According to this Wikipedia entry, the “limited liability company ("LLC") has grown to become one of the most prevalent business forms in the United States.” That is likely because state law gives substantial liability protections to LLCs, similar to traditional corporations, but allows for more flexible ownership and governance structures. That flexibility also creates more difficulties for creditors to pierce the liability shield. For a good review of that idea see Dave Rugani, Twenty-First Century Equity: Tailoring The Corporate Veil Piercing Doctrine To Limited Liability Companies In North Carolina, 47 Wake Forest L. Rev. 899 (2012).
LLC popularity is also due in no small part to the 1996 Treasury Regulations that give LLCs the power to choose how to be taxed by the federal government. For example, a single-member LLC can choose to be recognized as a separate taxable entity or can choose to be totally disregarded. Many times a single owner will choose disregarded status. Disregarded status just means that all business activity is the owner’s activity and the owner reports all activity on their Schedule C. There is no separate entity taxation, even though there is a separate legal entity under state law.
The upside of disregarded status is generally a reduced tax burden and reduced compliance burden. Today we learn of a potential downside to disregarded status: a lender’s discharge of a disregarded LLC’s debt results in income to the owner even though neither the owner nor the owner’s personal assets were on the hook to repay the loan and the discharge happened long after the LLC went defunct. In Steven Jacobowitz v. Commissioner, T.C. Memo. 2023-107 (Aug. 16, 2023) (Judge Ashford), the individual taxpayer was sole owner of an LLC that had taken out a small business loan. Under state law Mr. Jacobowitz had no obligation to repay the loan. It was the LLC’s obligation, not his. However, when the lender discharged the LLC from its obligation to repay, some 8 years after the LLC ceased to exist, that Discharge Of Indebtedness (DOI) was income to Mr. Jacobowitz. The bummer details are below the fold.
Background: Quick DOI Review
Remember, no one really knows why Discharge of Indebtedness (DOI) is income. There are two theories: I call them the balance sheet theory and the expectancy theory.
The balance sheet theory says the borrowed funds are not income because the loan creates an immediate offsetting debit on the taxpayer’s balance sheet. The taxpayer is no wealthier because the taxpayer’s assets are burdened by the obligation to repay. Accordingly, when the taxpayer is discharged from debt, those assets are “free up” and that is the accession to wealth. The classic case is United States v. Kirby Lumber, 284 U.S. 1 (1931) where the sainted Justice Holmes used the balance sheet theory to explain why a company had income from buying back its previously issued bonds, effectively cancelling $137k of its debt: As a result of its dealings, it made available [$137k] assets previously offset by the obligation of bonds now extinct.” 284 U.S. at 2.
The expectancy theory says that the borrowed funds are not income because we just expect they will be repaid over time so what looks like income is just imaginary. However, when the debt is forgiven, that expectation vanishes and the forgiven amount of unpaid debt becomes real, not imaginary income. Burdened assets? We don’t care about no burdened assets! The classic case for this is Commissioner v. Tufts, 461 U.S. 300 (1984).
To see the two theories at work in the same case, go read Zarin v. Commissioner, 916 F.2d 110 (3d Cir. 1990), where the majority uses the expectancy theory and the dissent relies on the balance sheet theory. For those who want more details on these theories, see Lesson From The Tax Court: The Phantom Of The Tax Code—Discharge Of Indebtedness, TaxProf Blog (Feb. 19, 2018).
Background: LLCs and Check the Box Regs
LLCs first appeared on the business organization scene in 1977, a creature of Wyoming state law, according to Wikipedia. At that time tax law had a top-down set of rules for how to classify business entities. It was top-down because the IRS would tell you what the proper classification was. Predicting how the IRS would classify LLCs was tricky because LLCs had some characteristics of corporations and other characteristics of partnerships. They did not fit neatly into either box.
Eventually the IRS interpreted Wyoming LLCs as partnerships in Rev. Rul. 88-76. After that more states began permitting the LLC structure. Eventually, in 1996, the IRS and Treasury issued what are called “Check the Box” regulations, now codified as Treas.Reg. 301.7701-1 through Treas.Reg. 301.7701-3. These regulations flipped the law from a top-down set of rules—where the IRS tells an entity its classification—to a bottom-up set of rules, where the entities themselves get to tell the IRS their classification. LLCs then became all the rage.
Tax law thus now permits the owner or owners of an LLC to elect how their LLC will be treated for federal income tax purposes. Treas.Reg. 301.7701-3(a). When the LLC is owned by multiple shareholders, they can elect for it to be treated like a traditional corporation or instead like a partnership where income or losses from the business are passed through.
When the LLC is owned by a single shareholder, however, their potential election is a bit different. They can elect for the LLC to be taxable as a separate corporation, or they can elect for it to be totally disregarded, so that the business activities of the LLC are treated as the business activities of the single owner, just as if the business was a sole proprietorship. If the single shareholder makes no election, the default tax rule is that the LLC will be disregarded. Treas.Reg. 301.7701-3(b)(2).
For a great article explaining the history and development of these Check-The-Box Treasury regulations, see Heather Field, Checking In On Check The Box, 42 Loyola L.A. Law Rev. 451 (2009).
The tax year at issue is 2016. But the events creating the tax problem that year started many years earlier. According to the Court, Mr. Jacobowitz owned and operated a single member LLC called Sagasolutions that “he established in November 2003.” Op. at 2. It appears that Sagasolutions was in the business of Customer Relations Management (CRM)
In 2006, the company obtained a $25,000 small business line of credit. Mr. Jacobowitz “executed on Sagasolutions’ behalf a promissory note and a security agreement.” Id.
It is not clear when the company ended. The court said it “ceased to exist in approximately May 2008.” Op. at 2. But at the same time, the Court also found that Sagasolutions “took advances from, and made payments to, the line of credit numerous times from January 2006 to September 2010.” Id. Hokay. And then there is an even different story in Mr. Jacobowitz’s LinkedIn page, which I’ll touch on in the Coda.
Regardless, the Court found that Sagasolutions’ last principal payment on the loan was in September 2010. In 2016, the lender wrote off the debt because the state statute of limitations for collecting the debt had run. The lender sent both Sagasolutions and the IRS a Form 1099-C (Cancellation of Debt) for just under $35,000.
On his 2016 Form 1040 Mr. Jacobowitz reported an adjusted gross income of just over $709,000 but none of it was from the DOI. Most of it was compensation from his employer at the time, who also required him to use the services of Ernst & Young to prepare his tax return. Op. at 3. From Mr. J's LinkedIn page it appears his employer was IBM during this year.
The IRS audited the 2016 year and thought Mr. Jacobowitz should have reported the $35k DOI. He disagreed and petitioned the Tax Court.
So let’s look at what we learn from Judge Ashford.
Lesson: A Disregarded LLC’s DOI is the Owner’s DOI Income
Mr. Jacobowitz (pro se) argued that, under state law, neither he nor any of his assets were burdened by the loan made to Sagasolutions. Thus, because the DOI did not free up any of his personal assets he personally could not have any DOI! And by the time the DOI occurred, in 2016, Sagasolutions was long dead. So none of its assets were freed up either. Truly, that was an argument that would have made Justice Holmes proud!
Judge Ashford, however, is not impressed, calling the argument “ill conceived.” Op. at 5. She explains that the argument assumes that Sagasolutions was a different taxable entity than Mr. Jacobowitz. It was not. “Although state law governs the legal relationships that are established when an entity is formed, federal tax governs whether an entity is taxed, or disregarded, as a corporation.” Op. at 6. In other words, the loan to Sagasolutions was, for federal tax law purposes, a loan to Mr. Jacobowitz at the time it was made. Discharge of Sagasolutions from the obligation to repay was thus also a discharge to Mr. Jacobowitz. “Sagasolutions is treated as a disregarded entity for federal tax purposes, and petitioner, as its sole member, is required to report on his federal income tax return any income (or loss) attributable to Sagasolutions.” Op. at 7 (internal citations omitted, emphasis supplied).
Alert readers will notice the implication of Judge Ashford’s reasoning here. It’s the expectancy theory at work! When the line of credit was active, Sagasolutions was a disregarded entity and the draws would count as income to Mr. Jacobowitz ... if they counted as income. But they did not count as income at that time, because of the expectation the loan was going to be repaid. Thus it was the expectation of repayment that allowed Mr. Jacobowitz to not have to report the draws on the line of credit as income, not the burdening of his assets (since his assets were not burdened). By 2016, the state statute of limitations had run and that expectation of repayment was gone, converting all the non-taxable draws into taxable income at that later time. Again, it does not matter that there were no assets to free up.
Notice, too, that the insolvency of the LLC does not matter. That’s because it’s disregarded! Sure, if Mr. Jacobowitz was insolvent in 2016, then maybe he could invoke §108. But gosh, the dude pulled in over $700,000 of income that year, making it unlikely he was insolvent at the time of the DOI.
Bottom Line: State law might well shield a single-member LLC’s owner from the LLC’s debt obligations. But it cannot shield the owner from the DOI tax consequences if that debt is later discharged when the LLC is a disregarded entity.
Coda 1: Other Loser Arguments Mr. Jacobowitz shows himself to be a creative advocate in several respects. First, he tried to argue that the DOI occurred in 2008 when, he claimed, he abandoned Sagasolutions business property. But that’s a facts-and-circumstances decision and he was unable to establish facts to prove up the contention. While he testified, Judge Ashford found him to be an unreliable narrator. Op. at 8. See Coda 2 below. Judge Ashford instead looked to the regulations governing a lender’s obligation to file a 1099-C to find that the lender here properly reported the DOI in the year the debt because legally unenforceable under state law.
Second, Mr. Jacobowitz had the good idea to try and argue that the portion of the DOI representing accrued interest should be excluded from income because payment of that interest would have deductible as an ordinary and necessary business expense. §108(e)(2). Again, he fell on his face on the facts. Judge Ashford points out that he offered no evidence to show how the loan proceeds were used and, more importantly, “the evidentiary record unminstakeably shows that that Sagasolutions stopped doing business in 2008 and that 2009 was the last year that Sagasolutions’ income (or loss) was reported to the IRS, before the interest stated accruing in 2010.” Op. at 10.
Coda 2: The Unreliable Narrator. I think Judge Ashford’s concerns about Mr. Jacobowitz’s testimony were justified. I found it interesting that the story Mr. Jacobowitz presented to the Tax Court seems quite different than the public story he tells on his LinkenIn site. Mr. Jacobowitz’s LinkedIn profile says that he started Sagasolutions in 1993 and then sold it in 2008. Here's his blurb: “Grew from 1 to 14 employees before company was sold. Our only focus was CRM Applications, Started with TeleMagic, Moved to GoldMine where we achieved Top 5 Reseller Status for 5 years, and Gold Managed Microsoft Partner for 4 years. Grew revenue from 0 to 5 million per year.”
Well, gosh. The LinkenIn claim that he sold Sagasolutions seems to directly contradict the story he apparently gave in Court where he testified that “when Sagasolutions ceased to exist in 2008, he left a lot of...furniture” and “was shocked in 2009 that [the lender] hadn’t come after [him] for whatever was left of Saga....” Op. at 8 (internal quotes omitted). Also, one wonders why, if he indeed grew revenue to $5 million per year at the end, he was unable to pay off the $34,000 line of credit. Or, if he really did sell the company, why didn’t he sell the debt as well? Is it possible...just possible...that the LinkedIn blurb is wrong? Perish the thought.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.
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