and others holding that they were executory – it depends on the terms of the agreements.

There was a 9th District opinion from Arizona (In re Ehmann) which, however, was withdrawn (so no citation), but the results indicate what could happen. It pertained to a limited partnership where the non-managing partners had no additional duties and responsibilities, in which case the partnership agreement was treated as a non-executory contract and the bankruptcy trustee stepped in as a full partner and then forced the liquidation of the partnership, bringing assets into the bankruptcy estate.

Remedy. To remedy this possibility, the limited partnership or LLC agreement may want to include some duties for all partners and members. (For limited partnerships, the attorney drafting the agreement will still want to stay within the safe harbor of what a limited partner can do without being deemed to have control of the business the same as a general partner and so be exposed to general liability.) Another remedy for this possibility is to have all LLC and limited partnership interests owned inside an irrevocable trust so that the bankruptcy trustee may only obtain the beneficial interest under the trust and not liquidate the LLC or limited partnership.

Single Member LLC. As indicated by the discussion on charging orders for Single Member LLCs above, the bankruptcy trustee may not be limited to the sole remedy of a charging order but the assets of the Single Member LLC may be treated as assets of the bankruptcy estate. A bankruptcy court in Colorado in 2003 held that charging order protection did not apply to a Single Member LLC because there was no non-debtor member to protect. The bankruptcy trustee then stepped into the shoes of the member/debtor, sold the LLC's property and distributed the proceeds to the bankruptcy estate. In re Albright, No. 01-11367 (Colo. Bkrpt. April 4, 2003.)

However, the Bankruptcy Appellate Panel of the Ninth Circuit in In re KRSM Properties, LLC, 318 B.R. 712 (9th Cir. Bank App. 2004), rejected such an argument as that would be tantamount to viewing the LLC as a sole proprietorship, having no separate legal status, when it was a separate legal entity authorized by state law. The court held that the mere election for tax purposes to be treated like a sole proprietorship did not overcome such entity characteristics such as a distinct entity which can sue and be sued, that the members have no direct ownership interest in the LLC assets and in most cases would have no liability for obligations of the LLC.

Remedy. To avoid a potential Ehmann result, well (hopefully a year or more) before the bankruptcy is filed, the member would sell some percentage of interest for bona fide consideration to an outside third party so there is another non-debtor member. This transfer should not be done close to the bankruptcy filing or it runs the risk of being deemed a fraudulent transfer.

D. Employment and Excise Tax Liability?

The only place in the Internal Revenue Code a LLC is defined is in the "check the box" regulations, which applies to the entire Code for all "federal tax purposes." For this reason, at least one court had insisted that the separate legal entity of the Single Member LLC be disregarded for purposes of federal employment tax delinquencies by the LLC and allowed collection against the owner (L & L Holding Company, L.L.C., DC La. 2008-1 USTC 50,324.)

Notice 99-6 had given some guidence in terms of employment tax reporting, and proposed Treasury Regulations issued in October of 2005 had proposed treatment of a disregarded entity as a separate entity for purposes of employment and certain excise taxes. The good news is that the IRS has now finalized the regulations (modification of Treas. Reg. section 301.7701-2) effective as of August 16, 2007.

For purposes of employment taxes, the final regulations apply to wages paid on and after January 1, 2009, and for purposes of the excise taxes apply as of January 1, 2008.

The final regulations provide that a disregarded entity (Single Member LLC and subchapter S corporation) is treated as a separate entity for purposes of employment taxes and related reporting requirements, and treats such entities as a corporation for these purposes. For other federal tax purposes, the entity remains a disregarded entity. The individual owner of a disregarded entity continues to be treated as self-employed (as a sole proprietorship) subject to taxes under the Self-Employment Contributions Act, and not as an employee of a disregarded entity, for employment tax purposes.

Thus, for wages paid on and after January 1, 2009, and certain excise taxes incurred on and after January 1, 2008, the final regulations recognize the separate entity structure of the single member LLC (treating it as a corporation), which entity is responsibility for any such tax liabilities.

Of course, one would want to check the applicability of these federal regulations to any state employment tax liabilities.

The contents of this publication are for information purposes only and are not meant nor should be construed to be legal advice. Note, also, the date of the document. Laws are constantly changing, and are subject to differing interpretations. We, therefore, urge you to do additional research or to contact your own legal or tax counsel before acting on the information contained herin.