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Considerations when asking: to be or not to be an LLC?

Even though Wyoming adopted the first limited liability company (LLC) statute in 1977, most of the other 30 states with these provisions have adopted laws within the past five years. As the number of states authorizing LLCs increased, the interest in this type of entity has grown exponentially.

The economic and other

nontax considerations

of the LLC

The LLC will soon be the entity of choice over the S corporation and partnership for start-up companies whose business does not cross state borders. In the future this choice will likely expand to cover new multistate corporations as well. Existing entities have additional liquidation concerns that may restrict their changing to the LLC form.

* Limited liability: For a business that wants personal protection for its owners but does not want the regimentation of a corporation, the LLC is a viable alternative Most statutes will not eliminate the professional malpractice liability for the owner's own negligence or for those who are subordinates of that owner. It will, in most cases, insulate the owner from the malpractice of other owners and noncontrolled subordinates.

* Reduced insurance costs: Malpractice insurance may be reduced because of this insulation. This may not fully insulate professionals when the LLC veil can be pierced and therefore may be of only small value in certain cases. Tort insurance (e.g., auto, product liability, etc.) can also be reduced when the fear of personal liability is removed, but this is a business decision that must include consideration of the business's net worth and its ability to continue operating in the face of a significant lawsuit.

* Stress reduction: With the proliferation of litigation, especially against professionals, an LLC may allow its owner(s) to concentrate more on operating the business and less on taking defensive measures.

* Freedom of movement: For entities that periodically adjust partners' profit participation, the possibility of adverse tax consequences that would arise in a corporate atmosphere is reduced.

* Importance of form: When professional corporations became popular in the late 1960s and early 1970s, these entities were advised to respect the law's formalities to avoid an unnecessary attack on the existence of the entity as a corporation. The same must be said of the new and untried LLC. With that in mind, and given the importance of establishing and maintaining the LLC limited liability protection, the LLC should invest in new stationery. While announcements are optional, the designation of "LLC" or "limited liability company" (much like "Inc.," "Corp." or "P.C.") is probably required, and certainly recommended, on letterheads, in telephone directories, in advertisements, etc.

Federal tax considerations

Corporate characteristics: To be recognized for tax purposes as a partnership, and avoid being treated as an association taxable as a corporation, the LLC must meet the IRS-imposed requirement of not having more corporate characteristics than noncorporate characteristics (Regs. Sec. 301.7701). The Service considers the following four traits as corporate characteristics: 1. Limited liability. 2. Centralization of management. 3. Continuity of life. 4. Lack of transferability of interests.

Having two of the characteristics will not cause the entity to be taxed as a corporation, since it is not more than half.

Rev. Rul. 93-38, involving the classification of a Delaware LLC, offers an in-depth analysis and discussion of the corporate characteristics as they relate to LLCs. It was important in this ruling that the Delaware act allowed some of its statutory provisions to be modified via the LLC agreement. The Service ruled that, depending on the provisions of the agreement, a Delaware LLC could be classified as either a corporation or partnership.

Most LLCs will have centralized management and limited liability, and therefore they will need to be structured so as not to have either free transferability of interest or continuity of life.

The IRS ruling policy will continue to play an important role in structuring agreements. For example, with regard to "continuity of life," the Service has ruled that majority consent 50+%) to dissolve is insufficient to defeat continuity of life (Letter Ruling 9010027), but 85% consent is sufficient (Letter Ruling 9010028) and a fixed duration in an agreement is, by itself, not sufficient to defeat continuity of life (Regs. Sec. 301.7701-2(b)(3)).

A critical factor in this analysis is the state law under which the LLC was created, since some state laws have what are termed bulletproof" noncorporate characteristic provisions that cannot be altered by the operating agreement. (For example, a state law that does not permit the LLC to alter its law with respect to unanimous consent required to transfer an interest and/or termination of the entity on a dissolution event (death, bankruptcy, etc.) - both of which are noncorporate characteristics-is a "bulletproof" statute.) While such a law prevents an entity from shooting itself in the tax foot, so to speak, it may interfere with the normal operation of a business. For that reason, a "flexible" statute (such as is proposed in New York) that allows the LLC to alter its provisions is preferable. It is then the LLC's responsibility to draft the appropriate language in its operating agreement to meet both the LLC's business needs and the Service's requirements.

Treatment of nonrecourse liabilities in the determination of a member's LLC tax basis: As is true with all partnerships, as long as no member bears the economic risk of loss on a nonrecourse debt, such debt will be allocated among all LLC members proportionately in determining the member's partnership basis for the purpose of determining his allowable deductible loss (Regs. Sec. 1.752-3(a)); however, an LLC that incurs losses may not be able to use the cash method of accounting.

Cost to convert from C and S corporations to LLC: To take future advantage of an LLC, existing C and S corporations may have to pay a liquidation toll charge (for a C corporation, the C corporate level tax plus the C shareholder's individual tax; for an S corporation, the S shareholder's individual tax (assuming there is no built in gains tax)). Because of the toll charge and, in the author's opinion, the continued significant advantages of the S corporation or LLC, existing C corporations may look to expand via the creation of a separate LLC. Such a separation must be structured carefully to avoid the imposition of constructive distributions to the corporate owners.

Unlike the corporate liquidation problem, a conversion from a partnership to an LLC should not create adverse tax consequences unless it affects the partners' share of liabilities (Letter Rulings 9010027, 9029019, 9119029, 9210019 and 9321047).

The cash method of accounting may not be available to some LLCs: Generally, a tax shelter must use the accrual method (Sec. 448(a)(3)). A tax shelter includes a syndicate (Sec. 461(i)(3)(B)). A syndicate means any entity (other than a C corporation) if more than 35% of the losses are allocable to limited entrepreneurs or limited partners (Sec. 1256(e)(3)(B)). A limited entrepreneur is a person who is not a limited partner and does not actively participate in the entity's management (Sec. 464(e)(2)). Unless the IRS rules otherwise, an LLC could be treated as a tax shelter and thereby be required to use the accrual method of accounting. In June 1993, the Service released Letter Ruling 9321047, ruling that a general law partnership that converted into an LLC was not a tax shelter and could remain on the cash method of accounting. To reach

its decision, the IRS analyzed the following facts:

* The LLC did not and would not offer interests for sale in any registered offering.

* All members of the LLC would actively participate in the practice of law.

* The LLC would not be organized for a tax avoidance motive (the old partnership represented that it always had reported taxable income).

Other advantages and

disadvantages of LLCs

over S corporations

and/or partnerships

LLC advantages:

1. Avoidance of S corporation traps such as the requirement of a timely filed election; basis limitation; unexpected taxation of distributions; built-in gain rule; and passive income to an S corporation with earnings and profits.

2. Limited liability for all of the owners.

3. More workable for foreign investors.

4. Any type of entity can be a member. However, be aware that a partnership including an LLC) with a C corporation (other than a qualified personal service corporation) partner must use the accrual method of accounting.

LLC disadvantages:

1. The unanswered IRS questions as to how to designate a tax matters partner since an LLC does not have a general partner; one-member LLCs; passive activity considerations.

2. The LLC concept is not court tested, which will result in a proliferation of litigation in state and local courts.

3. Multistate uncertainty (such as a Florida LLC doing business in Colorado being taxed as a corporation for Florida purposes but as a partnership in Colorado) and the tax and legal issues stemming from mergers, unitary tax rules, etc.


The LLC is certainly appropriate for a single state user. Hopefully, in the not too distant future, it will also be appropriate for multistate users.
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Article Details
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Title Annotation:limited liability corporation
Author:Weiner, Alan E.
Publication:The Tax Adviser
Date:Oct 1, 1993
Previous Article:U.S. estate taxation of nonresident aliens.
Next Article:Retroactive AMT break may be available to individuals and corporations.

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