LIMITED LIABILITY COMPANIES

Most states have enacted or are considering the enactment of legislation enabling the formation of a Limited Liability Company (LLC). Many states, such as Ohio, have also enacted legislation allowing partners of general partnerships to enjoy limited liability of the partnership registered as with the state as a “registered” partnership having limited liability.

Since each state is free to enact or modify statutes unique unto itself, this material will not be universally applicable. The following information is based on Ohio statutes, but is likely to be very similar to any other state that has acted.

THE LIMITED LIABILITY STATUTES

The LLC statue provides for a new entity that in many instances will be more attractive than either a corporation or a partnership. An LLC is a hybrid form of entity. Generally an LLC will combine the liability shield of a corporation with the tax advantages of a partnership.

First, like a corporation, the owners of an LLC, who are called “members", do not have any personal liability for the LLCs liabilities.

Second, like a partnership, a properly constituted LLC will be treated as a pass-through entity for federal income tax purposes. Therefore, no federal or state tax will be imposed on the LLC. Instead, the members of the LLC will include the income or loss of the LLC on their personal income tax returns.

An LLC may be formed for any kind of business, including the professions of accounting, architecture, dentistry, engineering, health care services, landscape architecture, and pharmacy. Attorneys will not be able to practice through the LLC form unless the state supreme court amends its rules regulating the practice of law. However, attorneys may be allowed to practice in the form of a registered partnership having limited liability.

COMPANY FORMATION

An LLC is formed simply by filing Articles of Organization (Articles) with the Secretary of State and paying a filing fee. The Articles must be signed by two or more people and must set forth the name of the organization (that must include the words “Limited Liability Company,” “Limited,” “Ltd,” or “Ltd.”), the duration or term of the LLC, and the LLCs address. None of the financial arrangements among the members such as the firm’s capitalization, profit and loss sharing, distributions or the percentage interests of the members needs to be set forth in the Articles.

An LLC must appoint a statutory agent that may be any natural person residing in the state, a state corporation, or a foreign corporation qualified to do business in that state.

OPERATING AGREEMENT

The affairs and the conduct of the business of the LLC are governed by the “Operating Agreement” that is an agreement among the members very much like a partnership agreement. The members’ interests in the LLC are represented by “membership interests” that are assignable.

New members may be admitted with a unanimous consent of the members or a lesser number as provided for in the Operating Agreement. Unlike the case of an S corporation that generally restricts the kinds of owners to individuals, estates, or certain kinds of trusts, a member of an LLC may be an individual, corporation, partnership, pension plan, trust, estate, or even another LLC.

MANAGEMENT

The management of an LLC is vested in all the members in proportion to the membership interests. However, the Operating Agreement may provide for the appointment of “managers” by the members to conduct the business of the LLC. Managers do not have to be members of the LLC, and like members, have no personal liability for the liabilities of the LLC.

FINANCIAL ARRANGEMENTS

The LLC provides total flexibility regarding the economic arrangements among the members. In exchange for their membership interests, the members may contribute cash, property, services, a promissory note, or other obligation.

Profits and losses are allocated among the members in proportion to their respective contributions unless otherwise provided in the Operating Agreement. Distributions are also made in proportion to the members’ contributions unless the Operating Agreement provides otherwise.

DISSOLUTION

One of the disadvantages of the LLC is that, like a partnership, an LLC is dissolved upon the occurrence of certain events. These events include the expiration of the period fixed by the Operating Agreement, unanimous written consent of the members, and the withdrawals of a member.

The “withdrawal” of a member includes not only resignation, but also expulsion, bankruptcy, death, adjudication of incompetence, and dissolution of any member that is an entity.

Upon a dissolution resulting from a withdrawal, the business of the LLC must be wound up and liquidated unless all of the remaining members or a much lesser number of members as is provided for in the Operating Agreement, agree to continue the business of the LLC.

FEDERAL TAXATION

In 1988, the IRS ruled that an LLC formed in the United States (in that case in Wyoming) was taxable as a partnership rather than as a corporation. Generally, this ruling and those that followed held that an LLC qualifies for tax purposes as a partnership rather than a corporation because it lacks the two corporate attributes of “continuity of life” and “free transferability of interests.”

The IRS has ruled that an LLC lacks continuity of life if a dissolution event such as bankruptcy causes a dissolution of the LLC so that its business is required to be wound up and its assets liquidated unless all of the members vote to continue the business. In some rulings, the IRS has ruled that an LLC lacks continuity of life even if a mere majority in interest of the members may vote to continue the business.

An LLC properly formed under statute will lack the corporate characteristic of continuity of life so long as the Operating Agreement requires at least a majority in interest of the members to vote to continue the business of the LLC after a dissolution caused by the withdrawal of a member.

The second corporate attribute that the IRS has found to be lacking in LLCs is free transferability of interests. Here the IRS is concerned not with the assignability of the economics of the membership interest but rather the right to admit a new member to the LLC.

If an LLC statute requires the unanimous vote of the members in order to admit a new member, than the LLC lacks the corporate characteristic of free transferability of interests.

The recent IRS rulings have found that free transferability of interests is also lacking where a mere majority of the members may vote to admit a new member. Most statutes require unanimity of the members to admit a new member, but this may be reduced under the provisions of the Operating Agreement.

CONVERSION OF PARTNERSHIP

Existing partnerships may be converted to LLCs without adverse tax consequences.

S and C corporations cannot be converted to LLCs without adverse tax consequences at the corporate and shareholder levels.

SECURITIES IMPLICATIONS

Membership interests in LLCs constitute securities so that the registration requirements of state securities laws must be satisfied.

LLCs provide an attractive new form of business entity, particularly for real estate and closely held businesses. In many cases, LLCs will be selected as the preferred form of entity over general partnerships, limited partnerships, and S corporations. However, in each case, a careful analysis of the tax and other attributes should be made before reaching a final decision as to which form of entity is best suited for the particular business entity to be formed.

PARTNERSHIPS WITH LIMITED LIABILITY

A general partnership (such as in Ohio) may become a “registered partnership having limited liability” by filing with the Secretary of State a registration application containing the following information:

1. Name.
2. Address of principal office.
3. Number of partners.
4. Description of business.
5. Statement that the partnership is applying for status as a registered partnership having limited liability.

The registration application must be executed by a majority in interest of the partners or one or more partners authorized by the partnership to execute the registration application. Upon filing the registration application and the payment of a fee, the Secretary of State is required to register any partnership that has complied with the above filing requirements as a registered partnership having limited liability.

A registered partnership having limited liability must include in its name the words “registered partnership having limited liability” or the abbreviation “P.L.L.” or “PLL.”

Once the registration for a registered partnership having limited liability has been filed, it is effective until voluntarily withdrawn by the filing with the Secretary of State of a written withdrawal notice. Changes in the information contained in the registration application occurring after the filing of the registration application does not affect the status of the partnership having limited liability.

LIMITED LIABILITY OF PARTNERS

A partner in a registered partnership having limited liability is not jointly or severally liable for the partnership liabilities that are allegedly caused by an act or omission of another partner in the partnership or an employee, agent, or other representative of the partnership unless the partner has direct supervision or control over the other partner or that employee, agent or other representative of the partnership.

The partner in a registered partnership, having limited liability does not have immunity from liability that is caused by his or her own actions or omissions.

REPORTING REQUIREMENTS

Annual reports are required to be filed by a registered partnership having limited liability with the Secretary of State verifying, and, if necessary, updating the information contained in the original registration application. The annual reports are to be made on a form prescribed and furnished by the state and signed by a majority in interest of the partners or one or more partners authorized by the partnership to execute such report.

Failure to file the annual report after notice could result in cancellation of the registration by the partnership. A canceled registration may be reinstated by filing an application for reinstatement, together with the required reports and paying the reinstatement fee.

ATTORNEYS

In most states, attorneys will not be able to avail themselves of the immunity from liabilities provided by registered partnerships having limited liability.

THE IMPORTANCE OF LEGAL COUNSEL

For more information about formation and use of LLCs or registered partnerships having limited liability, please consult local counsel who specializes in this area. The above information is not intended as legal advice. Readers should not act upon the information contained in it without professional counsel.

Source: Tax Facts 2002, National Underwriter Company