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A new breed of company.

You see those puzzling initials everywhere: LLC and LLP. But do limited-liability companies and partnerships make dealing with your vendors and service suppliers a whole different ballgame?

One Monday morning, you get an alarming phone call. Your accounting firm has made a serious error, and the consequences could cost your company a bundle. You take a deep breath. Okay, we can get back most of that by suing the firm and, if necessary, the partners, you think. Then you remember: The firm is a limited-liability partnership, so you might not be able to go after all the partners. You may be limited to the amount for which the partnership is insured - not nearly enough to cover your costs. Uh oh.

While this isn't a likely picture for most companies, you should be aware that the limited-liability company and limited-liability partnership structures may become a bigger factor for your company during the next few years. That's because recent legislation has made it easier to form these entities. And although these structures probably aren't suitable for your corporation (especially if it's a large public company), many of the companies and firms you deal with will be selecting these new organizational structures, so you should have a general understanding of how they work and how they'll impact your company.

For many closely held companies, the LLC and LLP are attractive organizational alternatives to S corporations, general and limited partnerships and professional corporations. Currently, 47 states and the District of Columbia permit the formation of LLCs, and the remaining states (Hawaii, Massachusetts and Vermont) are considering adopting laws that would authorize LLCs. LLPs are permitted in fewer than 20 states, in part because some states extend the LLC definition to include what essentially are LLPs.

The LLC combines the best features of a partnership and an S corporation: the partnership's pass-through tax benefits and flexibility with the corporation's limited liability of management and owners. Yet an LLC has certain tax advantages that a limited partnership or an S corporation doesn't. For example, to qualify for favorable tax treatment, an S corporation can't have other corporations, partnerships or nonresident aliens as shareholders, and it can't own 80 percent or more of another corporation. Also, it's not allowed to have more than 35 shareholders and may have only one class of stock. None of these restrictions apply to an LLC.

Of course, the LLC is subject to certain parameters. Generally, to qualify for the favorable federal income tax treatment of a partnership, the LLC must not possess more than two of the following four corporate characteristics: limited liability; continuity of life, in which a corporation is assumed to continue existing indefinitely; the ability of shareholders to freely transfer their interests in the corporation; and centralization of management. Since an LLC by definition already has limited liability, in practice it must lack two of the remaining three traits. The Internal Revenue Service recently issued a proposal to replace this approach with a simple election that the unincorporated entity would make to be taxed as either a partnership or a corporation.

SOMEONE'S ON THE HOOK

The protection an LLC or LLP offers the partners involved is an important advantage. While a limited partnership isn't subject to the qualification restrictions of an S corporation, it must have at least one general partner who is personally liable for its debts. In contrast, all the members of an LLC may be protected from such personal liability. What's more, partners in a limited partnership can lose their limited-liability protection if they become too active as managers. LLC managers don't suffer this adverse effect; they can be as involved in managing the company as they want. However, if they act negligently or in bad faith, they are subject to personal liability comparable to that of corporate officers and directors.

Still, the LLC form is well-suited to many businesses. It's particularly appealing to entrepreneurial businesses with a small number of active investors because all members can enjoy limited-liability protection and favorable tax treatment and still participate in the business. Family businesses that want to maintain control within the family can obtain partnership tax benefits and restrict the transfer of voting rights outside the family by using the LLC.

LLCs also are appealing for passive investments like venture capital projects, technology and real estate. In these investments, limiting the liability of all owners is important, and the freedom to plan distributions and allocations of LLC income and losses is a desirable quality. Under an LLC structure, distributions don't have to be equally divided - the company can target certain shareholders to receive preferred allocations. Companies can also use the LLC form to set up debt offerings and structured finance transactions.

The LLC form is especially desirable for foreign investors because they can't be shareholders of an S corporation. Plus, the LLC is the most common business form in Europe and Latin America. This should encourage foreign investors to engage in more ventures and capital investments in the United States.

Businesses that are currently in corporate form, however, won't convert to LEG status because they'd incur adverse income tax consequences. Such a conversion would result in a deemed liquidation of the corporation, thereby accelerating the realization of gain on any appreciated property (including unbooked goodwill or other intangible assets) transferred to the new LLC and creating other undesirable tax consequences. In the case of a C corporation, the distribution also would be taxed at the shareholder level.

In contrast, the conversion of a partnership to form an LLC (which is treated for income tax purposes as a partnership) won't be treated as a taxable transaction unless it results in a deemed cash distribution from the partnership in excess of the partner's basis.

Publicly traded businesses or entities with a large number of owners will find their access to the LLC structure limited for several reasons. All four corporate characteristics - limited liability, continuity of life, free transferability of interest and centralization of management - are integral to the operation and management of a large, public corporation, and it's unlikely that large corporations would sacrifice any two traits to obtain the tax benefits to be derived from an LLC. For example, an LLC typically must lack free transferability of interest, which means that a member may not transfer a membership interest without the vote or written consent of a significant percentage of the remaining members - something unheard of in public companies. Also, at least until LLCs become more well-known to the general investing public, selling interests in them may be more difficult than selling stocks of corporations or interests in limited partnerships.

However, existing corporations contemplating a new venture that will be conducted through a subsidiary or an affiliate may want to consider creating an LLC. Because an LLC, unlike an S corporation, can own more than 80 percent of another corporation, it can insulate its other assets from the separate business risks of a new enterprise by creating subsidiaries, yet retain its favorable tax treatment. And each corporate joint venturer is able to limit its risk in the venture to its invested assets in the LLC. Bear in mind, however, that the courts recently have shown a trend toward expanding the scope of liability from the subsidiary to the parent company.

Traditionally, corporate joint ventures concerned with limiting liability formed a third corporate entity, which couldn't be an S corporation because of the shareholders' corporate status. Forming an LLC permits the losses from the venture to flow back to the venture partners. Also, an LLC permits greater flexibility in allocating the venture's revenues to meet the business goals and objectives of each joint venture party, including options like preferred returns, back-end returns, front-load returns and special rights.

STRICTLY PROFESSIONAL

The LLC's cousin, the LLP, is merely a form of partnership that registers with the state. Instead of making such partnerships spend the time and expense of organizing an entirely new LLC entity, many states now permit partnerships to convert to an LLP. Their existing partnership agreements can stay intact; they don't need specific modifications to satisfy the LLP's statutory requirements.

The variations among LLP statutes are much greater than among LLC statutes. In some states, any business can be conducted as an LLP. In others, such as New York, only professionals can use the structure. Still other states allow any business except professionals to be an LLP.

For years, many professionals have been able to avoid the personal liability of the partnership form of business by forming a professional corporation. But the trade-off here has always been that the professional corporation must pay corporate income tax, unless it qualifies as an S corporation. The introduction of the LLP structure allows professionals to enjoy the partnership's tax benefits while avoiding personal liability for the malpractice of other partners. In New York and Minnesota, the partners also can limit their personal liability for the partnership's commercial liabilities, such as leases, accounts payable and payroll taxes, but they're generally not liable for each other's professional errors and omissions or those of most employees.

The new limitation on personal liability of nonresponsible partners in an LLP is an important thing to remember, because if you're involved in a lawsuit with professional advisers whose firm is set up as an LLP, you may find that fewer assets are available to satisfy any judgment you win against the company.

The good news is that the LLP structure doesn't allow professionals to avoid personal liability for their own malpractice and the malpractice of other people under their direct supervision and control. In many states, an LLP is required to carry a designated amount of liability insurance, post a bond or otherwise designate and segregate partnership funds to satisfy potential judgments against the partnership or its partners. So during contract negotiations with a limited-liability firm, you can specify that certain parties have a greater degree of financial responsibility than others.

Now that you've had a primer on limited-liability companies and partnerships, you'll know what to expect if one of the companies you deal with adopts this structure or if you use it yourself for a joint venture. While for the most part your dealings with the firm won't change, remember that LLCs and LLPs differ somewhat from other forms of ownership, so proceed with caution.

Ms. Calderon is a professor at New York University's Stern School of Business in New York; you can reach her at (212) 998-0058.
COPYRIGHT 1996 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1996, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:limited-liability companies and partnerships
Author:Calderon, Jeanne
Publication:Financial Executive
Date:Jan 1, 1996
Words:1741
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