Fred Witt PLC, Phoenix Federal Tax Attorney
   

Tax Alert — January 2018 (Updated May 2018)

Avoid LLC Malpractice: Update Operating Agreement Now

Like scheduled car maintenance, every LLC operating agreement should be reviewed to determine if it is “up-to-date” with the latest developments. Your warning light is blinking. Fast action is required. Time began to run out in 2018.

Fred Witt, J.D., LL.M. in Taxation

 

Fred Witt

 

Limited liability companies (“LLCs”) are a popular choice of entity. Generally, a multi-member LLC taxed as a partnership is a hybrid entity that has some characteristics of a corporation, yet is treated as a partnership for federal and state tax purposes and for determining the existence of federal district court jurisdiction, among others.

Multi-Member LLCs Taxed as Partnerships are Subject to Federal Law

Treatment as a partnership under various federal laws adds enormous complexity that can be ignored at the LLC’s peril. The complexity, and perils, are evidenced in the case law.

There is case law authority for the following:

  • Bankruptcy Chink in LLC Armor: An Arizona bankruptcy court trampled conventional wisdom that a member’s chapter 7 trustee is a mere economic “transferee,” concluding a trustee may have broad, sweeping, powers to take over and appoint a receiver to operating the LLC and even liquidate and dissolve the entity.

  • Likely Stuck in State Court: An Arizona Federal District Court refused removal in a dispute between a limited liability company and a trust, finding no federal diversity jurisdiction and remanding back to Superior Court of Arizona (the State Court).

  • Members Have No Cash to Pay Taxes: An appellate court held that LLC cash distributed to members to pay their estimated taxes on LLC income to the IRS was subject to turnover/clawback by the LLC’s chapter 7 trustee (“an LLC is not a personal piggy bank ...” from which the members may withdraw to pay their taxes).

  • A Second, Longer, TEFRA Limitations Period Still Open for Partners: Even though their earlier individual statute of limitations had expired (under which the taxpayer/partners owed nothing), the Ninth Circuit Court of Appeals granted the IRS a “do-over” and held the later, TEFRA partnership, statute remained open (so they owed everything).

But, why commit LLC malpractice? Have an operating agreement that is up-to-date and considers the impact of federal law.

In 2018, Multi-Member LLCs Taxed as Partnerships Must Comply with New BBA 2015 IRS Tax Rules

Perhaps there are no more important federal rules than those provided by the IRS. On that count, the news is not good.

There are new IRS partnership audit rules that apply to multi-member LLCs taxed as partnerships in 2018. Failure to have new 2018 IRS tax language in the operating agreement amounts to LLC malpractice.

For 2018, an LLC’s operating agreement should answer the following questions:

  • Who is authorized to sign its annual IRS Form 1065 (due on March 15)?

  • Who will be designated as the “Partnership Representative” on that return for the tax year covered by the return?

How can a tax partnership LLC provide this detailed information on its 2018 IRS Form 1065 without specific written authorization set forth in the LLC’s operating agreement?

Who can sign a tax return is a big deal.

If you open a bank account for your LLC, the bank will ask to see a copy of your operating agreement. The bank will look for language authorizing a member to open the account and sign bank documents and checks as the LLC’s duly authorized representative. The bank wants documented legal authority.

Do you think the IRS is any different?

For multi-member LLCs taxed as a partnership, the IRS wants a “member” to sign the return under penalties of perjury. If this does not occur, the IRS regards an improperly signed return as being “invalid.” An invalid return will not start the “time clock” – the running of the statute of limitations.

The designation of a “Partnership Representative” in its 2018 return is a new requirement imposed by the BBA 2015 partnership audit rules. On Page 3 of 2018 IRS Form 1065, the IRS now requires specific information regarding the person designated (who must have a substantial presence in the United States): Name; U.S. address; U.S. taxpayer identification number; and U.S. phone number.

How can this designation occur without specific written authorization in the operating agreement?

Whether you own or advise an LLC taxed as a partnership, you have a choice: you can waste a lot of time becoming familiar with these new IRS rules and spend countless hours drafting your own LLC operating agreement language; or you can start with our easy solution.

Our online form store – www.taxllc.com – offers new LLC operating agreement forms for sale that are updated to reflect the new BBA 2015 IRS tax rules. With the ease of computer access (trips to the bookstore are no longer necessary), a purchaser instantly downloads our forms as a Word document. Then, you can use the document or “cut and paste” any portion you want.

Why tackle this problem alone? Why waste your time? We’ve worked weekends so you don’t have to! Check out www.taxllc.com for more details. Help is just a click away!

In 2019, a New Arizona LLC Statute Becomes Effective

For Arizona LLCs, the problems compound. After 25 years on the books, the old Arizona LLC statute was repealed and replaced by the legislature in 2018.

Beginning effective September 1, 2019, a new Arizona LLC statute -- the Arizona limited liability company act -- becomes effective. Found in A.R.S. § 29-3101 et seq., the new statute generally provides “default” rules that will govern an Arizona LLC in the absence of provisions in an operating agreement to the contrary. A.R.S. § 29-3105 provides the terms set forth in the operating agreement will govern, with the provisions of the statute as “backup” in the event an operating agreement does not exist or is silent on the subject matter.

Without an operating agreement, the new statute may dramatically change the economics of the deal. A.R.S. Section 29-3404 provides that distributions are to be made in equal shares among the LLC’s members. This means, in the absence of terms in the operating agreement to the contrary, distributions will be made pro rata – in equal shares -- among the members. If there are five members, for example, each member will receive an equal 20% share – without regard to their actual ownership percentages.

This is one of many problems. Can you imagine owning an Arizona LLC without an operating agreement?

Conclusion and Call to Action

This is a call to action. Whether you own or advise a multi-member LLC taxed as a partnership, the operating agreement must be reviewed and updated to reflect changes in the law.

There are new IRS partnership audit rules that apply to multi-member LLCs taxed as partnerships in 2018. Failure to have new 2018 IRS tax language in the operating agreement amounts to LLC malpractice. For LLCs in Arizona, a new operating agreement must be drafted to comply with the new statute in 2019.

Avoid LLC malpractice. Update the operating agreement now. Check out www.taxllc.com for more details.