Ward on Iowa Limited Liability Company Law

Interesting PLR Involving LLCs and S Corps

IRS Private Letter Ruling 200927014 (March 20,2009), presents an interesting fact pattern.   The two individuals who own all of the shares of X, an S corporation, will each transfer their shares to two LLCs. They will manage their LLCs and retain all rights to profits, losses and distributions.  But each of them will also transfer certain management rights to Y.  It is not clear whether Y is an individual or an entity.  These rights include the right to participate in management of the LLCs, the right to vote on their business activities, merger or sale of substantially all of their assets, borrow money, make distributions, liquidate the LLCs, amend their operating agreements, and transfer their interests to others.  Y would also appoint new managers if the shareholders die while acting as managers. All of these actions would indirectly affect the S corporation.  Y is not a member of either LLC.

The IRS held that the transfer of the S corporation's shares to the LLCs and the role of Y in the management of the LLCs would not cause the corporation to lose its S corporation status. For tax purposes Y is not considered a member of either LLC and each LLC will be treated as owned, respectively, by the two former shareholders of X.  The shares of X are treated as owned directly by the two individuals.  The LLCs will be disregarded entities for tax purposes.

It appears from the ruling that Y will participate in management but not have sole responsibility for management.  It is not clear if Y has control, but the tenor of the ruling suggests that the outcome was not be dependent on control, but on the determination that for tax purposes membership status is based solely on the right to the economic interest in the LLC.

-Marc Ward

When Does Inadvertence Become Negligence? IRS Excuses Another

Here are the facts of PLR 200841007 (June 30, 2008).  An S corporation was owned entirely by an individual through his or her wholly-owned LLC, a disregarded entity for tax purposes.  The individual transferred interests in the LLC to five trusts, all wholly-owned grantor trusts with respect to the individual.  Later in the same year as the transfer to the trusts, the individual dies an the LLC becomes a partnership for tax purposes, ineligibleto be a shareholder in an S corporation.  Again in the same year, the LLC was liquidated and its stock in the corporation was distributed to the trusts.

The corporation represented to the Service that the circumstances resulting in the termination of the S election were inadvertent and not motivated by tax avoidance or retroactive tax planning.  The IRS granted the corporation's request to be treated as an S corporation despite the disqualifying events.

The shareholder's death was foreseeable and the consequences predictable.  What will the Service consider not to be inadvertent?

-Marc Ward

A Tax Levy will Attach to the Property Rights of Sole Member

In Chief Counsel Memorandum GL-101770-08 (No. 200836002; released 9/5/2008) the Service ruled that a levy served on an LLC will attach to the property rights of the sole owner of the LLC.  In this case it was a lawyer receiving income from the LLC as a result of contingent fee agreements between the LLC and the clients.

The lawyer owed income tax to the government.  Notices of tax liens were filed by the IRS.  The only asset available to satisfy these liens was the income generated by the LLC.  The Chief Counsel concluded that the right to receive a return of a member's capital contribution and to share in the LLC's profits is a property right subject to the levy. Accordingly, the LLC would be required to turn over the income in its possession to the IRS.  However, the contingent rights represented by the contingent fee agreements belonged to the LLC and were not subject to the levy.

-Marc Ward

IRS Allows Another S Corporation to Avoid Inadvertent Termination

In PLR 200834007 (released August 22, 2008) the Service concluded that an S Corporation's election to be treated as an S corporation was terminated inadvertently.  Here are the facts.

The corporation was formed on "a" and elected S corporation treatment.  At the time the shareholder was "A" who owned the stock directly and indirectly through a wholly-owned LLC (a disregarded entity for tax purposes).

On a later date ("b") "A" sold his LLC interest to "B" and "C" which caused the LLC to no longer be a disregarded entity and an ineligible shareholder.

The corporation represented to the IRS that the S election termination was inadvertent and not motivated by tax avoidance or retroactive tax planning.  The corporation and its shareholders agreed to make such adjustments as required by the Service to treat the company as an S corporation.

The IRS ruled the termination was inadvertent and the corporation would continue to be treated as an S corporation from date "b."  The ruling is contingent on A, B, and C being treated as owning the corporation's stock held by the LLC in proportion to their ownership interests in the LLC on "b."

-Marc Ward

An LLC Can Qualify as a 501(c)(3) Organization

The Service was busy on our nation's birthday.  In another Private Letter Ruling released on July 4, 2008 the IRS spelled out the 12 requirements that both the articles of organization (if state law permits) and the operating agreement must satisfy in order for an Service to recognize the 501(c)(3) exemption of an LLC that otherwise qualifies for the exemption. 

The organizational language must:

1.  Include a specific statement limiting the LLC's activities to one or more exempt purposes.

2.  Specify that the LLC is operated exclusively to further the charitable or social welfare purposes of its members.

3.  Require the LLC members to be section 501(c)(3) or (4) organizations or governmental units or wholly owned instrumentalities of a state or political subdivision (a "Qualified Member").

4.  Prohibit any transfer of a membership interest to a transferee other than a Qualified Member.

5.  State that the LLC, interests in the LLC, or its assets may only be availed of or transferred to any nonmember in exchange for fair market value unless the nonmember would qualify as a Qualified Member.

6.  Guarantee that upon dissolution the LLC's assets will continue to be devoted to charitable purposes.

7.  Require that any amendments to the articles of organization and operating agreement must be consistent with 501(c)(3).

8.  Prohibit the LLC from merging with or converting into a for-profit entity.

9.  Require that the LLC not distribute any assets to members who cease to be a Qualified Member.

10.  Contain a contingency plan in the event one or more members ceases to be a Qualified Member.

11.  State that the "LLC's exempt members will expeditiously and vigorously enforce all of their rights in the LLC and will pursue all legal and equitable remedies to protect their interests in the LLC." (Not really sure what that means!)

12.  Represent that all of its organizing document provisions are consistent with state LLC law and are enforceable at law and in equity.

PLR 200827041

-Marc Ward

Has the IRS Gone Soft? PLR 200827029

I'm impressed.  The IRS never rests.  It released Private Letter Ruling 200827029 on July 4, 2008.

And an interesting ruling it is.  Company is an S Corp. One of its shareholders sold all of his Company stock to an LLC that was an ineligible S Corp shareholder.  Oops.  The Company later discovers the transfer and termination of its S Corp status.  Still later these shares were transferred by the LLC to its individual members.

The Company and its shareholders represented that the termination of the S Corp election was inadvertent and the Company was unaware that the LLC was an ineligible S Corp shareholder.

The Service ruled that the termination of the S Corp election was inadvertent and it unrung the bell.  The Company would continue as an S Corp as if the transfer to the LLC never occurred, the individual shareholders to whom the LLC transferred its shares would be deemed shareholders from the time of the original transfer to the LLC, and adjustments would be made for this period consistent with the treatment of the Company as an S Corp and the shareholders as S Corp shareholders. 

The transfer to the LLC never happened.

-Marc Ward

S Corp stock can be owned by Single-Member LLC

In a trio of private letter rulings released on April 18, 2008, the IRS concluded that S corporation stock can be owned by a single-member LLC (SMLLC) so long as (1) the SMLLC did not elect to be treated as a corporation and (2) the single member of the LLC could own the stock directly without causing the S corporation to lose its S status. 

The fact pattern in these rulings involved existing single shareholder S corporations.  The shareholder proposed to transfer his/her shares in the S corporation to a SMLLC.  In essence the LLCs were treated as disregarded entities and the shareholder continued to be considered the shareholder of the S corporations. See PLRs 200816002, 200816003, and 200816004 (January 14, 2008; released April 18, 2008).

-Marc Ward

Personal Goodwill in Business Acquisitions

Many of you are aware of the Martin Ice Cream tax court decision (Martin Ice Cream Company v. Commissioner, 110 TC 189 (1998)).  In that case the Tax Court recognized that a shareholder's personal relationships and contacts with customers can be personal assets.  In the event of a sale of a business these assets can be sold by the individual, not the company.  This treatment can have tax advantages for the owners.  It is important to recognize that the Martin holding arose because of the exceptional personal services provided by the taxpayer (according to the court he "changed the way ice cream was marketed to customers in supermarkets") and he never entered into a non-compete or employment agreement with his company.

The Tax Court had a chance to revisit its Martin Ice Cream decision recently in Solomon v. Commissioner, TC Memo 2008-102 (April 16, 2008).  The taxpayers did not fare so well in this case.  Martin Ice Cream was distinguished on the basis that the Martin taxpayer was the controlling shareholder and the success of the ice cream distribution company depended entirely on the taxpayer and the quality of his personal services and customer relationships.  The Court also highlighted three other differences between the two cases:  (1) the types of businesses were different (personal services in the Martin case versus processing, manufacturing and selling in the Solomon case); (2) the Martin taxpayers signed the acquisition agreements in their personal capacities, the Solomon shareholders did not; and (3) the buyer in Solomon required noncompetes from the taxpayers, but not employment agreements.  On this last point, the court interpreted this to mean that the buyer was not acquiring their personal goodwill.

It would appear from the Solomon case that the Tax Court narrowed or at least clarified its ruling in Martin.  It is also clear from a reading of the facts in Solomon that careful planning in advance might have led to a different result.

-Marc Ward

Tax Court Endorses LLCs for Estate Planning

We may have seen the demise of family limited partnerships (FLPs) with the decision of the Tax Court in Estate of Mirowski, TC Memo 2008-74 (March 28, 2008).  The taxpayer funded a new LLC with $63 million of mostly marketable securities and immediately gifted 16% interests in the LLC to her three children, leaving her with 52% and the manager of the LLC.  A short time later she died.  The Tax Court held that the assets transferred to the LLC were not includable in her gross estate under IRC 2036(a) and applied a 40% discount to her interest in the LLC.

This case is important for LLCs for two reasons.  First, is the recognition by the Tax Court that involving the family in the management of the LLC's investments is a sufficient non-tax reason for forming the LLC (thus meeting one of the tests to qualify for the 2036(a) exception).  But most intriguing is the Tax Court's response to the IRS argument that the assets should be included in her estate because she was the sole, exclusive manager of the LLC with the right to control distributions from the LLC.  The Tax Court rejected this reasoning because it believed the fiduciary duties imposed on the taxpayer as manager of the LLC under the Maryland LLC Act together with the obligation contained in the operating agreement to distribute the LLC profits annually limited her discretion as manager.  This is a long way from being a limited partner with no ability to manage or control the operation of the limited partnership.  On the strength of Mirowski is there any reason to use family limited partnerships for estate planning purposes anymore?

For a recent perspective on the use of FLPs see Joe Kristan's Tax Update Blog.

For more information about estate planning contact my colleague, David Repp

-Marc Ward

IRS Ruling Grants Relief to LLC that wants to be an S Corporation

In PLR 200818017 (January 31, 2008/Released May 2, 2008) the Service granted relief to an LLC desiring to become an S corporation for federal income tax purposes that inadvertently failed to timely file either Form 8832 (to become an association taxable as a corporation) or Form 2553 (to become an S corporation).

The LLC was formed on A.  In B, after becoming a single member LLC instead of an entity taxable as a partnership (presumably a multi-member LLC) the company and its accountant decided the LLC should become an S corporation by making the appropriate election effective in C.

The Service granted the LLC an extension of time of 60 days under Treas. Reg. 301.9100-1 to file Form 8832 (entity classification election) effective C.  The IRS further found that the LLC had reasonable cause for failing to make the S corporation election and granted it 60 days to file Form 2553 effective C.

-Marc Ward