Limited Liability Companies: An Overview
A new form of business organization, the limited liability company (LLC), could present new planning opportunities for business owners. Basically, the LLC has the pass-through tax attributes of a partnership, but can provide the shareholder-liability protection of a corporation. The LLC is neither fish nor fowl. It is a kind of corporation-partnership hybrid that is a creature of the state law under which the company is organized. Most states now have LLC statutes. There are some state-by-state quirks, but there are also some common threads that characterize the LLC.
Following is a sampling of new terms in the LLC lexicon:
- Articles of Organization. A public document that informs the state about the formation of an LLC.
- Operating Agreement. An internal agreement among the equity participants that governs ownership privileges, ownership obligations and various specific operational issues.
- Member. A member can be a person or another entity. In most states, a member is an equity participant who is entitled to influence the management and affairs of the LLC. But ownership of an LLC interest does not necessarily confer membership. That is, the LLC can have non-member equity participants who are entitled to economic benefits and costs (like distributions and taxable allocations), without being entitled to influence (say by vote) the operational aspects of the business.
- Manager. A person(s) or entity designated by the members to oversee the affairs of the business. Managers can be either members or non-members, so LLCs can be either “member-managed” or “manager-managed” (depending on terms of the Operating Agreement). For manager-managed LLCs, the Operating Agreement will usually include a voting mechanism for naming the manager(s).
One of the principal advantages of organizing as an LLC is the federal tax benefit of partnership treatment; i.e., having just one level of tax on profits and passing through tax losses and credits to help shelter earnings from other sources. In order to qualify for partnership tax status, LLCs cannot have more than two of the following corporate characteristics:
- Limited Liability
- Centralization of Management
- Free Transferability of Interests
- Continuity of Life
Limited Liability. By definition, an LLC automatically has this corporate characteristic. Practically speaking, an LLC can therefore possess just one of the other three characteristics.
Centralization of Management
Under U.S. Treasury Regulations, centralization of management means that a person, entity or narrow group (either from within or without the overall membership) has continuing, exclusive and unilateral authority to make management decisions. A member-managed LLC generally will not have this characteristic, and a manager-managed LLC generally will. When member-managers behave more like general partners of a partnership than like shareholders of a corporation, management tends to become less centralized. This is a flexible and prickly issue. Sometimes it can be difficult to distinguish between centralized and non-centralized management, so facts and circumstances tests might come into play.
Free Transferability of Interests
To transfer a membership interest means to completely confer upon the transferee all attributes of ownership, including rights to vote, act on behalf of the LLC, share in the profits, etc. Restricted transferability of LLC membership is a corollary to a general feature of partnership interests. Somewhat like partners, LLC members cannot transfer their ownership and compel their co-owners to be in business with someone they consider to be undesirable. LLC statutes usually ensure that member interests are not freely transferable by requiring that at least a majority of the non-transferring members consent to the transfer. States vary by the degree to which consent of co-owners must be obtained. Some require unanimous consent and some require majority consent. It is important to note that the concept of free transferability contemplates all of the rights and privileges of ownership, so an assignment to a transferee of an economic interest in the profits and distributions of an LLC is not necessarily the same as a transfer of the membership interest itself. Freedom to transfer economic interests does not constitute free transferability of interests.
Continuity of Life
Under federal tax regulations, a business organization lacks continuity of life if it is required to dissolve upon the death, insanity, bankruptcy, retirement, resignation, expulsion or other event of withdrawal of an equity owner. This kind of language is generally written into LLC statutes as an organizational requirement. However, mechanisms can be put in place to grant non-withdrawing members an option to continue the business of the LLC upon an event of dissolution. If properly written, the business continuation option will not impart continuity of life to the LLC.
Some business owners will view these features of an LLC as advantages:
- Taxed as a partnership
- Limits personal liability like a corporation, while permitting members to participate in management
- Flexibility in structuring ownership features. Equity can be set up to have varied rights — common vs. preference shares, special allocations of profits, losses, credits, etc.
There could also be some disadvantages:
- Restricted transferability impairs the ability to raise equity via new offerings
- Restricted continuity of life – could be forced to terminate business or liquidate upon departure of a member under certain circumstances
There might be more questions than answers in the LLC valuation arena because facts and circumstances can be so varied. An LLC membership interest can have blended features of a stock, a general partnership interest and a limited partnership interest. Valuation of a specific interest can be tricky when the features are specially tailored to the needs of the company and its owners. In addition, certain partnership tax rules can affect LLCs, either adding or detracting from value, depending on the circumstances and specific agreements among the members. Some of the issues affecting LLC valuation include:
- State law. A valuation should consider provisions of the LLC statutes in the state of organization. This could be particularly important when the Articles of Organization or the Operating Agreement are silent about such matters as member withdrawal, rights to transfer interests, buy-out pricing mechanisms, and certain other rights to act on behalf of the company or the other members.
- Operating Agreement. Any unique features of membership interests are usually described in the operating agreement. In the agreement, the members will state their intentions as to how they expect their business relationship to work. It might outline specific rights, options and obligations that constitute membership. It might specify how the members agree to carve up profits, losses and other items. It might explicitly define how long the members expect to be in business with one another. And it might enumerate specific kinds of behavior to be either rewarded or punished. The point is that the operating agreement is important in valuing an LLC membership because it can define the rights and some of the economic expectations of the owner.
- Asset/Liability Structure. The source and mix of assets and liabilities might affect the investment quality and attractiveness of an LLC interest. When a member contributes certain types of assets and liabilities to an LLC, tax laws might require special allocations of income and deduction. Some pre-existing tax attributes of built-in-gain property and of certain debts contributed to an LLC are attributes that trace to a specific member and the tax effects cannot be transferred to co-owners.
- Minority Interest Features. The concept of the minority interest is centered around the degree to which an owner can unilaterally influence the use of assets, the business plan, the risks undertaken, the spending of discretionary cash flows, the timing of returns and the timing of additional investments. It would not be unusual for a minority stockholder of a corporation (or a limited partner) to be in a position that is almost completely devoid of influence and extremely impaired as to transferability. However, this lack of influence can be less distinct in a general partnership or an LLC, where minority interest equity owners can withdraw from ownership. Agreements can place restrictions on the demands of a withdrawing partner or member, but they cannot forever and irreversibly revoke withdrawal rights. It is important for an LLC operating agreement to be explicit about the members’ withdrawal rights and the basis on which they can exit.
- Marketability Features. The marketability discount is the way business appraisers quantify the extra required return that accompanies illiquidity. Market-clearing prices are discounted when assets cannot be actively traded, but are otherwise comparable. For LLCs, both state laws and operating agreements can uniquely impair liquidity, so both need to be considered in a valuation. And, of course, buy/sell and other restrictive agreements might also be important factors. Depending on the structure of agreements, it is likely that many LLC interests will be slightly less liquid than similar stock interests in corporations. The lack of transferability of LLC voting rights could tend to restrict the number of potential willing buyers.
We are expecting to see increased interest in LLCs and a rise in LLC formations. They should be useful tools for managing family business wealth, transferring ownership from one generation to the next, streamlining ownership of cumbersome portfolios and pursuing new business growth opportunities. At the same time, they will limit liability for their owners and provide flexibility in structuring ownership features.
Competent legal and tax counsel should be obtained to establish an LLC. Please call if you have any questions or if we can help you in any way.
Reprinted from Mercer Capital’s Bizval.com – Vol. 6, No. 4, 1994.