August 1994
Vol 17 No 12
A totally different kind of business organization is beginning to sweep the country. It's going to change many of the ways we conduct our affairs and do business. If you had to come up with the best way to organize your business, and there were no restrictions, what features would you try to include? One way to approach this might be to take the best attributes of existing types of organizations, and to avoid the worst. What might the advantages be?
First let's look at S corporations. They offer personal liability protection, but they also require conscientious observance of various formalities, procedures, meetings, etc. S corporations are fragile entities. Only 35 living, breathing U.S. citizens can hold shares. Suppose a shareholder died and his share became the property of a foreign national or a Trust. That would cause the S corporation to become a regular C corporation without warning. That could have an extremely expensive tax effect in some circumstances.
The same thing holds true when a share of S corporation stock is held by a corporation. There are lots of rules about not having more than a single class of stock. Even a shareholder's taking the company car home over the weekend has caused his shares to be deemed a different class of stock, and the S corporation status being lost.
Limited Liability Companies don't have any citizenship requirement, or limitation on size and/or number of members, or limitation on numbers of classes of stock. They can own 100% of other corporations and vice versa, and usually, there are no tax penalties upon liquidation. They're going to make both S corporations and partnerships obsolete. Here's why.
A General Partnership is just too risky. Partners are jointly and severally liable. Suppose that Joe and Bill team up to be Partners. Joe is going to run the business and Bill is going to back it with his money. Joe makes a mistake and the business goes broke. Joe can walk away, and Bill can be made to pay for any debts. LLCs share none of these disabilities. Managers and owners are fully protected from company liability.
A Limited Partnership protects limited partners from liability but at the cost of control. In the same situation as above, the business could be run by Joe as a General Partner with all the liability and total control. Operations could be paid for by Bill as a Limited Partner with only his capital at risk, but Bill would have no control over how Joe spent his money.
If Bill started trying to influence Joe, he'd become a General Partner with Joe and we'd be back to square #1. It would be easy for people to sue Bill or Joe and to collect on their judgments. Each year their Partnership report would show not only all assets, but the names and addresses of the Partners. In an ideal situation, we'd want to be able to make management decisions without incurring management risks while maintaining a degree of privacy. LLCs protect all members, especially those who participate in management.
This sounds pretty complicated, why not just open up a sole proprietorship? First of all, it's hard to raise money to go into business all by yourself. And if you borrow the capital you need, you'll be personally liable for the debt as well as for any mishaps in the business. Sole proprietorships are simple. We'd surely want to have a simple form of business organization. But they're risky and usually under-capitalized. LLCs are one of the simplest forms of business organization.
AN ENTIRELY DIFFERENT TYPE ORGANIZATION IS NEEDED!
Neither a Corporation, a Trust nor a Partnership, but containing many of their best features; Limited Liability Companies seem to be the answer to the maiden's prayer. LLCs can combine ways to raise business capital, avoid personal liability, maintain privacy while including some of the best features of all other forms of business organization without their disadvantages. Why are we just now hearing about them?
Limited Liability Companies have existed for most of this century in countries throughout Europe and Latin American whose laws are based upon Civil rather than Common Law. They sprang into being under German law in 1892 and this became the legal model for most of the subsequent enabling legislation around the world. At about the same time, 120 years ago, unincorporated associations resembling limited partnerships began to be recognized by various States in America.
In 1977, Wyoming enacted a Limited Liability Company act patterned after the 1892 German Code. In 1982, Florida passed a similar act in an effort to attract Latin American capital to Florida and to provide a familiar business organizational form. Since then, some 36 states have passed LLC legislation patterned after the Wyoming law, and 10 more are working on Limited Liability Company Acts. LLCs are sweeping the nation. They'll soon be operating in all states.
IRS RULES LLC IS TAXED LIKE A PARTNERSHIP
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.
LLC's 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.
LLC's 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 LLC's 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.
THIS IS ONLY THE TIP OF THE ICEBERG . . .
We've recently formed an 'experimental' LLC which we're using as a practice model. On the 13th and 14th of August, we'll introduce a brand new seminar on LLCs in Philadelphia where we'll discuss what we've leanred first hand. Come on down and be among the first to get the insider's point of view on this exciting new tool to use for liability-free business operations.
Copyright Sunjon Trust All Rights Reserved
Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
1-888-282-1882 www.CashFlowDepot.com
