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LLC update.

Last year, this column published an article on limited liability companies (LLCs) and the increased interest in LLCs generated by the change in AICPA Code of Professional Conduct Rule 505. (See Tax Practice Management, "Conducting a Tax Practice in the 1990s," TTA, Dec. 1992, at 835.) This article will cover current developments.

LLCs are created under state laws. Instead of filing articles of incorporation, LLCs file articles of organization. The organization must have one or more members and have a business objective and a method to divide profits. These characteristics are common to both corporations and partnerships. The objective of an LLC is to achieve passthrough tax treatment while protecting the personal assets of its members from liability for the debts and obligations of the business. Therefore, LLCs almost always have the limited liability corporate characteristic. Note: In some states, limited liability may be waived in the LLC's articles of organization (e.g., the Virginia Limited Liability Company Act allows such a waiver; see Rev. Rul. 93-5).

Regs. Sec. 301.7701-2 lists six characteristics that may require a business to be subject to corporate taxation:

1. Associates.

2. An objective to carry on business and divide the profits.

3. Limited liability.

4. Continuity of life.

5. Free transferability of interests.

6. Centralized management.

LLCs generally have the first three characteristics. Recent revenue rulings have addressed the remaining three characteristics. The test for favorable tax treatment relies on whether the business entity has more than one of the remaining three corporate characteristics (items 4 through 6). Corporate taxation will apply unless the association lacks at least two of these characteristics.

Corporate characteristics

Free transferability of interests: LLCs formed under the applicable state laws lacked the corporate characteristic of free transferability of interests if, under the state law, a member of the LLC could assign or transfer that member's interest to another person who is not a member of the organization, but the assignee or transferee would not become a substituted member and would not acquire the attributes of the member's interest in the LLC. The IRS has ruled on the following state laws: Colorado, Dela-ware, Florida, Illinois, Nevada, Virginia and West Virginia.

Continuity of life: LLCs formed under the applicable state laws lacked the corporate characteristic of continuity of life when, under the law and the articles of organization, the LLC would dissolve on the occurrence of certain events, unless within a specified time period all of the remaining members consented to continue the business, or the right to continue the business was specifically set out in the articles of organization. "Certain events" would include death, retirement, resignation, expulsion, insanity or dissolution of a member, or any other event that terminates the continued membership of a member in the company.

The IRS has ruled on LLCs organized under the state laws of Colorado, Delaware, Florida, Illinois, Nevada, Texas, Virginia and West Virginia that if a member of the LLC ceases to be a member f or any reason, the continued life of the LLC is not assured; all or a portion of the remaining members must agree to continue the business. The IRS did rule that an LLC in Delaware possessed continuity of life, since the LLC agreement provided that the LLC would continue after certain events (Rev. Rul. 93-38).

Centralized management: Most state statutes allow management authority to rest in the hands of each member of the LLC unless they choose to concentrate management authority in the hands of just a few members or to hire non-members to manage the business. When all members can exercise management authority to bind the LLC as a membership right, the corporate characteristic of centralized management is lacking. LLCs formed under the following states' laws possessed the corporate characteristics of centralized management, when, under the LLCs' articles of organization, the LLCs were managed by elected managers: Colorado, Delaware, Florida, Illinois, Nevada, Virginia, West Virginia and Wyoming. Each of the LLC laws for these states provides that an LLC may be managed either by an elected manager or managers or by its members.

Recent revenue rulings dealing with LLCs formed under the applicable LLC laws for the states listed in Table 1, at right, were classified as partnerships for Federal purposes. Each ruling addressed the characteristics that enabled the LLC to be treated as a partnership.
Table 1: LLCs Classified as Partnerships

 Colorado Rev. Rul. 93-6
 Delaware Rev. Rul. 93-38
 Florida Rev. Rul. 93-53
 Illinois Rev. Rul. 93-49
 Nevada Rev. Rul. 93-30
 Texas IRS Letter Ruling 9210019
 Virginia Rev. Rul. 93-5
 West Virginia Rev. Rul. 93-50
 Wyoming Rev. Rul. 88-76

Note: Rulings on other state statutes are pending.

The number of states allowing the formation of LLCs is continuing to grow, as exhibited in Table 2, at right.
Table 2: States That Have Approved LLC Formation

 Alabama Effective 10/1/93) Michigan (effective 6/1/93)
 Arkansas (effective 4/12/93) Minnesota (effective 1/1/92)
 Arizona (effective 9/30/92) Montana (effective 10/1/93)
 Colorado (enacted 4/18/90) Nebraska (effective 9/9/93)
 Delaware (effective 10/1/92) Nevada (effective 10/1/91)
 Florida (enacted 4/82) North Dakota (effective 7/1/93)
 Georgia (effective 3/1/94) Oklahoma (effective 9/1/92)
 Idaho (effective 7/1/93 Rhode Island (enacted 9/19/92)
 Illinois (effective 1/1/94) South Dakota (effective 7/1/93)
 Indiana (effective 7/1/93) Texas (effective 9/1/91)
 Iowa (effective 7/1/92) Utah (effective 7/1/91)
 Kansas (effective 7/1/90) Virginia (effective 7/1/91)
 Louisiana (enacted 7/7/92) West Virginia (enacted 3/6/92)
 Maryland (effective 10/1/92) Wyoming (enacted 1977)

In addition, authorizing legislation is pending in several other states, including California, Hawaii, Massachusetts, Missouri, New Jersey, New York, Pennsylvania, South Carolina and Tennessee.

LLCs will continue to be approved, and the IRS will continue to make rulings. LLCs are common south of the border (they have been allowed in Mexico since 1934) and may be even more popular if the North American Free Trade Agreement is passed. Similar forms of business entities have been established in Europe as well.

An LLC has several advantages over other flow through entities such as S corporations and partnerships.

S corporations

Structure: Under the Code, an S corporation may have no more than 35 shareholders. An LLC, on the other hand, is not limited as to the number of members it may have. However, most states do require at least two members to form an LLC. In addition, if an LLC has more than 500 members it could be classified as a corporation under the publicly traded partnership rules (see Notice 88-75).

LLC statutes do not restrict the types of members that may own LLC interests. In contrast, S corporations may not have shareholders that are corporations, nonresident aliens, partnerships, pension plans, certain trusts or charitable organizations. In addition, S corporations cannot be members of an affiliated group or own more than 80% of the stock of another corporation. No such restrictions apply to LLCs.

Taxation: An LLC is treated as a partnership for tax purposes and, therefore, has a number of options not available to S corporations. For example, an LLC may take advantage of the special allocation rules under Sec. 704(b), while an S corporation is subject to the one-class-of-stock rule under Sec. 1361.

Another significant advantage of an LLC is that the members will get an increase in basis in their LLC interests for their share of the LLC's liabilities. In contrast, S shareholders receive no such increase in basis.

Limited partnerships

Structure: The most significant difference between LLCs and limited partnerships is that a limited partnership must have at least one general partner who is personally liable for the obligations of the limited partnership; an LLC, on the other hand, has no such requirement.

Taxation: A key difference between the tax treatment of LLCs and limited partnerships is the basis of the owners. Sec. 752 explains the difference between recourse debt and nonrecourse debt on the basis of the liability of the partner. If there is no economic risk of loss to a partner for a liability, that liability is nonrecourse debt. One of the characteristics of an LLC is that no member has personal liability for the obligations of the entity; therefore, it would appear that all LLC debt would be nonrecourse. There are, however, no specific rulings that address this conclusion.

Under Sec. 469, a taxpayer's passive losses are suspended to the extent that such losses exceed the income from the taxpayer's passive activities. The Code defines a passive activity as a trade or business in which the taxpayer does not materially participate. There are different standards for material participation among corporate shareholders and general and limited partners, but no guidance has been issued on the standard that will be applied to LLC members. However, Sec. 469 will apply to LLC losses when the members do not materially participate.


It is evident that as more states adopt LLC legislation, and more businesses choose this structure to operate under, Congress will have to decide whether to continue to allow LLCs to operate as they do today or to restrict their flexibility in the future. The beginnings of change have already appeared: the Select Revenues Subcommittee of the House Ways and Means Committee has included LLCs on a list of areas that it hopes to hold meetings on this year. A subcommittee report expresses concern that, if left unchecked, LLCs could be a sanctioned way to undercut the two-tier system of corporate taxation.

Mr. Pascarella is a member of the AICPA Tax Division Tax Practice Management Committee. Mr. Bushnell is also a member of the committee.
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Article Details
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Title Annotation:Limited Liability Company; tax practice tips
Author:Bushnell, Willet R.
Publication:The Tax Adviser
Date:Dec 1, 1993
Previous Article:Deducting losses on worthless or abandoned assets.
Next Article:Allocating nonrecourse deductions - determining permissible sharing ratios.

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