An LLC taxed as a C corporation can choose any year end as the tax year end (an LLC classified as an S corporation generally must use a calendar year end). If an LLC is classified as a partnership for federal income tax purposes, however, its tax year is governed by Sec. 706(b). Generally, this section provides that the tax year of a partnership must conform to that of its partners or, for an LLC, to that of its members. (A single-member LLC’s required tax year is the tax year of the owner unless corporate classification is elected.) However, if certain requirements are met, there are exceptions to this rule. To determine the tax year-end options of an LLC taxed as a partnership, the following steps must be performed in order:
Determine the “required year.” Even if the LLC’s required year is not used as its tax year, several rules and limitations are based on the required year, such as the allowable year end when making an election to use a tax year other than the required year under Sec. 444. Since changes in member status can cause changes in the LLC’s required year, the required year must be determined annually.
Determine if the LLC can elect a “nonconforming” tax year (i.e., a year other than the required year) under the natural-business-year or business-purpose exceptions (see Rev. Proc. 2002-39).
If the natural-business-year or business-purpose exceptions do not apply, determine if the LLC can elect a nonconforming tax year under Sec. 444. As the price for making this election, the LLC may be required to make prepaid tax deposits with the IRS.
An LLC adopts a tax year by filing its first federal income tax return using that tax year. Filing an application for an employer identification number, filing an extension, or making estimated tax payments indicating a particular tax year does not constitute adoption of that year (Regs. Sec. 1.441-1(c)(1)). This item focuses on the required year rules.
The Required Year Rules
The required year is generally the tax year of the members who own, in the aggregate, more than 50% of the interests in the capital and profits of the LLC (Sec. 706(b)). This provision is the “majority interest” rule. If there is no member or combination of members with the same tax year owning more than 50% of profits and capital, the LLC’s required year is the tax year of its principal members. Principal members are those owning 5% or more of either profits or capital. This provision is the “principal members” rule. If neither of these rules applies, the LLC’s required year is the year end resulting in the least aggregate deferral of income to the members. This provision is the “least aggregate deferral” rule.
Caution: Many practitioners believe an LLC can always use the calendar year as its required year. This is not so. If the required year cannot be determined under the majority-interest rule or principal-members rule, the LLC’s required year is the tax year with the least aggregate deferral of income (Regs. Sec. 1.706-1(b)(2)(i)). Although the rules often result in a required year ending December 31, practitioners should not assume that the calendar year is always available.
Majority-Interest Required Year Rule
The majority-interest rule is applied first when determining an LLC’s required year. If an LLC’s ownership permits a year-end determination under the majority-interest rule, this is the LLC’s required year. There is no application of the principal-members rule or the least-aggregate-deferral rule. Under the majority-interest rule, an LLC must adopt the same tax year as that of its member or members who cumulatively own more than 50% of the LLC’s profits and capital interests. In determining if the majority interest rule can be applied, the test date is the first day of the LLC’s tax year (Sec. 706(b)(4)).
When determining an LLC’s tax year, the tax year of a tax-exempt member is disregarded if the member was not subject to tax on its distributive share of income from the LLC in the immediately preceding year. Likewise, the tax year of a tax-exempt entity that was not a member during the immediately preceding tax year is disregarded if the member is not expected to be subject to tax on its share of the LLC’s current-year income (Regs. Sec. 1.706-1(b)(5)). Similar rules apply to foreign entities not subject to U.S. tax (see below).
An LLC may be required to change its tax year to comply with the majority-interest rule if changes in ownership occur. If the LLC changes its tax year for this reason, no further change (due to changes in majority members’ tax years) in the LLC’s tax year is required for the two tax years following the year of change.
When determining an LLC’s tax year, a member’s interest in LLC profits is generally the member’s percentage share of LLC net income for the current tax year. If the LLC does not expect to have income for the current tax year, the member’s interest in LLC profits is the member’s percentage share of LLC net income for the first tax year in which the LLC expects to have net income. A member’s share of LLC net income is the ratio of the member’s distributive share of LLC income (taking into account all rules and regulations affecting that determination) to the LLC’s net income for the tax year. A member’s interest in LLC capital is determined by reference to the LLC assets the member would be entitled to upon withdrawal from the LLC or liquidation of the LLC. If the LLC maintains capital accounts under the substantial-economic-effect safe-harbor rules of Regs. Sec. 1.704-1(b)(2)(iv), a member’s interest in capital equals the ratio of the member’s capital account to all members’ capital accounts (Regs. Sec. 1.706-1(b)(4)).
Principal-Members Required Year Rule
If an LLC cannot use the majority-interest rule, it must try to determine its required year based on the tax year of its principal members. A principal member is any member with a 5% or more interest in profits or capital (Sec. 706(b)(3)). However, the same rules for disregarding the tax year of a tax-exempt member apply as under the majority-interest rule. Similar rules apply to foreign entities not subject to U.S. tax (see below).
Least-Aggregate-Deferral-of-Income Required Year Rule
If an LLC cannot use either the majority-interest rule or the principal-members rule, it must select a required year end (from among the members’ year ends) resulting in the least aggregate deferral of income to the members. In determining the appropriate year end under this rule, the year end and profits interest of each member must be considered. However, the same rules for disregarding the tax year of a tax-exempt member apply as under the majority-interest rule. Similar rules apply to foreign entities not subject to U.S. tax (see below).
The least aggregate deferral of income is determined by multiplying each member’s percentage of LLC profits for the year by the number of months of deferral that would arise through selection of the proposed year end (Regs. Sec. 1.706-1(b)(3)). Months of deferral for this purpose are counted by going forward from the proposed LLC year end to the members’ year ends, using the information available at the beginning of the current tax year (unless the members have made voluntary changes in their year ends—see Letter Ruling 8907042). After testing each proposed tax year, the year producing the least aggregate deferral of income is the required year. If the test produces more than one qualifying tax year, the LLC can select any one of those years. However, under the special consistency rule, if one such year end meeting the test is the LLC’s existing year end, the LLC must retain its existing tax year.
If the tax year with the least aggregate deferral produces a difference in aggregate deferral less than 0.5 (i.e., the result of the equation described in the preceding paragraph is smaller than 0.5) compared to the aggregate deferral of the LLC’s existing tax year, a de minimis rule applies. The LLC’s existing tax year is treated as the tax year with the least aggregate deferral, and no change in tax year is necessary or permitted (Regs. Sec. 1.706-1(b)(3)(iii)).
Comparing the Three Rules
The majority-interest rule and the principal-members rule look at members’ interests in capital and/or profits. The least-aggregate-deferral rule looks only at the members’ interests in profits. LLCs subject to the least-aggregate-deferral rule must redetermine the year end of least aggregate deferral each year there is a change in members’ profits interests and/or year ends. When such a change occurs, the only relief is the de minimis rule discussed in the preceding paragraph.
Tax Years of LLCs with Foreign Members
The interests of disregarded foreign members are not taken into account in determining the tax year of an LLC classified as a partnership. A foreign member is disregarded unless it is allocated gross income of the LLC that is effectively connected (or treated as effectively connected) with the conduct of a trade or business within the U.S. during the LLC’s tax year immediately preceding the current tax year (or if the member was not a member during the immediately preceding tax year, the LLC reasonably believes that the member will be allocated any such income during the current tax year) and taxation of that income is not otherwise precluded under any U.S. income tax treaty (Regs. Sec. 1.706-1(b)(6)).
A foreign member is any member that is not a U.S. person (other than a controlled foreign corporation or a foreign personal holding company). However, if each member that is not a disregarded foreign member (regarded member) holds less than a 10% interest in the LLC, and the regarded members hold less than 20% of the LLC’s capital or profits, the interests of the disregarded foreign members are taken into account in determining the LLC’s tax year.
This case study has been adapted from PPC’s Guide to Limited Liability Companies , 17th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, Virginia R. Bergman, William R. Bischoff, James A. Keller, and Linda A. Markwood, published by Thomson Tax & Accounting, Ft. Worth, TX, 2011 ((800) 323-8724; ppc.thomson.com ).
Albert Ellentuck is of counsel with King & Nordlinger, LLP, in Arlington, VA.