North Carolina has a statute providing that the manager of an LLC doing business in North Carolina must on behalf of out-of-state members remit to the state the estimated tax obligations of those out-of-state members. A recent decision from a bankruptcy court, In re North Carolina Tobacco International, LLC, Case No. 17-51077, 2020 WL 4582282 (Bankr. M.D.N.C. Aug. 10, 2020), considered whether an LLC in bankruptcy is obligated to make those tax payments. Spoiler alert—the court said “no.”
North Carolina Tobacco International, LLC (NCTI) was organized in Missouri but did most if not all of its operations in North Carolina. At least two of its four members were not resident in North Carolina. That NCTI was classified as a partnership for purposes of federal and North Carolina state taxation was not in dispute. The North Carolina tax code requires that with respect to each member of an LLC taxed as a partnership, the LLC’s manager is obligated to remit the estimated taxes of the nonresident members. This statute is far from unique; many states have similar mechanisms for collecting taxes on behalf of nonresident partners/members.
In 2017, NCTI sought protection under chapter 11 of the Bankruptcy Code. In early 2018 the case was converted to a case under chapter 7. Thereafter, the chapter 7 trustee effected several sales of NCTI property. Due to the absence of reliable information as to basis, the entire proceeds of the transactions were treated as gain. The opinion does not lay out the path leading to the trustee’s Motion to Determine that the Estate Should Not Remit Pass-Through Taxes on Behalf of Out-of-State Members, and although North Carolina participated and argued against the motion, the individual members on whose behalf the payments would have been made did not.
North Carolina argued that the tax obligation was that of the LLC, not of its members, and that the LLC was obligated to remit the tax payment. “[T]he Department argues that, contrary to traditional principles of flow through taxation, North Carolina has chosen to place the burden of reporting and paying income tax liability of nonresident partners on the manager of the partnership instead of the nonresident members. Based on Personal Tax Bulletins issued by the Department, the Department argues that the obligation to pay nonresident members’ taxes itself creates a separate and distinct tax obligation on the partnership.” The trustee argued that the tax obligation is that of the members and that the LLC may not under the North Carolina LLC Act nor the bankruptcy code expend its resources to satisfy their obligations.
According to Trustee, payment of income tax on behalf of Debtor’s equity interest holders from the assets of the estate would constitute a distribution to the members ahead of the creditors of the LLC, and therefore would violate the distribution priorities mandated in 11 U.S.C. § 726. Under § 726, creditors must be paid prior to any distribution to equity holders. [Footnote 4: This distribution priority does not differ from the winding up of an LLC under North Carolina law. See N.C. Gen. Stat. §§ 57D-6-07(d) and 57D-6-08(2) (2014).] Therefore, Trustee argues that, to the extent N.C. Gen. Stat. § 105-154(d) purports to require payment of member taxes prior to distributions to creditors, it is preempted by the distribution scheme under § 726.
The court’s ultimate holding was not dependent upon either of these paradigms, but the trustee won the day. The court’s analysis focused upon 11 U.S.C. § 346, finding that it preempted the North Carolina statute in question. The decision recited subsection (b) and (c) of section 346, adding emphasis to a portion of (b) as follows:
(b) Whenever the Internal Revenue Code of 1986 provides that no separate taxable estate shall be created in a case concerning a debtor under this title, and the income, gain, loss, deductions, and credits of an estate shall be taxed to or claimed by the debtor, such income, gain, loss, deductions, and credits shall be taxed to or claimed by the debtor under a State or local law imposing a tax on or measured by income and may not be taxed to or claimed by the estate. The trustee shall make such tax returns of income of corporations and of partnerships as are required under any State or local law, but with respect to partnerships, shall make such returns only to the extent such returns are also required to be made under such Code. The estate shall be liable for any tax imposed on such corporation or partnership, but not for any tax imposed on partners or members.
(c) With respect to a partnership or any entity treated as a partnership under a State or local law imposing a tax on or measured by income that is a debtor in a case under this title, any gain or loss resulting from a distribution of property from such partnership, or any distributive share of any income, gain, loss, deduction, or credit of a partner or member that is distributed, or considered distributed, from such partnership, after the commencement of the case, is gain, loss, income, deduction, or credit, as the case may be, of the partner or member . . . . (emphasis and ellipses in original).
Finding preemption, the court explained:
Under federal law, any taxes in this case are taxable to the members and are not imposed on the corporation or partnership. It is well settled that pass-through entities, such as LLCs like Debtor, are not subject to federal taxation at the entity level. As an LLC with more than one member, Debtor is treated as a partnership for federal taxation purposes unless it elects to be treated as a corporation. . . . Income taxes of a pass-through entity like an LLC or S corporation are liabilities of that entity’s members.
From there the court concluded that:
Having determined that any taxes were imposed solely on the nonresident members rather than the LLC under federal law, § 346(b) dictates the result in this case. That section expressly prohibits such taxes from being a liability of the estate. 11 U.S.C. § 346(b) (“The estate shall be liable for any tax imposed on such corporation or partnership, but not for any tax imposed on partners or members.”). Furthermore, the North Carolina statutes and tax bulletins make it abundantly clear that the members at all times remain ultimately liable for the taxes, and the Department does not argue otherwise. Since the members are unquestionably liable for their respective tax obligations, the estate cannot also be liable. Section 346(b) expressly prohibits any dual tax obligation of the members and the estate, providing that the estate shall not be liable for any tax imposed on the members. For these reasons, the Court finds that the estate has no liability for the taxes imposed against the resident or non-resident members of the LLC.
North Carolina is still owed taxes by the nonresident members of NCTI, but it will have to pursue them individually and cannot use the LLC in bankruptcy as its collection mechanism.
 See N.C. Gen. Stat. § 105-154(d).
 See generally Bruce P. Ely & William T. Thistle II, An Update on the State Tax Treatment of LLCs and LLPs, State Tax Notes (Oct. 28, 2019), at Table 1.
 2020 WL 4582282, *3.
 Id. at *2.
 Id. at *4.
 Id. at *4 (citations omitted).
 Id. at *5 (footnote omitted).