The New York limited liability company (LLC)1 recently celebrated its 15th anniversary. In its 15 years, it has reformed the legal landscape for the way in which most businesses operate.
Here is a thought provoking analysis to be considered for existing LLCs and future LLCs.
1. Tax Flexibility
Why an LLC? The LLC is a tax driven entity. It is the best type of entity for almost any type of business and in its 15 years, 511, 8392 LLCs and LLPs have been formed or registered to do business in New York State. Here are a few well known uses of the LLC:
a. Real estate investment. It permits the owners to refinance the property (once the economy gets back to normal) and withdraw the proceeds without tax consequences.
b. Professionals. Before the advent of LLCs and LLPs, most professionals practiced as general partnerships because it gave them operating flexibility, but it also exposed them to personal liability. Since 1970, New York professionals could form professional corporations (PC) to mitigate some of the liability exposure (e.g., from anothershareholder’s malpractice) but it was constraining taxwise. LLCs/LLPs give almost complete commercial liability protection (except for one’s own malpractice) plus freedom to apportion income among the owners and more easily transfer ownership interests than can be done with PCs.
c. Liquidation. In most instances an LLC can be liquidated without adverse tax consequences – not so with a corporation.
2. The Single Member Limited Liability Company (SMLLC) As its name connotes, the SMLLC has only one owner. That owner can be an individual or any type of entity. The SMLLC acts like a corporation in that it protects its owner from most personal liability. In addition to any type of business, it can be used by a licensed (by the New York State Education Department or Appellate Division) sole practitioner professional whereas an LLP, as its name indicates, would need to have two or more licensed professional owners. While almost like a corporation for legal purposes, it is disregarded for federal and state income tax purposes; however, recent changes to IRS regulations3 cause the SMLLC to be treated separate and apart from its owner for payroll and excise tax purposes. While this change (previously the SMLLC owner was legally liable for such taxes) will make it easier for the IRS to administer the collection of such taxes, the effect for the SMLLC owner will be to prevent the IRS from suing the owner for non-trust fund taxes (e.g., the employer’s share of social security expense). A ‘responsible person’ always can be sued for unpaid ‘trust fund’ withholding taxes.
3. Estate Planning With the New York LLC The technique of using an LLC for estate planning is rife with tax litigation. The next few comments touch on just two of them.
a. August 31, 1999. An important date in LLC history. An important part of estate planning is determining the value of gifted property (in this case, the LLC interest). Prior to August 31, 1999, no matter what the LLC agreement said about limiting or preventing withdrawal as a member of the LLC, the statute provided that the member could withdraw by giving the LLC six months notice. The statute trumped the operating agreement. This was commonly referred to as a “Pack and Go” statute. An appraisal of an interest in a New York LLC could not allow for as large a discount as would be allowed (under other states’ laws) if the withdrawal prohibition was valid. For that reason, estate planners formed their estate-plan LLCs in other states which had more favorable prohibitive withdrawal laws, thereby giving the appraiser the ability to calculate a lower LLC-interest value for gift tax purposes. It is important to note that, for purposes of interpreting any LLC agreement provision, it is the law of the state in which the entity is formed (not the state in which the entity operates or the owners live) that controls the interpretation of an agreement section. “Pack and Go” in New York is gone4 with one BIG caution. Pre August 31, 1999 LLCs are governed by old law unless the operating agreement provides otherwise. The old law required the consent of 2/3 of the members other than the withdrawing member.
b. The IRS has taken the position in several cases that a gift of an interest in a SMLLC is a gift of the underlying property and, accordingly, it (the IRS) refused to recognize discounts for lack of control (aka minority interest) and lack of marketability where the SMLLC was broken up into smaller (50% or less) pieces. In the recent case of Pierre v. Commissioner,5 however, the court, in a 10-9 decision, held that a New York SMLLC was a legally organized and recognized entity that had to be treated separate from its single owner because state law controls property rights. Just because the IRS disregards6 the LLC for income, employment and excise tax purposes, as it is allowed to do under its regulations, does not mean that it can disregard the SMLLC for other tax related areas where state law is controlling. Two important follow-up points to this taxpayer-favorable decision: (i) the IRS may appeal the decision in this case; and (ii) in footnote 3 of the Pierre case, the court said that a separate opinion it would address whether the “step transaction doctrine” should apply. There were 12 days between the formation of the New York entity and its transfer to the trusts.
Also see item 9 below, “New York’s View on Real Estate Ownership by a SMLLC.”
4. Respect the LLC Entity and It Will Protect Its Owners From Personal Liability (except for sales tax exposure)
For a corporation, where the owners do not respect the integrity of the entity, (commingling corporate assets with personal assets; not entering into agreements in the corporate name; not including something akin to ‘incorporated’ on business literature; not keeping separate books and records; etc.), a corporate veil can be pierced and so can an LLC veil be pierced to get at the personal assets of the owners. It very rarely happens but it is better to adhere to operating the business in a businesslike manner.
With regard to the New York State sales tax, however, it can be deceptively dangerous to be an LLC owner even if the owner is passive. That’s because the New York Sales Tax Law7 imposes a burden (personal responsibility) to collect sales tax on “any member of a partnership or limited liability company.” Neither a limited partner nor a passive LLC member is exempt from enforcement under this section.8 That represents a significant difference of legal liability between an inactive shareholder and an inactive LLC member.
Ah, the tortured history of the publication requirement for a New York LLC. Suffice it to say – Live with it! It’s not going away. New York is the only state in the nation to have such a requirement. Ostensibly, its purpose is to protect the public by notifying the public of the LLC’s existence. Even if that were true in the 1800’s, certainly today’s public could be better protected by simply providing the information on the state’s website where everyone could access it instead of publishing in small print in newspapers that are not read by the public. Publication is a nuisance and it’s unnecessarily costly to business. It does no one (except the newspapers) any good. For the current publication requirements, go to http://www.dos.state.ny.us/ corps/news06012006a.html. P.S.: No one knows what ‘suspend’ (for failure to publish) means but it can’t be good. As an example, an accountant’s footnote should disclose on the financial statements if the LLC has not complied with the publication requirement. Non-publication also can have an adverse effect on lending agreements.
6. 50 States – 50 Laws9 Use common sense when advising a business that will operate in states in addition to New York. The other states’ laws should not impact your client’s LLC (as explained elsewhere in the article) but the income, employment and sales tax laws, inter alia, can vary significantly. Consult with local counsel.
7. The Foreign Word Except for this caution, this article will not attempt to give you the caveats. Suffice it to say, if you are advising a GmbH (Germany, Austria, Switzerland, et al), a SARL (France), a PLC (United Kingdom), et al, get help. The US tax rules for LLCs differ significantly when foreign entities are involved and while many foreign entities can file an election with the IRS to be treated as other than a corporation for US tax purposes, the rules are tricky and the wrong result can be disastrous. A ray of hope if an error is made – the IRS recently made it easier to correct misclassifications by easing the method of correction for achieving the desired result.10
And if you represent a client considering operating outside of the United States, be alert to the fact that some countries do not recognize our form of limited liability company as they would recognize a US corporation.
This has both legal and tax ramifications. Canada only recently began to recognize a US LLC as a transparent flow through entity.11
8. Self Employment Tax (or not) (SE) Is S(h)E or isn’t S(h)E? When does the SE tax apply to a member’s income? The IRS never has finalized its regulations for making the determination. The proposed (January 13, 1997) regulations got caught up in a political firefight in that year. The SE tax under the proposed regulations was described as a “Stealth Tax” and, in an appearance by Newt Gingrich on the Rush Limbaugh show on April 3, 1997, it was regarded as a tax increase via a proposed regulation instead of by an Act of Congress. The IRS became gun-shy about finalizing the said regulations believing instead that since Congress had intervened in the process, it should be Congress that resolves the question. And there it has sat for 13 years. Most tax professionals believe that the IRS did a credible job in interpreting the law. Very briefly put, the proposed regulations focus on deriving income from services resulting in an SE tax, but it’s much more complicated than that simple explanation.
9. New York’s View on Real Estate Ownership by a SMLLC An LLC interest is intangible property. As a result, it (and not the underlying assets that it owns) is subject to the estate tax (if there is one) of the state in which the decedent lived (not the state where the assets are located). For example, a Florida domiciliary owning an LLC interest in a multi-member New York LLC owning New York real estate would not be subject to the New York estate tax on the value of that interest. However, New York took the position, in an Advisory Opinion (which technically only applies to the taxpayer to whom it was issued but in reality is regarded as the view of the issuing agency), that New York real estate owned by a disregarded SMLLC which is owned by a non-New York individual, is subject to the New York estate tax.12
It stands to reason, therefore, that the estate of a New Yorker who owns non-New York real estate via a SMLLC would not be subject to the New York estate tax. It remains to be seen, when the opportunity presents itself, if the state is consistent in its position.
The above Opinion was issued prior to the Pierre case (item 3 (b) above). They reach opposite conclusions. The Pierre case holds the LLC to be a recognizable entity under New York law and the New York Advisory Opinion essentially holds the opposite. Of course, one is a Federal opinion (that can be cited as authority) and the other is a state opinion (which cannot be cited as authority).
10. The Written Operating Agreement The New York Limited Liability Company Law (NYLLCL) says that the operating agreement shall be written13 and in the Department of State’s guide on forming an LLC in New York (see item 18 below), it says “The law is silent on the consequences of not adopting an operating agreement.” It makes good business sense to memorialize the business agreement but what happens when New York Law is not complied with? Perhaps nothing. In two cases, New York courts held that, despite the absence of LLC written operating agreement, the LLC was a valid LLC and the statutory default provisions of the New York Limited Liability Company Law became the operating agreement of the LLC.14 Nevertheless, don’t allow your client to buy a lawsuit by not having a written operating agreement.
If a written operating agreement is not possible, consider forming the client’s LLC in a state which does not require a written operating agreement (e.g., Delaware). The LLC would have to register to do business in New York as a foreign (in this case ‘foreign’ simply means not New York) LLC, but the inner workings of the LLC would be controlled by the other state’s LLC law; hence, no need for a written operating agreement.
11. Online Formation Don’t! That’s what I tell my fellow15 accountants and anyone else that will listen. Only attorneys should form legal entities – especially LLCs which can have nuances (such as the requirement for a written operating agreement described above). Even journalists continually make mistakes when writing about the LLC. Frequently, they refer to it as a Limited Liability Corporation. It’s confusing and the layman could wind up forming the wrong type of entity.
Comparing the LLC to an S Corporation16
A Sampling of Thoughts
12. An LLC never can lose its status as an LLC; however, an S corporation can lose its S status through an inadvertent action (e.g., the S stock is bequeathed to an invalid shareholder or a corporation becomes an owner of the S stock) with disastrous tax consequences.
13. An LLC cannot pay salaries (as we commonly understand salaries) to a member whereas income to an S shareholder-employee can be in the form of reasonable wages (subject to social security and Medicare tax) and dividends (not subject to social security and Medicare tax). An LLC member’s earnings from an LLC in which he works is generally (but not always) entirely subject to the self-employment tax.
14. An LLC must publish the notice of its formation but an S corporation does not publish.
15. An LLC can determine the apportionment of its income any time before the original due date of the partnership tax return for the immediately preceding year, but an S corporation would need to project its income before year end if it wanted to allocate its income, via year-end bonuses to the owner-employees, disproportionately.
16. You can’t take an LLC public (unless you first convert it into a corporation). You can take an S corporation public but it would immediately transform it to a regular taxable corporation (referred to as a C corporation).
17. Federal Statistics for 200717 a. 3,096,334 partnership tax returns were filed. Of the aforementioned number, 1,818,681 were self-classified as LLCs of which about 873,000 showed income and about 946,000 showed a loss.18 18,515,694 is the number of partners to whom income and loss were reported.
18. Forming a Limited Liability Company in New York State New York has a website which provides a short guide. Go to http:// www.dos.state.ny.us/corp/llcguide.html. Among other guidance, it says “Anyone forming an LLC should consider utilizing a lawyer. However, there is no requirement to use a lawyer when forming an LLC.”
19. New York Tax Status of Limited Liability Companies and Limited Liability Partnerships
For a tutorial primer on the New York tax rules, fees, responsibilities and forms, access a copy of Publication 16 (September 2009) at http://www.tax.state. ny.us/pdf/publications/multi/pub16.pdf
This article has provided you with memory joggers or points on which you will want to follow up with your clients. Review your client base, old and new, and be in contact with them while the items are fresh in your mind.
Alan E. Weine, Partner Emeritus of CPA firm of Holtz Rubenstein Reminick LLP, founded the Firm’s tax department in 1975 and headed it through 2006. He is active on the tax committees of the Bar Associations of Nassau County and Suffolk County, and is a Past President of he New York State Society of CPAs. He is the author of All About Limited Liability Companies and Partnerships and DFK International’s Worldwide Tax Overview.
1. Most of the comments herein are equally applicable to New York limited liability partnerships (LLP).
2. As at July 31, 2009. Source: New York Department of State, August 2009
3. Internal Revenue Service (IRS) Reg. § 301.7701-2 (c) (2) (iv)
4. New York Limited Liability Company Law (NYLLCL) § 606. Partnership Law Section 121-603 mirrors the above as it applies to limited partnerships.
5. 133 T.C. No. 2 (August 24, 2009)
6. IRS Reg. § 301.7701-2 (2) and 3 (a)
7. New York State Sales Tax Law § 1131 (1)
8. See Matter of Bartolomei, DTA No. 812888 (April 3, 1997); Matter of Santo, DTA No. 821797 (December 23, 2009); Matter of Davis, DTA No. 822377 (February 11, 2010)
9. It’s even worse for LLPs. An LLP in New York only can be owned by, in most instances, New York licensed professionals but other states may permit an LLP to be used by other types of businesses, leading to confusion when attempting (unsuccessfully) to register to do business in New York.
10. Revenue Procedure 2009-41, issued September 3, 2009; published September 28, 2009, Internal Revenue Bulletin 2009-39
11. 5th Protocol to the Canada-U.S. Tax Treaty (December 10, 2008)
12. Martinez-Catinchi, Advisory Opinion, TSB-A-08 (1) M, October 24, 2008
13. NYLLCL § 417
14. Spires v. Lighthouse Solutions, LLC, Supreme Court, State of New York, Monroe County, 2004 and Merrell-Benco Agency, LLC et al v. HSBC Bank USA et al, Supreme Court, Appellate Division, 3d Dept. 2005
15. The author is a both a CPA and an attorney.
16. Both the LLC and an S corporation are considered to be flow through entities. That is, in both cases, the income or loss of the entity flows through to its owners’ tax returns. That’s the reason that the practitioner needs to compare the merits of both when advising a client as to which form of entity to use. Although the following is not the subject of this article, it may be helpful in understanding the subject. A corporation and an LLC each is a creature of state law. One does not form an S corporation. One forms a corporation if that is the type of entity selected. After the corporation has been formed in accordance with state law, the corporation’s owners look to the Internal Revenue Code, subchapter S (that is from where the S corporation derives its name), to file the election with the IRS. An LLC formed in the United States is, by default, treated as an unincorporated entity (i.e., a partnership if there are two or more owners). No election is necessary. IRS Reg. § 301.7701-3 (b)
17. Internal Revenue Service, Statistics of Income Bulletin, Fall 2009, Washington, D.C.
18. Ibid. Figure H, P. 64
Nassau County Bar Association ALL Rights Reserved
15th and West Streets | Mineola, NY 11501 | (516) 747 4070 | Fax (516) 747 4147