The sole owner of a limited liability company (LLC) who fails to have the entity treated as a corporation for federal tax purposes may be personally liable for the LLC’s unpaid payroll taxes. “Limited liability” in an LLC structure does not necessarily mean automatic insulation from federal tax liability, especially on payroll tax obligations.

Under IRS “check-the-box” regulations, unincorporated businesses may elect to be treated as a corporation. To make such an election, the entity must file IRS Form 8832, Entity Classification Election, in accordance with IRS regulations. If the entity fails to elect treatment as a corporation, by default the entity will be disregarded as separate from its owner and taxed as a sole proprietorship. Under the default classification, the owner may be personally liable for all debts and other liabilities of the entity.

State limited liability law

The Second Circuit Court of Appeals recently held that, despite the Internal Revenue Code’s failure to directly address the LLC structure, Treasury regulations provide reasonable guidance as to how LLCs are treated for federal tax purposes; do not contravene state limited liability laws or provisions of the Code, and; are not unreasonable or arbitrary. The court also held that the IRS’s collection of an LLC's unpaid payroll taxes personally from the owner does not violate the limited liability granted to LLCs by state law; state limited liability laws do not abrogate an LLC owner's federal tax liabilities. While state incorporation laws control aspects of business relations, “they may affect, but do not necessarily control federal tax provisions,” the court said.

Reasonable regulations

As the court explained, current regulations allow the single owner of an LLC to choose to be treated either as a corporation or to be disregarded as a separate entity. According to the court, "The IRS check-the-box regulations, allowing the single-owner LLC to make the choice, are therefore eminently reasonable."  That may be so, but they also pose a dangerous trap for the unwary.  If you operate as an LLC and have any questions about payroll tax liability, please feel free to call this office for further details.

(McNamee, CA-2 May 23, 2007)