The enormous potential of the LLC as a business entity is beginning to be realized. But there are many traps and pitfalls that must be avoided. Here are some of the details that will make or break the LLC as the entity of choice.

The U.S. is in the midst of a business entity law revolution. For the first time in two generations (since the adoption of the Uniform Limited Partnership Act in 1916), new forms of doing business, the limited liability company (LLC) and its cousin, the limited liability partnership (LLP), are becoming generally available throughout the country. Only three states have failed to pass LLC legislation.

In a sense, LLCs are not new; they are a blend of previously existing corporation and partnership law. Yet this blend has created a new mix of business law and tax features previously unavailable in U.S business entities. Before the arrival of the LLC, this mix of features had been available only in Germany with the GmbH, France with the SARL, and certain Latin American countries with the limitada.

Even though nearly all states have made LLCs available, the revolution is just underway. Business advisors have only begun exploring the uses that the unique set of features offered by the LLC brings to the table. Also, business advisors have been concerned about a number of new tax issues presented by LLCs.

New (for U.S.) Basket of Features

LLCs combine two state-law and two tax-law traits in a manner previously unavailable in a single U.S. business entity. In some states, a fifth trait has appeared.

First, the LLC offers its owners (technically speaking, its members) the limited liability protection heretofore only available to shareholders of corporations. (For a list of other LLC terms used in this article, see the sidebar "Understanding LLC Terms of Art.") LLC members are only liable for debts of the business to the extent of their investment in the business. (Of course, an owner is always liable for business debts he or she guarantees or co-signs for the business and any fraud or torts he or she commits personally. This is also true of corporate shareholders.)

Second, the members of an LLC need not be concerned with the degree of activity they have in the entity. Although this is also true for shareholders in corporations, it is not true of limited partners in limited partnerships formed trader statutes based on the original Uniform Limited Partnership Act. In those limited partnerships, the limited partners lose their limited-liability status if they become too active in the daily affairs of the business.

Third, LLCs are free of the limitations imposed by the IRC on corporations seeking S corporation flowthrough status. In other words, an LLC can have foreign owners, more than 35 owners, multiple classes of ownership, and so on.

Fourth, LLCs generally will be classified as partnerhips for tax purposes and therefore generally avoid two layers of tax. This classification currently depends on whether certain corporate "characteristics" are present in the LLC. The U.S. Department of the Treasury recently issued a proposal to allow unincorporated entities including LLCs and LLPs to simply elect whether to be taxed as a partnership or a corporation. (See sidebar, entitled "Tax Classification of LLCs.")

A fifth advantage, structural flexibility, is available in states with so-called flexible LLC statutes. By permitting their LLC owners to determine which of the corporate characteristics apply to their business, these states enable LLC owners to control how their LLCs will be classified for tax purposes.

LLC statutes generally fall into two categories: "bullet-proof" and "flexible." LLCs formed under bullet-proof statutes will be classified as partnerships for federal tax purposes. Depending on the owners' structural design, LLCs formed under flexible statutes may or may not be classified as partnerships. Under the operation of most flexible statutes, if an LLC's organizational documents are silent on those issues pertinent to tax classification, the "default" provisions of the statute will govern and cause the LLC to be classified as a partnership. But, depending on the particular state statute, some or all of these default provisions may be overridden.

Recently Closed LLC Tax Issues

Commentators have struggled with a number of tax issues posed by an entity that is taxable as a partnership but has no general partners as such. Several of these issues were either recently solved or at least a general consensus has formed.

Need a New Employer ID Number? No! In any situation where a partnership converts into an LLC that is structured to be classified as a partnership for tax purposes and the ownership interests of the LLC members remain the same as they had been in the partnership, the IRS rules that the LLC is a continuation of the partnership. This means, among other things, that there is no need for the LLC to file for a new EIN. In fact, doing so would be misleading to the government.

Numerous letter rulings have held that LLCs created under these circumstances are simply continuations of the predecessor partnership. Two recent examples are PLRs 9501033 (conversion of a law partnership) and 9432018 (conversion of a real estate management business). Never really an open issue, nevertheless some financial institutions still attempt to require converted LLCs to obtain new EINs. Business advisors facing this difficulty are advised to have a copy of one of the numerous no-termination letter rulings handy for the financial institution's reference.

Self-Employment Tax Consequences. IRC Sec. 1402, which imposes the self- employment tax, carves out an exception for limited partners. Income passed through to general partners, on the other hand, is always self- employment income. Although LLCs are generally taxable as partnerships, and LLC members have limited liability similar to limited partners, LLC members also can be quite active in the management of their LLC similar to the relationship of general partners to their partnerships. Are LLC members "limited partners" for these purposes, such that LLC earnings are not subject to the self-employment tax? The exposure of LLC member flowthrough income to the self-employment tax has been an open issue.

Recently, the Department of the Treasury issued a proposed regulation, Prop. Treas. Reg. 1.1402(a)-18, to address this issue. The proposed regulation treats an LLC member as a limited partner if 1) the member is not a manager and 2) the entity could have been formed as a limited partnership rather than an LLC in the same jurisdiction and the member could have qualified as a limited partner, that is, was not too active in management to be deemed a general partner in the hypothetical limited partnership.

Based on a mid-1994 private letter ruling PLR 9432018, and informal comments of former IRS personnel, some practitioners were fearing that the IRS would take a rigid position on this issue and treat any LLC member's distributive share as subject to self-employment tax. The proposed regulation represents a more balanced position. The proposed regulations are expected to become final shortly after the public hearings on the proposed regulation are held on June 15, 1995.

Criteria for IRS Rulings. The accompanying sidebar entitled "Tax Classification of LLCs" lists the four corporate characteristics presently used to determine whether an LLC will be treated as a partnership or an association taxable as a corporation. But just how far can a business planner water down those characteristics before they no longer count? For instance, how much authority to manage the LLC can LLC members delegate to managers before "centralized management" is present? How much freedom can be given an LLC member to dispose of his or her ownership interest before the IRS will rule there is "free transferability of ownership interests?"

The IRS recently shed light on these issues when it published Rev. Proc. 95-10, which specifies the conditions under which the IRS will consider a ruling request that relates to classification of an LLC as a partnership for federal tax purposes. The procedure provides certain minimum characteristics, beneath which the IRS is likely to reject partnership treatment. This discussion will focus on these minimum criteria and will not list all of the items to be included in a ruling request. The reader is commended to the procedure itself to obtain this information. Rev. Proc. 95-10 does not purport to set out safe harbors, so meeting its criteria will not necessarily result in a favorable ruling.

Single-owner LLC's. The IRS will issue no ruling on single-owner LLCs. The exclusion of single-owner LLCs leaves open, perhaps, the most intriguing issue involving LLCs. You cannot organize a one-partner partnership; so how do you classify a one-member LLC? When the interest of one member in a two-member LLC is redeemed, is the LLC somehow magically converted from a flowthrough entity into an association taxable as a corporation?

In the wake of Rev. Proc. 95-10 this issue remains open. Meanwhile, business advisors should finesse the issue by including at least two owners, each with meaningful ownership interests. The IRS has informally indicated that it will not rule favorably, that is, will not rule that an LLC is a partnership for tax purposes if a second owner does not have a meaningful interest. Merely providing a second member, therefore, may not finesse the issue. The IRS has informally cautioned that if facts and circumstances indicate the minority member is merely a nominee of the other member, the majority member will be treated as a single owner. For example, if the sole owner of an S corporation wants to drop down a corporate division into a newly formed LLC, the IRS is not likely to rule favorably on an arrangement where the S corporation owns 99.99% of the LLC and its sole owner owns the remaining .01%.

Minimum Share of Income Items.

Generally, to obtain a ruling that an LLC lacks continuity of life or free transferability of interests, if the LLC has managers, member- managers in the aggregate must own at least a one percent interest in each material item of the LLC's income, gain, loss, deduction, or credit during the entire life of the LLC. Also, to obtain a ruling that the LLC lacks the corporate characteristic of limited liability, the member or members personally exposed to the entity's liabilities ("assuming members") must collectively own a one percent interest. This one percent minimum is reduced in accordance with a formula specified in the revenue procedure for LLCs with a capitalization exceeding $50 million.

Minimum Capital Accounts. Again, to obtain a ruling that an LLC lacks the corporate characteristics of continuity of life or free transferability of interests, generally member-managers in the aggregate must own the lesser of one percent of the total positive capital account balances or $500,000. If the LLC requests a ruling that the entity lacks the characteristic of limited liability, the assuming members must collectively meet this same capital requirement.

The procedure includes a special exception in this area for LLCs having one or more members who contribute substantial services. In these LLCs, the capital account requirement summarized above does not apply to any member-managers. Instead, to meet the minimum capital account requirement, the LLC's operating agreement must provide that, upon dissolution or termination, the member-managers (or assuming members) must contribute capital to the LLC up to the lesser of a) the aggregate deficit balance of their capital accounts or b) the excess of 1.01% of the total capital contributions of the nonmanaging members (or nonassuming members) over the total capital contributions of the member- managers (or assuming members). For example, Nu LLC is capitalized with $1 million and has one member-manager, Ms. Dudley-Smythe, who contributes only substantial services. To meet the IRS' minimum guideline for a ruling on lack of free transferability of interests or continuity of life, Ms. Dudley-Smythe must be required on termination to contribute up to the lesser of her deficit capital account or $10,100 (1.01% of $1 million).

TABULAR DATA OMITTED

The IRS advises that it will closely scrutinize contributions in the form of services that are not associated with the operation of the LLC. These closely scrutinized services include, among other things, forming, syndicating, or accounting or planning for the LLC.

Continuity of Life: Dissolution Events. If the LLC has member-managers, and if the death, insanity, bankruptcy, retirement, resignation, or expulsion of any member-manager causes an automatic dissolution of the LLC, the IRS will generally rule that there is no continuity of life. However, to obtain a ruling, all member-managers must be subject to the specified dissolution event or events. Continuity of life will be absent even if at least a majority in interest of the remaining members may elect to continue the LLC following a dissolution event. If the LLC is managed directly by its members, that is, there are no managers, there will be no continuity of life so long as all the members are subject to the dissolution event or events. If less than the entire list of dissolution events is used, the LLC must be able to establish that the chosen dissolution events "provide a meaningful possibility of dissolution." For these purposes, a majority is made up of those partners owning a majority of the profits, interests, and a majority of the capital interests.

Free Transferability of Interests. If the LLC has member-managers, free transferability will be lacking if members cannot confer all attributes of their interests without the consent of a majority of the nontransferring member-managers. However, it is unnecessary to restrict every member's interest. Free transferability will be lacking if more than 20% of an LLC's membership interests are restricted. For example, if an LLC has a member owning a 25% interest that is subject to transfer restrictions and the owners of the remaining 75% have no restrictions on the transfer of their interests, the LLC would be found to lack free transferability of interest.

If the LLC has no member-managers, free transferability will be lacking if a majority of the nontransferring members must consent. Here a majority means a majority in the interest of both the capital and the profits, or a majority in interest of either capital or profits, or a majority on a per-capita basis.

Free Transferability: Meaningful Consent. To be effective in showing the absence of free transferability, the required consent must be a "meaningful" requirement. Furthermore, if a member is prohibited from unreasonably withholding consent, the consent requirement will not be considered meaningful. This is an important factor for practitioners to note, because provisions forbidding the unreasonable withholding of consent in these matters were not uncommon in the context of limited partnership agreements. Similar provisions could creep into LLC organizational documents prepared by business law attorneys who are unfamiliar with the tax rules applicable to LLCs.

Centralized Management. If the LLC is managed by the members in their membership capacity, the IRS will rule the LLC lacks centralized management. (If member-managers are elected, the IRS might still rule that there is no centralized management, but only if the member-managers collectively own at least 20% of the LLC.) But even here, the IRS will not rule that centralized management is absent if the relevant facts and circumstances fail to support the ruling. For instance, if the member- managers are subject to periodic elections or the nonmanaging members have a substantially unrestricted power to remove the member-managers.

Limited Liability. To obtain a ruling that an LLC lacks limited liability (likely to be a rarely requested ruling), the LLC must show that at least one member has assumed personal liability for all LLC liabilities. Furthermore, the assuming members must collectively have a net worth that is at least 10 percent of the total contributions to the LLC.

Cash Method of Accounting. Some commentators had been concerned that the cash method of accounting would not be available to professional firm LLCs. Their concern arose from IRC Sec. 448, which precludes "syndicates" from using the cash method of accounting. The IRS has repeatedly ruled that the typical professional firm LLC is organized in a way that precludes it from being classified as a syndicate.

The IRS's reasoning is as follows. The definition of "tax shelter" for purposes of IRC Sec. 448 is found in IRC Sec. 461(i)(3) and includes -

* entities that must register as tax shelters;

* any plan, arrangement, or entity, the principal purpose of which is to avoid or evade federal income tax; and

* a "syndicate."

A "syndicate," pursuant to IRC Sec. 1256(e)(3)(B), is as any entity other than a C corporation if more than 35% of the entity's losses are allocable to limited partners or "limited entrepreneurs." And a "limited entrepreneur" is any interest holder in the enterprise (other than a limited partner) who does not actively participate in the enterprise management.

Typically, or at least in the cases of the firms receiving private rulings, professional firms' owners are actively engaged in the management of the firm. The LLC owners in these professional firms, therefore, are not limited entrepreneurs and the firms are not syndicates. This is true even if the firm is governed By an executive committee, as long as all the members are still responsible for determining such things as admission of new members, locations of offices, mergers with and acquisitions of other firms, how the firm will be governed (that is, by executive committee), retirement plans, terms of the LLC's operating agreement, and dissolution of the firm (See PLR 9501033).

Although the use of the cash method of accounting is available to professional-firm LLCs, it is no more available than it is to partnerships in general. For instance, some LLCs will be "syndicates" and, therefore, meet the definition of a "tax shelter." Others will have to register as partnerships or be organized with the requisite tax avoidance purpose to meet one of the other definitions of a "tax shelter." Finally, even though an LLC may not be a "tax shelter," IRC Sec. 448 will still preclude the use of the cash method of accounting if the LLC is taxable as a partnership and has a C corporation as a partner.

Open LLC Issues Remaining

A number of additional LLC-related tax issues are currently outstanding. These include the following:

* What tax return should a single-member LLC file, that is, how is it classified for tax purposes?

* Who is the "tax matters partner" of an LLC?

* How are the passive-activity loss "material participation" rules to be applied to LLCs?

* Can LLC members be treated as "general partners" for purposes of the partner retirement provisions of IRC Sec. 736?

Common Uses of LLCs

To date, the key uses of LLCs have been businesses traditionally conducted in the partnership form, but which entail a high level of risk. These include oil and gas businesses, which, incidentally, were responsible for the passage of the first LLC statute in Wyoming in 1977, real estate ventures, multinational operations, and professional firms.

Professional Firms. Since the early 1970s, professional firms have been able to choose an entity which provides protection against liability from torts committed by co-owners (vicarious liability) and still provides flowthrough taxation. The entity that provided this basket of benefits was the professional corporation - together with the filing of an S election.

But PCs had certain drawbacks. First, in some states, the protection against vicarious liability was not established law. Second, typically, ownership of PCs was limited to professionals licensed to practice by the state of incorporation. In other words, multistate practice by PCs was not allowed. Lastly, to obtain flowthrough treatment, PCs must elect S corporation status with all the incumbent S corporation restrictions, which limit the PCs owners' flexibility to determine who may be shareholders (other PCs could not be shareholders), classes of ownership interest (only one class of stock), and owner compensation (partner compensation can be determined after year-end, shareholder compensation cannot).

None of the drawbacks of PCs exist for professional firms using LLCs. Although outside the scope of this article, we must mention that an even newer arrival on the business entity scene, the limited liability partnership or LLP, may be even more suited to professional firms because of the ease with which an existing partnership can register to obtain LLP status.

However, some business advisors consider the LLP to be a distant second to the LLC. The primary drawback these advisors point to is that less than 20 states recognize LLPs and some of those that do permit the establishment of LLPs do not allow professional firms to use them. Typically, the states that do not allow their own professional firms to form or practice as LLPs do allow out-of-state professional-firm LLPs to practice their profession within the state, but they do not recognize the limited liability shield of these out-of-state LLPs. A second drawback to LLPs is that, except in New York and Minnesota, LLPs only offer their partners liability protection against tort liability. This leaves LLPs formed in states other than New York and Minnesota exposed to unlimited commercial liability.

Examples of professional firms choosing the LLC form can be found in PLRs 9501033 (law firm) and 9412030 (accounting firm).

Multinational Operations. Certain countries apply different classification standards than the U.S., that is, an LLC treated as a partnership in the U.S. will be taxed as a corporation in some other countries. Due to the different tax rates applied to corporations in other countries, the treatment of a U.S. LLC as a flowthrough entity in the U.S. and a corporation in the other countries, and vice versa, presents planning opportunities.

Real Estate and Oil and Gas Ventures. LLCs have proven excellent entities for these types of business. They are structurally simpler than a limited partnership with a corporate general partner, the previously preferred entity configuration. Unlike professional firms, however, LLCs in these businesses frequently will be treated as "tax shelters" for purposes of IRC sec. 448 and will be required to use the accrual method of accounting.

Examples of these types of businesses choosing the LLC form can be found in PLRs 9432018 (general partnership owning and managing rental properties), 9119029 (real estate limited partnership), and 9325048 (oil and gas).

LLCs Used in Place of S Corporations. LLCs have been successfully used in place of, or in conjunction with, S corporations. For instance, where a multitiered structure is desired, an existing S corporation can form or drop down business or investment ventures into an LLC and retain a greater than 80% interest in the venture. There is the need, however, for a second owner of the LLC. In such situations, it is essential the facts show that the minority owner holds the membership interest on its own behalf and not as a nominee for the S corporation. Otherwise, the result could be a single-member LLC.

A second use of LLCs to avoid S corporation limitations occurs where an S corporation wants to involve a nonqualifying person as an equity holder in part of the S corporation's business. This may be necessary to operate the business in the foreign jurisdiction, or simply to attract foreign investment capital. In addition, foreign investors seeking a flowthrough, limited liability entity organized in the U.S. now have one with the LLC.

Third, an S corporation seeking to offer preferred earnings to some equity holders can do so by dropping down all or part of the corporation's business into an LLC organized to provide preferred earnings or other equity incentives to the targeted investor.

The Future of LLCs

Tax Law Considerations. As discussed above, depending on which of the corporate attributes are drafted into the governing documents, LLCs formed under flexible statutes can be classified for tax law purposes either as partnerships or corporations. Some business owners might very well want their LLC to be taxed as a corporation. Historically, the top tax on corporations was significantly lower than the top tax on flowthrough income from partnerships. At this writing, Congress is considering the repeal of the corporate alternative minimum tax, but leaving the minimum tax on individuals. Consolidated groups might prefer to have the businesses controlled within the group taxed under the consolidated return rules rather than have some taxed under those rules and others taxed under subchapter K principles. So practitioners could very well see LLCs specifically designed to be taxable as corporations, particularly in instances posing less risk of double taxation.

For the present, these business owners will undoubtedly use corporations. LLCs are still relatively novel and business advisors are much more comfortable with the developed business law applicable to corporations. Yet, as time passes and business advisors become more familiar with the principles governing LLCs, this may change.

The legal side of a switch from partnership taxation to corporate taxation is quite involved. A shift from a corporation to a partnership, for example, entails at a minimum the drafting of a plan for liquidation and dissolution (or some other form of merger or conversion documentation), directors' approval of the plan, shareholders' approval of the plan, a partnership agreement, one or more bills of sale, deeds for real property, and assignments for other property. To shift the taxability of an LLC from one taxable as a corporation to one treated as a partnership, all that is needed is amendment of the LLC's operating agreement and, of course, the tax returns. The ease of a legal shift, such as the one described, doesn't lessen the tax impact, however. For tax purposes, there would still be a corporate liquidation and the formation of a partnership, even though all that occurred was amendment of an operating agreement.

Business Law Considerations. Tax law aside, LLCs organized in states such as New York, Delaware, and Texas are exceedingly pliable. They can easily be structured to resemble partnerships and operate the way partnerships operate. On the other hand, they can be structured to look and operate very similarly to corporations, with classes of stock, boards of directors, officers, and so on. True, in the hands of a skilled attorney, a partnership can be made to look and smell very much like a corporation; and a corporation, when articles, bylaws, shareholders' agreements, and other side agreements are viewed together, can operate very much like a partnership. But in both these instances, the lawyer is doing some very fancy, skilled drafting.

On the other hand, LLCs formed under flexible LLC laws are statutorily designed to be completely fluid. In the not too distant future, we may see publicly traded LLCs supplanting the publicly traded partnership. They have already largely eroded the use of S corporations for new start-ups. The LLC is well on its way to becoming the entity of choice - the single alternative to both corporations and partnerships.

RELATED ARTICLE: THE TAX CLASSIFICATION OF LLCS

The taxation of U.S. businesses depends on their classification. And while most business entities fall neatly into one category or other, some do not. The LLC is one such entity. Others have included limited partnerships and business trusts. To help determine the classification of these entities, the Treasury Department promulgated a number of regulations interpreting IRC Sec. 7701's definitions of "corporation," "partnership," and "association taxable as a corporation."

The regulations identify six characteristics that are found in corporations -

* associates,

* intent to carry on a trade or business for profit,

* limited liability,

* free transferability of ownership interests,

* unlimited life, and

* centralized management.

The regulations go on to say that when the choices in classifying an entity are corporation and partnership, the first two characteristics, associates and carrying on a business for profit, are disregarded because they are common to both types of entities.

The classification of an entity that could potentially be classified either as a partnership or a corporation, then, turns on the remaining four characteristics. If an entity has a majority of corporate characteristics, that is, three of the four, it will be taxed as an association taxable as a corporation. If it has two or fewer of those corporate characteristics, it will be taxable as a partnership.

The Department of the Treasury and the IRS have proposed to replace this approach with a simple election that every multiowner, unincorporated entity could make. The election would have to be taxed either as a partnership or a corporation and would have prospective effect only. There will be public hearings about the proposal on July 20, 1995. The proposal is very preliminary at this stage; no proposed regulations have been written.

James A. Woehlke, CPA, MLT, is director of tax policy for the New York State Society of Certified Public Accountants. Previously, he served as a technical manager with the AICPA Tax Division in Washington, D.C. Mr. Woelke is a co-author of the recently published monograph, A Practical Guide to the New York Limited Liability Company Act.

William B. Kelliher, JD, is a principal in KMPG Peat Marwick LLP, Washington National Tax. He is the national director - technical tax services for LLCs.

Brian L. Schorr, JD, is executive vice president and general counsel of Triarc Companies, Inc. He is chair of the Committee on Corporation Law of the Association of the Bar of the Drafting Committee of the City Bar and the New York State Bar Association that prepared the initial draft of the New York limited liability company law.

Walter M. Primoff, CPA, is director of professional programs for the New York State Society of Certified Public Accountants and consulting editor of The CPA Journal.