Limited liability companies: the perfect hybrid?

Business owners seeking a form of business organization usually want to limit their (and their investors') exposure for liabilities arising out of the operation of the business. They also want to maximize their right to make basic business operating decisions, including the allocation of business revenues, without the influence of investors. Perhaps above all, they want to minimize the income taxes payable on the income generated by the business. It is the goal of business lawyers and accountants to suggest a form of business organization that satisfies the foregoing desires, to the extent they can be satisfied.

Until about 1949, California business owners had to choose between the limited liability of the corporation and the operational flexibility and tax advantages of the general partnership. Each of these forms had (and has) its own peculiar disadvantages. As California and other states began to adopt statutes authorizing the formation of limited partnerships, a new choice of entity appeared which, to a certain extent, combined some of the advantages of the corporate and partnership forms. The limited partnership, however, retains some of the disadvantages of both forms.

Recently, a new form of business organization -- the limited liability company (LLC) -- has emerged. LLCs offer business owners an alternative form of business entity that combines the best features of corporations and partnerships, and minimizes the disadvantages. The LLC is not a "drawing board" idea -- this form of business organization is already available by statue in 24 states, and some 12 other states have enacted statutes under which foreign LLCs can qualify to conduct intrastate business. There over 10,000 LLCs nationally.

California law has lagged somewhat behind that of other states. California has not yet enacted a statute authorizing the formation of LLCs in this state, and its qualification statutes does not recognize foreign LLCs. With the current state of California law, a foreign LLC that conducts business in California does so without assurance that the limitation of liability granted to them by the laws of its state of formation will be recognized by California courts. However, two bills are pending before the California Senate that, if passed, will authorize and regulate LLCs in California. LLC legislation is expected to be adopted in California some time in 1995; and it is likely that the LLC will soon thereafter become a popular choice of form of business organization in California.

Small business owners, and those whose businesses involve real estate and venture capital should be aware of the potential advantages that an LLC may offer.

WHAT IS A LIMITED LIABILITY COMPANY?

The easiest way to describe an LLC is as a form of business entity that combines the most desirable qualities of corporations and of limited partnerships. To understand the LLC's advantages, it is helpful to review the shortfalls of the corporate form and of the partnership form, as these are the two basic forms of business entities currently used in California.

THE CORPORATE FORM

Business owners generally elect to do business as a corporation in order to limit their (and their investors') exposure for liabilities arising out of the operation of the business. In general, shareholders of a corporation are not liable for the debts of the corporation beyond the amount they have paid in or promised to pay in to the corporation's capital. Assuming that basic corporate formalities are observed (e.g., adequate capitalization, regular corporate meetings, and separation of personal and corporate funds and financial obligations) the corporate structure generally will achieve the goal of giving its owners limited liability.

All business corporations are taxed under one of two sets of federal tax provisions, collected in Sections 301 through 385 (commonly referred to as Subchapter "C"), and Sections 1361 through 1379 (commonly referred to as Subchapter "S") of the Internal Revenue Code. Corporations taxed under Subchapter "C" are often referred to as "C-corporations," those taxed under Subchapter "S" as "S-corporations".

The major disadvantage of C-corporations is that their income is subject to double taxation. The corporations's net earnings are taxed first at corporate tax rates (which now range from 15% to 39%); then, when the corporation's after-tax earnings are distributed to the shareholders as dividends, they are taxed again at individual tax rates (which now range from 15% to 39.6%).

Corporate shareholders can avoid the double taxation of C-corporation earnings by electing to have the corporation taxed under Subchapter "S" and the analogous provisions of state income tax law (if any). The net earnings of an S-corporation are not subject to federal corporate income tax at all; instead, the net income arising from the operation of the S-corporation passes through to, and is reported and taxed at, the shareholder level.

Unfortunately, many corporations are not eligible to elect to be taxed under Subchapter "S." To be eligible, a corporation must: (i) have been formed in the United States; (ii) have 35 or fewer shareholders, each of which must be an individual citizen or resident alien, or qualify as a qualifying trusts; and (iii) have only one class of stock.

The relatively small maximum number of shareholders precludes public corporations or other corporations with many shareholders from electing Subchapter "S" status. It is difficult to structure transactions to avoid this limitation because of the narrow shareholder eligibility requirements -- an S-corporation cannot have a partnership or another corporation as a shareholder.

The restriction on the number of classes of stock precludes many corporations that need a complicated capital structure from electing Subchapter "S" status. An S-corporation cannot make distributions of cash and allocations of tax items disproportionately among its shareholders.

Further, S-corporations are not permitted to own more than 80% of the stock of another corporation. This restriction precludes corporations with wholly-owned subsidiaries from electing Subchapter "S" status. There is also a limit on the amount of passive income that an S-corporation can receive.

Although S-corporations escape double federal taxation, the California Revenue and Taxation Code imposes a 2.5% corporate income tax on S-corporation earnings. This tax is in addition to the federal and state income taxes paid at the shareholder level.

A corporation that has elected Subchapter "S" status is at risk of losing this status if the corporation ever fails to meet any of these eligibility requirements. Thus, if the shares of a shareholder pass on his death to a non-qualifying trust, or if the corporation issues preferred shares, the corporation's Subchapter "S" status would be lost.

THE LIMITED PARTNERSHIP FORM

There are several reasons why business owners elect to do business as a limited partnership rather than as a corporation, even if the choice of doing business as an S-corporation is available.

The primary reason is the organizational and financial flexibility that the partnership form offers. In a limited partnership, management control is reserved to the general partners, who generally make relatively small contributions to the capital of the partnership. The limited partners, who have little or no management control, generally make the lion's share of the capital contributions. The partnership agreement can provide for distributions of cash more or less unrelated to the partners' "percentage interests." A typical structure is for the limited partners to receive almost all (90% or 99%) of the cash available for distribution until they have received distributions equal to their aggregate capital contributions, plus an interest factor (referred to as a "preferred return"), and 50% of the cash available for distribution thereafter. Such a structure rewards the limited partners for their risk capital by returning it with an interest factor out of the first dollars available, and provides an incentive to the general partners to make the partnership's business successful by deferring most of their compensation until the investment has been repaid.

The partners of a limited partnership are taxed more or less like shareholders in S-corporations. And, like corporate shareholders', limited partners' exposure for liabilities arising out of the operation of the partnership's business is limited to the amount they have paid in or promised to pay in to the partnership's capital (unless they are deemed to be general partners by reason of having participated in management). However, the liability of the general partners is unlimited. Thus, limited partnerships often have corporate general partners, since the corporate structure of the general partner in turn allows the general partner to limit its exposure).

THE LIMITED LIABILITY COMPANY STRUCTURE

The LLC is a hybrid entity formed under state law which combines many of the best attributes of both S-corporations and limited partnerships: the limited liability of a corporation; the single-level taxation of S-corporations and partnerships; and perhaps more organizational and financial flexibility than even partnerships have.

The legislation authorizing the creation of LLCs varies from state to state and, therefore, issues related to the operation of LLCs may be resolved differently, depending upon the particular laws under which they were created.

To form an LLC, the organizers file articles of organization with the secretary of state of the state of formation. The articles provide information that is similar to that found in the articles of incorporation of a corporation or in a certificate of limited partnership formed under the Revised Uniform Limited Partnership Act: the name of the entity; the address of its principal place of business; the name (and address) of its agent for service of process; and the date of expiration of its term, if any.

The owners of equity interests in an LLC are called members. California's pending LLC legislation requires at least two members. In addition, if the LLC is not managed by all of its members, a statement to such effect must be set forth in the LLC's articles of association.

Unlike S-corporations, which are prohibited from having shareholders that are corporations, foreign persons, or non-qualifying trusts, there are no prohibitions on who can be the member of an LLC. Thus, the members of LLCs may be individuals (including U.S. citizens, resident aliens and non-resident aliens), U.S. or foreign corporations, partnerships, pension plans, charitable organizations, any kind of trust, or even other LLCs.

The management structure of an LLC is governed by a document called an "operating agreement." The operating agreement is the LLC analog of a corporation's bylaws and of a limited partnership's partnership agreement. The operating agreement, which is not part of the public record, addresses all of the operational aspects of the LLC, such as the respective duties and rights of members, and can include provisions for non-ratable distributions of cash available for distribution and special allocations of tax items among members, similar to those often found in an agreement of limited partnership. Contrast the bylaws of an S-corporation, which can not provide for non-ratable distributions or special allocations because of the requirement that S-corporations have only one class of stock.

The operating agreement also may provide that the members manage the LLC, or vest management authority in a particular member. Unlike limited partnerships, in which the limited partners must sacrifice their right to participate in the operations of the partnership in exchange for limited liability, there is no restriction on the level of any member's involvement in an LLC. The right to wield management authority can even be made to shift depending on the financial results, in much the same manner as it does in some C-corporations that have preferred stock.

THE CHARACTERISTICS REQUIRED FOR PREFERENTIAL TAX TREATMENT

Wyoming was the first state to adopt legislation authorizing the creation of LLCs. Until the Internal Revenue Service ruled that Wyoming LLCs would be taxed like partnerships, there was little interest in this new form of business entity. The IRS ruling was based on a traditional partnership taxation analysis: The IRS found that Wyoming LLCs lacked at least two of the following four "corporate characteristics": (i) limited liability: (ii) centralization of management; (iii) continuity of life; and (iv) free transferability of interests.

Since the members of an LLC generally have limited liability, the four-characteristic test, as applied to LLCs, means that an LLC may have only one of the remaining three characteristics if it is to avoid being taxed like a C-corporation. This requires a careful balancing of the relative advantages of the remaining characteristics.

For example, if centralized management is vital to the members of an LLC, it may be necessary to provide for: (i) the dissolution of the LLC upon the death, insanity, bankruptcy, etc. of any one member (thus eliminating the corporate characteristic of continuity of life); and (ii) the consent of the remaining members to the transfer of a member's interest (thus eliminating the corporate characteristic of free transferability of interests).

However, satisfying these requirements does not need to be too draconian: An operating agreement that allowed all the remaining members of an LLC to elect to continue an LLC notwithstanding the loss of one member has been deemed to lack continuity of life; and an LLC whose operating agreement provided for transfer of a member's interest only with the approval of a majority of the interests of the non-transferring members has been deemed to lack the corporate characteristic of free transferability of interests.

Thus, it is imperative that the person responsible for drafting an LLC's operating agreement balance the objectives of the members carefully, and with an eye on applicable tax rules.

THE TAX ADVANTAGES OF A LIMITED LIABILITY COMPANY

There are also other respects in which the tax treatment of LLCs is more favorable than that of S-corporations. Unlike S-corporations, LLCs can distribute appreciated property to members without recognizing taxable income. Members of an LLC who contribute appreciated property to the LLC and who do not control the LLC after such contribution also need not recognize gain from the appreciation, whereas the shareholders of an S-corporation do have recognition of gain.

The tax advantages of an LLC over an S-corporation also extend to the deductibility of losses. In an S-corporation, the amount of a shareholder's deductible losses is limited to the shareholder's basis in his stock, plus the amount of any loans made by the shareholder to the S-corporation. In contrast, a member of an LLC may deduct losses which include his allocated share of the debt of the LLC. Unlike S-corporations, LLCs have no restrictions on the amount of passive income that they may generate.

The main advantage of an LLC over a limited partnership is that the shield of limited liability covers all of the members of the LLC, including those who (like the general partner of a limited partnership) actually operate the LLC. While it is true that the general partner of a limited partnership can be an S-corporation, thereby avoiding double taxation while achieving limited liability, this structure is not only more cumbersome and expensive that merely having an LLC, but also does not provide perfect pass-through of income (because of the 2.5% California tax on the earnings of S-corporations) to the shareholders of a California S-corporation that serves as general partner. In addition, members of an LLC can actively participate in its operation without fear of losing their limited liability.

Because LLCs are simpler than limited partnerships with corporate general partners, and more flexible than corporations, the LLC may be an excellent form of entity for small businesses, especially family business, and for estate-planning purposes. LLCs are also attractive in businesses with foreign participants who are ineligible to be the shareholders of S-corporations.

DISADVANTAGES OF LIMITED LIABILITY COMPANIES

It would be wrong to assume that LLCs are appropriate in every circumstance. There may be considerable comfort to a passive investor in knowing that the general partner of a limited partnership has unlimited liability for its acts. This may cause the general partner to act more cautiously and may create a higher duty of care to the limited partners than a managing member would owe to the other members of an LLC.

Similarly, if continuity of life and free transferability of interests are important, conducting business as an S-corporation may be preferable to operating as an LLC. In addition, there are also certain tax advantages, such as provisions dealing with corporate reorganizations, available to S-corporations that LLCs are not permitted to enjoy.

As California's LLC legislation works its way through the legislative process, interest in this new form of business organization will grow. Owners of businesses in other states, and people planning future businesses in California, especially owners of family-held businesses, should be sure to ask their legal and accounting advisers if an LLC is the right form for them.

Kevin J. Brody and Halliwell Smith are with Century City-based Valensi, Rose & Magaram, a professional law corporation. Mr. Brody specializes in corporate, securities and real estate law; Mr. Smith is a principal and practices in the areas of corporate, real estate, general business, and securities law.