Limited liability companies: features and uses.by Schorr, Brian L.
The limited liability company is an attractive new business entity which may appeal to investors, entrepreneurs, privately owned businesses with too many owners to be S corporations, S corporations seeking more flexible ownership arrangements, and numerous others. It also presents opportunities for practicing professionals to somewhat limit their exposure for vicarious liability without the costs of using a professional corporation. The ability to use an LLC is determined on a state by state basis through the enactment of LLC legislation.
For years, entrepreneurs, partnerships of professionals or others, and investors have sought a business form that offers the beneficial tax status and flexibility of a partnership along with the limited liability of owners afforded by a corporate structure. The vehicles generally available have been limited partnerships with corporate general partners and S corporations. Professionals in some states have been able to achieve some degree of limited liability by practicing in professional corporations or partnerships with one or more professional corporations as partners. While each vehicle offers some benefits, each has certain drawbacks. A new entity, the limited liability company (or LLC), has emerged as an alternative business form. A properly structured LLC eliminates certain drawbacks of the limited partnership, the S corporation, and the professional corporation and combines the partnership's beneficial Federal tax status and flexibility with the corporation's limited liability of owners.
As set forth on the accompanying map, there are now 18 states that permit the formation of LLCs and two states that recognize LLCs formed in other states. LLC statutes are pending or are being considered in approximately 28 other states, and the National Conference of Commissioners on Uniform State Laws is drafting a uniform LLC statute. In New York, LLC bills were introduced in both houses of the New York State Legislature this past spring (such legislation is referred to in this article as the "New York Legislation"). Because of certain revenue concerns, the New York Legislature recessed for the summer without taking any action on these bills, thereby deferring consideration until the 1993 legislative session.
Bulletproof or Flexible: Which is Best?
LLC statutes typically are either "bullet-proof" or "flexible."
Bulletproof Statutes. The LLC statutes in Colorado, Virginia, and Wyoming are examples of bulletproof statutes. They contain mandatory provisions concerning limited liability, transferability of interests, centralized management, and continuity of life, which provisions, as discussed later, are designed to ensure that an LLC organized under them will be classified as a partnership for Federal tax purposes.
Flexible Statutes. The New York Legislation and the Delaware, Illinois, Maryland, and Texas statutes are examples of flexible statutes. They allow an LLC's organizers broad flexibility in structuring the LLC, and allow the provisions concerning transferability of interests, centralized management, and continuity of life to be varied by the agreement of the owners of the LLC, with "default" provisions that otherwise govern. It should be emphasized that by not following the default provisions in the flexible statutes there is the risk that the LLC will not be structured properly from a Federal tax standpoint. The costs of such a mistake could be enormous. Accordingly, before a decision is made to depart from the default rules, careful attention should be given to the question of whether the resulting structure will continue to receive Federal partnership characterization.
The first LLC statute was adopted in Wyoming in 1977. In 1982, Florida adopted a similar statute. In 1988, the IRS published Rev. Rul. 88-76 classifying a Wyoming LLC as a partnership for Federal income tax purposes. Subsequently, the IRS has issued a number of private letter rulings treating limited liability companies as partnerships. Classification as a partnership or corporation for Federal income tax purposes is made by reference to Sec. 7701 of the Internal Revenue Code of 1986, as amended (the "IRC"), and the regulations promulgated thereunder. The so-called Kintner regulations (Treas. Reg. Sec. 301.7701-2) identify six characteristics indicative of corporate status: 1) the presence of associates, 2) an objective to carry on business and divide the gains, 3) continuity of life, 4) free transferability of interests, 5) centralization of management, and 6) limited liability. An unincorporated organization, like an LLC, is treated as a corporation for Federal tax purposes if it has more corporate than non-corporate characteristics. Because both partnerships and corporations possess the characteristics of associates and business objectives, those characteristics are not considered when classifying the LLC. Moreover, by their nature, LLCs will possess the characteristic of limited liability because under applicable state laws a member of an LLC is generally not personally liable for an LLC's liabilities beyond the member's investment in the LLC. Consequently, to ensure partnership status, LLCs must generally lack two of the three remaining corporate characteristics--continuity of life, free transferability of interests, and centralized management.
While it appears, based on rulings issued to date, that partnership tax provisions will apply to LLCs, the IRS has offered no specific guidance on the application of a variety of provisions to LLCs, including the passive loss rules under IRC Sec. 469 and the treatment of indebtedness of an LLC, which is, by the very nature of an LLC, non-recourse. Although it seems likely that LLCs will be treated as partnerships for these purposes, the IRS has not issued direct authority which can be relied upon.
Although the various LLC statutes differ in certain respects, the basic characteristics of an LLC are generally the same.
Articles of Organization. An LLC is formed by filing articles of organization, which are similar to a corporation's certificate or articles of incorporation. LLC statutes typically provide that the articles must state, among other things, the name, address, and the latest date the LLC is to dissolve (and in some cases, the purpose of the LLC). Depending on the state of organization, the name must usually contain the words "limited liability company," the abbreviation "l.l.c." or some derivation thereof. In most states, an LLC may be formed to carry on any business or purpose that may be carried on by a corporation or general partnership, except as prohibited by law.
Members and Membership. The members of an LLC are its owners. Substantially all of the LLC statutes require that an LLC have at least two members (an exception is the Texas statute, which permits an LLC to have one member). Members of an LLC may include an individual, corporation, partnership, other LLC, or other entity. There is no limit on the maximum number of members an LLC may have (although the number of partners is one of the criteria the IRS may use in determining whether a partnership is publicly traded within the meaning of IRC Sec. 7704, and the same criteria may apply to LLCs). Many LLC statutes permit the articles of organization to provide for classes or groups of members having such relative rights and powers as provided in the operating agreement (analogous to a limited partnership agreement or a corporation's by-laws).
Pursuant to most LLC statutes, except as provided in the operating agreement, the assignment of a membership interest entitles the assignee to receive the assignor's distributions and allocations of profits and losses. Under the New York Legislation, in order for the assignee to exercise any rights or powers of a member, including the right to participate in the LLC's management and to vote, except as otherwise provided in the operating agreement, at least a majority in interest of the remaining members must consent to the assignee's admission as a member. The requirement of consent of a majority in interest of the other members to a transfer of the membership interest is intended to cause a New York LLC to lack the corporate characteristic of free transferability of interests.
Management. Management of an LLC is vested in one or more managers. Under the New York Legislation, if the operating agreement or articles of organization do not provide for such managers, then each member of an LLC is deemed to be a manager. Accordingly, if the LLC is operated directly by the members, an LLC will generally lack the corporate characteristic of centralized management. It should be noted that there is some uncertainty as to the IRS's position on the lack of centralization of management in situations where not all of the members actually perform management functions. However, because many LLCs will be able to establish that they lack both free transferability of interests and continuity of life (as described below), centralized management will not generally determine tax classification. The New York Legislation permits articles of organization to provide for classes or groups of managers having such relative rights and powers as provided in the operating agreement.
Limited Liability. One of the most important features of an LLC is that, like shareholders of a corporation, its members are not liable for obligations of an LLC beyond their investments. As described in more detail below, limited liability in an LLC of professionals is typically very similar to that of a professional corporation.
Operating Agreement. The internal operations of an LLC are governed by its operating agreement. The operating agreement contains all provisions not in the articles of organization regarding the internal governance of the LLC. As set forth on Exhibit 1, an organizer of an LLC under the New York Legislation has considerable flexibility when structuring an LLC.
Limited Life. Unlike a corporation, an LLC generally does not have perpetual existence. For example, under the New York Legislation, an LLC is dissolved upon the first of the following to occur: 1) the occurrence of the latest date for dissolution, if any, set forth in the articles of organization, 2) the happening of events specified in the operating agreement, 3) the written consent of two-thirds (or such other percentage designated in the operating agreement) in interest of the members, and 4) the entry of a decree of judicial dissolution. In addition, an LLC is dissolved upon the bankruptcy, death, dissolution, expulsion, incapacity or withdrawal of any member (or any such member or members specified in the operating agreement) unless the LLC has, after such event, at least two members and is continued with the consent of a majority in interest of all of the remaining members (or such lesser percentage set forth in the operating agreement). The inclusion of these dissolution provisions in the New York Legislation is intended to cause a New York LLC to lack the corporate characteristic of continuity of life.
Capital Contributions and Allocation of Profits, Losses, and Distributions. Member contributions to an LLC may typically be in the form of cash, property, or services rendered, or an obligation to contribute cash or property, or to render services. Profits, losses, and distributions of an LLC are typically allocated among the members as provided in the operating agreement. If the operating agreement does not provide an allocation, profits, losses, and distributions are allocated in the manner specified in the relevant LLC statute.
Use by Professionals. A number of LLC statutes, including those in Arizona, Kansas, Louisiana, Minnesota, Oklahoma, Texas, Utah, and Virginia, as well as the New York Legislation, permit the use of LLCs by professionals. Under the New York Legislation, the provisions dealing with professionals (which include, among others, doctors, accountants, engineers, architects, attorneys, pharmacists, veterinarians, and optometrists) are adapted from the comparable provisions of the New York Business Corporation Law and incorporate and carry over the standards of liability contained therein. Therefore, the LLC itself would remain liable for any negligent or wrongful act or misconduct committed by one of its members or employees, and individual members would be personally liable for their own negligence, wrongful act or misconduct or for that committed by a person under his or her direct supervision and control. However, a member would not be personally liable for any negligence, wrongful act, or misconduct committed by any other member or employee of the LLC who was not under his or her direct supervision and control.
Non-resident members of a professional LLC organized under the New York Legislation would have to be properly licensed in the state of organization of the LLC or in some other jurisdiction. The ability of an LLC to practice its profession in a state other than its state of organization would depend on the statutes of the "foreign" state.
The use of LLCs by accountants is consistent with the January 1992 amendment to Rule 505 of the AICPA Code of Professional Conduct. As a result of the amendment, accountants may practice accountancy in any form permitted by state law, including LLCs.
Comparison of LLCs, S Corporations and Limited Partnerships
While S corporations, limited partnerships, and LLCs each result in Federal pass-through tax treatment, a limited liability company is more flexible and has certain advantages compared to a limited partnership or an S corporation. Exhibit 2 sets forth in some detail a comparison of New York LLCs, limited partnerships, and S corporations. For example, an S corporation has stringent qualification rules. It may only have one class of stock, may not have more than 35 shareholders, may not own 80% or more of another corporation and may not have other corporations, or non-resident aliens as shareholders. None of these restrictions applies to an LLC. While a limited partnership does not have the qualification restrictions of an S corporation, a limited partnership must have at least one general partner who is liable for the debts of the partnership. In contrast, all the members of an LLC may be protected from such liability. Moreover, the participation of limited partners in the management of a limited partnership can result in a loss of limited liability protection, while participation by members of an LLC will not have such effect.
Available for Many Uses
There are numerous appealing applications for limited liability companies, some of which are set forth on Exhibit 3. Investors who cannot comply with the constraints placed on S corporations and who wish to exercise more control over their investment than a limited partnership allows may find the LLC the only practicable vehicle for investing. LLCs may also provide a welcome alternative for business owners and investors who have used S corporations and limited partnerships, but who could benefit from the greater flexibility provided by an LLC.
Actively Managed Businesses and Passive Investments. If so desired, all members may actively participate in the management of an LLCs business. Unlike participation by limited partners in a limited partnership, this active management role will not result in the loss of limited liability protection for members. Furthermore, this attribute would substantially eliminate the need for a complicated two-tier ownership structure of a limited partnership requiring a capitalized general partner (usually a newly-formed special purpose corporation) with unlimited liability. This feature makes the LLC an especially attractive business entity for start-up businesses, entrepreneurial businesses with active investors, professional firms (with a modified level of limited liability), joint ventures, and other undertakings where participants seek a high degree of managerial participation without assuming unlimited liability. On the other hand, an LLC can be structured to provide for centralized management by a small number of members or managers, and is therefore ideal for passive investments, i.e., investment partnerships and commodity pools, as well as real estate, oil and gas, and theatrical investments.
It should be noted that it is not entirely clear how the passive loss rules would be applied to LLCs by the IRS.
Businesses Where Retention of Control is Important. An LLC is also an ideal entity for businesses where the owners desire to restrict transfer of the ownership interests. As mentioned above, LLC statutes typically provide that, unless otherwise provided for in the operating agreement, a member may not transfer his or her membership interest without the consent of a significant percentage interest of the remaining members. Alternatively, a member's rights to profits are generally freely transferable, thus providing some degree of liquidity. While similar provisions may be found in the partnership laws, S corporations often require highly complex and heavily negotiated shareholders' agreements to restrict free transferability of ownership interests. This feature makes the LLC particularly attractive for family businesses which desire control to be preserved within the family or among certain family members, for professionals, and for businesses controlled by investor groups interested in maintaining control of the business.
Tax Treatment on Transfer of Interests. Transfers of interests in LLCs may be treated favorably for tax purposes. Upon the purchase of an interest in an LLC, IRC Sec. 754 should permit a step up of the tax basis of property held by the LLC and attributable to the purchaser, so that the basis will reflect the purchase price. Furthermore, under certain circumstances when an LLC purchases a member's interest, payments by the LLC may be treated as liquidating payments, which under IRC Sec. 736 may be made with pre-tax dollars.
Lack of Ownership Restrictions. As noted above, an LLC lacks many of the S corporation's restrictions on ownership. Unlike an S corporation, an LLC can have 1) more than one class of ownership interest, 2) subsidiaries, 3) an unlimited number of investors, and 4) shareholders who are corporations, nonresident aliens, partnerships, trusts, pension funds, or charitable organizations.
An LLC can be used in place of an S corporation when a multi-tiered corporate structure is desired. Because an LLC can own more than 80% of another corporation, the LLC can insulate its other assets from the separate business risks of a new enterprise by creating subsidiaries. In addition, an LLC allows for an unlimited number of members. While on its face this may appear to be impractical because of the increased possibility of potential dissolution events, an LLC could be structured to limit this problem by having as its members a series of limited partnerships, each of which would in turn have numerous limited partners. Because limited partnerships do not dissolve when a limited partner withdraws, this structure would permit a great many investors to indirectly have an ownership interest in an LLC while preventing the occurrence of dissolution of the LLC upon a particular individual investor's bankruptcy, death, disability, or any other dissolution event with respect to such individual.
Particular Use in Real Estate Transactions. Real estate investors who wish to have limited liability, to manage the property they own, and to receive the favorable treatment of non-recourse debt that the IRC provides to partnerships may also find the LLC to be an attractive entity. Under IRC Sec. 752, non-recourse debt may create losses for partners, even in excess of their capital contributions, subject to the "substantial economic effect" limitation of IRC Sec. 704. As long as the qualified income offset provisions apply to each member, the losses should be recognizable. It should, however, be noted that while LLCs are likely to be treated as partnerships for this purpose, the IRS has not yet specifically confirmed that position. This treatment is not available to S corporation shareholders, whose losses are limited to their capital contributions plus loans which they personally have made to the corporation. While limited partners are permitted this advantageous tax treatment, they may not, as noted above, participate actively in the management of the limited partnership's business without the risk of losing their limited liability protection.
Familiar to Foreign Investors; Use Outside the U.S. Unlike S corporations, LLCs may be owned by foreign investors. Foreign investors may be attracted to LLCs not only because they offer both Federal pass- through tax treatment and participation in management without incurrence of liability, but also because they offer a business form that is similar to the limitada (Central and South America), the SARL (France), and the GmbH (Germany).
Flexible Capital Structure. The flexibility in allocation of income, gain, and loss is a significant advantage of partnership treatment. Because an S corporation can only have one class of stock, an LLC can be of particular use in place of an S corporation where more than one class of ownership interest is desired. Distinctions can be made between those equity interests of employees, investor/non-managers, or investor/managers based on 1) the future success of the LLC, 2) a segment of the LLC's business, or 3) realization of profit or loss upon sale of the LLC or its business.
Use as a Financing Vehicle. Certain LLC statutes, including the Delaware statute and the New York Legislation, specifically provide that creditors of members may not reach LLC assets in satisfaction of members' personal claims. Accordingly, an LLC organized under a statute with such a provision may be viewed as an attractive "special purpose vehicle" to be used in structured finance, monetization or factoring transactions, now typically set up using off-shore vehicles, or Delaware Business Trusts. Furthermore, an LLC would be an ideal entity to issue debt securities or short-term commercial paper for business financing transactions.
Conversion to LLC
Because of the benefits of operating in an LLC, many businesses presently operating as partnerships or in corporate form will wish to explore converting to an LLC. However, such a conversion must be contemplated with careful planning because the Federal tax consequences may be significant.
Partnerships. The partners of a general or limited partnership generally will not incur tax liability if the partnership converts into an LLC. In Rev. Rul. 84-52, the IRS ruled that when a general partnership converted into a limited partnership through an amendment to the partnership agreement, the partners were considered to have made a contribution to the partnership under IRC Sec. 721, and the conversion did not terminate the partnership. Consequently, the partners did not recognize gain or loss on the exchange of their general partnership interests, except as provided in IRC Secs. 731 and 752 (pertaining to distributions in excess of basis and to basis adjustments resulting from changes in partners' shares of partnership liabilities).
In subsequent private rulings, the IRS has applied the same analysis to conversions of general and limited partnerships into LLCs qualifying as partnerships. The IRS has also ruled that the merger of a limited partnership into an LLC is governed by Rev. Rul. 84-52, and that partners are not required to recognize gain by reason of the merger, subject to the limitations mentioned above.
Corporations. The conversion by either an S corporation or a C corporation into an LLC would result in a corporate level tax; in the case of a C corporation, there would be a shareholder level tax as well. Regardless of whether a conversion were structured as a contribution of corporate assets in exchange for LLC interests to be distributed to shareholders, as a liquidating distribution of assets to shareholders who would contribute the assets to an LLC in exchange for membership interests, or as a merger of a C or S corporation into an LLC with the LLC surviving and with the shareholders receiving membership interests in the LLC in exchange for their corporate shares, IRC Sec. 336 (implementing the repeal of General Utilities) would require the corporation to recognize gain on the appreciated value of its assets.
Because the gain recognized by an S corporation would increase its shareholder's basis in its stock, a conversion or merger would not give rise to additional tax on the shareholder. In the case of a C corporation, however, the shareholder's basis would not be increased, and IRC Sec. 331 would require the shareholder to recognize gain on the exchange of shares made pursuant to the conversion or merger.
Nationwide Use Requires State By State Enactment
The emergence of the LLC is an important business development. However, notwithstanding the appealing applications and significant advantages of LLCs, they still face certain obstacles because they are not recognized in all 50 states. In particular, it is not entirely clear how a limited liability company would be treated in a state that has not enacted LLC legislation. Among the unanswered questions are: whether that state will recognize the limited liability protection afforded to members of an LLC; will the LLC be permitted to maintain an action, suit, or proceeding in that state's courts; how will the LLC be treated for state tax purposes in such state; and is there a risk that the LLC will be enjoined from conducting business in such state? There also remains some uncertainty with respect to how the IRS will apply certain Federal tax provisions. Still, LLCs present an exciting new vehicle for business. With 20 states having adopted LLC legislation, it is fair to say, as one commentator has written, that this is "the dawn of a new era in business entities." As additional states enact LLC legislation and with the National Conference of Commissioners on Uniform State Laws drafting a uniform LLC statute, obstacles such as those mentioned above will be overcome, and the benefits of the limited liability company will be available on a widespread basis.
Brian L. Schorr, JD, is a partner of Paul, Weiss, Rifkind, Wharton & Garrison. Mr. Schorr is co-chair of The Association of the Bar of The City of New York and the New York State Bar Association Joint Drafting Committee of the Proposed New York Limited Liability Company Law. Paul, Weiss associates James T. Janover, Stuart C. Kaperst, Andrew A. Lipsky, and Nina A. Nichols assisted in the preparation of this article. Mr. Schorr gratefully acknowledges the comments of Richard J. Bronstein, Esq. on an earlier draft of this article.
FLEXIBLE COMPONENTS OF THE PROPOSED NEW YORK LIMITED LIABILITY COMPANY LAW
* Centralization of management * Continuity of life * Dissolution * Limited liability * Transferability of ownership interests * Purposes of the LLC * Voting rights * Contributions and distributions/sharing of profits and losses
"Default" provisions contained in the statute govern if no choice is made.
TABULAR DATA OMITTED
USES FOR LIMITED LIABILITY COMPANIES
* Corporate joint ventures * Entrepreneurial businesses * Family businesses * Start-up businesses * High technology and research businesses * Oil and gas investments * Investments in theatrical productions * Real estate investments * Venture capital projects * Professionals (accountants, lawyers, etc.) * Transactions involving international investors * Management leveraged buyouts * Structured finance transactions (receivable financings) * Commodity pools
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