LLCs and Employment Taxes
General Partnerships. A partnership is generally defined as an association of two or more persons to carry on, as co-owners, a business for profit. In Galletti, 541 US 114, 93 AFTR 2d 2004-1425 (2004), the Supreme Court held that IRS was entitled to collect a partnership's unpaid employment taxes from the individual partners. For the purpose of Code Sec. 3403, the partnership was the "employer." Because the partners were not primarily - but secondarily - liable for the debt, IRS was not required to assess the delinquent tax against each partner.
The Court rejected the argument that the partners were entitled to separate assessment. It held that a timely assessment of tax against the partnership by IRS extended the limitations period for collecting the debt in judicial proceedings against the partnership or partners. Pursuant to Code Sec. 6501 and Code Sec. 6502, the function of an assessment is to calculate and record a tax liability and not to assess the taxpayer.
S Corporations. An S corporation is a small business corporation, which gets special tax treatment if its shareholders consent to the corporation's election to be taxed under Subchapter S. Despite arguments from three S corporations that they should not be held liable for payroll taxes on payments to their shareholders for services performed by them, these entities were held liable by the Tax Court. In an unpublished opinion, the Third Circuit, affirming the three Tax Court decisions (Joseph M Grey Public Accountant, P. C. (CA 3 2004), 93 AFTR2d 1626), held that the presidents of the S corporations, who handled the companies' business transactions and were also shareholders in the corporations, were employees. The Court ruled that a similar situation occurred in Nu-Look Design, Inc. (CA 3 2004), 356 F3d 290, 93 AFTR2d 2004-608, where the shareholder/officer performed services and was held to be liable for employment taxes. However, it pointed out that if shareholders/officers performed minor services and neither received nor were entitled to receive any compensation, they would not be employees for federal unemployment tax purposes.
Limited Liability Companies. LLCs are hybrid entities created under state law, which have the attributes of both partnerships and corporations. IRS treats the LLC as an eligible entity under the "check-the-box" rules, whereby an LLC has the flexibility to be classified as either a partnership, an association taxable as a corporation, or a disregarded entity.
Under Reg § 301.7701-1, the classification of an LLC depends on whether the LLC is a multi-member or single member LLC, and whether the LLC has elected how it wants to be treated. A multi-member LLC may elect to be treated as a corporation (Reg § 301.7701-3(a)); if no election is made, a multi-member LLC is treated as a partnership for tax purposes. (Reg § 301.7701-3(b)) A single-member owner may make an election to have the LLC classified as a corporation. If the single member does not make an election, Reg § 301.7701-3(b)(1)(ii) stipulates that the LLC is disregarded as an entity separate from its owner. The activities of a disregarded entity LLC are reported on Schedule C of the owner's Form 1040.
Code Sec. 1401 and Code Sec. 1402 impose a self-employment tax on a general partner's distributive share of income from the partnership's trade or business. Code Sec. 1402(a)(13) excludes the distributive share of a limited partner from self-employment taxes other than guaranteed payments. Under Code Sec. 707(c), guaranteed payments are payments made by the partnership to partners for services rendered to the partnership or for the use of capital, without regard to the partnership's I income. Guaranteed payments are considered to be made ` to a recipient that is not a member of the partnership.
To clarify the self-employment status of limited partners and LLC members, IRS proposed amendments to the current Reg § 1.1402(a)-2(h)(2). Under the proposed amendments, an individual is treated as a limited partner unless the partner;
... has personal liability for the debts of or claims against the partnership by reason of being a partner;
... has authority (under the law of the jurisdiction in which the partnership is formed) to contract on behalf of the partnership; or
... participates in the partnership's trade or business for more than 500 hours during the partnership's tax year.
An exception in the proposed amendments is that a service partner (a partner who provides services to or on behalf of the professional service partnership) is not treated as a limited partner for self-employment tax purposes. Also, a partner is not considered a service; partner if that partner provides only de minimis services to or on behalf of the partnership. A professional service partnership is one in which substantially all the activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting.
Single-Member LLC. An important question relating to a disregarded, single-member LLC is whether such an entity could be treated as an "other person" for purpose of collecting employment taxes under Code Sec. 3505(a). IRS in Chief Counsel' Advice 200338012 concluded that a disregarded LLC is not an "other person." IRS ruled that it can collect unpaid payroll taxes from the owner of a single-member LLC, but it cannot place a lien on the assets of the LLC for the payment of those taxes.
The single-member owner of an LLC is the employer for purposes of employment tax liability. The disregarded LLC is not separate from its owner for federal tax purposes; the single-member owner is the taxpayer with respect to liabilities arising from the LLC's business. IRS can assess and collect these liabilities against a single-member owner. IRS can also pursue an administrative collection action and may file a notice of federal tax lien and levy on the single-member owner's property and rights to property. Because the taxpayer is liable for these taxes for operations of the LLC, the single-member owner must file the tax returns from which IRS can make assessments.
Under Code Sec. 3505(a), if a lender, surety, or other person, who is not an employer, directly pays the wages of the employees of a taxpayer/employer, the lender, surety, or other person is liable to the U.S. for the amount the employer is required to withhold from the wages. An "other person" is a person who directly pays the wages of the employees of another person.
Whether the LLC is an "other person" under Code Sec. 3505(a) is complicated in that state and federal law view the business from different perspectives. Under state law, the taxpayer/single-member owner has no interest in the LLC's property. From this perspective, the LLC appears to be a separate entity, which, as the direct payer of the payroll, may be held liable for the failure to remit withholdings.
However, from the standpoint of federal tax law, the LLC has been disregarded as an entity separate from the taxpayer/single-member owner. Because the LLC is a disregarded entity for federal tax purposes and is treated like the taxpayer/single-member owner for purposes of assessment, the Chief Counsel Advice concluded that it was not appropriate to treat a single-member LLC as an "other person" for purposes of collection.
Multi-Member Domestic LLCs. In Rev Rut 200441, 2004-1 CB 845, IRS held that if members of the LLC are not liable for the LLC's debts under state law, IRS cannot collect the LLC's federal employment tax liabilities from the LLC's members, despite the classification of an LLC as a partnership for federal tax purposes. This is true even if they were general partners of a partnership for federal tax purposes.
Unless an election is made to have it taxed as a corporation, for federal tax purposes, a multi-member domestic LLC is classified as a partnership. IRS may seek to collect unpaid federal tax liabilities incurred by a partnership, such as federal employment taxes, from the general partners of the partnership. Under state laws, however, members of an LLC are generally not liable for the LLC's debts. Therefore, in those states, ~ IRS may not levy on the property and rights to property of the members, in their capacity as members, to collect the employment taxes owed by the LLC. However, in cases of trust fund recovery, a member may be liable for the trust fund recovery penalty under Code Sec. 6672, depending on the facts of a particular case.