Limited liability: a business form worth considering.

One of the most important and far reaching decisions that an accounting practitioner must make is that of selecting a business form. Alternative forms available have historically been limited to sole proprietorships, partnerships or corporations. The limited liability attribute pushes heavily for the corporation form of organization. However, the resulting double taxation has made many practitioners hesitate in selecting the corporate form. In partial answer to this double taxation disadvantage, limited partnerships and subchapter S corporations arose. However, these two business forms also have real limitations.

Today, 44 states allow an additional option for business form: the limited liability company (LLC). Unlike corporations, LLC members (owners) avoid double taxation since the LLC is taxed as a partnership. LLCs provide the same limited liability as S corporations, C corporations and limited partners within limited partnerships. LLCs could answer the accounting practitioner's need for a superior business form.

LLCs are often better than other business forms. Subchapter S corporations or limited partnerships are often perceived to be sufficient as a business form for practitioners; however, their limitations are real. The subchapter S corporation has limits on both formation and continued operations. The real limit of having a corporate general partner in a limited partnership to reduce liability is avoided since all LLC members enjoy limited liability. Participation restrictions and partner ownership share are irrelevant to LLC members. LLCs offer more favorable tax attributes then other business forms while avoiding the restrictions.

Limited Liability Company History

The power to formulate and regulate artificial entities such as corporations and LLCs is given to the states through legislation. The state of Wyoming passed the first LLC statute in 1977. Other states were slow to follow this initial legislation since the Internal Revenue Service immediately made attempts to tax the new form as a C corporation, nullifying LLC advantages. Other states have now followed, however, especially since the Internal Revenue Service ruling 88-76. This ruling, promogated in 1988, provides that LLCs will be treated like partnerships for taxation purposes. This meant that income from an LLC would flow directly to each member through the partnership conduit to then be taxed at their individual rates. This ruling meant that double taxation was avoided by LLC members.

After this ruling, interest in LLCs grew rapidly. Now members could finally be assured of favorable tax treatment to accompany the desired limited liability. Other states then followed Wyoming in enacting LLC statutes, including Florida in 1982 (even before the final favorable ruling), Kansas and Colorado in 1990 and Utah and Virginia in 1991. Today, more then 40 states have LLC legislation.

From the period 1982 to 1988, several other IRS rulings occurred that affected LLCs. Prior to 1982, the IRS issued several conflicting Letter Tax Rulings (LTRs) concerning LLCs. These significantly slowed LLC development. Because of significant differences in LTR 8106082 and LTR 8304138, additional LLC classification rulings were delayed by the IRS. This delay concerning classification ended with Revenue Ruling 88-76, which held that a Wyoming LLC would be taxed as a partnership. Later, in LTR 8937010, partnership treatment was also given to a Florida LLC.

To be safe, the accounting practitioner should check to be sure that the LLC enabling legislation in their state has received a favorable LTR. However, in general, LLCs are being treated by the IRS as partnership conduits for taxation.

Why an LLC For Practitioners?

The root of the LLC advantages can be traced to its limited liability and partnership taxation characteristics. Limited liability is present in LLCs. A review of IRS rulings illustrate that an LLC is taxable as a partnership if it lacks two of the four corporate characteristics set forth in Treasury Regulation 301.7701.2. This regulation adopted the definitive classification test under Morrissey v. Commissioner [296 U.S. 344 (1935)]. The characteristics under this classification test are centralized management, continuity of life, free transferability and limited liability.

Since limited liability and centralized management are so important, LLC agreements (similar to partnership agreements) should be structured to eliminate the two characteristics of continuity of life and free transferability of interest. These eliminations allow the LLC to receive the desired and attainable partnership taxation status.

Typically, continuity of life is avoided by requiring the unanimous consent of all remaining members to continue the LLC after the death, withdrawal, retirement, bankruptcy or other event causing removal of a member. Free transferability of interests is avoidable by requiring unanimous consent to transfer actual membership rights in the LLC. Majority consent as opposed to unanimous consent to transfer has not been tested. Centralized management can be vested in the members in proportion to capital contributions.

Arguments that limited partnerships possess adequate characteristics and counter the need for LLCs are not sound. Although limited partners of a limited partnership are not personally liable for partnership debts, the general partner is subject to unlimited liability. The use of C corporations as general partners is cumbersome and raises issues of subchapter K.

Moreover, limited partners run the risk of being characterized by the IRS as general partners and becoming wholly liable if their participation in management is deemed excessive. Participation in management activities actually strengthens the LLC since the member passive activity rules.

Subchapter S corporations would seem an alternative to LLCs in that they also offer limited liability and pass-through of tax. Yet the LLC has even more advantages. Membership in an LLC is not restricted to 35 owners. LLC members can be C corporations, partnerships, trusts, pension plans, foreign investors, not-for-profit, charitable organizations and another LLC. An LLC is not subject to a one-class-of-stock limitation and may even make disproportionate allocations and distributions of income and losses. Also, the ownership of other corporation stock by an LLC is not limited to 80% or less.

Additionally, as a Federally taxable partnership, LLCs do not worry about the section 351 tax-free incorporation requirements and can take advantage of section 754 special basis adjustments for external sales of interest. Likewise, liquidating distributions of LLCs are not taxable. All LLC debt is nonrecourse unless a member accepts personal liability. An LLC possesses real and unique advantages for the accounting practitioner.

Creation of an LLC

The creation of a LLC may occur for any purpose except insurance and banking. Most states have modeled their statute after the existing Uniform Limited Partnership Act and the 1977 Wyoming LLC statute. Usually formation costs of an LLC compare favorably to C corporation formation and are below limited partnership cost. The costs, including attorney fees and filing fees, are usually $750 to $3,000.

The created LLC is a legal entity distinct from its members. Corporate right to sue, be sued, own, convey, etc. are possessed by the LLC. The two or more original members of the LLC can possess any business form as previously described.

Life for an LLC is not perpetual as with a corporation. At the end of stated length of life, the articles of organization (similar to articles of incorporation for a corporation and the partnership agreement for a partnership) may be amended. Additionally, the old LLC assets may be simply transferred to a sister LLC. However, unless properly structured, the transfer may key a tax event.

The name of the company must in some way designate the LLC's status. Florida requires a name ending of "limited company" while Wyoming requires "limited liability company." To be safe, the LLC status should be identified in the name.

The articles of organization must contain:

* name,

* duration,

* purpose (usually broadly defined),

* place of business and registered agent in state,

* initial capital contribution,

* method of admitting new members,

* method of continuation when a membership is withdrawn,

* management procedure, and

* other desired provisions.

Similar to the Uniform Partnership Act, silence in the articles causes default. If silent on management, all members are deemed to share votes according to their capital accounts. Absent a management procedure, managers cannot bind the LLC to third parties. This would rest only with the members as a group.

Subordinate to the articles of organization are an LLC's regulations. Similar to a corporation's bylaws or a detailed partnership agreement, these regulations should contain provisions for the LLC's operation and management. Because of this, the LLC can allocate items of income, gain or loss, deduction and credit under the "substantial economic effect" of IRS 704(b)(2) and Treasury regulations 1.704-1(b)(2)(ii)(a). These allocations should not create a deficit in the member's capital account, since dissolution with deficits will cause special problems. To maintain limited liability, the articles of organizations should avoid requiring additional member contributions when certain events occur.

Why An LLC?

Most accountants currently operate in sole proprietor or partnership form for tax reasons or because states do not permit incorporation to limit professionals' liability. The Companies Act of 1989 removed the ban on accountants' incorporation although care must still be exercised toward contractual limitations. This limitation carried over from 310 of the earlier 1985 Act.

A relatively inexpensive LLC will answer these limitations. Liability can be limited and undesirable double taxation will not occur. Recently, the IRS even sweetened the LLC environment with LTR 9321047. This allows that professionals (accountants) will be able to retain the cash method of accounting in an LLC. Of course, accrual accounting under Generally Accepted Accounting Principles was already LLC-allowed.

The LLC's greatest weakness may be its status in states without LLC legislation. When a LLC organized in a LLC state does business in a non-LLC-recognized state, the limited liability doctrine may vanish. In this non-LLC state, liability for members may exceed the entities' net worth. Because of this, an accounting firm may have to alternatively organize in these states in order to do business with limited liability.

Finally, the IRS is allowing rollover of existing partnerships, both full and limited, into LLCs without considering the partnerships' end as a terminating event causing taxation. AsO additional experience with LLCs occur and as case law develops, risk in formulating LLCs will decline further.

Conclusion

The relatively new form of business named the limited liability company (LLC) is a real alternative to the older forms such as C corporation, S corporation, limited and full partnerships and sole proprietorship. LLCs offer an end to double taxation and provide limited liability. Furthermore, LLCs eliminate the real limits of S corporations and limited partnerships. Accounting practitioners should strongly consider the limited liability company as a viable business form.

References

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17 Schor, BL, "Limited Liability Companies: Features and Uses." CPA Journal 62 (Dec 1992): 26-33.

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20 Tompkins, AW, "The LLC Is Coming--Will Your Firm Be Ready?" Practical Accountant 25 (Nov 1992): 36-45.

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22 Weiner, AE, "Considerations When Asking: To Be or Not To Be an LLC?" Tax Adviser 24 (Oct 1993): 645-647.

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Donald Martin, PhD, is an associate professor of accounting at Central Missouri State University, Warrensburg, Missouri.