Magazine article The CPA Journal

Tax Aspects of Limited Liability Companies

Magazine article The CPA Journal

Tax Aspects of Limited Liability Companies

Article excerpt

Until recently, the principal forms of business organization recognized for tax purposes were sole proprietorships, partnerships (general or limited), and corporations (C or S). A new entity, the limited liability company (LLC), is gaining popularity and may become the major way of doing business for nonpublic companies.

An LLC is a partnership-corporation hybrid. Like a partnership, it is an unincorporated organization that provides pass-through tax consequences; like a corporation, it limits liability. This sounds like an S corporation, but the two entities differ significantly. LLCs are subject to the more liberal tax rules of Subchapter K and are feee from encumbering eligibility restrictions.

An LLC can he viewed as-

* a general partnership where the partners have no personal liability;

* a limited partnership where there is no general partner; or

* a partnership surrounded by a corp rate shell.

BRIEF HISTORY AND POPULARITY

LLCs are not all that new. In 1975 and 197, Alaska introduced LLC legislation but neither attempt became law. In 1977, Wyoming passed the first LLC statute and in 1982 Florida passed the second. Eight years later, in 1990, Kansas and Colorado passed their statutes. The LLC legislation gap from 1982 to 1990 is attributable to IRS reluctance to decide whether LLCs were partnerships or corporations for Federal tax purposes. The issue was resolved in Rev. Rul. 88-76 ("the Ruling"), when the IRS concluded that a company formed pursuant to Wyoming's LLC statute was a partnership for Federal tax purposes. This ruling enabled the LLC bandwagon to gain momentum. As of September, 1992, 20 states had enacted LLC statutes (see Table 1).(Table 1 omitted)

LLC TERMINOLOGY

Understanding the mechanics of LLCs requires understanding the language of LLCs. Some commonly used LLC terms, along with their corporate and partnership counterparts, include-

Members. Corporations have shareholders; partnerships have partners; and LLCs have members. An LLC is formed by two or more members who have equal status; that is, there are no general partners.

Managers. Corporations have directors and officers; partnerships have general partners; and LLCs have managers. Under most state statutes, members can either designate managers or reserve management to themselves. Unless otherwise agreed, members manage (i.e., vote or govern) in accordance with their proportionate interests in the LLC. Managers, depending upon the powers granted to them, may function in a manner similar to general partners.

Interest. No shares of stock are issued. Just as a partner has an interest in a partnership, a member has an interest in an LLC.

Articles of Organization. Corporations have articles of incorporation; partnerships have certificates of partnership; and LLCs have articles of organization. An LLC comes into existence when this document is filed with the Secretary of State or other appropriate state agency or officer.

Operating Agreement. Corporations have bylaws; partnerships have partnership agreements; and LLCs have operating agreements. This document details the entity's inner workings and how members relate to each other.

CLASSIFICATION REGULATIONS

According to the Regulations (301.7701-2), an unincorporated entity is classified as a corporation if it has more corporate characteristics than noncorporate characteristics. The four corporate characteristics at issue are: limited liability, continuity of life, centralized management, and free transferability of interest.

If an entity has three or more of these characteristics, it is a corporation for Federal tax purposes. The objective for LLC organizers is to lack two or more corporate characteristics. Some LLC statutes dictate which corporate characteristics are present or absent while other LLC statutes allow organizers to choose.

REV. RUL. 88-76 (THE WYOMING STATUTE)

LLCs are creatures of state statute. …

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