Court Rules That LLC Owner Personally Liable for Payroll Taxes
Over the past few years, the limited liability company (LLC) has become a popular choice of business structure both inside and outside of agriculture. Colorado and Wyoming were the first states to authorize LLCs, and did so in the late 1970s. In the early 1990s, the LLC concept caught fire. Presently, all states authorize the creation of LLCs. From a tax perspective, the LLC is unique. An LLC is a hybrid type of entity that resembles a corporation with respect to limited member liability, but is also characterized by partnership tax status. That’s just like an S corporation, but the LLC doesn’t have the restrictions on stock ownership that S corporations are subject to. The LLC also can have multiple members or only a single member.
So, the LLC is a relatively new and unique form of business structure - they have some features of corporations and some features of partnerships. The Internal Revenue Code neither expressly mentions LLCs nor defines them. As a result, their tax treatment is determined by the Treasury regulations. Before 1997, the regulations treated an LLC as a partnership unless it had more corporate than non-corporate characteristics. The tax outcome under that test could only be determined on a case-by-case basis, and eventually the “corporate characteristic” regulation proved unworkable in the context of LLCs. Thus, beginning in 1997, the Treasury specified in regulations that any business entity that was not required to be treated as a corporation could choose its classification by making an election. By default, an eligible entity is treated as a partnership if it has two or more members, and is disregarded as an entity separate from its owner (i.e., is treated as a sole proprietorship) if it has a single owner. IRS Form 8832 is used by eligible entities that choose not to be classified under the default rules.
In this case, the plaintiff was the sole member and owner of an LLC that operated a six-person accounting firm. The plaintiff did not file Form 8832 to elect corporate tax treatment for the LLC so, by default, the LLC was disregarded as an entity separate from the taxpayer. The taxpayer failed to pay both parts of the payroll tax – the “trust fund” amount that is withheld from an employee’s paycheck, and the part the employer pays. An officer of a corporation or an LLC (but not a director or shareholder) that elects corporate tax treatment can be held personally responsible for unpaid trust fund amounts, and the part the employer pays is a corporate (or LLC) debt for which the shareholders or members are generally not responsible.
But, what if there are unpaid payroll taxes involving a single-member LLC that has not elected corporate tax treatment - is the member-owner liable for those taxes? The owner-member claimed that state law prevented the IRS from reaching the owner’s personal assets and that the governing regulation was invalid. But, the court disagreed. When a single-member LLC does not make an election to be taxed as a corporation, the court noted, the owner is personally liable for those taxes. The applicable regulation states, “…an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner.” Since, the plaintiff had not made an election to have the LLC taxed as a corporation, the LLC was disregarded as an entity separate from the plaintiff – it was as if the LLC didn’t exist. So, when the payroll taxes didn’t get paid, the plaintiff became personally responsible for the entire amount. The court noted that there is a tax trade-off with LLCs – the owners can choose not to elect corporate tax treatment and by doing so can avoid double taxation, but the owners will be liable for corporate debts; if an election is made, the owners are not liable for LLC debts, but there is double taxation. The taxpayer made the choice not to elect corporate status and became personally responsible for the unpaid payroll taxes. The court also ruled that the regulation stating that federal tax law trumps state law with respect to LLC taxation was reasonable and would be upheld. Furthermore, proposed regulations that would have provided the result the taxpayer wanted had not yet been adopted and were not binding.
So, what lessons can be taken from the case? First, it is apparent that some taxpayers (even apparently some accounting firms) do not fully understand the implications of the LLC form of business when it comes to payroll tax liability. Second, single-member LLCs provide little protection against creditors taking action against the owner’s personal assets if default tax status is utilized. Third, additional planning steps are probably necessary to protect personal assets. Clearly, the owner of the firm involved in this case could have prevented IRS from pursuing personal assets by having a nominal business partner (such as a corporation also owned by the LLC having a small ownership interest in the LLC) or by electing corporate tax status for the LLC.
But, a single-member LLC still probably works to protect the LLCs assets from the single-member owner’s liabilities. In 1999, IRS ruled that they could not levy on the assets of a single-member LLC to satisfy a tax liability of the LLCs single owner because the LLC was disregarded for federal tax purposes (ILM 199930013 (Apr. 18, 1999)). In a 2008 Chief Counsel Advice, IRS again stated that it could not use the assets of an LLC to satisfy a judgment or debt of an LLC owner because, under state law, the LLC was separate and distinct from the single-member owner. (CCA 200835030 (Jul. 18, 2008)). But, in a subsequent 2008 CCA IRS concluded that a federal tax liability owed by a corporation or LLC may be collected from its successor in interest if the successor corporation or LLC is liable under the relevant state law. (CCA 200840001 (Aug. 28, 2008)). Thus, if the payroll tax is a personal liability of the single-member owner of an LLC (as the court ruled in this case), the owner should have placed his assets in the LLC, where they would be beyond the IRS’ reach. McNamee v. Comr., 488 F.3d 100 (2d Cir. 2007).
Note: Effective Jan. 1, 2009, Treas. Reg. §301.7701-2(c)(iv) treats a single-member LLC that is disregarded as an entity for federal income tax purposes as a corporation for federal employment tax purposes with respect to wages paid on or after January 1, 2009. A disregarded LLC is taxed as a corporation for employment tax purposes and many of the issues surrounding collection of a tax liability from a disregarded LLC are eliminated.
Update: The United States Court of Appeals for the Sixth Circuit had similarly ruled about a month before the Second Circuit rendered its opinion in McNamee. See Littriello v. United States, 484 F.3d 372 (6th Cir. 2007). A few weeks after the Second Circuit's opinion, the Federal District Court for the District Eastern District of Michigan agreed. See Stearn & Co., L.L.C. v. United States, 499 F. Supp. 2d 899 (E.D. Mich. 2007). On February 19, 2008, the United States Supreme Court declined to hear the Littriello case. Littriello v. United States, 484 F.3d 372 (6th Cir. 2007), cert. den., 128 S. Ct. 1290 (U.S. 2008). Later, on April 30, 2008, the Federal District Court for the Western District of Louisiana followed McNamee, Littriello, and Stearn & Co., L.L.C. L & L Holding Co., L.L.C. v. United States, et al., No. 1:05-CV-00794, 2008 U.S. Dist. LEXIS 35229 (W.D. La. Apr. 30, 2008). In early 2009, the U.S. Tax Court again upheld the "check-the-box" regulations and said that IRS could collect unpaid payroll taxes from a single-member LLC owner. Medical Practice Solutions, LLC v. Comr., 132 T.C. 125 (2009). The Tax Court's opinion has been affirmed by the U.S. Circuit Court of Appeals for the First Circuit. Britton, et al. v. Comr., No. 09-1994 (1st Cir. Aug. 24, 2010). On June 6, 2011, the U.S. Supreme Court declined to hear the case. Britton, et al. v. Comr, No. 10-134, 2011 U.S. LEXIS 4363 (U.S. Jun. 6, 2011).
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