Keeping an Eye on Asymmetrical Issues and Problems
With many closely-held entities electing (or defaulting into) a “pass-through” status, either as an entity to be treated as an “S corporation” under the Federal tax law, or as a “partnership” under the Federal tax law, or as a “disregarded entity” under the Federal tax law (when there is only one owner, under the facts and circumstances), state laws and the Federal tax law can become asymmetric. In other words, a LLC formed under state law may elect its way into either C or S corporation entity status under the Federal tax law, or default into treatment as a partnership, with two or more owners, or disregarded as an entity separate from its owner, if there is only one owner under the facts and circumstances. At other times, a person or entity labeled as an owner (e.g., member, partner, limited partner, or even shareholder) or treated as such under state law, may not be properly classified as such under the Federal tax law’s application of a facts and circumstances approach. Under these situations, it may be critical for an owner to take affirmative action with regard to any K-1s he or she or it has been issued, applying applications and advice rendered in our special program, Partners in Peril.
Another issue of concern lies with the fact that ownership in flow-through entities like S corporations is not determined by legal title; rather, by beneficial ownership. Bonilla v. United States, 2019 U.S. Dist. LEXIS 47853 (D. Conn. March 22, 2019). Practitioners must not look solely to whether or not certificates have been re-titled, but rather at whether orders or judgments exist giving rise to enforceable rights in an interest in a S corporation or presumably a LLC. Id.
Federal courts will not be bound by the so-called Dunne factors, when determine whether a beneficial interest exists. Id. Instead, the Federal courts will look to state law to determine whether a taxpayer has a beneficial interest. Federal common law choice of law rules then are to be applied to determine which jurisdiction's substantive law should apply. Wells Fargo Asia, Ltd. v. Citibank, N.A. 936 F.2d 723, 726 (2d Cir. 1991).
If a matter is pursued before the Tax Court, then the Tax Court will look to all of the facts and circumstances surrounding the transfer, relying on the objective evidence of the parties' intentions provided by their overt acts, and the Tax Court has provided a list of factors relevant to identifying a beneficial owner. Dunne v. IRS, T.C. Memo 2008-63.
Here at the Tufts Law Firm, we are prepared to assist owners with understanding and working with this asymmetry, and either anticipate or avoid or deal with business disputes that may then arise. If you have asymmetrical issues or concerns, please contact us.