Tax Aspects of Limited Liability Companies: Is the LLC a State-of-the-Art Entity? (1992)

One of the most challenging decisions business enterprises, including CPA firms, face is selecting a form of organization. Among the available options, the limited liability company (LLC) is not new but certainly is gaining favor as a way of doing business. Unlike C corporation owners, LLC owners (called members) avoid double taxation (LLCs are taxed as partnerships) while at the same time enjoying the same limited liability as C and S corporation owners. To many, LLCs may sound no better than or different from S corporations or limited partnerships. But the S corporation limits on formation and continued operation do not apply to LLCs, and the problems of having a corporate general partner in a limited partnership are avoided since all members enjoy limited liability. Limited partner ownership and participation restrictions are irrelevant to LLCs, which offer more favorable tax attributes than limited partnerships and avoid the restrictions of S corporations. If LLCs are potentially so beneficial from both tax and liability viewpoints, practitioners may wonder why they are relatively unused. This article examines that question as well as others about LLC formation and operation; a detailed comparison of LLCs with limited partnerships and S corporations and some unresolved tax and nontax issues also are discussed. (For information on LLCs' applicability to CPA firms, see the sidebar on page 51. ) LLCs AND THE IRS--PAST AND PRESENT LLC legislation was introduced in Alaska in 1975 and 1976, but neither attempt passed. Wyoming passed the first LLC statute in 1977. Florida passed its statute five years later; Kansas and Colorado, in 1990; and Utah and Virginia, in 1991. Today, a total of 16 states have approved LLCs, and legislation has been introduced in 8 others. (Georgia and Indiana allow only foreign LLCs to conduct business in the state, subject to registration requirements.) The exhibit on page 52 shows states' LLC status. The LLC legislation gap from 1982 to 1990 can be attributed to the Internal Revenue Service's failure to decide how LLCs would be classified. Under Treasury regulations sections 301.7701-2 and 301.7701-3, the issue was whether LLCs should be taxed as partnerships or given association status, forcing taxation as regular corporations. Classification remained a problem until revenue ruling 88-76 determined what criteria would be used to classify an LLC. Morrissey v. Commissioner [296 U.S. 344 (1935)] provided perhaps the bestknown classification test for business organizations. The U.S. Supreme Court identified six long-used criteria to determine corporate resemblance: * Associates (beneficiaries, partners or shareholders). * An objective to carry on a business and divide its gains. * Continuity of life. * Centralized management. * Limited liability. * Free transferability of interest. The Court was careful to state these not as requirements but, rather, as factors that make an entity resemble a corporation. In 1953, the IRS.required only two criteria, continuity of hfe and centralized management, in deciding to tax an entity as a corporation or as an association. In 1960, Treasury regulations section 301.7701-2 adopted the six criteria used in Morrissey. Since the first two characteristics on the list above are common to most business organizations, the last four became the focus of the classification test. Presence of more than two forced taxation as a corporation. As tax-shelter limited partnerships became popular, the government lost two important decisions--Zuckman v. United States [524 F.2d 729 (Ct. C1. 1975)] and Larson v. United States [66 T.C. 159 (1976)]. The government failed in its attempts to classify two limited partnerships as associations and thus tax them as corporations. Larson became important because the Tax Court required equal weight to be applied to each of the four items not common to both types of organization. …