In 1988 the IRS issued Revenue Ruling 88-76 which established that Limited Liability Companies would be taxed the same way as Partnerships are taxed, IF, they avoided having more than two corporate characteristics as identified in 26 CRF 301.7701-2,3 and 4 present in the entity. These include Centralization of Management, Free Transferability of Interests, and unlimited Continuity of Life, and Limited Liability. Most state LLC Acts attempt to achieve this.
By drafting Articles of Organization which meet this Revenue Ruling, the LLC can flow through earnings and losses to its owners allocated in accordance with their agreement between themselves. Here's how they might proceed to meet Rev. Rul 88-76:
Centralization of Management: The Articles of Incorporation for the LLC would specify that all members would either directly manage the enterprise or agree to employ management which would be answerable to all members. In some States, it's possible for a single entity to form the LLC. In such instances, it can be seen that this corporate attribute could be a problem unless a separate board of directors were called for to make management decisions.
Unlimited Life: This is an easy problem to avoid. Most state laws allow 20 or 30 years of life to the LLC. By limiting its life in the Articles of Organization, the LLC easily circumvents this corporate attribute.
Free Transferability of Shares: The Articles of Organization should specify that only the original members would have voting rights to direct the LLC unless these rights were conferred by unanimous consent on subsequent shareholders. Any shares transferred without first being offered to the other members or to the LLC itself would lose all voting rights. This makes free transferability of shares a moot point.
Limited Liability: This is the sole corporate attribute you want to retain. It's the essential feature that makes the LLC so desirable.
The IRS doesn't concern itself with how the internal business affairs are managed so long as the above requirements are met. That means that LLCs need not concern themselves with fear that an audit might disallow some treatment because of the lack of a resolution, formal meeting minutes and other corporate formalities. Furthermore, unlike an S corporation, in most states LLCs can be formed by anyone or any entity.
A Trust, Corporation, Partnership, Foreign National, Joint Venture and another LLC can form a Limited Liability Company in any combination imaginable. Mergers of Partnerships, Corporations and other LLCs into LLCs is just beginning to take place in a no-man's land of tax law. It's creating new opportunities for those willing to go where no man has gone before. Once done the new LLC can re-allocate profits and losses among their members disproportionately if they want.
LLCs can form in one state and register to operate in another, flowing profits back through to owners in yet another tax environment or off shore. They can issue a variety of classes of membership shares with various attributes at will all without interference or penalties imposed by the IRS. When one considers the advantages of being able to conduct a business in an organizational environment virtually devoid of any Treasury Regulations or regulatory red tape, it boggles the mind. Let's talk about liability.
LLCs ARE DESIGNED TO PROTECT YOUR ASSETS . . .
Under the Limited Liability Acts of most of the states, a civil suit may not be launched against any of the members or managers of the LLC for matters connected with the operation of the LLC. An exception is that a suit by members themselves against other members or managers of the LLC whom they suspect are violating the terms of the LLC's Operating Agreement isn't precluded. Warning! If it can be proven that the LLC is merely an alter ego of its member/managers rather than a bonafide business entity, it can be pierced in much the same way as a corporate shield.
Because artificial legal entities can form LLCs, it's possible to completely conceal ownership by having a Corporation with bearer shares, or a Trust with concealed Beneficiaries form the LLC. The LLC obtains its own federal tax identification number and can make a determination as to whether to retain or distribute earnings. Distributed earnings are transmitted to the owners via a K-1 form and reported at the transferee level on its own tax return in its own jurisdiction. When corporations are the managers, active earnings and losses could flow through and be allocated in such a way as would be most beneficial to the members.
Suppose a member of the LLC were to have a judgment for some reason not associated with the operation of the LLC. If the Articles of Organization permitted it, distribution of the earnings would only be subject to a Charging Order rather than actual levy.
The jury is still out when it comes to the use of LLCs in lieu of Professional or Personal Service Corporations. Some states will issue professional licenses. Other's haven't ruled on it. But consider the benefits of C corporation fringe benefits and tax brackets, then letting the C corporation own a medical practice LLC which passes earnings to owners risk free.
