Editor: Michael D. Koppel, CPA/CITP/PFS, MSA, MBA
LLCs & LLPs
In 1996, Treasury issued the check-the-box regulations (T.D. 8697) and, by doing so, sanctioned the default status of a single-member LLC as a disregarded entity for federal income tax purposes (Regs. Sec. 301.7701-3(b)(1)(ii)). Since these regulations became final, the single-member LLC has increased in popularity among sole proprietors, investors, and other taxpayers. Despite the widespread use of single-member LLCs, some confusion still exists regarding the tax treatment of the initial expenditures to form and operate this type of entity. This item attempts to clarify the rules for organizational and startup costs of single-member LLCs by comparing and contrasting them to the rules for corporations and partnerships.
Organizational expenditures are costs incurred to form the entity (Secs. 248(b) and 709(b)(3)). Common examples include legal expenses to draft the formation documents (articles of incorporation, partnership agreement, etc.) and filing fees paid to the state of organization (Regs. Secs. 1.248-1(b)(2) and 1.709-2(a)). Startup expenses are not organizational costs (S. Rep’t No. 1036, 96th Cong., 2d Sess., p. 11 (1980); Regs. Sec. 1.709-2(a)). Corporations (including S corporations) follow the rules of Sec. 248, while partnerships follow the provisions of Sec. 709. Both sections allow corporations and partnerships to deduct up to $5,000 of organizational costs in the year the business begins and amortize the remainder over 180 months beginning in the month the business begins. If costs exceed $50,000, the $5,000 deduction is reduced dollar for dollar by the excess over $50,000 (Sec. 248(a); Sec. 709(b)(1)). Both partnerships and corporations have the option to forgo the election discussed above and capitalize the expenses (Regs. Secs. 1.248-1(c) and 1.709-1(b)(2)).
What about the organizational costs for single-member LLCs? Unless these entities elect to be taxed as corporations, they are treated as disregarded entities (Regs. Sec. 301.7701-3(b)(1)(ii)). No Code section directly addresses the tax treatment of organizational expenditures for disregarded entities. This lack of guidance raises the question of whether the expenses should be deducted, capitalized, or treated the same as the expenditures for corporations and partnerships.
In 2003, Treasury addressed this issue in regulations for Sec. 263 (T.D. 9107), which require capitalization of the formation costs incurred by disregarded entities (Regs. Sec. 1.263(a)-5(a)(6)). However, there is a de minimis rule. Organizational costs that do not exceed $5,000 in total are not required to be capitalized under Sec. 263 (Regs. Secs. 1.263(a)-5(d)(1) and (3)). If a taxpayer prefers not to deduct the costs that qualify as de minimis, it may elect to capitalize them under Regs. Sec. 1.263(a)-5(d)(4). This election may be advantageous in the case of an expiring net operating loss.
Example 1: Assume L, a single-member LLC classified as a disregarded entity, begins its business on July 1, 2012, and incurs $800 of legal expenses for the articles of organization and operating agreement and $200 of state filing fees. Under Regs. Sec. 1.263(a)-5(d)(1), L would deduct $1,000 of organizational expenses since they fall below the $5,000 de minimis threshold.
Example 2: Assume the same facts as Example 1, except L incurs $5,800 of legal expenses for the articles of organization and operating agreement and $200 of state filing fees. In this case, no organizational costs are deductible or amortizable. L would capitalize the $6,000 of organizational expenditures under Regs. Sec. 1.263(a)-5(a)(6). These costs would be deductible as a Sec. 165 loss upon L’s dissolution and termination.
Startup costs are investigation and operating expenses incurred before the active business begins (Sec. 195(c)(1)). Unlike organizational expenditures, startup costs are governed by only one provision, Sec. 195, which applies to all entities, including single-member LLCs. Similar to Secs. 248 and 709 for organizational expenditures, Sec. 195 allows taxpayers to deduct $5,000 of startup costs in the year the active business begins and amortize the remainder over 180 months beginning in the month the active business begins. If the costs exceed $50,000, the $5,000 deduction is reduced dollar for dollar by the excess over $50,000 (Sec. 195(b)(1)). Taxpayers may choose to forgo this election and capitalize all startup costs (Regs. Sec. 1.195-1(b)).
Example 3: Assume L, a single-member LLC classified as a disregarded entity, begins its business on July 1, 2012, and incurs $6,800 of startup expenses. Under Sec. 195(b)(1), L would deduct a total of $5,060 for startup costs in its first year of operation [$5,000 immediate deduction + $60 amortization ([6 ÷ 180] × $1,800)]. The remaining $1,740 would be amortized over the next 15 tax years.
Although it would appear to be a rare case where organizational expenditures of a single-member LLC would exceed the $5,000 de minimis threshold, practitioners should be familiar with the capitalization rules of Regs. Sec. 1.263-5. If costs exceed $5,000, they cannot be amortized, and they are deductible under Sec. 165 only upon dissolution of the entity.
Michael Koppel is with Gray, Gray & Gray LLP in Westwood, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
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