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Software Club 210: Light Red
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1997-02-04
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@222 CHAP 2
┌──────────────────────────────────────────────────┐
│Limited Liability Companies and Limited Liability │
│Partnerships -- New Choices of Legal Entity │
└──────────────────────────────────────────────────┘
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, not only do most
states allow you to change your partnership into a "limited
liability partnership," but there is also 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.
- Is it recognized in all states? Yes, or will be
by April 1, 1997.
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 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 always had to have at least one GENERAL
partner, who was 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 was 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 very recently , the official IRS
position had been that an LLC with only one member could
not be treated as a partnership, and thus would be taxed
as a corporation.
However, under new IRS regulations that went into effect
on January 1, 1997, taxpayers who form an LLC or LLP 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, the
above factors will no longer be tax considerations, and
taxpayers will now 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).
I.T. Regs. Sec. 301.7701-3.
The regulations provide that any newly formed "eligible
entity," which excludes corporations and, in most cases,
banks, will be treated by default as a partnership, unless
the owners or members of the eligible entity elect corporate
tax treatment, by filing Form 8832. A noncorporate entity
with only one owner, such as a one-person LLC, will be
treated as not being an entity that is separate from its
owner -- that is, its existence will be ignored -- unless
the owner elects corporate tax treatment. Thus, a sole
proprietorship that becomes an LLC will continue to be
treated as a sole proprietorship by the IRS, and an LLC
set up by a corporation will be treated as just another
branch or division of the corporation, and not treated as
a separate legal entity.
The IRS will continue to honor the noncorporate tax status
of any entity that was reporting as a noncorporate entity
(such as an LLC reporting as a partnership) before 1997,
generally.
An existing eligible entity, if previously treated as a
corporation before 1997, is now able to elect noncorporate
status by simply filing Form 8832 with the appropriate IRS
service center, specifying the date the election is to
become effective, provided the date is not more than 75
days after, or 12 months prior to, the date of filing. If
no date is specified on the form, the election becomes
effective on the date filed. A copy of this form must 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. (Note, however, that such a change from corporate
to noncorporate status would be the equivalent of a
corporate liquidation, with potential capital gains or
other taxable income resulting at both the corporate and
owner level at the time of such changeover. Don't make
such a change without first consulting a competent tax
advisor, as the tax consequences can be severe in certain
situations.)
This new set of IRS regulations is a truly revolutionary
change in the very old and long-established ground rules
for choosing a legal entity.
Under the new "check-the-box" regulations, there is very
little reason for any business with more than one owner to
operate in "naked" form, without limited liability, as a
partnership. Also, now that the new IRS regulations are
in effect, it is very likely that most of the large number
of states which now require an LLC to have at least two
members will eventually 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, including sole proprietorships, partnerships
or corporations, to create separate LLCs for new business
ventures, such as new stores for a retail c