The primary purpose of the Check-the-Box Regulations is to provide guidelines for determining the federal tax classification of at least of the various types of domestic and foreign specific state-law business entities. An entity’s federal tax classification, in turn, determines the Internal Revenue Code federal tax regimens (sole proprietorship taxation or taxation under Subchapters C, K or S) that are available to it.
Both for LLC tax lawyers and for LLC lawyers who aren’t tax specialists, the Check-the-Box Regulations are among the most important LLC practice tools.
A key concept in the Check-the-Box Regulations is that of “eligible entities.” Eligible entities comprise single-owner unincorporated business entities (such as single-member LLCs) and multi-owner unincorporated business entities (such as multi-member LLCs). The Check-the-Box Regulations permit eligible entities to elect their federal tax classification . The term “eligible entity” does not denote the federal tax classification of any entity. Rather it denotes a preclassification status.
- For single-owner unincorporated business entities, the default federal tax classification is that of “disregarded entities,” but these entities can elect to be taxable as “associations,” and thus, if they qualify, to be taxable as C or S corporations.
- For multi-owner unincorporated business entities, the default federal tax classification is that of partnerships, but these entities, too, can elect to be classified as associations and, if they are eligible, as C or S corporations.
All of the above elections must be made on IRS Form 8832. A few days ago, in revising the chapter on the Check-the-Box Regulations in my Wolters Kluwer LLC book and adding to it a section about Form 8832 and the Form 8832 instructions, I discovered, to my amazement, that in the first column of Page 4 of the Form 8832, the IRS wrongly defines eligible entities as associations. They aren’t associations. “Association” is one of the four federal tax classifications under the Check-the-Box Regulations (corporations, partnerships, associations and disregarded entities). As noted, “eligible entity” is a preclassification.
I’ve pointed out this error to the IRS. I hope the IRS will correct the error soon. It’s a dangerously misleading error for LLC lawyers and accounts who don’t happen to be experts in the Check-the-Box Regulations.
Mike Smith is a first-rate Indiana LLC lawyer. He publishes an excellent blog on, among other things, LLC law. Here is a recent blog post in which he discusses the above issue. It’s a very good introduction to the issue.
There are many situations in which it is appropriate to form LLCs under the Delaware Limited Liability Company Act (the “DLLC Act”) rather than under one’s home-state LLC Act. But if you’re forming Delaware LLCs, you need to be aware of any changes in the DLLC Act that may affect your clients. Every year, the Delaware Bar proposes at least a few changes in the DLLC Act, and the Delaware legislature routine enacts these changes. The changes in the DLLC Act for this year will become effective on August 1, 2014. Since none of them are likely to affect any Delaware deal you’re doing, I won’t list them here. But if you’d like to know what they are, I suggest you click on the attached link:
When I am assisting clients in forming multi-member LLCs, I usually begin the process by asking them to review the attached memo and to send me their mark-ups of it. The memo seeks to identify for them all of the principal legal and tax issues that, in my view, they should address before we begin discussing the operating agreement as such. I’m attaching this memo in the hope that it may also be useful to you.
As you may know, I write two or three posts every week. These posts provide current information about, among other things (i) significant new LLC cases; (ii) significant new LLC statutory developments; (iii) recent writings on topics of LLC law, tax and practice in blogs, law journals and other secondary sources; and (iv) LLC practice techniques.
I’m delighted that so many of you have sent me e-mails expressing gratitude for these posts. I love writing the posts because they keep me on my toes; but it’s nice that other people also find them useful.
My associate prepares an updated list of my posts monthly. In case the updated list is of interest to you, here’s a link to it: http://www.cunninghamonoperatingagreements.com/wp-content/uploads/Table-of-JMC-posts-to-WC-listservs-as-of-7-12.docx.
I chair a committee that is revising the New Hampshire Revised Limited Liability Company Act (the “Revised Act”). I’m presently drafting a set of provisions to provide in the Revised Act for LLC domestications. The Delaware and Florida acts contain these provisions. In case you’re not sure what a domestication is: it’s a statutory procedure by which an LLC formed under one LLC act changes the act that governs it to another act. Thus, for example, the domestication of a foreign LLC means the change of the LLC act that governs it from the foreign act to the act of another jurisdiction. If you domesticate an LLC, you can change the LLC act that governs it without having to use a merger, and the domestication eliminates any possibility of transfer taxes, since the domesticated entity will be the same after the domestication as before.
In Xcell Energy and Coal Company LLC v. Energy Investment Group LLC, C.A. No. 8652-VCN (June 30, 2014), the Delaware Court of Chancery answered the above questions as follows:
- Members of member-managed LLCs and managers of manager-managed LLCs owe fiduciary duties to their LLCs unless the operating agreement provides otherwise, but they owe them to members as such only if the operating agreement so provides.
- Members of manager-managed LLCs do not owe fiduciary duties to the LLC unless the operating agreement so provides.
There are many LLC acts besides the Delaware Limited Liability Company Act in which the answers to the questions in the subject line of this post are unclear. Under these acts, the Xcell case obviously will not be dispositive, but, given the prestige of the Court of Chancery, it may well be persuasive.
A link to the Xcell case is http://www.delawarebusinesslitigation.com/files/2014/07/Xcell-Energy.pdf.
The May 2014 issue of the ABA Business Lawyer contains forms, drafted by the LLCs, Partnerships and Unincorporated Entities Committee of the ABA Section of Business Law, for single-member LLCs whose members are entities and for single-member LLCs whose members are individuals, with explanatory articles about each of these forms. When my schedule permits, I intend to study all of these materials carefully, and I will share my thoughts about them in this listserv.
The Utah RULLCA case discussed in this recent post by Doug Batey illustrates the great importance of drafting LLC operating agreements to make crystal-clear when a manager’s actions will bind the LLC and when they will not.
Whenever you form an LLC for your clients, you have to be aware of the issue whether the memberships issued by the LLC will be, at least for one or more members, securities subject to regulation under federal and state securities laws.
There are many LLC cases on this issue, but the short answer to the above issue is provided in Williamson v. Tucker, 645 F.2d 404, Fed. Sec. L. Rep. (CCH) ¶98003, 32 Fed. R. Serv. 2d 361, 58 A.L.R. Fed. 371 (5th Cir. 1981). As applicable to LLCs, this case can be said to hold that any LLC memberships granted to passive members—i.e., members who have little or no right to participate in LLC management—are securities. If LLCs you form will have passive members and if you yourself are not a securities lawyer, you should consult with a securities lawyer before the LLC is formed.