IRS Collections for Payroll Taxes & Single Member LLC Owners

Published Categorized as Employment Tax, IRS Debts, Tax, Tax Procedure
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The IRS has broad collection powers. These powers generally trump state law. This is even true of state Limited Liability Company (“LLC”) rules that prevent parties from suing or reaching the LLC’s assets.

There are nuances to these rules when it comes to income and payroll taxes. The payroll tax rules have changed completely. Many taxpayers and even accounting firms fail to fully understand the implications of operating a business as an LLC when it comes to payroll tax liabilities.

The McNamee v. Department of the Treasury, 488 F.3d 100 (2d Cir. 2007) case is a prime example of the potential risks and consequences of failing to comply with employment tax requirements. The case highlights the importance of seeking professional advice and staying informed about tax laws and regulations to avoid any potential legal and financial challenges in the future.

Facts & Procedural History 

This case involves a six-person accounting firm that was operated as a single-member LLC. The accounting firm failed to pay $64,736.18 in payroll taxes for tax years 2000 and 2001. The LLC ceased operations in March 2002. The IRS disregarded the LLC and imposed tax liens on the sole member’s personal property.

The LLC ceased operations, and the owner disputed the IRS’s determination, claiming it contravened state law and the federal statutory scheme.

The accounting firm owner contested the government’s ability to disregard the entity, arguing that state law prevented the IRS from reaching the owner’s personal assets and that the federal regulations were invalid. The IRS asserted that the former owner failed to elect to have the LLC treated as a corporation.

The district court ruled in favor of the IRS, and the former owner appealed. The Second Circuit Court of Appeals rejected the accountant’s arguments.

Limited Liability Companies

LLCs are popular among small business owners because of their simplicity, flexibility, and liability protection. An LLC is a business entity that combines the liability protection of a corporation with the tax benefits and flexibility of a partnership.

Like a corporation, an LLC provides liability protection for its owners (known as members) by separating personal assets from business debts and liabilities. Corporations generally have more complex record-keeping requirements compared to LLCs. For example, corporations are required to maintain more detailed records of their corporate structure, including articles of incorporation, bylaws, and minutes of meetings. They are also required to hold regular shareholder meetings and maintain records of those meetings. Additionally, corporations are required to comply with more stringent financial reporting requirements, including filing annual reports with the state and providing regular financial statements to shareholders. They may also be subject to more rigorous auditing and accounting standards.

In contrast, LLCs are generally subject to less regulatory oversight, and their record-keeping requirements are often less burdensome. LLCs are not required to hold regular meetings or maintain detailed corporate minutes, although they may choose to do so to document important decisions and events. Additionally, LLCs are not required to file annual reports with the state or provide regular financial statements to members, although they may be required to do so under certain circumstances.

The Limited Liability Aspect of LLCs

One of the main advantages of forming an LLC is that it provides its members with limited liability protection, meaning that the personal assets of the members are generally shielded from the liabilities of the business.

Under most circumstances, if someone sues an LLC, they can only go after the LLC’s assets and not the personal assets of the members. This is because an LLC is a separate legal entity from its members, and the liability of the LLC is generally limited to its assets.

This is where the state charging order rules come into play. A charging order is a legal order that allows a creditor of an LLC member to obtain the member’s share of profits and distributions from the LLC. Essentially, a charging order places a lien on the member’s ownership interest in the LLC.

The purpose of a charging order is to provide a remedy to the creditor without disturbing the LLC’s business operations or the personal assets of the other members. Instead of seizing the member’s ownership interest in the LLC, the charging order allows the creditor to receive any profits and distributions that would otherwise be paid to the member. The member is still considered an owner of the LLC, but the creditor has a priority right to receive any payments due to the member until the debt is satisfied.

Charging orders are not available in all states, and the rules governing charging orders vary by state. Some states require the creditor to exhaust all other remedies before seeking a charging order, while others allow a creditor to obtain a charging order immediately upon obtaining a judgment against the member.

Income Taxation of LLCs

Corporations are subject to tax at the entity level. They are subject to corporate income tax at the federal and state levels on their profits, and may also be subject to other taxes, such as payroll taxes and excise taxes. Additionally, if the corporation distributes profits to shareholders in the form of dividends, those dividends are also subject to individual income tax.

Unlike a corporation, an LLC is not taxed as a separate entity at the federal level (although some states may impose a separate tax on LLCs). Each member reports their share of the LLC’s profits or losses on their individual tax return and pays taxes on that income accordingly. This is why LLCs are generally referred to as “pass-through” entities, as the profits and losses of the business are passed through to the individual members’ personal tax returns.

There are certain tax elections that an LLC can make that would change its tax treatment. For example, an LLC can elect to be taxed as a corporation by filing IRS Form 8832, and can then choose to be taxed as either a C corporation or an S corporation. Similarly, a corporation can elect to be taxed as an S corporation by filing IRS Form 2553, which allows it to be taxed as a pass-through entity like an LLC.

Absent an election to be a corporation, the IRS does not need to reach the assets of the LLC. The income taxes are reported and paid at the individual level. Thus, the IRS collects from the individual owners.

Employment Taxation of LLCs

This case is not about income taxes. It is about employment or payroll taxes. Employment taxes include federal income tax withholding, Social Security and Medicare (FICA) taxes, and Federal Unemployment Tax Act (FUTA) taxes.

In 2007, the rules say that payroll taxes for a single-member LLC were reported under the owner’s personal Social Security Number and the owners are liable for unpaid payroll taxes. That is what this case is about.

The appeals court affirmed the district court’s decision, holding that the Treasury Regulations and the tax code impose tax on the owners. The owner’s argument that the regulations were invalid because they conflicted with state law and the federal statutory scheme was rejected by the courts.

This mismatch of law between income tax and payroll taxes for single-member LLCs created uncertainty. This uncertainty was cleared up in 2009 as the law was changed shortly after this case was decided.

Since 2009, single-member LLCs have been required to collect and report employment taxes to the IRS under their company’s Employer Identification Number (“EIN”) and the taxes are only collectible from the entity. As with corporations, the IRS has to assert a trust fund recovery penalty under Section 6672 to effectively make the employment taxes a personal liability of the owners or other responsible persons. This allows the IRS to collect unpaid taxes from the responsible person’s personal assets, including bank accounts, real estate, and other property. This means that if an LLC fails to pay payroll taxes, the IRS can hold the responsible members personally liable for the unpaid taxes and pursue their personal assets to satisfy the debt.

The Takeaway

This case highlights the importance of understanding the tax implications and responsibilities associated with operating a business as an LLC. The case also illustrates the potential risks and consequences of failing to comply with employment tax requirements. It is important for business owners, especially those operating as LLCs, to seek professional advice and stay informed about tax laws and regulations to avoid any potential legal and financial challenges in the future.

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