Vol. 73, No. 18, June 15, 2002

OBA Taxation Section:
Using One-Member L.L.C.s as 'Disregarded Entities'
By Timothy M. Larason

One-member limited liability companies treated as "disregarded entities" for Federal tax purposes have been found to be very useful in a number of situations. This article will discuss this particular type of entity and its uses.

What is a Disregarded Entity L.L.C.?

A one-member limited liability company (L.L.C.) that does not file IRS Form 8832 to elect corporate treatment is classified for Federal tax purposes under the "check the box" regulations1 as a "disregarded entity." This means that, for Federal tax purposes, it is not considered a separate entity from its owner, but is considered a mere branch or division. It generally remains a separate entity for state law purposes.

When limited liability companies were first authorized by statute, two members were required. Whether the entity was considered a corporation or partnership for Federal tax purposes was determined under complex regulations decipherable only by experienced tax professionals. Now, virtually every state allows L.L.C.s with a single member2 and the "check the box" regulations provide simply that such an L.L.C. is a "disregarded entity" unless it elects corporate treatment by so designating on a properly filed IRS Form 8832. This "disregarded entity" treatment is available to corporations only if the corporation is wholly owned by a corporation electing under Subchapter S.3 It is not generally available to partnerships because partnerships, by statutory definition, must have at least two owners. However, if all owners of the partnership (for example, an individual and a disregarded entity L.L.C.) for Federal tax purposes are the same person, then the partnership also has only one owner for Federal tax purposes and is disregarded.4

Is an L.L.C. where all interests are held by husband and wife as tenants in common or tenants by the entirety a one-owner L.L.C.? Probably not, but the IRS has not ruled on this point.

A one-member L.L.C., as any other L.L.C., may be formed under the Oklahoma Limited Liability Company Act5 by filing Articles of Organization6 with the Secretary of State and issuing ownership interests, usually termed "Units," to only one person. Under an amendment effective Nov. 1, 2001,7 it may also be formed by "converting" an existing one- owner corporation, but that will ordinarily be a taxable event8. An existing multi-member L.L.C. that has not elected corporate treatment will become a disregarded entity if all interests in the L.L.C. become owned by one person.9

As with corporations, L.L.C.s can be formed in any state and then qualify to do business in the states where the properties or activities are located10. Delaware is popular, particularly when out-of-state lenders or investors are involved.

The L.L.C. statutes envision an "operating agreement"11 to detail the management of the L.L.C.12 It is not required to be in writing, but a written agreement is advisable in every case to help safeguard the limited liability and to apply if the entity ever has more than one owner.13

Reasons for Use of Disregarded Entity L.L.C.s

Liability Protection

A primary reason for use of L.L.C.s is almost always to provide corporate type liability protection to the owner and manager without the tax and legal complexities of corporations or limited partnerships. The statutory protection in this regard is even more specific than with corporations.14 However, as with corporations, the protection is not absolute.

Individuals are not protected against liability for their own negligent acts. Officers and managers may have personal liability for payroll or sales tax not properly remitted. Owners may have liability for unpaid subscriptions or for return of improper distributions. Environmental laws provide for personal liability in certain cases.

Owners and other involved individuals may also be held liable in certain situations under the "piercing the veil" or "alter ego" theories.

While there are no Oklahoma court decisions regarding piercing the veil of an L.L.C., decisions in other states indicate the principles applied to corporations will be applied to L.L.C.s.15 In Oklahoma, the corporate veil has been pierced when the corporate shield is used to commit fraud, protect illegal action or the owners have habitually disregarded the entity and some inequity will result unless the entity is disregarded.16

To avoid liability to the owner or individuals involved in management, one authority has advised that these factors should be avoided:17

1. Initial financing is inadequate.
2. The entity is not operated separately from its owner.
3. Finances of the entity and its owner are commingled.
4. Operating decisions are made by the owner rather than by the officers, directors or managers of the entity.
5. Legal requirements and record keeping rules of the entity are not observed.
6. The entity is used to justify wrong, protect fraud or defend crime.

This raises the question whether the L.L.C. should have at least one manager other than the owner. Many Oklahoma corporations have the owner as the only director and officer and this has not occasioned a piercing of the veil. Nevertheless, having an additional manager who actually participates in management may be a worthwhile feature.

In addition to giving protection to owners from liabilities generated by the L.L.C. operations, the transfer may also protect against unwanted foreclosure on the L.L.C. assets by other judgment creditors of the owner. By statute, such other creditors may receive only a "charging order," giving them the right to receive distributions from the L.L.C. until the debt is repaid.18 However, foreclosure or disruption of management is not allowed.

Simplicity With Flow Through Tax Treatment

An L.L.C. provides "flow through" tax treatment and limited liability without the complexities and formalities of the alternatives, an S corporation, or a limited partnership with a corporation or L.L.C. as the general partner. No annual meetings are required for L.L.C.s. No separate tax return is required for a disregarded L.L.C. and there are no complex rules regarding tax basis.

Particular Uses of One-Member L.L.C.s

One-member L.L.C.s are often used when liability protection or separate management is desired for a new business, for a particular segment of an existing business or for a particular property.

One-Owner Businesses

A one-member L.L.C. may be used as a substitute for a corporation where limited liability and flow through tax treatment are desired. In Oklahoma this saves the franchise tax and eliminates some corporate formalities. Note, however, that if the business is already held in a corporation, converting it to a disregarded entity L.L.C. will generally be a taxable event.19 This taxable liquidation is avoided, of course, if the L.L.C. files Form 8832 to elect corporate treatment.

If the business is now held in a corporation with an S election, converting to an L.L.C. that meets the Subchapter S requirements20 and immediately elects corporate treatment on Form 8832 is simply a type "F" reorganization (mere change in form) that does not require ending the tax year or securing a new tax identification number.21

Corporate Subsidiaries

Corporations may use one-member L.L.C.s in almost any situation where a corporate subsidiary might otherwise be used. In Oklahoma this would avoid the franchise tax. For income tax purposes it would avoid the complexities of the consolidated return rules that apply to corporate subsidiaries.

Corporate Reorganizations

One member L.L.C.s may have a very important place in corporate reorganizations. But first it is important to recognize that the corporate reorganizations described in Section 368, which can qualify for tax free treatment, apply only to entities classified for Federal tax purposes as "corporations." Thus, a statutory merger of a corporation into a multi-member "partnership" L.L.C. is not covered by those provisions, but is a taxable event unless covered by some other exemption provision.

However, proposed regulations provide that a merger of one corporation into a disregarded L.L.C. that is wholly owned by a parent corporation can qualify as a type "A" reorganization (statutory merger).22 This will be very significant if it becomes final because it allows the parent corporation to avoid assuming the liabilities of the acquired corporation which would occur if the acquired corporation were merged directly into the parent. Of course, this liability separation can also be accomplished by use of "triangular" mergers with corporate subsidiaries of the acquiring parent, but the requirements for tax free treatment of triangular mergers are more stringent than for a straight "A" merger.23

Subsidiaries of Indian Tribal Governments

Single member L.L.C.s may be put to good use by Indian Tribal Governments. In 1994,24 the IRS indicated that it would no longer treat corporations organized under state law and wholly owned by an Indian tribe as exempt from income tax. The tax status of a tribal law corporation wholly owned by the tribal government is uncertain. A wholly owned L.L.C. should have the same tax exemption as the tribal government.

Subsidiaries of Section 501 Exempt Organizations

Exempt organizations which wish to separate liability exposure of a part of their operations may make use of single member L.L.C.s. In Announcement 99-102 the IRS clarified the treatment of L.L.C.s wholly owned by organizations exempt under Section 501(c)(3). The disregarded entity can, if it chooses, request a tax exempt determination on its own, in which case it will be treated as a separate corporation. Otherwise, it will be treated as a part of its owner and its operations should be included in any income tax filings required of its owner. The IRS later confirmed25 that a one-owner L.L.C. that does not desire corporate income tax treatment will not need to file any request for tax exempt status on its own, but may rely upon its parent's classification.

This would logically mean that a contribution made to the one-owner L.L.C. should be deductible the same as a contribution made to its parent. The IRS National Office has this question under consideration,26 but has not yet issued any official statement. It would be surprising if the IRS rules such contributions are not deductible. Even if approved by the IRS, however, one disadvantage of this approach is that the name of the L.L.C. will not appear in Publication 78, the IRS list of charities to which deductible contributions may be made.

Bankruptcy Remote Entity for Real Estate Loans

Real estate lenders often require the property be held by a "bankruptcy remote entity" with no other assets or activities. Sometimes the existing owner conveys to an L.L.C. of which the original owner is the sole member. A more complicated format may be placing title in a partnership with two owners, the original property owner as a limited partner and a one- member L.L.C. owned by the original property owner as the general partner. In this case, the title holding entity has two owners under state law. However, assuming the one-member L.L.C. serving as general partner does not elect corporate treatment, the title holding entity is a disregarded entity for income tax purposes since each of the owners is regarded, for income tax purposes, as the same person.

Like Kind Exchanges of Real Estate
To make tax deferred exchanges under Section 1031, the tax owner of the existing property must generally become the direct tax owner of the like-kind replacement property. Placing the original property or the replacement property in a one-owner L.L.C. prior to the third party transfers may relieve concern about unwanted liabilities and simplify the closing as assignments of the L.L.C. interests would replace transfer by deeds.

For example, in one transaction described in a private letter ruling27 a partnership desired to replace one property with several smaller properties and did not want to receive direct title. The IRS ruled that receipt of title in disregarded L.L.C.s established for each property would qualify for deferral of gain under Section 1031.

Estate Planning Purposes

A one-member L.L.C. may serve some estate planning purposes. Acting as a title holding entity for oil and gas or similar properties is one example. Even if the owner has transferred assets into a revocable trust to avoid probate, the L.L.C. can avoid the need for transfer documents for the underlying assets on change of trustees or distribution from the original trust. However, such ownership may shift the situs of the property for estate tax purposes from the location to the state of residence of the owner.

Possible Effects of Disregarded Entity L.L.C.s under the "At Risk" Rules

Transfer of assets to a disregarded-entity one-member L.L.C. is not considered a transfer at all for income tax purposes, and it is difficult to imagine how any taxable gain could result. Future transactions, however, could impact the application of the at risk rules.28 For example, future borrowing by the L.L.C., if not guaranteed by the owner, would be considered "nonrecourse." Unless it is "qualified nonrecourse financing," a loan from an institutional lender secured by real estate,29 the financing will not be considered "at risk" and future loss deductions could be limited or prior loss deductions might be "recaptured."30

No "Disregard" for Certain State Taxes

The Federal characterization of a disregarded entity applies for all purposes of the Internal Revenue Code. Such treatment is automatically recognized for Oklahoma income tax purposes as the Oklahoma income tax is based on the Federal taxable income provisions. However, this does not carry over to other state taxes such as sales tax and documentary stamp tax.

Sales Tax

The Oklahoma sales tax generally applies to the purchase or rental of tangible personal property. A transfer upon organization of a limited liability company is exempt if the property owners become members of the limited liability company and each receives interests "substantially in proportion to the interest in the property prior to the transfer."31 In kind distributions on dissolution are also exempt.32 Other transfers however, will be taxable unless they qualify for some other sales tax exemption.

Documentary Stamp Tax

The Oklahoma documentary tax generally applies to conveyance of real estate at a rate of $1.50 per $1,000 of consideration or value. There is an exemption for a transfer on organization of an L.L.C. if the transferor and related parties are the only owners, but the tax must be paid later if the ownership of the L.L.C. is transferred to anyone other than a spouse, parent, or child of the original owner.33

Cap on Ad Valorem Tax Valuation

For purposes of the ad valorem property tax, the Oklahoma Constitution limits annual valuation increases to 5% except when the property is transferred or improved.34 No exemption is provided for transfer to an L.L.C.35 However, if that transfer is exempt from the documentary stamp tax it may not trigger a revaluation. Subsequent transfers accomplished by assignment of the ownership of the L.L.C. may also escape revaluation.

Vehicle Excise Tax

The Oklahoma vehicle excise tax generally applies to the title registration or transfer of vehicles. One important exemption is for transfers to a limited liability company.36

Oklahoma Franchise Tax

L.L.C.s are free of the Oklahoma corporate franchise tax. However, beginning July 1, 2002, an L.L.C. will be required to file an annual Certificate in order to remain in good standing and protect its name.37

Texas and Other States

If the L.L.C. is to conduct operations or own property outside of Oklahoma, the tax and other rules of each state must be considered. Texas is particularly unfriendly to L.L.C.s as it imposes its corporate franchise-income tax on L.L.C.s. Since this tax is not imposed on partnerships, a common structure is to operate in a partnership where 99% is held by limited partners who are either individuals or out of state entities and 1% is held by a Texas L.L.C.. Thus, the franchise tax is imposed only on the 1% held by the L.L.C.. As mentioned above, if the L.L.C. is a disregarded entity owned by same person who is the sole limited partner, the limited partnership may be disregarded for Federal tax purposes.

Tax Identification Numbers

Should the one-member L.L.C. have its own tax or employer identification number? The tax regulations specify that a disregarded entity must generally use its owner's tax identification number.38 One exception is that a disregarded entity may file payroll tax returns under either its own number or its owner's number.39 An entity which is once issued a number retains that number even though its status may change.

CAUTION: Under present IRS procedures, use of the owner's TIN by a disregarded entity for investments, such as an interest-bearing bank account, will raise a risk of backup withholding unless the name of the disregarded entity includes the owner's last name. Publications 1679 and 1281 indicate a name mismatch will result unless the last name of the owner of the TIN appears in the first line of the style of the account. On the other hand, a disregarded entity that uses its own TIN number on such an account in order to avoid backup withholding may receive an inquiry resulting from a Form 1099 issued under a number for which no income tax return has been filed. That may be easier to deal with than instigation of backup withholding.

One of the authors of the regulations indicated that the name mismatch and backup withholding problem had not been considered in mandating use of the owner's number, but no solution to the problem has been issued by the IRS.

If the L.L.C. has payroll and chooses not to use a number of its own and the owner does not have an employer identification number to use, the owner will need to secure one in the style, "John Smith dba XYZ L.L.C."

1. Reg. § 301.7701-2 and -3, specifically -2(a) and (c) and -3(b). The Section 7701 definitions apply for all purposes of Title 26, U.S.C. Section references in this article are to the Internal Revenue Code of 1986, as amended, 26 U.S.C. Reg. references are to Title 26 CFR.
2. At last report Massachusetts was the only state that did not allow formation of a one-member L.L.C., although it does allow registration of a one-member foreign L.L.C..
3. In which case, the parent can elect for the wholly owned subsidiary to be a "QSub".
4. For an example, see Ltr. Rul. 200107025 (not binding precedent).
5. 18 O.S. § 2000-2060
6. A form may be found in Faught, OKLAHOMA BUSINESS ORGANIZATIONS, 13.302(a). The Secretary of State has a form posted on the Internet. http://www.sos.state.ok.us/forms/forms.htm
7. 18 O.S. § 1090.5 as added by S.B. 610.
8. This is avoided if the L.L.C. immediately elects corporate treatment by filing IRS Form 8832. Conversion may also be tax free under Section 332 if the sole owner is a corporation.
9. This would result in liquidation of the "partnership" for income tax purpose, Reg. § 301-7701-3(f), Although this is generally free of income tax, there may be reallocation of basis of assets and some other consequences.
10. As to qualifying in Oklahoma, see 18 O.S. § 2043.
11. Called "regulations" in the Texas statute.
12. 18 O.S. § 2001(17).
13. A form may be found in Faught, OKLAHOMA BUSINESS ORGANIZATIONS, 13.203(a).
14. 18 O.S. § 2022. By contrast, the corporate statutes only indicate certain situations when an officer or shareholder may have personal liability. See 18 O.S. §§ 1043, 1053, 1124.
15. See, for example, Ditty v. Checkrite, Ltd., Inc., 973 F. Supp 1320 (D. Utah 1997); and Faught, OKLAHOMA BUSINESS ORGANIZATIONS, 13.402(c).
16. See, for example, Seitsinger v. Dockum Pontiac Inc., 1995 OK 29, 894 P.2d 1077, and Faught, OKLAHOMA BUSINESS ORGANIZATIONS, 6.202(c).
17. Faught, OKLAHOMA BUSINESS ORGANIZATIONS, 13.402(c).
18. 18 O.S. § 2034.
19. One exception is that where a corporation is the sole owner, the deemed liquidation may be exempt under Section 332.
20. The Operating Agreement must be carefully drafted to meet the one class of stock requirement of Section 1361(b).
21. See these Ltr. Ruls. (not binding precedent) applying the same concept to other entities electing corporate treatment: 200043001 (convert to electing co-tenancy), 199942009 and 200007011 (electing partnerships).
22. Prop. Reg. § 1.368-2(b)(1), REG-126485-01 (Nov. 15, 2001).
23. See Regulations under Section 368.
24. Rev. Rul. 94-16.
25. Letter to Catherine E. Livingston from Marvin Freedlander of the IRS published by Tax Analysts on November 3, 1999, as Doc 1999-35218.
26. Tax Notes, March 20, 2000, p 1686.
27. Ltr. Rul. 9807013 (not binding precedent).
28. Section 465.
29. Section 465(b)(1).
30. Section 465.
31. 68 O.S. § 1360(A)(6).
32. 68 O.S. § 1360(A)(7).
33. 68 O.S. § 3202(4).
34. Const. Art. 10, § 8B.
35. 68 O.S. § 2802.1. Note that transfer to an express revocable trust is exempt. This might be used in combination with transfer to an L.L.C. by first transferring to the revocable trust and then transferring the beneficial interest of the trust to the L.L.C.
36. Note that this exemption, 68 O.S. § 2105(9)(f), requires that the former owner of the vehicle must, immediately after the transfer, be the owner of the L.L.C.
37. 18 O.S. § 2055.2. A similar provision will apply to limited partnerships. 54 O.S. § 311.1.
38. Reg. § 301.6109-1(h).
39. Notice 99-6 and Rev. Rul.2001-61.

TIMOTHY M. LARASON is a member of the Oklahoma City law firm of Andrews, Davis, Legg, Bixler, Milsten & Price Inc. and is editor of the Oklahoma Tax Journal. He represented the taxpayers in securing a limitation on income tax assessments in Fort Howard Paper Company v. OTC, 1989 OK CIV APP 101, 792 P.2d 87, cert. denied 1990, and in securing a refund of gross production taxes in Samson (formerly Grace Petroleum) v. OTC, 1998 OK 82, 976 P.2d 532. He is listed in The Best Lawyers in America, is a member of the editorial board of Tax Ideas and served as president of Legal Aid of Western Oklahoma.