Sep 26, 2007

LLCs and the Dreaded Tax Code

I have a confession to make: LLC taxes scare me. I have been studying LLC taxation on and off for more years than I care to count, and I still break out in a cold sweat whenever a reader asks me why my LLC books do not contain special allocation language.

Let's back up a little. LLCs are taxed just like any other business: a one-owner LLC is just like a sole proprietorship; and a co-owned LLC is like a partnership, with a few special tax wrinkles (let's ignore the wrinkles for now).

Early in my LLC research, when I started my first LLC book for Nolo, Form Your Own Limited Liability Company, I realized that taxes were a big part of the picture when one surveyed the LLC landscape. So I decided to enroll in MBA tax classes to supplement my law school taxation curriculum. That's when the trouble started.

Sitting as a somewhat-senior member in a classroom filled with wide-eyed, soon-to-be tax professionals, I would occasionally raise my hand to ask the long-toothed professor ‑ my teeth weren't a whole lot shorter ‑ some real-world LLC tax questions, such as:

Is it easy to adopt the safe-haven special allocation language contained in the Internal Revenue Code to be sure that disproportionate allocations of profits and losses set out in an LLC operating agreement are respected by the IRS?

The immediate answer seemed to be "No, not really." I say "seemed" since tax professors rarely provide direct answers to direct questions ‑ given the enormity of the tax code and the muddiness of its clarifying regulations, they've understandably learned to hedge their bets by providing multiple-answer responses.

Over the next several months, I gradually coaxed the following fuller answer from the professor:

If two people form an LLC and make special allocations of profits and/or losses ‑ for example, one person gets a larger slice of the profit pie because she puts up cash and the other owner agrees to work for the business it may be necessary under the technical regulations that apply to special allocations for the co-owners to agree in the LLC operating agreement to be personally liable for any losses incurred by the LLC that exceed the balance in their capital accounts. If they don't add this provision to their LLC operating agreement, the IRS may not respect their special allocation of extra profits to the cash-contributing owner, and it may recalculate the owners' prior-year profits (and taxes) if the LLC or its owners' tax returns are audited.

Gee, I concluded aloud, doesn't that type of "I'll pay back the LLC" provision in an operating agreement defeat the whole purpose of forming an LLC, which is to be free from personal liability for business debts and claims?"

Yes it does, he answered, moving back to his prepared lecture notes.

In the course of several more tax classes, I received equally daunting and surprisingly unhelpful answers to my real-world LLC tax questions. For example, it turns out that when a person contributes property to a co-owned LLC, in effect, each person sells their property to the other owners, and from then on the computation of the owner's tax basis in the property becomes amazingly complicated and subject to a number of special technical tax elections, which most LLC owners never find out about.

Here's another example: when an LLC borrows money, as many must, the owners personally get a boost in their tax basis, which is a good thing. But as the LLC pays off the debt, the owners are supposed to lower their tax bases each year. Many don't. In other words, many tax advisors don't do this for the owners, nor do they report the lowered basis correctly to the IRS. Since tax basis is used to figure out the amount of LLC losses that can be passed through to the owners, and how much tax each owner pays when an LLC interest is sold, a lot of people are getting the math and the tax results wrong.

I, too, have learned to hedge my bets when discussing LLC taxation. I also try to temper some of my gloomier tax thoughts with the good news that even though LLCs, like partnerships, have significant tax complexity and uncertainty, they provide the unique advantage of limited liability legal protection to all LLC owners. Thanks goodness for silver linings.

Copyright 2007 by Anthony Mancuso

This article is provided as information and opinion. Please check with a legal or tax advisor for legal or tax advice.

2 Comments

O.k. now you have me scared!
We have set up 2 different LLCs this year and are now trying to figure out how the taxes are going to work-that is-really work. Your books are one of the only reliable sources of information we have found and you're not sure? Help!
One has elected to be taxed as an S-corp and the other is going to be taxed as a partnership, we think. I have read every tax publication that seemed remotely relative on the IRS's website and that still doesn't help with the nitty-gritty details of how this whole thing works.
There are so many gray areas and we have yet to find a tax professional that knows more than we do. Most know less; we end up educating them and I am not willing to pay for that privilege.

Please get to the point. Rid of unnecessary waste. Example:

"Look at the positives and the negatives. While LLCs, like partnerships, have complex and uncertain tax laws, they provide the unique advantage of limited liability legal protection to all LLC owners."

I'm sorry that piece failed to lay the advantages/disadvantages in an organized and user-friendly manner.