Thursday April 18, 2024

4.8.1 LLC Taxation and Unrelated Business Income

LLC Taxation and Unrelated Business Income

Limited Liability Company:  An LLC is similar to a C corporation in that its members enjoy limited liability.

"Pass Through" Taxation:  An LLC is different from a C corporation in that it does not pay tax at the entity level.

Unrelated Business Income Tax (UBIT):  Because an LLC is a pass-through entity, any income earned by the LLC passes through to the LLC members.
A limited liability company (LLC) is a newer form of business entity created by state law. The owner of an LLC is called a member. While many LLCs have more than one owner or member, some states allow "single-member LLCs." Single-member LLCs have only one owner and for tax purposes are not recognized as separate from that owner.

The LLC is a popular choice for business operations because it affords its owners the limited liability that C corporations typically provide combined with the pass-through taxation that partnerships offer.

Limited Liability Company
An LLC is similar to a C corporation in that its members enjoy limited liability. This means that in the event of a lawsuit or bankruptcy, the LLC member's liability is limited to his or her investment in the LLC and any personal assets are not available to satisfy the LLC's creditors.

"Pass Through" Taxation
An LLC is different from a C corporation in that it does not pay tax at the entity level. Instead, the members of an LLC must include their share of the LLC's income, deductions and credits on their personal tax returns - even if that income isn't actually distributed. This is called "pass-through" taxation because the LLC "passes" its income, deductions and credits "through" to its members. Partnerships and S corporations are also pass-through entities.

Unrelated Business Income Tax (UBIT)
Because an LLC is a pass-through entity, any income earned by the LLC passes through to the LLC members. When the income is passed through to the members, it maintains the same character in the hands of the members as it had in the LLC. As a result, if an LLC operates a business, its income will pass through to its members as active trade or business income.

If a charity is an LLC member, that charity will pay unrelated business income tax (UBIT) on all active trade or business income that passes through to it from the LLC. While charities are permitted to pay UBIT, they need to be concerned with the amount of UBIT they pay each year because it could jeopardize the charity's tax-exempt status. Small amounts of UBIT, however, should not cause great concern.

If a charitable remainder trust (CRT) is an LLC member, there may be an excise tax on income. See Newhall v. Commissioner. With LLC assets from an active trade or business in the charitable remainder trust, there will be tax on the UBI. The trust will be subject to 100% excise tax on the unrelated business income. Sec. 664(c)(2)(A). Since a unitrust with unrelated business taxable income does not lose exempt status, an active LLC business asset may still be transferred to the trust and sold fairly quickly. If the asset is sold quickly, a donor may receive the capital gains bypass benefit with a modest cost for the 100% excise tax on trust unrelated business income.

For this reason, the trustee of a CRT should carefully consider whether or not it should accept gifted LLC interests. If a CRT does accept gifted LLC interests, it is preferable that the LLC does not conduct an active trade or business.

Case Studies on LLC Taxation and Unrelated Business Income

Developer Doubles Unitrusts:   Donald Developer was a creative and entrepreneurial person. His business and personal affairs often made newspaper headlines. Through a stormy and turbulent career, he acquired large parcels of property and developed them with either commercial buildings or residential structures.

Grizzly Gordon and the Ranch LLC, Part I:   Grizzly Gordon grew up in the Big Sky country. He loved the mountain and plain vistas of this beautiful ranching country. During his youth, Grizzly acquired his nickname by discovering a grizzly bear that had gotten too near his cattle.

Private Letter Rulings

FSA 200049003 IRS Outlines Valuation Attack Strategies for LLCs and FLPs:   Audits of family limited partnerships and limited liability companies are now the primary focus for many gift and estate tax IRS attorneys. With many audits presently underway of FLPs and LLCs, the IRS in a reasonably comprehensive field service advice has set forth its primary strategies for attacking LLC and FLP valuation discounts.

PLR 200252096 CRUT's Creation of a For-Profit Corporation Insulates Trust from UBIT:   Charitable Remainder Unitrust (CRUT) intends to form a wholly owned for-profit corporation. CRUT will contribute the necessary capital to fund Corporation. However, CRUT will not incur any debt in the process. Once created and funded, Corporation will purchase an interest in LLC. LLC operates an active business that leases business equipment and commonly uses debt financing to partially fund its purchase of business equipment.

PLR 200623069 Charitable Remainder Trust Will Not Realize UBTI from Partnership LLC:   CRT intends to invest in stocks, securities and other financial instruments by purchasing a limited partnership in LLC, which is classified as a partnership for federal income tax purposes.

Related Topics on LLC Taxation and Unrelated Business Income

4.14.1  Sub S Taxation:    The most common type of corporation is a traditional "C corporation." All companies whose stock is publicly traded are C corporations. C corporations pay tax on their net income at the corporate level and then when that income is distributed to shareholders in the form of dividends, the shareholders also pay tax. The result is that C corporation income is taxed twice - once at the corporate level and once at the shareholder level.

Hackl:    Thousands of gifts of LLC and FLP interests are made to others, usually family members, each year. These gifts frequently are believed to qualify for the annual exclusion. In a potentially far-reaching decision in Christine M. Hackl, et vir v. Commissioner; 118 T.C. No. 14; No. 6921-00; No. 6922-00 (27 Mar 2002), the Tax Court rejected the claim that gifts of LLC interests qualified for the annual exclusion.

Hackl CA7th:    In Albert J. Hackl Sr., et ux. v. Commissioner; No. 02-3093; No. 02-3094 (7th Cir. 11 Jul 2003), the Seventh Circuit denied the use of annual exclusions for gifts of Treeco LLC units. The Hackls had created Treeco LLC and transferred $8 million in cash and $4.5 million in tree farm properties to it. They then made gifts of LLC units to children and other family members and claimed that the gifts qualified for the annual exclusion. The IRS disagreed and assessed a gift tax deficiency. The Tax Court agreed with the IRS, Hackl v. Comm'r, 118 T.C. 279 (2002), resulting in a gift tax deficiency of roughly $400,000 for the couple.

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