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Forming a Limited Liability Company and 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.

A Limited Liability Company (LLC) is a business structure allowed by state statute. Each state may use different regulations, and you should check with your state if you are interested in starting a Limited Liability Company.

Owners of an LLC are called members. Most states do not restrict ownership, and so members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit "single-member" LLCs, those having only one owner.

A few types of businesses generally cannot be LLCs, such as banks and insurance companies. Check your state's requirements and the federal tax regulations for further information. There are special rules for foreign LLCs.

Classifications

Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC's owner's tax return (a "disregarded entity"). Specifically, a domestic LLC with at least two members (not husband and wife in community property states) is classified as a partnership for federal income tax purposes unless it files Form 8832 and affirmatively elects to be treated as a corporation. And an LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes (but as a separate entity for purposes of employment tax and certain excise taxes), unless it files Form 8832 and affirmatively elects to be treated as a corporation.

Effective Date of Election

An LLC that does not want to accept its default federal tax classification, or that wishes to change its classification, uses Form 8832, Entity Classification Election, to elect how it will be classified for federal tax purposes. Generally, an election specifying an LLC's classification cannot take effect more than 75 days prior to the date the election is filed, nor can it take effect later than 12 months after the date the election is filed. An LLC may be eligible for late election relief in certain circumstances. See Form 8832 General Instructions for more information.

By default, a single-member LLC (or a husband and wife multi-member LLC in community property states) 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.

For those of you in Texas or other community property states, a limited liability company that has a husband and wife as the only members is considered to be one member and a disregarded entity for federal tax purposes. For state tax purposes the entity would not be disregarded and would be required to file state franchise, margin or similar tax returns.

If 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 (not a husband and wife in community property states) 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."

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