Tax aspects of limited liability companies.by Simons, Kathleen
Until recently, the principal forms of business organization recognized for tax purposes were sole proprietorships, partnerships (general or limited), and corporations (C or S). A new entity, the limited liability company (LLC), is gaining popularity and may become the major way of doing business for nonpublic companies.
An LLC is a partnership-corporation hybrid. Like a partnership, it is an unincorporated organization that provides pass-through tax consequences; like a corporation, it limits liability. This sounds like an S corporation, but the two entities differ significantly. LLCs are subject to the more liberal tax rules of Subchapter K and are free from encumbering eligibility restrictions.
An LLC can be viewed as--
* a general partnership where the partners have no personal liability;
* a limited partnership where there is no general partner; or
* a partnership surrounded by a corporate shell.
Brief History and Popularity
LLCs are not all that new. In 1975 and 1976, Alaska introduced LLC legislation but neither attempt became law. In 1977, Wyoming passed the first LLC statute and in 1982 Florida passed the second. Eight years later, in 1990, Kansas and Colorado passed their statutes. The LLC legislation gap from 1982 to 1990 is attributable to IRS reluctance to decide whether LLCs were partnerships or corporations for Federal tax purposes. The issue was resolved in Rev. Rul. 88-76 ("the Ruling"), when the IRS concluded that a company formed pursuant to Wyoming's LLC statute was a partnership for Federal tax purposes. This ruling enabled the LLC bandwagon to gain momentum. As of September, 1992, 20 states had enacted LLC statutes.
Understanding the mechanics of LLCs requires understanding the language of LLCs. Some commonly used LLC terms, along with their corporate and partnership counterparts, include--
Members. Corporations have shareholders; partnerships have partners; and LLCs have members. An LLC is formed by two or more members who have equal status; that is, there are no general partners.
Managers. Corporations have directors and officers; partnerships have general partners; and LLCs have managers. Under most state statutes, members can either designate managers or reserve management to themselves. Unless otherwise agreed, members manage (i.e., vote or govern) in accordance with their proportionate interests in the LLC. Managers, depending upon the powers granted to them, may function in a manner similar to general partners.
Interest. No shares of stock are issued. Just as a partner has an interest in a partnership, a member has an interest in an LLC.
Articles of Organization. Corporations have articles of incorporation; partnerships have certificates of partnership; and LLCs have articles of organization. An LLC comes into existence when this document is filed with the Secretary of State or other appropriate state agency or officer.
Operating Agreement. Corporations have bylaws; partnerships have partnership agreements; and LLCs have operating agreements. This document details the entity's inner workings and how members relate to each other.
According to the Regulations (301.7701-2), an unincorporated entity is classified as a corporation if it has more corporate characteristics than noncorporate characteristics. The four corporate characteristics at issue are: limited liability, continuity of life, centralized management, and free transferability of interest.
If an entity has three or more of these characteristics, it is a corporation for Federal tax purposes. The objective for LLC organizers is to lack two or more corporate characteristics. Some LLC statutes dictate which corporate characteristics are present or absent while other LLC statutes allow organizers to choose.
Rev. Rul. 88-76 (The Wyoming Statute)
LLCs are creatures of state statute. The Wyoming LLC statute is significant because it was the first and received the IRS' blessing.
In the Ruling, an LLC was formed pursuant to the Wyoming statute. The entity was created to own, operate, and improve real property. With respect to management, the entity had 25 members, but only three of them were managers. According to the Ruling, this constituted centralized management.
With respect to liability, no member or manager was liable for LLC debts beyond his or her capital contribution. The Ruling stated that this constituted limited liability.
With respect to transferability, each member's interest was transferable only with the unanimous written consent of remaining members. If consent was not obtained, the transferee could participate in profits but not in management. The Ruling considered this a lack of free transferability.
With respect to continuity of life, the LLC dissolved upon the occurrence of any of the following events:
a) when its term (not to exceed 30 years) expired;
b) by the unanimous written consent of all the members;
c) by the death, retirement, resignation, expulsion, bankruptcy, or dissolution of a member; or
d) by the occurrence of any other event that terminates the continued membership of a member.
After dissolution, the LLC's articles of organization permitted the business to continue upon the unanimous consent of the remaining members. According to the Ruling, this constituted a lack of continuity of life.
In counting corporate characteristics, there was a two to two tie: centralized management and limited liability existed; but free transferability of interest and continuity of life did not. Consequently, the Wyoming LLC was a partnership for Federal tax purposes. Table 2 shows the four corporate characteristics as they relate to different forms of business organization.
Bulletproof Versus Flexible Statutes
Statutes modeled after Wyoming's are said to be "bulletproof." The statute dictates the structure of LLCs so all Wyoming LLCs have limited liability and centralized management, and they all lack continuity of life and free transferability of interest.
More recently-enacted statutes provide flexibility. While these statutes mandate limited liability, they make the three remaining corporate characteristics optional. Some of the flexible statutes provide a safety net. For example, if an LLC's organizing documents are silent on continuity of life, a safety net type statute supplies a dissolution provision. Thus, in the absence of specific reference, the safety net type statute supplies default provisions that favor pass-through tax treatment.
LLCs Versus S Corporations
LLCs resemble S corporations in that they both provide limited liability and pass-through tax consequences. Nevertheless, they are very different. An S corporation has many eligibility restrictions. It may not--
* be part of an affiliated group (i.e., be part of a parent-subsidiary arrangement that files a consolidated return);
* have more than 35 shareholders;
* have more than one class of stock; and have a corporation, partnership, or a non-resident alien as a shareholder.
Because LLCs are subject to the partnership tax rules of Subchapter K, they are not subject to the S corporation eligibility restrictions mentioned above. As a result, they may be part of parent-subsidiary arrangements that file consolidated returns, provided they own more than 80% of another corporation, or another corporation owns more than 80% of them. They may have any number of members (two or more) who can be individuals, corporations, partnerships, non-resident aliens, or other LLCs.
In today's environment when LLCs are not universally accepted, it is particularly important for businesses that operate across state lines to have an LLC be a subsidiary or to have a subsidiary. If an LLC is not recognized by a neighboring state, it can still conduct business in that state by means of a corporate subsidiary.
Because LLCs are subject to Subchapter K, they may--
* make IRC Sec. 704(b) special allocations of income, gain, loss, deduction, or credit;
* make IRC Sec. 754 elections to adjust basis of LLC assets under certain circumstances; and
* use entity-level debt, pursuant to IRC Sec. 752, to increase a member's basis in the entity interest. An S corporation cannot do any of the above.
While LLCs are never subject to entity-level Federal income taxes, S corporations may be subject to entity-level taxes for built-in gains and passive receipts. Table 3 compares various attributes of corporations, partnerships, and LLCs.
LLCs Versus Limited Partnerships
A limited partnership must have at least one general partner who has unlimited liability for partnership debts. With an LLC, however, every member has limited liability.
If limited partners participate in the management of their partnership, they jeopardize their limited liability. By contrast, members of LLCs can participate in management and retain their limited liability.
Limited partners, more so than members, run afoul of the passive activity rules. To preserve their limited liability, limited partners cannot participate in management. Because they do not materially participate, their share of profit and loss is "passive." Members of an LLC, however, can participate in management. So if they meet the material participation test, their share of profit and loss is "active." Table 3 compares various attributes of corporations, partnerships, and LLCs.
LLCs are so new and rare there is uncertainty and confusion about them. Businesses and advisers alike may not understand or appreciate them. Multistate businesses, in particular, may encounter difficulties. For example, members of a Wyoming-based LLC have limited liability in Wyoming because that state recognizes such entities. But, if this particular LLC conducts business in Idaho which does not recognize LLCs, the members may not have limited liability in that neighboring state.
Several ways to overcome the uncertainty and liability exposure are illustrated with the help of the Wyoming-Idaho example. Before conducting business in Idaho, the Wyoming LLC could register as a foreign corporation. If permitted, such registration should enable the LLC to be treated as a corporation in Idaho. Registration should not affect the LLC's classification for Federal tax purposes. This determination is made by reference to the four corporate characteristics, none of which pertain to an entity's registration under local law. Such registration may, however, affect the LLC's classification for Idaho tax purposes.
Another alternative would be for the Wyoming LLC to form a corporate subsidiary in Idaho through which it conducts its Idaho business. There are no restrictions upon LLCs being part of a TABULAR DATA OMITTED parent-subsidiary arrangement, as there are with S corporations.
Besides registering as a foreign corporation or forming subsidiaries, an LLC can reduce uncertainty and liability exposure in other ways. The LLC could insert an acknowledgment in its written agreements that all parties to those agreements understand they are dealing with a Wyoming LLC that grants limited liability protection to its members. As another safeguard, the LLC could incorporate into its written agreements a waiver of any claim of personal liability against members. Lastly, the LLC's written agreements could require that all disputes be resolved according to Wyoming law.
Miscellaneous Tax Matters
As a general rule, cancellation of debt creates income. There's an exception to this general rule under IRC Sec. 108 when the debtor is insolvent. The insolvency exception is applied at the entity level for C and S corporations, but it is applied at the member level for LLCs.
Under IRC Sec. 1244, losses on the sale or worthlessness of stock in certain C and S corporations are treated, to a certain extent, as ordinary losses. Because LLCs are not corporations under Federal tax law and because they do not issue stock, they have nothing comparable to Sec. 1244 stock.
The sale of C or S corporation stock does not terminate those entities. But, a sale of 50% or more of LLC interests in any twelve-month period terminates the LLC for tax purposes.
C and S corporations may engage in tax-free corporate reorganizations. LLCs, on the other hand, may not.
When shareholders contribute appreciated or depreciated property to their C or S corporations in exchange for stock, they do not have to account for that appreciation or depreciation later. But when members contribute such property to LLCs, they must account for it later. For example, assume taxpayer owns land with an adjusted basis of $40,000 and a fair market value of $60,000. The appreciation of $20,000 ($60,000 - $40,000) becomes "built-in gain" when taxpayer TABULAR DATA OMITTED becomes a member by contributing the land to an LLC. If the LLC eventually sells the land for a gain, the first $20,000 of that gain will be taxed to the contributing member.
State Tax Treatment
The state tax treatment of LLCs is varied. Some states follow the Federal example and treat them as partnerships for state tax purposes. Other states impose a corporate income tax. This is no criticism of LLCs, however, because the same states would likely tax S corporations. Some states do not impose an income tax, but they impose a franchise tax. This annual charge, usually based on capitalization, gives the right to conduct business in the state. New York and California have been slow to pass LLC statutes while they study the likely effects on revenue of other forms of businesses switching to LLCs. Most, if not all, states will pass LLC legislation, but many states will impose some type of entity-level tax to avoid draining state coffers.
The LLC may meet many needs as illustrated by the following examples. Corporate Joint Ventures. If corporation 1 and corporation 2 want to join forces, they could form a corporate joint venture by becoming shareholders in corporation 3. This arrangement raises the specter of triple taxation: first, when corporation 3 earns income; second, when corporations 1 and 2 receive dividends (this tax is mitigated somewhat by the dividend received deduction of IRC Sec. 243); and third, when shareholders of corporations 1 and 2 receive dividends.
Triple taxation is avoided if corporations 1 and 2 join forces as members of an LLC. Because an LLC is a pass-through entity, there is no tax at the first level. Thus, as members, corporations 1 and 2 have limited liability, the right to participate in management, and one less level of taxation.
Foreigners Are Welcome. S corporations cannot have nonresident aliens as shareholders. Consequently, if foreigners want to invest in a pass- through entity, their only choice--until recently--was a limited partnership. But, as limited partners, they cannot participate in management. By becoming members in an LLC, foreigners can enjoy pass- through tax consequences while they participate in management.
The Great Facilitator. LLCs may facilitate the buying and selling of businesses. Consider Seller who owns all the stock in C corporation with two assets: a nonassignable lease (basis = zero, fair market value = $1,000) and personal property (basis = $2,000, fair market value = $5,000). The fair market value of corporate assets ($1,000 + $5,000) exceeds their adjusted basis ($ 0 + $2,000). Enter Buyer who wants to acquire Seller's business. Their negotiations are difficult.
If Buyer acquires the C corporation stock from Seller, he acquires the assets at their reduced basis. Because Buyer's depreciation and amortization deductions are thereby reduced, he offers to pay less for the stock, disappointing Seller. On the other hand, if Buyer acquires the assets of C Corp., he can step-up their basis to their fair market value. In so doing, however, he must negotiate with landlord over the assignment of the lease. If landlord wants to extract a premium for an assignment, Buyer offers to pay less for the assets--disappointing Seller. There is a possibility that Seller will incur a state or local sales tax when he sells the personal property to Buyer. The predicament surrounding stock purchase versus asset purchase is avoided if Seller's entity is an LLC, rather than a C corporation.
If the entity is an LLC, with Buyer acquiring Seller's interest, there are none of the drawbacks mentioned above. Because the LLC remains the lessee before and after the sale, there is no TABULAR DATA OMITTED assignment of the lease. The personal property is not being sold, so there is no sales tax. For tax purposes, the transaction is treated as an asset purchase, so Buyer gets a step-up in basis. This follows under IRC Sec. 708(b)(1)(B) which treats the LLC as terminated when more than 50% of the interests are sold within a 12-month period.
Converting Other Entities to LLCs
Existing corporations and partnerships may wish to become LLCs. A converting corporation undergoes a two-stage process. First, it liquidates by distributing its assets to shareholders in exchange for their stock. Second, the shareholders contribute these assets to a newly formed LLC in exchange for LLC interests.
For a C corporation, liquidation is a taxable event for both corporation and shareholders. If corporate assets are appreciated (i.e., fair market value exceeds basis), a liquidation produces a taxable gain at the corporate level equal to the excess of the assets' fair market value over their adjusted basis. But if corporate assets are depreciated (i.e., basis exceeds fair market value), a liquidation generates a loss at the corporate level. For assets such as inventory and IRC Sec. 1231 assets, the loss would be ordinary.
Any resulting net operating loss would be carried back three years to offset previously taxed corporate income. Loss associated with corporate capital assets would be carried back three years to offset previously taxed corporate capital gains. To the extent there is not enough corporate income or capital gain in the carryback years to absorb the losses, the losses are wasted.
Liquidation of a C corporation also produces tax consequences at the shareholder level. If the fair market value of the corporate assets distributed to shareholders in exchange for their stock exceeds the basis of that stock, shareholders have a taxable gain. If the reverse is true and the basis of shareholder stock exceeds the fair market value of distributed assets, shareholders have a loss. This loss will be an ordinary loss if the stock qualifies under IRC Section 1244. Otherwise, it will be a capital loss, deductible up to capital gains or $3,000, whichever is greater.
In situations where a liquidation would cause a tax at both the corporate and shareholder levels (i.e., double tax), conversion is hindered. In situations where a liquidation would cause losses at the corporate and shareholder levels that are "absorbable" or deductible in full, conversion is not hindered. The other possible tax consequences (e.g., loss at the corporate level and gain at the shareholder level) require a more detailed analysis than is permissible within the scope of this discussion.
For an S corporation to convert to an LLC, it must undergo the same two- step process mentioned above for C corporations. The first step involves a liquidation. Unlike C corporations, when an S corporation distributes appreciated assets to its shareholders in exchange for their stock, there is no double tax. Because the S corporation is a flow-through entity, the gain incurred at the corporate level passes through to the shareholders. Thus, with one exception, there is only one tax, and it occurs at the shareholder level. The exception relates to "built-in gains." If the entity began as a C corporation and elected S corporation status after 1986 when its assets were appreciated, any distribution of these assets within 10 years of the election will trigger an entity level tax. A double tax effect is mitigated because the entity level tax reduces the amount of gain that passes through to shareholders. Even though there is only one tax, it may be enough to impede an S corporation's conversion to an LLC. If S corporation assets are not appreciated, the tax consequence is minimized, and a conversion is feasible.
The IRS has already ruled that converting a general partnership to an LLC will not generate tax consequences. Under the facts of PLR 9226035, the partners of a general partnership plan to file articles of organization to create an LLC. The partners will contribute their interests in the partnership to the LLC in exchange for interests in the LLC. Their interests in the LLC will be in the same proportion as their interests in the partnership. The partnership will dissolve and distribute its assets to the LLC which will assume the partnership's liabilities. The IRS ruled the LLC is a continuation of the partnership and that the conversion would not result in a termination of the partnership under IRC Sec. 708. Consequently, there would be no tax to any of the parties involved. The authors see no reason why the same rationale and the same tax-free treatment should not apply to limited partnerships converting to LLCs.
Its Time Has Come
The LLC, with its pass-through taxation characteristics, flexibility of ownership, and limited liability, under the right conditions, is the ideal way of conducting business. The idea has spread like wildfire with daily reports of state legislatures passing the necessary legislation. In June 1993, Connecticut and New Jersey joined the ranks of those states permitting LLCs. If New York and California adopt LLC statutes, this form of business organization will have achieved a significant standing as a form of business entity from coast to coast.
Larry Witner, JD, LLM, CPA, and Kathleen Simons, DBA, CPA, are professors at Bryant College, Smithfield, Rhode Island.
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