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Text File | 1996-10-09 | 29KB | 642 lines

@222 CHAP 2

        ┌────────────────────────────────────────────────┐
        │Limited Liability Companies--A New Fourth Choice│
        └────────────────────────────────────────────────┘

The age-old choice of entity in starting a business has
always been a threefold one (except for such oddities as the
"Massachusetts business trust"):  sole proprietorship,
partnership, or corporation.  But now there is a new kind of
business entity, which has recently arrived on the scene:
the "limited liability company."

     What, you may wonder, is this new entity?

     - Is it a corporation?  No, not exactly.

     - Is it a partnership?  Yes, sort of.

     - Is it a sole proprietorship?  No, not quite.

Starting with the pioneering state of Wyoming in 1977, and
ending with the Hawaii legislature in 1996, every state has,
in recent years, now passed laws creating a new type of
legal entity called a "limited liability company" (or LLC).
These new entities, which closely resemble (and are usually
taxed as) partnerships, offer limited liability, like
corporations.  While it has long been possible for
partnerships to offer limited liability to their LIMITED
partners, a limited partnership must always have at least
one GENERAL partner, who is fully liable for the debts of
the business.

The new "limited liability companies" have, in effect, done
away with the need to have unlimited liability for any of
the owners of what is, in essence, a partnership form of
business organization.

In addition, all but a few states have now adopted a similar
type of entity, the limited liability partnership (LLP) or
registered limited liability partnership (RLLP).  An LLP (or
an RLLP) is simply a garden variety partnership that registers
with the state and pays a specified fee, in order to become
an LLP or RLLP and to have limited liability conferred upon
the partnership, which is generally quite similar to an LLC,
except that it may be operated like a regular partnership,
for the most part.

In 1988, in Revenue Ruling 88-76, the IRS concluded that a
Wyoming limited liability company could be classified as a
partnership for Federal income tax purposes (which is very
favorable, from the taxpayer's standpoint, in many cases).
The IRS ruling was based on the following rationale:

       .   No member has any personal liability for
           debts of the company; therefore the company
           has limited liability.  (Like a corporation)

       .   The interests of the members are assignable
           only upon written consent of all of the
           remaining members.  (Like a partnership;
           however, the Ruling recognized that mere
           assignees are entitled to receive profits
           and other compensation.)

        .  The company is dissolved in situations which
           are very similar to the dissolution of a
           limited partnership.  (Like a partnership)

        .  The company has centralized management.
           (Like a corporation)

Under IRS criteria, any entity that has NO MORE THAN
two of the four above features of a corporation is not
considered to be a corporation.  Thus because of the absence
of "continuity of life" and "free transferability" of
interests in the LLC entity, the Wyoming limited liability
company was held to be a partnership for tax purposes.

Needless to say, these very technical definitions of when
an LLC would or would not be taxed as a corporation have
tended to discourage many small businesses (or their legal
advisers) from setting up LLCs, as many business or general
practitioner attorneys are not tax experts, and have been
understandably wary of setting up an entity when they did
not fully comprehend the tax implications of what they
were doing.

In addition, until late 1996, the official IRS position
has been that an LLC with only one member could not be
treated as a partnership, and thus would probably be taxed
as a corporation.

However, under proposed IRS regulations that will probably
soon become final regulations, taxpayers who form an LLC
or LLP will soon no longer have to be concerned with such
complex tax issues as whether the LLC or LLP has continuity
of life centralized management, free transferability of
interests, or other corporate-like features.  Under these
new regulations, when they become effective (which may
well be before you read this), the above factors will
no longer be tax considerations, and taxpayers will be
allowed to simply file an election form with the IRS and
check a box on the form to elect to either be taxed as a
corporation or as an unincorporated entity -- as a
partnership (if there are multiple owners), or as a sole
proprietorship (if an LLC has only one owner).  Prop. Regs.
Sec. 301.7701-3.

The regulations provide that any "eligigle entity," which
excludes corporations and, in most cases, banks, will be
treated by default as a corporation if all owners or members
of the eligible entity have limited liability.  However,
such an eligible entity would be able to elect noncorporate
status by filing a specified form with the appropriate IRS
service center, specifying the date the election is to
become effective, provided the date is not more than 75
days prior to the date of filing.  A copy of this form
would also be attached to the tax return of the person or
entity filing the form for the first year in which the
election is in effect.

This is truly a revolutionary change in the long-established
ground rules for choosing a legal entity.  Once these new
"check-the-box" regulations become final (probably in the
fall of 1996), there will be very little reason for any
business to operate in "naked" form, without limited
liability, as a sole proprietorship or a regular partnership.
Once these new IRS regulations go into effect, it is very
likely that the large number of states which now require an
LLC to have at least two members will amend their LLC laws
to permit formation of one-member LLCs.  At that point, it
will make good business sense for almost any sole proprietor
to become an LLC, since the IRS will ignore the existence of
the LLC and continue to treat its income as being earned by
a sole proprietorship.  In short, you will gain the benefits
of limited liability for your sole proprietorship without
any increase in your federal tax compliance chores.

Indeed, it may soon become standard practice for any form of
business, sole proprietorships, partnerships or corporations,
to create separate LLCs for new business ventures, such as
new stores for a retail chain, so that the failure of such
a new venture or store will not devastate the entire company.
This has always been possible to accomplish by setting up
multiple corporations for each business segment, but the
heavy accounting, legal, and tax return compliance costs of
setting up and maintaining numerous corporations has
generally made doing so prohibitively expensive for smaller
businesses.

Under the new set of ground rules, the main business entity
will be able to set up a series of LLCs that create "fire
walls" between different segments of the business, but
which can be totally ignored for tax filing purposes -- the
main business will still file one partnership or corporate
tax return, or file one Form 1040 with Schedule C's, in the
case of an individual owner, combining the results of all
the separate "sole proprietorship" LLCs on the single tax
return.  No multiple tax returns, no horrendously complex
consolidated corporate tax returns will be required for
such arrangements -- very clean, very simple, and very
effective in reducing your liability exposure to creditors.

The upshot of these major law changes will probably be to make
corporations, sole proprietorships, and general partnerships
"endangered species," as almost every business will now be
able to gain some measure of limited liability by adopting
LLC or LLP formats.  Since your lawyer will no longer need
to be a rocket scientist or tax genius to properly set up an
LLC that qualifies for non-corporate tax treatment, the
legal costs of forming an LLC will probably come down quite
a bit as well, and an explosion in the number of businesses
operating as LLCs (or LLPs) in the near future seems to be
a virtual certainty.

Note that, in Rev. Rul. 95-37, the IRS has ruled favorably
that an existing partnership may generally be converted,
tax-free, to an LLC (if the LLC qualifies for partnership
tax treatment).  In fact, such a conversion can be done
without terminating the partnership's taxable year (the
LLC is simply treated as a continuation partnership) and
without need to obtain a new Federal Employer Identification
Number.  In many states, a simpler approach may be to
merely register the partnership as an LLP, however, where
state law permits.

Note that, if an LLC is treated as a partnership, the members
will generally be subject to self-employment tax on their
earnings from the partnership.  However, proposed IRS tax
regulations, if adopted, would treat some members in an
LLC, where management control is vested in one or more other
members of the LLC, like limited partners in a limited
partnership, so that those passive members of an LLC will
not be subject to self-employment tax on their distributive
share of earnings from the LLC.  The managing members of an
LLC would continue to be subject to self-employment tax on
their share of any self-employment earnings of the business.

@CODE: AL
Alabama has recently adopted a limited liability partnership
act, which provides for LLPs as well as LLCs, effective as
of January 1, 1997.

To become an LLP, a partnership must file a registration
statement, approved by a majority of the partners in most
cases.  One copy must be filed with the judge of probate
for the county in which the partnership has its principal
office, and a second copy is to be filed with the Secretary
of State of Alabama.  Fees of $35 for the probate judge
and $40 for the Secretary of State must accompany the
registration form.

Professional firms will be allowed to operate as LLPs, but
a partner will not obtain any limitation of liability with
respect to his or her own malpractice, the same as if
practicing as a sole proprietor.

Foreign LLPs must register with the Secretary of State and
pay a $40 fee before transacting business in Alabama.

Both domestic and foreign LLPs will be required to file an
annual statement (on the date specified by the Secretary of
State) and pay an annual $70 fee.

CODE:OF
@CODE: AR
The Arkansas LLC law became effective April 12, 1993.
Arkansas is one of the few states whose LLC laws specifically
permit 1-person LLCs, and its tax laws even specify that
such an LLC will be treated like a sole proprietorship for
STATE tax purposes, with all income and expenses reported
directly on the tax return of the sole owner.  As noted
above, the federal tax treatment of 1-person LLCs is likely
to be the same, as soon as proposed IRS regulations become
final.

@CODE:OF
@CODE: NB
The Nebraska LLC law went into effect on September 9, 1993.

Nebraska has more recently (effective July 19, 1996) also
adopted limited liability partnership (LLP) legislation.  A
partnership (domestic or foreign) must file an application
with the Secretary of State and a $200 fee to be recognized
as an LLP.  Like LLCs, LLPs confer limited liability upon
the owners, and are taxed as partnerships under both federal
and Nebraska tax laws.

@CODE:OF
@CODE: WS
The Wisconsin LLC law went into effect on January 1, 1994.
On December 11, 1995, Wisconsin also adopted a limited
liability partnership (LLP) law.  Professional firms may
now operate as LLP's, which offer essentially the same
(partial) liability protection as professional corporations.
The procedure for registering an LLP in Wisconsin is very
much like that for a Wisconsin corporation or an LLC.  A
new Department of Financial Institutions has taken over
the relevant filing duties previously provided by the
Secretary of State, effective as of July 1, 1996.

Recent legislation has, as of July 1, 1996, repealed the
Wisconsin requirement that an LLC have at least two members.
Most other states will probably follow suit once the IRS
issues final tax regulations that allow for one-person
LLCs, which should occur by the time you read this.

@CODE:OF
@CODE: TN
The Tennessee LLC law went into effect on June 1, 1994.
Under this law, an LLC can be formed by two or more persons,
and must have at least two members at all times.

@CODE:OF
@CODE: SC
The South Carolina LLC law went into effect on June 16,
1994. Under this law, an LLC can be formed by two or more
persons, by filing articles of organization with the
Secretary of State, along with a $110 filing fee.

@CODE:OF
@CODE: NY
The New York LLC legislation also provides for creation of
Registered Limited Liability Partnerships ("RLLP's").
These are general partnerships that provide professional
services (such as law, medical, or accountancy firms),
which elect to register as RLLPs and thereby obtain limited
liability.  However, as with a professional corporation, an
RLLP will not protect a professional practitioner against
malpractice claims against him or her, or wrongful acts
that are committed by someone acting under his or her direct
supervision or control while rendering professional services
for the RLLP.

An annual fee of $50 per member (minimum fee of $325, maximum
of $10,000) is imposed under New York law on any LLC (or
RLLP) that is structured to qualify as a partnership for
income tax purposes.  In addition, such LLCs or RLLPs doing
business in New York City will generally be subject to the
New York City unincorporated business tax.  These taxes
tend to detract somewhat from the federal and state income
tax benefits of operating as a non-corporate entity.

@CODE:OF
@CODE: CA
California, one of the last holdouts, was the 46th state
to adopt an LLC law, which Governor Pete Wilson signed
into law on September 30, 1994.

The California LLC law contains some interesting and unusual
provisions, not found in other state LLC laws, designed to
make the favored tax treatment of LLCs "revenue-neutral"
under California's budgeting process.  The new law imposes
the following special taxes and fees on LLCs:

  . MINIMUM TAX -- As in the case of limited partnerships,
    an LLC doing business in California is generally free
    of any income tax on the entity itself, except for an
    annual $800 minimum tax, the same as is imposed on
    corporations that have little or no taxable income.

  . LIMITED LIABILITY COMPANY FEE -- California also imposes
    a special annual fee on LLCs, based on the LLC's "total
    income" from all sources, as follows:

    For tax years beginning on or after January 1, 1994 and
    before January 1, 1996:

 Total income                               (Fee increased
 of at least    But less than      LLC Fee  1-1-96 to 1-1-99)
 ------------   -------------      --------
  $      0        $  250,000         $   0
  $  250,000      $  500,000         $ 500
  $  500,000      $1,000,000         $1000          $1500
  $1,000,000      $5,000,000         $2000          $3000
  $5,000,000          --             $4000          $4500

Note that the fees increase for companies with $500,000 or
more of total income in years beginning on or after January
1, 1996, but before January 1, 1999 (right-hand column).
In addition, the above fees may be increased substantially
beginning in 1999, if the state finds it is losing tax
revenues from having instituted the LLC form of doing
business.

Creating an LLC in California is fairly simple for a new
business, which need only file a one page "Articles of
Organization" form with the Secretary of State (Sacramento).
There is a $70 fee for filing articles of organization
of a California LLC or foreign LLC with the Secretary of
State.  The members (owners) of a California LLC should
also memorialize their agreement in the form of a written
operating agreement, although (like a partnership agreement)
the law does not require such an agreement to be in writing.

Foreign LLCs (organized under the laws of another state)
must register as such in order to legally do business in
California, and must file Form LLC-5 with the Secretary
of State.

All LLCs must file a Statement of Information (Form LLC-12)
within ninety days after articles are filed, and thereafter
once a year, with a $10 filing fee.

An LLC that is taxable as a corporation in California must
file a California franchise tax return (Form 100) or income
tax return (Form 200).  An LLC that is taxable like a
partnership must file new Form 568.

Note that, for LLC purposes, the California Secretary of
State's office has been interpreting the restriction on
"professionals" very broadly, taking the position that it
applies to all professions licensed or certified by the
state, such as beauty operators, auto mechanics, or real
estate brokers, and is refusing to accept LLC articles of
organization filed on behalf of such businesses, under the
view that they are also professionals and thus not permitted
to operate in LLC form.

Regulated professionals such as attorneys, accountants,
dentists and physicians are not permitted to operate in the
LLC form in California, unlike many other states that have
LLC laws.

@IF173xx]Since @NAME is a professional service
@IF173xx]firm, you probably will not be allowed to operate as an LLC
@IF173xx]in California.
@IF173xx]
However, the 1995 legislative session enacted a new Limited
Liability Partnership law.  It allows certain professionals
to adopt a limited liability partnership (LLP) entity,
similar to an LLC, for professionals only, as has been done
in a number of other states.  LLPs must register with the
California Secretary of State by filing Form LLP-1.  An
LLP, unlike an LLC, is not required to file articles of
organization; normally, it will merely amend the existing
partnership agreement, and file the LLP-1 form.

The California LLP law differs significantly from that of
LLP statutes in most other states:

  . Only certain law and accounting firms may qualify for
    LLP status, and to do so must either maintain $100,000
    of professional liability insurance per licensed person
    rendering legal or accounting services (with a maximum
    $5 million required for accountants, $7.5 million for
    attorneys); or, in the case of accounting firms, confirm
    having a net worth of at least $10 million, or for law
    firms, meet other financial responsibility requirements.

  . The protection afforded members of an LLP is much broader
    in California than under other states' LLP statutes for
    professionals.  The only statutory exception to limited
    liability for a qualifying law or accounting LLP in the
    state of California is for torts (such as malpractice)
    committed by the LLP member himself or herself.  A partner
    in an LLP is not a proper party to a legal proceeding
    against the LLP, unless the partner is personally liable.

@CODE:OF
@CODE: MA
The Massachusetts LLC law went into effect on January 1, 1996.
Provisions for limited liability partnerships (LLPs) for
professional service firms, were also enacted.  LLCs are
required to pay a $500 filing fee and to file an annual
report.

@CODE:OF
Major benefits of LLCs over the traditional business
entities available up till now include the following:

  . Unlike a general partnership, owners of an LLC have
    limited liability; and, unlike limited partners in
    a limited partnership, they do not lose their limited
    liability if they actively participate in management.

  . After proposed IRS regulations become effective, a
    business that is currently a sole proprietorship will
    also be able to change to LLC form and thus obtain
    limited liability, with no tax consequences or
    added tax compliance requirements, as the IRS will,
    in effect, ignore the existence of the one-owner
    LLC for tax purposes.

  . Like a regular corporation (a C corporation), an LLC
    provides limited liability to its owners, but taxable
    income or losses of the business will generally pass
    through to the owners (but may not always necessarily
    be deductible, due to the "at-risk" and "passive loss"
    limitations of the tax law).

  . An LLC is more like an S corporation, in that it
    provides for a pass-through of taxable income or losses,
    as well as limited liability, but can qualify in many
    situations where an S corporation cannot, since an
    S corporation cannot:

        . have more than 75 shareholders;

        . have nonresident alien shareholders;

        . have corporations or partnerships as shareholders;

        . own 80% or more of the stock of another
          corporation;

        . have more than one class of stock (or otherwise
          have disproportionate distributions); or

        . have too much of certain kinds of "net passive
          income."

  .  Also, LLC owners may be able to claim tax losses in
     excess of their investment, such as on certain
     leveraged real estate investments, which would not
     ordinarily be possible in the case of an S corporation
     or even a limited partnership.

  .  LLCs are also much simpler entities to maintain than
     are corporations.  An LLC is required to file its
     "articles of organization," which are similar to
     articles of incorporation, but the operational
     similarities tend to end there.  It is also a good
     idea for an LLC to have a written operating agreement,
     which spells out how the company is to be operated,
     much like a partnership agreement.  However, from
     that point on, the LLC is governed by its operating
     agreement, and there is generally no need for any
     of the tedious corporate formalities such as minutes
     of meetings, resolutions and annual meetings of the
     shareholders ("members" in the case of an LLC).  This
     operating flexibility, in addition to freedom from
     corporate level income tax (except in the few states
     that impose state income taxes on them) makes the LLC
     a highly advantageous form of doing business for the
     closely-held or family-owned business.

On the other hand, most of the LLC statutes have certain
built-in disadvantages, as compared to S corporations or
other corporations, such as the fact that LLCs must usually
provide in their articles of organization that the entity
will terminate in not more than 30 years, and the fact
that an LLC must (generally) have more than one owner,
unlike corporations.  (But many of these provisions will
probably be repealed by the states, once the IRS final
regulations make such restrictions unnecessary for tax
purposes.)

Even the federal tax treatment of LLCs is no longer
uniformly favorable.  Perhaps unintentionally, a new
partnership tax law provision in the Revenue Reconciliation
Act of 1993 may adversely impact professional service
firms that are organized as LLCs, rather than as true
partnerships.  Under the 1993 tax law amendments, certain
payments made by partnerships to outgoing partners (for
"goodwill" or "unrealized receivables") are no longer
deductible to the partnership, EXCEPT if made to a general
partner in a service partnership, such a a law or medical
partnership.  Since LLCs, if properly organized, are treated
as partnerships for income tax purposes, this new law will
apply equally to professional service firms that are either
LLCs or partnerships....With one important Catch-22:  Since
an LLC has NO general partners (all of its partners have
limited liability, like limited partners), then NO payments
(for goodwill, etc.) by an LLC to buy out one of its members
can qualify as deductible under the 1993 tax law change.
This can be a serious tax disadvantage for a professional
service firm that operates as an LLC, rather than as a
partnership.  (In addition, some states with LLC laws do
not yet ALLOW professional service firms to operate in the
LLC form.)

@IF173xx](@NAME is a professional service firm.)

In addition, several states, which have corporate income
taxes or franchise taxes based on income, treat LLCs as
corporations for state income tax purposes.  This can result
in double state taxation of income in such states, if you
distribute income, since the distributions will be treated
as taxable dividends to the recipients, after being taxed
once already at the LLC level, or, in states like Alaska,
Florida, or Texas, which have no personal income tax, can
at least result in one layer of state tax on income, which
would not be incurred with a regular partnership or sole
proprietorship.

Also, some states impose other income-based taxes at the
entity level on LLCs, just as for corporations, such as the
Michigan Single Business Tax or the Illinois Personal Property
Replacement Tax.  Other business entity taxes such as in
Washington, D.C., Washington (state), and New Hampshire,
also apply equally to LLCs and other unincorporated
businesses, as well as to corporations.

@CODE:OF
@CODE: TX
In fact, Texas itself treats LLCs as corporations for
purposes of the state franchise tax on corporate income,
even though the Texas LLC is treated as a partnership for
federal income tax purposes.

@CODE:OF
@CODE: AK FL PA
In fact, @STATE itself treats LLCs as corporations for
purposes of the @STATE corporate income tax law, even
though the @STATE LLC is treated as a partnership for
federal income tax purposes.

@CODE:OF
@CODE: AK FL TX
(There is no individual income tax in @STATE, so the
income of an LLC would entirely escape state taxation if
@STATE did not tax its income at the entity level, which
probably explains why the state of @STATE chose not to
follow the federal tax treatment in this case.)

@CODE:OF
@CODE: PA
However, Pennsylvania will also allow an LLC to elect to be
treated as an S corporation for state income tax purposes.

@CODE:OF

Even so, LLCs seem to have many advantages that almost
guarantee a boom in their popularity in coming years.

LIMITED LIABILITY PARTNERSHIPS.  As noted above, most states
have now adopted limited liability partnership (LLP) laws
that provide for an entity similar to an LLC, with limited
liability, that can usually be formed simply by registering
an existing partnership.  It is generally not necessary to
file articles of organization or to comply with certain
other formalities that are required of an LLC.  A few words
of caution about LLPs are in order, however:

  . A significant (but shrinking) number of states
    still do not recognize LLPs, so you won't have
    limited liability to the extent your LLP operates
    in any such state.

  . In some states, the LLP law allows only certain
    professional service firms to elect LLP status,
    although most states with LLP laws now allow any
    type of business partnership to elect limited
    liability status.

  . If your business is a partnership that is eligible
    to convert to LLP status, be sure if you do so that
    you don't simply adopt your existing partnership
    agreement as the LLP's operating agreement.  For
    example, if your partnership agreement has provisions
    that require a partner with a negative partnership
    capital account to make up such a deficit, such a
    provision in your LLP's operating agreement would
    open a "swinging back door of liability" for partners
    in your LLP, defeating your primary goal of having a
    limited liability legal entity.

  . In many states, you will be required to take out large
    liability insurance policies for negligence or other
    wrongful acts of the LLP or its partners, as part of
    the price you must pay to the benefits of limited
    liability.

@CODE: CO CT DE FL GA HI ID IL IN IA KS KY MS NM OK
@STATE has recently enacted LLP legistration, which will
allow any partnership to register with the Secretary of
State and pay a filing fee to become an LLP.

@CODE:OF
This may be the first you have heard of limited liability
companies and limited liability partnerships, but it
certainly won't be the last.  They are definitely the trend
of the future and, as soon as the new IRS "check-the-box"
regulations, allowing unincorporated businesses to simply
elect not to be taxed as corporations, LLCs and LLPs will
become the best game in town for nearly every small
business.

Remember, you heard it here first....