Tax aspects of limited liability companies: is the LLC a state-of-the-art entity?
To many, LLCs may sound no better than or different from S corporations or limited partnerships. But the S corporation limits on formation and continued operation do not apply to LLCs, and the problems of having a corporate general partner in a limited partnership are avoided since all members enjoy limited liability. Limited partner ownership and participation restrictions are irrelevant to LLCs, which offer more favorable tax attributes than limited partnerships and avoid the restrictions of S corporations.
If LLCs are potentially so beneficial from both tax and liability viewpoints, practitioners may wonder why they are relatively unused. This article examines that question as well as others about LLC formation and operation; a detailed comparison of LLCs with limited partnerships and S corporations and some unresolved tax and nontax issues also are discussed. (For information on LLCs' applicability to CPA firms, see the sidebar on page 51. )
LLCs AND THE IRS--PAST AND PRESENT
LLC legislation was introduced in Alaska in 1975 and 1976, but neither attempt passed. Wyoming passed the first LLC statute in 1977. Florida passed its statute five years later; Kansas and Colorado, in 1990; and Utah and Virginia, in 1991. Today, a total of 16 states have approved LLCs, and legislation has been introduced in 8 others. (Georgia and Indiana allow only foreign LLCs to conduct business in the state, subject to registration requirements.) The exhibit on page 52 shows states' LLC status.
The LLC legislation gap from 1982 to 1990 can be attributed to the Internal Revenue Service's failure to decide how LLCs would be classified. Under Treasury regulations sections 301.7701-2 and 301.7701-3, the issue was whether LLCs should be taxed as partnerships or given association status, forcing taxation as regular corporations. Classification remained a problem until revenue ruling 88-76 determined what criteria would be used to classify an LLC.
Morrissey v. Commissioner [296 U.S. 344 (1935)] provided perhaps the bestknown classification test for business organizations. The U.S. Supreme Court identified six long-used criteria to determine corporate resemblance:
* Associates (beneficiaries, partners or shareholders).
* An objective to carry on a business and divide its gains.
* Continuity of life.
* Centralized management.
* Limited liability.
* Free transferability of interest.
The Court was careful to state these not as requirements but, rather, as factors that make an entity resemble a corporation. In 1953, the IRS.required only two criteria, continuity of hfe and centralized management, in deciding to tax an entity as a corporation or as an association. In 1960, Treasury regulations section 301.7701-2 adopted the six criteria used in Morrissey. Since the first two characteristics on the list above are common to most business organizations, the last four became the focus of the classification test. Presence of more than two forced taxation as a corporation.
As tax-shelter limited partnerships became popular, the government lost two important decisions--Zuckman v. United States [524 F.2d 729 (Ct. C1. 1975)] and Larson v. United States [66 T.C. 159 (1976)]. The government failed in its attempts to classify two limited partnerships as associations and thus tax them as corporations. Larson became important because the Tax Court required equal weight to be applied to each of the four items not common to both types of organization. The IRS wanted to add to the list or place emphasis on limited liability. The IRS acquiesced to the Larson case in 1979.
In 1980, proposed regulations (not generally directed toward general and limited partnerships) were issued saying an organization would be classified as a corporation if no LLC member was personally liable for the organization's debts. These proposed regulations came after two IRS attempts to find other ways to force LLCs into corporate status. Effective dates for these regulations were changed five times before they were withdrawn in 1982.
In 1982, the IRS announced it would study the classification rules, giving extra attention to the limited liability issue. Two LLC letter rulings were issued. In LTR 8106082, an LLC was treated as a partnership. In LTR 8304138, an LLC was treated as a corporation. The latter had three of the noted four corporate characteristics. After this ruling, the IRS said advanced LLC classification rulings would be delayed until its study was completed. This position continued until IRS announcement 88-118 said the study was complete. Revenue ruling 8876 followed, holding a Wyoming LLC would be taxed as a partnership. In LTR 8937010, the IRS gave partnership treatment to a Florida LLC. Other states with LLC statutes should have letter ruling requests answered soon.
FORMING AND OPERATING AN LLC
LLCs may be formed for any lawful purpose except banking or insurance. Costs for LLC formation usually range from $1,000 to $5,000, including attorney fees and filing fees. States with LLC statutes tend to model the statutes on their existing Uniform Limited Partnership Act and the 1977 Wyoming LLC statute. Florida's act also was influenced by a similar organization called the limitada, popular in Central and South America.
LLC acts tend to make clear the entity resembles a partnership, but an LLC is a legal entity distinct from its members, a fact that distinguishes it from a partnership. Corporate rights seemingly are given to LLCs (the rights to sue, be sued, sell, convey, etc.). Two or more members must form an LLC and these members may be virtually any legal conception (individuals, partnerships, S corporations, regular corporations, estates, trusts or another LLC).
An LLC's life may extend up to but not beyond 30 years. At the end of the 30*year period, the articles of organization, similar to articles of incorporation for a C or S corporation and articles of partnership for a partnership, may be renewed by amendment or net assets can be transferred to a sister LLC or partnership. In Florida, the company name must end with "limited company" or "L.C." Wyoming requires the company name end with "limited liability company."
The articles of organization usually must contain the entity's
* Place of business and agent (registered in state).
* Initial contributions to capital (agreed value for noncash property, which cannot include services).
* Additional contributions to capital.
* Right and conditions necessary to admit new members.
* Potential continuation when membership is withdrawn.
* Management (all members, certain members or other managers).
* Other desired provisions.
If the articles are silent on management, all members are deemed to share votes according to their capital accounts. If the articles vest management only in members, then they, not any managers, can bind the LLC to third parties. Managers not having the authority to bind the LLC may cause problems by restricting managers' actions.
Subordinate to the articles of organization are an LLC's regulations. Similar to a corporation's bylaws or a partnership's operating agreement, the regulations may contain provisions for the LLC's operation and management. This embodies one of the advantages of being taxed as a partnership, the ability to specially allocate items of income, gain, loss, deduction and credit as long as the allocation has "substantial economic effect" under Internal Revenue Code section 704(b)(2) and Treasury regulations section 1.704-l(b)(2)(ii)(a). However, this can present a special problem at dissolution when flow-through losses have created a deficit in a member's capital account. Also, the regulations may have to contain a "minimum gain chargeback" provision under temporary regulation section 1.7041T(b)(4)(iv)(d) when special allocations of nonrecourse deductions are provided.
The premise of limited liability for LLC members may be breached when the articles of organization require additional capital contributions as certain events occur, when other states do not recognize the LLC member's limited liability or when an insolvent LLC makes distributions to a member. Any of these situations may require additional contributions by LLC members.
LLCs VS. OTHER ENTITIES
The LLC is not burdened by many of the requirements constraining the S corporation, which can
* Have no more than 35 shareholders.
* Generally not own 80% or more of another corporation's stock.
* Have only certain types of shareholders.
* Have only one class of stock (therefore allowing disproportionate distributions).
* Have no nonresident alien shareholders.
As rederally taxable partnerships, LLCs do not have to worry about the section 351 tax-free incorporation requirements and can take advantage of section 754 special basis adjustments for external sales of interests or certain distributions. LLCs' operating and liquidating distributions should be nontaxable. This is not true for liquidating, appreciated property and certain operating distributions in S corporations.
Unlike S corporation shareholders, LLC members can increase their bases for the amount of the entity's debt under IRC section 752. Since all LLC debt is nonrecourse, unless a member is personally liable, the allocation is similar to a limited partner's share, under temporary regulation section 1.752-IT(e)(1). For nonrecourse debt, LLC members get their portion of required "minimum gain chargebacks" under sections 704(b) and (c). The remaining nonrecourse debt is allocated as part of each member's profit-sharing ratio.
Limited partnerships formed with a corporate general partner face minimum net worth and profits allocation requirements for advanced rulings. In LTR 9052039, the IRS conceded these requirements are not relevant to LLCs. Also, limited partners may be charged with centralized management of a limited partnership and risk reclassification if the partnership owns substantially all partnership interests.
For purposes of requesting an advance IRS ruling, revenue procedure 89-12 requires the IRS not say the partnership lacks centralized management if limited partners own more than 80%. This should not be a problem for LLCs since members own 100% of the entity. Limited partners generally cannot be involved in day-to-day management of a limited partnership without losing limited liability and being treated as general partners. For an LLC, day-to-day management by its members generally is assumed. (In 1986, Florida revised and liberalized its Uniform Limited Partnership Act to allow this.)
OTHER PARTNERSHIP CLASSIFICATION ISSUES
No discussion of pass-through entities would be complete without some reflection of IRC section 465's at-risk rules and the passive loss rules of section 469.
Closely held corporations, individuals, sole proprietors and pass-through entity members all are subject to the at-risk rules. Generally, partners may deduct losses only to the extent they have a risk in connection with the activity. Nonrecourse liabilities added in the general basis calculation (under section 752) must be subtracted to atfive at the at-risk basis. Since all debts are nonrecourse, except those a member has assumed primary liability for, subtraction from general basis may be a significant consideration. (Merely guaranteeing a loan will not change it from nonrecourse status.)
Recourse debt usually can be added to the general partner's basis and at-risk basis, but LLCs do not have general partners. So, even though the debt may be state law recourse, it is nonrecourse for federal income tax purposes and therefore does not increase LLC members' at-risk basis. A major exception to the above rules is the real estate exception under IRC section 465(b)(6). Qualified nonrecourse financing secured by real property (except for mineral property) used in a real estate holding activity (for example, rental real estate) increases the members' at-risk basis. In real estate financing operations, state law recourse and all nonrecourse financing should be added to LLC members' at-risk basis. Losses suspended as a result of the at-risk rules may be used to offset gain recognized from the sale or exchange of the investors' interest according to proposed regulations section 1.465-66.
Section 469's passive activity loss restrictions provide another hurdle for deducting LLC flow-through losses. Any LLC member who is an individual, a closely held C corporation or a personal service corporation should be subject to the passive activity rules. Losses from passive activities are deductible only to the extent the taxpayer has passive income. A passive activity is defined as any rental activity, trade or business in which the taxpayer does not materially participate. Material participation may depend on whether the member is treated as a limited or general partner.
The section 469 temporary regulations appear to suggest all LLC members are in fact limited partners because of their limited liability under state law. If this is true, the greater-than-500-hour-per-year requirement for participating in the business or activity would have to be met to participate materially. But revenue procedure 8912 defines "general partners" as members of the organization with significant management authority relative to other members (with respect to organizations not designated as partnerships under state law). If this definition applies for material participation, all LLC members are general partners subject to section 469's broader material participation requirements. This result seems more consistent with the intent of the temporary regulations.
Practitioners should remember significant participation activity classification (between 100 and 500 hours of participation) generally makes LLCs unattractive for loss-generating activities in which members will participate within this range of hours. Members who are managers and have significant authority relative to other members may be treated as general partners.
OTHER LLC CONCERNS
Classification issues regarding continuity of life, free transferability of interests and centralization of management still may present some pitfalls for an LLC. If less than a majority of members can vote to continue the LLC upon a member's withdrawal, or if the articles of organization provide an advance agreement to continue the business, the IRS may consider this a corporate characteristic of continuity of lffe.
As long as all members manage the LLC, centralization of management should not be an issue. Sometimes this may not be possible or reasonable. Extreme care should be taken the IRS does not assert centralization of management. Free transferability of interests generally is avoided by the LLC statute requiring unanimous written consent of all members before a new LLC member may be admitted. Without this approval, a new member may participate only in profits, not in management. If LLC members are related parties, the IRS could try to use the "no separate interests" theory to reclassify the LLC as an association.
A VEHICLE FOR THE FUTURE
Today, the LLC's greatest weakness may be its status in states without LLC legislation, which may not follow LLC members' limited liability status. Some states may not recognize the LLC statute from the state where the business is organized. If this occurs, members may be subject to liability beyond the entity's net worth. This is changing almost daily, however, with many states currently listing LLC statutes as pending and many others studying the possibility of adopting them. The IRS seems comfortable with the rollover of partnerships into LLCs; limited partnerships and general partnerships have been given the green light to convert to LLCs without treatment as a terminating event.
General and tax case law for LLCs does not really exist, making a venture into this uncharted territory still quite risky. As with all the organizational forms, however, LLCs are favorable for some ventures and not for others. Time and general acceptance will cure the LLC's youthfulness.
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|Title Annotation:||includes related article on accounting firms organizing as limited liability companies|
|Author:||Price, Charles E.|
|Publication:||Journal of Accountancy|
|Date:||Sep 1, 1992|
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