Whose Tax Liability?

In order to properly assess and collect a tax, the IRS first needs to identify the taxpayer that is responsible for reporting the income, and for collecting and remitting the tax, at issue. This is not always a simple proposition. In the case of a business entity, it may depend, in part, upon the entity’s classification for tax purposes.

For example, a business entity that was incorporated under State law will be treated as a taxable C corporation for tax purposes. The same corporation may file an election with the IRS to be treated as a pass-through small business (“S”) corporation, and it may subsequently elect to revoke its “S” election.

In the case of every other business entity, however, the classification is more “fluid.” In order to provide certainty both to the IRS and to taxpayers, the IRS has issued entity classification regulations. These regulations provide certain “default” classifications that coincide with what most taxpayers would desire for the entity in question. Where the taxpayer wants to elect a classification other than the “preferred” default status, it must affirmatively notify the IRS of its decision.

Thus, an LLC that has only one member is ignored for income tax purposes; it is treated as partnership if it has at least two members; regardless of how many members it has, it may elect to be treated as an association that is taxable as a corporation.

The importance of properly making and filing an election so as to change the classification of a business entity for tax purposes cannot be understated.

An Illustration

Taxpayer was the sole shareholder of Corp., a “C” corporation on behalf of which he consistently filed Form 1120, U.S. Corporation Income Tax Return.

Taxpayer formed LLC at the end of Year 1 and became LLC’s sole member. Immediately after the formation of LLC, Corp. merged with and into LLC, with LLC as the surviving entity, and Corp. ceased to exist. LLC continued to own Corp.’s assets and to operate Corp’s business. Since the merger, LLC filed Forms 1120 using Corp’s employer identification number (“EIN”). However, LLC did not file IRS Form 8832, Entity Classification Election.

Taxpayer filed Forms 940 and 941 on behalf of LLC, but did not make sufficient tax deposits or pay the tax due for its employment tax liabilities for several taxable periods after the merger (but before 2009 – see later).

The IRS issued a Notice of Intent to Levy for these periods and filed a Notice of Federal Tax Lien.

Taxpayer argued that LLC, and not Taxpayer individually, was liable for the employment tax liabilities due from LLC.

The only issue for consideration by the Tax Court was whether Taxpayer, as the sole member of LLC, was personally liable for the payment of the employment tax liabilities of LLC for the taxable periods in question.

Entity Classification

The so-called “check-the-box” regulations allow an “eligible business entity” to elect its classification for federal tax purposes. An eligible business entity is one that is not treated as a corporation, per se, under the regulations.

An eligible entity with a single owner, such as the LLC and Taxpayer in the present case, may elect to be classified as an association – i.e., as a corporation – for tax purposes, or it may choose to be disregarded as an entity separate from its owner.

An eligible entity with a single owner that does not file an election is disregarded as an entity separate from its owner; its default status is that of a disregarded entity.
An election is necessary only when an eligible entity chooses to be classified initially as something other than its default classification, or when an eligible entity chooses to changes its classification.

The tax treatment of a change in the classification of an entity for federal tax purposes by election is determined under all relevant provisions of the Code and general principles of tax law, including the step transaction doctrine.

For example, if an eligible entity that is disregarded as an entity separate from its owner (the default status of a single-member LLC) elects to be classified as an association, the following is deemed to occur: the owner of the eligible entity contributes all of the assets and liabilities of the entity to the association in exchange for stock of the association.

If an eligible entity classified as an association (a business entity that elected to be treated as a corporation for tax purposes) elects to be disregarded as an entity separate from its owner, the following is deemed to occur: the association distributes all of its assets and liabilities to its owner in liquidation of the association.

Form 8832

An entity whose classification is determined under the default classification rules retains that classification until the entity makes an election to change its status by filing IRS Form 8832, Entity Classification Election.

An election will not be accepted unless all of the information required by Form 8832 and its instructions is provided. Further, to avoid penalties, an eligible entity that is required to file a federal tax or information return for the taxable year in which an election is made must attach a copy of Form 8832 to its tax or information return for that year.

Under these rules, LLC was disregarded as a separate entity from Taxpayer, its owner, because it was a single-member LLC that had never filed Form 8832.

Notwithstanding this conclusion, Taxpayer made a number of arguments as to why Form 8832 was not the only method by which an eligible entity could elect to change its classification.

The Taxpayer’s Position

First, Taxpayer argued that the merger of Corp. and LLC was a valid reorganization under Section 368(a)(1)(F) of the Code (an “F reorganization,” or “mere change” in corporate identity or form) and, as a result, LLC should be treated as a corporation for federal tax purposes.

Second, Taxpayer argued that the filing of Forms 1120 for the first year after the merger of Corp. and LLC constituted a valid election for LLC to be taxed as a corporation.

Third, Taxpayer argued that the doctrine of equitable estoppel prevented the IRS from contending that LLC was not a corporation because the IRS had “tacitly acquiesced” to the filings of Forms 1120 for the year of the merger and subsequent years.

The Tax Court’s Response

The Court responded that regardless of whether the merger of Corp. and LLC qualified as a valid F reorganization, LLC never filed Form 8832 electing its classification for federal tax purposes as an association and, thus, was not a corporation but, rather, was disregarded as an entity separate from its owner. (Incidentally, this would have caused the merger to be treated as a taxable liquidation of Corp.)

Next, the Court stated that an eligible entity could not elect its entity classification by filing any particular tax return it wished; it had to do so by filing Form 8832 and following the instructions within the regulations. Thus, LLC could not elect to be treated as an association/corporation merely by filing corporate income tax returns.

Finally, according to the Court, equitable estoppel did not bar the IRS from treating LLC as a disregarded entity. The Court noted that equitable estoppel was to be applied against the IRS with the utmost restraint. The elements of estoppel, it stated, are: “(1) * * * a false representation or wrongful misleading silence; (2) the error must be in a statement of fact and not in an opinion or a statement of law; (3) the person claiming the benefits of estoppel must be ignorant of the true facts; and (4) he must be adversely affected by the acts or statements of the person against whom an estoppel is claimed.” The IRS made no false statement to Taxpayer, and the Court did not agree that the IRS’s failure to reject LLC’s filed Forms 1120 was a wrongful misleading silence. Moreover, Taxpayer knew that LLC had never filed a Form 8832 to elect to be treated as anything other than a disregarded entity.

For the foregoing reasons, the Court rejected Taxpayer’s arguments, and found that LLC was disregarded as an entity separate from Taxpayer.

The Taxes At Issue

The Code requires employers to pay employment taxes imposed on employers and to withhold from employees’ wages certain taxes imposed on employees. Employers are required to withhold from employees’ wages the amounts of federal income tax owed by those employees. The Code also imposes a tax on every employer with respect to individuals in his employ.

For employment taxes related to wages paid before January 1, 2009, a disregarded entity’s activities were treated in the same manner as those of a sole proprietorship, branch, or division of the owner.

Accordingly, the sole member of a limited liability company and the limited liability company itself were treated as a single taxpayer who is personally liable for purposes of the employment tax reporting and wages paid before January 1, 2009. Taxpayer was, therefore, liable for LLC’s unpaid employment tax liabilities arising during the tax periods at issue since they related to wages paid before 2009.

Did the Court Get it Right?

On a strict reading of the regulations, yes, it did.

However, the Court’s decision seems harsh. Taxpayer clearly intended to treat LLC as an association taxable as a corporation for tax purposes. He caused LLC and Corp. to merge as part of a transaction that was reported as a tax-free corporate reorganization, not as a taxable liquidation. He treated LLC as the continuation of Corp. for tax purposes, causing LLC to file income tax returns as a “C” corporation, using Corp.’s EIN, after the merger.

What Taxpayer failed to do was file a Form 8832 to elect to be treated as an association.

Interestingly, an eligible entity, including a single-member LLC, that timely elects to be an S corporation, by filing IRS Form 2553, is treated as having made an election under the regulations to be classified as an association, provided that (as of the effective date of the “S” election) the entity meets all other requirements to qualify as a small business corporation. The deemed election to be classified as an association will apply as of the effective date of the S corporation election and will remain in effect until the entity makes a valid election to be classified as other than an association.

When this provision of the check-the-box regulations was adopted, the IRS explained that requiring eligible entities to file two elections in order to be classified as S corporations – Form 8832 and Form 2553 – creates a burden on those entities and on the IRS. The regulations sought to simplify these paperwork requirements by eliminating the requirement that the entity also elect to be classified as an association by filing Form 8832. Instead, an eligible entity that makes a timely and valid election to be classified as an S corporation by filing Form 2553 will be deemed to have elected to be classified as an association taxable as a corporation.

The regulation also provides that, if the eligible entity’s “S” election is not timely and valid, the default classification rules will apply to the entity unless the IRS provides late S corporation election relief or inadvertent invalid S corporation election relief.

Unless the IRS amends the regulations to expand the relief available thereunder beyond “S” elections, to cover eligible business entities in general, a taxpayer seeking a particular entity classification for tax purposes must file Form 8832. It will not be enough that the taxpayer has otherwise acted consistently with the desired status.