Excerpt from Limited Liability Companies and Limited Liability Partnerships

CHAPTER 1

Section 1.01 Introduction to LLCs and LLPs

This book is about the limited liability company (LLC) and the limited liability partnership (LLP). The LLC is a new state law entity that provides the benefits of limited liability for its members and, if its owners desire it, pass-through tax treatment. The LLP is a type of partnership which also provides limited liability for its members and, again if its owners desire it, pass-through tax treatment.

Although it sounds like a bold statement, LLCs and LLPs are destined to become the entity of choice in the United States for nonpublicly traded business and investment enterprises. The reasons for this are relatively simple. First of all, given the choice, a rational person will always choose (1) pass-through taxation rather than the double level income tax on corporate earnings under current U.S. federal income tax law, (2) limited liability for the members of a business organization rather than unlimited liability and (3) the most simple pass-through vehicle, rather than a more complicated one. Put another way, a rational person would choose a simple pass-through vehicle with limited liability, if one exists, to carry on business or investment activities. Second, the federal income tax law has evolved to accommodate this choice. The effect of the current federal income tax law is to provide a federal definition of a corporation, rather than a state law one. Under this definition, corporate entities are taxed as corporations and noncorporate entities are treated as partnerships or corporations for federal income tax purposes based on (1) whether interests in the entity are publicly traded and (2) whether an election is made by the entity under the "check-the-box" regulations, adopted by the Internal Revenue Service (IRS) in December 1996.¹ Third, although certain corporations can elect flow-through tax treatment (i.e., S corporations), this pass-through regime is infinitely more complicated and fragile (from a federal income tax standpoint) than the treatment of LLCs and LLPs. Accordingly, it can be expected that use of the S corporation will decline as LLCs and LLPs become recognized vehicles. Therefore, considering the rational person's desire to avoid tax and liability and the evolution of the federal income tax law to accommodate this desire, the LLC or LLP is the simplest pass-through vehicle which provides limited liability.² Accordingly, other than entities that must be corporations (e.g., publicly-traded entities), the fundamental rules of rational economic/legal behavior dictate the choice of LLC or LLP status. Since there is no liability benefit to corporate status, and a corporate level tax results if a corporation is used and since S corporation status is complicated, the choice is easy: LLC or LLP offers the best of both worlds: limited liability and pass-through tax treatment. This is why LLCs and LLPs will become the entity of choice for non-publicly traded business and investment enterprises.

The evolution of the LLC and LLP has occurred with blinding speed. At the beginning of the 1990s, LLC statutes were on the books of only a few states. By 1998, all of the states had adopted LLC statutes. Most of these jurisdictions have also adopted statutes creating the LLC's cousin, the limited liability partnership (LLP).³ LLCs and LLPs are potentially the preeminent pass-through vehicle under federal income tax law which will have paved the way for one of the most amazing transformations in U.S. business history, the formation of hundreds of thousands of new business entities as pass-through entities for federal income tax purposes.

As previously mentioned, the most recent chapter in LLC evolution occurred in December, 1996 when the IRS issued its final "check-the-box" regulations.⁴ These regulations, in effect, ratify the changes made by each state in their laws by making flow-through tax treatment for LLCs and LLPs elective. In response to check-the-box, most states either have amended, or are expected to amend, their state statutes to accommodate the "check-the-box" regulations. The reasons for this are set forth in detail below.⁵

This book is designed to be a comprehensive discussion of the LLC and LLP vehicles from a tax and legal perspective. It will help the practitioner decide whether an LLC, an LLP or another form of business organization is appropriate for his or her client. It will also help the practitioner in implementing the decision with practical insights into the LLC and LLP laws of the major states as well as federal and state tax considerations applicable to LLCs and LLPs. The forms in this volume should enable the practitioner to form a basic LLC or LLP "from scratch."

1. Treas. Reg. Sections 301.7701-2, 301.7701-3; 26 C.F.R. Sections 301.7701-2, 301.7701-3.

2. Another form of business enterprise known to many professionals is the professional corporation (PC). The PC is a corporation under state law whose members are professionals of some sort, such as doctors, lawyers or accountants. PCs can be either S corporations or C corporations under federal income tax law. PC use can be expected to decline, however, as LLCs, and more importantly, LLPs are adopted as the business form for professional organizations. The difficulties in converting a PC to an LLP are discussed in Chapter 5 infra.

3. As of June 1998, the only state without LLP legislation is Vermont (awaiting signature-foreign LLPs only).

4. The "check-the-box" regulations are discussed in detail in Section 5.02[3] infra..

5. See discussion in Sections 2.02[1][e], [2][d] and 3.01 infra.