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Putting Limited Liability Companies In Perspective - By ProGuide™
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I. FAMILIARITY WITH CHARACTERISTICS OF ENTITIES
A.
Most business advisors are already familiar
with entities such as partnerships,
corporations, and limited partnerships.
B.
We understand the nature of the entity, the
exposure of its owners and agents for its
liabilities, the nature of the ownership
interests in it, and many of the other legal
and tax attributes associated with it.
1.
Some corporate attributes with which we
are familiar are:
a.
Entity is created and governed by
state
statutes
b.
Owners have limited liability for
most debts
c.
Entity is managed by directors
through officers
d.
Owners can have some variations in
interests
in profits and may have
different liquidation rights -
through use of common or preferred
stock
e.
Officers and directors may have some
liability for their actions or
failure to act.
f.
Entity is taxed unless an election is
filed
to be taxed under Subchapter S
of the Internal Revenue Code of 1986,
as from time to time amended
(hereinafter "IRC"). If election
is
filed, then in most instances, the
owners are taxed rather than the
entity.
g.
Entity's existence is generally
perpetual.
h.
Ownership interests can be freely
transferred.
2.
Some partnership attributes with which we
are familiar are:
a.
Entity is not dependant on state
action for creation, however, state
statutes regulate the relationship of
the entity and its owners to each
other and to third parties.
b.
Owners fully liable for debts of
entity.
c.
All owners may participate in running
of the business and act as an agent.
d.
There is great flexibility in
structuring the ownership of
interests in profits & losses,
capital, and cash flow.
e.
Taxation occurs at the owner, rather
than
entity, level.
f.
Entity's existence terminates when a
partner disassociates himself or
herself from the partnership in any
of
a variety of ways.
g.
Ownership interests are not freely
transferable.
3. Some limited
partnership attributes with
which we are familiar are:
a.
Entity is created and governed by
state statutes
b.
Limited partners have limited
liability for most debts if they act
only in manner authorized by statute.
General partners liable for all
debts.
c.
Entity is managed by general
partners.
d.
There is great flexibility in
structuring the ownership of
interests in profits & losses,
capital,
and cash flow.
e.
Taxation occurs at the owner, rather
than entity, level.
C.
In general, our familiarity with the main
characteristics
of these entities enables us to
use them effectively and/or advise our
clients
with regard to their use.
D.
A similar understanding of Limited Liability
Companies is needed in order to use them
effectively and/or advise our clients with
regard to their use.
E.
Materials which follow, discuss many of these
attributes as well as others and try to put
them into practical prospective.
Some of these
topics are:
1.
Sources of law
2.
Some considerations in selecting a form of
entity
3.
Wisconsin's LLC statute
4.
Comparison of various types of entities
5.
Federal Tax issues -
a.
Partnership v. Association taxable as
a corporation
b.
Other tax considerations
6. Member and manager
fiduciary duties
7.
Limited liability, the ability to sue and
be sued, exposure of managers and members,
and other liability issues
8.
Some business and tax planning
opportunities
9.
Starting up an LLC; shifting a business
operation to function through an LLC
10. Some
tax return, financial statement, and
audit considerations
11. Wisconsin
tax considerations
12. A
look at the future
II. SOURCES OF LAW AFFECTING LLCs
A.
LLCs are governed by the typical array of state
and federal legal considerations.
However,
because they are a relatively new form of
entity, both state law and federal tax law
considerations are of considerably more
concern
in the case of an LLC than they are with
regard
to some other entities.
B.
We look to the state law of the state of
formation for:
1.
a stable body of well settled case law
regarding:
a.
the relationship of the owners to
each other and the entity
b.
some of the relationships of the
owners and the entity to third
parties
c.
other matters of the type enumerated
below
However, we find that this does not
exist with regard to LLCs.
2.
statutory rules regarding:
a.
how the entity is created
b. who may own the
entity
c.
what activities the entity may
undertake
d.
what property may be contributed to
and
owned by the entity
e.
what rights the owners get regarding:
(1) profits
& losses
(2) capital
interests
(3)
liquidation rights
(4) rights
to cash & property
distributions
(5) voting
rights
(6)
the ability to transfer their
interests
(7) the
ability to customize these
items to meet their needs
f.
the obligations and liabilities for
which the owners are responsible
3.
the determination of the characteristics,
rights and obligations which must be used
in order to apply federal tax law.
C.
We look to the state law of the state in which
the LLC operates to ascertain some of the
relationships between the LLC and its
owners,
on the one hand, and third parties located
in
or operating in such state, on the other
hand.
1.
Certain "conflict of law" rules and
federal
Constitutional requirements may
also be applicable.
a.
These may require the application of
the law of the state of formation to
ascertain the relationship of the LLC
and its owners, on the one hand, to
third parties, on the other hand.
2.
Uncertainty regarding how an LLC and its
owners will be treated when they operate
in a state that does not have either an
LLC statute or a statute which
specifically
recognizes foreign LLCs is
presently the biggest single impediment to
the wide spread use of LLCs.
D.
Wisconsin state law is found in the statutes
(Chapter 183 as well as others), the
Wisconsin
Administrative Code, and the decided cases
issued by the Wisconsin state courts and
some
federal courts.
1.
In general, they may all be relied upon.
However,
a.
cases may not be relied upon if they
have been overruled
b.
the Administrative Code may not be
controlling if it is inconsistent or
otherwise not supported by the
statute.
E.
We look to federal tax law for a stable body of
well settled statutory rules and case law
regarding:
1.
the "classification" of the entity, for
federal tax purposes, as either a
"partnership" or as an
"association
taxable as a corporation"
2.
the tax consequences to the entity and the
owners which result from the formation,
operation, and termination of the entity
as well as the tax effect of various types
of transactions
However, we find that while some of this
exists
with regard to LLCs, there are many
unanswered
questions.
F.
Federal tax law:
1.
Is generally found in:
a.
Internal Revenue Code
b.
Treasury Regulations
c.
Temporary Regulations
d.
Published Revenue Rulings
e. Tax Court cases
(1)
Memorandum Decisions do not
establish precedent
f.
Decisions of the Federal District
Courts, Courts of Appeal, U.S.
Supreme
Court, and Court of Claims ,
2.
Some other IRS materials, such as Private
Letter Rulings, General Counsel Memoranda,
and Revenue Procedures may provide
insights into IRS positions and may be
persuasive because of:
(1) a
well reasoned analysis
(2) right
to consistent treatment
(3) IRS
decision to follow
However, they may not constitute legal
precedent.
3.
In particular, watch out for Revenue
Procedures and Private Letter Rulings.
a.
Generally, Revenue Procedures set
forth criteria and procedures which
must be followed in order to obtain a
Ruling from the IRS regarding a
matter.
(1) Often
times the criteria are
more stringent than those
contained in the statute and
merely describe a "safe harbor"
which, if satisfied, will
provide
a basis for a ruling.
(2) The
failure to meet the criteria
set out in a Revenue Procedure
does not mean that the statutory
requirements have not been met.
b.
Private Letter Rulings reflect the
thinking of the IRS regarding the
application
of the law to a specific
set of facts at a particular moment
in time. No one other than
the
person obtaining the PLR may rely on
it and IRS need not follow it with
regard to any other person or facts.
(1) Many
large exempt organizations
are learning this lesson now
with
regard to "unrelated
business income" as IRS's
litigation and audit position of
late is not consistent with its
prior PLR positions.
Those who
relied upon PLRs issued to
others are being hurt.
(Note - The details of the precedential
effect of the
numerous sources of federal tax law is
beyond the scope
of this discussion and the above comments
are neither
complete nor true in all instances.)
III. CRITERIA FOR SELECTING A PARTICULAR
TYPE OF ENTITY
A.
Some desirable non-tax attributes are:
1.
Limited liability for owners
2.
Flexibility in:
a.
the nature of the business operations
which may be conducted
b.
the nature and number of the owners
c.
the ability of owners to participate
in
the management of the business
d.
voting rights
e.
rights to profits, losses,
distributions upon liquidation, cash
and
property distribution
f.
the nature of the property which may
be contributed
3.
Control over the transferability of
ownership
interests
B.
Some desirable tax attributes are:
1.
No double tax on distributed profits -
Avoid impact of a tax at both the entity
level and again at the owner level
a.
get pass through tax treatment
2.
Avoid the double tax arising from the sale
of the business of the entity or its
assets - General Utilities case
a.
Ability to distribute appreciated
assets in a non-taxable transaction
3.
Obtain an increase in basis for debts of
the
entity, not just for actual capital
contributions and loans to the entity (Sub
S corp)
4.
Avoid restrictions on the number or types
of
owners
5.
Have greater flexibility with regard to
the allocation of profits and losses - at
least as compared with a Subchapter S
corporation
C.
Many of these desirable tax characteristics are
characteristics of "partnerships".
IV. RELEVANT DOCUMENTS, ETC.
A.
This topic will generally be discussed
throughout these materials.
B.
However, it should be noted that numerous
partnership tax considerations are based on
the
contents of the "partnership
agreement" and an
understanding of that concept is important.
C.
The term "partnership agreement" is defined in
IRC 761 (c).
D.
However, it is best explained by Treas. Reg.
1.761-1(c) which provides that:
(c) PARTNERSHIP AGREEMENT. For the
purposes of subchapter K, a partnership
agreement includes the original agreement
and any modifications thereof agreed to by
all the partners or adopted in any other
manner provided by the partnership
agreement. Such agreement or modifications
can be oral or written. A partnership
agreement may be modified with respect to
a particular taxable year subsequent to
the
close of such taxable year, but not
later than the date (not including any
extension of time) prescribed by law for
the filing of the partnership return. As
to any matter on which the partnership
agreement, or any modification thereof, is
silent, the provisions of local law shall
be
considered to constitute a part of the
agreement. (emphasis added).
Question - If we fail to meet the
partnership
classification tests because of a term in
the
partnership agreement can we fix it prior to
the time of filing the return?
If we did not
qualify for partnership qualification, do
these
definitions apply?
How about the other
direction - classified as partnership but
now
would prefer corp taxation for some reason?
E.
Note - This is not the same as the "operating
agreement" definition as used in the
State LLC
statute.
F.
Although not law, Rev. Proc. 89-12, 1989-1 C.B.
798, provides some further guidance as
as to
what the "partnership agreement"
is in an LLC
by providing that:
In the case of an
organization not formed as a partnership,
references to "partnership"
documents,
including the "partnership
agreement", apply to
the organization's comparable documents,
however designated.
V. LLCS - WHAT ARE THEY - BRIEFLY
A. A Limited Liability
Company is a relatively new
form of business entity in the United
States.
1.
Although in use in the U.S. for
approximately 15 years, it is only in the
last
two years that they have become
popular.
B.
An LLC is a non-corporate form of entity which,
like a corporation and a limited
partnership,
may only be created by
authority of a specific
state statute.
1.
In Wisconsin, Chapter 183 of the Wisconsin
Statutes authorizes their creation. A copy
of
the statute appears as part of 1993
Wisconsin Act 112, which created Wisconsin
LLCs, a copy of which is in Appendix A.
C.
Typically, the state enabling statutes give the
LLC a combination of characteristics found
in
corporations, partnerships and limited
partnerships.
Some of the more important of
which are:
1.
They provide the LLC's owners with limited
liability, presumably to the same extent
afforded owners of corporations.
a. There
is an open question as to the
exact extent of this protection when
the LLC operates in a state with no
LLC statute of any kind.
2.
They allow the owners of the LLC to choose
between two forms of management for the
LLC.
a.
One alternative is to allow all
owners to participate actively in the
management of the entity and in its
business operation.
(1) This
may be accomplished without
any
loss of limited liability.
b.
The other alternative is to allow the
LLC to be managed more or less
exclusively by a group specifically
designated as "managers".
(1) This
group may include none,
some, or all of the owners.
3.
They usually allow the owners of the
entity to vary the characteristics of the
entity and/or their relationship to it so
that it may be taxed as either a
"partnership" or a
"corporation" for
federal income tax purposes.
a.
Wisconsin allows such flexibility.
4.
They allow the owners to vary the
relationship
between themselves and
between themselves and the entity, with
much of the flexibility afforded partners.
D.
Since the owners of the LLC have limited
liability, LLC statutes generally contain
some
provisions regarding the protection of
creditors and others dealing with the LLC.
1.
Thus, most LLC statutes contain some
unchangeable provisions regarding
disclosure of the form of management,
contributions, distributions, and rights
of
creditors upon dissolution of the
entity.
VI. HISTORY OF LLC STATUTES & FEDERAL TAX
"CLASSIFICATION" RULES
A.
Entities similar to LLCs have existed and have
been in common use in Europe and Latin
America
for many years, although the first LLC
legislation in the United States was adopted
in
Wyoming in 1977 and only Wyoming and Florida
had
statutes prior to 1990. See generally L.
Ribstein and R. Keatinge, Ribstein and
Keatinge
on Limited Liability Companies
(Shepard's/McGraw-Hill, Inc. 1992-1994).
1.
Other forms of unincorporated
organizations which grant limited
liability to its owner existed in the U.S.
before 1977. These include:
a.
Partnership Association or Limited
Partnership Association existed under
Pennsylvania, Michigan, New Jersey
and Ohio law prior to 1900.
b.
Business Trusts, sometimes referred
to as Massachusetts Business Trusts,
have also existed in several states,
including
Delaware, Texas, Missouri
and Oklahoma.
B.
LLCs in the United States got off to a slow
start, primarily because of uncertainties
regarding their tax treatment.
1.
Although the first LLC statute was
introduced in Alaska, the bill did not
pass.
2.
In 1977, as special interest legislation
for an oil company, Wyoming enacted its
Limited Liability Company Act.
3.
In January of 1977, the IRS issued and
then
withdrew Proposed Reg. 301.7701-1
through -3, which would have made
partnership classification more difficult
than was previously the case.
4.
Then, on November 18, 1980, the IRS issued
a Private Letter Ruling to an entity
organized under the Wyoming Act.
This
ruling held that the entity would be taxed
as
a "partnership" for federal income tax
purposes.
5.
However, one day earlier, on November 17,
1980, the IRS issued proposed regulations
which would have denied partnership
classification to any organization in
which none of the owners was personally
liable for the debts of the entity. (Prop.
Treas. Reg. 301.7701-2).
a.
These regulations were heavily
criticized as interfering in
customary business transactions and
being inconsistent with longstanding
rules re classification of entities
for federal tax purposes.
6.
On December 16, 1982, shortly before their
effective date, the Proposed Regulations
were withdrawn and a study project was
opened to determine the proper
classification of LLCs.
7.
Despite the uncertain tax treatment,
Florida adopted an LLC act in 1982 in an
effort to attract foreign capital into the
State.
a.
It provided a business entity similar
to the Limitada, an entity often used
in Central and South America.
8.
In 1988 the IRS study project regarding
"partnership" culminated with the
issuance
of Rev. Rul. 88-76, 1988-2 C.B. 360 which
finally determined that an entity created
as an LLC under the Wyoming LLC statute
qualified as a "partnership" for
federal
income tax purposes.
9.
Finally, in GCM 39798, issued on October
18, 1989, the IRS reconfirmed that an
entity could be treated as a
"partnership"
for tax purposes despite the fact that its
owners
lacked "personal liability".
10. Probably
as a result of the elimination of
some of the tax uncertainties, many states
took steps to adopt LLC statutes.
VII. SOME GENERAL ADVANTAGES AND
DISADVANTAGES OF THE LLC
A.
Some Possible Advantages:
1.
Limited liability for owners
2.
Very flexible ownership, management, and
economic benefits (see comments at )
3.
No double tax on distributed profits - get
pass through tax treatment, if classified
as
a "partnership" for federal tax
purposes.
4.
Ability to distribute appreciated assets
in a non-taxable transaction, if
classified as a "partnership" for
federal
tax purposes.
5.
Obtain an increase in basis for debts of
the entity, not just for actual capital
contributions and loans to
the entity - if
classified as a "partnership" for
federal
tax purposes.
6.
Avoid restrictions on the number or types
of
owners
B. Some Possible
Disadvantages:
1.
Unclear as to the treatment afforded LLCs
operating in states without LLC statutes.
a.
Will the state recognize the limited
liability
of an LLC's members?
b.
Will the state allow the LLC to
commence or defend an action in its
courts?
c.
How will the LLC be treated for state
tax purposes?
(1) No
uniform treatment
(2) Possible
complications for those
LLCs operating in multiple
states or with members residing
in multiple states.
2.
No developed body of law to aid in
business planning and statutory
interpretation.
3.
Some uncertainty regarding the IRS's
application of certain federal tax law to
LLCS.
4.
No consistency between states as to the
type of business which may be conducted in
an LLC - eg. law, insurance etc.
a.
Complicates multi-state operations.
5.
Usually cannot have single owner
6.
May not be useful for large business with
many members
a.
Existence of limited liability along
with a need for centralized
management and freely transferable
interests, would preclude
classification as a
"partnership" for
federal tax purposes.
Putting LLCs In Perspective. Copyright c 1994-2000 Institute of Professional and Consumer Education, LLC. All Rights Reserved.