" Since their inception, a number of LLC statutes have been adopted across the country and becaue of the RULLCA initiative, the various jurisdictional disparities are slowly being replaced with more uniform approaches and interpretations. According to Greubner, LLCs have "evolved [into] a more of a distinct form and less of a hodgepodge of existing corporate and limited partnership rules."

The LLC, though, remains a relatively new governance regime compared to the traditional partnership structure that has been around as a common law form of organization far longer than the first limited partnership statute adopted in 1822.

To date, the remains a paucity of relevant case law adjudicating LLC statutes or agreements; however, recent trends make it clear that there will likely be a growing body of case law in the future as various states hammer out their remaining differences in the inexorable march to universal adoption of the RULLCA. As Gruebner points out, "The entity's rising popularity will cause litigation involving LLC agreements and statutes to increasingly appear before the courts. It is uncertain whether or not a unique LLC jurisprudence will develop, but courts will undeniably look to existing forms-general or limited partnerships or corporations -- and apply the rationale and principles behind them to disputes involving LLCs"

There are some important steps that should be following when forming an LLC, including the need for all LLC members to comply with statutory requirements and the need to create an operating agreement. In the case of LLCs, operating agreements are similar to partnership agreements in general partnerships and typically set forth the relevant governing rules of the company.

Despite these common features, different approaches and regulations are still used in various jurisdictions across the country in ways that provide greater flexibility for the LLC members in shaping their governing rules and corresponding organizational structure with some caveats. For instance, Greubner et al. note that, "Inconsistent provisions in LLC operating agreements displace conflicting statutes if the statutes supply default, rather than mandatory, controls. Most LLC statutes have few mandatory provisions, giving the parties great freedom to construct their governing rules."

A study by Siepel, Tunnell and Zimmerman (2008) examined the similarities and differences between LLCs, S Corporations and partnerships and identified a number of salient characteristics that highlighted the advantages of the LCC for many enterprises of all sizes and types today. According to these authorities, "Within the last few years a relatively new type of entity, the limited liability company (LLC), has become widely available to small business owners. One of the primary advantages of the LLC is that it provides all of its owners protection from the liabilities of the business."

Moreover, the LLC form eliminates double taxation since the LLC is treated as a partnership for tax purposes.

The LLC business organization alternative also avoids a number of constraints that are associated with S corporations including the built-in gains tax and restrictions on the types of owners and classes of stock that can be issued.

Generally, LLCs can be regarded as:

1. A general partnership where the partners have no personal liability;

2. A limited partnership where there is no general partner; or,

3. A partnership surrounded by a corporate shell.

In addition, the IRS has provisions that stipulate an LLC can be taxed as a partnership in the event it does not have more than two of the following four corporate characteristics:

1. Free transferability of ownership interest;

2. Continuity of life for the business entity;

3. Centralization of management; and,

4. Limited liability.

The supporting reasoning behind the foregoing IRS provisions is that if an entity has only one or two of these characteristics, it has at least as many partnership characteristics as corporate characteristics and the entity is therefore allowed to be taxed as a partnership.

Because all LLCs provide limited liability for their members by definition, LLCs are allowed to have at most one of the other three corporate characteristics at any given point in time, but here again there are differences across the country.

For example, Siepel et al. emphasize that:

In fact, some state statutes determine which other corporate characteristic (for example, centralized management in the Wyoming statute) the LLCs registered in their state are allowed to have. These statutes are sometimes said to be 'bulletproof' because their requirements are so detailed and rigid as to leave no doubt that the LLC will be taxed as a partnership. Other states leave each entity the choice of which, if any, other corporate characteristic...

This characterization can be different for LLCs because limited partners cannot participate in active management of the business without losing their liability protection and their profits and losses are therefore classified as "passive"; conversely, because all LLC members can actively participate in the management of business of the LLC, their profits and losses of members can be either "passive" or "active" as the specific situation dictates.
The IRS has established that a business that exhibits two or less of a list of four corporate characteristics should be taxed as a partnership and because the LLC by definition has the characteristic of limited liability, this means that the business can have only one of the other three characteristics, to-wit: (1) free transferability of ownership interests, (2) continuity of life for the entity, and (3) centralized management.

Some of the common methods of limiting these other three corporate characteristics are provided in Table 1 below.

Table 1

Common Methods of Limiting Liability in LLCs

Method

Description

Transferability of interests

In many cases, LLCs limit the transferability of interests in the business in order to obtain partnership tax status. Therefore, in order to limit transferability, LLCs frequently require the unanimous consent of the existing members before anyone who purchases an interest can become a fully participating member of the LLC; unanimous consent may not be necessary though. The IRS has ruled that, in some cases, the free transferability of interests may not exist even if unanimous consent is not required for the transfer to take place. In such cases, some appropriate level of consent must be required, but it does not have to be unanimous. Despite this IRS ruling, some states have much stricter requirements - some do not allow for the admission of any new members. Therefore, before setting up an LLC in a particular state, the small business owner should consult the statutes in that state.

Continuity of life

In order to obtain partnership tax status, a number of LLCs also limit the life of the LLC. In this case the LLC will be terminated upon the death, retirement, resignation, expulsion, or bankruptcy of any of its members. LLCs are also often terminated automatically after a certain number of years; however, the LLC is not required to discontinue its existence in any of these situations. The IRS has ruled that the LLC can continue in existence, and still not be determined to have "continuity of life," if the remaining members must give their unanimous consent that it do so.

Centralization of management

A number of LLCs choose this corporate characteristic, in addition to limited liability, for their LLC. However, if members wish to limit centralization of management within their LLC, they must either (1) assign the management of the LLC to the members, or (2) elect one of the members as a manager or elect a management committee made up of members. If the members themselves decide to share the responsibilities, the operating agreement should specify the method used to determine each member's proportion of the management duties. If the members elect a manager or management committee to run the day-to-day operations of the LLC, then management should own more than 20% of the LLC for the LLC to avoid the corporate characteristic of centralization of management.

Source: Adapted from Siepel, 2008

The issue concerning whether an interest in that LLC qualifies as a security must be answered in order to determine the financial accounting rules that are…