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Treatment of LLCs Under the ASG Rules
(Posted March 26, 2002)
Question 148: How is an LLC treated for purposes of the affiliated service group rules? If it makes a difference, my client's LLC is taxed as a corporation.
Answer: For the most part, the affiliated service group rules do not care about the form of an entity. Any type of organization -- sole proprietorship, partnership, trust, corporation, association, LLC, LLP, estate, etc. -- can be an "organization" or a "service organization" under IRC 414(m).
But application of the attribution rules of 414(m) depends very much on the type of organization involved. Each partner in a partnership is deemed to own a pro rata interest of whatever the partnership holds. The same is true of S corporation shareholders. Beneficiaries of a trust (other than a retirement trust) are deemed to own their pro rata interest of whatever the trust holds. However, there is a special rule for C corporation shareholders. Only shareholders who own or are deemed to own at least 50% of the value of the C corporation's stock are deemed to hold a pro rata share of assets held by the C corporation.
How do LLC's fit into this scheme? The Code does not specifically address the treatment of LLC's. Rather, according to IRS regulations, they can elect to be taxed as corporations. If they do so, then they are treated for essentially all tax purposes as though they were incorporated. For example, an LLC that chooses to be taxed as a corporation can elect to be taxed as an S corporation. Moreover, a member in such an LLC who works in the business is treated as a common law employee and given a W-2, just as he would be if he worked for a corporation.
Because an LLC that elects to be taxed as a corporation would be treated as though it were a corporation for purposes of the ASG rules, the C corporation attribution rules would apply to it (unless it elected S corporation status).
On the other hand, an LLC that does not elect to be taxed as a corporation is treated as a partnership if it has more than one member. If it only has one member, its separate existence is disregarded-- if an individual is the only member of an LLC, it is treated as a sole proprietorship and the owner reports the LLC's income on Schedule C of Form 1040. Attribution would follow this same pattern.
There is one other issue where corporate status is important for an ASG. A corporation that is not a professional service corporation cannot be a First Service Organization ("FSO") for purposes of the A-Org test. This is not by operation of the Code, but rather by operation of the proposed regulations. The 19-year-old proposed regulations talk about corporations "organized under state law." To my mind, this makes it arguable that the regulations are referring to "real" corporations, rather than to entities taxed as corporations. This is why I recommend that an organization that wishes to take advantage of the benefits of the professional corporation exemption should formally incorporate, in order to make the issue moot. Altneratively, in my view such an organization should seek a determination letter from the IRS on the subject.
The entity rules are discussed in more detail in Chapter 1 of my book Who's the Employer. The ASG rules are in Chapters 13 and 14.
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