Source: https://www.llrx.com/2006/06/the-limited-liability-company-the-importance-of-choosing-the-correct-business-vehicles/
Timestamp: 2019-04-24 02:18:45+00:00

Document:
Sarah Spear is a third year law student at Florida Coastal School of Law and expects her J.D. in May 2006. She received her B.S. in English Literature with a minor in Financial Economics from Vanderbilt University in 2003. In law school, Sarah served as a Research Assistant for Professor Alexander Moody, assisting him with gathering empirical data relating to Delaware appraisal rights. Additionally, Sarah served as recruitment officer for the United Way’s Real Sense Prosperity Campaign and the Volunteer Income Tax Assistance (“VITA”) Program. Before entering law school, Sarah worked for U.S. Senator Bob Graham as a Constituent Advocate in the fields of Social Security and Medicare.
a. What are the Entity Choices?
Choosing an entity that compliments a business’s needs is paramount to its success. In the 2006 business environment, entrepreneurs have access to a wide variety of information. Many websites purport to take the place of a lawyer and allow the owner to choose his/her business vehicle online. The website then asks for contact information, files the name of the business with the correct state agency, and drafts the necessary documents and agreements. Absent adequate research and information, owners are uninformed of the advantages and disadvantages of the choice of entities available. Tax implications, liability issues, and management structure are factors that should be considered before the start up of an enterprise.
One of the most recent entities to emerge, the Limited Liability Company (“LLC”), has been the increasing choice of many business owners and an advantageous tool for estate planners. For most businesses, the LLC provides a hybrid of the pass-through tax benefits of a partnership and the limited liability of a corporation. Many entrepreneurs are not aware of the flexibility provided by an LLC and those who incorporate online default to a corporation because the entity is more familiar. Websites do not apprise the owners of the strict guidelines and laws that govern corporations. In some instances, failure to comply results in the liability shield stripped from a corporation, making the owners personally liable.
This paper will begin by distinguishing the LLC from other common forms of business entity, discussing the various LLC management structures, highlighting businesses thriving as LLCs, and pointing out some of the tax advantages realized by the LLC. The paper will conclude with a discussion of the LLC as an advantageous estate planning tool.
(A) What are the Entity Choices?
Each business requires the correct planning and structure in the business agreement. Without an agreement delineating the relationships between the members, managers, partners, and shareholders, the court applies default provisions. There is a significant possibility that the default provisions dictating the law will not align with the needs of the organizers. The most common methods of business operations are as sole proprietorships, general partnerships, limited partnerships, limited liability companies, and corporations. A number of derivations of these entities will be discussed, including family limited partnerships and S-corporations.
A sole proprietorship is the most simplistic form of business. It requires no formal filing with the state, and the operators require only a business license. In the eyes of the government, the owner is the business and is personally liable for all business debts, liabilities, and taxes. The profits and losses of the sole proprietorship pass through to the owner in a single level of taxation. The individual owner pays income tax on the profits of the sole proprietorship regardless of profit distribution at the end of the fiscal year.
A general partnership is a business in which two or more owners agree to share profits and losses. Each partner is the agent of the partnership and has the capacity to bind the partnership to transactions and liabilities. The general partnership is given pass-through tax treatment by the Internal Revenue Service (“IRS”). The profits and losses of the partnership are based on a single level of taxation and “pass-through” to the partners based on their allocated percentage of partnership interests. The partners must claim capital gains or losses on their personal income tax forms reflecting their interest in the partnership.
The limited partnership has two types of partners: limited partners and at least one general partner, who is personally liable for all debts and liabilities of the partnerships. To maintain limited partnership status, there must be at least one limited partner who cannot participate in the active management of partnership activities. The liability shield may at times be “pierced” if the limited partner participates too much in the control of the business. Both the limited partners and the general partner are given pass through tax treatment. In order to function as a limited partnership, the partners must file a certificate of limited partnership with the state and pay a filing fee.
A Family Limited Partnership (“FLP”) is a unique entity used by small family businesses or family’s with a desire to protect assets and avoid ancillary probate. The FLP is a limited partnership, but under the tax code it receives some tax advantages. Parents transfer assets to an FLP and then gift ownership interests of the partnership units to their children. The parents maintain control of the assets as general partners and appoint their children as limited partners.
A Subchapter C corporation (“C-corp”) is rigidly structured of all the business entities. The owners are shareholders who are issued stock in direct proportion to capital contribution and do not participate in management. Every corporation is required to have a board of directors. The board of directors, in turn, elect officers who manage and run the day-to-day business. The directors must hold annual meetings, maintain minutes of the meetings, issue proxies, and prepare formal documentation. A C-corp is taxed at two levels: once as a separate entity at the corporate level and again at the individual level when and if dividends are distributed to shareholders.
A Subchapter S corporation (“S-corp”) is a corporate organization formed under State law as a corporation. The organizers, however, elect specific tax status with the IRS to be treated as a single level taxpayer. By electing an S-class tax status, the corporation will not be taxed as a separate entity. Rather, the corporation is given pass-through tax treatment with the profits and losses passing through to the shareholders. In order to maintain S-class status, the S-corp must comply with a vast number of regulations, i.e., (1) the company may have no more than 100 shareholders, (2) shareholders are restricted to individuals, estates, certain trusts and tax exempt organizations, and (3) the company may issue only one class of stock.
The LLC combines the best tax and legal features of a partnership and a corporation. The result is that LLCs have become the favored form for new business and investment undertakings.
In an LLC every member may participate in management of the business entity while enjoying a shield of limited liability for their personal assets. The members of an LLC also receive the advantageous pass-through tax treatment of a partnership.
An LLC avoids having to categorize partners; the operating agreement allows for varied participation in management, provides for the sharing of profits and losses as well as provides limited liability to all members and managers.
The LLC achieves the benefits of asset protection and ability to gift ownership interest without exposing parents, as general partners, to liability. If the parents transfer real property as an asset into the LLC, any claim arising from that property will be solely the responsibility of the LLC. In addition, the family avoids the expenses of forming another business, i.e., LLC or S-corp, to act as its general partner.
The LLC affords the members the right to choose tax treatment as well as provides all members the luxury of personal liability. The LLC does not incur the stringent requirements of an S-corp to maintain partnership tax treatment. An LLC has no limitations on the number of members or type of member. In addition, an LLC may issue more than one type of stock.
Like a C-corp, the LLC is afforded the flexibility to make special allocations of distributional interests to certain members as well as the opportunity to change the distributional interests at any time in the LLC’s lifetime by a vote of the managers or members. The LLC, however, does not incur the double layer of taxation recognized by a corporation. The LLC can issue varied classes of stock and the members receive pass through tax treatment.
In summary, the benefits of an LLC include (1) limited liability and full participation in management afforded to all members, (2) the option to elect partnership tax treatment or corporate tax treatment, (3) the flexibility to make special allocations of distributional interests, (4) the ability to limit the liability of the members and decision makers, (5) the ability to easily transfer assets, and (6) the ability to issue more than one class of stock. Henceforth, it becomes clear that the LLC provides the most advantageous business vehicle for start up companies.
Research shows that LLCs have grown exponentially since their emergence in the late 1970s. Despite the rapid influx of LLCs, there is relatively little case law on the entity. This may be indicative of its malleability to change in the fast-paced business environment. The ease with which members may amend the operating agreement and the fact that the courts respect almost any provision in an operating agreement makes it hard for the courts to choose between partnership and corporate case law.
The first limited liability company act emerged in Wyoming in 1977 in response to growing demands for an entity that provided limited liability without having to incorporate. The Wyoming Limited Liability Company Act did not lure businesses at the outset due, in part, to the uncertainty of tax treatment. In 1982, Florida enacted its own limited liability company act, but the pace promotes organizing as an LLC remained marginal. In 1980 the IRS issued a Revenue Ruling that classified a Wyoming LLC as a partnership for tax purposes. After 1988, when it became clear that LLCs would be regarded as partnerships by the IRS for tax purposes, all remaining states adopted limited liability company acts. In 1996, the National Conference of Commissioners on Uniform State Laws adopted and presented to the legislature the Uniform Limited Liability Company Act (“Act”). The legislature adopted the Act and it now operates as the default provisions for many states.
The LLC must retain certain characteristics to enjoy the prized “flow through” or pass-through tax treatment. Those characteristics include (1) a defined lifespan and (2) the general non-transferability of assets. A term company specifies the date the LLC will dissolve, as opposed to an “at-will” LLC, which dissolves upon the occurrence of certain events. The Act defines an event as “specified in the operating agreement, consent of the number or percentage of members specified in the operating agreement, and an event that makes it unlawful for all or substantially all of the business of the company to be continued.” The members may, however, include provisions in the operating agreement allowing for the continuity of the business despite these events. With the exception of a few unalterable provisions, the owners of an LLC have the ability to personalize provisions and still retain pass through tax treatment.
Typically, there are two choices for LLC management: (1) member-managed or (2) manager-managed. The Act does not provide a default rule for management structure. Most state statutes default to member-management, but no state statute requires an LLC to be member-managed.
Both the Act and most state acts permit an LLC to be owned and managed by only one member, i.e., “a single member LLC.” The member may elect to be manager-managed, electing himself or herself as the manager with one hundred percent of the voting interest. This management structure mirrors that of a sole proprietorship; the LLC, however, is defined as its own separate entity, and the owner is shielded from personal liability for debts incurred in furtherance of the business.
If the organizers opt for member-management, “each member is an agent of the limited liability company for the purpose of its business,” and each member has a vote in the business decisions of the LLC. This structure mirrors that of a general partnership or limited partnership. The members of an LLC, however, have the luxury of limited liability without being personally liable for the debts incurred by the business or other members. Distinct from a limited partnership where the limited partners relinquish participation in management in order to retain limited liability, every member has decision making power as allocated in the operating agreement.
Members of a member-managed LLC make decisions on behalf of the company, not other partners. A decision made by a member to enter into a contract or loan agreement usually must be approved by a majority of the members. Although each member has the agency to bind the LLC, the remaining members of the LLC will not be personally liable for that decision made. In contrast, the creditor of a general partnership may seek recovery from any partner jointly and severally to satisfy the judgment that the partnership incurred regardless of the percentage of capital interest held by that partner.
If the members choose to be manager-managed, the manager is an agent for the purpose of the LLC’s business and the members no longer have agency to make decisions on behalf of the business, unless provided otherwise in the operating agreement. The members of an LLC may decide to elect either a manager or a management team; the manager may consist of a group of the members or a third party. The manager has certain fiduciary duties and responsibilities to uphold that may not be waived in the operating agreement; note, however, that certain categories may be identified as not violating the duty of loyalty.
A manager does not have to be a member, nor does a manager have to be a human being; a manager of an LLC may be a corporation or another LLC. This management structure is prudent for LLCs with investors who do not wish to participate in the day to day activities of the business and would rather hire a management company to operate the enterprise. A manager’s position as manager may be indefinite, with the operating agreement dictating when a manager may be removed, or provide for reelection.
A discussion on management structure evidences the reasons the LLC is quickly becoming the most prevalent business organization. Whatever the needs of members, the flexibility of the operating agreement provides greater latitude for personalizing a company’s strategic plan. The members of an LLC may elect member-management or manager-management based on their particular needs for structure.
Most any type of business, with the exception of certain insurance, professional, and banking companies, has the ability to organize as an LLC. The members follow the mandatory procedures of filing articles of organization, as provided by the state, pay a filing fee, and obtain an EIN (employer tax identification number). The date of organization varies from state to state, but in most instances, as soon as the articles of organization are filed, and assuming the LLC is not thinly capitalized, the LLC is a separate entity shielding the owners’ personal assets.
The LLC is also advantageous for businesses that need to split profits and losses flexibly without having the consequences of a second level of income taxation. Since the LLC may be taxed as a partnership, the members of an LLC do not have to split profits and losses based on their capital contributions, nor do they have to maintain the same percentage of profit splitting for the life of the LLC. Members may include in the operating agreement that the membership percentages will maintain at a certain level until the capital contributions have been returned, or they may decide to change the membership percentages at a certain date.
The LLC may also be appropriate for startup companies that may anticipate early capital losses. Pass-through tax treatment indicates that both profits and losses pass through the LLC to the members based on their respective percentages of membership interest or as agreed to under partnership tax law. If the members anticipate capital losses for the first two years of their business endeavor, it may be advantageous to set up as an LLC. When the LLC incurs a capital loss, those losses pass through to the members and the members may off-set profits made through other investments with the losses of the LLC so as to decrease their individual income tax liabilities.
Additionally, the LLC is an effective tool for estate planning and business succession planning. A parent minimizes estate tax by transferring assets to an LLC, where the parent is a manager and the children own a distributional interest. The parents do not pay a gift tax for gifts over $11,000. The children do not have access to the money; the money is owned by the LLC and the parents control when membership interests are distributed.
Also, an LLC is important to protect assets. An investor who owns real estate properties may shield the properties from liability by creating a separate LLC for each rental property, transferring the property as a capital contribution to the LLC, managing the LLCs separately, and thus insulating the properties from crossing liability.
The procedures for filing tax returns depend on the number of members of an LLC. If the LLC has only one member, the owner files a Form 1040 and attaches a Schedule C, and a Schedule SE (self-employment). LLCs with more than one member must file a Form 1065 partnership return. This form is strictly informational and is meant to provide the IRS with balance sheets for the LLC along with data showing each owner’s capital interest. Form 1065 generates a Schedule K which reports to the owners the record of their capital investments, allocations, and distributions. The owners then attach the K-1 to their Form 1040.
As mentioned earlier, members have great flexibility in allocating profits and losses when opting for pass-through tax treatment. The members may carefully fashion their operating agreement to plan for the members’ distributional interest. The distributional interest refers to the percentage of profits or losses allocated to each member at the end of each fiscal year. Unlike a corporation that allocates capital interests based on purchase price per share, the LLC, under partnership taxation, may distribute interests unequal to the capital investment of each member. In addition, members may decide that the capital interests will change and adapt throughout the life of the LLC. The members may decide to allocate percentages based on capital contributions until those contributions are returned, then change to a per capita distribution schedule. Furthermore, the operating agreement may allow for a change in the capital interests based merely on a majority vote from the members.
Disproportionate distributions made by an LLC are addressed by the Internal Revenue Code. The IRS requires that there to be a “substantial economic effect” in order for the special allocations to be valid. If one member manages the business’s affairs on a daily basis and the other members do not actively participate, this substantial economic effect warrants a disproportionate allocation of the capital interest to the active member. The members may not allocate all the profits or losses to one member, however, without a substantial economic reasoning behind doing so. The IRS will consider the economic substance of the transaction and will not allow an LLC to allocate distributive shares in order to evade taxes as its primary purpose.
Under limited circumstances, it may be beneficial for an LLC to “check the box” and elect corporate tax treatment. For example, if the members of an LLC intend on retaining the majority of profit in the LLC rather than making dividend distributions, the corporate tax treatment may be advantageous. In other words, it is advantageous to defer the recognition of gain by allowing said gains to accumulate in the corporation rather than immediately recognizing said gains on an individual tax basis as in a partnership. If the majority of capital will be left in the LLC, electing corporate tax treatment may allow the entity to incur less taxes on a whole. This is through the deferral of recognition and the time value of money.
The choice of tax status and flexibility of distributions allow members to work with the rigid structure of the Internal Revenue Code (“IRC”).
The many reasons a family organizes as a business may include: structure, asset protection, avoid probate, and minimize taxes. The needs of each family are distinct and require case-by-case analysis of objectives and goals. As discussed earlier, the choice and structure of the entity is paramount to its success.
Many asset protection entities are designed to allow senior family members to retain control of the assets during their lifetime. For example, the assets are transferred into a trust, limited partnership, corporation, or LLC and the senior members act as trustees, general partners, managing partners, or officers. This structure allows the elder members to decide when the transfer is complete, i.e., when the younger generation reaches an age of maturity. Additionally, the operating agreement can provide for the passing of interests upon the death of a member, which avoids probate. The membership interest would pass by operation of law, i.e., through the operating agreement, rather than probate court.
The LLC provides a more advantageous entity for asset protection than an FLP. An FLP must be structured to include a general partner. The general partner must be personally liable for the debts, liabilities, and obligations of the partnership; only the limited partners are afforded the liability shield. The family has the option of hiring a general partner, or organizing a corporation or LLC to act as their general partner, which requires the creation of another entity. This translates to additional filing fees and attorney’s fees to achieve what the LLC already provides: limited liability to all its members.
The LLC is a separate legal entity altogether. The decisions of one member do not affect the personal assets of another. An FLP may not be the right decision for families whose parents individually own numerous assets and real estate. If the parents act as general partners, a judgment against one parent may translate into the creditor going after the assets of the general partnership, as well as the non-marital assets of the other parent.
For a family run business, organizing as an LLC will ensure the correct distribution of interests to other family members. Many times, upon the occurrence of divorce or death, the court will transfer all said interests in a business to one spouse or the other. It is advantageous for a family to direct the distribution of interest in the operating agreement in case of the aforementioned events. It also provides confidence that the assets the senior members are passing down to loved ones. The right of first refusal ensures that the elderly members may restrict the transfer rights of the younger generation. If the elderly members do not wish a third party to hold an interest in the small family-run business, they may exercise their right of first refusal and buy the interest.
The valuation discount may be the sole reason a family-run business decides to organize as an LLC. The parents can transfer distributional interests to younger generations without making the beneficiaries members. The younger generation will have ownership of interest, yet will not have voting rights or control over the LLC. The transfer will receive a valuation discount, and incur lower taxes because of its lack of marketability. Instead of giving younger family members assets outright, the parents will gift an interest in the family-run business, and the members of the LLC may decide whether or not the transferee will become a member as a result of the transfer.
The LLC may be advantageous by allowing for marketability and control premium discounts. The transfer of a non-marketable asset, i.e., a distributional interest in a family run LLC, will incur lower taxes than one freely marketable, i.e., shares in a S-corp or C-corp. A family run LLC takes advantage of discounts by transferring the asset into the LLC, and distributing, in turn, an interest in the entity to younger members in the family. The “minority” interest in an entity is valued less in the eyes of the IRS than an interest in the underlying assets, thus reducing the tax liability.
For purposes of estate and gift taxes on a family-run business, the LLC provides additional advantages over S-corps and C-corps. The fair market value is defined as the “price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” In the instance where a family member gifts interests to other family members, larger valuation discounts may be available to members of an LLC then shareholders in a corporation. The valuation discount results from the lack of marketability of certain interests and the type of ownership and control associated with each interest. As provided by the Act, distributional interests in LLC lack control, whereas interests in corporations include greater rights with respect to purchased stock.
The overarching benefits of transferring interests of a family run business through the use of a LLC becomes apparent: the distributional interests are kept in the family, the assets are protected from creditors and avoid probate, the interests may receive a valuation discount, and the assets are successfully transferred to future generations.
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 2 Business Organizations with Tax Planning § 33.02[a] (Aug. 1997).
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 Unif. Ltd. Liab. Act § 203, 6A U.L.A. 580 (2003).
 Unif. Ltd. Liab. Act § 801, 6A U.L.A. 619 (2003).
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 1 Larry Ribstein & Robert Keatinge, Ribstein and Keating on Limited Liability Companies § 2:3 (Dec. 2003).
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1. 1 LARRY RIBSTEIN & ROBERT KEATINGE, RIBSTEIN AND KEATING ON LIMITED LIABILITY COMPANIES § 1:2 (Dec. 2003).
2. 1D WEST’S LEGAL FORMS Business Organizations § 3.2, § 3.29, § 5.11 (3d ed. 2000).
3. 2 BUSINESS ORGANIZATIONS WITH TAX PLANNING § 33.01, § 33.02, § 33.05 (Aug. 1997).
4. 9 MERTENS LAW OF FED. TAXATION § 35A:07 (Jun. 2005).
5. ANTHONY MANCUSO, NOLO’S QUICK LLC: ALL YOU NEED TO KNOW ABOUT LIMITED LIABILITY COMPANIES (Ilona Bray, ed., 2nd ed. 2003).
6. Charles W. Murdock, Limited Liability Companies in the Decade of the 1990s: Legislative and Case Law Developments and Their Implications for the Future, 56 BUS. LAW. 499 (2001).
7. COUNSELING THE SMALL BUSINESS CLIENT IN FLORIDA (Nat’l Bus. Inst., Inc. 2003).
8. David M. Hastings, Construction and Application of Limited Liability Company Acts, 79 A.L.R.5th 689 (2000-2005).
9. Deborah A. Wisnowski, The Louisiana Limited Liability Company Law: A Gumbo of Previously Existing Business Entities, 39 LOY. L. REV. 187 (1993).
10. LOUIS A. MEZZULLO, AN ESTATE PLANNER’S GUIDE TO FAMILY BUSINESS ENTITIES (Aen W. Webster et al. eds., A.B.A. 2nd ed. 2003).
11. MARK A. SARGENT AND WALTER D. SCHWIDETZKY, LIMITED LIABILITY COMPANY HANDBOOK § 4:8 (Sep. 2004).
12. MARTIN M. SHENKMAN ET AL., STARTING A LIMITED LIABILITY COMPANY (John Wiley & Sons, Inc. 2d ed., 2003).
13. Priv. Ltr. Rul. 81-06-082 (Nov. 17, 1980).
14. RAYMOND E. MAKOWSKI, THE GREATEST ESTATE PLANNING TECHNIQUES (Lorman Educ. Servs. 2005).
15. ROBERT W. WOOD, LIMITED LIABILITY COMPANIES: FORMATION, OPERATION AND CONVERSION (Aspen Publishers, Inc. 2d ed., 2001).
16. UNIF. LTD. LIAB. ACT, 6A U.L.A. 560 (2003).
17. U.S. MASTER TAX GUIDE (CCH Inc. 2004).
1. Ehle v. Williams & Boshea, L.L.C., No. 0-3757, 2002 WL 373271 (E.D. La. March 7, 2002).
2. Rodale Press, Inc. v. Salm, No. CV000374983S, 2001 WL 496895 (Conn. Super. April 25, 2001).
Tax Resources for Business Owners. The Internal Revenue Service website is government sponsored and provides the most current rules governing business owners. It also provides information to assist in basic business decisions.
Information on Obtaining Loans from the Small Business Administration: The Small Business Administration website is government sponsored and enables the establishment of many small businesses by providing the financing. This link provides information on eligibility and types of financing available.
Ownership Structures: Nolo.com provides a plethora of plain-language information on the basics of business startup. It provides checklists for drafting the business plan, outlines types of management and ownership structures, and tips on making a profit.

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