Question: Since limited liability companies do not pay taxes, is there any reason why I should concern myself with the tax consequences of a limited liability company in which I am buying a minority interest?
Answer: Tax due diligence is an important prerequisite to the acquisition of an interest in any business entity, regardless of whether or not the entity pays tax. The issue is more pronounced when one becomes a minority owner where presumably there will be little or no control over the company’s activities.
You are correct in that limited liability companies (“LLCs”), like S corporations, are pass-thru entities and do not pay Federal income tax. Instead, the taxable income of LLCs is reported on the tax returns of the company’s owners or members, generally in proportion to their ownership interests. The larger the amount of taxable income reported on an LLC tax return, the larger the amount of income which will be reported on the personal tax returns of the LLC’s members.
Tax due diligence, the process of investigating and reviewing the tax characteristics of a business entity, is important for a number of reasons. The company could have deferred income reportable in future years which the members will be obligated to report on their tax returns. The company could be under investigation by the Internal Revenue Service or another taxing body which could result in more reportable income or the disallowance of deductions in future years. Other circumstances could arise where a purchasing member could incur unanticipated tax liabilities thereby making the tax due diligence process of utmost importance.
Once you complete your tax due diligence and satisfy yourself as to the LLC’s tax posture, an equally important task remains. As the LLC reports taxable income on its tax returns and you as a member report your share of such income on your personal tax returns, you must be mindful of the corresponding tax obligations. You will want some assurance that the LLC will make distributions to enable you to pay the tax liability attributable to the LLC income reportable on your personal tax returns.
Consider the recent Tax Court case of Kumar v. Commissioner where the taxpayer became a minority owner of an S corporation and was not permitted to participate in the corporation’s management. The taxpayer argued that his removal from the corporation’s management should prevent him from being taxed on his pro rata share of the corporation’s income since he was excluded from the benefits of stock ownership. The court disagreed and found that being frozen out of company management did not negate a shareholder’s liability for tax on his pro rata share of S corporation income. While Kumar involved an S corporation, the same principle will subject an LLC member to taxes based on the member’s share of LLC income, regardless of whether or not the member is participating in company management or operations.
As an LLC owner, particularly a minority owner, you need to protect yourself from the phantom income trap, having to report LLC income without an accompanying tax distribution from the LLC. The normal means of protecting oneself from phantom income is for the LLC members to agree to make tax distributions on company income. Incorporating a tax distribution covenant in an LLC’s governing document, typically an operating agreement will permit you to avoid the dreaded consequence of phantom income.
Limited liability companies which are treated as partnerships for Federal income tax purposes because there is more than one owner can pose traps. The mere fact that LLCs do not pay Federal income taxes causes many persons purchasing LLC interests to overlook important tax ramifications. Appropriate tax due diligence can prevent many of these tax consequences.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.
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