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Last week I covered the tax structure for a Utah LLC in conjunction with the release of STARTright to form a Utah LLC.   We released California this week and on Thursday, I will write about California’s tax treatment of the California LLC.   Today I am going to  expound on the general LLC tax concept which is founded upon the IRS’s 1997 Check-The-Box Regulation.  In that ruling, the IRS declared that the owners of an LLC would have discretion as to the tax regime the LLC would be taxed under.   The rules within the regulation are certainly clear, but the broadness and numerous contexts a business owner has to sort through can make the regulation unwieldy.  For the sake of business owners looking to understand their LLC tax options, lets see if we can’t find the consistent threads that give us some simplicity in what the legislators turned out as less than clear.

Note: For those interested, the “Check-the-Box-Regulations” are codified in the Code of Federal Regulations in 26 CFR § 301.7701-1 through § 301.7701-4.

Thread 1: Domestic LLC v. Foreign LLC  (CFR § 301.7701-5)
The terms domestic llc and foreign llc can be very confusing because they generally mean one thing at the state level and have a different meaning at the federal level.  An LLC formed in Utah is a Utah Domestic LLC.  If that Utah LLC goes to California and registers to do business in California, it is not a California LLC; rather the Utah LLC is considered to be a foreign llc operating in California.  This distinction between foreign and domestic at the state level is different than the distinction between foreign and domestic at the federal level.  The Code of Federal Regulations distinguishes a domestic llc as one that is formed in any of the 50 United States.  At the federal level, a foreign LLC is one that is formed under the laws of another country and then registered in one of the 50 US states.  The code does not give the same options to a foreign LLC that it gives to a domestic LLC.  We will be looking at the US domestic LLC in the context of an LLC being domestic when it is formed in any of the 50 US states.

Thread 2: The Association
In the tax world, there are basically two camps.

1. Camp 1/The corporate camp.  Base theory: the company is completely separate from its owners for liability purposes thus it should be separate for tax purposes.  These entities are “incorporated”, and have charters and bylaws that make them stand apart from their owners as a distinct legal person (theoretically speaking of course).
2. Camp 2/Everything else camp.  Base theory: these businesses are merely the business life of the owner.  It is merely an extension of the owner and thus the owner should be taxed.  Basically there is no independent company.

By the end of the 1980’s, the lines between camp one and two had begun to blur.  Corporations had gained popularity among sole proprietors and small partnerships over the previous two decades.  These corporations enjoyed the “identity seperation” of camp 1, with all its protections and yet the owners of these corporations were closely involved in the corporate management.  The introduction of the LLC in the 1970’s, and its growth in popularity during the 1990’s created even more confusion.  The LLC had the protections of Camp 1 as discussed above, but it was run informally as though it were a camp 2 entity.   The IRS realized that the lines between camp one and camp two had been blured and businesses needed to be allowed to tax flexibility.   The word “Association” is used by the IRS to fill the gap between true camp 1 entities that are seperate and distinct sufficient to be taxed as a coporation, and camp 2 entities that are more of an extention of their owner.  Federal case law defines associations as: “[bodies] of persons united without a charter, but upon the methods and forms used by incorporated bodies for the prosecution of some common enterprise. Hecht v. Malley, 265 US 144 (1924).   Thus, in the beginning we had a duck and we had a goose.  We knew how the goose was to be treated and how the duck was to be treated, but then there arose a duck who said, “I walk like a goose, and fly like a goose, I wish to be treated as a goose.”   Thus, the LLC is taxed similar to a Partnership or Sole Proprietorship (depending upon its number of members) by default, and may choose to be taxed under subchapter S or subchapter C under the guise of an association if it chooses.

Tags: Check The Box Tax, Corporate Tax, LLC Flexibility, LLC Tax, Partnership Tax