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:
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. By definition, an LLC automatically has this corporate characteristic. Practically speaking, an LLC can therefore possess just one of the other three characteristics.
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.
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.
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:
There could also be some disadvantages:
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:
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.