LIMITED LIABILITY COMPANIES
IS AN LLC SUPERIOR TO A PARTNERSHIP IN ANY WAY?
An LLC is superior to a partnership in that it provides its members with the benefit of limited liability. An LLC is closer in relationship to a partnership than it is to a corporation. However, unlike a partnership, where the general partner remains personally liable, an LLC can allow members to be involved in the management of the business without exposing the members to personal liability for the LLC's debts and obligations. Limited partners, although shielded from personal liability beyond the amount of their contribution to the partnership, cannot participate in the partnership's management.
To circumvent the liability problem, many partnerships are structured as limited partnerships with a corporate general partner, responsible for management of the partnership. This allows the partners to be shielded from personal exposure. While this approach can be quite effective as far as personal liability protection for the partners, it requires the formation of two distinct entities: the partnership and a corporation which is to act as the General Partner. This is necessary in order to achieve basically equal limited liability benefits provided in a single LLC. With record?keeping and reporting requirements necessitated in maintaining two (2) entities, a single LLC may offer a more streamlined approach. However, admittedly, in some situations, business owners may desire a dual entity approach.
There is another form of limited liability entity, related to a partnership, called a Limited Liability Partnership (LLP's). This form of entity may be an alternative to the General and/or Limited Partnerships.
HOW DOES AN LLC COMPARE TO AN "S" CORPORATION?
A Sub?chapter "S" corporation, is generally a newly formed corporation which has made a formal election to be treated as Sub?"S", and is then taxed under the Sub?chapter "S" provisions of the Internal Revenue Code. A formal election, means the filing of a sub-S election form with the Internal Revenue Service. Like an LLC, which is also taxed as a partnership, the income in a Subchapter "S" corporation "passes through" the entity to its owners. Thus, with the exception of certain special situations, the "S" corporation does not pay federal income taxes at the corporate rate. Rather, the corporation's shareholders report their pro rata share of Sub-S income, loss, deductions, and credits on their individual federal income tax returns, and pay federal income taxes at their individual rate.
However, unlike an LLC, an "S" corporation does not have the flexibility to make special allocations of these items. Moreover, certain restrictions placed on "S" corporations under the tax law may make electing Sub "S" status unworkable for some businesses. For example, an "S" corporation must be a domestic corporation that is not a member of an affiliated group, and, as stated above, it has been limited to 35 shareholders, although those limitations are being expanded. Moreover, it used to be that none of the shareholders could be other corporations. This is now in the process of change as well. The shareholders on a Sub-S corporation cannot be foreign corporations or foreign trusts, and a Sub-S company can have only one class of stock. All shareholders must be U.S. citizens or resident aliens, estates, or certain trusts. This is pointed out because an LLC typically provides much the same benefits as the "S" corporation, but without the "S" corporation restrictions.
WILL AN LLC ALWAYS BE TAXED AS A PARTNERSHIP?
In most jurisdictions, classification as a partnership for federal income?tax purposes depends on whether or not the LLC exhibits more than two of the following corporate characteristics:
Continuity of Life - An LLC generally does not possess the corporate characteristic of continuity of life if it automatically dissolves on the death, insanity, bankruptcy, retirement, resignation or expulsion of any member (so?called "dissolution of events").
Centralization of Management - Unlike a corporation, where management is "centralized", with the officers of the corporation, an LLC is typically "decentralized" since all of its members participate in management of the business. If the LLC provides in its operating agreement or articles of organization to designate or elect one or more members as managers, the IRS will look at all the facts and circumstances to determine whether centralized management exists. Generally, the management of the LLC will be considered decentralized if member?managers own at least 20 % of the LLC.
Free Transferability of Interest - In a corporate setting, a shareholder is generally not precluded or other?wise prohibited from transferring his or her shares. However, in an LLC, each member (or those members who own more than 20 % of all interests in the LLC's capital, income, gain, loss, deduction, and credit) must secure the consent of a majority of the LLC's non?transferring members to transfer his or her interest in the LLC. The IRS will generally conclude that the LLC lacks the corporate characteristic of free transferability of interest if such consent is required prior to transfer.
Limited Liability (liability for corporate debts limited to corporate property). - Because LLC's are designed to provide limited liability, and will normally have this corporate characteristic for tax purposes, it is necessary to eliminate two of the other three preceding corporate characteristics in order to achieve partnership tax status. However, the IRS has indicated it will rule that an LLC lacks limited liability if one or more members, having an aggregate net worth equaling at least 10% of the total contributions to the LLC, validly assumes personal liability for ail obligations of the LLC as expressly allowed by state law.
As stated above, an LLC can generally possess no more than two of these four corporate characteristics in order to qualify for partnership tax status. Some states, such as Nevada, have adopted what can be referred to as "bulletproof" LLC statutes to ensure that an LLC formed and operated under state law must possess no more than two of these characteristics; thus qualifying as a partnership for federal income tax purposes.
Other, more flexible, states permit an LLC's members to modify the LLC's operating agreement to suit their particular needs. For example, with regard to the corporate characteristic of continuity of life, some states permit an LLC's members to provide in the operating agreement that a majority of the remaining members have the right to vote to continue the LLC when a dissolution event occurs. Such a provision, while achieving continuity upon a membership vote of approval, normally will not cause the LLC to take on the corporate characteristic of continuity of life.
Too many people who form business entities, whether corporations or LLC leave it at the chartering stage. They do not want to spend further monies in order to have quality and/or entity specific Bylaws or Operating Agreements drafted. However, it is very important for a wide variety of reasons, to have a properly and competently drafted Operating Agreement for an LLC. In those states permitting flexibility, the LLC operating agreement must be carefully drafted to ensure the desired tax results. It may be prudent to seek an IRS letter ruling in unique situations as to a new LLC tax status, before beginning operations. The LoBello Law Firm, can provide this necessary service.
WHAT ARE THE POTENTIAL DISADVANTAGES OF OPERATING AS AN LLC?
Because the LLC is a relatively new form of business organization in the United States, it is as yet largely untested in the courts. Unlike corporations, in which large bodies of law have developed over the years, LLC's do not possess this rich history of case law interpretations. Further, all the states have not adopted LLC statutes, making an LLC member's limited liability subject to question, and possibly even non?recognition, in states lacking such statutes. While those states, which do not recognize the LLC as a viable business entity are quickly vanishing, and a lack of established case law and uniformity may be viewed as a possible disadvantage.
A number of tax issues also remain unresolved in the LLC arena. For example, the extent to which LLC members will have to treat losses passed through from the LLC as passive losses is uncertain. (A passive loss is a loss from an activity in which the taxpayer does not materially participate. With limited exceptions, a taxpayer cannot claim a current deduction for passive losses in excess of passive income.) Other open tax questions include: whether an LLC with passive investors will be permitted to use the cash method of accounting; and the correct method for allocating LLC debt among members for purposes of determining the member's adjusted tax basis in his or her LLC interest. Until these and other tax issues have been settled, LLC members and their advisors should proceed cautiously. This is the reason for mentioning private letter rulings from the IRS herein above. A competent CPA is also worth the investment early in the business game.
e-mail: mlobello@lobellolaw.com
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