The use of LLC’s has been increasing rapidly.  Many corporations and partnerships have been converting to LLC status to take advantage of the definite benefits over traditional business forms.  The issues involved in the conversion of existing partnerships and corporations to limited liability companies should be reviewed carefully. The California LLC legislation provides for mergers between LLC’s and other types of business entities.  The merger provisions provide a method through which existing corporations and partnerships may convert into LLC’s. A limited liability company may be formed for real estate ownership, development and management, manufacturing, wholesale, retail and service businesses, professional practices, and many others. 

Limited liability companies provide the protection of limited liability for all owners.  A general partner is not required as in the case of a limited partnership.  Limited liability companies benefit from partnership tax treatment.  Also, since there are no restrictions on the number and identity of shareholders, this form of business entity offers several important benefits that no other business entity offers. Business attorneys and accountants should understand the operation of these entities and recommend them in appropriate circumstances. Business owners should understand the basic features of LLC's. An LLC is an unincorporated form of doing business that provides its members with limited liability and allows them to actively participate in the management.  LLC’S are accepted for tax purposes by the Internal Revenue Service.  LLC’s are normally organized to provide partnership treatment for federal income tax purposes.

The California LLC legislation allow the members to manage the business of the LLC. In addition, the LLC statute provides that the members may elect managers who may or may not be members to manage the business of the LLC.  All members may participate in the management of the business of the LLC, whereas corporate shareholders are merely passive investors and limited partners may lose limited liability protection by participating in the management of a limited partnership business.

LLC’s Are Flexible
LLC’s permit flexibility in capital structure.  There are no detailed requirements covering the issuance of shares or the determination of classes and series in a share issuance.  The articles of organization or the operating agreement may provide for capital contributions of members.  The contribution of a person may be in money, property, or services, a promissory note or other obligation to contribute money or property or to render services.
The LLC legislation permits financial or economic rights to be transferable without consent of other members.  In order for an assignee to acquire full membership rights, including voting and management rights, the assignee must ordinarily obtain unanimous consent of the members, although this may be altered by the members.

LLC’s are similar taxwise to S-Corporations to the extent that they provide limited liability to the owners and also pass-through tax treatment.  An LLC which lacks a majority of corporate characteristics is treated as a partnership for federal tax purposes.  However, LLC’S offer many advantages over an S-Corporation. LLC’s may be formed for a variety of business situations.  A LLC can be formed for any business in which owners want limited liability, flow-through tax treatment, and control over management.  LLC’s are appropriate vehicles for joint ventures, foreign investment, venture capital, real estate, and high tech transactions, as well as family-owned and other closely held businesses.

Although limited partnerships are managed by general partners who are personally liable, managing members of LLC’s are not personally liable.  LLC members do not lose their limited liability protection by participating in management of the business of the LLC.  An LLC achieves the same result as a limited partnership with a corporate general partner without forming a corporate general partner.

Foreign investors who cannot be shareholders in S corporations can utilize LLC’s.  The structure of LLC’s is analogous to the structure of the entities which are used in foreign countries.  Moreover, American business owners may use LLC’s for business investments in foreign countries because many countries recognize the limited liability nature of the LLC.
In order to maintain partnership tax treatment, LLC’s need careful structuring to avoid the corporate attribute of continuity of life.  Careful planning is required to permit a flexible transfer approach without violating the free transferability test.

LLC’s Compared to Corporations

LLC’s are formed by a filing with the California Secretary of State.  The document that is filed is usually referred to as the LLC's "Articles of Organization."  There are detailed rules regarding the number of organizers and the number of members.  A California LLC permits as few as one member or as many members as the business needs and has no restrictions with regard to types of stock. The required contents of the articles of organization consist of certain minimal information regarding the name, business purpose, agent for service of process, and names of managers, if any, etc.
           
Corporations are managed by a board of directors.  Shareholders may become active in the business by becoming an employee, officer, or director, however, passive shareholders have no management function.  However, the California LLC legislation provides for management either by the members or management by managers.

An LLC membership interest may be evidenced by a certificate issued by the LLC.  In a corporation, shares of stock are freely transferable under state law, unless restricted by agreement.

A California LLC may be dissolved upon the occurrence of events specified in the articles of organization or by the vote of a majority of the members or upon the death, withdrawal, resignation, expulsion, bankruptcy, or dissolution of a member, subject to the option of continuation of the business by a vote of all the remaining members.

For entities which do not fall under the merger provisions, they may convert to an LLC by means of a distribution and contribution of assets.  For tax purposes, however, mergers under these statutes may not be treated as tax-exempt reorganizations.  The California LLC legislation recognizes LLC’s organized in other states and foreign countries and allows foreign LLC’s to qualify to do business in California.

LLC’S Compared to Partnerships

LLC’s differ from general and limited partnerships because all general partners are liable for partnership debts and liabilities.  However, there is some concern that the concept of "piercing the veil" may be applied to LLC’s as it does to corporations, although the law requires clarification in this area.

The LLC filing with the California Secretary of State notifies third parties that the business has limited liability.  On the other hand, partnerships are formed by the agreement of the partners and are not subject to any filing requirement.  California LLC legislation does not specify the scope of a member's power to bind the LLC in transactions with third parties.

LLC’s have similarities to limited partnerships.  However, the basic difference between LLC’s and limited partnerships is that LLC’s do not have a general partner.  In addition, limited partners may lose their limited liability protection by participating in the management of the business of the limited partnership.  The past practice of forming a limited partnership with a corporate general partner in order to combine limited liability for investors and partnership tax treatment may be achieved by a LLC.

Tax Treatment

The LLC permits the check box alternatives of taxation to permit its owners to elect be taxed as a standard corporation so that the LLC may be taxed at the entity level, and the members upon individual distributions. Alternativey, the LLC may elect to be taxed as a partnership, with pass through taxation so that there is no tax at the LLC level (except for franchise tax). This permits flexibility regarding tax strategies and offers substantial tax savings.

A fundamental benefit of forming an LLC will be to obtain treatment as a partnership under the Internal Revenue Code.  The IRS determination regarding an LLC will be based upon parameters for determining whether an unincorporated business entity is taxed as a partnership or as a corporation.

There are four corporate traits:  limited liability; continuity of life; free transferability of interests; and centralization of management.  An unincorporated entity which has three of the above four characteristics will be taxed as a corporation.  However, if an entity lacks two of the four corporate attributes, it will be taxed as a partnership.  LLC’s have the attribute of limited liability and should therefore be structured carefully to avoid two of the other three characteristics, thereby permitting partnership tax treatment.

Limited Liability

An entity possesses the corporate characteristic of limited liability if no member is personally liable under local law for the debts of or claims against, the entity.  The California LLC statute provides that neither the members nor the managers of an LLC are personally liable for a debt, obligation, or liability of the LLC.  The IRS has issued rulings which indicate that LLC’s possess the characteristic of limited liability.

Continuity of Life

It is important to draft the LLC articles and/or operating agreement to allow continuity, while at the same time, not creating the corporate characteristic of continuity of life.  The IRS has ruled that an LLC does not possess continuity of life when it is dissolved upon the death, retirement, resignation, expulsion, bankruptcy, or dissolution of any member, or upon the occurrence of any other event that terminates the continued membership of a member in the LLC, unless the remaining members consent unanimously to continue the business of the LLC.
           
The California LLC statute permits the articles of organization to provide for a variety of dissolution-causing events and a selective voting ratio, e.g. majority vote, to continue the business of the LLC upon the happening of a dissolution event.  In other states, the IRS has permitted partnership classification to LLC’s formed under flexible state LLC legislation.  It remains to be seen whether the IRS will deny partnership treatment due to adaptable dissolution provisions which reduce the likelihood of dissolution.

Free transferability of interests will apply under IRS regulations when a member has the right, without the consent of other members, to substitute a non-member in his or her place.  The IRS has issued rulings indicating that LLC’s lack free transferability of interests when a member cannot transfer the attributes of management and ownership in the LLC unless all of the other members approve the assignment.

The California LLC statute permits members in their articles of organization or operating agreement to provide for different requirements regarding transfers of interests.  It may be appropriate to allow a transfer of a member's interest based upon majority approval or upon the unanimous consent of the managers.  It is anticipated that the IRS will permit adaptable transfer solutions without denying partnership classification.  Generally, the provision of flexible requirements covering transfers of interests makes LLC’s a desirable business entity.

Centralized Management

The corporate characteristic of centralized management applies when one person or group of persons is given the authority to make business decisions for the entity.  Centralization of management of an LLC occurs when non-managing members own substantially all of the membership interests.

The California LLC Act does not require the election of managers, however, imposes management of the LLC on the members, unless the articles of organization provide for the election of managers.  If the LLC maintains either continuity of life or free transferability of interests, the LLC may obtain partnership tax treatment, provided centralized management does not exist.  This may be achieved by allowing any member to sign contracts and to incur liabilities for the LLC.

Flexibility

LLC’s are not subject to mandatory qualification requirements for S-Corporations.  (For tax years commencing 2004, the maximum number of shareholders an S-corporation may have was increased from 75 to 100). An LLC is not required to file an election with the IRS such as the S-Corporation election.

An LLC may have an unlimited number of members.  Also, the one-class-of-stock rules do not apply to LLC’s.  California requires that an LLC have a minimum of two members, while an S-Corporation may have just one shareholder. S-Corporations are not permitted to have shareholders that are corporations, nonresident aliens, general or limited partnerships, certain trusts, pension plans, or charitable organizations, there is no such restriction on the members of an LLC.  Domestic and foreign corporations may be members of LLC’s.

LLC’s do not suffer from restrictions on S-Corporations, including the inability to obtain capital from other corporations, partnerships and other entities.  S-Corporations suffer from other restrictions such as the inability to own more than 80 percent of the stock of another corporation and to be part of an affiliated group.
           
On the other hand, S-corporations may be used when the LLC requirements affecting transferability of interests and continuity of life are not practicable.  If the business is closely held, obtaining consent to transfer interests and to continue the business upon the occurrence of an event of dissolution may not be problematical.  In these cases, the restrictions necessary to obtain partnership treatment for an LLC may not cause difficulty.

Applications for LLC’s

Losses pass through directly to members because LLC’s receive pass-through tax treatment.  LLC’s may be desirable for businesses anticipating substantial start-up losses.  LLC’s may be used in venture capital and joint venture transactions in which the investors want both flow-through tax treatment and the ability directly to control the operations of the business without a formal board of directors.  Businesses can implement flexible management, voting rights and distribution rights because LLC’s have adaptable partnership allocation and distribution provisions.

An LLC may be appropriate if a general or limited partnership is not feasible because no single person or business is willing to take on the liability exposure as a general partner.  Professional service firms such as physicians, accountants, and attorneys use LLC’s to obtain limited liability and flow-through tax treatment.  California business and professions regulations need to be reviewed in determining the availability of LLC’s for professional practices.
           
To the extent that all 50 states have not yet enacted LLC legislation, the use of an LLC for inter-state business should be reviewed carefully.  An LLC can be utilized as a holding company as well as for investments that do not involve serious tort or product liability exposure. Conclusions

LLC’s offer business and tax advantages over traditional partnerships and corporations.  Under the recent 1994 California LLC statute, LLC’s are attractive because they combine the advantages of partnership flow-through tax treatment and operating flexibility, together with limited liability for owners.
           
Any member of an LLC receives liability protection.  LLC’s receive partnership tax benefits which are not available to S-Corporations.  LLC members may take advantage of flexible partnership allocation rules in structuring the allocation of profits, losses, and distributions in differing ratios among members.
           
Limited liability companies have become common business entities in the majority of American states.  Most states either have passed limited liability company legislation or have introduced such legislation.
           
LLC’s may be appropriate for a variety of businesses and individual investors, including real estate, high tech, research and development, start-up, and family businesses.  LLC’s provide new investors with limited liability and partnership taxation, as well as the opportunity of receiving equity from other partnerships, corporations or pension plans without removing pass-through tax treatment for the original investors.

This Newsletter is published for our clients, personnel and other interested persons.  Due to the continuing and rapid changes in this area, we strongly recommend readers to consult appropriate legal and tax advisors regarding specific needs and topics of concern.