Below is a headline from today’s tax updates by Thompson Reuters “Checkpoint Newsstand” related to potential IRS changes to tax forms in order to better capture income that is being reported to “disregarded entities”. Before reading the headline, I wanted to provide some background and share my personal experience in this area.
Over the past several decades, the use of Limited Liability Companies (LLC) has increased exponentially. In cases where an LLC is owned by more than one owner (aka “Member”), the LLC is generally treated as a “partnership” for tax purposes, and must file a Form 1065 tax return. The Form 1065 also has “Schedule K-1” forms that allocate income/expense to the various LLC Members (generally using their social security numbers – assuming the Members are individuals). In this way, the IRS can fairly easily track income that is allocated to a specific person – and thus, if one of the LLC’s Members does not show the applicable income on his/her personal tax return (Form 1040), the IRS will know.
However, an LLC that is owned by one Member is generally treated as a “disregarded entity” for tax purposes. This means that despite the LLC potentially buying, selling, transacting (e.g., holding real estate), the LLC does not file its own tax return, but instead the income must appear directly on the Member’s tax return. Also, any third party that issues a tax form to a disregarded entity LLC [e.g., K-1 (if the LLC is a Member of another LLC), Form 1099 (if LLC earns interest, capital gain, etc.)] is supposed to issue the tax form under the Member’s tax ID number (e.g., social security number), not the disregarded entity’s tax ID number [aka “Employer Identification Number” (EIN)].
The problem is that disregarded entity LLCs are often issued tax forms (showing income earned) under the LLC’s EIN, which is incorrect, but still happens all the time. This then leads to the problem of the IRS not being able to “connect the dots” between the Member’s tax return (e.g., Form 1040) and the income earned by the LLC. Further, the LLC’s Member is not currently required to list the disregarded entity LLC’s name and/or EIN that he/she owns on his/her personal tax return, so the IRS database has a difficult time matching things up. The headline below describes how the IRS could potentially improve their matching in these situations by requiring an individual who is the sole Member of an LLC to disclose the LLC’s EIN on the individual’s personal tax return.
[Side note: in my opinion, part of the problem here is the way in which the IRS issues EIN for disregarded entity LLCs. During the EIN application process (generally done online), the IRS asks for the name and tax ID number (e.g., SSN) of the LLC’s “responsible party”. The problem is that the term “responsible party” is extremely confusing and does not necessarily mean the LLC’s sole Member’s name and social security number. In single member / disregarded entity situations, if the IRS would just require that the “responsible party” be the LLC’s sole Member, then it would become easier for the IRS to track income allocated to the LLC’s EIN – because any income allocated (albeit incorrectly – see above) to the LLC’s EIN would be treated (by the IRS’s number matching system) as automatically allocated to the social security number of the sole Member.]
IRS MAY REVISE FORMS TO REQUIRE SOLE OWNER OF DISREGARDED ENTITY TO PROVIDE EIN
Program Manager Technical Advice 2016-008
A Program Manager Technical Advice (PMTA) has concluded that IRS has the authority to modify tax return forms and instructions under Code Sec. 6011(a) and Reg. § 1.6011-1(a) to require the sole owner of a disregarded entity to provide the entity’s Employee Identification Number (EIN) on the owner’s tax return, and suggested potential revision to the relevant forms and instructions in order to promote effective tax administration. However, the PMTA found that a return filed without the additional EIN would still be a valid return for purposes of the statute of limitations and failure to file penalties.
Background—IRS’s authority to require information reporting, etc. Under the Code, taxpayers themselves are the source of information necessary to compute tax and are required to report information that IRS considers relevant in doing so. Requirements for making and filing tax returns are found in Code Sec. 6011(a) and Reg. § 1.6011-1(a), which generally provide that any person liable for any tax imposed by the Code must file a return and that includes the information required by the forms and IRS regs. In addition, under Code Sec. 6011(b), IRS is authorized to require taxpayers to include on their returns the information necessary to properly identify the taxpayer.
Background—disregarded entities. Under the “check-the-box” rules at Reg. § 301.7701-1 et seq., an eligible entity that has a single owner and isn’t treated as a corporation is disregarded as an entity separate from its owner. (Reg. § 301.7701-2(c)(2)(i))
The activities of a disregarded entity are treated the same as a sole proprietorship, branch, or division of its owner. (Reg. § 301.7701-2(a)) The income earned by a disregarded entity must be reported on the owner’s income tax return and reported under the owner’s Taxpayer Identification Number (TIN) (Reg. § 301.6109-1(h)). However, disregarded entities can use an EIN for other purposes, such as for reporting employment taxes and other business taxes. (Reg. § 301.6109-1(d)(4)(ii))
Issue. Allowing a taxpayer to use two types of identification numbers (TINs and EINs) may cause problems for IRS in associating different types of returns with a single taxpayer. If a disregarded entity has an EIN, it typically does not appear on the owner’s tax return. Certain information returns such as Forms 1099 that reflect income earned by a disregarded entity may reflect the entity’s EIN and not the owner’s TIN. This makes matching the income reported on such an information return to what is reported on an income tax return difficult.
In light of the above, the PMTA specifically addresses whether IRS can, under existing regs, change tax return forms and instructions to require the sole owner of a disregarded entity to provide the disregarded entity’s EIN on the owner’s tax return.
Forms and instructions can require including EIN. The PMTA, citing IRS’s broad authority to require taxpayers to report certain information, concludes that tax return forms and instructions can be modified under Code Sec. 6011(a) and Reg. § 1.6011-1(a) to require the sole owner of a disregarded entity to provide the disregarded entity’s EIN on the owner’s tax return.
Further, the PMTA notes that IRS is authorized to require use of TINs on returns because it is necessary and helpful in securing proper identification of the filer. TINs enable IRS to identify in its records the type of taxpayer as well as the taxpayer’s account information. And, nothing in the TIN regs prevents IRS from requiring the owner of a disregarded entity to report all the EINs used in its business dealings on the owner’s tax return.
But return would still be valid without it. However, while the PMTA found that IRS has the authority to require the sole owner of a disregarded entity to provide the disregarded entity’s EIN on the owner’s tax return, the failure to do so would neither invalidate the return for statute of limitation purposes nor make the filer subject to failure to file penalties. Caselaw provides that to be deemed a return, a document filed with IRS must
- Contain sufficient data to calculate the taxpayer’s tax liability,
- Purport to be a return,
- Must be a reasonable attempt to satisfy the requirements of the tax law, and
- Be signed under penalty of perjury.
(See, e.g., Beard, (1984) 82 TC 76682 TC 766) Generally, the omission of the taxpayer’s identification number does not render a return invalid. (U.S. v. Grabinski, (CA 8 1984) 53 AFTR 2d 84-71053 AFTR 2d 84-710)
Possible future revision of forms. Requiring the owner of a disregard entity to include on his income tax return the EINs of his disregarded entities that have them, according to the PMTA, would assist in tax administration and wouldn’t be burdensome for the owner. The PMTA suggested that the individual who requested this advice coordinate with Forms and Publications in revising the relevant forms and instructions.