Llimited Liabilty Companies - Frequently Asked Questions (and Answers!)


In the last few years, businesspersons around the country have become very excited by a relatively new way to do business—the limited liability company (“LLC”). And with this excitement comes the stampede to form them and use them in business transactions. Yet not all these businesspersons fully understand LLCs, what LLCs can do for them, what they cannot do, and how they should be treated by others doing business with the LLC.

LLCs provide tremendous flexibility and are highly useful tools for tax and estate planning purposes. They should not be overlooked.

As foreign as they are to businesspersons, they are similarly foreign to many lawyers, accountants, and bankers, who are just now having their first encounters with LLCs in many jurisdictions. This article is simply a short introduction to LLCs, an area of the law that is much more complex than can be fairly treated in these few pages.

What exactly is a Limited Liability Company?

To best understand LLCs, one should understand what corporations and partnerships were intended to accomplish for their owners, albeit imperfectly. In other words, an understanding of LLCs comes from an understanding of the failings of corporations and partnerships and how LLCs fill the gap.

What are the alternatives to LLCs?

Until LLCs came on the scene, businesspersons had a choice of business entity that was generally limited to corporations or partnerships, involving a trade off between, on the one hand, limitations on the liability of the business owners for debts of and judgments against the business, and, on the other hand, tax savings through a single, rather than a double, tax on business income. The ultimate business entity, theoretically, would be to have both. The enclosed chart gives an overview of some of the basic differences influencing your choice of entity.

Why not use a Corporation?

A corporation, formed by filing a Charter of Incorporation with the state and governed by bylaws, normally provides its shareholders with a shield against creditors (whether lenders, suppliers, or tort judgment creditors) of the corporation, unless the shield could be “pierced” or the shareholders give personal guarantees. Generally, therefore, regardless of the financial strength of the corporation, the assets of the shareholders not invested in the business (for example, one’s residence) cannot be attached by the corporation’s creditors.

Yet there is often a tax price to be paid for this protection; a regular “C” corporation is subject to tax as if it were a separate person, and the shareholders receive only the earnings of the corporation reduced by the taxes paid by the corporation, on which they must then pay taxes once again. Also, if the corporation incurs a net loss, the shareholders are not able to claim the loss on their own tax returns.

Of course this may be mitigated to some extent in several ways. For instance, if otherwise permissible under the tax code, closely held corporations might pay out all of its earnings to its shareholders as salary or rent, thereby leaving no corporate income to be taxed. However, corporate losses would still be stuck within the corporation. With careful planning, the corporation still is a very powerful tax reduction and asset protection tool.

Having said this, one should not always conclude that C corporation status must be avoided. Under current law, with the corporate income tax rate typically lower than the highest personal income tax

rate, profitable businesses planning to plow earnings back into the business as working capital rather than distribute these earnings might be better off as a C corporation. Also, certain benefits, such as medical expense reimbursement plans are, as a practical matter, more readily available to C corporations than are available or beneficial to other entities.

Alternatively, the shareholders might make an election with the IRS under Subchapter S of the Internal Revenue Code of 1986 (creating what is known as an “S” corporation), thereby allowing the income and expenses of the corporation to be largely ignored at the corporate level, with the shareholders paying all of the tax themselves on the net income earned by the corporation or claiming all of the corporation’s losses as their own.

To qualify as an S corporation, the corporation must pass through several hoops. Because of this, S corporations are unavailable in a wide variety of situations and potentially unattractive where the corporation might own a significantly appreciating asset or have a substantial amount of passive income. Thus, if a corporation were the preferred form of doing business, one could get limited liability and one level of tax if one qualified as an S corporation, or the shareholders must accept the cost of paying tax at the corporate level. S corporations are still a very viable business entity.

Should I think instead about using a Partnership?

At the other end of the spectrum lie partnerships. In its most basic form, the general partnership, the income and losses of the partnership business flow through directly to the partners and are not subject to tax at the partnership level. However, all the partners are jointly and severally liable for the debts and judgments of the partnership, which is totally unacceptable to most businesspersons. Furthermore, each partner is each other partner’s “agent.” This causes more problems than most people would imagine. One partner can financially ruin another, intentionally or unintentionally.

Of course, limited partnerships are employed by many to retain these tax benefits while reducing the liability of the partners. Nonetheless, as every limited partnership requires at least one general partner, this leaves at least one person with complete exposure for partnership debts and judgments. One common mechanism is to form a special purpose corporation with finite assets to hold a small partnership interest as general partner. While this is an accepted way to do business, many businesspersons accept this cumbersome structure only begrudgingly. Also, business operators, rather than passive investors, cannot be, as a practical legal matter, a limited partner. Therefore, those who run the business may be exposed to unlimited liability even when the business is operated through a limited partnership. Some planning strategies can mitigate this, but not absolutely.

Accordingly, if a partnership were the preferred business vehicle, one is able to keep taxes down and limit liability with a limited partnership having a corporate general partner, at the cost of administrative complexity. And even then the liability limits are less than perfect for those active in operating the business. Nonetheless, a limited partnership with a corporate general partner is often preferable to an S Corporation.

If LLCs are generally better, how are they taxed?

With LLCs, the ideal business entity is closer at hand, if not in our grasp. Under the typical LLC statute, the “members” (analogous to shareholders in corporations and partners in partnerships) are all shielded from the company’s debts unless they affirmatively undertake responsibility for such debt, such as by a guarantee to a lender.

Also, just by making an election, the company can be treated as a partnership for tax purposes, which is often the best option for small businesses and rental real estate ventures. Originally, the IRS made a determination based on the nature of the company’s management structure, the transferability of member interests, and how the company would dissolve. If not formed appropriately in light of the IRS regulations, rulings, and case law, the LLC would be treated as a corporation for federal income tax purposes (and for state tax purposes in the many states that rely on federal tax classification). Recent IRS pronouncements have greatly eased this classification test, making partnership taxation (or corporate if preferred) as simple as choosing it with the first tax return.

Despite the flexibility now allowed by the IRS, caution remains the touchstone when forming LLCs to assure that they will be treated as a partnership for federal tax purposes. To provide for maximum non-tax benefits, a well thought out and carefully drafted Operating Agreement is essential.

Some have predicted that it won’t be too long before S Corporations are as rarely used as LLCs are today! In the right circumstances, there is no longer a need to use a corporation or a limited partnership with a corporate general partner to provide complete liability protection and there is no need to live with the statutory limitations of the S corporation in order to get federal income tax advantages of a conduit entity.

It should be noted that in some states the LLC itself will have to pay state income or franchise taxes on its income, despite it tax transparency for federal tax purposes. Also, the LLC might be subject to hefty filing fee requirements initially and annually depending on the states in which the LLC is formed and in which it is doing business. Tennessee has recently chosen to tax LLCs directly on business income and the capital invested. In addition, Tennessee has set the current minimum filing fee (and minimum annual fee) at $300. For those who recognize the benefits of the LLC, this is a small price to pay for the liability protection these entities afford the businessperson.

For rental real estate activities, it has almost universal appeal, since the net income (or more commonly losses) pass through to owners, while providing above average asset protection. Obviously, even for rental properties, where LLCs provide an excellent fit, sometimes it is advisable to utilize other structures. Nonetheless, the LLC should be the first entity owners of rental property should examine.

Similarly, their relative newness makes them less attractive for multi-state companies and certain other businesses. Even though all states now recognize LLCs, corporations still provide the certainty that comes from years of legal precedents. Also, tax consequences may sometimes be more advantageous with other entities, depending on the facts.

How do you create an LLC?

The limited liability company, a creature of state law, is created by the filing of Articles of Organization with the Tennessee Secretary of State. However, the company is not governed by bylaws; instead it is governed by an Operating Agreement. The Operating Agreement is closer in form to a partnership agreement (or, to use a corporate analogue, bylaws plus a shareholders’ buy- sell agreement).

The Operating Agreement sets the rules for governing the company (such as the rules for meetings, if any) as well as the rights and responsibilities of the members vis-à-vis the company and vis-à-vis

each other. Thus, it states the members’ understanding of who is responsible for contributions to capital and how much, who is to receive distributions and how much, who is to be allocated the various tax attributes of the company such as profits, losses, gains and credits, and under what circumstance the company will dissolve, among others. The Operating Agreement is not filed with any federal or state agency.

What if I want to do business outside of Tennessee?

If the company is organized in a jurisdiction other than that in which it will be doing business, or will be doing business in several jurisdictions, then the company must be authorized to do business as a foreign LLC in these other jurisdictions, much like corporations have done for years.

Do I have evidence of ownership like a stock certificate?

The ownership interests in LLCs may be reflected in share certificates in many jurisdictions, but need not be. In fact, it is not unusual for LLC interests to be stated as a percentage of the company’s capital, as in a partnership. Typically, the capital accounts reflected in the LLCs accounting records are reflective of the degree of ownership.  Because of the law the Tennessee Hall Tax is written, we recommend that no certificate be issued.  Evidence of ownership is accomplished by the LLC Operating Agrement and any Minutes that alter the percentate of ownership.

Who manages and controls the LLC?

It is up to the members to define in the Operating Agreement how the LLC will be managed. In some cases, the members might vest virtually all control of the LLC in one or a few managers (analogous to the officers and directors of a corporation or the managing general partner in a limited partnership). In other cases, the members might want a more active hand in company policy and day-to-day management, in which case the Agreement will provide for an appropriate quantum of votes in a variety of circumstances.

Unlike limited partnerships, the members retain limited liability protection no matter how actively they participate. Tax treatment does, however, vary depending on the level of participation (active versus passive).

Do I need to have meetings with an LLC?

Depending on the management structure of the company, the Operating Agreement should generally require regular meetings, as does typical corporate bylaws, but the members might forego meetings altogether other than once a year. We advise that certain formalities be observed to assure the desired asset protection and tax reduction results.

What if I decide to terminate the LLC?

The Operating Agreement will also set forth the events that cause dissolution of the company. For instance, there may be a requirement that it dissolve upon the death or bankruptcy of a member or of a manager. While this is an important operational issue to consider when forming the LLC, its significance is even greater than appears on its face, as this is one aspect of the company the IRS previously examined to determine if the company should be taxed as a partnership or as a corporation. This is also one of the areas of greatest concern to LLC investors insofar as, depending on how a dissolution provision is formulated, the LLC might dissolve at an inopportune and unanticipated time.

Are transfers of LLC ownership interests allowed?

The members will also provide in the Operating Agreement the rules governing when LLC interests may be transferred and which aspects of these interests may be transferred. It is also possible to prohibit or limit the rights of members to transfer their LLC ownership interest. These rules might include a right of first refusal for the remaining members. Again because of IRS criteria, the “economic rights” of the LLC interest might be freely transferable to an outsider, but the recipient of these rights might not be admitted as a full member, with full rights of LLC membership, unless admitted by an affirmative vote of the remaining members.

To achieve greater protection from unexpected judgment creditors (resulting from lawsuits), certain provisions should be included in the Operating Agreement that makes the interest in the LLC unattractive to a would-be plaintiff. This opportunity to limit creditors rights could theoretically make lawsuits less likely.

What about securities regulations and blue sky laws?

In general, interests in an LLC will not constitute a security under federal securities laws or Tennessee “blue sky” laws when all of the members are activly working in the business and are not passive investors. Nonetheless, it is important is some circumstances to determine that the LLC falls within an exception from registration under these statutes. This is an important consideration. Corporations and limited partnerships are always securities and an exemption must be found. It is advisable, however, to determine the appropriate exemption from registration for a newly formed LLC when “outsiders” are involved.  

May I raise capital by selling a portion of the LLC to investors?

LLCs may bring in captial from outsiders who are going to be passive investors - but it is necessary to complete a public offering or create a private placement memorandum under federal and state laws.  Those statutes apply equally to LLCs, corporations, and other entities.  It is typcially an expensive process.

Do I have any special tax reporting with an LLC?

When tax time roles around, the LLC will typically file a partnership tax return with the federal government and any requisite state tax forms and will provide each member with a Schedule K-1. Most states do not tax income of LLCs, but many states have fees and tax schemes that must be examined, to receive the maximum benefit from the pass-through of taxable income.  Tennessee has a minimum tax of $100 on LLCs but the franchise and excise tax can be significant depending on the value of assets owned in the LLC name and whether the net income of the company is “self-employment” income.  You should thoroughly discuss the tax rules and cost of return preparation with your CPA prior to forming an LLC.

Are there some creative uses for LLCs?

We can’t  no business enterprise for which an LLC would be inappropriate. Real estate, oil and gas ventures, any operating business, professionals (in some states), businesses with foreign investors, businesses seeking venture capital, and joint ventures between established enterprises, including huge corporations, are just a few of the ventures that might benefit from doing business through an LLC.

Also, in the context of estate planning, where family limited partnerships are now being used, LLCs are providing an alternative outlet. Finally, as outside creditors of LLC members typically can get only a “charging order” against that member’s LLC interest, LLCs provide an excellent component in an asset protection plan. Some clients are even using LLCs as a will or trust substitute.

CONCLUSION

A full description of LLCs would take a books to properly discuss, and the issues are terribly complex, despite the simplicity with which they are presented in this summary.

Whether you would be best served by an LLC in any given situation, and how the LLC should be operated, are determined based on specific facts unique to each case, including the laws of the state under which you will be opaerating. Competent and experienced counsel should be consulted before undertaking any business venture, particularly one as complicated and as poorly understood as limited liability companies. Accordingly, nothing herein is to be interpreted as legal advice as such advice can only be rendered upon a complete understanding of all of the relevant facts in any particular case.

Carpenter & Lewis Business Attorney Consultation:

As you can see, LLCs are likely to be a useful ‘tool’ in your business. If you desire more information about LLCs, we will be more than glad to assist you. 

Carpenter & Lewis Business Attorney Consultation:  For a consultation with one of the business attorneys at Carpenter & Lewis, please call (865) 690-4997 or you may prefer to send an e-mail to:  contact@carpenterlewis.com.
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