Plan now to protect your LLC and partnership clients from potential tax traps. Study the complex issues necessary to ensure that the LLC, partnership and its owners attain the maximum benefits. Focus on a broad range of distribution issues including disproportionate distributions of "hot" assets and structuring distributions to retiring partners in order to maximize tax benefits for both the retiring partner and the partnership. Apply complex rules of Subchapter K to related “groups” of partnerships or LLCs and understand tax consequences of partnership/LLC acquisitions and divisions, technical terminations, etc.
Objectives:Prerequisite: Completion of LLC and Partnership Taxation: Beyond the Basics or equivalent knowledge and experience.
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The Effect of Issuance of New Regulations on the Authority of Older Regulations
Kandi v. U.S., (CA 9 September 25, 2008), 102 AFTR 2d ~¶~2008-5342
In Kandi,7 the U.S. Court of Appeals for the Ninth Circuit ruled that the sole owner of a limited liability company (LLC) was personally liable for the LLC's unpaid payroll taxes, even though the Code did not clearly address how LLCs should be taxed, and even though regulations later were issued that would not have held the taxpayer liable for the taxes.
In March 1999, Emiel Kandi and a business partner formed Lounge Lizards, LLC. Kandi and his business partner were the only members of the LLC. In January 2001, Kandi bought out his partner's interest in the LLC and became the sole member of the LLC. In September 2001, Kandi sold all of his interest in Lounge Lizards, LLC, to another individual.
During the first two quarters of 2001, Lounge Lizards, LLC incurred employment tax liabilities of $101,024.06 and $115,226.90, respectively. The parties do not dispute that these liabilities remain unpaid. The Internal Revenue Service (IRS) attempted to collect the unpaid employment taxes from Kandi personally on the theory that because Kandi had never filed an election (Form 8832) to have Lounge Lizards, LLC be taxed as a corporation during the time period at issue, Kandi, as the owner and single member of the LLC, was also the employer responsible for payment of employment taxes.
After a collection due process hearing at which Kandi was permitted to voice his opposition, the IRS determined that the collection action against Kandi (instead of the LLC) was proper. Kandi then filed an action in a District Court, seeking judicial review of the IRS's decision. During the time the parties' cross-motions were pending, the IRS issued proposed regulations squarely addressing the single issue at stake in this case, and supporting Kandi. The Court permitted additional briefing regarding the parties' positions on applicability to or other impact of the proposed regulations on the present case. The District Court held for the IRS, and Kandi appealed to the Ninth Circuit Court of Appeal.
The Ninth Circuit concluded that the IRS's interpretation of the Internal Revenue Code at the time the employment taxes were incurred was reasonable. The regulations at issue (those in effect at the time the employment taxes were incurred) were a reasonable attempt by the Treasury Department to fill in gaps left in the statute regarding the taxation of LLCs and other new forms of business entities. The later decision by the IRS to adopt new regulations regarding the taxation of sole member LLCs was held not to change the result. The Ninth Circuit held that the new regulations are applicable to taxes on wages paid after January 1, 2009, and thus did not apply to Kandi's unpaid 2001 employment taxes.
The Court also opined that the IRS’s later decision to adopt an alternative approach also does not mean that the regulations challenged were incompatible with the statute. Because the IRS’s attempt to fill in gaps in the Internal Revenue Code was reasonable, the Circuit Court affirmed the District Court's decision granting summary judgment to the IRS.
Deficit Restoration Obligation Does Not Increase Owner's At-Risk Amount with Respect to the Entity's Recourse Liabilities
Hubert Enterprises, TC Memo. 2008-46, February 28, 2008
In essence, the regulations issued in 2006 take the position that the owner of a single member LLC does not bear personal responsibility for otherwise recourse liabilities of the LLC unless the owner personally guarantees those liabilities. The owner's risk of loss is limited to the net value of assets of the LLC to which the creditors will ultimately have recourse in the event of default on the debt.
The Tax Court has extended this position in a 2007 case, Hubert Enterprises. In this case, taxpayer was one of two members of an LLC that purchased equipment and partially financed its purchases using recourse debt. The members amended the LLC's operating agreement to add deficit capital account restoration obligation (DRO). They then used this DRO to support the allocation of additional LLC recourse liabilities to taxpayer.
The Tax Court ruled that the additional recourse liabilities allocated to taxpayer in connection with the DRO did not increase taxpayer's amount at risk with respect to the LLC. The court determined that the DRO did not create an "unconditional obligation" on the part of the taxpayer to contribute additional capital to the LLC. The court's rationale was the DRO would require the taxpayer to make an additional contribution to the LLC only if the taxpayer liquidated its interest in the LLC at a time when it had a deficit balance in its capital account. Because a recourse creditor lacks the power to force the taxpayer to liquidate his interest in the LLC, the creditor could not force the taxpayer to make good on the recourse debt in the event of an LLC default. Thus, the court reasoned that the obligation caused by the DRO was contingent on the taxpayer voluntarily liquidating his interest in the LLC.
The rest of the Tax Court's opinion is somewhat more difficult to defend. It further suggested that even in the event the taxpayer did liquidate his interest in the LLC, his obligation would be limited to the deficit balance in his capital account, which may or may not equal his allocable share of the LLC's recourse liabilities. While this is true, if the allocated share of recourse liabilities exceeds the deficit balance in the taxpayer's capital account, the difference is likely due to a misapplication of the ~§~752 regulations under which recourse liabilities are allocated.
Finally, the Tax Court asserted that even if taxpayer actually makes an additional contribution to the LLC under the DRO, there is no requirement that any of the additional contribution be paid to creditors of the LLC. The DRO states specifically that the LLC may transfer the additional contribution to its members with positive capital accounts. Again, this argument appears to be inconsistent with the regulatory framework underlying the allocation of recourse debts. In the event that some partners have negative capital balances and others have positive balances at liquidation of the partnership or LLC, those with deficit balances are obligated to make additional contributions to the partnership/LLC. These contributions may be used to liquidate the positive balances in other partners' capital accounts, but only after partnership recourse liabilities have been satisfied. In such a case, the deficit balance in one or more partner/member's capital accounts would, in the aggregate, exceed the partnership/LLC's outstanding recourse liabilities. In such a case, they would also exceed the share of such recourse liabilities allocated to those partner/members obligated under the DRO.
In sum, the Tax Court, in Hubert Enterprises, appears to be inconsistent with the regulatory framework underlying the Section 752 regulations. It will be interesting to see how this argument develops in subsequent cases.
7 Kandi v. U.S., (CA 9 9/25/08), 102 AFTR 2d ~¶~2008-5342.
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