Is Your LLC Really a Single Member LLC?

Limited Liability Companies or LLCs are all the rave today for acquiring, holding, managing and disposing of real estate.  They are easy to form, easy to administer, and easy to deal with for income tax purposes, especially if the LLC is a single member LLC ("SMLLC").

Single Member LLCs Have One Member
Single member LLCs are Limited Liability Companies that have one and only one member (owner) for tax purposes. LLCs that have a husband and wife as the sole members may still be treated as a single member LLC if they live in a community property state and file a joint income tax return. 

The single member LLC generally uses the Taxpayer Identification Number ("TIN") or Social Security Number ("SSN") of the sole member, but can apply for its own separate TIN if it so chooses.  

Single Member LLCs Are Pass-Thru and Disregarded Entities
Single member LLCs are not only treated as pass-thru entities (income tax consequences inside of the LLC pass-thru to the sole member's income tax return) but are also treated as disregarded entities (SMLLC is ignored as if it does not exist for income tax purposes). The assets held (owned) inside the single member LLC are treated as if they are owned directly by the sole member for income tax purposes.

However, since they are generally so easy to administer it also means they are easy to screw up, especially because most taxpayers do not fully understand how the single member LLC should be treated and/or reported. 

I think the vast majority of those taxpayers who set-up limited liability companies intend to use, treat and report the LLCs as single member LLCs, but it is truly amazing how many accidentally end up as something other than single member LLCs.

Most Common Mistake Made
The most common mistake made with single member LLCs is when tax return preparation time comes around.  Generally, tax consequences from a single member LLC should be reported on the sole member's income tax return since the single member LLC is a pass-thru entity and a disregarded entity. 

Partnership Treatment; No Longer Single Member LLC
However, the taxpayer and/or his or her tax advisor all too often incorrectly file IRS Form 1065, which is a partnership income tax return.  There are many reasons used to "rationalize" why this was done, often for administrative convenience, but in the end Filing IRS Form 1065 effectively serves as an election by the taxpayer to treat the LLC as a partnership rather than a single member LLC. 

The LLC is still a pass-thru entity, but it is no longer a disregarded entity.  The LLC is now treated as a partnership and is now considered a completely separate and distinct legal entity from the taxpayer.  The taxpayer will receive a K-1 from the partnership. 

Complications For 1031 Exchanges
Why am I discussing this issue on my blog where I usually talk about 1031 Exchanges?  It absolutely affects the successful outcomes of 1031 Exchanges when there is a single member LLC involved in the sale or purchase of properties inside a 1031 Exchange. 

1031 Exchange Case Study
Let's review an example of what can go wrong when what is thought to be a single member LLC actually turns out to be a LLC that has been treated and reported as a partnership. 

Taxpayer owns property in a LLC.  Taxpayer is the sole member of the LLC and therefore assumes that the LLC is a single member LLC.  Taxpayer tells the Qualified Intermediary that the LLC is a single member LLC and that Taxpayer will be buying his or her replacement property in the same single member LLC. 

The Qualified Intermediary drafts the 1031 Exchange documents listing the single member LLC as the Exchangor (taxpayer/seller) for the relinquished property and the sale closes. 

The Taxpayer discovers that his or her lender will not lend to the LLC, so the Taxpayer is 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 the LLC. 

Generally, this would still qualify for tax-deferred treatment in a 1031 Exchange if the LLC is considered a single member LLC because it is a disregarded entity and the property owned by the LLC is treated as if it is owned by the underlying Taxpayer who is the sole member of the LLC.

However, if the Taxpayer had actually been filing IRS Form 1065 for the LLC, then the transaction may not qualify for tax-deferred exchange treatment because there would be two different entities involved in the transaction.  The sale would have been closed in a partnership's name and the subsequent purchase of the replacement property would have been closed in the individual's name.  The partnership and the individual are completely different taxpaying entities.  


Remember, properties must be sold and acquired by and in the name of the same taxpaying entity in order to properly structure a Tax-Deferred Exchange pursuant to Section 1031 of the Internal Revenue Code and the California Franchise Tax Board. 

California Franchise Tax Board Audit
I have been involved as an expert witness in two (2) transactions that were audited by the California Franchise Tax Board and in one (1) that was audited by the Internal Revenue Service.  


The issues and outcomes described above are the exact positions taken by the California Franchise Tax Board and the Internal Revenue Service.  Owners intending to use single member LLCs need to consult with their legal and tax advisors to ensure they are in fact treating, reporting, administering and documenting their LLCs as single member LLCs.