If you are thinking about starting a small business, why not start with a Single Member LLC.? The most important reason to form a Single Member LLC or "Single" is simplicity. As a Single you file no separate tax return apart from your personal tax return Form 1040. The law says you are “disregarded” for tax purposes as a separate entity and therefore no separate tax return is required. A second reason to stay single is most if not all states now recognize LLC’s for asset protection. Even the IRS must now follow state law if you owe back payroll taxes as per Aquilino v United States 363 US 509 (1960). Sounds easy and a bit too good to be true, doesn't it? Well it is not too good to be true but it is anything but easy because the IRS has set up various Single traps out there. If you should get trapped during the holiday audit season, you might have to pay tax to get yourself out of that trap.. So if you are thinking about becoming a Single or have already set one up, stay tuned on TaxView with Chris Moss CPA so you can learn how to save taxes by bullet proofing your Single from IRS holiday traps.
The IRS can tax a Single, but a Single is regulated by state law. If you or your Single get audited the IRS may try to convince you that you and your Single are one and the same, but as the Government found out in Suzanne Pierre v IRS US Tax Court (2009), that is not the case. The facts are simple: Pierre formed Pierre LLC under New York State Law defining a single member LLC as a separate legal entity from its owner. The IRS audited Pierre’s 2000 and 2001 gift tax return and concluded that the gift transfers of discounted membership interests to trusts were really disguised gifts of the assets in the LLC. Valued without the discounts the IRS assessed Pierre's gift transfers for an additional gift tax of $11 Million. Pierre appealed to US Tax Court in Pierre v IRS US Tax Court (2009).
The IRS argued before Judge Wells that because Pierre LLC is a single member LLC it should be treated as a disregarded entity under the check the box regulations, IRS Regulation 301.7701-3, IRS Publication 3402, and Revenue Ruling 99-5. Therefore, Pierre’s membership transfers should also be disregarded, and be treated as if Pierre had transferred the assets directly to the trusts. Pierre on the other hand reasoned that New York State law, not IRS regulations control the nature of the property transferred from the LLC to the trusts. Pierre also maintained that under New York State law a membership interest in an LLC is personal property and consequently a member has no interest in the individual assets of the LLC, citing NY Limited Liability Company Law Section 601.
Agreeing with Pierre, Judge Wells concluded that only New York State law., not Federal law, could create a property right in the LLC's underlying assets. For that reason, the discounts on the Single membership interests were valid. Moreover, with New York State law controlling, the gift tax liability was determined by the value of the discounted transferred membership interests. Pierre Wins IRS Loses. Also see LexisNexis 2009 Commentary.
Be aware, however, that the Government can lure you into a reverse Single trap if your structure lacks business purpose. Take Robucci v IRS US Tax Court (2011). Robucci was a psychiatrist whose CPA converted him from a sole proprietorship to a two member LLC. Robucci owned 95% as the first member and a PC manager owned the remaining 5% as the second member. Additional corporations and entities were set up with the sole purpose of reducing self-employment tax. Indeed Robucci paid very little or no self-employment tax for 2002-2004. The IRS audited and reversed all of the Robucci entities to a single member LLC with Robucci as the Single owner. The IRS then held Robucci personally liable for tax and penalty of over $50,000 in 2002-2004. Robucci appealed to US Tax Court in Robucci v IRS US Tax Court (2011). The Court easily concluded all of Robucci’s business structure had no substantial purpose other than tax avoidance and was nothing more than a sham.. The Court “pierced the corporate veil” holding all of Robucci's income was subject to self-employment tax under Section 1401.
Our final case, Medical Practice Solutions (MPS) and Carolyn Britton Sole Member v IRS US Tax Court (2009) focuses on a former IRS Single trap with respect to payroll taxes: Carolyn Britton of Massachusetts formed MPS as a single member LLC. The LLC failed to pay employment tax for several periods in 2006. Notices of liens were sent both to Britton and MPS. Britton requested a hearing pursuant to Section 6330, Britton argued that she was not liable for the lien. It was only MPS her Single that was liable as the “employer”. The hearing did not go well for Britton so she appealed to the US Tax Court in Britton v IRS US Tax Court (2009). The Court citing Littriello v US, 484 F.3d 372 (6th Circuit Court of Appeals) upheld the regulations of a single-member LLC in the context of employment tax liabilities even though the IRS was in the process of changing the regulations to favor Britton. Unfortunately, Britton was a few months to early and the Court decided in favor of the Government.. IRS Wins Britton Loses.
After September 1, 2009 however new IRS regulations 301.7701-2 were enacted. The new law treats a Single with payroll liability as if that payroll had been paid by a corporation, Therefore a Single owner is now shielded from payroll tax liability.. Both Single owner Britton, Littriello and Robucci would have been protected from payroll tax liability under these new regulations provided their Single had a primary business purpose.
What does all this mean for you? Your Single now has just about absolute limited liability as long as you did not lack business purpose in setting up the Single. What to do now to avoid IRS traps? First, have your tax attorney create a special and unique operating agreement just for you explaining your Single business purpose and also detailing who would replace you if you should pass. Second, as a Single without a partner you may wish to create a Board of Advisors to meet once or twice a year to give you advice and inspiration as your grow your business. Finally, as we head towards the New Year be prepared for potential business opportunity to surface, Perhaps a reverse 1031 exchange before year end? Or perhaps a possible mergers or acquisition? Have a Merry Christmas from Chris Moss CPA on TaxView.
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Chris Moss CPA