Limited Liability Company: The Growing Entity Of Choice

by Donald J. Scotto and Sharon Matthews, Coopers and Lybrand LLP and C&L
 
Limited Liability Companies (LLCs) are rapidly becoming the entity of choice for businesses of all types and sizes. To date, 47 states, including New Jersey, have adopted limited liability company laws. Legislation is pending in the remaining three: Hawaii, Massachusetts and Vermont.

LLCs are hybrid business entities which possess a unique combination of favorable legal, business and tax attributes that do not exist in any other single entity. Properly structured, LLCs provide the benefits of limited liability protection, operational flexibility, and pass through taxation without the restrictions generally applied to S Corporations and limited liability partnerships.

This article discusses the choice of entity issues that should be examined when considering the LLC form, and particularly LLCs organized under New Jersey law.

Classification of LLCs

The LLC, because it combines the partnership benefits of pass through taxation and operational flexibility with the corporate benefit of limited liability protection, is an attractive business entity. The benefits, however, are largely dependent upon the LLC being treated as a partnership for federal and state income tax purposes.

Under the New Jersey Limited Liability Company Act, an LLC will be classified as a partnership for New Jersey tax purposes only if it is so classified for federal tax purposes. The determination for federal tax purposes depends on how the LLC measures up against the following four characteristics of a corporation; continuity of life, centralization of management, limited liability, and free transferability of interest.

If an LLC possesses a majority (three or more) of the corporate characteristics, it will be classified as an association taxable as a corporation. Almost by definition, an LLC will always possess limited liability. Thus, for an LLC to be classified as a partnership for federal tax purposes, it must lack at least two of the remaining three corporate characteristics:  centralization of  management, continuity of life, and free transferability of interests.

An LLC organized under New Jersey’s Limited Liability Company Act will generally be classified as a partnership for federal income tax purposes because the Act contains default provisions which insure that an LLC will lack the corporate characteristics of continuity of life and free transferability of interests. The default provisions, however, are not `bullet proof.’  The Act provides the drafters of LLC operating agreements with enormous flexibility in deciding which corporate characteristic the LLC will possess. As a result,  a New Jersey LLC may be classified as corporation for federal income tax purposes depending upon the provisions adopted in the LLC’s articles or operating agreement.

LLCs Versus Other Entities

In New Jersey, an LLC may be formed to carry on any lawful business, purpose of activity. The use of the LLC form, however, has become increasingly popular in activities that demand excess capital or involve substantial risks, such as start up businesses, real estate ventures, family or closely held companies, professional practices, joint ventures, high risk enterprises, and other ordinary business ventures, which require special combinations of business and tax attributes. Before deciding to conduct business as an LLC, however, it is important to understand the relative advantages and disadvantages of LLCs over other existing business entities.

Advantage Over C Corporations

Like the LLC, C corporations provide their shareholders with the benefit of limited liability protection. C corporations, however, are potentially subject to two levels of federal tax:

• 1. a corporate level tax on earnings and any appreciated property distributions made to shareholders, and

• 2. a tax at the shareholder level on any distributions received out of the corporation’s earnings and profits.

Also, C corporations in New Jersey may be subject to the same two levels of state tax on earnings and distributions to resident shareholders.

Unlike the C corporation, an LLC that is properly structured will be treated as a partnership for federal and state income tax purposes, thus allowing earnings to be taxed only once, at the member level.

Advantage Over S Corporations

Like the LLC, S corporations, generally, are not subject to federal tax at the corporate level and offer limited liability protection. An LLC, however, still offers significant advantages over an S corporation, which is subject to stringent restrictions, including a limit on the number of shareholders and the exclusion of pension plans, nonresident aliens and others corporations as qualified shareholders. S corporations also are prohibited from becoming members of an affiliated group.

LLCs bear none of the above restrictions. Nonresident aliens, corporations, partnerships, pension plans and members of affiliated groups are all permitted to own membership interests, an important distinction when seeking venture capital or outside investment.

In addition, an S corporation is prohibited from having more than one class of stock outstanding. An LLC, on the other hand, may provide for different classes, rights, and priorities of members. This flexibility allows an LLC to accommodate multiple classes of equity interests as well as to provide for special tax allocations.

Advantage Over Limited Partnerships

As with an LLC, limited partnerships provide pass through tax treatment so that no federal or state tax is imposed on a partnership’s earnings at the entity level. Limited partnerships, however, do not provide the same level of liability protection as an LLC. A limited partner who participates in the management of a limited partnership may be classified as a general partner and thus risk exposure to unlimited liability. In contrast, an LLC provides limited liability protection for all of its owners whatever their level of management participation. Moreover, a limited partnership, generally, must have at least one general partner who is personally liable for the debts of the entity. There is no such requirement for an LLC.

Advantage Over General Partnerships

General partnerships also provide the benefit of pass through tax treatment. However, in most situations, general partners are personally liable for the debts, obligations and liabilities of the partnership. A principal advantage of an LLC over a general partnership is that no member is held liable for debts, obligations and liabilities of the partnership. In the case of professional LLCs (e.g. law firms, CPA firms), however, members are liable for their own negligence and that of their subordinates.

Disadvantage of LLCs

There are several disadvantages to using LLCs, most significantly because of the uncertainties surrounding the operation of the LLC, and primarily, because of the lack of uniformity in state tax treatments of LLCs. The need to review the laws in each state where the LLC will conduct business may increase administrative costs. Also, some additional guidance may be needed from the IRS to resolve certain issues. For example, the IRS has yet to clarify the application of the passive loss rule and cash method of accounting to LLCs.

Another disadvantage is that in order for an LLC to be classified as a partnership for federal (and some states) tax purposes, it must lack at least two of the corporate characteristics cited earlier: centralized management,  free transferability of interests, and continuity of life. The absence of these characteristics, however, may seriously impact an LLC’s ability to effectively conduct its business activities.

Without centralized management, an LLC’s decision making process may become less efficient since all members will be permitted to participate in the management of the business. Without free transferability of interests, the LLC may encounter difficulties obtaining new equity due to the restrictions placed on an investor’s ability to transfer his interest. Also, without a perpetual life span, inherent limits are placed on the LLC’s ability to continue operations should circumstances discontinue the membership of one of its participants.

Converting to an LLC

Because the advantages to conducting business as an LLC appear to outweigh the disadvantages, many business owners may wish to consider converting from an existing corporation or partnership to an LLC. The resulting tax consequences, however, may make converting to an LLC impractical in some circumstances, especially if the converting entity is a corporation.

Conversion From General And Limited Partnerships

In most situations, the conversion of a limited or general partnership into an LLC that is classified as a partnership for federal tax purposes is treated as a nontaxable event. This conversion is usually accomplished by contributing the assets of an existing partnership into a newly formed LLC in exchange for membership interests that are proportionately distributed to the partners. Under this scenario, the IRS has determined that the conversion will not cause a termination of the partnership for tax purposes and that no gain or loss need be recognized by the partnership, its partners, the LLC or its members.

Conversion From C Corporation

Unlike the conversion from a partnership, conversion from a C corporation to an LLC may result in tax consequences at both the corporate and shareholder level. In general, this conversion is treated as though the corporation had distributed, in complete liquidation, its assets to the shareholders, who then contributed the distributed assets to the newly formed LLC in exchange for membership interests. Both the corporation and the shareholders will be taxed on their respective gain or loss from the liquidating distributions. In most instances, the significant tax costs of liquidating an existing corporation with appreciated assets will tend to make conversion to an LLC impractical.

Conversion From S Corporation

Unfortunately, S corporations are subject to the same liquidation provisions as the regular C corporation. However, although an S corporation  recognizes taxable gain on liquidating distribution, the taxable gain generally flows through to the shareholders under normal Subchapter S rules, generally avoiding the corporate level tax. Nevertheless, the single tax on liquidation may be sufficient to make conversion from an S corporation to an LLC impractical.

Forming the LLC

To establish an LLC under New Jersey’s law, which took effect in January of last year, one or more individuals must file, with the Secretary of State, a certificate of formation that includes a statement showing that the LLC has two or more members. The certificate must also contain the name of the LLC, the name and address of the registered office and agent for service of process, the date of dissolution (if a specific date exists), and any other issues the members wish to include. The LLC takes effect at the time of the filing and may, thereafter, engage in the conduct of any lawful business, purpose or activity in New Jersey.

Conclusion

The LLC represents an exciting new business entity that provides an excellent operating vehicle for most business activities. However, careful consideration should be given to the issues discussed in this article, and others beyond the scope of the article, before any decision is made to organize a new business activity as an LLC, or to convert an existing partnership or corporation into an LLC.