Is a Single Member LLC Really a Single Member LLC?

Limited Liability Companies (“LLCs”) are all the rave today for acquiring, holding and managing real estate. They are easy to form, easy to administer, and easy to deal with for income tax purposes. This is especially true if the LLC is a Single Member Limited Liability Company (“SMLLC”) since a SMLLC is not only a “pass-thru entity” but also a “disregarded entity” (see discussion below).

SMLLCs are Limited Liability Companies that have one – and only one – member (owner) for income tax purposes. LLCs owned by a husband and wife as the sole members may still be treated as a SMLLC if they live in a community property state and file a joint income tax return.

SMLLCs Are Pass-Thru and Disregarded Entities

As stated above, SMLLCs are “pass-thru entities” and “disregarded entities” for Federal income tax purposes. This is a huge benefit because the assets held (owned) inside the SMLLC are treated as if they are owned directly by the sole member of the SMLLC for income tax purposes.

The term “pass-thru entity” simply means that any and all income tax consequences occurring inside of the SMLLC pass-thru to the sole member’s income tax return. The SMLLC does not file a separate Federal income tax return.

The term “disregarded entity” means that the SMLLC exists for legal purposes but is ignored as if it does not exist for Federal income tax purposes. The SMLLC does not need to obtain its own Federal Taxpayer Identification Number (“TIN”). The SMLLC generally uses the TIN or Social Security Number of the sole member of the SMLLC. The Taxpayer can apply for a separate TIN for the SMLLC if desired or needed for business purposes such as payroll or banking.

However, since SMLLCs are generally so easy to administer it also means SMLLCs are easy to screw up because most Taxpayers do not fully understand how the SMLLC should be treated and/or reported for legal and tax purposes. A common mistake made in the administration of SMLLCs is in the preparation and filing of the SMLLC’s income tax returns. Generally, tax consequences from a SMLLC should be reported on the sole member’s Federal income tax return since the SMLLC is a pass-thru entity and a disregarded entity.

Partnership Treatment; No Longer SMLLC

However, the Taxpayer and/or his or her tax advisor all too often file IRS Form 1065, which is a partnership income tax return. There are many reasons why IRS Form 1065 may have been filed, but, in the end, Filing IRS Form 1065 for a SMLLC may effectively serve as an election by the Taxpayer to treat the SMLLC as a partnership rather than a SMLLC.

The LLC will remain a pass-thru entity in either case, but may now be treated as a partnership entity, which is a completely separate and distinct entity for income tax purposes, instead of a SMLLC.

Potentially Fatal for 1031 Exchanges

The Taxpayer (person or entity) that acquires replacement property as part of a 1031 Exchange must be the same Taxpayer that originally sold the relinquished property in the same 1031 Exchange. If a SMLLC involved in a 1031 Exchange is recharacterized into a partnership entity (no longer a disregarded entity) it could be fatal to a 1031 Exchange transaction.

1031 Exchange Case Study

Let’s review a case study involving a 1031 Exchange and see what can go wrong when a SMLLC is actually treated and reported as a partnership.

Taxpayer is the sole member of a SMLLC. The SMLLC owns investment property (“relinquished property”). Taxpayer contracts to sell the relinquished property and retains a Qualified Intermediary to structure a 1031 Exchange. Taxpayer tells the Qualified Intermediary the same SMLLC will also be acquiring the replacement property. The Qualified Intermediary drafts the 1031 Exchange documents listing the SMLLC as the Taxpayer (Exchangor/Seller) of the relinquished property and the sale transaction closes.

The Taxpayer later discovers that the lender will not finance the replacement property if it is held (owned) by the SMLLC. The Taxpayer is therefore forced to acquire the replacement property in his or her individual name. The replacement property closes and the legal title is in fact deeded (conveyed) into the Taxpayer’s individual name and not to the SMLLC.

So far, so good. Generally, this transaction would qualify for tax-deferred exchange treatment because the LLC is a SMLLC and is therefore a pass-thru entity and a disregarded entity. The relinquished property owned by the SMLLC would be treated as if it were owned directly by the underlying Taxpayer who is the sole member of the LLC. The replacement property was acquired by the individual Taxpayer. Therefore, the relinquished property was sold by the Taxpayer and the replacement property was acquired by the same Taxpayer.

However, if the Taxpayer files IRS Form 1065 (partnership income tax return) for the SMLLC, the IRS or state taxing authority may recharacterize the SMLLC as a partnership entity. Partnerships are no longer disregarded entities and the relinquished property discussed in this case study would no longer be treated as being owned by the Taxpayer.

The relinquished property would have been considered sold by the partnership entity and the replacement property would have been acquired by the Taxpayer. The partnership and the Taxpayer are completely separate and distinct entities for income tax purposes. Therefore the transaction would not qualify for tax-deferred exchange treatment if the SMLLC was recharacterized as a partnership because there would be two different taxpaying entities involved. Properties must be sold and acquired by the same taxpaying entity.

IRS and California FTB Audits

I have been involved as an expert witness in three separate 1031 Exchange audits within the last twelve months – two with the California Franchise Tax Board and one with the Internal Revenue Service. The IRS and FTB have both taken the position described in this article – that the Taxpayers’ action of filing IRS Form 1065 was tantamount to an election by the Taxpayer to have the SMLLC treated as a partnership for income tax purposes and not a SMLLC (disregarded entity). The Taxpayers’ are strongly disputing the audit agency’s positions.

Taxpayers using SMLLCs must consult with their legal and tax advisors to ensure they are using, treating, reporting and documenting their SMLLCs correctly.

Contact Bill Exeter at wexeter@exeterco.com

3 Comments »

  1. This is great information Bill, thank you. I have a few questions. In the case study you presented, if the Taxpayer had been able to purchase the property in the name of the SMLLC, despite the fact that he had filed a 1065, would that have been a property 1031 exchange?

    If a Taxpayor files the 1065, thereby “electing” to have a partnership, can he change the manner in which he files and file the income on his personal return thereby “electing” to make the entity a SMLLC again?

  2. Hi Vicky,

    Yes, if the relinquished property was sold out of the SMLLC and the replacement property was acquired in the same SMLLC the 1031 Exchange would qualify because it would be considered the same taxpaying entity throughout.

    Changing the way in which the SMLLC is taxed (i.e. from a partnership to a SMLLC by eliminating the IRS Form 1065 and filing on the individual’s tax return might work. It would not be full proof, and if the partnership reporting has been done for many years, I don’t think it would work. But, if the change was done relatively soon it would certainly help support the intent.

  3. Hi Bill. This is a fantastic site. I have a question- Assumming the 1031 exchanger had a SMLLC that was managed by a manager that was NOT the member (1031 exchanger) and did NOT file for partnership taxation but sold the initial property from the SMLLC (managed by the non-member manager) and then purchased the replacement property individually (or in the same SMLLC with the same non-member manager) how would this be regarded for 1031 purposes?

    Thanks!

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