The LLC tidal wave: why it swept across America.
What caused the LLC phenomenon? To answer that question, look at the alternatives available to business owners as forms of doing business. When the legal and operating characteristics of general and limited partnerships and corporations are reviewed, each has some limitation that is "cured" by the LLC.
What is an LLC?
A limited liability company is a distinct legal entity. It is not a partnership or corporation. Its owners are called "Members." In order to establish an LLC, a document must be filed with the Arkansas Secretary of State which is called "Articles of Organization." The internal affairs of the LLC are governed by a written document called the "Operating Agreement." External affairs of the Company are conducted either by the Members or, if stated in the Articles of Organization, by one or more "Managers."
Under Arkansas law, the Operating Agreement must be in writing. The Articles of Organization need only state the name of the LLC, its date of termination, the name of the registered agent, the registered address and whether the LLC is to be managed by managers. The person who signs the Articles of Organization and the one who serves as registered agent need not be a member. The LLC can provide anonymity if that is desired since the Operating Agreement is not filed of record, the members do not have to be identified if a non-member is agent and organizer.
Within this simple framework the LLC can operate anywhere from the informality of a simple partnership to the rigid structure of a widely held corporation. This flexibility is one of the attractive features of LLCs. How this flexibility is implemented will depend upon the business and personal goals of the members.
Once properly organized, an LLC will give its members the benefit of taxation as a partnership with the corporate benefit of limited liability. Although it is a distinct legal entity, a properly organized LLC will qualify as a partnership for federal income tax purposes. The result of that classification is that the LLC itself does not pay income taxes. It serves as a "pass through" entity to channel the profits and losses of its operation to the members. The Internal Revenue Service ("IRS") has recently issued a Revenue Procedure which describes the characteristics an LLC must have in order to receive this tax-favorable classification. Generally speaking, these are easy to satisfy although in some cases the application of the rules is somewhat complex. A proposal being considered would allow the members to simply elect partnership tax classification.
The corporate benefit of limited liability means that, like a shareholder of a corporation, the member is not liable for the LLC's debts. The member's investment in the LLC is at risk but his other personal assets are not. While a member cannot shield himself from the legal and economic consequences of his own acts (e.g., the member is driving the LLC truck that runs a stop light and causes an accident or the member personally guarantees an LLC debt), the LLC form of doing business does provide protection of the member from vicarious liability arising from the acts of others.
Two major benefits
Thus, the two major benefits of an LLC are (1) pass through tax treatment and (2) limited liability. One or both of these characteristics can be obtained through other forms of doing business, but with limitations not imposed on the LLC.
For example, pass through tax treatment is enjoyed by general and limited partnerships. However, in general partnerships, each partner is jointly and severally liable for all obligations of the partnership and for the actions of all partners. The extent of the liability goes to all of the personal assets of the partner. While limited partnerships allow a limited partner the same limited liability as a corporate shareholder or member, there must be at least one general partner with unlimited personal liability. In addition, limited partners may not engage in the management of the partnership without losing their limited liability. in an LLC,each member can be fully participating in management yet retain full limited liability.
A regular "C" corporation does not possess pass through income tax treatment but does provide its shareholder with limited liability. The tax cost of double taxation of profits (once at the corporation level and again at the shareholder level when dividends are paid) can be a substantial price to pay for limited liability. Also, the corporate form of business requires certain legal formalities which if not followed can lead to the imposition of personal liability on shareholders.
An electing "S" corporation obtains pass through tax treatment and provides its shareholders with limited liability. However, there are limitations to the use of the S corporation that are not present with LLCs.
For example, there are strict rules with respect to the shareholders of S corporations. There can be no more than 35 shareholders, no corporation, partnership or nonresident individual can be a shareholder. Only certain kinds of trusts may be shareholders and estates are limited in how long they may be shareholders. None of these limitations are found with respect to LLC membership.
Another area of substantial difference between the LLC and S corporations is the "one class of stock" rule. S corporations are only allowed one class of stock. Thus, although voting and nonvoting common are permissible, common and preferred stock are not. If a shareholder wishes priorities on distributions from the entity, providing those priorities can create a second class of stock which disqualifies the corporation from electing S status. No such prohibition exists with LLCs. With careful attention to the rules set out in regulations under the Internal Revenue Code, special allocations of LLC income, loss or deductions can be accomplished. Accordingly, one group of members can receive preferential returns over another group without loss of pass through tax treatment.
Assume that there are no shareholder problems to electing S status and that special allocations are not desired. Does the LLC still have any advantage over the S corporation? Yes, because the liquidation of an S Corporation will, in all cases, be a tax recognition event, while the liquidation of an LLC can, under certain circumstances, not be a tax recognition event. In other words, when the owners of the entity are ready to move on, there is no way to do so in an S corporation without a tax event while it is possible to avoid a tax event with an LLC.
What are the negatives?
Because the IRS has not determined how single member LLCs will be classified for federal tax purposes, the LLC is not advisable for a single-owner entity even though Arkansas law allows the formation of single-member LLCs.
Second, because the LLC is a relatively new form of business entity, there has not developed a body of case law interpreting LLC issues. This concern is somewhat lessened by the analogies that can be drawn to partnership and corporate law.
Third, the explosion of LLC legislation has caught the IRS somewhat off guard. The IRS is working on guidance as such issues as the treatment of LLC profits for self-employment taxes, the at-risk rules, the passive activity loss limitation rules, use of accounting methods, estate tax implications of LLCs and standards for determination of classification as a partnership or as a C corporation. Until the IRS has considered and made public pronouncements of its positions, practitioners are having to rely upon analogous rules for partnerships and private rulings.
Finally, there is the issue of practitioner ignorance. If attorneys or accountants are not familiar with LLCs, they will not recommend them. This will be solved with time as the popularity of the LLC grows. If nothing more, knowledgeable clients will force their advisors to become "experts" in LLCs.
What applications lend themselves to the use of the LLC?
In any situation where the owners of the business desire pass through tax treatment and limited liability, the LLC should be considered. They are excellent choices for real estate development companies, professional practices or service businesses, manufacturing, hazardous operations, transportation companies, environmentally sensitive operations and sales companies. Families involved in farming can use the LLC to hold the family farm together through several generations. Persons with substantial net worth can use a closely held LLC as a means to reduce estate taxes, increase annual gifts and yet maintain control over the assets within the LLC.
With the combination of benefits and flexibility provided by the LLC form of doing business, it will truly be the entity of choice. How an LLC can be used in any particular situation will require a careful analysis of the business and personal considerations involved. However, the LLC tidal wave will cause the LLC to be the predominant form of organization for the foreseeable future and the business landscape will never be the same.
John C. Lessel is a member of the firm, Mitchell, Williams, Selig, Gates & Woodyard, P.L.L.C. He is a Board recognized tax law specialist. Mr. Lessel assisted in the enactment of Arkansas' LLC Act and writes and speaks frequently concerning LLCs. His practice emphasis is tax planning for individuals and businesses.