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All of a sudden, businesspersons around the country have gotten very excited by a relatively new way to do business--the limited liability company ("LLC"). And with this excitement comes the stampede to form them and use them in business transactions. Yet not all these businesspersons fully understand LLCs, what LLCs can do for them, what they cannot do, and how they should be treated by others doing business with the LLC. As foreign as they are to businesspersons, they are similarly foreign to many lawyers, accountants and bankers, who are just now having their first encounters with LLCs in many jurisdictions. This memorandum is simply a short introduction to LLCs, an area of the law that is much more complex than can be fairly treated in these few pages.
WHAT EXACTLY IS AN LLC?
To best understand LLCs, one should understand what corporations and partnerships were intended to accomplish for their owners, albeit imperfectly. In other words, an understanding of LLCs comes from an understanding of the failings of corporations and partnerships and therefore how LLCs fill the gap.
Corporations and Partnerships
Until LLCs came on the scene, businesspersons (other than sole proprietors, who cannot form one-person LLCs in most states) had a choice of business entity that was generally limited to corporations or partnerships, involving a trade off between, on the one hand, limitations on the liability of the business owners for debts of and judgments against the business, and, on the other hand, tax savings through a single, rather than a double, tax on business income. The holy grail, so to speak, would be both.
A corporation, formed by filing articles of incorporation with a state agency and governed by by-laws, normally provides its shareholders with a shield against creditors (whether lenders, suppliers, or tort judgment creditors) of the corporation, unless the shield could be "pierced" or the shareholders give personal guarantees. Generally, therefore, regardless of the financial strength of the corporation, the assets of the shareholders not invested in the business (for example, one's residence) cannot be attached by the corporation's creditors. Yet there is a tax price to be paid for this protection; a regular, or "C", corporation is subject to tax as if it is a separate person, and the shareholders receive only the earnings of the corporation reduced by the taxes paid by the corporation. Also, if the corporation runs a net loss, the shareholders are not able to claim the loss on their own tax returns.
Of course this may be mitigated to some extent in several ways. For instance, if otherwise permissible under the tax code, closely held corporations might pay out all of its earnings to its shareholders as salary or rent, thereby leaving no corporate income to be taxed. However, corporate losses would still be stuck within the corporation. Alternatively, the shareholders might make an election with the IRS under Subchapter S of the Internal Revenue Code of 1986 (known as an S corporation), thereby allowing the income and expenses of the corporation to be ignored at the corporate level, with the shareholders paying all of the tax themselves on the net income earned by the corporation or claiming all of the corporation's losses as their own. Yet to qualify as an S corporation, the corporation must pass through several hoops. For instance, only US citizens and resident aliens may be shareholders, the company cannot have more than 35 shareholders, entities such as corporations, partnerships, estates and trusts (except for special trusts) cannot be shareholders, and there may not be preferred returns given to any shareholder over any other shareholder. Also, appreciated property might be subject to corporate tax when sold by certain S corporations, and there is a tax and overall limits on passive investment income of certain S corporations. Needless to say, this makes S corporations unavailable in a wide variety of situations, such as those with foreign investors, with venture capitalists, or with corporate families, and potentially unattractive where the corporation might own a significantly appreciating asset or have a substantial amount of passive income.
Thus, if a corporation were the preferred form of doing business, one could get limited liability and one level of tax if one qualified as an S corporation, or the shareholders must accept the cost of paying tax at the corporate level. (Having said this, one should not always conclude that C corporation status must be avoided. Under current law, with the corporate income tax rate typically lower than the highest personal income tax rate, profitable businesses planning to plow earnings back into the business as working capital rather than distribute these earnings might be better off as a C corporation. Also, certain benefits, such as medical expense reimbursement plans are, as a practical matter, available to C corporations that might not be available or beneficial to other entities.)
At the other end of the spectrum lie partnerships. In its most basic form, the general partnership, the income and losses of the partnership business flow through directly to the partners and are not subject to tax at the partnership level. However, all the partners are jointly and severally liable for the debts and judgments of the partnership. Of course, limited partnerships are employed by many to retain these tax benefits but reduce the liability of the partners. Yet, as every limited partnership requires at least one general partner, this leaves at least one person with complete exposure for partnership debts and judgments. One common mechanism is to form a special purpose corporation with finite assets to hold a small partnership interest as general partner. While this is the accepted way to do business, many businesspersons accept this cumbersome structure only begrudgingly. Also, business operators, rather than passive investors, cannot be, as a practical legal matter, a limited partner. Therefore, those who run the business are exposed to unlimited liability even when the business is operated through a limited partnership.
Accordingly, if partnership is the preferred business vehicle, one is able to keep taxes down and limit liability with a limited partnership having a corporate general partner, at the cost of administrative complexity. And even then the liability limits are less than perfect for those active in operating the business.
Limited Liability Companies
With LLCs, the holy grail of business entities is closer at hand, if not in our grasp. Under the typical LLC statute, the members (analogous to shareholders in corporations and partners in partnerships) are all shielded from the company's debts unless they affirmatively undertake responsibility for such debt, such as by a guarantee to a lender. Also, the Internal Revenue Service has ruled repeatedly in precedential rulings that if the LLC is formed in a particular manner the company would be treated as a partnership for tax purposes. This determination turns on the nature of the company's management structure, the transferability of member interests, and how the company would dissolve. If not formed appropriately in light of the IRS regulations, rulings, and case law, the LLC will be treated as a corporation for federal income tax purposes (and for state tax purposes in the many states that rely on federal tax classification). Caution, therefore, is the touchstone when forming LLCs that must be treated as a partnership for federal tax purposes.
Thus, in the right circumstances, there is no longer a need to use a corporation or a limited partnership with a corporate general partner to provide complete liability protection and there is no need to live with the statutory limitations of the S corporation in order to get federal income tax advantages. It should be noted that in some states the LLC itself will have to pay state income or franchise taxes on its income, despite it tax transparency for federal tax purposes. Also, the LLC might be subject to hefty filing fee requirements initially and annually depending on the states in which the LLC is formed and in which it is doing business.
LLC Certificate and Operating Agreement
The limited liability company, a creature of state law, is one created by the filing of a document similar to articles of incorporation with a state authority. However, the company is not governed by by-laws; instead is governed by an Operating Agreement (in Delaware, known as the LLC Agreement). The Operating Agreement is closer in form to a partnership agreement (or, to use a corporate analogue, by-laws plus a shareholders' agreement). The Operating Agreement sets the rules for governing the company (such as the rules for meetings, if any) as well as the rights and responsibilities of the members vis-a-vis the company and vis-a-vis each other. Thus, it states the members' understanding of who is responsible for contributions to capital and how much, who is to receive distributions and how much, who is to be allocated the various tax attributes of the company such as profits, losses, gains and credits, and under what circumstance the company will dissolve, among others. The Operating Agreement is not filed with any state agency.
Authorization To Do Business In Other Jurisdictions
If the company is organized in a jurisdiction other than that in which it will be doing business, or will be doing business in several jurisdictions, then the company must be authorized to do business as a foreign LLC in these other jurisdictions, much like corporations formed in Delaware have done for years.
Evidence of LLC Interests
The ownership interests in LLCs may be reflected in share certificates in many jurisdictions, but need not be. In fact it is not unusual for LLC interests to be stated as a percentage of the company's capital as in a partnership.
Management of the LLC
It is up to the members to define in the Operating Agreement how the LLC will be managed. In some cases, the members might vest virtually all control of the LLC in one or a few managers (analogous to the officers and directors of a corporation or the managing general partner in a limited partnership). In other cases, the members might want a more active hand in company policy and day to day management, in which case the Agreement will provide for an appropriate quantum of votes in a variety of circumstances.
Annual and Special Meetings
Depending on the management structure of the company, the Operating Agreement might require regular meetings, as does typical corporate by-laws, or the members might forego meetings altogether.
Dissolution of the LLC
The Operating Agreement will also set forth the events that cause dissolution of the company. For instance, there may be a requirement that it dissolve upon the death or bankruptcy of a member or of a manager. While this is an important operational issue to consider when forming the LLC, its significance is even greater than appears on it face, as this is one aspect of the company the IRS will examine to determine if the company should be taxed as a partnership or as a corporation. This is also one of the areas of greatest concern to LLC investors insofar as, depending on how a dissolution provision is formulated, the LLC might dissolve at an inopportune and unanticipated time.
Transfers of LLC Interests
The members will also provide in the Operating Agreement the rules governing when LLC interests may be transferred and which aspects of these interests may be transferred. These rules might include a right of first refusal for the remaining members. Again because of IRS criteria, the "economic rights" of the LLC interest might be freely transferable to an outsider, but the recipient of these rights might not be admitted as a full member, with full rights of LLC membership, unless admitted by an affirmative vote of the remaining members.
Tax Reporting for LLCs
When tax time roles around, the LLC will file a partnership tax return with the federal government and any requisite state tax forms. If treated as a partnership for federal tax purposes, the LLC will provide to each member a Form K-1.
Creative Uses of LLCs
There is virtually no business enterprise for which an LLC would be inappropriate, except if the company is expected to be publicly traded, or if there are so many members of the LLCs that it could not legitimately be qualified for partnership tax treatment (unless of course partnership tax treatment was not desired). Real estate, oil and gas ventures, any operating business, professionals (in some states), businesses with foreign investors, businesses seeking venture capital, and joint ventures between established enterprises, including huge corporations, are just a few of the ventures that might benefit from doing business through an LLC. Also, in the context of estate planning, where family limited partnerships are now being used, LLCs are providing an alternative outlet. Finally, as outside creditors of LLC members typically can get only a charging order against that member's LLC interest LLCs provide an excellent component in an asset protection plan.
A full description of LLCs would take a volume to properly discuss, and the issues are terribly complex, despite the simplicity with which they are presented in this memorandum.
Whether one is best served by an LLC in any given situation, and how the LLC should be operated is a determination that depends are specific facts unique to each case, including the laws of the state under which it is formed. Competent and experienced counsel should be consulted before undertaking any business venture, particularly one as complicated and as poorly understood as limited liability companies. Accordingly, nothing herein is to be interpreted as legal advice as such advice can only be rendered upon a complete understanding of all of the relevant facts in any particular case.
by David S. Neufeld Freer & McGarry, P.C. Washington, D.C. 20007 copyright 1994, David S. Neufeld
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