Limited Liability Companies

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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 business,


           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 31, 1996



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 1, 1997



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



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 for LLCs



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 (LLPs)



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.