What Is a Limited Liability Company?
A limited liability company (LLC),
a statutory form of business entity authorized by law in all states, offers many of the advantages available to partnerships
and corporations, while avoiding some of the disadvantages of these entities. An LLC is an organization that offers the pass-through
attributes of a partnership and S corporation while providing the limited liability, including limited liability to all members
(owners), that ordinarily exists only with a C corporation. Although similar in structure to an S corporation, an LLC offers
considerably more flexibility.
Persons who hold interests in
an LLC are referred to as "members." The LLC equivalent of a chief executive officer or general partner is the "manager."
The LLC counterpart to the Articles of Incorporation or Certificate of Limited Partnership are the "Articles of Organization."
LLC operations are governed by an "Operating Agreement." The LLC business form generally allows for a more relaxed operating
style, without some of the formalities required in a corporation.
The LLC business form generally
seeks to combine the corporate advantage of limited liability for owners with the flow-through tax advantages of partnerships—and
to achieve this perhaps with less complications than an S corporation. Major advantages of LLCs include:
• members are not personally liable for debts of the
• income and expenses may flow through the business entity
to the individual members for tax purposes, and
• some flexibility is allowed in allocating income and
losses to individual members.
State Law Considerations
While LLCs are now authorized
in all 50 states, the LLC legislation is not uniform from state to state. In some states, so-called "bulletproof" statutes
essentially "force" a state-compliant LLC to be federally taxed as a partnership. More flexible enabling statutes in other
states permit the LLC to choose whether to be taxed as a partnership or a corporation.
The lack of consistency among
state enabling statutes can make it difficult for an LLC to operate across state lines and remain in compliance with all applicable
laws. And because of the LLC's relative newness, there are still tax and legal uncertainties and questions that are yet unresolved.
Single-member LLCs are sanctioned
by statute in some jurisdictions, while others require a minimum of two members. Although regulations for LLC taxation as
a partnership vary from state to state, in so-called flexible statute states, the federal "check-the-box" regulations now
permit entities to elect the form in which they will be taxed, subject to certain restrictions.
Some states allow for Limited
Liability Partnerships (LLPs) which, in general, are treated much like LLCs, but retain more partnership characteristics.
Professional LLCs or LLPs are also permitted in some states, which may provide special rules for professionals who wish to
practice under this business form. LLPs are discussed in more detail later in this section.
An LLC is treated as a partnership
for tax purposes under the default classification absent a contrary election [Reg. Sec. 301.7701-3(b)].
Tax Aspects of LLCs
Regardless of when it was formed,
an LLC may elect to be taxed as a C corporation by filing Form 8832 (Entity Classification Election), unless precluded from
doing so by state law. If no such election is made, the following rules govern.
LLC Formed on or before December
An LLC that was formed on or before
December 31, 1996 generally may be taxed as a partnership for federal tax purposes. However, it may be taxed as a C corporation
if it possesses certain corporate characteristics, which include:
• continuity of life,
• centralized management,
• limited liability for owners, and
• free transferability of interests.
If two or more of these characteristics
are not present, the entity may be taxed as a partnership.
LLCs Formed on and after January
An LLC that was formed on or after
January 1, 1997, generally will be taxed as a partnership if it has two or more members. If it has only one member, it will
be taxed as a sole proprietorship.
Valuation discounts for minority
interests or for lack of marketability may be available, much as is the case with family limited partnerships and other closely
held business entities. Family LLCs are becoming popular with business and estate planners in some regions of the country.
Gift Tax Annual Exclusion
Older-generation taxpayers often
make gifts of LLC units to younger-generation family members, and claim the gift tax annual exclusion for such gifts. A Tax
Court case has put that strategy in some jeopardy in certain circumstances.
Taxpayers, a husband and wife,
created an LLC named Treeco to invest in substantial timber properties in Georgia and Florida.
The operating agreement gave the husband exclusive authority over management of the LLC's assets. The operating agreement
prohibited the sale or other transfer of LLC units. Because of the growing period for timber, the LLC anticipated no revenue
for an initial period of five years.
Husband and wife gave LLC units
to more than 40 family members and took the gift tax annual exclusion for these transfers. The IRS denied the annual exclusion,
saying that the gifts did not convey a "substantial present economic interest" in the donees. The Tax Court agreed with the
IRS, noting that there would be no income payable to the donees for several years, nor the right to sell the units for cash,
nor the right to withdraw their capital accounts. Further, any distribution of income to the members was in the discretion
of the manager, the husband. While the donees had a vested interest in their LLC units, the operating agreement prevented
the donees from having a substantial present economic interest, and the gift tax annual exclusion was lost [Hackl v. Comm'r,
118 T.C. No. 14 (2002)].
Business Continuation Planning
Members of LLCs face the same
basic choice as other business owners with respect to the form of a buy-sell agreement. Should the agreement be an entity-purchase
(called a liquidation-of-interest in an LLC) or a cross-purchase (called a sale in an LLC)? There are some special considerations
that affect this choice in an LLC.
Suppose that applicable state
law or an LLC's Operating Agreement provides that if more than 50% of the total capital-and-profits interest in an LLC is
sold within any 12-month period, the LLC is dissolved. On the other hand, if a member's interest is liquidated by the LLC
rather than sold, no dissolution occurs even if the liquidating member's interest exceeds 50%.
Generally, then, a liquidation-of-interest
(entity) approach would be recommended, especially if the LLC has a member whose interest exceeds 50%. The LLC would apply
for, own, pay premiums on, and name itself beneficiary of a life insurance policy on each member. If the LLC holds all incidents
of ownership and the death proceeds are 100% payable to the LLC, the LLC's incidents of ownership should not be attributed
to the insured member. However, the IRS might be tempted to apply the rationale of Reg. Sec. 20.2042-1(c)(6) to increase the
estate tax value of the LLC interest of a deceased member deemed to be the equivalent of a controlling shareholder in a corporation.
Generally, an LLC member may withdraw
amounts from the LLC federal income tax-free up to the basis of his or her LLC interest. So, the higher a member's basis,
the more that may be withdrawn tax-free.
An LLC is permitted to make special
allocations to members' accounts that are not necessarily proportionate to their respective interests as long as the allocation
of income, gain, loss, deduction, or credit under the operating agreement has substantial economic effect. For example, premiums
paid by an LLC on an entity-owned policy on Helen's life could be allocated as expenses to other LLC members, Anne and Natalie.
Similarly, upon Helen's death, the tax-free policy proceeds also could be specially allocated to Anne and Natalie, thereby
increasing their bases in their LLC interests. Since the policy on Helen was in no way allocated to her interest, it probably
would not increase the estate tax value of her interest, even if she was a more-than-50% owner.
IRC Section 736 confers considerable
flexibility in arranging a liquidation-of-interest agreement. The purchase may be structured so that the distribution from
the LLC is either a return of basis or an income/expense item. Some of the purchase price may be assigned by the LLC to goodwill.
In some LLC situations, particularly
where a less-than-50% member is involved, a sale (cross-purchase) approach may make sense. In this case, each member would
be the owner, premium payer, and beneficiary of a policy on the other member(s), and would use the policy proceeds to purchase
the LLC interest of a deceased member from his estate or heir. The seller would enjoy a step-up in basis to the estate tax
value of the LLC interest.
According to IRS private letter
rulings, LLC members are treated the same as partners for purposes of the transfer-for-value rule [Ltr. Ruls. 9625013, 9625019,
200120007]. This benefits LLC members in that co-partners of the insured are exempt transferees under the rule, whereas co-shareholders
of the insured are not exempt transferees. In an LLC, this means that the full income tax exclusion for life insurance death
proceeds would be preserved if there had been a prior transfer of the policy, for a valuable consideration, to a co-member
of the insured.
Limited Liability Partnerships
Most states now have enacted enabling
legislation authorizing the creation of limited liability partnerships. In general, these states have amended their version
of the Uniform Limited Partnership Act (ULPA) to make it possible for all partners (not just the limited partners) to enjoy
limited liability. Thus, the LLP will appeal to traditional limited partnerships that want to insulate the general partner(s)
from unlimited liability.
The observation is often made
that the LLP resembles the earlier forms of LLC in that the entity must be classified as a partnership for tax purposes, because
it must comply with the statutory rules under ULPA applicable to limited partnerships. As time goes on, more flexibility may
be permitted, as was the case with LLCs. Until then, newly forming entities may prefer the advantages of the LLC form.
The states generally allow an
existing limited partnership to convert to an LLP through a streamlined process that avoids a complete refiling of all the
legal documentation that must accompany a new business entity.