__________ Why Form Your Own Entity?
Order more Information
    We'll help guide you - Business Formations and Incorporation Services...

Forming Your Own Entity

Planning, Review & Preparation

Electing Mark-to-Market

Trading through an entity

Trader definitions

Tax information & news

Discussion Board, F.A.Q.,
Futures, Benefit Plans
& other info

Search this site add text to search window

  Copyright© 2004 to 2015 Colin M. Cody, CPA and, LLC, All Rights Reserved.

This is an old archived webpage.  To access the mobile-friendly website, click here.

This desktop version website will only have limited updates to its content.  The mobile-friendly website is where newer information will be added, as time permits during the transition.

As a trader you need to form a separate trading entity for the following reasons:
  • For a situation where the individual might not (or cannot) be treated as "a trader" by the IRS because he or she earns a living from activities in addition to her trading activities, such as:
    • receiving income from a full-time W-2 wage job
      • recently we've seen several self-prepared returns where the unwavering pre-audit IRS position is that any W-2 received by either spouse negates their ability to be treated as a securities trader or commodities trader.
    • earning dividend and interest income
    • having (other business) self-employment earnings
    • ... or any SMLLC business activity
    • receiving income or loss from an active pass-thru entity activity
    • receiving income or loss from passive pass-thru entity investments
    • holding substantial investments of any kind
    • being supported in a way other than from active trading
    • having a primary source of income other than active trading
    • earning a living in any other way, besides active trading

    then a 100% pure-play trading entity can be set up and the entity itself will be the trader as 100% of its activities and 100% of its capital are employed in an active business of trading.

  • It can be said that a better rule of thumb is to only claim trader status as an individual, reporting income on tax form 1040, whenever the activity is your only "job" and you have no other funds available to support yourself with.  Otherwise, consider forming a separately filing entity that will not use form 1040.
  • When your job is in the securities industry (stock brokers, financial investment advisors, registered reps, etc. ), often your purchases and sales need to monitored or reported to and approved by your employer's compliance department.  Investing your funds one time into a separate entity where it is the entity that will be doing the actual trading, in some situations, can eliminate this need to go to your compliance department and disclose details regarding every transaction.

  • Virtually every retail broker automatically treats a LLC or other entity as a "professional user" by default.  There must be a reason!  LLC's and other entities command respect, they show that you mean business, are serious about your trading and are a professional.  When seeking the best and largest tax deductions, having an entity in your corner can only help.
  • For more sophisticated mark-to-market elections and revocations:
    • To facilitate a so-called "retroactive" mark-to-market election filing.
    • To help facilitate a so-called "retroactive revocation" mark-to-market election.
    • To allow an easy and permanent proactive revocation of a mark-to-market election, simply by stopping the use of the entity.
    • To isolate and protect an individual who has a large capital loss carry-forward from a prior tax year.
    • As "insurance" to temporarily elect mark-to-market for commodities (futures) trading during a potential isolated loss year, so that you will retain the special lower "60/40" tax rate for use in a profitable year.
  • Unlike individual taxpayers filing form 1040, all entities (such as those filing tax forms 1065 and 1120S) are clearly exempt from the 2005 rule (temporarily retracted in January 2006) that each sale be listed directly on an  IRS Schedule D-1 (see 2005 instructions page D-6) rather than attaching a supporting statement to the tax return (Downloaded info, Excel spreadsheet,  Quicken report, Broker provided gain/loss report, etc.)
    • Individual tax form 1040 has the Schedule D-1 to be used with the requirements found in the 2005 instructions
      • The temporary January 2006 retraction remained in place so a supporting statement could be used with Schedule D-1 in subsequent years.
      • Starting with 2011 Schedule D-1 was replaced with Form 8949.
      • Starting with 2013 the requirement for a detail listing on Form 8949 / support statement was canceled for certain situations were the broker reported the gain or loss to the IRS and if there were no wash sales or other adjustments.
    • Individual tax form 4797, used by M2M traders, requires the use of a free-form statement in the same format as a Schedule D.
    • Entity tax returns using Schedule D require the use of a free-form statement in the same format as a Schedule D.
      • Starting with 2013 the requirement for a detail listing on Form 8949 / support statement was canceled for certain situations were the broker reported the gain or loss to the IRS and if there were no wash sales or other adjustments
    • Entity tax returns using form 4797 for M2M traders require the use of a free-form statement in the same format as a Schedule D.
  • To qualify for and obtain more tax deductions!!
    (if you read elsewhere that sole-proprietor traders are allowed al! the same tax deductions as an entity-based trader, perhaps you need to keep reading and learn the correct facts):
    • health insurance (though, a sole-proprietor trader can arrange to have this deduction by paying the spouse an appropriate W-2 salary and then providing all employees and their families with health insurance).  Of course, the employee-spouse must be a bona fide employee paid for personal services actually rendered to the business.
    • self-insured medical reimbursement plan (see spouse trick above)
    • disability insurance deduction
    • de minimis fringe benefits and occasional supper money Regs. §1.132-7(a)(2)
    • gym and athletic facilities, including tennis courts, swimming pools and exercise equipment  (see spouse trick above)
    • no interest or low interest loans
    • company purchase of home, when a loss makes selling expenses non-deductible (see spouse trick above)
    • tax-free transportation, limos and chauffeurs
    • free parking, vanpools and transit passes (this is also not deductible with 20% or more s-corp shareholders)
    • tax-free lodging (Rowan Companies, Inc. v. United States, 101 S. Ct. 2288 (1981), Ct. D. 2009, 1981-2 C.B. 191)
    • tax-free meals, including meals furnished because all employees must be available during lunch for emergencies (Boyd Gaming, 106 TC No. 19   and   IRC §274(n)(2)(B))
      • note that per McDowell v. Commissioner, T.C. Memo. 1974-72 the meals and lodging must be furnished by the entity.  Reimbursing the employee for receipts submitted will not qualify as tax-free
    • retirement plans (because of the IRS Code that prohibits sole proprietorship traders from contributing)

    the above list is mostly "courtesy" of Sandy Botkin, CPA (see page 175 of his book advertised elsewhere on this web page)

  • To lower your risk of being selected for IRS audit.
    • The IRS has obsolete computer systems, including magnetic tapes and 70 different operating systems.  With what little they have to work with, they must concentrate on the individual form 1040, where most non-compliance issues are found.
  • To lower your risk so that, if selected for IRS audit, your trader status tax position will be more likely to stand up against IRS attack.
    • Business entities are assigned to the more experienced field auditors who are savvy enough to understand a business-person's perspective.
    • Often, the tax form 1040 is assigned to a less-experienced office audit examiner who starts off assuming the taxpayer is guilty of some level of underpaying his taxes.
    • The overwhelming majority of trader status cases that go to Tax Court are those of Individuals filing as a Sole Proprietorship on a Schedule C.   Few cases come to Tax Court for trader status with an entity that files a separate tax return, and of those cases, many are egregious with multiple infractions besides a questionable claim of trader status.
    • The majority of trader status cases that go to Tax Court for Individuals filing as a Sole Proprietorship on a Schedule C result with a win for the IRS.
  • To lower the chances of any issues arising under the IRC §469 Passive Activity and Material Participation Rules as concluded by the U.S. Supreme Court in Groetzinger.
    •  IRS Regs 1.469-1T(e)(6)  (alt link) state that when a properly setup partnership or LLC is a trader, the §469 Passive Activity Rules for the most part do not apply to the owners.  IRS Regs §1.469-1T(e)(6)(iii)
    • It should be noted that generally the §469 Passive Activity Rules continue to not apply to the owners even if trader status is not upheld.  IRS Regs §1.469-1T(e)(6)(i)
    • Amazingly, an identical management/profit sharing arrangement except without a properly organized separate entity (which is common with "managed accounts") results in very different and unfavorable taxes for both the investor and for the trading manager.
      • IRS Chief Counsel, in 2007, has reiterated this position.  CCA200721015 states that under IRS Regs §1.266-1(b)(1)(iv) a flat fee paid to a stockbroker for investment services is an itemized deduction and is not a "carrying charge."
  • Corporations generally do not have a form 1099 sent to the IRS reporting their activity.  This lack of a 1099 matching program lowers the exposure of your corporation's tax return to IRS scrutiny.
    • Conversely the lack of a 1099 to tie in to requires that your own internal recording keeping needs to be maintained at a higher level to make sure your numbers are accurate.

  • To allow Income Shifting or Income Splitting.
    • If you had significant trading gains this can allow you to shift a portion of that income from your highest income tax brackets, for example, to the lower tax brackets of your children.
    • If you want to trade the funds for other family members or friends - the tax deductions they receive for your compensation generally can be structured to be fully deductible for federal & state purposes, rather than being limited as with typical "full discretion managed accounts."
    • Many other beneficial, "special allocations having substantial economic effect under the §704(b) regulations." (Allocations of partnership items are permitted only if these allocations are agreed upon in the partnership agreement)
      • §1.704-1(b)(2) has three requirements based on the principles contained in paragraph §1.704-1(b)(2)(ii)(a) and except as otherwise provided in §1.704-1, an allocation of income, gain, loss, or deduction (or item thereof) to a partner will have economic effect if, and only if, throughout the full term of the partnership, the partnership agreement provides--
        • 1.704-1(b)(2)(ii)(b)(1)  For the determination and maintenance of the partners' capital accounts in accordance with the rules of paragraph (b)(2)(iv) of this section,
        • 1.704-1(b)(2)(ii)(b)(2)  Upon liquidation of the partnership (or any partner's interest in the partnership), liquidating distributions are required in all cases to be made in accordance with the positive capital account balances of the partners,z as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs (other than those made pursuant to this requirement (2) and requirement (3) of this paragraph (b)(2)(ii)(b)), by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), and
        • 1.704-1(b)(2)(ii)(b)(3) If such partner has a deficit balance in his capital account following the liquidation of his interest in the partnership, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs (other than those made pursuant to this requirement (3)), he is unconditionally obligated to restore the amount of such deficit balance to the partnership by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), which amount shall, upon liquidation of the partnership, be paid to creditors of the partnership or distributed to other partners in accordance with their positive capital account balances (in accordance with requirement (2) of this paragraph (b)(2)(ii)(b)).
  • Good way to allow you the ability to create "earned income" and thereby make tax deductible retirement plan contributions of $44,000+ each for yourself and for family members, including young children.
    • Keep in mind that "earned income" is subject to Social Security taxes of 15.3% on the first $100,000 (or so) per year, per person and 2.9% on amounts over that.
  • The "earned income" also allows the possibility of deducting 100% of your family's health insurance.
  • The "earned income" also allows the possibility of deducting your family's medical & health expenses, if a c-corporation is formed.
    • Note though, the "earned income" method can also be used to hire your spouse to legitimately perform viable services to a non-c-corporation business, including a self-employed business - a sole proprietorship securities trader.
  • To allow you to deduct a  higher meals expense allowance, if a c-corporation is formed.
  • To provide some level of asset protection against "charging orders" should you have a judgment rendered against you for some non-trader reason, if a multi-member LLC is formed.
  • To lower or eliminate, to a limited extent, the IRS and State taxes for any income allocated to an out-of-State c-corporation (using a multi-entity set-up).
    • The c-corporation tax rate is 15% on the first $50,000 of taxable income per year, limited to an accumulation over several years of up to $250,000 (or even $150,000).  Further subject to any limitations applicable to personal holding companies (PHC).
  • Be aware that an entity often has higher fees charged by the brokerage and to obtain real-time quote services. (at many brokerages, with a little foresight, it often is easy enough to avoid these higher fees)
    • On the other hand some brokerages charge less for entity accounts, IB for example.
  • Obtaining credit, opening a bank account, opening a brokerage account, trading options and futures and obtaining margin may entail more red-tape when working through an entity.  (again, with a little foresight, it often is easy enough to work around these problems)
  • Of course, when business assets become large, I am a big believer in not putting all of your eggs in one basket.  Consider using multiple entities at the same and in staggered levels of ownership to help reduce your tax burdens, as well as the inevitable liability and lawsuit exposure that success brings. These can include an assortment of C and S corps, as well as LLCs, LLLPs and trusts.
  • Here's a nice 167 page booklet (PDF file) entitled "Incorporate The Road To Riches" that reinforces many of the above reasons, and adds several more in an easy to read format.
  • This web page link explain more reasons to for a separate entity: "Protect Your Business Losses by Incorporating"

Clarification needed:
Some information can be found on the internet that purportedly offers to save taxpayers money by having them form a type of entity for traders that does not need to file a separate tax return, and thereby you have lower tax preparation fees if you use these preparers.  Unfortunately for taxpayers who follow that line of thinking, it turns out to be more hype than it is substance.

The fact here is that it is not the "separate entity" that creates the "magic" discussed on this web-page.  Rather, it is a separately filed tax return in addition to your personal tax form 1040 that results in the tax benefits.

And how does one file a separate tax return?  One forms a type of entity that is required to file a separate tax return!

Nothing here on this web page, on the web site or in the accounting practice of Colin M. Cody, CPA, CMA comes even close to being construed to be a "so called" IRC §6700 activity or transaction.  It is improper to secure any tax benefit by reason of holding an interest in an entity or participating in a plan or arrangement which the person knows or has reason to know is false or fraudulent as to any material matter.  Only legitimate business traders having legitimate business purposes (as described above) for using an entity are welcomed here.  Please click this link for a zillion more
required disclaimers <- please note that this is prominently disclosed, as required by law.


Per IRS data tables, tax years 2008 compared to 1998 had the following filed for the combined finance & insurance industry:

      2008                                                                          1998
     90,245  c-corporation tax returns                   115,309
   163,848  s-corporation tax returns                   102,884
     85,093  general partnership tax returns       113,083
     88,164  limited partnership tax returns            63,643
   147,327  LLC partnership tax returns                 32.425
   693,065  schedule c tax returns                        598,959
1,267,742  total                                                       1,026,303


Some types of entities most popular with traders:

  • Domestic Multi-Member Limited Liability Company (LLC), taxed as a partnership
    • This entity structure offers great flexibility and versatility in allocating the taxable gains and losses and operating expenses to the LLC members, to be taxed on the members' own individual income tax returns.  The LLC itself pays little or no federal or State income tax. Special care must be taken so not to inadvertently get trapped by Prop. Regs. §1.1402(a)-2(d) when aggregating earned income for the year.  LLCs may also offer some limited asset protection against "charging orders." (Rev Ruling 77-137 says the plaintiff pays the taxes on the income, even if you, as the defendant  keep full control the money and other assets)
      • Caution must be used with LLC's that trade commodities (futures) when more than 35% of the member interest is held passively. This could cause the LLC to be considered a syndicate
    • Owners (members) must number two or more and may include, for example: husband, wife, child (caution if less than two members are of legal age), other friend or relative, a corporation, a LLC, an estate or a trust.
      • we strongly prefer that all members hold more than a mere token percentage of ownership in the multi-member LLC.  Owning relatively too small of a percentage interest in the LLC could be looked upon as peppercorn co-memberships which is possibly only one step away from sham co-members in certain circumstances.  Especially if the co-members have not paid for their membership interest (they received a gift of the membership, for example).
    • You must maintain an Operating Agreement, which at times can be cumbersome.
    • The entity may elect to be taxed as an S-Corporation, if desired.
      • If an EIN has been issued to the LLC it may be retained pursuant to Regs. 301.7701-3 and the instructions to Form 8832.
      • Be sure to amend the LLC operating agreement to meet all S corporation requirements.
      • Then, if important, later convert to a state law corporation. This conversion ought to be an F reorg with retention of the EIN.  See PLR 200528021 where a state law corporation with an S election converted to a state law LLC/S corporation and was allowed to retain its EIN
    • Some statistics:  This entity type surpasses in number all other entity types since 2002. In 2003 LLC's filed 46.0% of all partnership tax returns, which is more than any other type.  For partnership tax returns taken as a whole the IRS says that more than 50% of newly formed entities are in the category "finance and insurance," which is the category traders file under.  The LLC is becoming the defacto standard form of doing business for trader status taxpayers, soon to be surpassing even sole proprietorships.
    • A web site devoted to provided everything you can imagine about LLC formations:
    • A web site that tries to answer  Is LLC the best entity for your business?  (note that this site is written from a regular non-trader perspective)
    • Three Three Dumbest LLC Formation Mistakes
    • Advantages of an LLC (web site)
    • Disadvantages of an LLC (web site)
    • LLC vs. S-Corp (web site)

    • From IRS web site: Can I be an LLC?  A Limited Liability Company (LLC) is an entity organized under the laws of a state. You must file or intend to file articles of organization with your state before you can be recognized as an LLC. There can only be one LLC with the same name in any one state.

    • From IRS web site: Limited Liability Company (LLC)  A limited liability company (LLC) is a structure allowed by state statute. An LLC is formed by filing articles of organization with the individual state's secretary of state. Owners of an LLC are called members. Members may include individuals, corporations, other LLCs, and foreign entities. An LLC can be formed by one or more members, and there is no maximum number of members.

      There can be no more than one active LLC with the same name in the same state.

      For federal tax purposes, an LLC may be treated as a partnership or a corporation, or be disregarded as an entity separate from its owner.

      An LLC can also be organized as a professional limited liability company (PLLC) or a limited company (LC). .

    • From IRS web site: Limited Liability Company - What it is...

      • A limited liability company (LLC) is a structure allowed by state statute.
      • An LLC is formed by filing articles of organization with the state's secretary of state office.
      • An LLC must be unique in its state. There can be no more than one active LLC with the same name in the same state.
      • For federal tax purposes, an LLC may be treated as a partnership or a corporation, or be disregarded as an entity separate from its owner.
      • An LLC can have two or more members (multi-member) or one member (single-member).
      • An LLC can have an unlimited number of members.
      • An LLC's members may include individuals, corporations, other LLCs, or foreign entities.

      What it is not...

  • Domestic B-Corporation and/or Benefits Corporation
    • A B-Corporation is a "certification" given by B Lab to businesses that pass a socially responsible certification process. B Corporation is not a legal form and has no legal on income tax significance.

      A B Corp can be structured legally as a C corporation, an LLC, or a sole proprietorship. A company can be certified as a B Corporation without ever incorporating as a benefit corporation.

    • A benefit corporation is a legal form that became law in Maryland on October 10, 2010. Legislation similar to that in Maryland will become law in Vermont in July 2011 and was recently passed by the New Jersey legislature.

      An entity may be a benefit corporation under Maryland law without being a B Corporation. The Maryland law does not require that benefit corporations be certified as a B Corporation. Rather, it requires that benefit corporation's social and environmental performance be assessed by an independent third party that makes publicly available or accessible the following information:
      • The factors considered when measuring the performance of a business.
      • The relative weightings of those factors.
      • The identity of the persons who developed and control changes to the standard and the process by which those changes were made.

    • The key difference is that the law requires a third party assessment, whereas a B Corporation is a certification.

  • Domestic S-Corporation
    • When only one person is desired to be the owner of the entity, an S-Corp has many of the same benefits as does the Multi-Member LLC.  The S-Corp is more tightly structured than the LLC which for many purposes makes it particularly less desirable than an LLC when there is more than one owner.
      • generally speaking, there is no home office deduction available when using an s-corporation.
      • generally speaking, there is no deduction for unreimbursed expenses paid out by the shareholders.
      • a separate checking account should be maintained by the s-corporation and all expenses paid from this account, or the shareholders reimbursed for any advances made on behalf of the business.
    • On the other hand, an S-Corp makes for a more bullet-proof assignment of a portion of the annual trading gains into "earned income."  The shareholder(s) are able to receive W-2 wages which can clearly define the income to be used when computing your retirement plan deduction. update: Congress started looking into this in 2005.
      • It might be successfully argued by IRS that the shareholders be paid a reasonable salary, subjecting some trading gains to Social Security and Medicare tax and unemployment tax and possible disability or other employee related taxes.
    • Additionally by availing yourself to the little know rule known as IRS Regulation 1.1366-1(b) you might be able to convert capital losses in old long-term dog stocks you've been holding into usable fully-deductible ordinary losses.
    • You elect to be an S-Corp with the IRS as follows:
      • Form a corporation and immediately upon obtaining a federal id number using form SS-4, elect S-Corp status using form 2553 or...
        update: new Rev. Proc. 2007-62  (Alternative link)  (Alternative link) issued in October 9, 2007 allows the S-Corp election form 2553 to be filed late - filed with the initial federal income tax return in certain circumstances.
      • Form an LLC and immediately upon obtaining a federal ID number using form SS-4, elect check-the-box corporate status using form 8832 and S-Corp status using form 2553.
        update: new IRS Regs issued in July 2004 allow LLCs to forgo filing form 8832 and rather only file form 2553 under certain circumstances.  see §301.7701-3T(c)(1)(v)(C) for where form 2553 can be filed alone, see Rev. Proc. 2004-48
    • Trap - Do not overlook that to elect to be an S-Corp with the State as follows:
      S-Corporation Checklist
      Determine that the corporation has fewer than 75 shareholders
      Determine that all shareholders are natural persons or estates
      Determine that the corporation has only one class of stock issued and outstanding
      Determine that the corporation is already incorporated in the U.S or in one of its possessions
      Determine that the corporation hasn’t had "S" status within the past five years
      All shareholders must consent to the election to be treated as an S-corporation
      Notice of a special shareholders meeting for the purpose of consenting to the election as an S-corporation should be provided to all shareholders of record
      A special shareholders meeting should be held at which all shareholders of the corporation consent to the election by the corporation to be treated as an S-corporation
      A shareholders resolution consenting to the election to be treated as an S-corporation should be signed by all shareholders of record
      The secretary of the corporation should complete IRS Form 2553: Election by a Small Business Corporation
      All shareholders of record must sign IRS Form 2553: Election by a Small Business Corporation
      The secretary of the corporation should file IRS Form 2553: Election by a Small Business Corporation


    • You do not maintain an Operating Agreement, as you would with an LLC, but you do need to maintain minutes and by-laws.  For many cumbersome items that would normally need to go into an LLC Operating Agreement, the S-Corp may use an employment agreement to make things easier to handle.
    • Because of the numerous tricks and traps of the s-corporation, this should only be used in rare and unusual circumstances.   When a solo trader has no "2nd member" to form a partnership or LLC with, a c-corp can be formed to stand in as this "2nd member."
    • A wonderful little s-corporation information web site:

    • From IRS web site: S Corporation Status Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. On their tax returns, the S corporation's shareholders include their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of nonseparately stated income or loss.

    • From IRS web site: An S corporation - What it is...

      • A corporation is a person or group of people who establish a legal entity by filing articles of incorporation with the state's secretary of state granting it certain legal powers, rights, privileges, and liabilities.
      • An S corporation is an eligible domestic corporation that wants to avoid double taxation (once to the shareholders and again to the corporation) by electing this status using Form 2553 (Election by a Small Business Corporation).
      • Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income.

      What it is not...

  • Domestic or Out-of-State C-Corporation as a member of your LLC or Limited Partnershipfont>
    • When a member of your LLC is a C-Corporation you can run your medical and health expenses through it as a non-taxable employee benefit. Also you might qualify for a 100% deductible IRC §119 mid-day meal deduction.
      • Note that the C-Corporation is a co-owner with you in yet another entity.  Double the number of entities and you double your fees and red-tape.  Keep that in mind before jumping into this style set-up.
    • Other c-corporation fringe benefits include (if not discriminatory in nature): group term-life insurance, disability insurance, $ 5,000 death benefit, stock purchase plans, option plans, cafeteria plans, child care plans, employer provided housing an meals.  Also non-qualified deferred compensation plans - are available to c-corporations enabling them to provide non-tax deductible contributions to a non-qualified plan (on a discriminating basis), with tax deferred benefits to the company executives.
    • When a member of your LLC is an Out-of-State C-Corporation, legitimately domiciled and operated in Nevada for example, you can allocate a portion of your income to Nevada where there is no State income tax and where the IRS might tax the gains at the lower 15% tax rate.
      • Note we said "might" tax the gains at the lower 15% tax rate.  This presumes that the corp is not classified as a personal service company earning revenues from activity involving the performance of services in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.
        • or that you have more than one C-Corporation, which are classified as a "controlled group" which can result in forgoing the 15% tax rate.
        • or where you have accumulated gains and profits without having paid out taxable dividends (subject to double taxation) otherwise being subjected to the "accumulated earning tax."   Or being forced to lower the accumulated earnings by declaring wage-bonuses subject to employment taxes, unemployment taxes and sometimes other red tape issues with the State Labor Departments and Disability Insurance authorities and other compliance issues and potential penalties for not filing any of a number of additional tax forms.
        • or where the corporation is treated as a "personal holding company" because roughly 60% or more of the annual income comes from dividends and interest or a few other items.
          • a point here.  We've seen on the internet an "expert" claiming that our cautionary statement here is an "odd practice" -"We say odd because traders by definition are not subject to the personal holding company tax, regardless of their choice of corporate entity."    [emphasis added].  And of course that is the case if your definition is that year-after-year your trading gains or other income will always be high enough so that your dividends and interest income never exceed 60%  and  that the IRS will never challenge your "definition" that you are a trader.

            Many traders have periods where they might slow down. Perhaps their volume is too low for the IRS's liking and then what if trader status is challenged?  What better incentive to leave on a red carpet for the IRS but a potential "personal holding company" assessment?   Or what if the trading results in a small loss, with the result that dividends and interest exceed 60% of income?  Why take chances?  There's no good reason to in our opinion, when with a little professional foresight it can be done with appropriate safeguards in place.   Proper tax planning thinks ahead several steps and hopefully does not risk a total and irretrievable meltdown if the first line of defense fails.
      • Note that we also said "legitimately domiciled and operated."  There are vendors out there mass-marketing a "C-Corp solution" to taxpayers residing in high-tax States, particularly to those living in California.  We have seen many of these setups were the taxpayer was charged thousands of dollars in consulting, planning and incorporation fees where the tax and legal benefits were overstated.
      • You cannot trade from California through a registered Nevada C-Corp and legally avoid all California State taxes on your earnings - due to the concept of taxation called "nexus" (for more information, search for "nexus" on this page: A Trader's Choice of Entities )
      • You can allocate a reasonable portion of your income to Nevada, if you properly structure and segregate the business activities of each entity. But unless you change your State of residence to Nevada, and perform your work in Nevada, then you will not necessarily be able to legally allocate all of your income to Nevada.
      • update: recently (2005) the IRS has been attacking owners of NV entities due to the high probability that those participating in aggressive tax abuse schemes have established a NV entity under the direction of Tax Fraud Promoters who are under observation due to the stepped-up enforcement in that area by the US Gov't.  Sure, NV may promise secrecy - but when the IRS is threatening you with obscure fines of up to $10,000 for each tax form allegedly misfiled and for each allegedly required tax form not filed unless you cooperate fully by disclosing everything regarding your finances and investments, everything you know about the promoters and about all the people you know - well you get the picture, NV "secrecy" is a mere joke unless perhaps you have a team of high-power lawyers representing you.
        • update: So-called Nevada secrecy was dealt a strong blow by the Court:  (Martini v. US district of Nevada 5/10/2006).  IRS summons to get secret taxpayer information is enforceable.
      • We feel that for most traders this is too costly and has extra red tape that outweighs the potential tax savings - but on the other hand, in special circumstances, there are many consistently profitable traders who use this type of multiple-entity set-up to their advantage.
  • Family General Partnership (FGP)
    • Less formal, easy and less expensive to form and offering many of the same features as an LLC taxed as a partnership.
    • Partners must number two or more and may include, for example: husband, wife, child (caution if less than two members are of legal age), other friend or relative, a corporation, a LLC, an estate or a trust.
    • The FGP offers no liability protection at all.  All FGP assets are at risk by the actions of any partner.
    • We recently saw a newsletter sent to traders mentioning this concept with a husband & wife JTWROS account as their so-called new "idea."  But bear in mind that family partnerships have been around for a long time.  We have been putting clients into family partnerships including husband/wife partnerships, the correct way, for decades.  Do not be concerned that this is some "new" unproven scheme.  A partnership comprised solely of a domestic couple is nothing new to tax advisor's or to the IRS.  They have been a proven method of doing business and filing taxes for decades.
    • The concept of bona-fide family partnerships has been mentioned for free on this web site since it was first established in 1999, after the "new entity rule" was established by Rev. Proc. 99-17.  So this can hardly be thought of as a new "idea" even for traders - but be aware that experience has shown that when the owners are solely a husband and wife (or other domestic couple) care must be taken to qualify under IRC Code §6231(a) and §761.  The mere co-ownership of assets does not qualify under scrutiny.  Regs. §§1.761-1(a), 301.7701-1(a)(2).  While we have been doing bona-fide family partnerships for traders since 1999 and for other taxpayers for many, many years prior to that, this is not necessarily preferable to the other entity structures listed above.
    • Regardless, it is inappropriate to flaunt something implying that it is somehow an underhanded tax-motivated scheme.  Substance over form and taxpayer intent go a long way in establishing credibility with the IRS.  In all cases, the family partnership must be a bona-fide economic, business-like arrangement.  These should be handled on a one-on-one basis, not some mass-marketing cookie cutter approach that is sure to peak the interest of the IRS once they think they smell a tax cheat.
    • You may optionally choose to maintain a Partnership Agreement.
    • The general partnership can be preferable when non-active owners are partners in the entity which trades commodities (futures) - if more than 35% of the ownership interest is held by the non-active partners.  See limited entrepreneur.
  • Family Limited Partnership (FLP)
    • More formal, difficult and more expensive to form than a LLC or a FGP. These have similar tax attributes with added features that are useful for asset protection plans and valuation discounts related to family gifting estate plans.
    • Usually used by wealthy, solidly successful, somewhat more mature traders with children as part of their estate planning.
  • Domestic or Out-of-State Single-Member Limited Liability Company (SMLLC)
    • A SMLLC may be owned, for example, by one individual, by one LLC or by one corporation.
    • This specialized entity might be used for somewhat limited asset protection, SEC rule work-arounds, to definitively segregate some trading activity from other activities and for other purposes that need a separate legal entity for non-tax purposes.  The SMLLC is disregarded by the IRS for tax purposes unless it files the appropriate election to not be a disregarded entity on form 8832.  In that case the SMLLC would be taxed as a C-Corp or if form 2553 is also filed, as an S-Corp. (In certain cases, under §301.7701-3T(c)(1)(v)(C) form 2553 can be filed alone, see Rev. Proc. 2004-48 and Rev. Proc. 2007-62 )
    • If form 8832 and/or form 2553 are not filed the entity generally is disregarded for all tax purposes and elections as an entity separate from its owner.  It is treated under the IRS regulations as an "Alter-Ego entity."  Alter-Ego theory also allows the IRS to undo many "creative" but ineffectively designed tax-motivated schemes using corporations, trusts or SMLLCs.  It is simply foolish to try any "creative" games using a disregarded SMLLC when all such problems and concerns can be avoided with a multi-member LLC or S-Corp.
    • Even if disregarded, a SMLLC owned by an individual (rather than by an entity) may create earned income for a trader's spouse by paying a salary or fee for services rendered by the spouse. Of course a similar result could be accomplished without the bother of using a SMLLC. (since a SMLLC is disregarded by the IRS anyway)

    • Other entities that are disregarded as taxable entities from their owners including: Qualified Real Estate Investment Trust Subsidiaries (QRSs), Qualified Subchapter S Subsidiaries (QSubs) and Single Owner Eligible Entities should be avoided for trader status strategies.

    • Under §301.7701-3(b)(1) and (2), an eligible entity with a single owner may be disregarded as an entity separate from its owner. Section 301.7701-3(b)(1)(ii) provides that a domestic eligible entity with a single owner is disregarded unless the entity makes an election to be classified as an association (and thus a corporation under §301.7701-2(b)(2)). Section 301.7701-3(b)(2)(C) provides that a foreign eligible entity with a single owner that does not have limited liability is disregarded unless the entity elects to be classified as a corporation. Under §301.7701-3(c), a single owner eligible entity that has elected to be treated as a corporation and a foreign eligible entity with a single owner that has limited liability (that would otherwise be treated as a corporation under §301.7701-3(b)(2)(i)(B)) may elect, subject to certain limitations, to be disregarded.


  • Limited Liability Limited Partnership (LLLP) & Family Limited Liability Limited Partnership (FLLLP)
    • The new kid on the block, the LLLP form of entity offers stronger asset protection compared to the LLC.

  • Separately Managed Accounts (SMA)
    • Friends & Family (generally 15 or fewer clients)
    • While this is a popular method for many advisors, the use of a SMA set-up alone is often a very tax inefficient way to go.  Saving less than a thousand dollars a year (slightly more in some situations - CA registered entities, most notably) can cost your investors a meaningfully tax write-off for your fees, and can result in your fees being subject to double federal taxation (federal income tax as well as self-employment taxes).  SMA's generally are prohibited from electing Mark-to-Market, whereas with a proper entity selection this is yet one more benefit for your investors.
    • often SEC and State Blue Sky registration issues are relaxed when a proper relationship, including a separately filing trading entity, is created.


Most traders start out as individual sole proprietorships (form 1040 Schedule C).  Some observations regarding Schedule C:

  • If mark-to-market is desired, generally you must notify IRS that you elect in advance of filing your tax return - sent via certified mail between the dates of January 1 and April 15 of the year that mark-to-market is to begin. 
    • This is more cumbersome than a separate newly formed entity which elects mark-to-market when it is formed or when operations begin, but does not actually notify IRS until its first separate tax return is filed.
    • Note that SMLLCs generally do not file their own separate tax returns, therefore making a retroactive election under the guise of a newly formed SMLLC is foolhardy at best.
  • Mark-to-market is a permanent election.  To drop the election you need to secure the written permission from the IRS Commissioner.  It is not clear if mere changing or closing the trading business or trading account has any ability to revoke the mark-to-market election.
  • IRS audits are primarily targeted at individuals (form 1040), and among individuals they are more specifically targeted at those filing Schedule C and showing a loss.
    • Traders, by definition, show a loss on Schedule C.  That's where your expenses are deducted, whereas your trading gains are reported on Schedule D or Form 4797.
    • It is improper for a trader to reclassify any portion of interest income, dividend income, trading gains or losses from Schedule B,  Schedule D or Form 4797 to Schedule C to obfuscate the Schedule C loss.  By law, only a Securities Dealer is allowed (is required) to report gains and losses on Schedule C.
      • Taking this improper position could result in an underpayment or overpayment of tax, but often this is not too serious an amount for IRS and State tax  purposes - though it can occasionally have significant implications.
      • Taking this position to obscure the proper reporting of your deductions can be a violation of IRS procedures subject to penalty (unless form 8275 or 8275-R is filed).
      • While the odds are with you against getting caught in a random audit and penalized for taking this kind of position, if you are selected for audit you run the risk of being pegged as an uncooperative adversary at worst or a poor tax preparer at best, making the audit itself more difficult to satisfactorily complete.
      • To date, over 50% of the IRS audits we've handled here (of tax returns that were initially prepared elsewhere) have been triggered specifically because the preparer reported some portion of trading gains and losses on Schedule C, and the IRS then sent the tax return to an agent/examiner to investigate.
  • Individuals selected for audit typically find their position of trader status under scrutiny.
    • If the trader also has W-2 wages, the standard line from the IRS is that that is your gainful employment and that the trading is merely an investment activity.
    • If the trader has significant investment income, the standard line form the IRS is that your trading is merely more of the same investment activity.
    • If the trader has investment income generally a portion of his expenses need to be allocated between trading and investing.  Expenses allocated to investing are generally limited in their usefulness.

Breaking the corporate shield:

Courts have identified a fair number of instances where they will "pierce the veil" and hold the officers, shareholders or members personally liable and/or attach company and personal assets. (for clarity the words corporate, company and entity are used interchangeably in this list):

  • Failure to segregate funds of separate entities.
  • Commingling of company funds and other assets.
    • not properly maintaining separate bank accounts for the entity.
  • Use of corporate assets for personal use.
    • using the entity's bank account "as the owner's personal checkbook."
  • Absence of any major corporate assets.
  • Unauthorized diversion of corporate assets.
    • failing to maintain a strong board of directors and maintaining minutes of their meetings.
    • using money for non-business purposes.
    • using money without authority as granted in the minutes or operating agreement.
  • Failure to maintain arms-length transactions.
    • transactions with owners treated more preferentially than might be with 3rd parties.
    • failing to authorize loans or advances between entity and owners in the minutes or operating agreement.
    • failing to maintain written interest bearing loan agreements.
    • failing to charge and pay adequate interest on loans and advances.
    • failure to make appropriate periodic payments of interest and principal.
    • failure to pay appropriately competitive wages to the owners.
  • Failure to adequately capitalize the corporation.
    • failure to transfer some assets into the corporation. i.e.Underfunding the corporation
    • failure to issue corporate stock or maintain corporate ledger.
    • failure to actually pay for your common stock or interest in the entity.
  • Unauthorized issue or subscription of shares.
  • Use of the corporation for illegal or fraudulent transactions.
  • Meetings & Records:
    • failure to have regular board of directors' meetings.
    • failure to have annual shareholders' meetings.
    • failure to have the required initial organizational meeting.
    • failure to maintain up-to-date corporate records.
    • failure to adopt corporate by-laws.
    • failure to get the proper state and local business licenses in the name of the corporation.
  • Taxes & Fees:
    • failure to pay taxes, particularly "trustee" (payroll) taxes.
    • failure to pay required Secretary of the State fees.
    • failure to file required (annual) Secretary of the State forms and fees.
  • Failure to advertise and serve notice that the business was operating as a corporation i.e. holding yourself out as a corporation ( letterheads, etc. and always sign documents as the corporate officer, not just personally )

On March 2, 2004 the US Supreme Court decided Yates.  Dr. Yates had a corporation with employees in addition to himself and his spouse and as such under ERISA was able to protect his profit sharing plan from creditors.

On April 4, 2003 the United States Bankruptcy Court decided Albright.  Ms. Albright had a single-member LLC plan that was unable to protect assets from creditors because it was a single-member LLC.  This has no effect on liability shields

On January 13, 2005 the United States Bankruptcy Court decided Fiesta Investments.  This multi-member LLC was unable to protect assets from creditors because of the non-business-like manner it was run.  This has no effect on liability shields

On May 18, 2005 a United States District Court decided F.A. Littriello,.  The "corporate shield" protecting the assets of the owner was ignored by the court because this single-member LLC chose not to elect to be treated as a corporation.  Held: the debts of the SMLLC were the responsibility of the individual owner not as an agent of the SMLLC.  The court relied on Chevron  analysis and Kintner  regulations in making its final ruling.

On May 17, 2006 a United States District Court decided Townley.  Since the setting up of their separate entity and the related planning was admitted to be done for "asset protection" to protect assets from future unknown creditors, the court ruled that this was enough to prove that their actual intent was to engage in a fraudulent transfer.  The creditor (The Internal Revenue Service in this case) was given the assets to satisfy their unpaid taxes.

On April 13, 2007 the United States Court of Appeals decided Littriello.  Mr. Littriello had several single-member LLCs and was unable to protect any assets from a tax levy because they each were single-member LLCs that were "disregarded."

On June 24, 2010 the Florida Supreme Court decided Olmstead.  Shaun Olmstead, et al. had several single-member LLCs against which the Court ruled in a split-decision that "Florida law permits a court to order a judgment debtor to surrender all right, title, and interest in the debtor's single-member limited liability company to satisfy an outstanding judgment."      The Olmstead decision and the problem of single member LLCs

On March 3, 2011 the New York Supreme Court decided Rossignol v. Rossignol.  In this divorce case the legal rights and protections of their two-member husband-wife LLC
were basically ignored when the appellate court affirmed: "Inasmuch as the husband and wife are the only owners of the LLC, and both are parties to the divorce action, we see no reason why any issues should be left for resolution after equitable distribution of the parties' property. Given the availability of complete relief pursuant to Domestic Relations Law §234 and our public policy of resolving equitable distribution within the context of a divorce action, we conclude that dismissal of the second action was within Supreme Court's broad discretion." This now opens the door for possible further attacks against the LLCs legal structure, by piercing the corporate veil.

Catch 22?br> Under the default rules of many of the State LLC acts, upon the death of the member of a single-member LLC, the member's management rights cannot pass to another person without the consent of "the other members." Arguably, this means that upon the above death, the LLC has no members (since there are no "other members" to approve a transfer of management rights) and thus, under many state LLC acts, while a single-member LLC's assets pass to the member's estate upon the member's death, the LLC itself ceases to exist.  Therefore the estate now has no liability shield for the terminated single-member LLCs business operations unless it creates a new LLC and contributes the above assets to it, and how this would protect against pre-death acts or liabilities is questionable at best. This Catch 22 shows just how important it is for single-member LLCs to have written operating agreements that alter otherwise harmful statutory default rules.  Otherwise, just avoid the use of SMLLCs in the first place.

Different States offer different levels of Asset Protection.  See discussion on Choosing a State to form in.

Also see "charging orders"

 A Traders Tax Responsibilities

Colin M. Cody, CPA, CMA LLC
6004 Main Street
Trumbull, Connecticut 06611-2400

(203) 268-7000


                  Member PCPS                                        
                  The AICPA Alliance for CPA Firms
                  Private Companies Practice Section

                  American Institute of CPAs
                  Connecticut Society of CPAs
                  California Board of Accountancy
                  Institute of Management Accountants

online verifications:

email inquiries




No. 02—458. Argued January 13, 2004–Decided March 2, 2004

Enacted “to protect … the interests of participants in employee benefit plans and their beneficiaries,” 29 U.S.C. § 1001(b), the Employee Retirement Income Security Act of 1974 (ERISA) comprises four titles. Relevant here, Title I, 29 U.S. C. §1001 et seq., mandates minimum participation, vesting, and funding schedules for covered pension plans, and establishes fiduciary conduct standards for plan administrators. Title II, codified in 26 U.S. C., amended various Internal Revenue Code (IRC) provisions pertaining to qualification of pension plans for special tax treatment, in order, inter alia, to conform to Title I’s standards. Title III, 29 U.S. C. §1201 et seq., contains provisions designed to coordinate enforcement efforts of different federal departments. Title IV, 29 U.S.C. § 1301 et seq., created the Pension Benefit Guaranty Corporation and an insurance program to protect employees against the loss of “nonforfeitable” benefits upon termination of pension plans lacking sufficient funds to pay benefits in full. This case concerns Title I’s definition and coverage provisions, though those provisions, indicating who may participate in an ERISA-sheltered plan, inform each of ERISA’s four titles. Title I defines “employee benefit plan” as “an employee welfare benefit plan or an employee pension benefit plan or … both,” §1002(3); “participant” to encompass “any employee … eligible to receive a benefit … from an employee benefit plan,” §1002(7); “employee” as “any individual employed by an employer,” §1002(6); and “employer” to include “any person acting … as an employer, or … in the interest of an employer,” §1002(5).

        Yates was sole shareholder and president of a professional corporation that maintained a profit sharing plan (Plan). From the Plan’s inception, at least one person other than Yates or his wife was a Plan participant. The Plan qualified for favorable tax treatment under IRC §401. As required by the IRC, 26 U.S.C. §401(a)(13), and ERISA, 29 U.S. C. §1056(d), the Plan contained an anti-alienation provision. Entitled “Spendthrift Clause,” the provision stated, in relevant part: “Except for … loans to Participants as [expressly provided for in the Plan], no benefit or interest available hereunder will be subject to assignment or alienation.” In December 1989, Yates borrowed $20,000 from another of his corporation’s pension plans (which later merged into the Plan), but failed to make any of the required monthly payments. In November 1996, however, Yates paid off the loan in full with the proceeds of the sale of his house. Three weeks later, Yates’s creditors filed an involuntary petition against him under Chapter 7 of the Bankruptcy Code. Respondent Hendon, the Bankruptcy Trustee, filed a complaint against petitioners (the Plan and Yates, as Plan trustee), asking the Bankruptcy Court to avoid the loan repayment. Granting Hendon summary judgment, the Bankruptcy Court first determined that the repayment qualified as a preferential transfer under 11 U.S.C. § 547(b). That finding was not challenged on appeal. The Bankruptcy Court then held that the Plan and Yates, as Plan trustee, could not rely on the Plan’s anti-alienation provision to prevent Hendon from recovering the loan repayment for the bankruptcy estate. That holding was dictated by Sixth Circuit precedent, under which a self-employed owner of a pension plan’s corporate sponsor could not “participate” as an “employee” under ERISA and therefore could not use ERISA’s provisions to enforce the restriction on transfer of his beneficial interest in the plan. The District Court and the Sixth Circuit affirmed on the same ground. The Sixth Circuit’s determination that Yates was not a “participant” in the Plan for ERISA purposes obviated the question whether, had Yates qualified as such a participant, his loan repayment would have been shielded from the Bankruptcy Trustee’s reach.

Held: The working owner of a business (here, the sole shareholder and president of a professional corporation) may qualify as a “participant” in a pension plan covered by ERISA. If the plan covers one or more employees other than the business owner and his or her spouse, the working owner may participate on equal terms with other plan participants. Such a working owner, in common with other employees, qualifies for the protections ERISA affords plan participants and is governed by the rights and remedies ERISA specifies. Pp. 8—20.

    (a) Congress intended working owners to qualify as plan participants. Because ERISA’s definitions of “employee” and, in turn, “participant” are uninformative, the Court looks to other ERISA provisions for instruction. See Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 323. ERISA’s multiple textual indications that Congress intended working owners to qualify as plan participants provide, in combination, “specific guidance,” ibid., so there is no cause in this case to resort to common law. ERISA’s enactment in 1974 did not change the existing backdrop of IRC provisions permitting corporate shareholders, partners, and sole proprietors to participate in tax-qualified pension plans. Rather, Congress’ objective was to harmonize ERISA with these longstanding tax provisions. Title I of ERISA and related IRC provisions expressly contemplate the participation of working owners in covered benefit plans. Most notably, Title I frees certain plans in which working owners likely participate from all of ERISA’s fiduciary responsibility requirements. See 29 U.S.C. § 1101(a) and 26 U.S.C. § 414(q)(1)(A) and 416(i)(1)(B)(i). Title I also contains more limited exemptions from ERISA’s fiduciary responsibility requirements for plans that ordinarily include working owners as participants. See 29 U.S.C. § 1103(a) and (b)(3)(A) and 26 U.S.C. §401(c)(1) and (2)(A)(i), 1402(a) and (c). Further, Title I contains exemptions from ERISA’s prohibited transaction exemptions, which, like the fiduciary responsibility exemptions, indicate that working owners may participate in ERISA-qualified plans. See 29 U.S. C. §§1108(b)(1)(B) and (d)(1) and 26 U.S.C. §401(c)(3). Exemptions of this order would be unnecessary if working owners could not qualify as participants in ERISA-protected plans in the first place. Provisions of Title IV of ERISA are corroborative. For example, Title IV does not apply to plans “established and maintained exclusively for substantial owners,” §1321(b)(9) (emphasis added), a category that includes sole proprietors and shareholders and partners with a ten percent or greater ownership interest, §1322(b)(5)(A). But Title IV does cover plans in which substantial owners participate along with other employees. See §1322(b)(5)(B). Particularly instructive, Title IV and the IRC, as amended by Title II, clarify a key point missed by several lower courts: Under ERISA, a working owner may wear two hats, i.e., he can be an employee entitled to participate in a plan and, at the same time, the employer who established the plan. See §1301(b)(1) and 26 U.S. C. §401(c)(4). Congress’ aim to promote and facilitate employee benefit plans is advanced by the Court’s reading of ERISA’s text. The working employer’s opportunity personally to participate and gain ERISA coverage serves as an incentive to the creation of plans that will benefit employer and nonowner employees alike. Treating the working owner as a participant in an ERISA-sheltered plan also avoids the anomaly that the same plan will be controlled by discrete regimes: federal-law governance for the nonowner employees; state-law governance for the working owner. Excepting working owners from ERISA’s coverage is hardly consistent with the statutory goal of “uniform national treatment of pension benefits,” Patterson v. Shumate, 504 U.S. 753, 765, and would generate administrative difficulties. A 1999 Department of Labor advisory opinion (hereinafter Advisory Opinion 99—04A) accords with the Court’s comprehension of Title I’s definition and coverage provisions. Concluding that working owners may qualify as participants in ERISA-protected plans, the Department’s opinion reflects a “body of experience and informed judgment to which courts and litigants may properly resort for guidance.” Skidmore v. Swift & Co., 323 U.S. 134, 140. Pp. 8—14.

    (b) This Court rejects the lower courts’ position that a working owner may rank only as an “employer” and not also as an “employee” for purposes of ERISA-sheltered plan participation. The Sixth Circuit’s leading decision in point relied, in large part, on an incorrect reading of a portion of a Department of Labor regulation, 29 CFR § 2510.3—3, which states: “[T]he term ‘employee benefit plan’ [as used in Title I] shall not include any plan … under which no employees are participants”; “[f]or purposes of this section,” “an individual and his or her spouse shall not be deemed to be employees with respect to a … business” they own. (Emphasis added.) In common with other Courts of Appeals that have held working owners do not qualify as participants in ERISA-governed plans, the Sixth Circuit apparently understood the regulation to provide a generally applicable definition of “employee,” controlling for all Title I purposes. The Labor Department’s Advisory Opinion 99—04A, however, interprets the regulation to mean that the statutory term “employee benefit plan” does not include a plan whose only participants are the owner and his or her spouse, but does include a plan that covers as participants one or more common-law employees, in addition to the self-employed individuals. This agency view, overlooked by the Sixth Circuit, merits the Judiciary’s respectful consideration. Cf. Clackamas Gastroenterology Assoc., P. C., 538 U.S., at ___. Moreover, the Department’s regulation itself reveals the definitional prescription’s limited scope. The prescription describes “employees” only “[f]or purposes of this section,” i.e., the section defining “employee benefit plans.” Accordingly, the regulation addresses only what plans qualify as “employee benefit plans” under ERISA’s Title I. Plans that cover only sole owners or partners and their spouses, the regulation instructs, fall outside Title I’s domain, while plans that cover working owners and their nonowner employees fall entirely within ERISA’s compass. The Sixth Circuit’s leading decision also mistakenly relied on ERISA’s “anti-inurement” provision, 29 U.S. C. §1103(c)(1), which states that plan assets shall not inure to the benefit of employers. Correctly read, that provision does not preclude Title I coverage of working owners as plan participants. It demands only that plan assets be held to supply benefits to plan participants. Its purpose is to apply the law of trusts to discourage abuses such as self-dealing, imprudent investment, and misappropriation of plan assets, by employers and others. Those concerns are not implicated by paying benefits to working owners who participate on an equal basis with nonowner employees in ERISA-protected plans. This Court expresses no opinion as to whether Yates himself, in his handling of loan repayments, engaged in conduct inconsistent with the anti-inurement provision, an issue not yet reached by the courts below. Pp. 14—20.

    (c) Given the undisputed fact that Yates failed to honor his loan’s periodic repayment requirements, these questions should be addressed on remand: (1) Did the November 1996 close-to-bankruptcy repayments, despite the prior defaults, become a portion of Yates’s interest in the Plan that is excluded from his bankruptcy estate and (2) if so, were the repayments beyond the reach of the Bankruptcy Trustee’s power to avoid and recover preferential transfers? P. 20.

287 F.3d 521, reversed and remanded.

    Ginsburg, J., delivered the opinion of the Court, in which Rehnquist, C. J., and Stevens, O’Connor, Kennedy, Souter, and Breyer, JJ., joined. Scalia, J., and Thomas, J., each filed an opinion concurring in the judgment.

Ashley Albright, 291 B.R. 538 (Bankr. D. Colo. 2003

THIS MATTER is before the Court on the (1) Motion to Allow Trustee to Take Any and All Necessary Actions to Liquidate Property Owned by Western Blue Sky LLC ("Motion to Liquidate"); (2) Motion to Appoint and Compensate Bob Karls as Real Estate Broker to the Trustee; and (3) Debtor's Response to Trustee's Motion to Retain Realtor and Liquidate LLC Property. Following a hearing on February 4, 2003, the parties agreed to submit the matter on briefs.

Ashley Albright, the debtor in this Chapter 7 case ("Debtor"), is the sole member and manager of a Colorado limited liability company named Western Blue Sky LLC. n1 The LLC owns certain real property located in Saguache County, Colorado (the "Real Property"). The LLC is not a debtor in bankruptcy.

n1 The Debtor initiated this case on February 9, 2001, under Chapter 13. It was converted to Chapter 7 by the Debtor on July 19, 2001.

The Chapter 7 Trustee contends that because the Debtor was the sole member and manager of the LLC at the time she filed bankruptcy, he now controls the LLC and he may cause the LLC to sell the Real Property and distribute the net sales proceeds to his bankruptcy estate. n2 The Debtor maintains that, at best, the Trustee is entitled to a charging order n3 and cannot assume management of the LLC or cause the LLC to sell the Real Property.

n2 If the Trustee is entitled to control of the LLC, he could, presumably, as an alternative, dissolve the LLC, distribute its property to his bankruptcy estate, and then sell the property himself. The Trustee has not asserted any alter ego theory and has not attempted to pierce the veil of the LLC.

n3 The Debtor further asserts that because the LLC is "non-profit" pursuant to its operating agreement, no distribution of "profit" will ever be made and thus the value of this interest is zero. This argument erroneously assumes that a member of a Colorado limited liability company's distribution rights are limited only to "profits." They are not. Colo. Rev. Stat. § 7-80-102(10)("Membership interest means a member's share of the profits and losses of a limited liability company and the right to receive distributions of such company's assets.") See also Colo. Rev. Stat. § 7-80-702(1).

Pursuant to the Colorado limited liability company statute, the Debtor's membership interest constitutes the personal property of the member. Upon the Debtor's bankruptcy filing, she effectively transferred her membership interest to the estate. See 11 U.S.C. § 541(a). n4 Because there are no other members in the LLC, the entire membership interest passed to the bankruptcy estate, and the Trustee has become a "substituted member." n5

n4 11 U.S.C. § 541(a)(1) provides, in relevant part: "The commencement of a case ... creates an estate. Such estate is comprised of ... all legal or equitable interests of the debtor in property as of the commencement of the case."

n5 Colo. Rev. Stat. § 7-80-702 provides (emphasis added):

(1) The interest of each member in a limited liability company constitutes the personal property of the member and may be transferred or assigned. However, if all of the other members of the limited liability company other than the member proposing to dispose of his or its interest do not approve of the proposed transfer or assignment by unanimous written consent, the transferee of the member's interest shall have no right to participate in the management of the business and affairs of the limited liability company or to become a member. The transferee shall only be entitled to receive the share of profits or other compensation by way of income and the return of contributions to which that member would otherwise be entitled.

(2) A substituted member is a person admitted to all the rights of a member who has died or has assigned his interest in a limited liability company with the approval of all the members of the limited liability company by unanimous written consent. The substituted member has all the rights and powers and is subject to all the restrictions and liabilities of his assignor; except that the substitution of the assignee does not release the assignor from liability to the limited liability company under section 7-80-502.

Section 7-80-702 of the Limited Liability Company Act requires the unanimous consent of "other members" in order to allow a transferee to participate in the management of the LLC. n6 Because there are no other members in the LLC, no written unanimous approval of the transfer was necessary. Consequently, the Debtor's bankruptcy filing effectively assigned her entire membership interest in the LLC to the bankruptcy estate, and the Trustee obtained all her rights, including the right to control the management of the LLC. n7

n6 This reading of § 7-80-702 is reinforced in Colo. Rev. Stat. § 7-80-108(3)(a). Section 108 sets forth the effect of an operating agreement and what provisions are non-waivable. Section 108(3) states that "unless contained in a written operating agreement or other writing approved in accordance with a written operating agreement, no operating agreement may [...] vary the requirement under section 7-80-702(1) that, if all of the other members of the limited liability company other than the member proposing to dispose of the member's interest do not approve of the proposed transfer or assignment by unanimous written consent, the transferee of the member's interest shall have no right to participate in the management of the business and affairs of the limited liability company or to become a member." Colo. Rev. Stat. § 7-80-108(3)(a). The clause "other than the member proposing to dispose of the member's interest" confirms that the "other members" identified in § 7-80-702 does not include the transferee..

n7 Under Colo. Rev. Stat. § 7-80-702, supra, the result would be different if there were other non-debtor members in the LLC. Where a single member files bankruptcy while the other members of a multi-member LLC do not, and where the non-debtor members do not consent to a substitute member status for a member interest transferee, the bankruptcy estate is only entitled to receive the share of profits or other compensation by way of income and the return of the contributions to which that member would otherwise be entitled. Thus, Mountain States Bank v. Irwin, 809 P.2d 1113 (Colo. App. 1991); Union Colony Bank v. United Bank of Greeley National Association, 832 P.2d 1112 (Colo. App. 1992) and Prefer v. Pharmnetrx LLC, 18 P.3d 844 (Colo.. App. 2000), cited by the parties, are distinguishable as they relate to multi-partner or member entities.

The Debtor argues that the Trustee acts merely for her creditors and is only entitled to a charging order against distributions made on account of her LLC member interest. n8 However, the charging order, as set forth in Section 703 of the Colorado Limited Liability Company Act, exists to protect other members of an LLC from having involuntarily to share governance responsibilities with someone they did not choose, or from having to accept a creditor of another member as a co-manager. A charging order protects the autonomy of the original members, and their ability to manage their own enterprise. In a single-member entity, there are no non-debtor members to protect. The charging order limitation serves no purpose in a single member limited liability company, because there are no other parties' interests affected. n9

n8 Colo. Rev. Stat. § 7-80-703 provides:
Rights of creditor against a member. On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the membership interest of the member with payment of the unsatisfied amount of the judgment with interest thereon and may then or later appoint a receiver of the member's share of the profits and of any other money due or to become due to the member in respect of the limited liability company and make all other orders, directions, accounts, and inquiries which the debtor member might have made, or which the circumstances of the case may require. To the extent so charged, except as provided in this section, the judgment creditor has only the rights of an assignee of the membership interest. The membership interest charged may be redeemed at any time before foreclosure. If the sale is directed by the court, the membership may be purchased without causing a dissolution with separate property by any one or more of the members. With the consent of all members whose membership interests are not being charged or sold, the membership may be purchased without causing a dissolution with property of the limited liability company. This article shall not deprive any member of the benefit of any exemption laws applicable to the member's membership interest.

n9 The harder question would involve an LLC where one member effectively controls and dominates the membership and management of an LLC that also involves a passive member with a minimal interest. If the dominant member files bankruptcy, would a trustee obtain the right to govern the LLC? Pursuant to Colo. Rev. Stat. § 7-80-702, if the non-debtor member did not consent, even if she held only an infinitesimal interest, the answer would be no. The Trustee would only be entitled to a share of distributions, and would have no role in the voting or governance of the company. Notwithstanding this limitation, 7-80-702 does not create an asset shelter for clever debtors. To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with "peppercorn" co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse. 11 U.S.C. § § 544(b)(1) and 548(a).

The Colorado limited liability company statute provides that the members, including the sole member of a single member limited liability company, have the power to elect and change managers. n10 Because the Trustee became the sole member of Western Blue Sky LLC upon the Debtor's bankruptcy filing, the Trustee now controls, directly or indirectly, all governance of that entity, including decisions regarding liquidation of the entity's assets.

n10 See Colo. Rev. Stat. § 7-80-402 and § 7-80-405.

Because of the Court's ruling herein, the Debtor may be entitled to a claim for her contributions made to preserve an asset of this bankruptcy estate based on post-petition mortgage payments on the Real Property. The parties were asked to brief the issue, but the Debtor has not formally asserted such a claim. Therefore, the Court does not rule on the issue at this time.

Based on the foregoing, it is hereby:

ORDERED that the Trustee, as sole member, controls the Western Blue Sky LLC and may cause the LLC to sell its property and distribute net proceeds to his estate. Alternatively, the Trustee may elect to distribute the LLC's property to [*9] the bankruptcy estate, and, in turn, liquidate that property himself; and it is

FURTHER ORDERED that the Trustee's Motion to appoint Bob Karls as real estate broker for the Trustee is hereby granted; and it is

FURTHER ORDERED that the Debtor may file a claim, subject to objection in the regular course of this case, for her expenditures made to preserve an asset of this estate based on post-petition mortgage or other payments made by the Debtor.

DATED: 4-4-03


A. Bruce Campbell
U.S. Bankruptcy Judge

In April, 2003, a Federal Bankruptcy Court in Colorado held that a bankruptcy trustee could seize control of a single member limited liability company ("SMLLC") and liquidate its assets to satisfy the debtor-member's creditors. In re: Ashley Albright, 291 B.R. 538 (Bankr. D. Colo. 2003). The debtor argued that her member status should limit the trustee's recourse to a charging order and could not assume control or management of the LLC. While slightly different from state to state, a charging order generally permits a creditor to satisfy its claim from a partner's interest in a partnership or an LLC. In the Colorado case, the debtor attempted to use it to restrict the trustee from taking control of the LLC and liquidating its assets to satisfy her creditors' claims.

The Court rejected the premise that a charging order could even be granted in the context of a SMLLC. The Court focused on the primary purpose of a charging order, which is to protect other members of a partnership or LLC from sharing ownership with a member they did not select, (e.g. a bankruptcy trustee). Similar to California, Colorado law permits a member to assign their economic interest in an LLC to outside parties. To assign a membership interest, which permits the holder to participate in the management of the LLC, Colorado law requires unanimous written consent by all other members. California requires majority consent of other members. The Court in this case found, however, that unanimous consent is unnecessary in a SMLCC, because there are no other members to protect. Thus, the goal of a charging order, which is to protect other members, is irrelevant. By filing for bankruptcy, the debtor effectively assigned her entire membership interest in the LLC to the bankruptcy court.

A different situation arises, however, when an LLC includes a passive member and one controlling or dominant member. If the dominant member files for bankruptcy, can a passive member's nonconsent bar the trustee from assuming the debtor's membership interest? The court concluded that the answer is yes, even if the passive member has a minimal interest and management role in the LLC. Rather, the trustee would simply be entitled to a charging order, which would provide the bankruptcy with the normal share of distributions attributed to the debtor-member. Nonetheless, the Court warned that this does not create "an asset shelter for clever debtors." The debtor will be subject to bankruptcy avoidance provisions and fraudulent transfer laws if they intend to hinder or defraud creditors through a "multi-member LLC with 'peppercorn' co-members."

The ramifications of this case are clear. A business planner should not create a SMLLC where creditors of the member are a concern. Under no circumstances should a SMLLC be used solely for asset protection. Asset protection is still a valuable result of an LLC; however, to realize these benefits, the LLC must include other members with more than minimal interests and demonstrable control commensurate with their interest. Furthermore, the SMLLC should protect the member from creditors of the SMLLC, similar to the veil provided by a corporation. These additional members need not be on equal footing with the dominant member, but they must be more than "peppercorn" members. So far this is the first case following this view, but it is reasonable to expect that other bankruptcy courts will adopt a similar rule to reach assets assigned to a SMLLC solely for asset protection.

A word to the wise is that no single structure provides "bullet-proof" asset protection. Asset protection is best done in layers and there should be other economic or business reasons to justify the planning.



In re ) Chapter 7
Debtor. )

LOUIS A. MOVITZ, Trustee, ))

Plaintiff, ) ADVERSARY NO. 04-00956


Defendant. )

The Court here concludes that because the operating agreement of a limited liability company imposes no obligations on its members, it is not an executory contract. Consequently when a member who is not the manager files a Chapter 7 case, his trustee acquires all of the member’s rights and interests pursuant to Bankruptcy Code1 §§ 541(a) and (c)(1), and the limitations of §§365(c) and (e) do not apply.

Procedural Background
Plaintiff Louis A. Movitz (“Trustee”) is the Chapter 7 Trustee for the estate of Debtor Gregory L. Ehmann (“Debtor”). The Trustee has sued Defendant Fiesta Investments, LLC (“Defendant” or “Fiesta”), an Arizona limited liability company of which the Debtor was a member when his bankruptcy case was filed. The Trustee’s suit seeks a declaration that the Trustee has the status of a member in Fiesta, a determination that the assets of Fiesta are being wasted, misapplied or diverted for improper purposes, and an order for dissolution and liquidation of Fiesta or the appointment of a receiver for Fiesta.

Fiesta has moved to dismiss the complaint. The Court understood Fiesta’s motion as directed to Count II of the complaint to be based solely on an argument that the Court lacks subject matter jurisdiction, which this Court has already denied. The motion to dismiss Count I rests more on substantive law, arguing essentially that the Trustee has no rights with respect to Fiesta other than the right to receive a distribution that might have been made to the Debtor if and when Fiesta decides to make such a distribution. Such a motion to dismiss should be granted only if the Court concludes that the Trustee could prove no set of facts that would entitle him to any remedy other than simply waiting to see if Fiesta should ever decide to make a distribution.

Background Facts
The Trustee’s complaint identifies Fiesta as an Arizona limited liability company that was formed in approximately 1998 by the Debtor’s parents, Anthony and Alice Ehmann. At the time it was formed, it had two assets, a 17% interest in City Leasing Co. Ltd. and 25% interest in Desert Farms LLC. Shortly after this bankruptcy case was filed, however, City Leasing was liquidated and as a result of that liquidation Fiesta received cash distributions in the amount of approximately $837,000 in the summer of 2000. Fiesta is still receiving regular quarterly distributions of cash from its other asset, Desert Farms.

The Trustee’s complaint stems from the fact that although no formal distributions have been declared or paid to members, and certainly not to the Debtor, substantial amounts of cash have flowed out of Fiesta to or for the benefit of other members, including $374,500 in loans to members or to corporations owned or controlled by members, a $42,500 payment to one member, and $124,000 paid to another member to redeem his interest. In response to the Trustee’s demand for information and distributions, the managing member of Fiesta, the Debtor’s father, responded that he had created “Fiesta a few years ago to remove assets from our estate for estate tax purposes, and to accumulate investments for the benefit of our children after our deaths .

[W]e see no reason to accede to the wishes of any member or assignee of any member which runs contrary to our original goals.” Yet the outflow of over half a million dollars does not seem to be consistent with the original goal “to accumulate investments for the benefit of our children after our deaths.”

The Parties’ Arguments
While the parties disagree on several relevant legal principles, a dispute that is absolutely central to the motion to dismiss is whether the Trustee’s rights are governed by Bankruptcy Code § 541(c)(1) or by § 365(e)(2). In a very general sense, the latter provision, if applicable, permits the enforcement of state and contract law restrictions on the Trustee’s rights and powers, whereas the former provision, if applicable, would render such restrictions and conditions unenforceable as against the Trustee. Because § 541 applies generally to all property and rights that the Trustee acquires, whereas § 365 applies more specifically to executory contract rights, the answer to this question hinges on whether the Trustee is asserting a property right or an executory contract right.

The Trustee’s complaint does not expressly seek to exercise any rights under an executory contract, nor does it identify the Fiesta Operating Agreement as being an executory contract, but merely attaches it as an exhibit. Indeed, as Fiesta notes, the deadline for the Trustee to have assumed or rejected an executory contract has long since passed.2 In its motion to dismiss, Fiesta relies heavily on various provisions of the Fiesta Operating Agreement which provide that in the event a trustee acquires a member’s interests, such action shall not dissolve the company or entitle “any such assignee to participate in the management of the business and affairs of the company or to exercise the right of a Member unless such assignee is admitted as a Member . . . .” Operating Agreement ¶7.2. “Such an assignee that has not become a Member is only entitled to receive to the extent assigned the share of distributions . . . to which such Member would otherwise be entitled with respect to the assigned interest.” Id. Fiesta further notes that such limitations on the rights of assignees of members’ interests in LLCs are specifically authorized by state law, Arizona Revised Statutes (“A.R.S.”) § 29-732(A). Fiesta also argues that the Trustee is akin to a judgment creditor, and that A.R.S. § 29-655(c) provides that a charging order is the exclusive remedy by which a judgment creditor of a member may satisfy a judgment out of the member’s interest in an LLC. Nowhere in its motion to dismiss, however, does Fiesta argue that the Operating Agreement creates an executory contract between Members and the LLC, that § 365(e)(2) renders such provisions on which Fiesta relies enforceable against the Trustee, or that § 541(c)(1) is for some other reason inapplicable.

In response, the Trustee argues that he is not a mere assignee of the Debtor’s membership interest, but rather acquired all of the Debtor’s right, title and interest pursuant to §541(a). He argues, further, that the Trustee took the Debtor’s rights free of certain conditions and restrictions that would otherwise devalue the asset in the hands of any other assignee, pursuant to § 541(c)(1).

In reply, Fiesta relies on § 365(e) to maintain that the state and contract law restrictions are enforceable against the Trustee notwithstanding § 541(c)(1). Nowhere, however, does Fiesta ever establish, much less even attempt to demonstrate, that the Trustee’s complaint seeks to enforce rights under an executory contract. To the contrary, Fiesta simply assumes or flatly asserts that the Trustee’s rights hinge entirely on an executory contract: “In the case at bar, there is no dispute that if the Operating Agreement is considered as a partnership agreement it is an executory contract.” Fiesta Reply at 6. And yet the very case that Fiesta cites after making that assertion itself concluded that a partnership relationship may include both an executory contract and a nonexecutory property interest in the profits and surplus. Cutler v. Cutler (In re Cutler), 165 B.R. 275, 280 (Bankr. D. Ariz. 1994)(Case, B.J.).

If a partnership relation entails both executory contract rights and nonexecutory property rights, then it would seem to necessitate a threshold determination of which kind of rights are at issue for the particular kind of relief a Trustee seeks with respect to a partnership or LLC. Before reaching that issue, however, it may be fruitful first to examine whether the Fiesta Operating Agreement even includes any executory contract rights.

Legal Analysis
Although the Bankruptcy Code contains no definition of an executory contract, the Ninth Circuit has adopted the “Countryman Test”: “[A] contract is executory if ‘the obligations of both parties are so far unperformed that the failure of either party to complete performance would constitute a material breach and thus excuse the performance of the other.’”3

While Fiesta undoubtedly owes many obligations to its members pursuant to the Operating Agreement, for the contract to be executory there would also have to be some material obligation owing to the company by the member. Moreover, such member’s obligation must be so material that if the member did not perform it, Fiesta would owe no further obligations to that member.

As noted above, in its briefing on the motion to dismiss Fiesta has not attempted to demonstrate that the Operating Agreement is in fact an executory contract, much less to demonstrate exactly what material obligation is owed to the company by its members. Moreover, the founding member’s statement of the purposes for which the company was formed suggests that it is very likely there are no such obligations. The purpose was twofold: to remove assets from the parents’ estates for estate tax purposes, and to accumulate investments for the benefit of their children after their deaths. One would certainly not expect the children-members to have any obligations with respect to satisfaction of that first goal, which was a unilateral act by the parents, and it is highly unlikely the children-members undertook any obligations with respect to the second goal, any more than would an ordinary prospective heir.

This suspicion is borne out by a close reading of the Operating Agreement itself. It imposes many obligations on the managers, but as noted above the manager is the Debtor’s father, not the Debtor. Article V is entitled “Rights and Obligations of Members,” but in fact it identifies only rights and no obligations. It (1) limits members’ liability for company debts, (2) grants members the right to obtain a list of other members, grants members the right to approve by majority vote the sale, exchange or other disposition of all or substantially all of the company’s assets, (4) grants the members rights to inspect and copy any documents, (5) grants members the same priority as to return of capital contributions or to profits and losses, and (6) grants the permissible transferee of a member’s interests the right to require the company to adjust the basis of the company’s property and the capital account of the affected member. In short, the Article of the Operating Agreement that is partially titled “Obligations of Members” reveals that members have no obligations to the company.

In the entire Agreement, the only provision where members, who are not managers, agree to do anything is Article 7.4, which provides in part that “Each member agrees not to voluntarily withdraw from the company as a member . . . .” It is now questionable in the Ninth Circuit whether such an agreement merely to refrain from acting is sufficient, standing alone, to create an executory contract.4 But we need not go that far to resolve this issue, because the sentence in which each member agrees not to voluntarily withdraw goes on to say: “[A]nd each Member further agrees that if he attempts to withdraw from the Company in violation of the provisions of this paragraph, he shall receive One Dollar ($1.00) in payment of his interest in the Company and the remaining portion of such Member’s interest shall be retained by the Company as liquidated damages.” This reveals that what at first may have appeared as a mandatory obligation is in fact merely an option, which gives each member the option of withdrawing if he is willing to accept $1.00 for his interest. But under Helms, such an unexercised option is not an executory contract.5

As demonstrated by the excellent analysis in Smith,6 it is facile to assume that all partnership agreements are executory contracts. Closer analysis reveals that if there are no material obligations that must be performed by the members of a limited liability company or the limited partners in a limited partnership, then the contract is not executory and is not governed by Code § 365.7 This case is therefore unlike others that have expressly found “an obligation to contribute capital” and other “continuing fiduciary obligations among the partners that make this [Partnership] Agreement an executory contract.”8

In the absence of any obligation on the part of the member, it is difficult to see where an executory contract lies. This is consistent with the whole purpose of Fiesta. It was created simply as a way to reduce the estate tax liabilities that might otherwise have been incurred upon the death of the parents and the distribution of their estate to their heirs. Indeed, as King Lear suggests, the irrevocable transfer of the parents’ assets to Fiesta and the irrevocable gift of membership interests in Fiesta to their children probably creates even less obligations on the children than the ordinary filial obligations morally felt by most expectant heirs.

Moreover, not only do there not appear to be any obligations imposed upon members by the Fiesta Operating Agreement, but there are certainly none with respect to either receipt of a distribution or proper management of the company by its managers. Members do not have to do anything to be entitled to proper management of the company by the managers. The Trustee’s complaint does not involve the Debtor’s lone arguable obligation not to voluntarily withdraw.

Because there are no obligations imposed on members that bear on the rights the Trustee seeks to assert here, the Trustee’s rights are not controlled by the law of executory contracts and Bankruptcy Code § 365. Consequently the Trustee’s rights are controlled by the more general provision governing property of the estate, which is Bankruptcy Code § 541.

Code § 541(c)(1) expressly provides that an interest of the debtor becomes property of the estate notwithstanding any agreement or applicable law that would otherwise restrict or condition transfer of such interest by the debtor. All of the limitations in the Operating Agreement, and all of the provisions of Arizona law on which Fiesta relies, constitute conditions

and restrictions upon the member’s transfer of his interest. Code § 541(c)(1) renders those restrictions inapplicable. This necessarily implies the Trustee has all of the rights and powers with respect to Fiesta that the Debtor held as of the commencement of the case.

It therefore appears that the Trustee may be able to prove a set of facts that would entitle the Trustee to some remedy. The appropriate remedy might include a declaration of the Trustee’s rights, redemption of the Debtor’s interest,9 appointment of a receiver to operate the partnership in accordance with its purposes and the members’ rights,10 or dissolution, wind up and liquidation. Consequently Fiesta’s motion to dismiss must be denied.

1 Unless otherwise indicated, all chapter, section, and rule references are to the Bankruptcy
Code, 11 U.S.C. §§ 101-1330, and to the Federal Rules of Bankruptcy Procedure, Rules 1001-9036.

2 The bankruptcy case was filed as a voluntary Chapter 7 on May 26, 2000. Bankruptcy Code § 365(d)(1) provides that in a Chapter 7 case, an executory contract is deemed rejected unless assumed or rejected by the Trustee within 60 days after the filing of the case.

3 Unsecured Creditors’ Comm. v. Southmark Corp. (In re Robert L. Helms Constr. and Dev. Co., Inc.), 139 F.3d 702, 705 (9th Cir. 1998), quoting Griffel v. Murphy (In re Wegner), 839 F.2d 533, 536 (9th Cir. 1988), and citing Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 MINN. L. REV. 439, 460 (1973).

4 In the case where the Ninth Circuit first expressly adopted the Countryman test, it held that such an agreement to refrain from acting may be sufficient to make a contract executory: “ Because of the exclusive nature of the license which Fenix received, Select-A-Seat was under a continuing obligation not to sell its software packages to other parties. Violation of this obligation would be a material breach of the licensing agreement.” Fenix Cattle Co. v. Silver (In re Select-A-Seat Corp.), 625 F.2d 290, 292 (9th Cir. 1980)(decided under the prior Bankruptcy Act). That decision was legislatively repealed in 1984 by the adoption of § 365(n). More recently, the en banc decision in Helms, supra note 3, reformulated the test in a way that focuses only on affirmative performance: “The question thus becomes: At the time of filing, does each party have something it must do to avoid materially breaching the contract?” 139 F.3d at 706. And the Andrews/Westbrook analysis, as thoroughly explained in In re Bergt, 241 B.R. 17, 21-36 (Bankr. D. Alaska 1999), demonstrates that it makes no sense to determine the “executoriness” of a contract if its assumption would impose no administrative liability on the estate, because the avoidance of such administrative liability when it exceeds the contractual benefits is the sole reason for executory contract law.

5 Helms, supra note 3, at 705.

6 Samson v. Prokopf (In re Smith), 185 B.R. 285, 292-93 (Bankr. S.D. Ill. 1995) (a majority of courts that have found limited partnership agreements to be executory contracts “have either accepted the executory contract characterization summarily or have dealt with limited partnership agreements under which the limited partner has continuing financial obligations to the partnership.”).

7 See, e.g., In re Garrison-Ashburn, L.C., 253 B.R. 700, 708-09 (Bankr. E.D. Va. 2000)(there is no executory contract and § 365 does not apply to an operating agreement that imposes no duties or responsibilities on its members, but merely provides for the structure of the management of the entity); Smith, supra note 6, at 291-95 (limited partnership agreement was not executory as to a limited partner/debtor who had no material obligations to perform; the Chapter 7 trustee steps into the shoes of the debtor and may exercise debtor’s right to dissolve the partnership).

8 Calvin v. Siegal (In re Siegal), 190 B.R. 639, 643 (Bankr. D. Ariz. 1996)(Case, J.), citing In re Sunset Developers, 69 B.R. 710, 712 (Bankr. D. Idaho 1987). See also Summit Invest. and Dev. Corp. v. Leroux, 69 F.3d 608 (1st Cir. 1995)(§ 365 applies to general partner debtors who have duties and obligations to limited partnership); Broyhill v. DeLuca (In re DeLuca), 194 B.R. 65 (Bankr. E.D. Va. 1996)(§ 365 applies to debtors who were managers of limited liability companywith ongoing duties and responsibilities; because debtors’ personal identity and participation were material to the development project, the § 365(e)(2) exception to assumption applies); In re Daugherty Constr., Inc., 188 B.R. 607, 612 (Bankr. D. Neb. 1995)(operating agreements are executory contracts because there are material unperformed and continuing obligations among the members, including participation in management and contributions of capital).

9 As noted above, Fiesta has already redeemed one member’s interest for $124,000. That suggests that it has the power to do so, that redemption of a member’s interest is not contrary to Fiesta’s interests or purposes, and that $124,000 might be an appropriate value for the Debtor’s interest. Because the schedules filed in this case reflect priority and unsecured debts of less than $70,000, such a remedy might entirely satisfy the Trustee while simultaneously avoiding any disruption of the partnership or any conflict with the purposes for which it was created.

10 Although § 105(b) provides that “a court may not appoint a receiver in a case under this title,” the precise language of that provision and case law make clear that it applies only to the administrative bankruptcy “case,” not to an adversary proceeding. A “case” is what is commenced by the filing of a petition, e.g., § 301, whereas a “proceeding” is commenced by a summons and complaint, Bankruptcy Rules 7001 & 7004. The provision was added simply because the Code “has ample provision for the appointment of a trustee when needed.” S. Rep. No. 989, 95th Cong. 2d Sess. 29 (1978). Consequently § 105 (b) “does not prohibit the appointment of a receiver in a related adversary proceeding if otherwise authorized and appropriate.” 2 LAWRENCE P. KING, COLLIER ON BANKRUPTCY ¶ 105.06, at 105-84.7 (15th Ed. 2004). Accord, Craig v. McCarty Ranch Trust (In re Cassidy Land and Cattle Co.), 836 F.2d 1130, 1133 (8th Cir. 1988); In re Memorial Estates, Inc., 797 F.2d 516, 520 (7th Cir. 1986)(“The power cut off by section 105(b) of the Bankruptcy Code is the power to appoint a receiver for the bankrupt estate, that is, a receiver in lieu of a trustee.”).

Dated this 13th day of January, 2005.
/s/ Randolph J. Haines
Randolph J. Haines
U.S. Bankruptcy Judge
Copy of the foregoing mailed
this 13th day of January, 2005, to:
Terry A. Dake, Esq.
11811 North Tatum Boulevard, Suite 3031
Phoenix, AZ 85028-1621
Attorney for Trustee
Louis Movitz
P. O. Box 3137
Carefree, AZ 85377-3137
Mark W. Roth, Esq.
Hebert Schenk P.C.
4742 North 24th Street, Suite 100
Phoenix, AZ 85016-4858
Attorney for Fiesta
/s/ Pat Denk
Judicial Assistant



Kentuckiana Healthcare, LLC (the “Company”), a limited liability company formed under the laws of Kentucky, operated a nursing home in Scottsburg, Indiana, under the trade name Scott County Healthcare Center. It failed to pay withholding and FICA taxes for some of the tax periods ending between 12/2000 and 3/2002. Frank Littriello (“Littriello”), the plaintiff in this case, was the sole member of the Company during the tax periods in question. The IRS notified Littriello of its intent to levy his property to enforce previously filed notices of federal tax liens for the Company’s unpaid withholding and FICA taxes.1 Littriello requested a due process hearing with the IRS Appeals office in Louisville, Kentucky.

The Appeals Office determined that Littriello was individually liable for the Company’s unpaid withholding and FICA taxes. It held that under Treas. Reg. § 301.7701-3(b)(1)(iii), a single member limited liability company that did not elect to be treated as a corporation is considered as a disregarded entity for federal tax purposes. As such, its activities are treated in the same manner as a sole proprietorship, division or branch of the owner under Treas. Reg. §301.7701-3(a). Through this federal action Littriello seeks judicial review and redetermination of that decision.

The real dispute here concerns the validity of the so-called “check-the-box” regulations for corporations and partnerships. Treas. Reg. § 301.7701-1 through 3. Littriello contends that the check-the-box regulations constitute an invalid exercise of the Treasury’s authority to issue interpretive regulations under Internal Revenue Code (“IRC”) § 7805(a) and are, thus, unenforceable. If the regulations are invalid, then the Company alone is liable for the taxes at issue. The Commissioner argues that the regulations are valid and that as applied here Littriello is individually liable for the Company’s tax obligation. Both sides have moved for summary judgment.


The IRS and the Treasury Department proposed the check-the-box regulations in 1996 to simplify entity classification for tax purposes, believing that the prior regulations had become unnecessarily cumbersome, complex and risky for affected entities. The current regulations function in a relatively straightforward fashion. The Internal Revenue Code treats business entities differently depending upon whether the business entity is classified as a corporation or a partnership. IRC § 7701(a)(3) defines the term “corporation” to include associations, joint-stock companies, and insurance companies. IRC § 7701(a)(2) defines the term “partnership” to include any syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation. The regulations provide that for the purposes of IRC § 7701(a)(3) any unincorporated business entity that is not a publicly traded partnership covered by IRC § 7704 may elect whether or not to be classified as an association. Thus, an unincorporated business entity like the Company can generally elect whether or not to be subject to the corporate tax. A default treatment applies under a variety of circumstances where a business entity chooses not to be considered a corporation. If an unincorporated business entity with more than one member elects not to be treated as an association, it will be treated for federal tax purposes as a partnership. If an unincorporated business entity with only one member elects not to be treated as an association, it will be treated for federal tax purposes as a disregarded entity and taxed as a sole proprietorship. Treas. Reg. §301.7701-3(a).


The Court now considers the validity of the check-the-box regulations.2 Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1989), governs the analysis for reviewing agency regulations. The Supreme Court established a two-part analysis:

When a court reviews an agency's construction of the statute which it administers, it is confronted with two questions. First, always, is the question whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress. If, however, the court determines Congress has not directly addressed the precise question at issue, the court does not simply impose its own construction on the statute, as would be necessary in the absence of an administrative interpretation. Rather, if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency's answer is based on a permissible construction of the statute.

Id. at 842-43 (footnotes omitted). The Sixth Circuit has employed Chevron when assessing the validity of interpretive Treasury regulations. Hospital Corporation of America & Subsidiaries v. Commissioner, 348 F.3d 136, 140 (6th Cir. 2003); Ohio Periodical Distributors, Inc. v. Commissioner, 105 F.3d 322, 324-326 (6th Cir. 1997).


Under step one of the Chevron analysis the Court looks to whether the intent of Congress is clear on the precise issue of business classification for federal tax purposes. The IRC defines “partnership” and “corporation” as being mutually exclusive. A business entity for tax purposes is defined either as a partnership or as a corporation. Littriello contends that the check-the-box regulations violate this manifest intent because two identical business entities may elect different classifications. The Commissioner responds that the term “association” in the statutory definition of a corporation is ambiguous.

Read together IRC § 7701(a)(2) and § 7701(a)(3) do not seem to make a clear distinction between an “association” which is treated for tax purposes as a corporation and a “group pool or joint venture” which is treated for tax purposes as a partnership. The definition of the “corporation” in the IRC dates from the Revenue Act of 1918 and the definition of the term “partnership” was added in 1932. Since then, Kentucky has endorsed the limited liability company as a popular business form. Business entities formed under state law most often seek to combine the limited liability of a corporation with the tax benefits of a partnership exacerbating the ambiguity in the definitions section of the statute. A business entity registered in Kentucky as a limited liability company does not fall squarely in either the partnership or corporation category as defined in the IRC. This is undoubtedly true in most other states as well. Indeed, the ambiguity is part of the reason for providing unincorporated business entities with a choice of treatment. Therefore, the Court concludes that the Commissioner’s argument that the statute is ambiguous on this point is more persuasive than Littriello who seeks to impose clarity where the Court finds none.


Step two of the Chevron analysis requires the Court to decide “whether the agency’s answer is based on a permissible construction of the statute.” Id. at 843. The Treasury promulgated the check-the-box regulations pursuant to its general authority to issue “needful rules and regulations for the enforcement of [the IRC].” IRC § 7701(a). The regulations at issue interpret the definitions sections of the IRC. The classification of a business entity affects how the IRS assesses tax liability.

Littriello argues that the plain meaning of the Internal Revenue Code forecloses the possibility of an elective regime because “taxation as intended by Congress is based on the realistic nature of the business entity.” Pls.’ Mot. for Summ. J. p 8. Littriello’s primary evidence in support of this contention appears to be the previous Treasury regulations, effective prior to January 1, 1997. Former Treas. Reg. § 301.7701-2(1960). These regulations, commonly referred to as the Kintner regulations, looked to six corporate characteristics to determine the tax status of a business entity. The Kintner regulations enumerated the factors used by the Supreme Court in Morrissey v. Commissioner, 296 U.S. 344 (1935) to define the characteristics of a pure corporation: (1) associates; (2) an objective to carry on a business and divide the gains there from; (3) continuity of life; (4) centralization of management; (5) liability for corporate debts limited to property; and (6) free transferability of interests. Most every business entity has associates and an objective to carry out a business and profit. Before the check-the-box regulations, any business entity the IRS found to meet three of the remaining four corporate characteristics was classified as a association and taxed as a corporation. Business entities that contained only two of the remaining four where classified and taxed as a partnership. Former Treas. Reg. § 301.7701-2(a)(1).

Littriello is correct that under the former regulations the Company might have been classified differently. Of course, under the current regulations, the Company could have elected to be classified differently. Moreover, Congressional intent does not attach to the previous regulations. Indeed, Congress appears only to have spoken on this issue through the existing statutes. The check-the-box regulations are only a more formal version of the informally elective regime under the Kintner regulations. A business entity could pick at will which two corporate characteristics to avoid in order to qualify as a partnership under the Kintner regulations. The importance of the change is that under the current regulations a business entity may elect to be taxed as a corporation without specific reference to its corporate characteristics.

While some reasonable arguments support Littriello’s position, the Court ultimately finds them unpersuasive. Under the circumstances, the check-the-box regulations seem to be a reasonable response to the changes in the state law industry of business formation. The rise of the limited liability corporation presents a malleable corporate form incompatible with the definitions of the IRC. The newer regulations allow similar flexibility to the Kintner regulations, with more certainty of results and consequences. Considering the difficulty in defining for federal tax purposes the precise character of various state sanctioned business entities, the regulations also seem to provide a flexible permissible construction of the statute.


Littriello advances a number of arguments that the Court finds not sufficiently persuasive to change its basic analysis. Littriello says that the check-the-box regulations violate the basic principle of treating like entities alike under the IRC. It is fundamentally wrong, according to Littriello, that two business entities identical in every relevant respect would be classified and thereby taxed differently solely because of a box checked on a form. A single member LLC with all six of the pure corporation characteristics could elect not to be treated as a corporation for federal tax purposes. Conversely a single member LLC with no traditionally corporate characteristics could nevertheless elect to be classified and taxed as a corporation perhaps with the goal of limiting the assets available to that organization’s tax liability. This elective function is of course the very point of the check-the-box regulations. In today’s business environment, not all corporations are alike and not all partnerships share the same characteristics. In response to an ambiguous statutory definition coupled with a variety of legally created business forms, the Treasury decided that entities may choose their form for tax purposes within the limits of the IRC. Business entities get the good and the bad with their choice. This new criterion added with the check-the-box regulations appears eminently reasonable.

In a somewhat related argument, Littriello argues that the check-the-box regulations impermissibly alter the legal status of his state law created LLC. This construction of the statute, the argument goes, is impermissible because it disregards the separate existence of the LLC and its sole member created under state law.3 The Court finds this argument unpersuasive because the check-the-box regulations apply only for federal tax liability purposes. Littriello will not be held liable for other debts of his LLC, he is only being held liable for the relevant tax liability under the IRC. The Court concludes that the reasonableness of this approach considered with the Treasury’s general authority to interpret what is on its face an ambiguous statutory provision supports a finding that the check-the-box regulations are valid.

Littriello also argues that, at least with regard to taxes withheld from employees of the Company, his obligation is a debt owed the IRS as its agent not a tax liability. As a member of an LLC, Littriello would not be liable for that LLC’s debts under Kentucky law. While Littriello’s is a novel argument, the Court agrees with the IRS that taxes withheld from employees of the Company are the responsibility of the employer, here Littriello, not as an agent but as a taxpayer. IRC § 3402.

Finally, Littriello argues that IRC § 6672 is the IRS’s sole statutory recourse. To impose tax liability against him under this section, the IRS must prove that Littriello was the responsible person for the lapses in turning over withheld wages which it has not done. This argument lacks merit because the IRS has imposed tax liability upon Littriello as the owner of a sole proprietorship. The Commissioner’s assertion that the IRS has not pursued a claim against Littriello under IRC § 6672 is well taken and supported by the evidence. Moreover, that the IRS might have more than one possible avenue for enforcement does not imply an impermissible construction of the statute.

The Court will grant Defendant’s motion for summary judgment on the issue of the validity of the check-the-box regulations. The Court will enter an order consistent with this Memorandum Opinion.

cc: Counsel of Record
May 18, 2005

1 Defendant seeks to have the Commissioner of Internal Revenue (the “Commissioner”) substituted as the proper defendant. Littriello makes no objection to this suggestion.

2 The Court can find no appellate or district court opinions considering the validity of the check-the-box regulations. One Tax Court opinion, Dover Corporation v. Commissioner of Internal Revenue, 122 T.C. 324 (2004), discusses the regulations and notes that “some commentators” had questioned whether they constitute a valid exercise of regulatory authority. Id. at 330-31 (n.7). Neither party challenged the validity of the regulations in that case.

3 Littriello relies heavily on U.S. v. Galletti, 541 U.S. 114 (2004) contending that Galletti is in conflict with disregarding a state law entity. In Galletti, the Supreme Court held that the assessment of a general partnership as the relevant taxpayer under IRC § 6203 extended the time for collecting from that employer’s general partners who were liable for payment of partnership's debts. To the extent that it is relevant at all, this case supports the Commissioner’s contention that the definition of a taxpayer is not made with reference to a person’s legal status under state law.

Supreme Court of Florida
No. SC08-1009
SHAUN OLMSTEAD, et al., Appellants,
[June 24, 2010]

In this case we consider a question of law certified by the United States Court of Appeals for the Eleventh Circuit concerning the rights of a judgment creditor, the appellee Federal Trade Commission (FTC), regarding the respective ownership interests of appellants Shaun Olmstead and Julie Connell in certain Florida single-member limited liability companies (LLCs). Specifically, the Eleventh Circuit certified the following question: ―Whether, pursuant to Fla. Stat. § 608.433(4), a court may order a judgment-debtor to surrender all ‗right, title, and interest‘ in the debtor‘s single-member limited liability company to satisfy an - 2 - outstanding judgment.‖ Fed. Trade Comm‘n v. Olmstead, 528 F.3d 1310, 1314 (11th Cir. 2008). We have discretionary jurisdiction under article V, section 3(b)(6), Florida Constitution. The appellants contend that the certified question should be answered in the negative because the only remedy available against their ownership interests in the single-member LLCs is a charging order, the sole remedy authorized by the statutory provision referred to in the certified question. The FTC argues that the certified question should be answered in the affirmative because the statutory charging order remedy is not the sole remedy available to the judgment creditor of the owner of a single-member limited liability company. For the reasons we explain, we conclude that the statutory charging order provision does not preclude application of the creditor‘s remedy of execution on an interest in a single-member LLC. In line with our analysis, we rephrase the certified question as follows: ―Whether Florida law permits a court to order a judgment debtor to surrender all right, title, and interest in the debtor‘s single-member limited liability company to satisfy an outstanding judgment.‖ We answer the rephrased question in the affirmative. .

IRS Regs 1.469-1T(e)(6)
Activity of trading personal property--
1.469-1T(e)(6)(i) In general.
An activity of trading personal property for the account of owners of interests in the activity is not a passive activity (without regard to whether such activity is a trade or business activity (within the meaning of paragraph (e)(2) of this section)).
1.469-1T(e)(6)(ii) Personal property.
For purposes of this paragraph (e)(6), the term "personal property" means personal property (within the meaning of section 1092(d), without regard to paragraph (3) thereof).
1.469-1T(e)(6)(iii) Example.
The following example illustrates the application of this paragraph (e)(6):
A partnership is a trader of stocks, bonds, and other securities (within the meaning of section 1236(c)). The capital employed by the partnership in the trading activity consists of amounts contributed by the partners in exchange for their partnership interests, and funds borrowed by the partnership. The partnership derives gross income from the activity in the form of interest, dividends, and capital gains. Under these facts, the partnership is treated as conducting an activity of trading personal property for the account of its partners. Accordingly, under this paragraph (e)(6), the activity is not a passive activity.

[ Home ] [ Webmaster ] [ We Listen ] [ CPA Services ] [ Who We Are ] [ Order the TradersTaxPlan ]

Last updated: November 26, 2015

web counter
visitors since
January 2014
, TradersTaxPlan, TradersAdvantage,
, DoYourOwnTaxes, DoingYourOwnTaxes,,,,
, DoYourOwnTaxesOnline
,, and
are trademarks and service marks of Colin M. Cody, CPA and, LLC, Trumbull Connecticut
Copyright© 2004 to 2015 Colin M. Cody, CPA and, LLC, All Rights Reserved