Thursday, February 06, 2003

Limited Liability and Its Discontents, Part 2

LLCs do have a certain Chesire cat aspect to them. For instance, single member LLCs may be disregarded for all income tax purposes, but, for state law purposes, they nevertheless have identities separate and apart from their owners. And, there has always been a tension in the partnership tax area between treating a tax partnership as an entity versus treating it as an aggregation of individual members. Undoubtedly, the limited liability shell present in all LLCs affects this tension.

In PLR 200235023, the IRS began to address these issues. Specifically, the ruling addresses the following questions: (i) Who is liable for the tax resulting from the operation of a multi-member LLC?; (ii) Who is liable for the tax resulting from the operation of a single member LLC?; (iii) If the Service makes an assessment against an LLC that is a disregarded entity, is that a valid assessment against the single member owner?, (iv) If the Service files a Notice of Federal Tax Lien ("NFTL") naming the disregarded LLC as the taxpayer, is that a valid NFTL against the single member owner?; and (v) Are there state law theories that the Service could use to collect the single member owner's liability from the disregarded LLC?

The first question was answered quite easily. If a multi-member LLC has elected to be classified as a corporation for income tax purposes, the LLC will be liable for the tax, except to the extent that IRC Section 6672 is applicable. Significantly, however, even if an LLC is classified as a partnership, members are not liable for federal taxes except to the extent that the members are either liable for the LLC's obligations under state law or IRC Section 6672 is applicable. Thus, in a multi-member business, a multi-member LLC has liability advantages, even for income tax liabilities, over a plain vanilla general partnership.

In a single member LLC, as is the case with a multi-member LLC, a single member LLC that has elected to be classified as a corporation is liable for the tax and the sole member is only liable to the extent that IRC Section 6672 is applicable. Not surprisingly, the Service takes the position that in a single member LLC that is a disregarded entity, the assessment is against the single member. Thus, the single member's assets may be attached, but the assets of the LLC may not be.

Surprisingly, however, the Service stated that it will honor the division between the LLC, as an entity, and its sole member, when it comes to collecting the tax obligation of the member. Thus, the Service will not, automatically, move to use the assets of the LLC to satisfy the obligations of the sole member. However, collection action can be taken against the single member's ownership interest in the LLC. This may result in a foreclosure action which ultimately exposes the LLC's assets to the IRS's claims.

However, note that it is the member who is the taxpayer of a single member LLC that is a disregarded entity. Thus, all income, loss, etc., as well as obligations for withholding taxes, flows directly to the owner. The Service is not limited to relying, for instance, on Section 6672 if there has been a failure to pay over withholding.

With respect to notice of federal tax liens, a notice inadvertently naming as the taxpayer an LLC that is a disregarded entity for the obligations of the member may sometimes be valid. To determine whether the notice of lien is valid, the so-called "substantial compliance" test is used. As stated in the ruling, "The guiding legal principle is that the name on the NFTL must be sufficient to put a third party on notice of a lien outstanding against the taxpayer. . .Such a determination will depend on the facts and circumstances in each particular case. . . .[T]he substantial compliance test is met when the third party examining the public record is alerted to the possibility of the federal tax lien."

In cases where the notice of lien has been filed incorrectly and there is no substantial compliance (e.g., the lien is filed in the name of Eagle, LLC, a single member LLC owned by John Jones), the Service can withdraw the notice of lien and refile under the name of John Jones.

Finally, PLR 200235023 discusses various state law theories that the Service could use to collect the single member's liability from his or her disregarded LLC. It is in this area that the ruling becomes troubling.

For instance, in its discussion of the "piercing the corporate veil" or "alter ego" doctrine, the Service described the doctrine as follows: "The alter ego theory has been asserted in the corporate context when facts show that there is such a unity of interest and ownership between the subject taxpayer and corporation that the individuality or separateness of the taxpayer and the corporation has ceased. Generally there are facts that show that adhering to the fiction of a separate existence of the corporation would, under the particular circumstances, sanction a fraud or promote an injustice."

In a sense, this is a correct, black-letter statement of the law. However, the formula that leads to this conclusion is not necessarily composed of the same factors in every state. The Service listed some of these factors as "occurrences of fraud; inadequate capitalization of the corporate entity; failure to adhere to corporate formalities (such as commingling of funds); and abuse of the corporate entity so as to amount to complete dominance by the shareholder or shareholders."

Well, some of these probably don't apply in Maryland (complete dominance by one shareholder and lack of corporate formalities, for instance). Maryland, correctly I think, applies an economic analysis: Did the principals of the corporate debtor act to divert assets that should have gone to pay the creditor. At its core, this concept is very close to the concept of a fraudulent conveyance.

The Service seems to go further, however. In one particularly chilling remark, the ruling stated that "the fact that the LLC is disregarded under the 'check-the-box' regulations for purposes of computing the taxpayer's tax liability may make the courts amenable to applying the alter ego/piercing the corporate veil concepts to the LLC. Arguably, where due to the 'check-the-box' regulations the individual taxpayer is responsible for reporting and paying all income earned by the LLC, and the individual arranges his business affairs so that the LLC, rather than the individual taxpayer, has the assets to pay the tax liability, this could be significant factor supporting piercing the LLC veil."

In other words, a single member LLC is more at risk for veil piercing than a multi-member LLC. This idea runs counter to the basic predicate of an LLC--that the assets of the LLC and its business are the assets and business of an entity that has an identity that is separate from the owner. It should not matter that the LLC has one member or one hundred members.

Finally, the ruling also states that liability may also be founded on a theory that the LLC is a mere nominee, that transferee liability is applicable, or that the LLC may be liable as a transferee under IRC Section 6901. With respect to transferee liability, the ruling notes that "many of the factors which tend to support piercing the LLC veil--such as pervasive control by the individual taxpayer over the LLC--also tend to support transferee liability."

While PLR 200235023 ostensibly gives guidance only to the employees of the IRS, bad news travels fast. To the extent that the Service misstates the law (as in the veil piercing context with respect to Maryland law) or undermines the efficacy of the limited liability shield in single member situations, the theories espoused in PLR 200235023 might be adopted by non-governmental creditors with devastating effect. Going one step further, to the extent that the law is not settled, PLR 200235023 is even more troublesome, since the Service may take litigating positions that are more extreme than those a private creditor might take. And, going even one further step, courts might be less reluctant to rule in the creditor's favor in breaking down limited liability shields when the creditor is the government.

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