The following scenario occurs: An individual taxpayer owns a membership interest in an LLC. The LLC owns real or personal property. The LLC is a pass through entity, meaning the income and expense of the LLC passes through to the taxpayer’s individual tax return. If the individual taxpayer does not pay the tax when due and after a demand for payment by the IRS, the IRS may file a Notice of Federal Tax Lien to incumber the property of the taxpayer. But does the Notice of Federal Tax Lien also encumber the property owned by the LLC, in which the taxpayer owns a membership interest?
The following discussion of this question will apply both federal law and general state law and more specifically Montana state law.
Background Law. Federal tax liens are generally filed in the county in which the taxpayer resides or holds property, and they “attach” to all the taxpayer’s property (real and personal) located in that county. Because federal tax liens are matters of public record, they are quickly picked up by title companies as encumbrances on property and therefore can make it difficult – if not impossible – to sell real estate in the county in which the lien is recorded. The title companies will list the tax lien as an encumbrance and exception to the title insurance property.
As to what constitutes “property” for federal tax lien attachment purposes, the term generally gets its definition from state laws. Thus, the question here is whether, under Montana law, or the law of the state where the property is located, “property” subject to a federal tax lien can include (a) the assets of a limited liability company owned in whole or in part by a taxpayer, or (b) the taxpayer’s ownership/distributional interest in the LLC. Although the answer is not entirely clear, the most likely potential outcomes can be summarized as follows:
Either:
(1)(a) the separate and distinct legal status of the LLC is fully respected, and the assets (real property) of the LLC are not considered the taxpayer’s property and are therefore not encumbered by the federal tax lien;
OR
(1)(b) the IRS could argue that the LLC is a mere “alter ego” of the taxpayer and that the assets therefore should be available to satisfy the taxpayer’s individual tax liability under the “reverse veil piercing doctrine” (discussed in more detail in part 2 of 2),
AND:
(2) the IRS can use a federal tax lien to obtain a charging order against the taxpayer’s ownership/distributional interest in the LLC to get at the proceeds of the sale of the LLC’s property.
Under Montana law, it appears that the assets of the LLC would likely not fall within the definition of the individual taxpayer’s “property” subject to a federal tax lien. Specifically, Mont. Code Ann. § 35-8-701(1) (2019) provides that “property transferred to or otherwise acquired by a limited liability company becomes property of the limited liability company” (emphasis added). In other words, “[a] member has no interest in specific limited liability company property.” Id. To the same end, Mont. Code Ann. § 35-8-703(1) (2019) notes that “a member is not a co-owner of, and does not have a transferable interest in, property of a limited liability company.” Thus, the real property owned by the LLC is likely protected from the direct reach of a federal tax lien.
In Part 2 of this article, I will analyze the effect of a federal tax lien on the membership interest in the LLC through reverse veil piercing and a charging order on the member’s interest in the LLC.
Jared M. Le Fevre is a Partner in the Tax, Trusts and Estates Practice Group of Crowley Fleck PLLP. Mr. Le Fevre represents taxpayers before the IRS, IRS Independent Office of Appeals, Tax Court, Federal District Court and state tax agencies throughout Montana, Wyoming, North Dakota, Idaho, and Utah. Mr. Le Fevre is involved in federal and state and local tax audits, appeals, and tax resolution throughout these western states. Mr. Le Fevre also advises clients on the tax effects of business and real estate transactions.