Employment Tax Reporting for Disregarded Entities

Many tax-exempt organizations have formed single-member limited liability companies (SMLLCs) as integral parts of their entity structure. Because of their flexible treatment for tax purposes, limitation of liability, easy transferability of ownership interest by sale or exchange, and separate governance and management, SMLLCs are widely used to conduct various activities and hold investments. However, SMLLCs with employees have new reporting requirements effective January 1, 2009.

Background

Some of the important benefits associated with an SMLLC come from its treatment as a disregarded entity for income and employment tax purposes. Absent an election to the contrary,¹ federal tax law treats an SMLLC as a division of the single member rather than as a separate entity.² In the context of income tax reporting by a tax-exempt organization, classification as a disregarded entity means that the SMLLC’s revenue, expenditures, and activities are attributed to (and reportable by) the single member on Form 990, Return of Organization Exempt from Income Tax.³

Under the prior version of Regs. Sec. 301.7701-2(c)(2), a noncorporate entity with a single owner was disregarded as a separate entity for most federal purposes. The Service clarified in Notice 99-6 that this disregarded entity status also included exemption from federal employment tax reporting.⁴ Notice 99-6 gave employer organizations an option: The disregarded entity’s employment taxes could be paid and reported using the name and employer identification number (EIN) of either the owner or the disregarded entity. ⁵

On October 18, 2005, the IRS published a notice of proposed rulemaking, saying that disregarded entities should be treated as separate entities for purposes of employment tax and related reporting requirements.⁶After the comment period, Treasury made revisions based on comments received and adopted the proposed regulations.⁷

Before the regulations were adopted, taxpayers had a choice of treating the SMLLC’s employees as employees of either the SMLLC or the single member. But the rules have changed; effective January 1, 2009, separate reporting will be required for federal employment tax purposes.⁸ T.D. 9356 explicitly supersedes Notice 99-6 as the law relating to the employment taxes of disregarded entities for any wages paid on or after January 1, 2009.⁹

The Service’s two stated purposes for the change were (1) to improve federal tax law administration and simplify federal tax compliance with respect to reporting, payment, and collection of employment taxes and (2) to align federal and state reporting, the latter of which often recognizes a disregarded entity for state employment tax purposes.¹⁰

FUTA Taxes

SMLLCs owned by Sec. 501(c)(3) organizations should note that the new regulations do not adversely affect the exemption from paying FUTA taxes on Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return. Therefore, the owner organization’s exemption protects the SMLLC from paying FUTA taxes.¹¹ The owner entity, not the disregarded entity, retains liability for any backup withholding required under Sec. 3406 for any reportable payments made by the owner.¹²

Employee Retirement and Fringe Benefit Plans

Among the not so obvious collateral tax issues created by the new rules is the potentially important (and possibly adverse) effect on existing employee retirement and fringe benefit plans. Employee benefit plans contain very specific language that defines the employees covered under the plan. The technical question arises whether an SMLLC’s employees are eligible to participate in the single member’s retirement plan.

The retirement plan sponsor (usually the single member) should immediately seek the advice of counsel with respect to how the new rules may or may not affect the “eligibility” of participants in its retirement and fringe benefit plans. For example, existing provisions in some employee benefit plans allow participation by only the employees of the “employer” (i.e., the single member). Under the provisions of other plans, participants may include the employees of the employer and all affiliated organizations automatically or may include only the employees of affiliated organizations who explicitly adopt the plan—or the plan documents may simply be silent as to those eligible to participate. Plan provisions should be reviewed and amended as necessary to prevent a very unpleasant surprise.

Cost-Sharing Agreements

In some cases, tax-exempt owner organizations ease the administrative burdens of their SMLLCs by using cost-sharing reimbursement (or management fee) agreements to account for the wages, benefits, and attendant employment and withholding taxes chargeable to an SMLLC. Under such agreements, all employees are considered employed by the single member and the attendant wages, benefits, employment, and withholding taxes attributable to the SMLLC are shared with and reimbursed by (or, in the case of management fee agreements, charged to) the SMLLC. Such arrangements are likely to be acceptable because the SMLLC has no employees of its own, but they should be revisited and formalized in light of the new rules.

Planning Ahead

Because the new regulations apply to wages paid on or after January 1, 2009, exempt organizations and disregarded entities must immediately put systems in place to prepare for the administrative burden of calculating, collecting, depositing, and reporting employment taxes and wages. Each SMLLC must have a federal EIN and also enroll in the electronic federal tax payment system (EFTPS).

Exempt organizations and disregarded entities may want to reassess whether employees are employed by the single member or the SMLLC. In addition to ensuring compliance with the new rules, this may require a legal analysis because the decision may affect whether the SMLLC is treated as a separate entity with respect to the limitation of legal liability.

If all employees are employed by the single member (e.g., the tax-exempt organization), the practitioner may want to review and formalize the cost-sharing and reimbursement (or management fee) agreement between the single member and the SMLLC.

If the SMLLC has employees, consider whether the employees are able to participate in the owner organization’s retirement plan. To do so, look at the retirement plan documents and see who is technically eligible to participate in the plan. It may be advisable to seek the advice of counsel to help determine whether the SMLLC’s employees technically qualify as participants in the single owner’s retirement plan.

Editor Notes

Mary Torretta is a senior legal tax associate with Grant Thornton LLP in Washington, DC. Edgar Adkins is a partner in Grant Thornton’s National Tax Office in Washington, DC. Greg Goller is partner in charge of Grant Thornton’s not-for-profit tax practice in Washington, DC.

Notes

¹ Regs. Sec. 301.7701-3(a) (as amended in 2006).

² Regs. Secs. 301.7701-2(a), (c)(2) (as amended in 2008).

³ Id.

⁴ Notice 99-6, 1991-1 C.B. 321.

⁵ Id.

⁶ REG-114371-05.

⁷ T.D. 9356.

⁸ Preamble to T.D. 9356, Effective Date.

⁹ Preamble to T.D. 9356, Effect on Other Documents.

¹⁰ Preamble to T.D. 9356, Summary of Comment and Changes Made, ¶3.

¹¹“A disregarded entity owned solely by a section 501(c)(3) organization will not be subject to FUTA tax on wages it pays its employees.” Preamble to T.D. 9356, Summary of Comment and Changes Made, ¶4.

¹² Id., ¶5.