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Partnerships, Limited Liability Companies,
Joint Ventures
Structure and formation of general and limited
partnerships, and limited liability companies ("partnerships"); sales of
partnership interests; admission to partnerships; amendments to partnership
agreements and partnership tax advice.
WHAT EXACTLY IS AN LLC?
To best understand LLCs, one should understand what corporations and
partnerships were intended to accomplish for their owners, albeit
imperfectly. In other words, an understanding of LLCs comes from an
understanding of the failings of corporations and partnerships and
therefore how LLCs fill the gap.
Corporations and Partnerships
Until LLCs came on the scene, businesspersons (other than sole
proprietors, who cannot form one-person LLCs in most states) had a
choice of business entity that was generally limited to corporations
or partnerships, involving a trade off between, on the one hand,
limitations on the liability of the business owners for debts of and
judgments against the business, and, on the other hand, tax savings
through a single, rather than a double, tax on business income. The
holy grail, so to speak, would be both.
Corporations
A corporation, formed by filing articles of incorporation with a
state agency and governed by by-laws, normally provides its
shareholders with a shield against creditors (whether lenders,
suppliers, or tort judgment creditors) of the corporation, unless the
shield could be "pierced" or the shareholders give personal
guarantees. Generally, therefore, regardless of the financial
strength of the corporation, the assets of the shareholders not
invested in the business (for example, one's residence) cannot be
attached by the corporation's creditors. Yet there is a tax price to
be paid for this protection; a regular, or "C", corporation is
subject to tax as if it is a separate person, and the shareholders
receive only the earnings of the corporation reduced by the taxes
paid by the corporation. Also, if the corporation runs a net loss,
the shareholders are not able to claim the loss on their own tax
returns.
Of course this may be mitigated to some extent in several ways. For
instance, if otherwise permissible under the tax code, closely held
corporations might pay out all of its earnings to its shareholders as
salary or rent, thereby leaving no corporate income to be taxed.
However, corporate losses would still be stuck within the
corporation. Alternatively, the shareholders might make an election
with the IRS under Subchapter S of the Internal Revenue Code of 1986
(known as an S corporation), thereby allowing the income and expenses
of the corporation to be ignored at the corporate level, with the
shareholders paying all of the tax themselves on the net income
earned by the corporation or claiming all of the corporation's losses
as their own. Yet to qualify as an S corporation, the corporation
must pass through several hoops. For instance, only US citizens and
resident aliens may be shareholders, the company cannot have more
than 35 shareholders, entities such as corporations, partnerships,
estates and trusts (except for special trusts) cannot be
shareholders, and there may not be preferred returns given to any
shareholder over any other shareholder. Also, appreciated property
might be subject to corporate tax when sold by certain S
corporations, and there is a tax and overall limits on passive
investment income of certain S corporations. Needless to say, this
makes S corporations unavailable in a wide variety of situations,
such as those with foreign investors, with venture capitalists, or
with corporate families, and potentially unattractive where the
corporation might own a significantly appreciating asset or have a
substantial amount of passive income.
Thus, if a corporation were the preferred form of doing business, one
could get limited liability and one level of tax if one qualified as
an S corporation, or the shareholders must accept the cost of paying
tax at the corporate level. (Having said this, one should not always
conclude that C corporation status must be avoided. Under current
law, with the corporate income tax rate typically lower than the
highest personal income tax rate, profitable businesses planning to
plow earnings back into the business as working capital rather than
distribute these earnings might be better off as a C corporation.
Also, certain benefits, such as medical expense reimbursement plans
are, as a practical matter, available to C corporations that might
not be available or beneficial to other entities.)
Partnerships
At the other end of the spectrum lie partnerships. In its most basic
form, the general partnership, the income and losses of the
partnership business flow through directly to the partners and are
not subject to tax at the partnership level. However, all the
partners are jointly and severally liable for the debts and judgments
of the partnership. Of course, limited partnerships are employed by
many to retain these tax benefits but reduce the liability of the
partners. Yet, as every limited partnership requires at least one
general partner, this leaves at least one person with complete
exposure for partnership debts and judgments. One common mechanism
is to form a special purpose corporation with finite assets to hold a
small partnership interest as general partner. While this is the
accepted way to do business, many businesspersons accept this
cumbersome structure only begrudgingly. Also, business operators,
rather than passive investors, cannot be, as a practical legal
matter, a limited partner. Therefore, those who run the business are
exposed to unlimited liability even when the business is operated
through a limited partnership.
Accordingly, if partnership is the preferred business vehicle, one is
able to keep taxes down and limit liability with a limited
partnership having a corporate general partner, at the cost of
administrative complexity. And even then the liability limits are
less than perfect for those active in operating the business.
Limited Liability Companies
With LLCs, the holy grail of business entities is closer at hand, if
not in our grasp. Under the typical LLC statute, the members
(analogous to shareholders in corporations and partners in
partnerships) are all shielded from the company's debts unless they
affirmatively undertake responsibility for such debt, such as by a
guarantee to a lender. Also, the Internal Revenue Service has ruled
repeatedly in precedential rulings that if the LLC is formed in a
particular manner the company would be treated as a partnership for
tax purposes. This determination turns on the nature of the
company's management structure, the transferability of member
interests, and how the company would dissolve. If not formed
appropriately in light of the IRS regulations, rulings, and case law,
the LLC will be treated as a corporation for federal income tax
purposes (and for state tax purposes in the many states that rely on
federal tax classification). Caution, therefore, is the touchstone
when forming LLCs that must be treated as a partnership for federal
tax purposes.
Thus, in the right circumstances, there is no longer a need to use a
corporation or a limited partnership with a corporate general partner
to provide complete liability protection and there is no need to live
with the statutory limitations of the S corporation in order to get
federal income tax advantages. It should be noted that in some
states the LLC itself will have to pay state income or franchise
taxes on its income, despite it tax transparency for federal tax
purposes. Also, the LLC might be subject to hefty filing fee
requirements initially and annually depending on the states in which
the LLC is formed and in which it is doing business.
LLC Certificate and Operating Agreement
The limited liability company, a creature of state law, is one
created by the filing of a document similar to articles of
incorporation with a state authority. However, the company is not
governed by by-laws; instead is governed by an Operating Agreement
(in Delaware, known as the LLC Agreement). The Operating Agreement
is closer in form to a partnership agreement (or, to use a corporate
analogue, by-laws plus a shareholders' agreement). The Operating
Agreement sets the rules for governing the company (such as the rules
for meetings, if any) as well as the rights and responsibilities of
the members vis-a-vis the company and vis-a-vis each other. Thus, it
states the members' understanding of who is responsible for
contributions to capital and how much, who is to receive
distributions and how much, who is to be allocated the various tax
attributes of the company such as profits, losses, gains and credits,
and under what circumstance the company will dissolve, among others.
The Operating Agreement is not filed with any state agency.
Authorization To Do Business In Other Jurisdictions
If the company is organized in a jurisdiction other than that in
which it will be doing business, or will be doing business in several
jurisdictions, then the company must be authorized to do business as
a foreign LLC in these other jurisdictions, much like corporations
formed in Delaware have done for years.
Evidence of LLC Interests
The ownership interests in LLCs may be reflected in share
certificates in many jurisdictions, but need not be. In fact it is
not unusual for LLC interests to be stated as a percentage of the
company's capital as in a partnership.
Management of the LLC
It is up to the members to define in the Operating Agreement how the
LLC will be managed. In some cases, the members might vest virtually
all control of the LLC in one or a few managers (analogous to the
officers and directors of a corporation or the managing general
partner in a limited partnership). In other cases, the members might
want a more active hand in company policy and day to day management,
in which case the Agreement will provide for an appropriate quantum
of votes in a variety of circumstances.
Annual and Special Meetings
Depending on the management structure of the company, the Operating
Agreement might require regular meetings, as does typical corporate
by-laws, or the members might forego meetings altogether.
Dissolution of the LLC
The Operating Agreement will also set forth the events that cause
dissolution of the company. For instance, there may be a requirement
that it dissolve upon the death or bankruptcy of a member or of a
manager. While this is an important operational issue to consider
when forming the LLC, its significance is even greater than appears
on it face, as this is one aspect of the company the IRS will examine
to determine if the company should be taxed as a partnership or as a
corporation. This is also one of the areas of greatest concern to
LLC investors insofar as, depending on how a dissolution provision is
formulated, the LLC might dissolve at an inopportune and
unanticipated time.
Transfers of LLC Interests
The members will also provide in the Operating Agreement the rules
governing when LLC interests may be transferred and which aspects of
these interests may be transferred. These rules might include a
right of first refusal for the remaining members. Again because of
IRS criteria, the "economic rights" of the LLC interest might be
freely transferable to an outsider, but the recipient of these rights
might not be admitted as a full member, with full rights of LLC
membership, unless admitted by an affirmative vote of the remaining
members.
Tax Reporting for LLCs
When tax time roles around, the LLC will file a partnership tax
return with the federal government and any requisite state tax forms.
If treated as a partnership for federal tax purposes, the LLC will
provide to each member a Form K-1.
Creative Uses of LLCs
There is virtually no business enterprise for which an LLC would be
inappropriate, except if the company is expected to be publicly
traded, or if there are so many members of the LLCs that it could not
legitimately be qualified for partnership tax treatment (unless of
course partnership tax treatment was not desired). Real estate, oil
and gas ventures, any operating business, professionals (in some
states), businesses with foreign investors, businesses seeking
venture capital, and joint ventures between established enterprises,
including huge corporations, are just a few of the ventures that
might benefit from doing business through an LLC. Also, in the
context of estate planning, where family limited partnerships are now
being used, LLCs are providing an alternative outlet. Finally, as
outside creditors of LLC members typically can get only a charging
order against that member's LLC interest LLCs provide an excellent
component in an asset protection plan.
CONCLUSION
A full description of LLCs would take a volume to properly discuss,
and the issues are terribly complex, despite the simplicity with
which they are presented in this memorandum.
Whether one is best served by an LLC in any given situation, and how
the LLC should be operated is a determination that depends are
specific facts unique to each case, including the laws of the state
under which it is formed. Competent and experienced counsel should
be consulted before undertaking any business venture, particularly
one as complicated and as poorly understood as limited liability
companies. Accordingly, nothing herein is to be interpreted as legal
advice as such advice can only be rendered upon a complete
understanding of all of the relevant facts in any particular case.
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