LLC Tax Filing Consequences

Single-Member vs. Multi-Member LLCs: Federal Tax Filing Consequences

The limited liability company (LLC) form of business organization is extremely popular and provides many advantages to its members. The benefits of this form of organization includes limited liability for its owners (known as members) and the avoidance of the double taxation which afflicts corporations. Members can also participate in the management of the entity without losing limited liability protection. With the large proliferation of this form of business organization across the United States the federal tax filing consequences of the LLC are also important to consider.

By default, a single-member LLC is classified as a disregarded entity for federal tax purposes. Under this classification, the sole owner of the LLC if an individual would report and pay tax on the income, deductions, gains, losses, and credits related to the business on their own Form 1040. On the other hand, a multi-member LLC is classified as a partnership for federal tax purposes. Under the partnership classification, the LLC would be required to annually file Form 1065, the partnership tax return, and each individual member would report and pay tax on their distributive share of income, deduction, gain, loss, and credit on their own tax returns. An LLC can also be a corporation for federal tax purposes if an affirmative election to this classification is made. Under the corporate classification, the LLC would be required annually file a Form 1120. This classification scheme is known as the check-the-box regulations.

LLC Tax Filing ConsequencesIf an LLC has not chosen be taxed as a corporation a change in the number of members from a single member to multiple members or from multiple members to a single member affects entity classification and thus federal tax filing requirements. The Treasury Regulations under Internal Revenue Code (IRC) §7701 provide that a single member disregarded entity becomes a partnership when it has multiple owners although the specific form of the conversion is not laid out in the regulations. The guidance concerning the specific form of the change from a disregarded entity into a partnership and a conversion of a partnership into a disregarded entity for LLCs are addressed in Rev. Rul. 99-5 and Rev. Rul. 99-6, respectively.

Rev. Rul. 99-5 illustrates the specific form and the federal income tax consequences associated with a change in the number of an LLC’s members that causes the LLC to convert from a single member (disregarded entity) to multiple members (partnership). The ruling also provides alternative scenarios in which the number of members change. The overall point of the ruling is that a partnership begins when the membership of the LLC increases from one to multiple members.

Rev. Rul. 99-6 indicates that if the membership of an LLC declines to one member, due to an event such as the other members selling their ownership stakes, the partnership is terminated for purposes of IRC §708 (b) (1) (A). In general, IRC §708 (b) (1) (A) causes a partnership to terminate if “no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.”

Example: Advantage Sports LLC, a sports equipment manufacturer, has consisted of three members since its organization in 2012. The LLC never made an election to be treated as a corporation for federal income tax purposes and its tax year is the calendar year. On March 1, 2017, two of the members sold their ownership interests in the LLC to the remaining member. On October 1, 2017, the sole member of the LLC sold 25% of their ownership stake to a new member.

Advantage Sports LLC operated as a partnership for federal tax purposes from its organization in 2012 until its membership dropped to a single member on March 1, 2017. From March 1, 2017 until October 1, 2017 the organization was considered to be a disregarded entity. From October 1, 2017 until the end of the tax year the organization was considered a partnership for federal tax purposes.

On March 1, 2017, the “first” partnership which began in 2012 is terminated for purposes of IRC §708 (b) (1) (A). After operating as a disregarded entity for nine months, the October 1, 2017 transaction results in a new partnership forming. As a result, Advantage Sports LLC would be required to file a final partnership return for the first two months of the tax year for the original partnership and an initial partnership return for the last three months of the tax year for the new partnership. Each member would need to report and pay tax on their distributive share of income, deduction, gain, loss, and credit based on the time they held an interest in the LLC while it was a partnership. The member who owned 100% of the entity when it was disregarded for nine months would be required to report and pay tax on 100% of the of the income, deduction, gain, loss and credit during that time.

For more information on forming an LLC and the federal tax consequences of the LLC form of business organization business please seek legal and tax advice from a qualified professional.

About The Author

Daniel Quintana

Daniel Quintana of Kurtz & Company, P.C. in Dallas Texas. https://www.linkedin.com/in/drquintana