The Choice of Organizational Form: Why Some Entities Should Consider Becoming Limited Liability Companies
Cecil, H. Wayne, Ciccotello, Conrad S., Grant, C. Terry, Journal of Accountancy
Organizational forms such as limited liability companies (LLCs) and limited liability partnerships (LLPs) are emerging as desirable alternatives for many businesses. While LLPs are a popular choice for CPA firms, LLCs appeal to a wide range of entities. Which clients should CPAs advise to become LLCs? Based on tax and operating considerations, LLCs are not the best fit for all businesses. This article discusses the federal income tax rules for LLCs and compares them to the tax treatment of C corporations, S corporations and limited partnerships.
Tax considerations and reduced operating and ownership restrictions favor selecting LLCs--which, like partnerships, generally are not taxable entities. State laws also permit LLC owners (properly known as "members") to limit their liability to the amounts they invested, plus any capital commitments, making LLCs more attractive than partnerships. The reduced operating and ownership restrictions also will make them more attractive to some S corporations.
THE LEGAL DEVELOPMENT OF LLCs
Exhibit 1, page 46, shows that as of November 1985, 47 states and the District of Columbia permitted the formation of LLCs. Legislation is under consideration in all three remaining states. The pace of adoption has been rapid. Thirty-two states have adopted LLC statutes since 1992. (For a discussion of the general business and tax implications of LLCs, see "Tax Aspects of Limited Liability Companies," JofA, Sep.92, page 48.)
The key tax issue for LLCs is achieving partnership status for federal income tax purposes. Before 1993, revenue ruling 88-76, which addressed Wyoming's LLC statute, was the primary authority. In 1993, the Internal Revenue Service issued 12 revenue rulings that expanded the authority for recognizing LLCs as partnerships on the federal level. Since 1993, five additional rulings have been issued, each covering a different state. All conclude that LLCs can achieve partnership status for federal income tax purposes. (Information on the rulings can be found in exhibit 1.)
TREATMENT AS PARTNERSHIPS
Compliance with a state's LLC statute (Delaware is a notable exception) generally ensures an entity will be classified as a partnership. For LLC members to be taxed like partners, LLCs must avoid two of the four corporate characteristics in Treasury regulations section 301.7701-2:
1. Limited liability.
2. Centralized management.
3. Continuity of life.
4. Free transferability of interests.
Each of these characteristics is assigned equal weight in determining how a business is classified.
By design, LLCs have limited liability and, for practical business purposes, management generally is centralized. Accordingly, LLCs must avoid continuity of life and free transferability of interests to achieve partnership status. For example, revenue ruling 88-76 says that if an LLC organizes so that the assignee of a member's interest may become a member without the remaining members' consent (free transferability of interests) or if the LLC continues to operate after an event that terminates a member's interest (continuity of life), the entity will be taxed as a C corporation.
To obtain favorable federal tax status, LLCs also must avoid classification as publicly traded partnerships. This means that partnership interests cannot be traded or be readily tradable on established securities markets, in secondary markets or their equivalents--IRS notice 88-75 is the primary authority on determination of trading of partnership interests.
CHOOSING AN LLC--A HYPOTHETICAL EXAMPLE
Exhibit 2, page 48, illustrates the tax treatment under two scenarios--all net income is distributed to owners or is reinvested in the business--when the owners do not participate in management. Exhibit 3, page 50, shows the tax treatment when the owners participate in management and all net income is distributed to them as wages. …