The choice of organizational form: why some entities should consider becoming limited liability companies.

Organizational forms such as limited liability companies (LLCs) and limited liability partnerships (LLPs) are emerging as desirable alternatives for many businesses. While LLPs are a popular choice for CPA firms, LLCs appeal to a wide range of entities. Which clients should CPAs advise to become LLCs? Based on tax and operating considerations, LLCs are not the best fit for all businesses. This article discusses the federal income tax rules for LLCs and compares them to the tax treatment of C corporations, S corporations and limited partnerships.

Tax considerations and reduced operating and ownership restrictions favor selecting LLCs--which, like partnerships, generally are not taxable entities. State laws also permit LLC owners (properly known as "members") to limit their liability to the amounts they invested, plus any capital commitments, making LLCs more attractive than partnerships. The reduced operating and ownership restrictions also will make them more attractive to some S corporations.

THE LEGAL DEVELOPMENT OF LLCs

Exhibit 1, page 46, shows that as of November 1985, 47 states and the District of Columbia permitted the formation of LLCs. Legislation is under consideration in all three remaining states. The pace of adoption has been rapid. Thirty-two states have adopted LLC statutes since 1992. (For a discussion of the general business and tax implications of LLCs, see "Tax Aspects of Limited Liability Companies," JofA, Sep.92, page 48.)

The key tax issue for LLCs is achieving partnership status for federal income tax purposes. Before 1993, revenue ruling 88-76, which addressed Wyoming's LLC statute, was the primary authority. In 1993, the Internal Revenue Service issued 12 revenue rulings that expanded the authority for recognizing LLCs as partnerships on the federal level. Since 1993, five additional rulings have been issued, each covering a different state. All conclude that LLCs can achieve partnership status for federal income tax purposes. (Information on the rulings can be found in exhibit 1.)

TREATMENT AS PARTNERSHIPS

Compliance with a state's LLC statute (Delaware is a notable exception) generally ensures an entity will be classified as a partnership. For LLC members to be taxed like partners, LLCs must avoid two of the four corporate characteristics in Treasury regulations section 301.7701-2:

1. Limited liability.

2. Centralized management.

3. Continuity of life.

4. Free transferability of interests.

Each of these characteristics is assigned equal weight in determining how a business is classified.

By design, LLCs have limited liability and, for practical business purposes, management generally is centralized. Accordingly, LLCs must avoid continuity of life and free transferability of interests to achieve partnership status. For example, revenue ruling 88-76 says that if an LLC organizes so that the assignee of a member's interest may become a member without the remaining members' consent (free transferability of interests) or if the LLC continues to operate after an event that terminates a member's interest (continuity of life), the entity will be taxed as a C corporation.

To obtain favorable federal tax status, LLCs also must avoid classification as publicly traded partnerships. This means that partnership interests cannot be traded or be readily tradable on established securities markets, in secondary markets or their equivalents--IRS notice 88-75 is the primary authority on determination of trading of partnership interests.

CHOOSING AN LLC--A HYPOTHETICAL EXAMPLE

Exhibit 2, page 48, illustrates the tax treatment under two scenarios--all net income is distributed to owners or is reinvested in the business--when the owners do not participate in management. Exhibit 3, page 50, shows the tax treatment when the owners participate in management and all net income is distributed to them as wages. Both exhibits assume the owners are single taxpayers with no other income. In both cases, pretax net income is $100,000.

Panel A of exhibit 2 shows the aftertax cash flows if all net income is distributed to owners. Under these assumptions, an LLC or S corporation has an advantage over a C corporation. Panel B shows the tax consequences when all net income is reinvested. In the current year, tax considerations favor a C corporation. In exhibit 3, owners are paid salaries equal to net income. Given these assumptions, the tax effect and the net cash flows are the same for all forms of ownership.

LLCs versus C corporations. Exhibits 2 and 3 demonstrate that, LLCs are preferable to C corporations when a business distributes its income and owners are not active in the business. While retaining income in a C corporation does not result in permanent tax deferral, businesses that reinvest their earnings are better candidates for C corporations. In addition, if salaries to owners eliminate all taxable income, an LLC has no tax advantage over a C corporation. Owners of businesses that have losses, however, do get pass-through treatment in an LLC, unlike in a C corporation. Absent tax advantages, C corporations have advantages because of the LLC's restrictions on transferability of ownership and limited life.

LLCs versus S corporations. This choice involves more than tax considerations. As exhibits 2 and 3 show, aftertax cash flows to the owners are the same under all scenarios. LLCs do have the advantage of permitting special allocations of income and losses to members. S corporations also have limits on the number and type of owners and on the types of income (such as rents and royalties). For example, S corporations may be subject to federal income tax if more than 25% of gross receipts are from particular types of income such as interest, dividends, rents and royalties. Exhibit 4, page 50, summarizes these restrictions and shows that LLCs generally have fewer limitations than S corporations.

LLCs versus partnerships and sole proprietorships. If owners want limited liability, LLCs have a clear advantage over a general partnership or a sole proprietorship. Choosing between an LLC and a limited partnership, however, is more complex. Exhibits 2 and 3 show similar aftertax cash flows, but LLCs have fewer restrictions. A limited partnership's trade or business activities usually are classified as passive for limited partners. Passive losses cannot generally be deducted against nonpassive income such as salary and bonuses. They can be carried forward to offset passive income in future years. Limited partners who participate in management risk being treated as general partners and losing limited liability status. On the other hand, LLC members enjoy limited liability regardless of their participation.

TYPES OF COMPANIES ELECTING LLCs

We gathered a sample of approximately 3,000 LLCs using Mead Data Central's Lexis/Nexis database. Using company names and other available information, 1,252 could be classified into two-digit SIC (standard industrial classification) codes. States sampled included Colorado, Georgia, Indiana, Maryland, Missouri, Texas, Nevada and Wisconsin. Although most states allow formation of LLCs for any purpose except banking or insurance, the sample LLCs cluster in several industries.

For example, 325 (26%) of 1,252 companies were classified in the management support service industry. Of these, about 60% were either engineering, consulting or professional employment companies. Other industries included maintenance, trash removal and painting. In most of these service industries, the owners didn't have large capital reinvestment needs, so LLCs, because they offer favorable tax treatment of cash distributions to owners over what a C corporation would provide, were a good choice. The second most-heavily represented industry was real estate services, including brokerage and property management; 233 companies (19%) were in this industry. These companies could earn significant revenues from rents, precluding their organization as S corporations. LLCs were thus an attractive alternative.

Construction and general contracting businesses represented 12% of the sample (149 companies). Owners could have had significant concerns about personal liability in industrial accidents, especially if they were active in managing the business. For them, organizing as LLCs would have been better than the limited partnership form. Similar explanations could be offered for the 74 companies (6%) from the amusement and recreation industry.

Concerns about professional liability may help to explain the 108 (9%) investment companies and 82 (7%) health services companies in the sample. Other industries notably represented included 105 retailers (8%), 87 agriculture related businesses (7%), 36 oil and gas extractors (3%), 27 restaurants (2%) and 26 leasing companies (2%). Most of the businesses were not in high-growth industries. Notably absent were companies that reinvest cash flows for growth prospects, such as software and pharmaceutical companies.

THE BOTTOM LINE

CPAs advising clients on choices of organizational forms face a bewildering set of alternatives. Exhibit 5, above, illustrates the decision process for LLCs and other organizational forms. If the client seeks limited liability, reduced restrictions and one level of federal taxation, LLCs are the best choice. As the evidence suggests, the LLC's attributes make it desirable for many types of companies, but this option is not right for all.

[Exhibits 1 to 5: [TABULAR DATA OMITTED]

RELATED ARTICLE: EXECUTIVE SUMMARY

* MANY BUSINESSES ARE CONSIDERING limited liability companies (LLCs) as a way to operate for both tax and liability reasons. LLCs have fewer ownership and operating restrictions than other choices and allow owners to limit their liabilities to the investment, plus any capital commitment.

* FORTY-EIGHT JURISDICTIONS PERMIT formation of LLCs. Internal Revenue Service rulings have generally conceded that LLCs can achieve partnership status for federal income tax purposes as long as they avoid two of the four corporate characteristics in Treasury regulations section 301.7701-2.

* LLCs HAVE AN ADVANTAGE OVER C corporations when a business distributes its income and owners are not active in the business. Choosing an LLC over an S corporation involves more than tax considerations; ownership and other restrictions must be considered. If all owners seek limited liability, LLCs have an advantage over partnerships or sole proprietorships.

* A SURVEY OF EXISTING LLCs SHOWED that the majority were concentrated in the engineering and management support service industries. Another heavily represented industry was real estate services, including brokerage and property management. Most of the businesses in the sample were not in high-growth industries, and companies that reinvest cash flows were noticeably absent.

* LLCs APE NOT THE ANSWER FOR ALL businesses. Companies that generate excess cash are candidates, as are those where the S corporation and partnership restrictions would be burdensome.

RELATED ARTICLE: CASE STUDY

A Good Idea for Some

Mary Lou Pier, CPA, a partner in the three-person CPA firm Pier & Associates, Chicago, cautions that "while I highly recommend limited liability companies, they are not for every business. State laws can vary drastically in regard to LLCs and therefore their treatment can vary state by state."

Pier and Associates' clients are mainly small businesses with up to $25 million in annual revenues. Pier would not recommend the LLC form to companies that need to keep large inventories on hand, such as manufacturers. She also generally does not recommend them to clients that are already incorporated. "It's not as easy to switch to the LLC form from an S corporation or a regular corporation as it is to start up as an LLC; you run afoul of more rules," she explained. "Some of our clients have asked about it, and I have not found an instance in which it would be beneficial to the company. In one case the client was an S corporation. In effect, you would be liquidating one company and starting up another. There would have been some potential gains that could have been taxed on liquidation."

The LLC form is not right for all start-up clients, either, Pier added. "With an LLC, the income is taxed to the individual as it is with a partnership. If the company is not able to distribute money to help pay the taxes, the client could have a problem."

RELATED ARTICLE: CASE STUDY

"We Talk About LLCs as an Option"

Horace Francis, CPA, president of Francis & Co., a 10-person Seattle firm, suggests that LLC status is available to all types of businesses but, in particular, "construction companies, restaurants, architectural firms and other businesses with above-average liability exposure might benefit more from this form of organization."

To determine the best form of organization, "I look at the two primary reasons a client might want to operate as a corporation rather than as a partnership or sole proprietorship: limitation of liability and the tax benefits," says Francis, whose clients include small businesses with revenues between $500,000 and $10. million. "The LLC form can provide the corporate liability protection with the tax planning flexibility available to a partnership."

In helping clients decide whether the LLC form is suitable, Francis analyzes various factors with each client, including business risks, taxes and operating and management structure. He often uses a standard spreadsheet program to analyze the financial and tax implications. In one case, the owners of a construction company in business for several years as a partnership wanted to limit their personal liability. "As is typical in this kind of business, it was started by one person, and later a partner joined," he explained. "The owners believed they had too much liability exposure and asked me about incorporating, possibly as an LLC. Since most of the business's earnings were being taken out by the owners, they would not get much tax benefit from forming a regular corporation. The LLC form provided them with the liability protection while still maintaining the partnership tax flexibility."

RELATED ARTICLE: Many CPA Firms Opt for Limited Liability Partnership Status

Organizational forms such as LLCs and LLPs evolve over time to meet the changing needs of businesses. LLCs offer favorable tax treatment--when certain conditions are met--and liability protection. Individual LLC members are only liable for their own acts and omissions. In contrast, LLPs are a form of partnership. Double taxation is avoided automatically but LLPs offer less liability protection than general corporations or LLCs. The personal assets of LLP partners are at risk for their own acts and omissions, acts of those under their supervision and for obligations the entity incurs in the ordinary course of business. Given these distinctions, are LLCs right for CPA firms?

The accounting profession has experienced many challenges in recent years, including meeting increased demands in its role as "public watchdog," evaluating complex transactions such as derivatives and interpreting a rash of difficult new standards. One important issue facing US. accounting firms is the liability crisis. Litigation, although often frivolous, frequently results in out-of-court settlements or judgments. Joint and several liability means audit firms often are targeted as "deep pocket" defendants.

The collapse of Laventhol & Horwath demonstrates the catastrophic effect on partners' personal assets when a partnership is forced into bankruptcy. Such events have increased awareness of the need for new organizational forms for CPA firms. Before the American Institute of CPAs changed its bylaws in January 1992 to permit CPAs to practice in any organizational form permitted under state regulation or law, most limited liability forms were not even an option for CPA firms.

LLCs do offer attractive features for CPA firms. However, this relatively new organizational form is not yet available in all states--a problem for national or even some regional CPA firms. Not only must LLCs be recognized in a state, but the state legislature and state board of accountancy must approve the form for CPA firms.

Accounting firms organized as limited liability partnerships, on the other hand, should not have this problem; an LLP is a form of general partnership. All states permit accounting firms to organize as general partnerships. As a result, the six largest accounting firms have reorganized as LLPs.

Although LLPs are an improvement over general partnerships in terms of personal liability protection, they generally provide less personal liability protection than corporations or LLCs. Given the personal liability protection limitations of LLPs, the role of LLCs in helping accounting firms deal with the liability crisis and other concerns probably will increase as the remaining states adopt LLC statutes and allow CPA firms to take advantage of them.

H. WAYNE CECIL, CPA, is an accounting doctoral student at the University of Kentucky, Lexington. CONRAD S. CICCOTELLO, PhD, JD, is associate professor of finance at the US. Air Force Academy, Colorado Springs, Colorado. C. TERRY GRANT, CPA, PhD, is assistant professor at the School of Professional Accountancy, University of Southern Mississippi, Long Beach.