Optimal Business Forms for Taxation

¶ … optimal business forms for taxation purposes in recent years has compelled many businesses to form limited liability companies (LLCs) or S Corporations. Both of these alternatives provide some measures of preferential treatment depending on the unique circumstances of the entities involved, but LLCs in particular have emerged as the alternative of choice for many companies of all sizes and types. The growing popularity of the LLC to the exclusion of the S Corporation is due in large part to the additional flexibility it affords its members in their governance structures and level of participation in the operation of their business, the avoidance of double taxation and the built-in tax and restrictions on the types of owners and class of stock associated with S Corporations, but the LLC alternative is not without its downsides, including most especially a lack of jurisdictional uniformity. Despite this and other considerations, this study shows that the limited liability company provides practitioners and businesses alike a number of advantages that make it worthy of consideration when searching for optimal business solutions.

An Examination of the Similarities and Differences between a Limited Liability Company (LLC) and an S Corporation: Formation, Tax Basis, Liquidations and Dissolutions

Introduction

The combination of corporate and partnership forms that are provided by a limited liability company (LLC) has make this an attractive alternative for a growing number of businesses of all sizes and types due in large part to the taxation advantage is affords as well as the flexibility it provides in structuring business governance. This paper provides a review of the relevant peer-reviewed and scholarly literature concerning the similarities and differences between limited liability companies (LLC) and S Corporations in regards to formation, tax basis, liquidations and dissolutions of each type of entity. A summary of the research in these areas and important findings are presented in the conclusion.

Review and Analysis

Limited Liability Company

Unlike a traditional corporation or partnership, a limited liability company or LLC is formed pursuant to "articles of organization" rather than either "articles of incorporation" or a partnership agreement, and is an unincorporated business that, by definition, provides limited personal liability to its owners who are termed "members."

In addition, when organized and administered properly, LLCs are taxed as partnerships with the taxable income being reported on the members' own federal income tax returns and taxed at each member's marginal income tax rate.

The LLC framework came into being following changes to the tax laws that made limited liability companies more attractive based on the favorable tax treatment they provided which resulted in their adoption by a majority of state legislatures.

As Pollack points out, though, "It would be a gross overstatement to say that in this case the federal tax laws developed to 'serve' the needs or demands of private economic interests."

The setting was right for the introduction of LLCs because there was growing concerning among practitioners, businesses and investors alike about the need for better corporate structures to protect and preserve their resources. For instance, Pollack points out that, "Businesses and individual investors turned away from the traditional business corporation and began to use alternative business entities, such as partnerships and common law creations (e.g., the Massachusetts business trust), precisely because of the more favorable tax results that could be achieved through such entities."

Not surprisingly, then, LLCs have become the alternative of choice for a growing number of enterprises, but their adoption is not without some consequences. For example, since their introduction, LLCs have compelled companies to restructure their operations to accommodate the new regulatory guidance from the IRS.

Nevertheless, despite these and other considerations involving their implementation and administration, LLCs have become increasingly popular for a growing number of practitioners and businesses in recent years. For instance, according to Pollack, "Law and accounting firms favor the limited liability company for the benefits it offers to both clients and themselves."

Likewise, Goodman (2007) emphasizes, "LLCs are the most versatile entity from an income tax standpoint. LLCs can generally elect between being classified as a disregarded entity or partnership on the one hand, or a corporation on the other. . . . LLCs open up new possibilities in structuring mergers and acquisitions."

In reality, though, LLCs are certainly not a recent phenomenon. In fact, limited liability companies were originally recognized as an alternative business entity as early as 1977 by the Wyoming legislature.

In this regard, Dylla reports that, "LLCs were first allowed in 1977 under the statutes of the state of Wyoming. After the IRS ruled in 1988 (in Revenue Ruling 88-76) that companies meeting the Wyoming requirements would be taxed as partnerships for federal income tax purposes, a large number of states passed similar legislation."

It required some time for practitioners to become sufficiently familiar with LLCs for them to gain credibility and widespread acceptance, but this process was facilitated by the promulgation of Revenue Ruling 88-76. According to Dylla, "This ruling announced that [a]n unincorporated [business] organization operating under the Wyoming Limited Liability Company Act [was] classified as a partnership for federal [income] tax purposes....:"

In its ruling, the IRS identified six primary corporate characteristics of LLCs as follows: (1) associates, (2) an objective to carry on business and divide the gains therefrom, (3) continuity of life, (4) centralization of management, (5) liability for corporate debts limited to corporate property, and (6) free transferability of interests"; in addition, the IRS added that "if an unincorporated organization possesse[d] more corporate characteristics than noncorporate characteristics, it constitute[d] an association taxable as a corporation."

In the event the unincorporated organization failed to achieve a majority of the corporate characteristics through a preponderance of the evidence, the entity would be taxed as a partnership.

This preferential tax treatment resulted in a number of state legislatures enacting their own LLC legislation, a process that resulted in the National Conference of Commissioners on Uniform State Laws (CCUSL) crafting a uniform LLC act. As a result, Dylla reports that, "In 1996, NCCUSL promulgated the Uniform Limited Liability Company Act (ULLCA). This act was the first generation of uniform state laws pertaining to limited liability companies drafted by NCCUSL. ULLCA was largely influenced by the Revised Uniform Partnership Act, the 1985 Revised Uniform Limited Partnership Act, and the Model Business Corporation Act."

Shortly after ULLCA was introduced, the Internal Revenue Service provided even more favorable tax treatment for LLCs with the approval of the "check the box" rules that made LLCs "an even more attractive entity option."

According to Dylla, "Beginning in 1997, with the adoption of what has become known as the 'check the box' rules, the preponderance of corporate characteristics test of Revenue Ruling 88-76 was eliminated along with the requirement to include certain language within the operating agreement in order to bulletproof the entity."

The adoption of the "check the box" protocol meant that businesses now enjoyed the alternative to be taxed as a partnership/pass-through entity or as an incorporated entity, almost entirely irrespective of how the business organization was structured. In addition, the "check the box" protocol simplified the operating agreement making the new rules more attractive to practitioners and businesses due to its enhanced flexibility to structure the business organization based on its real-world needs and operating environment from a relationship perspective.

Furthermore, the protocol made it possible to create a pass-through tax entity that has all four corporate characteristics built into the organization's documents.

The growing preference for limited liability companies, though, also created a concomitant issue for practitioners and businesses with respect to uniformity.

In this regard, Ribstein reports that, "Prior to 1996, nearly every state had its own LLC statute, resulting in significant variation in the applicability and enforcement of LLC law throughout the country."

The Uniform Limited Liability Company Act (ULLCA), though, did not resolve the issue of uniformity across jurisdictions, an issue that became even more problematic in hindsight because in most cases, states had already passed their own versions that either mirrored best practices in most states or otherwise involved variations that made subsequent legislative remedies more difficult and more expensive to enact. In this regard, Ribstein notes that, "Unfortunately, the promulgation of ULLCA did not solve the problem of variability in LLC law, in large part because it was introduced after most jurisdictions had already legislatively addressed LLCs."

In response to the lingering differences between LLC laws in the states in which it had been approved, the National Conference of Commissioners on Uniform State Laws approved and recommended that all states should adopt the Revised Uniform Limited Liability Company Act (RULLCA).

To date, a number of states have adopted the RULLCA while others in the process of reviewing it for their own jurisdictions. According to Ribstein, "The introduction of a new uniform act is significant because it enters the legal scene at a time when LLCs are widely considered to be the "go-to' entity."

This growing popularity of the RULLCA has fueled interest in the LLC for a wider array of business types. In this regard, Greubner (2007) reports that, "The combination of corporate and partnership forms in a limited liability company (LLC) has appealed to many entrepreneurs and has caused the LLC form not only to emerge as an alternative business governance structure, but also to explode as a favored corporate regime."

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 they acquire.

From a strictly corporate taxation perspective, there are some similarities between LLCs and limited partnerships.

In this regard, each member of the LLC portion of earnings is included on the member's individual income tax return just as with partners in limited partnerships; likewise, the members of LLCs just as the majority of the partners in a limited partnership also enjoy limited liability.

In contrast to LLCs, though, limited partnerships must have at least one "general partner" that continues to be liable for the business's debts but this requirement in not applicable to LLCs.

Another distinguish feature that makes LLCs advantageous for some business and practitioners is the fact that in the event limited partners actively participate in the management of the partnership can result in the actively participating partner being treated as a general partner and sacrificing the liability protection of the partnership; by contrast, LLC members are not subject to the LLC's liabilities irrespective of their level of participation.

A final distinguishing feature of LLCs that can make them an optimal alternative for businesses and practitioners is the manner in which the characterization of profits and losses is accomplished. 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 applicable to a particular LLC.

Some salient guidance provided by Siepel and her colleagues for practitioners and businesses includes their report that:

If the interest is not a security, the financial reports do not have to be disclosed to outside parties unless the LLC seeks funding from a lending institution. In such a case, the managers of the LLC would not have to strictly follow generally accepted accounting principles (GAAP) and could use either cash or accrual accounting, as long as any lending institutions which are involved are satisfied with the accounting treatment.

Conversely, in the event the interest is a security, the LLC is not necessarily required to register with the SEC and file financial statements when these securities are exempted pursuant to the Securities Acts of 1933 and 1934.

An example of a security that can be exempted in this fashion is one that is sold in a private offering that was made available only to a few people or institutions which had the ability to acquire detailed information directly the from issues company concerning the securities and the issuing company itself. According to Siepel et al., "In this situation, there are also limitations on future distributions of the securities."

Another example of a security that can be exempted in this fashion is the sale of a security by an issuing company that is restricted to a given state's residents wherein it is organized and does business. In this example situation:

If the interest is exempt, the LLC will still have some flexibility regarding the methods it uses to present financial information. However, the LLC will be subject to the possible penalties imposed by the Securities Acts and must therefore be careful to present fair and complete information to all investors and potential investors.

In the event the security fails to satisfy the foregoing exemption requirements, the LLC must register and file financial statements with the SEC.

In these situations, LLCs must comply with GAAP, including the use of accrual accounting as well as SEC requirements that generally require audits of annual financial statements.

Once again, there are some issues that have become apparent only after legislation in many states has already been enacted, making subsequent revisions difficult and the differences that exist across jurisdictions means that businesses might well look for more advantageous offerings in states where LLCs laws most suit their needs, particularly with respect to securities. For example, Siepel et al. note that, "Although the question of whether a particular interest is a security is obviously an important one, the federal government and most of the states have not yet set formal guidelines regarding which LLC interests constitute securities."

Just as the differences in interpretations that affect the manner in which securities are exempted, these jurisdictional differences also typically require the advice of practitioners in order to ensure that all statutory and regulatory requirements concerning security exemptions are satisfied by the LLC. According to Siepel and her associates, "The question of whether the LLC must file with the SEC, therefore, is one which is best discussed with an attorney or an accountant. It should be mentioned, however, that in a number of states the role of the members in the management of an LLC is a primary factor used to determine whether an interest is a security."

This distinction between partnerships and LLCs can become important when members' active management of the business of the LCC assumes the qualities of a security but this can depend on whether this management extends to other areas of operation. In this regard, Siepel et al. add that, "If the LLC's members manage the business or if they have rights to oversee the work of any outside managers, then the interests are less likely to be considered securities"

Notwithstanding the foregoing, it would seem that LLCs still enjoy a legal tactical advantage in many jurisdictions based on the current interpretations of these regulations. As Siegel and her associates conclude:

Even if an interest is found to be a security, it is likely that the security would be exempt from registration and filing requirements under the Securities Acts of 1933 and 1934. This is because it is unlikely that interests in LLCs would be publicly traded since LLCs which exhibit both 'continuity of life' and 'free transferability of interests' cannot be treated as partnerships for federal income tax purposes.

Irrespective of whether an LLC interest is determined to be a security or not, the financial statements of these entities should generally be kept in the same manner as for partnerships because they do not sell stock.

In these cases, capital accounts should be established for all members of the LLC wherein each member indicates the book value of their interest in the LLC. Cash or other asset investments serve to increase the account while withdrawals of other assets or cash serves to decrease the capital account. Here again, owners of small businesses are advised to consult with their accountants in order to determine the appropriate method of keeping financial records for a particular business as with other aspects of LLCs.

Despite the advantages of LLCs for many business of all sizes and types, there are a number of factors that must be taken into account when making the decision to adopt this business form or not. For example, some of the potential problems that are associated with LLCs is based on the aforementioned lack of uniformity across jurisdictions and the fact that some states still do not recognize LLCs.

In this regard, Siepel et al. note that, "Problems also arise because the extent to which states will respect out-of-state LLCs has not yet been determined. If a state does not recognize a particular LLC, and therefore does not recognize the liability protection that accompanies it, the members of the LLC may be personally responsible for any liabilities incurred by the business in that state."

Fortunately for practitioners and businesses alike, there are some different approaches that are available that can help mitigate potential jurisdictional differences in LLC laws, including creating a corporate subsidiary that conducts business in states that do not recognize the LLC form.

In those states where the LLC has subsidiary operations, the LLC's business owners would enjoy limited liability even in states where LLCs are not recognized.

Another way that state-to-state differences in LLC laws can be mitigated is to include a statement in all written agreements that stipulates the business is an LLC that organized according to the statutes of a particular state wherein LLC are recognized; in addition, the written agreements should also include a statement that the LLC grants limited liability to its members and to include another statement in all written agreements that legal disputes will be resolved under the laws of the state in which the LLC was organized in every event.

Because there are jurisdictional differences concerning the formation of LLCs, there are also corresponding differences in state laws across the country. For example, states such as Florida make LLCs liable for income taxes at the entity level, while other states such as Colorado treat LLCs as partnerships for tax purposes and impose no state taxes.

Consequently, an important consideration for determining whether the LLC alternative is most suitable are the current laws in a given state regarding LLCs and the costs of establishing subsidiary operations in states where the company does business but where LLCs are not recognized.

Dissolution of LLCs

All LLCs can be dissolved when certain events that are enumerated in the particular state's LLC statute take place.

For example, the Delaware Limited Liability Company Act (DEL. CODE ANN. tit. 6, §18-802, 2005) stipulates that an LLC will be dissolved when the following occur:

1. When the LLC operating agreement specifies a certain time for dissolution;

2. When the LLC operating agreement specifies a certain event for dissolution;

3. When the members consent in writing, unless otherwise provided;

4. When all members cease to exist, unless the personal representative of the last remaining member gives written consent to continue the LLC and is admitted to the LLC as a member within 90 days, unless otherwise provided; and,

One of the enumerated events of dissolution in Delaware states that the Court of Chancery has the authority to dissolve an LLC in the event one of the company's members maintains that it is "not reasonably practicable to carry on the business" pursuant to the LLC agreement's original purpose. According to Greubner, though, the claim by a member of the LLC is not always sufficient to invoke these dissolution provisions. In this regard, Greubner emphasizes that, "The key word in that section is 'may' -- which means that the court is not compelled to decree dissolution of an LLC, but may exercise discretion to do so."

In a number of states, the LLC can also be terminated upon a unanimous vote of its members.

S Corporation

According to Black's Law Dictionary, an S Corporation is a "small business corporation with a statutorily limited number of shareholders, which, under certain conditions, has elected to have its taxable income taxed to its shareholders at regular income tax rates."

S corporations

LLCs and S corporations are similar because: (a) both provide their investors with limited liability, and (b) the investors in both types of entities include the business's revenues and expenses on their own tax returns.

Despite these similarities, S corporations are regarded as being more restrictive in their administration compared to LLCs because:

1. S corporations do not allow non-resident aliens, corporations, partnerships, or trusts to be shareholders, while LLCs do not have such restrictions on their members;

2. S corporations generally may not own more than 80% of another corporation, while there is no restriction on one LLC's ownership in another LLC or corporation; and,

3. S Corporations are also restricted from issuing more than one class of stock, but LLCs are not limited as to the number of classes of membership that can be created. It is therefore possible for different membership classes of an LLC to be allocated different types of income and loss, just as in a partnership. Like a partnership, such allocations must have substantial economic effect.

4. The IRS may disallow partnership treatment for an LLC that has only one member, contending that a one-owner entity cannot be characterized as a partnership. S corporations do not have this problem when there is only one shareholder.