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Putting Limited Liability Companies In Perspective - By ProGuide™

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                    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


                              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


                              g.   Entity's existence is generally


                              h.   Ownership interests can be freely


                         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


                              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


                         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


                              c.   Entity is managed by general


                              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


                         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


                         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


                    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


                              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


                              c.   other matters of the type enumerated


                                   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


                              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


                                   (5)  voting rights

                                   (6)  the ability to transfer their


                                   (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.


                              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


                    E.   We look to federal tax law for a stable body of

                         well settled statutory rules and case law


                         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


                    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


                         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


                                   (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.)


                    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


                    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


                    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


                    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


                              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



                    "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


                         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


                         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


                              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.


                    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


                         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


                              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


                         3.   Some uncertainty regarding the IRS's

                              application of certain federal tax law to


                         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.

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