Limited Liability Company - Introduction and Forming

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Client Letter -

What this idea is about

The following is in response to your inquiry regarding the formation of a limited liability company (LLC) for your proposed new business.
The LLC is the newest of the forms of business entity, and as a result there are some unanswered questions concerning its use. All states now have enacted LLC statutes which provide that members of an entity incorporating under that state statute will not be personally liable for the debts of the entity. The entity will be treated as a partnership for federal, and generally state, tax purposes unless the entity elects taxation as a corporation.

The biggest advantage of an LLC is its flexibility. LLCs are hybrid entities which combine the flow-through attributes of partnerships with the corporate characteristic of limited liability. Therefore, like a corporation, the LLC offers limited liability to its members. Members of an LLC are only at risk to the extent of their investment and cannot be sued for actions of the LLC. The maximum amount a member can lose is the value of his investment in the LLC. His personal assets are protected.

Like general partners in a partnership, LLC members may participate in the management of the LLC. However, unlike limited partners, participation in management will not cause the member to lose his limited liability protection.

Unlike a corporation, an LLC is not subject to two levels of tax. Income or loss from the LLC flows from the LLC to the members and is recorded on the members' individual returns. The LLC operating agreement can provide for an allocation of most items of income and deduction in any manner in which the members see fit. The LLC is, however, required to file a partnership return.

LLCs are similar to S corporations in that they provide limited liability but are not subject to tax at the corporate level. However, unlike S corporations, an LLC is not subject to any limitation on the number and type of members it may have. In addition, the one class of stock restrictions and the complex regulations governing S corporation status do not apply to LLCs, thereby allowing flexibility in planning distributions and special allocations. The LLC operating agreement can provide for special allocation of most items of income and deduction.

An LLC is created by filing articles of organization with the state in which it is incorporating. Thus, certain filing fees will be incurred. Although an operating agreement is not required, it is an important document for setting forth the members' understanding of the procedures and formula for distributing profits and losses, as well as various other operational concerns.

Generally, a domestic entity with more than one member that is formed as an LLC, will default to partnership entity classification and nothing is required on the taxpayer's part to ensure such classification.

The main drawback to forming an LLC is the limited guidance available concerning their use. Because they are relatively new, there is limited case law and few IRS rulings and procedures to guide taxpayers as to the consequences of certain transactions. Most of the uncertainty stems from the fact that members of an LLC are not designated as limited or general partners as they are in a partnership. Therefore, it is unclear how various statutes which govern the consequences of limited partners versus general partners apply to LLC members.

In determining whether the LLC is the best choice of entity for operating your business, the advantages of limited liability and pass-through treatment must be carefully weighed against the disadvantages of the uncertainties which exist surrounding this type of entity. Only an overall examination of your objectives and the requirements of your business will yield the answer as to whether this is the best entity to use when starting your business.

Generally, C corporations, partnerships with a C corporation as a partner, and tax shelters are not allowed to compute taxable income under the cash method of accounting. §448(a).

The term "tax shelter" is defined as: (1) any enterprise if interests in such enterprise have been offered for sale in any registered offering; (2) certain syndicates; and (3) entities for which a significant purpose is the avoidance of federal income tax. §448(d)(3), §461(i)(3), and §6662(d)(2)(C)(iii).

Syndicates which are considered tax shelters include partnerships or other entities (other than a corporation which is not an S corporation), if more than 35% of the losses of such entity during the taxable year are allocable to limited partners or limited entrepreneurs. §1256(e)(3)(B).

A limited entrepreneur is defined as a person who has an interest in an enterprise other than as a limited partner and does not actively participate in the management of such enterprise. § 464(e)(2).

There is an exception from these rules for qualified personal service corporations, C corporations and partnerships with C corporations as partners.

These limitations on the cash method of accounting may be of concern to professionals who often use the cash basis method of accounting and are considering the LLC form. If the IRS views LLC members as limited partners, LLCs would be forced to use the accrual method of accounting. In addition, the exception for personal service corporations may not apply to LLCs when they are not classified as associations taxable as corporations. Alternatively, if an LLC member is not viewed as a limited partner, but does not actively participate in the management of the business, the member could be viewed as a limited entrepreneur. Therefore, if more than 35% of the LLC losses are allocated to such individuals, the LLC would be considered a syndicate not eligible for the cash method of accounting. The IRS has alleviated this concern somewhat by ruling that former active members, their estates, and relatives, may not be considered limited partners or limited entrepreneurs for purposes of determining whether the more than 35% limitation is met. PLR 9535036

The IRS has ruled that the limitations on the use of the cash method of accounting do not prevent an LLC from using such method. PLRs 9321047,9328005, 9350013, 9412030, and 9415005

The first ruling was issued to a general partnership which conducted a law practice and which proposed to convert to LLC status. PLR 9321047.

Based on representations by the partners of the law firm that all members would be engaged in the law practice of the new LLC and would participate in management activities, the IRS concluded that the members should not be treated as limited entrepreneurs and, therefore the LLC would not constitute a syndicate.

This and subsequent rulings 85 indicate that the IRS is not inclined to attempt to limit taxpayers' use of LLCs through arbitrary interpretations of certain Code sections enacted by Congress without any meaningful consideration as to how they might apply to LLCs. [PLR 9525058 (LLC law firm is not tax shelter and may use cash method of accounting).]

Engagement Letter

This entire site is for educational or informational purposes only. You are not to use the forms, concepts, strategies, or knowledge without assistance from a professional. The author, the corporation, the ISP, Bob Parrish CPA, Bob Parrish CPA, P.C. or other parties related to those or this site do not guarantee or warrantee in any manner the suitability, usefulness, accuracy, timeliness, or results of any portions of this site, nor the links contained in this site which link to other areas. At times, information is taken from other sources and is believed to be accurate, but no verification or confirmation is performed. Furthermore, if any federal or state law invalidates a portion of this disclaimer, the other portions still apply. In addition, any allegations or actions are restricted to arbitration only and must be arbitrated by the Better Business Bureau in Sarasota Florida. Reading of these pages constitutes complete acceptance and agreement with all disclaimer provisions on all pages of this site. .......

Learning Objectives

What it does, Why it works - Plain English Analysis

The LLC has significant advantages over other forms of doing business (i.e., sole proprietorships, general and limited partnerships, C and S corporations). LLCs generally possess five key elements in combination that do not exist in any other single entity: operational flexibility, limited liability, passthrough taxation, no restrictions on permitted owners, no legal restrictions on the amount of owners' activity.

Although management of an LLC is initially vested in its members, use of nonmember managers is permitted. Also, an LLC can have any of the special income allocations available to a partnership. The owners of an LLC need not conform their business practices to the rigid strictures associated with corporations. Therefore, the entity can much more closely resemble its owners' understanding of business realities.

As is the case with a corporation, the most significant nontax attribute of an LLC is the limited liability of its members. In general, members of an LLC, unlike a sole proprietor or a general partner, are not personally liable for the debts and obligations of the LLC. A member's liability is limited to the amount of capital contributions. CPAs, attorneys, doctors, and other licensed professionals who practice in PLLC form are subject to special rules to assure that they remain responsible for the quality of their own services and of those under their direct supervision. (See "Liability for Professional Services" on page 25.)

An LLC which is taxed as a partnership is able to avoid the double taxation attributable to a C corporation, and will pass through income and losses to its members.

Unlike S corporations, anyone may own an LLC interest, including corporations, nonresident aliens, qualified retirement plans, and all trusts. Nor is their any limitation on the number of owners permitted. (However, the PLLC/LLP entities for professional practice require that their owners be licensed professionals.)

Observation: New York even permits a single-member LLC, one of the few states to do so. Because the IRS corporate/partnership test under Reg. Sec. 301.7701-2 was intended to apply to entities with more than one owner, it is unclear how a single-member LLC will be taxed. The CPA Society is seeking clarification from the IRS on this issue. However, until IRS provides such clarification, it is prudent to advise against forming a single-member LLC. (See "Tax Classification of Single-Member LLCs" on page 22.)

Unlike limited partnerships, all owners may be active in the business and retain their limited liability protection.

The concepts contained in the LLC laws were largely drawn from two legal traditions, the law of partnerships and the law of corporations. Each of these areas of the law has been illuminated by hundreds of court cases. Lawyers are familiar with how to apply these areas of the law to best meet the needs of their clients. But there are very few cases interpreting the LLC laws. The blend of partnership and corporate concepts is still novel and breeds uncertainty.

There is a Uniform Partnership Act and a Uniform Limited Partnership Act which have passed in nearly all the states. The Delaware corporation code has served as a model for the business corporation laws of most states, with the result that there is a great deal of uniformity in corporate statutes.

There is no uniformity for LLC laws. True, the LLC laws fall into two broad categories "bulletproof" and "flexible." But within these categories, especially among the "flexible" states, there is a great deal of variation. Multistate businesses operating as LLCs will, until uniformity is achieved among the states, constantly need to monitor their legal rights and responsibilities throughout the area they serve.

There are currently a handful of states that sanction the use of one-member LLCs. They include Arkansas, Colorado, Delaware, Georgia, Idaho, New York, and Texas. [31] The most significant benefit associated with the use of a one-member LLC is the fact that the entity can be totally disregarded for federal taxation purposes resulting in a pure pass-through entity without sacrificing limited liability.

That is, under these states' laws, a one-member LLC is recognized as an LLC for state law purposes. For purposes of federal taxation, the check-the-box regulations acknowledge the existence of one-member LLCs and allow them to elect their classification.

A one-member LLC cannot by definition be classified as a partnership. Instead, a domestic one-member LLC is treated as a "non-entity" for purposes of federal taxation unless the LLC elects to be treated as an association taxable as a corporation. Effective January 1, 1997, the check-the-box regulations provide that a single-owner organization may choose to be recognized and taxed as an association (taxable as a corporation) or disregarded as an entity separate from its owner. Based upon Regs. § 301.7701-1(a)(4). Thus, the regulations allow single-owner organizations to achieve pass-through treatment functionally equivalent to partnership classification. Persons desiring limited liability, pass-through taxation, and 100% ownership can conduct a business through a wholly owned LLC rather than a wholly owned S corporation (previously the only safe option for ensuring pass through treatment of a one-member entity organized pursuant to a state statute).

A foreign one-member LLC is treated the same way if its owner has unlimited liability. If, on the other hand, the owner has limited liability, the foreign one-member LLC is taxed as a corporation unless there is an election to be treated as a "non-entity."

In the corporate context, there are many planning opportunities available through the use of a single-member LLC as an alternative to a corporate subsidiary. A corporate owner of a single-member LLC can treat the LLC as a division or branch as opposed to a separate corporate entity organized under state law.

[Footnote 31] In addition, in certain states (i.e., Wyoming) two members are required to form an LLC but the LLC can subsequently drop to one member.

Elective Classification Rules

A business entity that is not required to be taxed as a corporation and which has two or more members generally may elect to be taxed either as a corporation or a partnership. If such an entity has a single member, it may elect to be classified as a corporation or to be disregarded as an entity separate from its owner. If the entity elects to be disregarded, it is treated as a sole proprietorship (in the case of an individual owner) or a branch or division of the owner (in the case of a ownership by a business entity).

Under the default rules, a domestic entity which does not elect its classification is (i) classified as a partnership if it has two or more members, or (ii) disregarded as an entity separate from its owner if it has a single owner. A foreign entity that does not elect its classification is (i) classified as a partnership if it has two or more members and at least one member does not have limited liability; (ii) classified as an association if all members have limited liability; or (iii) disregarded as an entity separate from its owner if it has a single owner that does not have limited liability.

What It does, Why it works - Technical Analysis & Citations

§301.7701-1(a)(4) Single Owner Organizations. - Under Sections 301.7701-2 and 301.7701-3, certain organizations that have a single owner can choose to be recognized or disregarded as entities separate from their owners.

(a) In General.
A business entity that is not classified as a corporation under Section 301.7701-2(b)(1), (3), (4), (5), (6), (7), or (8) (an eligible entity) can elect its classification for federal tax purposes as provided in this section. An eligible entity with at least two members can elect to be classified as either an association (and thus a corporation under Section 301.7701-2(b)(2)) or a partnership, and an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner. Paragraph (b) of this section provides a default classification for an eligible entity that does not make an election. Thus, elections are necessary only when an eligible entity chooses to be classified initially as other than the default classification or when an eligible entity chooses to change its classification. An entity whose classification is determined under the default classification retains that classification (regardless of any changes in the members' liability that occurs at any time during the time that the entity's classification is relevant as defined in paragraph (d) of this section) until the entity makes an election to change that classification under paragraph (c)(1) of this section. Paragraph (c) of this section provides rules for making express elections. Paragraph (d) of this section provides special rules for foreign eligible entities. Paragraph (e) of this section provides special rules for classifying entities resulting from partnership terminations and divisions under section 708(b). Paragraph (f) of this section sets forth the effective date of this section and a special rule relating to prior periods.
301.7701-3(b) Classification Of Eligible Entities That Do Not File An Election--
301.7701-3(b)(1) Domestic Eligible Entities.
Except as provided in paragraph (b)(3) of this section, unless the entity elects otherwise, a domestic eligible entity is--
(i) A partnership if it has two or more members; or
(ii) Disregarded as an entity separate from its owner if it has a single owner.
301.7701-3(b)(2) Foreign Eligible Entities--
301.7701-3(b)(2)(i) In General.
Except as provided in paragraph (b)(3) of this section, unless the entity elects otherwise, a foreign eligible entity is--
(A) A partnership if it has two or more members and at least one member does not have limited liability;
(B) An association if all members have limited liability; or
(C) Disregarded as an entity separate from its owner if it has a single owner that does not have limited liability.
301.7701-3(b)(2)(ii) Definition Of Limited Liability.
For purposes of paragraph (b)(2) (i) of this section, a member of a foreign eligible entity has limited liability if the member has no personal liability for the debts of or claims against the entity by reason of being a member. This determination is based solely on the statute or law pursuant to which the entity is organized, except that if the underlying statute or law allows the entity to specify in its organizational documents whether the members will have limited liability, the organizational documents may also be relevant. For purposes of this section, a member has personal liability if the creditors of the entity may seek satisfaction of all or any portion of the debts or claims against the entity from the member as such. A member has personal liability for purposes of this paragraph even if the member makes an agreement under which another person (whether or not a member of the entity) assumes such liability or agrees to indemnify that member for any such liability.
301.7701-3(b)(3) Existing Eligible Entities--
301.7701-3(b)(3)(i) In General.
Unless the entity elects otherwise, an eligible entity in existence prior to the effective date of this section will have the same classification that the entity claimed under Sections 301.7701-1 through 301.7701-3 as in effect on the date prior to the effective date of this section; except that if an eligible entity with a single owner claimed to be a partnership under those regulations, the entity will be disregarded as an entity separate from its owner under this paragraph (b)(3)(i). For special rules regarding the classification of such entities for periods prior to the effective date of this section, see paragraph (f)(2) of this section.
301.7701-3(b)(3)(ii) Special Rules.
For purposes of paragraph (b)(3)(i) of this section, a foreign eligible entity is treated as being in existence prior to the effective date of this section only if the entity's classification was relevant (as defined in paragraph (d) of this section) at any time during the sixty months prior to the effective date of this section. If an entity claimed different classifications prior to the effective date of this section, the entity's classification for purposes of paragraph (b)(3)(i) of this section is the last classification claimed by the entity. If a foreign eligible entity's classification is relevant prior to the effective date of this section, but no federal tax or information return is filed or the federal tax or information return does not indicate the classification of the entity, the entity's classification for the period prior to the effective date of this section is determined under the regulations in effect on the date prior to the effective date of this section.
301.7701-3(c) Elections--
301.7701-3(c)(1) Time And Place For Filing--
301.7701-3(c)(1)(i) In General.
Except as provided in paragraphs (c)(1)(iv) and (v) of this section, an eligible entity may elect to be classified other than as provided under paragraph (b) of this section, or to change its classification, by filing Form 8832, Entity Classification Election, with the service center designated on Form 8832. An election will not be accepted unless all of the information required by the form and instructions, including the taxpayer identifying number of the entity, is provided on Form 8832. See Section 301.6109-1 for rules on applying for and displaying Employer Identification Numbers.
301.7701-3(c)(1)(ii) Further Notification Of Elections.
An eligible entity required to file a federal tax or information return for the taxable year for which an election is made under paragraph (c)(1)(i) of this section must attach a copy of its Form 8832 to its federal tax or information return for that year. If the entity is not required to file a return for that year, a copy of its Form 8832 must be attached to the federal income tax or information return of any direct or indirect owner of the entity for the taxable year of the owner that includes the date on which the election was effective. An indirect owner of the entity does not have to attach a copy of the Form 8832 to its return if an entity in which it has an interest is already filing a copy of the Form 8832 with its return. If an entity, or one of its direct or indirect owners, fails to attach a copy of a Form 8832 to its return as directed in this section, an otherwise valid election under paragraph (c)(1)(i) of this section will not be invalidated, but the non-filing party may be subject to penalties, including any applicable penalties if the federal tax or information returns are inconsistent with the entity's election under paragraph (c)(1)(i) of this section.
301.7701-3(c)(1)(iii) Effective Date Of Election.
An election made under paragraph (c)(1)(i) of this section will be effective on the date specified by the entity on Form 8832 or on the date filed if no such date is specified on the election form. The effective date specified on Form 8832 can not be more than 75 days prior to the date on which the election is filed and can not be more than 12 months after the date on which the election is filed. If an election specifies an effective date more than 75 days prior to the date on which the election is filed, it will be effective 75 days prior to the date it was filed. If an election specifies an effective date more than 12 months from the date on which the election is filed, it will be effective 12 months after the date it was filed. If an election specifies an effective date before January 1, 1997, it will be effective as of January 1, 1997.
301.7701-3(c)(1)(iv) Limitation.
If an eligible entity makes an election under paragraph (c)(1)(i) of this section to change its classification (other than an election made by an existing entity to change its classification as of the effective date of this section), the entity cannot change its classification by election again during the sixty months succeeding the effective date of the election. However, the Commissioner may permit the entity to change its classification by election within the sixty months if more than fifty percent of the ownership interests in the entity as of the effective date of the subsequent election are owned by persons that did not own any interests in the entity on the filing date or on the effective date of the entity's prior election.
301.7701-3(c)(1)(v) Deemed Elections--
301.7701-3(c)(1)(v)(A) Exempt Organizations.
An eligible entity that has been determined to be, or claims to be, exempt from taxation under section 501(a) is treated as having made an election under this section to be classified as an association. Such election will be effective as of the first day for which exemption is claimed or determined to apply, regardless of when the claim or determination is made, and will remain in effect unless an election is made under paragraph (c)(1)(i) of this section after the date the claim for exempt status is withdrawn or rejected or the date the determination of exempt status is revoked.
301.7701-3(c)(1)(v)(B) Real Estate Investment Trusts.
An eligible entity that files an election under section 856(c)(1) to be treated as a real estate investment trust is treated as having made an election under this section to be classified as an association. Such election will be effective as of the first day the entity is treated as a real estate investment trust. (Registered)REDO

Tax Killers

This is about Activity Based Taxplanning - maximizing deductions, minimizing cash outlay and maximizing the amount of cash retained and the net worth.

Tax is a subject that many view in order to cut costs. Taxes are a cost just as any other cost. It happens this cost is somewhat intangible and is defined by legislation without a tangible item to view and control. The money is spent and the control of the expenditure is more appropriately administered by someone trained in the law.

Cost Killers

This is about Activity Based Costing - methods to cut costs, management accounting, management information systems, decision support sytems - in general about being a manager.

Client Letter - What this idea is about	Engagement Letter	Learning Objectives	What it does; Why It Works - Plain English Analysis	What It does; Why It Works - Technical Analysis & Citations	Tax Killers: ABT, Activity Based Taxplanning
Cost Killers: ABC, Activity Based Cost & Profit Planning	What to Gather/Organizer	Assistance, What To Do, Forms - checklists, time-line to do, etc.	Spreadsheets & Computations	Contracts, Trusts, etc.	Reports Required
Checklists for Deployment	Checklist for Monitoring	Financial Accounting: Bookkeeping & Financials	Compliance - what is required for protection, defense, etc.	Alerts & Dangers - Risks, Asset Protection, IRS Defense, etc.

Client Letter -

What this idea is about

Engagement Letter

Learning Objectives

What it does, Why it works - Plain English Analysis

What It does, Why it works - Technical Analysis & Citations

Tax Killers

Cost Killers

What to gather - preparing for your CPA, your attorney, or preparing to start the job on your own

Assistance - What To Do - Forms - checklists, time-line to do, etc.

Spreadsheets & Computations

Contracts, Trusts, etc.

Reports Required

Checklists for Deployment

Checklist for Monitoring

Financial Accounting: Bookkeeping & Financials

Compliance - what is required for protection, defense, etc.

Alerts & Dangers - Risks, Asset Protection, IRS Defense