Key Federal Tax Issues in Forming Multi-Member LLCs

Published: New Hampshire Bar News
February 17, 2021

Ideally, any New Hampshire lawyer who handles LLC formations should be thoroughly versed not only in the Revised New Hampshire Limited Liability Company Act and in the legal issues potentially significant in forming single-member and multi-member LLCs, but also in the relevant federal and state issues; he or she should be both a law expert and a tax expert. This is because the legal and tax provisions in LLC operating agreements are often interactive: The way you address an operating agreement legal provision may affect the way you address a tax provision, and vice versa.

Thus, if you know LLC law but not LLC tax, you shouldn’t form even a relatively simple single-member LLC except in coordination with an expert in LLC tax. And ideally, that expert should be an LLC tax lawyer, not an accountant, since the lawyer will know not only the relevant tax rules but also how to address them in operating agreements.  Some accountants possess the former type of knowledge; very few possess the latter.  To illustrate, below are four major LLC federal tax issues that arise often in drafting operating agreements for New Hampshire multi-member LLCs. Even if you lack any tax expertise, you should at least be aware of these issues and address them with the LLC tax expert with whom you associate yourself.

1. Tax choice of entity. Before you ever draft an operating agreement for a multimember LLC, you need to determine which federal tax regimen will govern the LLC and its members, since any operating agreement should have at least basic federal tax provisions in it, and these provisions will vary dramatically depending on the federal tax regimen of the LLC in question.

The federal tax regimen choices are between Internal Revenue Code Subchapters C, K and S. In drafting the operating agreement for the LLC in question, you need to carry out a process known as “tax choice of entity.” First, you must do a traditional tax choice of entity, in which you compare which of these three federal tax regimens is best from a federal income tax and Social Security Tax viewpoint. Second, you must do a tax choice of entity under Internal Revenue Code section 199A. Sometimes the determination under the first tax choice of entity differs from that determination under the second.  If this happens, complex tailored drafting may be necessary, such as the use of S corporations to hold the LLC memberships of high-income members.

2. The “Prop. Reg.” Many members and managers of multi-member LLCs who are individuals want to reduce the Self-Employment Tax (the “SET”) they will owe on their shares of the income of their LLC.  There is a little-known but powerful proposed U.S. Treasury regulation designated Prop. Reg. § 1.1402(a)-2 that provides a lawful structure for achieving this reduction. The Prop. Reg. was issued on January 13, 1997 as a mere proposed regulation, and, for political reasons, it may never be issued as a final regulation. However, the Internal Revenue Service has stated a number of times in public forums that it views the Prop. Reg. as its Self-Employment Tax audit regulation. The Prop. Reg. can provide annual SET savings to individuals who are members of multimember LLCs amounting to thousands of dollars. Whenever you form a multi-member LLC with one or more individuals as members, you need to determine whether the capital structure of the LLC should reflect the capital structure required by the Prop. Reg.

3. Section 199A and section 761(c). Section 199A provides that individuals who are members of multi-member LLCs and whose joint or individual taxable income for the relevant taxable year is less than their section 199A “threshold amount” can obtain annual federal income tax deductions of up to 20% of their net business income if their LLCs are taxable as partnerships. Section 199A threshold amounts for married couples are $329,800; for most other taxpayers, it is $164,925.

However, to maximize their LLC net business income and thus their pass-through deductions, it is critical that the operating agreements of these individuals provide that they will be compensated for their services to or for their LLCs in the form of distributions of LLC income, not in the form of salaries (called “guaranteed payments” in partnership tax terms).

But if their operating agreements provide for guaranteed payments for past or current taxable years, these individuals may be able to realize the maximization of their section 199A pass-through deductions for their current and past taxable years by retroactive amendments of these agreements under IRC section 761(c).

4. The Bipartisan Budget Act partnership audit rules. Many individuals who are joining multi-member LLCs as members want to hold their memberships in revocable trusts that are key documents in their estate plans; and, for added liability protection, many other members may want to hold their memberships in single-member LLCs of which they are the members.

However, effective January 1, 2018, the Bipartisan Budget Act of 2015 imposes harsh new partnership audit rules on multi-member LLCs that have any members that are trusts or single-member LLCs. Under these rules, entities taxable as partnerships that have trusts or  single-member LLCs as members are taxable (with certain narrow exceptions) as if they were C corporations.

Thus, you should normally advise individuals who will be members of multi-member LLCs whose operating agreements you are drafting that they should hold their memberships not through trusts or single-member LLCs, but rather, in their own name as individuals.