The second-generation limited liability company.
The LLC's popularity and rapid acceptance have been driven by the status of LLCs as "hybrid entities" that marry in one entity the most desired characteristics of both corporations and partnerships. It is a distinct category of legal entity with a separate legal personality under state law. The applicable rules, usually set forth in the state's limited liability company act, shield the LLC's owners (and managers) from the debts and liabilities of the entity, just as state corporation laws shield shareholders. The LLC is nonetheless treated as a partnership for federal (and most state) income tax purposes, thereby avoiding the burden of double taxation of its income (at the enterprise level and again when distributed as dividends).
The First-Generation LLC
Although the combination of corporate and partnership attributes made early LLCs desirable, effective utilization posed a number of challenges for the typical corporate enterprise.
First and foremost of the difficulties was the level of uncertainty in federal tax treatment. The Internal Revenue Service had ruled that a limited liability company could be classified as a partnership in Rev. Rul. 88-76, 1988-2 C.B. 360, and similarly in a series of subsequent private letter rulings. Under those rulings, however, achieving partnership or flow-through treatment depended upon each LLC's ability to separately meet the then current IRS classification tests, as set forth in old Treas. Reg. [sections] 301.7701-2.
The old regulations provided four criteria for determining entity classification. Each was a characteristic that the IRS viewed as indicative of corporate, rather than partnership, character. They were:
* Limitation of Liability
* Centralized Management
* Free Transferability of Interests
* Continuity of Life
An LLC seeking to be classified as a partnership by the IRS had to possess no more than two of the foregoing corporate characteristics. Any LLC with more than two corporate characteristics failed to meet the IRS test and was treated as an "association taxable as a corporation." Moreover, because of its nature, every LLC possessed the "corporate" characteristics of limited liability and thus came to the classification arena with one strike against it.
This classification problem made tax planning difficult. In addition, the need to satisfy the four-factor test restricted businesses' flexibility in negotiating business arrangements utilizing an LLC structure. For example, an LLC might seem the ideal vehicle for structuring a joint venture between two corporations, since the participants would want both flow-through tax treatment and protection from investor liability. In addition, joint venturers would typically prefer to structure the venture to avoid dissolution in the event one member were to withdraw or become bankrupt; if the joint venture was so structured, however, the LLC would possess a second corporate characteristic, continuity of life. Similarly, joint venturers would also like to structure the venture with a traditional management structure -- officers reporting to a board of directors -- but then the LLC would possess a third and fatal characteristic, centralized management. It followed (counting limitation of liability) that a venture organized as the typical corporate participant would almost invariably possess one corporate characteristic too many, risking loss of partnership flow-through status to its corporate owners.
Moreover, since the partnership-versus-corporation classification issue depended on the particular facts in respect of a proposed LLC, the law afforded no certainty of tax treatment even for those willing to forgo desired characteristics to achieve IRS partnership classification. Only after the bargain was struck could the LLC documents be reviewed to obtain some comfort on the tax classification question, and tax certainty was available only if the parties then successfully sought an opinion of counsel or private letter ruling from the IRS on their first-generation LLC's tax classification.
The need to meet the four-factor test also led to a second problem -- the inclusion of inappropriate provisions in limited liability company acts in a number of states in a misguided effort to save taxpayers from their own potential mistakes and to force federal tax classification of first-generation LLCs created under such acts into partnership status. Such laws, referred to as "bullet-proof" LLC Acts, were designed to produce LLCs that were virtually guaranteed to be treated as partnerships under the old Treasury classification regulations. Such statutes limited LLC organizers' ability to contractually modify the LLC structure to suit specific needs. For example, under some bullet-proof acts, if an LLC were structured to have "managers" to run the business, then the LLC could not either (i) permit free transfer of the membership interests or (ii) provide for the automatic survival of the LLC upon the withdrawal of a member or a bankruptcy, dissolution, or other terminating event with respect to such member.
A third -- and even more challenging -- problem was the appropriate federal tax classification of first-generation LLCs organized by a single investor (a structure then permitted under a few more progressive LLC Acts, most notably Texas's). Although the IRS appeared comfortable with the concept of a sole corporate shareholder, the problem that the first-generation LLCs raised under the old classification regulations was that it was necessary to have "associates" (i.e., more than one investor) to have a partnership. This view was reinforced by the Uniform Partnership Act, which still requires two or more partners for the existence of a partnership.
Enter the Second-Generation LLC
The foregoing problems and others set the stage for a new and innovative IRS approach to entity classification that, in turn, has allowed the development of a truly different and improved generation of limited liability company structures. The new regime was unveiled in the proposed regulations issued by the IRS on May 9, 1996. These were followed very quickly by final regulations, effective January 1, 1997. Treas. Reg. [subsections] 301.7701-1 through 3.
The new regulations represent a radical back-to-basics conceptual restructuring of IRS rules regarding entity classification. In developing the new regulations, the IRS had come to view the existing rules as a trap for the unwary. It reasoned that a well-advised taxpayer could already obtain flow-through or non flow-through status electively by manipulating the number of corporate characteristics an entity would possess under the four-factor test.
Accordingly, the IRS asked the daring question: "What if, rather than squeezing themselves into the tests of the regulations, taxpayers were simply allowed to check a box indicating whether they desired to be taxed as a partnership or as a corporation?" The new final regulations derive their popular name of "Check-the-Box Regulations" from the early articulation of this bold concept, though (through the default rules) in many situations even checking a box is unnecessary.
The Second-Generation Regulations
The starting point for understanding the simplicity of final or second-generation regulations is a per se rule requiring corporate classification for a limited number of entities based on reference to state corporate law (and a similar per se list of types of entities required to be treated as corporations under foreign laws). Under the per se rule, any entity described as a "corporation," "body corporate," or similar term is mandatorily classified as a corporation.
Virtually all business entities other than those treated as corporations under the per se rule (called "eligible entities" in the regulations) may be classified as a partnership, with the mechanics of such classifications set forth in a further series of default rules. The most important default rule is that domestic non-corporate entities are automatically classified as a partnership unless they file an election to be taxed as a corporation.
New default rules also apply to classification of foreign eligible entities under a pair of default rules focused on member liability, as follows:
Characteristics Under Organizing Statute Default Classification All members have limited liability Corporation Some members have unlimited liability Partnership
Special rules are also provided for certain industries and situations. For example, oil-and-gas joint operating agreements rise to the level of a deemed entity and therefore are treated as a partnership under the default rules, and exempt organizations that claim to be exempt but fail, default into corporate classification.
The approach of the new regulations resolves one of the major problems of first-generation LLCs: lack of certainty of federal tax treatment. The new certainty of classification is illustrated by the response of Treasury Department representatives who were asked, "What classification would apply if Delaware cloned its state corporation law as an LLC Act but avoided the negative per se words "corporate" or "corporation"?" The reply was the Treasury had actually considered that question and concluded that an LLC or other entity organized under such an act would be an eligible entity and default (because it was organized under domestic law) to partnership classification.
A vital corollary of the new certainty with respect to classification is that the limitations that the old four-factor test imposed on first-generation LLCs are gone. Encrustations of additional classification limitations -- such as the "separate interest" rule previously applied by the IRS where separate partners or members traced back to a single common owner -- are also gone. An LLC or other entity may now have as few or as many "corporate" characteristics as the business situation demands.
An additional major advance of the new classification regulations is resolution of the issues relative to classification of single-member LLCs. Entities that have a single owner and are not treated as corporations are now disregarded. In other words, such entities are treated not as a partnership, but rather a proprietorship, branch, or division of the single owner.
Second-Generation LLC Acts
The additional condition for the emergence of the second-generation LLC rapidly followed the final promulgation of the Check-the-Box Regulations. There has been a rapid wave of revisions to state LLC acts, generally eliminating old bullet-proof restrictions and making LLCs more flexible entities. For example, a typical second-generation LLC act now permits LLCs to have perpetual existence as a company (without dissolution upon the bankruptcy or withdrawal of a member). Such acts also typically provide for organization of LLCs with a single member.
Many states have also moved to modify state corporate laws as well to increase flexibility in using LLCs, for example, by allowing mixed entity mergers. Thus, LLCs may merge with and into corporations and vice versa, making restructurings and reorganizations involving LLCs much simpler.
Using the Second-Generation LLC
The combination of the new Check-the-Box Regulations and improved state LLC laws lays the groundwork for greatly increased opportunities for the utilization of second-generation LLCs by the corporate tax executive. The experience after the first year of new tax and state law flexibility suggests LLCs will continue to be the vehicle of choice for a number of corporate transactions and increasingly play key roles in a growing number of new situations.
* Joint Ventures. As corporate joint ventures proliferate for compelling reasons -- such as allowing companies to share technology, reduce high capital costs, and limit risk exposures -- the LLC continues to be the joint venture vehicle of choice. It provides joint venturers with the liability protection they desire, while federal partnership tax treatment permits the venture participants direct realization of the tax attributes. The Check-the-Box Regulations and LLC statute amendments afford durability and longevity to the LLC while enhancing participants' ability to vary management roles and cash and tax allocations in significantly more flexible ways that can maximize the benefits and desirability of participation to each venture partner.
* Project Financing. LLCs continue to make excellent financing vehicles because of their flow-through at tributes. The second-generation rules enhance this capability, particularly with respect to lenders that insist on the use of "bankruptcy-remote" entities in a lending claim. In particular, LLCs can now be more easily structured to assuage lender (and investor) concerns with respect to durability (non-dissolution) of an LLC without sacrificing desired management control or structures.
* Ultimate Tax Consolidation. The new rules with respect to single-member LLCs afford new corporate planning opportunities. Since a wholly owned LLC (which is not a corporation) is treated as a division or branch of its corporate parent, an element of a business can be organized as a separate wholly owned LLC for liability protection or management structure purposes, while the tax results flow fully and automatically into the parent's return (as the earnings of a branch or division) without intercompany adjustments or suspense accounts. In effect, second-generation LLCs allow simultaneous organizational separation and ultimate tax consolidation. Moreover, for a multi-entity enterprise that has not made a consolidated return election, second-generation LLCs may also permit selective consolidation through use of LLCs for operations to be consolidated and simultaneous use of corporations (or LLCs that elect to be taxed as a corporation) for operations that are not desired to be consolidated.
* Reorganizations. There are numerous potential uses for second-generation LLCs in the corporate merger-and-acquisition area. For example, a public parent corporation desiring to acquire a target corporation often finds it necessary to resort to the triangular reorganization provisions of section 368(a)(2) (D) or (E) of the Internal Revenue Code in order to avoid, for example, a public shareholder vote on the merger. The merger may be executed in Delaware or in many other second-generation LLC act jurisdictions through the merger of a wholly owned LLC and the target without approval of the public parent's shareholders. Moreover, such a merger would appear to merit tax-deferred treatment as a reorganization under section 368(a)(1)(A) of the Code since the LLC is a mere division of the parent -- making compliance with the more restrictive triangular merger provisions under section 368(a)(2) unnecessary.
Of course, second-generation LLCs are not perfect. Not all states have caught up legislatively with the Check-the-Box Regulations or revised their LLC Acts with respect to single-member LLCs, mixed-entity mergers, etc. Thus, use of a second-generation LLC structure is an area where consultation with qualified tax counsel remains an important ingredient. Nonetheless, improvements represented by the second-generation LLC are substantial and can offer tax executives exciting new business planning opportunities and alternatives with which to face the new tax millennium.
WILLIAM E. ELWOOD is a member in Dickinson Wright PLLC, Washington, D.C., and Detroit, Michigan, and a member of the ABA Section of Taxation's National LLC Task Force and its Committee on Partnerships. He was formerly a member of Tax Executives Institute's Baltimore-Washington Chapter and served as chair of the Institute's Federal Tax Committee. His last article for The Tax Executive, "The Limited Liability Company in Seven Easy Lessons: A Tax Executive's Primer," appeared in the September-October 1994 issue.
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|Author:||Elwood, William E.|
|Date:||Sep 1, 1998|
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