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AMBRECHT & ASSOCIATES

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

(Updated April 2010)

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.

On the down side, there were some issues which had been unclear but over time are now being addressed in the case law. This article addresses four broad areas.

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 had indicated that it intended to apply to estate and gift taxes as well as income taxes. Most commentators and practitioners did not believe the Regulation should be applied this broadly. Until the August 24, 2009, en banc decision of the U. S. Tax Court in Pierre v. Commissioner, 133 T.C. No. 2, there was no other law, ruling or any guidance as to how Single Member LLCs should be treated for federal estate and gift tax purposes. (See Klompares & Youmans, "Single Member LLCs and Estate & Gift Tax Treatment," California Tax Lawyer, Spring 2006.)

In Pierre v. Commissioner, both taxpayer and the IRS agreed that the subject single member LLC was validly formed under state law, that state law recognized the LLC as an entity separate from its members (owners), and that the LLC was classified as a disregarded entity for Federal tax purposes. The issue to be decided was whether gifts of LLC membership interests were to be "valued as transfers of proportionate shares of the underlying assets owned by the LLC or are instead valued as transfers of interests in the LLC, and, therefore, subject to valuation discounts for lack of marketability and control."

The majority opinion by Judge Wells states that the check-the-box regulations apply to how the single member LLC entity is taxed as an entity, but

[W]e do not agree that the check-the-box regulations apply to disregard the LLC in determining how a donor must be taxed under the Federal gift tax provisions on a transfer of an ownership interest in the LLC. If the check-the-box regulations are interpreted and applied as respondent [IRS] contends, they go far beyond classifying the LLC for tax purposes. . . . The question before us (i.e., how a transfer of an ownership interest in a validly formed LLC should be valued under the Federal gift tax provisions) is not the question addressed by the check-the-box regulations (i.e., whether an LLC should be taxed as a separate entity or disregarded so that the tax on its operations os borne by its owner). To conclude that because an entity elected the classification rules set forth in the check-the-box regulations, the long-established Federal gift tax valuation regime is overturned as to single-member LLCs would be "manifest incompatible" with the Federal estate and gift tax statutes as interpreted by the Supreme Court."

Thus the Tax Court recognized the LLC entity structure for gift tax purposes.

In the context of the Court's discussion of the gift tax statutes and regulations, the opinion states, "[T]here is significant Supreme Court precedent interpreting them and guiding the implementation of the Federal gift and estate tax," and in footnote 9 (repeated in footnote 13) the opinion states, "The Federal estate tax is interpreted in pari materia with the Federal gift tax." ["In pari materia" means both pertain to the same subject matter or common purpose and thus are interpreted together if there is some ambiguity.] "See Estate of Sanford v. Commissioner, 308 U.S. 39, 44 (1939) (citing Burnet v. Guggenheim, 288 U.S. 280, 286 (1933))." Thus the Tax Court has made clear that it understands its holding in Pierre v. Commissioner is to apply in the estate tax context as well.

The Pierre holding thus would appear to lay to rest prior questions of how Single Member LLCs would be treated for estate and gift tax purposes (although it is always possible that an appeal or further case law may provide further refinement).

If concerns should remain for any particular situation, the clearest remedy to avoid any question is to change the LLC ownership intersts 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.

In a ruling by the U.S. District Court for the Southern District of California on a Motion to Dismiss a First Amended Complaint, the Court found that a Delaware LLC, which was alleged to be wholly owned by a Delaware corporation (with no evidence produced to the contrary), in which case it would be a single member LLC, was not subject to general personal jurisdiction of the Court because the LLC had maintained the corporate formalities separate from its parent corporation and thus was not the alter ego of the parent corporation. Stone v. Advance America (3/20/09) 2009 U.S. Dist LEXIS 24762; 2009 WL 765665. Thus, the separate legal existence of the single member LLC was recognized.

Remedy. The solution here (if one desires a greater hedge) is that the single member sell would 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. Obviously it would be better if the transfer were done prior to the events giving rise to the claim, but one could also consider making the sale after one is served with the lawsuit, again as a bona fide sale and not as a fraudulent transfer. Even for a transfer after one is served with litigation, 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, even if after the litigation had commenced, 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?

Courts have held that the "check-the-box" regulations (which, by default, treat a Single-Member LLC as a disregarded entity) apply to disregarded the LLC entity structure for purposes of federal employment tax delinquencies by the LLC and allowed collection against the member-owner - that is, for wages paid prior to January 1, 2009. See Littriello v. United States, 484 F.3d 372 (6th Cir. 2007); L & L Holding Company, L.L.C., DC La. 2008-1 USTC 50,324; McNamee v. Dept. of the Treasury, 488 F.3d 100 (2d Cir. 2007); Med. Practice Solutions, LLC v. Commissioner, 132 T.C. No. 7 (March 31, 2009).

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. But the IRS final regulations (modification of Treas. Reg. section 301.7701-2) effective as of August 16, 2007, provide that a disregarded entity (Single Member LLC and subchapter S corporation) is treated as a separate entity (corporation) for purposes of employment taxes and related reporting requirements, i.e., collection of unpaid employment taxes which are the responsiblity of the LLC may be sougt against the LLC and its assets, not against the Single-Member LLC member individually and the member's personal assets. Sec. 301.7701-2(c)(2)(iv), Proced. & Admin. Regs., T.D. 9356, 2007-2 C.B. 675.

For other federal tax purposes, the entity remains a disregarded entity (except see A., above, regarding gift and estate taxes). 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.

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 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.