The limited liability company in seven easy lessons: a tax executive's primer.
Lesson 1: What is an LLC?
Conventionally, in the United States, large businesses with significant capital needs have been established as C Corporations. Tax executives are usually aware that organizers of smaller businesses or discreet projects might use a partnership structure, but the tax adviser's role did not usually extend to determining whether a flow-through structure would produce tax savings.
For many years, the only significant variations in this simple C Corporation/partnership dichotomy arose in respect of small businesses. They were the possibilities that a smaller corporation's shareholders might elect to be taxed under Subchapter S of the Internal Revenue Code or that a partnership might be established as a limited partnership. Of course, both the Subchapter S corporation and limited partnership variations were efforts to obtain insulation from business liabilities while mitigating the socalled double tax that results when a C corporation pays federal income taxes on its profits and the shareholders pay federal income taxes a second time when those profits are distributed to them as dividends.
Enter the LLC--a legal entity with big business application that offers an exciting alternative to use of either a corporation or partnership.
The LLC is often described as a hybrid entity, something between a corporation and a partnership. This seems to be largely based on a properly organized LLC's combining the most desired business attribute of a corporation, statutory insulation against liability for all investors, with the most desired business attribute of a partnership--elimination of the double tax on business earnings. Although the LLCs combination of limited liability and tax savings is in some ways similar to the benefits afforded by a Subchapter S corporation or a limited partnership, the LLC is in many respects a very distinct and more flexible structure rather than the simple mixing of corporate benefits with partnership tax treatment.
Lesson 2: LLC Speak--A New Vocabulary
Key distinctions between the LLC and both corporations and partnerships are underscored by the LLC's unique nomenclature, reflecting its distinct organizational and documentary structure. First, the entity itself is referred to as a company when the full term "limited liability company" or the abbreviation "LLC" is not used. LLCs, like corporations and partnerships, are created by a filing with the State. But an LLC files neither corporate Articles of Incorporation nor a partnership Certificate of Partnership. Instead, it files Articles of Organization. Like the corporate and partnership counterpart documents, the LLC's Articles of Organization set forth the information needed to be in the public domain including the name and address of the company's registered office and agent.
The owners or investors in the company are members rather than shareholders or partners and, like a partnership and unlike a sole shareholder corporation in most States, there must be at least two members. The agreements and understamembers themselves with respect to operation of the LLC are reflected in an Operating Agreement. This may have some elements of a corporate shareholders agreement and bears a strong resemblance to a partnership's partnership agreement. Like partners in a general partnership and unlike shareholders, the LLC's members have the right to participate in management of the company and its business activities. Such participation, however, is not compulsory and some or all of the members may vote in a shareholder-like fashion to delegate supervision of the LLC's activities to managers. Managers' authority is comparable to corporate officers', and the managers may, but need not, be members of the LLC.
Lesson 3: The LLC's Background
The LLC came to America in part as an outgrowth of corporate America's international trade. When American businesses went abroad, they encountered new forms of legal entities such as the German Gesellschaft mit beschraenkter Haftung (or GmbH) and the Lati American limitadas. These foreign-law entities were company-type structures but could be organized to have more flexible management and investment return arrangements than the traditional U.S. corporation, while still avoiding liability under the foreign country's laws. Businesses needed to know, for U.S. foreign tax credit and other purposes, how the Internal Revenue Service would treat such unorthodox companies. In the late 1970s, it became clear that the IRS was willing to classify such entities for U.S. tax law purposes by applying the extant regulations on corporate-partnership determinations.
Ultimately, business began to push for laws permitting the establishment of similarly flexible entities in the United States. Although the first U.S. statute was enacted in Wyoming in 1977 in response to a special taxpayer situation, progress across the country was slow. Before 1990, only Florida had joined Wyoming in enacting an LLC statute. Other factors, however, were beginning to work that would significantly accelerate interest in the LLC as a business form.
Tax reform gave the movement a large push. Businesses and particularly closely held corporations, were beginning to feel the pinch of the Tax Reform Act of 1986. Shareholders who needed to withdraw earnings from a corporation found tax reform and the repeal of the General Utilities doctrine had eliminated techniques by which corporate shareholders had previously been able to avoid double tax on the withdrawal of corporate earnings.
Then, the IRS indirectly helped propel the LLC into contention when in late 1988 it ended a long period of uncertainty over how it would treat domestic LLCs by issuing Rev. Rul. 88-76, 1988 C.B. 360. The ruling dealt with the tax status of an LLC created under the Wyoming statute. It held that if a Wyoming LLC were structured with sufficient partnership attributes, then like the foreign GmbH or limitada, it could also be treated as a partnership for federal income tax purposes.
Lesson 4: When to Watch For or Use an LLC
By the end of 1992, the surge of interest in LLCs had resulted in approximately 20 States adopting some form of LLC legislation, including the corporate bellwether State of Delaware, which adopted a very flexible LLC Act. Delaware's action added clear business respectability to the LLC as an alternative business form. By mid-1994, the number of States with LLC statutes had grown to 43 with LLC legislation pending in each of the remaining seven States.
This expansion of LLC availability has greatly increased the opportunity for the corporate tax executive to encounter an LLC. The experience after the first several years of widespread LLC availability and use suggests LLCs are likely to become the vehicle of choice and play key rolls in several types of transactions even for enterprises whose status as a Subchapter C taxpayer is secured by publicly traded status.
* Joint Ventures. As corporate joint ventures grow to allow companies to share technology, reduce high capital costs, and limit risk exposures, the LLC has become the joint venture structure of choice. The LLC statutes provide joint venturers with the liability protections they desire while federal partnership tax treatment permits the venturers to vary cash and tax allocations in flexible ways that can maximize the benefits of participation to each venturer.
* Project Financing. LLCs make excellent vehicles for raising capital from outside and particularly from institutional investors seeking to improve their return through equity participation. The partnership tax treatment allows the corporate organizer to structure the project to provide priority cash flow allocations and tax benefits to investors. At the same time, the management provisions of most LLC acts allow the appointment of one or more managers with powers comparable to corporate executives, assuring an appropriate level of corporate business and financial control for the organizer.
* Business Restructuring. An LLC can be an ideal vehicle for holding the assets of a business during restructuring, particularly if creditors or other participants are involved. The partnership tax treatment allows allocation and flow-through of current losses to participants that can use them while avoiding additional tax burdens on the business trying to recover. At the same time, the LLC Act's liability protections assure participants of protection from potential downside liabilities associated with a business for which recovery may not be assured.
Lesson 5: Assuring Partnership Tax Classification of the LLC
One of the key issues for the tax executive whose business is considering use of, or participation in, an LLC is the proposed LLC's ability to meet the current IRS tests for partnership classification. The IRS position is that any LLC that fails to meet its tests will be classified, for federal tax purposes, as an association taxable as a corporation. Such a non-partnership LLC would presumably not qualify for the protection of section 704's safe harbors with respect to special allocations to participants. Moreover, since in many cases the presence of a corporate or foreign member or other factors might cause the entity to fail to be eligible or qualify for the Subchapter S election, the distributed earnings of an LLC that failed the IRS tests could be subjected to double federal income taxes, eliminating the flow-through treatment that is one of the major advantages of the LLC form of organization.
The IRS's current classification tests are set forth in Treas. Reg. [sections] 301.7701-2, which providefour criteria for determining entity classification. Each is a characteristic that the IRS views as indicative of corporate rather than partnership character. They are:
* Limitation of Liability
* Centralized Management
* Free Transferability of Interests
* Continuity of Life An LLC seeking to be classified as a partnership by the IRS may posses no more than two of the foregoing characteristics.
Limitation of Liability. Since statutory protection of LLC members from the company's liabilities is one of the key attributes making the LLC desirable, an LLC will almost invariably possess the first characteristic. Therefore, in practical terms, the burden is on the LLC to effectively demonstrate the absence of at least two of the three remaining characteristics.
Centralized Management. This characteristic will be present if any person (or group) has the exclusive authority to make the management decisions necessary to the conduct of the business. If the owners of an LLC have chosen to have the company run by managers, the company will also possess the corporate characteristic of centralized management. On the other hand, if the LLC is organized to be member-managed so that each member participates in the management or at least has voting rights on all material matters (as is frequently the case with a joint venture), then the characteristic of centralized management can be avoided.
Free Transferability of Interests. This characteristic is present if the owners of the business have the right to transfer all rights and incidents of ownership to another person who is not an owner without obtaining the consent of the non-transferring owners. Transfers and assignments by members of an LLC may be restricted in the Operating Agreement and in some States by the LLC legislation itself. Absent such restrictions, an LLC will be viewed to possess the corporate characteristic of free transferability of interests. Since businesses are typically very concerned about who their business partners are, restricting transfers (e.g., by requiring consent of the other members) is not ordinarily difficult to implement.
Continuity of Life. This characteristic is present if the bankruptcy, death, insanity, retirement, or expulsion of an owner will not cause dissolution of the organization. The Operating Agreement may provide that any such event terminates the entity and in some States the LLC legislation may provide for such termination. If such termination does not occur, an LLC will be viewed to possess the corporate characteristic of continuity of life. Careful planners, however, can also take advantage of the IRS's position that it will not regard an entity to possess continuity of life merely because its Operating Agreement provides that upon the occurrence of a terminating event the organization may be continued if the remaining owners vote for such continuation.
Lesson 6: Tax Compliance Issues
Having facilitated the LLC movement with the publication of the Wyoming revenue ruling, the IRS has continued to monitor the development of LLCs closely. Rulings have now been published for a number of additional States, again including the corporate bellwether Delaware in Rev. Rul. 93-38, 1993-21 I.R.B. 4. Moreover, the IRS's 1994 Business Plan includes the publication of a comprehensive revenue procedure addressing the organizational and operational federal tax issues the IRS has identified so far with respect to LLCs.
Applicability of Partnership Compliance Procedures. Although technical issues clearly remain, federal tax compliance for LLCs has proceeded relatively smoothly under the IRS's efforts. This is partly a function owing to the IRS's generally viewing LLCs as partnerships for tax purposes and, hence, its opinion that the established body of rules applicable to partnership compliance are largely applicable to LLCs. For example, the LLC files a Federal Form 1065 (Partnership Return) and the unified audit procedures provided for partnerships under sections 6221, et seq., apply to LLCs and their members. Thus, a well-prepared Operating Agreement will designate a Tax Matters Member or Tax Matters Person for the LLC, just as partners do in their partnership agreement.
Allocation of Partnership Tax Items. An LLC possess the same considerable flexibility that a partnership has in providing for differing classes of investors to receive differing rates or amounts of return on their investment at different times by means of special allocations. The differing investment returns that a partnership (or LLC) may offer, however, will be respected by the IRS for tax purposes only if the allocations are found to have "substantial economic effect" within the meaning of the detailed and highly complex set of regulations applicable to partnership allocations under sections 704 and 752. Therefore, the tax executive must take an active role in drafting or reviewing the proposed Operating Agreement to ensure that tax compliance has been addressed by provisions requiring capital accounts for the LLCs members, conformity with the mandatory provisions concerning contributed assets, use of non-recourse financing, and other tax items for which specific tax treatment is provided.
State Tax Consideratios. One of the most important business issues that owners or investors considering use of an LLC will have to consider is the question of the availability of an LLC statute in that State to provide the LLC's limitation. This will be particularly true during the transitional period before LLCs become universally recognized, since the status of an LLC in States that have not yet adopted LLC authorizing legislation is likely to be unclear.
If protection from liability cannot be confirmed, adoption of an LLC structure may have to be deferred and alternative transitional forms considered. In this situation, input from the business's Tax Department will be very important. For example, a joint venture LLC in which liability protection was the most important requirement might be organized to protect itself and the venturers through the use of subsidiary corporations (owned by the LLC) in non-LLC jurisdictions. Alternatively, an LLC in which avoiding multiple tiers of taxation was the most important motivation might be organized so that each owner would participate in the LLC through a separate corporation organized to serve as the owner's LLC member. A single tier of taxation can be preserved if the corporate owners' participating corporations are members of an affiliated group filing consolidated federal tax returns.
For similar reasons, the state tax consequences of adopting or using an LLC for business should also be carefully examined. Most States accept the federal classification of business entities for state tax purposes. Accordingly, if an LLC has been successful in obtaining partnership classification for federal income tax purposes, the LLC's members are likely to be taxed by such jurisdiction in the same fashion as that State taxes partners in conventional partnerships.
Not all jurisdictions that have adopted LLC legislation, however, have promulgated tax rules with respect to LLCs that accept the federal partnership classification and flow-through of income tax treatment for state tax purposes. State officials in a few jurisdictions, notably New York which has only belatedly passed an LLC statute, have expressed concern that the spreading use of LLCs may erode the States' tax base. While such concerns appear to be without foundation, there can be no assurance that the earnings of businesses conducted in LLC form will not be subjected to some form of additional entity-level taxation by such States as some jurisdictions already do with respect to Subchapter S corporations. It is certain that the tax executive in a business considering the use of an LLC should investigate the tax situation in each State in which significant operations are likely to be conducted as part of the decisionmaking process.
Lesson 7: The Other Guy's LLC
Finally, even if an LLC may not be the right vehicle for a particular business, there is no doubt that every tax and business executive will need to understand the LLC to understand and advise on the tax posture and tax concerns of that businesses' suppliers and customers. The unique combination of advantages and flexibility the LLC offers will make this new form of organization attractive to many businesses. That, together with rapidly growing American familiarity and acceptance of the LLC, virtually assure that the LLC will become the standard third option to a partnership or corporation as a form of business organization. As a consequence, LLCs can be expected to appear with increasing frequency as customers of and suppliers to other conventionally organized businesses. Dealing with such LLC-structured businesses will have corresponding implications for security, guaranty and other arrangements in numerous contracts and transactions. It follows that every tax executive will sooner or later need to understand America's newest and hottest business entity.