If there was ever any doubt, the U.S. Tax Court has clarified that the sole member of a single member LLC can, in certain circumstances, be held liable for the employment tax liability of the entity. In Heber E. Costello, LLC and Costello v. Comm’r, T.C. Memo. 2016-184 (Sept. 29, 2016), Scott Costello, the sole member of Heber E. Costello, LLC, a Louisiana LLC, disputed his responsibility for the unpaid employment taxes of the LLC. Costello contended that the LLC should be treated as a corporation since (1) it resulted from a reorganization under Code §368(a)(1)(F), and (2) he filed corporate tax returns (Form 1120) for the LLC, which he claimed constituted a valid election for the LLC to be taxed as a corporation.
Costello became the sole owner of the LLC’s predecessor, Heber E. Costello, Inc. (the “Corporation”), after his father’s death. His father had been the sole shareholder of the Corporation. Costello formed the LLC on December 31, 2003 and merged it with the Corporation, with the LLC as the surviving entity. Costello never filed a Form 8832 to make an entity classification election for the LLC. Costello filed Forms 1120 on behalf of the LLC using the Corporation’s employer identification number. Costello filed the appropriate employment tax forms for the LLC but did not pay the tax due for tax years 2006, 2007 or 2008.
The Court first considered Costello’s claim that the LLC is actually a corporation. The Court referred to the check the box regulations that provide that an eligible entity with a single owner, such as the LLC, may elect to be classified as an association by filing Form 8832. If that entity does not file an election, then it will be disregarded as an entity separate from its owner. The LLC never filed Form 8832 and therefore, it is disregarded as a separate entity from Costello. Costello argued that there are other methods of electing corporate classification, such as by reorganizing under Code §368(a)(1)(F) or by filing corporate tax returns, but he was not able to provide any legal support for these claims and the Court rejected them. According to the Court, “an eligible entity may not elect its entity classification by filing any particular tax return it wishes.” As such, the LLC was not a corporation.
Liability for Unpaid Taxes
The Court next considered Costello’s claim that he is not personally liable for the LLC’s unpaid taxes. Since the employment taxes at issue related to wages paid before January 1, 2009, Treasury Regulations § 301.7701-2(a) (former regulations) applied. Under the former regulations, a disregarded entity is treated as a disregarded entity. In other words, the sole member of the disregarded entity and the disregarded entity itself are treated as a single taxpayer. As a result, the sole owner (here, Costello) is personally liable for the employment taxes of the disregarded entity (the LLC).
The former regulations were amended in 2007 to provide that, for employment tax purposes with respect to wages paid on or after January 1, 2009, a disregarded entity is treated as a separate entity (e.g., a corporation). A disregarded entity continues to be treated as disregarded for other Federal tax purposes. Under the final regulations, the sole owner of a disregarded entity that is treated as a sole proprietorship continues to be treated as self-employed, and not as an employee of the disregarded entity.
While it should go without saying, a business owner should intentionally choose its structure and tax status and accept the related tax and governance implications. Inadvertently forming the wrong entity could have costly consequences. In this case, it seems that Costello believed he formed a corporation and treated the entity as a corporation, but failed to check the box by filing Form 8832. As a result, he was personally liable for the entity’s unpaid employment tax liability of approximately $200,000. Business attorneys should impress upon clients the importance of making timely filings — tax or otherwise — and ensure that clients fully understand the implications of selecting a particular form of business entity.