A little known Court Case has just sent ripples through the business community. If you, or someone you know, has one of the 1.2 million Limited Liability Companies in the US today, you'll want to read this alert.

In the case of Littriello v. United States, a Kentucky man formed an LLC (Limited Liability Company) for his nursing home. He did not use the "check the box" tax decision and instead decided to just run it under the "default" tax schedule.

An LLC is considered the chameleon of the tax world because it, alone of all the business structures, can choose how it wants to be taxed. But the LLC must make a choice by filing the appropriate election with the IRS. Otherwise, the IRS will automatically assign a default tax status, based on the number of owners. If there are two or more owners the LLC will be considered a partnership for tax purposes. But if there is only one owner, or the LLC is owned by a couple filing a joint tax return, the IRS will assign "single-member disregarded" status. What that means is that, as far as the IRS is concerned, the LLC is no different from a sole proprietorship.

There are times when this tax election can be to your advantage, most often with passive real estate, where you own rental properties. The LLC structure will give you much desired legal protection and limit your personal liability, while the single-member disregarded tax status can mean less record keeping and a simplified tax return (you will file on a Schedule C instead of having to prepare a Form 1065 return for the LLC and then a Form K-1 moving the profits to your personal returns.

If Mr. Littriello been my client, the LLC's tax status would have been the first thing I would have changed. We recommend active business operations to run either in an S Corporation, C Corporation or an LLC electing one of those strategies. The type of income being earned is better off, tax-wise, with corporation taxation, plus there is a much lower chance of being selected for an IRS audit by using this tax classification.

Mr. Littriello was an absent business owner, relying on his hired staff. But a trusted employee embezzled from the company and failed to pay payroll taxes for the staff. The IRS came after the company for the unpaid payroll taxes. Mr. Littriello thought that he personally was not liable, because, after all, he had an LLC through which he operated the business.

"Not so!" said the IRS. They maintained that because he had selected disregarded entity status for his LLC, it should be treated as a Sole Proprietorship in all aspects -- including the owner's personal liability for the debts of the business. Yet under state law, LLCs are considered "persons" in the eye of the law, and thus any debts or issues stop with the entity itself.

I have to say I didn't think there was a chance that the IRS was going to win that argument. But they did. Faced with a conflict between federal and state law, and despite a contrary position on the issue of "person" taken by the IRS in the past, when given a choice to decide the issue the courts sided with the IRS. Perhaps they felt it was in the greater public interest for payroll taxes to be paid, somehow. Legal analyses I've read on the case have concluded that the court decided not to decide -- and simply ignored the issue.

This case concerns me because it opens the door to the single-member disregarded LLC potentially losing its legal protection in other situations. There was a case in Colorado a few years ago where an LLC owner attempted to declare bankruptcy and protect the assets in his single-member LLC from the trustee. Again the court sided against the LLC. Ultimately I think that tax classification for single-member LLCs is going to continue to be a hot-button issue and it will become increasingly important to make sure you work with your advisors to get it right.

Published: April 24, 2008

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Diane Kennedy, the nation's pre-eminent tax strategist, is owner of Diane Kennedy & Associates, a leading tax strategy and accounting firm and founder of TaxLoopholes. She is the author of The Wall Street Journal and Business Week bestsellers, Loopholes of the Rich and Real Estate Loopholes, and co-author of The Insider's Guide to Real Estate Investing Loopholes, The Insider's Guide to Making Money in Real Estate, and TaxLoopholes for eBay Sellers. Register for free Tax Strategy updates and e-Newsletters delivered via email from TaxLoopholes.com. You will be updated on current tax law changes as well as proactive tax strategies the wealthy use plus news regarding Diane Kennedy.