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THE FEDERAL TAX CLASSIFICATION OF FLORIDA LIMITED LIABILITY COMPANIES
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johnbsims3Admin #1 - Posted: 20 Oct 2006 20:50 THE FEDERAL TAX CLASSIFICATION OF FLORIDA LIMITED LIABILITY COMPANIES
Practitioners traditionally structured businesses in the form of a corporation, general or limited partnership, business trust, or as a sole proprietorship. These entities, however, have inherent limitations. Some of these entities provide limited liability under state law, but constitute separate taxable entities under federal tax law. Others constitute nontaxable (flow-through) entities, but do not confer limited liability on business owners. S corporations and limited partnerships provide limited liability and flowthrough taxation. S corporations, however, are limited by numerous restrictions regarding ownership composition and business operations. Limited partnerships require at least one general partner that is subject to unlimited liability.
Limited liability companies are continuing to emerge as a viable alternative to these traditional business forms. Approximately 1,200 limited liability companies currently operate in Florida. Limited liability companies that are properly structured combine limited liability with flow-through taxation.
Wyoming enacted the first limited liability company legislation in 1977. [FN1] Florida adopted a limited liability company act in 1982. [FN2] There were virtually no limited liability companies formed in Wyoming or Florida between 1977 and 1988. This is because the state law classification of an entity is not determinative of federal tax status, and no guidance existed regarding whether the Internal Revenue Service (the "service") would classify a limited liability company as a flow-through entity or as a taxable association.
The service finally addressed this issue in Revenue Ruling 88-76. [FN3] This ruling classified a Wyoming limited liability company as a partnership under federal tax law. Since the issuance of Rev. Rul. 88-76, approximately 36 states have enacted limited liability company statutes and 10 other states have proposed limited liability company legislation. The ABA Business Law Section has prepared a prototype limited liability company act. The prototype act will be used to develop a uniform limited liability company act.
The service applies the entity classification criteria established by Treasury Regulation §301.7701-2 to determine the tax status of a limited liability company. These regulations provide that an unincorporated entity (with associates and an objective to conduct business and divide the gains) will be classified as a partnership under federal tax law if it lacks at least two of the following corporate characteristics: 1) limited liability; 2) centralized management; 3) continuity of life; and 4) free transferability of interests. An unincorporated entity that possesses three or more corporate characteristics is classified as a taxable association. [FN4]
A limited liability company's effectiveness is conditioned on partnership classification. Many practitioners, however, operate under the mistaken assumption that a limited liability company formed pursuant to the Florida Limited Liability Company Act [FN5] (the "act") automatically achieves partnership status under federal tax law. This assumption is entirely incorrect. A number of state statutes are drafted to ensure that a limited liability company automatically lacks at least two corporate characteristics. These are referred to as "bullet-proof" statutes.
The Florida act is not a bullet-proof statute. Instead, the act constitutes a flexible statute. Flexible statutes provide options regarding the formation and structure of a limited liability company. The improper combination of these options, however, will cause a Florida limited liability company to possess more than two corporate characteristics. Accordingly, the formation of a Florida limited liability company requires a careful analysis of the relationship between the act and Treas. Reg. §301.7701-2.
Treas. Reg. §301.7701-2(d)(1) states that an unincorporated organization possesses the corporate characteristic of limited liability if no member is personally liable for the organization's debts or claims. F.S. §608.436 provides that the members and managers of a limited liability company are not liable for the organization's debts and obligations. This is a limited liability company's primary state law benefit. As a result, a limited liability company possesses *85 the corporate characteristic of limited liability.
Treas. Reg. §301.7701-2(b)(1) generally provides that an unincorporated organization lacks the corporate characteristic of continuity of life if the entity dissolves upon the death, insanity, bankruptcy, retirement, resignation, or expulsion of a member, even though the remaining members have the right to continue the organization. F.S. §608.441 states that, among other trigger events, a limited liability company will dissolve upon the death, bankruptcy, or dissolution of a member, unless the business is continued by the consent of all remaining members or pursuant to a right to continue set forth in the articles of organization. A Florida limited liability company can include in its articles of organization a provision that automatically reconstitutes the organization after a dissolution event.
A limited liability company lacks continuity of life if it requires the consent of all remaining members to continue business operations after a dissolution event. [FN6] Conversely, a limited liability company utilizing an automatic reconstitution provision probably will possess continuity of life. Although there is no tax ruling discussing this Florida law provision, the service ruled that a Delaware limited liability company that eliminated the consent requirement possessed the corporate characteristic of continuity of life. [FN7] Practitioners who utilize an automatic reconstitution provision must ensure that the limited liability company lacks the other two corporate characteristics to obtain partnership tax status.
Treas. Reg. §301.7701-2(c)(1) states that an organization possesses the corporate characteristic of centralized management if any person, or group of persons that does not include all members, has the continuing exclusive authority to make necessary management decisions. F.S. §608.422 provides that a limited liability company's management is vested in the members in proportion to their capital contributions, unless otherwise provided in the articles of organization. A limited liability company, however, can elect to vest management functions in managers.
The service has ruled that a Florida limited liability company will not possess centralized management if management authority is vested in the members in proportion to their capital contributions. [FN8] A Florida limited liability company will possess centralized management when management authority is vested in managers. [FN9] Tax planners must exercise extreme caution in this area. In Rev. Rul. 93-6, [FN10] the service ruled that a Colorado limited liability company possessed centralized management notwithstanding that all members served as managers. The service ruled that the Colorado limited liability company possessed centralized management because the authority to make business decisions was vested with the owners in their capacity as managers and not as members.
Treas. Reg. §301.7701-2(e)(1) provides that an unincorporated organization possesses the corporate characteristic *86 of free transferability of interests if each member (or members owning substantially all of the organization) has the power, without the consent of the other members, to substitute a new member into the organization. This power does not exist unless the member can transfer all ownership attributes without the consent of the other members. Accordingly, free transferability of interests does not exist when a member, without the consent of the other members, can assign a right to profits but cannot assign the right to vote or participate in management. F.S. §608.433(1) provides that a member cannot transfer ownership attributes without the consent of all other members, unless otherwise provided in the articles of organization.
A limited liability company will not possess free transferability of interests if a member cannot transfer all membership attributes without the consent of the other members. [FN11] A Florida limited liability company, however, can alter this requirement through the articles of organization. Altering this consent requirement creates uncertainty regarding whether the limited liability company possesses free transferability of interests. The service ruled that a Delaware limited liability company possessed free transferability of interests when a member could transfer all ownership attributes without the consent of the other members or managers. [FN12]
The service, however, does not require unanimous consent by the nontransferring members for an organization to lack free transferability of interests. The service recently ruled that a limited liability company did not possess free transferability of interests when the transfer of all membership attributes was conditioned upon the consent of members owning a majority of the capital interests. [FN13] The number of nontransferring members that must consent to a transfer determines whether a Florida limited liability company possesses free transferability of interests.
In Rev. Rul. 93-53, [FN14] the service ruled that a Florida limited liability company constituted a partnership under federal tax law. The Florida limited liability company was operated by managers, dissolved on the standard trigger events (unless all remaining members consented to continue operations), and conditioned the transfer of membership interests on the consent of all nontransferring members. The service ruled that the limited liability company possessed the corporate characteristics of limited liability and centralized management but did not possess continuity of life or free transferability of interests. The service specifically noted that because of the flexibility accorded by the act, a Florida limited liability company could be classified as a partnership or as a taxable association depending on the provisions adopted in the articles of organization. The service has conferred partnership tax status to limited liability companies formed under the flexible statutes of eight other states. [FN15]
The service also has issued private letter rulings regarding the tax classification of Florida limited liability companies. In Private Letter Rulings 8937010 and 9030013, the service classified limited liability companies as partnerships because they did not possess continuity of life or free transferability of interests. The service did not address the issue of centralized management in either ruling.
A limited liability company formed pursuant to the act is not guaranteed partnership tax status. A Florida limited liability company could possess all four corporate characteristics. In fact, the service ruled that the Delaware limited liability company analyzed in Rev. Rul. 93-38 [FN16] possessed all four corporate characteristics. Florida practitioners must conduct a thoughtful analysis before utilizing the various options granted by Florida's flexible statute. There is little benefit to forming a limited liability company that is classified as a taxable association.
The service now issues private letter rulings regarding the tax classification of limited liability companies. [FN17] Tax professionals should consider requesting a ruling if there is any doubt about a limited liability company's tax status. Limited liability company rulings often condition a favorable response on compliance with Revenue Procedure 89-12, [FN18] which states that the service will not issue a favorable ruling unless the organization satisfies certain requirements.
Rev. Proc. 89-12, however, primarily addresses whether limited partnerships obtain partnership tax status. As a result, certain sections of this revenue procedure are inapplicable to limited liability company ruling requests. The service has informally acknowledged the problems with applying Rev. Proc. 89-12 to limited liability company ruling requests and indicated that this situation will be clarified by the issuance of a revenue procedure.
A limited liability company classified as a partnership under federal tax law provides significant advantages over other business forms. A complete discussion of the advantages of limited liability companies is beyond the scope of this article. The remainder of this article, however, discusses some of the significant advantages.
Although a C corporation provides owners with limited liability, it constitutes a separate taxable entity. If taxed as a pass-through entity, the limited liability company is not subject to the C corporation's double taxation problems. A limited liability company also is not subject to the personal holding company tax, [FN19] the accumulated earnings tax, [FN20] or the alternative minimum tax. [FN21] Additionally, members can receive a limited liability company profits interest in exchange for services without adverse income tax consequences. [FN22] A corporate shareholder generally cannot receive stock in exchange for services on a nontaxable basis. [FN23]
Limited liability companies also have significant advantages over S corporations. Limited liability companies are not subject to the S corporation restrictions regarding the number and composition of permissible owners. Limited liability companies also are not subject *87 to the single class of stock and safe-harbor debt rules. [FN24] Limited liability companies can own 80 percent or more of a corporation while an S corporation cannot be part of an affiliated group. [FN25] A limited liability company, unlike an S corporation, can specially allocate income, gains, losses, deductions, and credits. [FN26] Limited liability companies also have greater flexibility than S corporations regarding contributions and distributions of appreciated property. [FN27]
Another limited liability company benefit is the use of indebtedness to increase tax basis. Limited liability company members can utilize entity-level debt to increase their outside tax basis in the business. [FN28] This assists members in deducting entity losses on their individual income tax returns. S corporation shareholders cannot increase their stock's outside tax basis through entity-level debt.
A limited liability company is preferable to a general partnership and a sole proprietorship because limited liability company members possess limited liability while general partners and sole proprietors are individually liable for business obligations. [FN29] Limited liability companies also have advantages over limited partnerships. All members of a limited liability company possess limited liability while a limited partnership requires at least one general partner with unlimited liability for the entity's obligations. [FN30] Additionally, limited partners that participate in business operations risk the loss of their limited liability. [FN31] Limited liability company members can participate in management without the loss of limited liability.
Limited liability companies, however, have certain limitations. F.S. § 608.471 subjects limited liability companies to the Florida corporate income tax. The lack of continuity of life and free transferability of interests effectively restricts a limited liability company's membership base. Additionally, uncertainty exists regarding the retention of limited liability when operating in states without a limited liability company act. This concern has been significantly alleviated by the number of states with limited liability company acts.
Certain federal tax issues also remain unresolved. A significant unresolved issue is a limited liability company's ability to adopt the cash basis method of accounting. Recent rulings have allowed limited liability companies to adopt the cash basis of accounting, but the service will not allow all limited liability companies to utilize this accounting method. [FN32] Additionally, uncertainty exists regarding the application of the passive activity loss rules, the at-risk rules, the self-employment tax rules, the tax treatment of one-member limited liability companies (which are not allowed in Florida [FN33]), and the selection of a tax matters partner.
Tax professionals should consider limited liability companies as a viable business form. This includes utilizing limited liability companies for new business ventures or existing operations. The service has ruled that, under certain circumstances, both general and limited partnerships can convert to a limited liability company without adverse tax consequences. [FN34] Limited liability companies can provide limited liability coupled with significant tax benefits. Florida's statute provides maximum flexibility in structuring a limited liability company's operations. Practitioners should balance the use of these options to achieve both maximum flexibility in business operations and ensure that the limited liability company obtains partnership tax status.
[FNa]. William R. Swindle is a shareholder in the Tampa law firm of Fuller, Swindle & Holsonback, P.A. His practice primarily consists of federal and state tax matters, estate planning and probate administration, and corporate law. He received his B.S. in accounting from Florida Southern College, and his J.D. and LL.M. in taxation from the University of Florida College of Law. Mr. Swindle is a board-certified tax attorney. This column is submitted on behalf of the Tax Section, Robert E. Panoff, chair, and Michael D. Miller and Joseph B. McFarland, editors.
[FN1]. Wyo. Stat. §§17-15-101-136 (1977).
[FN2]. Fla. Stat. §§608.401-608.471 (1982).
[FN3]. 1988-2 C.B. 360.
[FN4]. See Larson v. Commissioner, 66 T.C. 159 (1976), acq., 1979-1 C.B. 1; Treas. Reg. §301.7701-2(a)(3); Rev. Rul. 88-76, 1988-2 C.B. 360.
[FN5]. Fla. Stat. §§608.401-608.514 (1993).
[FN6]. Recent revenue rulings that support this proposition include Rev. Rul. 94-6, 1994-3 I.R.B. 224; Rev. Rul. 94-5, 1994-2 I.R.B. 221; and Rev. Rul. 93-92, 1993-2 C.B. 318.
[FN7]. Rev. Rul. 93-38, 1993-1 C.B. 233 (Situation 2).
[FN8]. Priv. Ltr. Rul. 9010027.
[FN9]. Recent revenue rulings that support this proposition include Rev. Rul. 94-6, 1994-3 I.R.B. 224; Rev. Rul. 94-5, 1994-2 I.R.B. 221; Rev. Rul. 93-93, 1993-2 C.B. 321; Rev. Rul. 93-92, 1993-2 C.B. 318; and Rev. Rul. 93-91, 1993-2 C.B. 316.
[FN10]. 1993-1 C.B. 229.
[FN11]. Recent revenue rulings that support this proposition include Rev. Rul. 94-6, 1994-3 I.R.B. 224; Rev. Rul. 94-5, 1994-2 I.R.B. 221; and Rev. Rul. 93-93, 1993-2 C.B. 321.
[FN12]. Supra note 7.
[FN13]. Rev. Rul. 93-92, 1993-2 C.B. 318.
[FN14]. 1993-2 C.B. 312.
[FN15]. Rev. Rul. 94-6, 1994-3 I.R.B. 224; Rev. Rul. 94-5, 1994 I.R.B. 221; Rev. Rul. 93-93, 1993-2 C.B. 321; Rev. Rul. 93-92, 1993-2 C.B. 318; Rev. Rul. 93-91, 1993-2 C.B. 316; Rev. Rul. 93-81, 1993-2 C.B. 314; Rev. Rul. 93-49, 1993-2 C.B. 308; Rev. Rul. 93-38, 1993-1, C.B. 233 (Situation 1).
[FN16]. Supra note 7.
[FN17]. Rev. Proc. 88-44, 1988-2 C.B. 634.
[FN18]. 1989-1 C.B. 798.
[FN19]. See I.R.C. §542.
[FN20]. See I.R.C. §532.
[FN21]. See I.R.C. §55(b).
[FN22]. Campbell v. Comr., 943 F. 2d 815 (8th Cir. 1991), rev'g, T.C. Memo 1990-162.
[FN23]. See I.R.C. §§83(a) and 351(d).
[FN24]. See I.R.C. §1361.
[FN25]. See I.R.C. §1361(b)(2)(A).
[FN26]. See I.R.C. §704(b).
[FN27]. See I.R.C. §§311(b), 351(a), 721(a), and 731.
[FN28]. See I.R.C. §§704 and 752.
[FN29]. Fla. Stat. §620.63 (1993).
[FN30]. Fla. Stat. §§620.102(7) and 620.125(2) (1993).
[FN31]. Fla. Stat. §620.129 (1993).
[FN32]. See Priv. Ltr. Ruls. 9415005, 9412030, 9407030, 9350013, 9328005, and 9321047.
[FN33]. Fla. Stat. §608.405 (1993).
[FN34]. Priv. Ltr. Ruls. 9226035, 9119029, 9029019, and 9010027.
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