New York Sales Tax Trap

For many business owners, the LLC form of doing business is the preferred format. An LLC provides a number of benefits to the owner by limiting liability, providing for a single tax (no tax at the entity level) and by providing flexibility in capitalization and ownership. For those LLCs which are doing business in the State of New York, however, this form of business can be deadly. In a decision handed down on December 23, 2009 by the New York Tax Appeals Tribunal, the panel upheld the provision of the New York Sales and Use Tax law that imposes absolute personal liability on any member of a partnership or limited liability company for all of the unpaid liabilities of the partnership or LLC in which they hold an interest.

In the Matter of Santo DTA821797, N.Y.S. Tax App. Triv. December 23, 2009, the court found that Joseph P. Santo who entered into a business venture structured in the form of an LLC was personally liable for unpaid sales taxes. Mr. Santo entered into this business venture (a restaurant) with others. Mr. Santo contributed no capital to the LLC, but later loaned the LLC all of his savings - $15,000. Another member (Scotti) was in charge of all the financial operations of the LLC. In 2005, the restaurant opened, but had difficulty paying its construction creditors. In May of 2006, the tax department issued a Notice of Determination to Mr. Santo finding him liable for almost $200,000 of the LLC’s unpaid sales tax.

At trial, the Administrative Law Judge applied the “duty to act standard” found in the statute, and determined that Mr. Santo was not responsible for the financial management of the LLC and, therefore, was not responsible to pay the sales tax. In December 2009, however, the Appeal Tribunal reversed the Administrative Law Judge holding that it was an error for the Administrative Law Judge to treat Mr. Santo as if he were an officer or employee of a corporation. The Tribunal stated that Mr. Santo was a member of an LLC, and as with members of a partnership, such members are subject to the absolute liability standard and “subject to per se liability for the taxes due from the LLC.”

The statute involved in the decision is N.Y. Tax Law Section 1131. The applicable provision is Section 1 of the statute entitled “Persons Required to Collect Tax.” A careful reading of the statute indicates that a person required to collect tax is “any member of a partnership or limited liability company.” The Tribunal interpreted this provision of the Act to impose per se (absolute) liability on any member of a limited liability company.

This decision can be a ticking time bomb for many taxpayers. Moreover, the statue does not only apply to New York limited liability companies, but to all limited liability companies which would be subject to collecting New York sales tax. That would mean any LLC or partnership that was qualified to do business in New York no matter where they were formed.

It would seem that there is a “glitch” in the statute, however, the New York State tax department has issued numerous assessments against individuals who invested small amounts of money to LLCs formed to operate restaurants, bars or similar ventures in exchange for small minority interests in the LLCs with absolutely no right or ability to oversee their operations. It is common for restaurants and similar business to fail and have unpaid sales tax. Often these businesses have little or no records and assessments are made based on estimates which are often much greater than the actual liability. The tax department’s position is that each individual member of the LLC (as well as individual members of upper-tier LLCs) is jointly and severely liable for the full amount of the tax, penalties and interest.

Clients who find themselves in this position should be advised to review the structure of their business to determine their exposure and to modify their business to avoid personal liability.