LLPs: a new form of organization.

Until recently, businesses (other than sole proprietorships) considered three forms of organization: C corporation, S corporation and partnership. Since the 1970s, the limited liability company (LLC) has been available. Even more recently, the limited liability partnership (LLP) business structure has become available. The use of limited liability structures has increased because they provide the best of both worlds:limited legal liability and passthrough tax treatment.

In many cases, businesses organize as a general partnership because of state regulatory requirements, precluding organization as a C or S corporation. However, there may be alternatives to a general partnership that provide virtually the same tax treatment. For example, in an LLC, the liability protection of a corporation is combined with the passthrough tax treatment of a partnership. However, because it takes a considerable amount of work to operate as an LLC (changing partnership agreements, forming a board of directors, appointing officers, etc.), it is not always desirable. Therefore, organization as an LLP (which does not have these disadvantages) should be considered.

LLPs are growing in popularity. Presently, Texas, Louisiana, Delaware, North Carolina and the District of Columbia have enacted LLP legislation, while several other states have introduced LLP legislation. The increasing popularity of LLPs has been in response to many recent questions and concerns regarding the appropriateness of traditional concepts of partner liability. An LLP permits the continued conduct of business in a partnership form while limiting certain of the traditional liabilities of a partner in a general partnership.

In an LLP, under certain circumstances and in connection with certain types of conduct and exposures, the liability of a partner or the partnership is no longer joint and several among the partners. This liability has been eliminated, relieving a partner of liability for the negligence, wrongful acts and misconduct of other partners and of partnership employees, agents and representatives. A partner will generally be personally liable only for his own conduct and the conduct of those under his direct supervision. In addition, the partner remains personally liable for any commercial debts of the partnership.

Although the specific liability protection is assured in certain states, the tax treatment is not. Mere registration as an LLP does not establish its Federal income tax treatment. The characteristics of the business seeking passthrough tax treatment must be reviewed to ensure characterization as a partnership for Federal income tax purposes. A facts and circumstances determination must be made to decide whether an entity more closely resembles a corporation or a partnership. Regs. Sec. 301.7701-2 lists the six characteristics used to determine whether an entity should be classified as a corporation. 1. A joint enterprise among associates. 2. An object to carry on business and divide the gains therefrom. 3. Continuity of life. 4. Centralization of management. 5. Limited liability. 6. Free transferability of interests.

Since #1 and #2 exist in all business ventures, the remaining four characteristics must be reviewed to determine the entity's classification. If, and only if, the organization possesses at least three of these four other characteristics, the organization is treated as a corporation. If it has fewer than three of these characteristics, the organization is treated as a partnership. Put differently, for an entity to secure partnership classification, it must fail to possess at least two of these four corporate characteristics.

A close review of the characteristics of the business organization is essential, reviewing applicable state statutes and the organization of the business enterprise. Although the regulations under Sec. 7701 have existed since 1960, limited liability structures are fairly new. Accordingly, review of recent rulings on classification is crucial. In addition, there are still many unanswered questions as to the application of certain tax rules (e.g., nonrecourse debt, passive losses, methods of accounting, etc.). However, the IRS has indicated its dedication to resolving such issues.

Who should consider the LLP form? Business enterprises comprised of professionals (e.g., accountants, lawyers, architects and engineers) who must, for a variety of reasons, practice in partnership form. There is no reason why any partnership, particularly those involved in service related businesses, should not consider LLP status. For example, two individuals who, for convenience or for some other reason, are engaged in a service business but do not have day-to-day control or supervision over each other's work might be well served by the LLP form.

There are no tax consequences for an existing general partnership to convert its organization to an LLP. In recent rulings, the Service has found that conversion from a general partnership to an LLP did not result in terminations of the partnerships under Sec. 708. In addition, the same methods of accounting and accounting period used before conversion continued.