What is a limited liability company?
An LLC is an unincorporated organization of one or more persons in which all of the owners (called "members") have limited liability(2) and can participate in the management of the organization or its business. If the LLC is properly organized, its members will enjoy the beneficial pass-through tax treatment accorded partners in a partnership.(3)
How is a limited liability company formed?
An LLC is formed by filing articles of organization or a certificate of formation (the "Charter") with the secretary of state of the state selected for formation. The Charter may provide, among other things, whether the LLC is to be managed by one or more members or by one or more managers, and whether there are limitations on the authority of members or managers. Contributions by members to the capital of an LLC may be in the form of cash, property, services, a promissory note or an undertaking to contribute any of those items.
The business and the conduct of the affairs of an LLC are regulated by an Operating Agreement or Limited Liability Company Agreement (the "LLC Agreement") between the members. An LLC Agreement may contain any provisions relating to (i) the business of the LLC, (ii) the conduct of its affairs, and (iii) the rights, powers, preferences, limitations or responsibilities of its members, managers, employees or agents.
As another manifestation of the flexibility of an LLC, its profits and losses are allocated among its members in the manner provided in the LLC Agreement(4) and need not be in proportion to the members' investments in, or contributions to, the LLC.(5) Voting rights of the members of an LLC are also regulated by the LLC Agreement. In the event that the LLC Agreement is silent with respect to voting rights, the LLC statutes vary in their approach, with some allocating votes on a per capita basis, while others allocate votes on the basis of the value of the members' contributions or allocated share of profits. The LLC Agreement may also provide for the admittance to the LLC of new members.
Advantages of LLCs over other forms of business organizations.
In selecting a structure for a business entity, an LLC may be more attractive than a general or limited partnership because all members of an LLC may be insulated from personal liability for the debts of the business; in contrast, all partners in a general partnership and at least one general partner in a limited partnership must remain personally liable for the debts of the partnership. Furthermore, while limited partners are not permitted to participate in the management of a limited partnership (limited partners found to be actively involved in the management of the partnership's business risk losing their limited liability status), the members of an LLC are permitted to actively manage the business of the LLC.(6)
Although traditional C corporations provide shareholders with limited liability protection, the earnings of such corporations are subject to double taxation (taxed first as income to the entity and then as dividend income to the shareholders). Moreover, a traditional C corporation may not be able to make immediate use of its operating losses since such losses can generally only be used by such entity to offset income earned in other years.
If an LLC has more than one member and is properly organized, it will receive the same favorable pass-thru tax treatment as a partnership. Accordingly, its income, gains, losses, deductions and credits may be passed through to its members, thus avoiding the imposition of federal (and often state and local) income taxes at the entity level. The members of an LLC can generally use their share of operating losses to offset income from other sources.(7)
LLCs also have certain advantages over S corporations. S corporations have stringent qualification rules. For example, an S corporation must have only one class of stock, can have no more than 75 shareholders, and cannot have for-profit corporations or non-resident aliens as direct shareholders. LLCs are not subject to any of these restrictions. Furthermore, the ability of an S corporation to pass through to its shareholders deductions that are generated by entity level borrowings are more restricted than in the case of an LLC. The "single class of stock" requirement for S corporations limits severely the ability of the shareholders to agree to special allocations of profits and losses and may in some instances call certain income-splitting arrangements (such as payments to an employer based on gross margin) into question.
The Internal Revenue Service has proposed a set of revised entity classification regulations which, if adopted, would permit any unincorporated entity (including entities formed as an LLC under state law) to select its classification as a corporation or as a partnership for Federal income tax purposes, regardless of the number of corporate characteristics possessed by the entity. If these regulations (commonly referred to as the "check-the-box" regulations, because they permit entities to choose their tax classification by checking the appropriate box on an IRS form) are adopted, the restrictions on corporate characteristics described in the preceding paragraph will no longer apply.
Are there any disadvantages associated with forming an LLC?
LLCs, like partnerships, must avoid certain corporate characteristics in order to maintain their favorable tax treatment as partnerships for federal income tax purposes.(8) Thus, particular attention must be paid in drafting those provisions of the LLC Agreement which have some bearing on the salient corporate characteristics. For example, LLC Agreements often contain restrictions on the transferability of all or a portion of the members' interests. These restrictions are intended to ensure that the corporate characteristic of free transferability of interests is not present. Under such a provision, members may be absolutely prohibited from transferring all or a portion of their interests, or they may have the right to assign only the economic benefits (such as the right to participate in distributions and allocations of profits and losses) associated with their membership interests, but not the right to have the assignee admitted as a substitute member, entitled to exercise the powers of a member (e.g., vote), in the absence of the affirmative vote or consent of a majority of the remaining members.(9)
How would an LLC Venture be structured?
Several new ventures and funds are now coming to market in the form of LLCs instead of limited partnerships. Investors in these ventures or funds will subscribe for "membership" interests rather than limited partnership interests, and there will be no general partner. Under the LLC structure, the supervision, direction and control of the LLC venture or fund will be vested in the fund's manager(s) who is likely also to be a member of the LLC rather than a general partner. The manager/member also may have a de minimis membership interest in the fund or venture, although the managers' return may continue to consist principally of management, monitoring and transaction fees.
Consultation, communication and dialogue between fund managers and members and among members of LLC ventures/ funds is likely to be greatly enhanced, and some LLC ventures may now be structured to take advantage of this flexibility as they target specific investors or seek to broaden their client base to investors not previously able to participate.(10)
Can an existing partnership or corporation convert to an LLC?
Existing partnerships and corporations can convert to the LLC form. New organizational documents will be required in the event that a partnership or corporation elects to change its status to an LLC. However, while an existing partnership may convert to an LLC without incurring any additional taxes,(11) the conversion of an existing C or S corporation will generally be treated as a liquidation of the existing corporation followed by a contribution to the LLC; this treatment could result in unfavorable tax consequences to both the corporation and its shareholders.(12)
What is the effect of LLC legislation on future ventures?
We anticipate that many if not most newly formed ventures will be structured as LLCs instead of limited partnerships. Whether currently existing limited partnership ventures will be converted to LLCs is an issue that will likely be considered by venture managers and general partners in consultation with their counsel, and we expect several to conclude that conversion is beneficial to investors, the fund managers and the fund itself.
This memorandum provides a general overview of the significant rules relating to LLCs and should not be relied upon for planning purposes. Additional detailed rules may apply which may have adverse or unforeseen tax consequences, including state and local tax consequences.(13) Consequently, potentially affected parties are encouraged to consult tax counsel before deciding on the structure of a business organization. In this regard, if you have any questions concerning the foregoing, please do not hesitate to contact any member of the Coudert Brothers tax department at (212) 626-4400.
Footnotes
2. The extent of a member's limited liability can be varied by agreement.
3. The criteria for classifying an LLC as a partnership for federal income tax purposes are discussed below. Except as otherwise indicated, the remainder of this discussion assumes that the subject LLC is classified as a partnership for tax purposes.
4. Absent a provision in the LLC Agreement allocating profits and losses, allocation are made in proportion to the members' respective unreturned capital contributions.
5. Notwithstanding the apparent unfettered flexibility regarding allocations provided in the LLC statutes, LLCs that are treated as a partnership for federal income tax purposes will be subject to the rules relating to the allocation of profits and losses contained in the Treasury Regulations dealing with partnership allocations.
6. This ability to actively participate in the management of the business could be important where it is advantageous to avoid having losses generated by the business characterized as "passive activity losses" subject to limitation under the federal income tax rules.
7. The ability of the members to utilize such losses may be affected by basis limitations and the "at risk" and "passive activity loss" rules, and by other potentially applicable provisions of the Internal Revenue Code that restrict a taxpayer's ability to deduct certain losses.
8. These characteristics are: limited liability; continuity of life; free transferability of interests; and centralized management. An LLC may not have more than two of these corporate characteristics if it is intended to be treated as a partnership for federal income tax purposes.
9. While the requirement of the approval of a majority in interest should generally be sufficient to obviate the characteristic of free transferability, special attention must be paid where certain additional factors (such as the freedom to assign by proxy any existing non-economic rights) may indicate an unrestricted ability of the members to effectively transfer all rights associated with their interests. Furthermore, if the members of the LLC are all commonly controlled, the required consent of a majority in interest may be deemed Illusory, in which case an absolute prohibition on transfer of at least a portion of the LLC interests may be necessary.
10. Such consultation with limited partners in a limited partnership hedge fund previously was avoided because of fear that consultation could constitute participation by the limited partners in the fund's management, which participation could eradicate the limited partner's limited liability and expose him to the fund's debts and liabilities.
11. Special care must be taken in this circumstance to focus on any potential shift in the "debt-sharing" ratios of the partners resulting from such conversion. If a former partner's share of partnership debt which was included in his or her basis decreases as a result of the conversion, such decrease would be treated as a deemed cash distribution to such partner by the partnership, and could result in taxable gain being recognized by the partner.
12. The conversion of either a partnership or a corporation to an LLC should constitute a mere change of form of ownership and thus avoid state and local transfer, gains and/or documentary stamp taxes in most jurisdictions. However, care should be taken as the reach of these taxes is extraordinarily broad in some jurisdictions.
13. For example, a non-United States person who is a member of an LLC which is engaged in a United States business may be subject to United States tax on his share of the income of the LLC.