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CORPORATE LIABILITY.
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Compares the tax & legal advantages of 3 forms of organization for business companies.... More...
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Paper Abstract:
Compares the tax & legal advantages of 3 forms of organization for business companies. LLC (limited legal liability), LLP (limited liability partnership, & traditional S corporations. Examines changes in business law. Partnership laws. Small business. Bibliography includes laws, codes, regulations, statutes. Business law & law review articles.
Paper Introduction:
Corporate Liability
Introduction
Traditionally, businesses, other than sole proprietorships, considered three forms of organization: C corporation, S corporation and partnership. However, during the 1970s, a form of organization known as a limited liability company (LLC) became available. Now, even more recently, the limited liability partnership (LLP) is also available. Generally, limited liability business structures allow two benefits: limited legal liability and passthrough tax treatment. This paper will consider the tax and legal advantages of the LLC and the LLP versus the more traditional S corporation.
Limited Liability Corporations
Beginning with Wyoming in 1977 and ending with the Hawaii legislature in 1996, al
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[xxxii] Ibid. [lxxi] Ibid. "Limited Liability Companies: Features and Uses." TheCPA Journal Online. Endnotes ----------------------- [i] Sharon Kanovsky, "LLPs: A New Form of Organization." The TaxAdviser (July 1994): 4 9. [cii] Ibid. Rev. Stat. [cv] I.R.S. First, thedebts, obligations and liabilities of a company are solely those of thecompany and not the individual members of managers, regardless of whetherthese obligations arise in contract, tort, or otherwise.[xxxviii] Second, amember or manager is not personally liable for company debts, obligationsand liabilities solely by reason of being or acting as a member ormanager.[xxxix] Bishop concludes that together these two provisions makeclear that a member of manager is not personally responsible for a LLC'sobligations.[xl] Thus, once it is determined that any given obligationbelongs to the LLC rather than to one of its members or managerspersonally, the LLC is solely responsible for the obligation.[xli]Furthermore, section 4 3(a) of the ULLCA holds that an LLC must reimburseor indemnify a member or manager for payments and liabilities the member ormanager incurred in the ordinary course of company's business or for thepreservation of its property. Memberdissociation may occur without the dissolution of the LLC.[xxi] Anothersignificant distinction that should be made in the articles for purposes ofdissociation is whether the LLC is a manager-managed or member-managedcompany.[xxii] Finally, the articles should specify whether one or more members ofthe company are liable for all or specified debts of the company.[xxiii] Ifthe articles do not so specify, then a full liability shield protects allmembers.[xxiv] Bishop notes that an LLC possesses the federal taxclassification corporate characteristic of limited liability because itsmembers are not personally liable for the company's debts and obligationsmerely because they own the company.[xxv] However, he notes that section5. Ann § 29-244E(West Supp. In addition, the amendments relatedto trust and charitable organization ownership of S corporations will allowfor additional flexibility and creativity in both estate and non-profitorganization planning.[cxliv] Comparisons For each form of business entity discussed above, there are certainstatutory restrictions that may determine what type of organization a givenbusiness can form. Notice 95-14, 1995-14 I.R.B. § 3 1.77 1-2(a)(3) (1995). State Statutes Ariz. [lxxxii] Ibid., §§ 3 6(c), 4 1(b). 75 (1996): 1143. 273, 1993). § 3 1.77 1-2(a)(3) (1995). [l] Ibid., 93. If the partners executing and filing the statement exceed theirauthority, the internal abuse of authority has no effect on the liabilityshield with regard to third parties. [cxxxviii] Reg. [clii] Ibid. Code Ann. [lxxxvi] Ibid. For example, a group of automobile mechanics could findthemselves subject to personal liability for damages incurred by a carowner even though they had no way to supervise or control the negligentpartner's acts.[xcv] Nonetheless, the statutes generally provide that the limitation ofliability will not affect the liability of a partner who commits a wrongfulact giving rise to liability or a partner who is supervising the agent ofthe partnership who commits the wrongful act.[xcvi] For example, section3 6(c) of RUPA provides for a corporate-style liability shield thatprotects partners from vicarious personal liability for all partnershipobligations incurred while a partnership is a limited liabilitypartnership. Jenkins, Michael, "Everything You Ever Wanted to Know (And ProbablyMore) About Limited Liability Companies and Limited LiabilityPartnerships." Internet. § 1361. In closely held firms, thevoting agreements serve to combine tightly management and control.[li]However, in the case of an LLC, an operating agreement is optional.[lii]Furthermore, the agreement need not be in writing.[liii]Limited Liability Partnerships The principal impetus in the enactment of LLP legislation was theattempt to limit vicarious liability to third parties, particularly withrespect to malpractice claims.[liv] Generally, in an LLP, the liability ofa partner or the partnership is no longer joint and several among thepartners.[lv] Thus, partners are not liable for the negligence, wrongfulacts and misconduct of other partners and partnership employees, agents andrepresentatives.[lvi] However, a partner does remain liable for his conductand the conduct of those under his direct supervision, as well as for anycommercial debts of the partnership.[lvii] Thus, the most significantaspect of an LLP is that it gives businesses the option to organize as ageneral partnership while insulating the general partners from some of therisks of personal liability.[lviii] The Texas business law amendments of 1991 contained the original LLPprovisions as part of a major revision of Texas Business law.[lix] Thelanguage of the Texas law is instructive. [xciii] Goforth, 1151 [xciv] Ibid., 115 . (Treasury Regulation). [lxvi] RUPA, § 1 1(c)(1)-(5). [clxi] Schorr, Internet. Ann. 278, Tex. It islikely that such reservations will recede as LLPs become a more acceptedform of business entity. [clxv] Ibid. Bishop notes that the ULLCA clearly contemplates that an affectedthird party may attempt to pierce an LLC's liability shield to createpersonal liability to members for company debts, obligations andliabilities.[xlii] However, the statute provides that a company's failureto observe the usual formalities is not grounds for piercing the liabilityshield.[xliii] Although the statute does not define "usual," Bishopmaintains that the term would probably defined objectively according to thelevel of formality for similarly situated companies.[xliv] However, theULLCA liability shield primarily cuts off a member's vicarious personalliability. stillprohibit one-member LLCs. Income is allocated and taxed toshareholders under their individual income tax regardless of whether thereis any actual distribution of profits. Corporate LiabilityIntroduction Traditionally, businesses, other than sole proprietorships,considered three forms of organization: C corporation, S corporation andpartnership.[i] However, during the 197 s, a form of organization known asa limited liability company (LLC) became available. 4 of Revenue Procedure 95-1 [xxvi] provides that an LLC does not limitsits members liability when at least one member is personally liable for thecompany's obligations.[xxvii] That member is granted express authority forliability in the relevant state statute when the member has a net worthequal to 1 percent of the company's total contributions.[xxviii] Suchtreatment of liability by the ULLCA demonstrates one of the ways in whichthe LLC operates like the more traditional form of limited partnership. Kanovsky, Sharon, "LLPs: A New Form of Organization." The Tax Adviser(July 1994): 4 9. [liii] Ibid. Rev. Stat. R.I. 112(a), 2 2(a), respectively. United States Code 26 U.S.C.A. Code Ann. Paul: West Publishing, 1996): 317. [xcv] Ibid., 1151. [lxix] Ibid., citing e.g., Cal. Rev. Stat. Generally, classification as a partnership or corporation for federalincome tax purposes is made by reference to section 77 1 of the InternalRevenue Code (IRC), as amended, and the Treasury Regulations promulgatedunder that section.[vi] Traditionally, Treasury Regulations sections3 1.77 1-2 identified six characteristics that indicate corporate status:1) the presence of associates, 2) an objective to carry on business anddivide the gains, 3) continuity of life, 4) free transferability ofinterests, 5) centralization of management, and 6) limited liability.[vii]An unincorporated organization such as an LLC was treated as a corporationfor federal tax purposes if it had more corporate than non-corporatecharacteristics.[viii] However, because partnerships and corporationspossessed associates and business objectives, and LLCs inherently possessedlimited liability, those characteristics were not considered whendetermining an LLC's corporate or non-corporate status for federal taxpurposes. Stat. Schorr, Brian. Thus, thefirst step for any business seeking to organize must be a check of federaland state regulations to ensure its intended structure and purpose do notviolate the laws governing the type of business entity it wishes to form. Comments to the section note that the complete liabilityshield comports with the modern trend among the states.[xcvii] However,most states have adopted a partial liability shield that protects partnersonly from vicarious personal liability for partnership obligations arisingfrom negligence, wrongful acts or misconduct, whether characterized astort, contract or otherwise, committed while the partnership is anLLP.[xcviii] RUPA does not alter a partner's liability for personal misconduct anddoes not alter the normal partnership rules regarding a partner's right toindemnification from the partnership.[xcix] (Section 4 1(c)). Generally, the LLP was created in response to the need for anunincorporated business entity that afforded limited liability to itsowners while having the benefit of a well-established regulatoryenvironment.[clxxii] This form of organization is probably most comfortablefor professional service organizations, which traditionally have beenoperating as general and limited partnerships. [viii] Ibid. [xc] RUPA, § 3 1(b). [clxii] Ibid. [cxxi] H.R. See also Va. 1994)(requiring an LLP to carry at least $1 million ofliability insurance to cover incidents for which liability is limited underlegislation). [li] Ibid. Colo. [xii] Ibid. [xx] Ibid., § 2 3(a)(5). [xxx] Jenkins, Internet. § 5 -15(B)(Michie1994)(shielding actions "sounding in tort, contract, or otherwise, arisingfrom negligence, malpractice, wrongful acts or misconduct"). [xxi] Gary Bishop, "The Uniform Limited Liability Company Act: Summary& Analysis." The Business Lawyer 51 (November 1995): 56. [xlix] Larry Ribstein, "Limited Liability and Theories of theCorporation." Maryland Law Review 5 (1991): 92. 6132b (amended Tex.H.B. [cxxiv] Peddie, Internet. 95-55, 1995-35 I.R.B. [xli] Ibid. [lxxviii] Ibid. Keatinge, Robert, Donn, Allan, Coleman, George and Hester, Elizabeth,"Limited Liability Partnerships: The Next Step in the Evolution of theUnincorporated Business Organization." The Business Lawyer 51 (November1995): 159. On the other hand, if a business entity incorporates togain limited liability, it becomes subject to numerous federal and stateincome and franchise tax burdens, plus much more complicated tax compliancerequirements. [clviii] Ibid. 2 . [lxxxix] Ibid. [xxxiii] Ibid. Stat. LLCs also generally allow that a member's rights to profits aregenerally freely transferable, thus providing some degree ofliquidity.[clxviii] Schorr notes that while similar provisions may be foundin the partnership laws, S corporations often require highly complex andheavily negotiated shareholders' agreements to restrict freetransferability of ownership interests. This does allow for some control over membershipinterests, which would be beneficial to a company seeking such control butnot needing the strict control of a closely held firm. State law, with federal law playing catch-up hasgenerally driven these changes. [iv] Schorr, Internet. 95-55, 1995-35 I.R.B. [cx] Ibid. Professional organizations tend to prefer LLPs because an LLP is ageneral partnership rather than a separate organization.[cxlvi] An LLP is apartnership for purposes of state law and, in theory, subject to all non-tax rules and statutes applicable to partnerships.[cxlvii] The LLP mayregister without having to create an entirely new organization or negotiatenew organizational documents.[cxlviii] Also, the rules developed forpartnerships will be applied to LLPs, rather those developed forLLCs.[cxlix] Keatinge et. The act reasons that when partners vote to become an LLP, theyclearly intend to sever their personal responsibility to make contributionsto the partnership when partnership assets are insufficient to coverpartnership indemnification obligations.[lxxxix] Thus, section 3 6(c)automatically amends the partnership agreement to shield the partners frompersonal liability for contribution obligations that may have existed underthe partnership agreement as it existed before the vote. In many states, an LLP offers only very limitedprotection, insulating only against the liability arising from malpracticecommitted by another partner in the firm, and does not confer generalprotection against trade creditors or against other liabilities of the LLP,as a rule. al., 2 4. [lxxxviii] Ibid. 3448 (1996). 6 § 1544(e) (1993). [xcii] Keatinge, 158. [cxx] Ibid. Once a business entity determines that its structure and purpose donot violate the governing laws, there still remain numerous substantiveissues that should be considered when deciding what form of business entityis best suited for their organization. Art. 3448 (1996). In addition, the IRS ruled that a one-owner LLCwould be taxed as a corporation in all instances.[ix] Given theserequirements, few businesses and tax lawyers were willing to attempt to setup LLCs for their small business clients.[x] However, following the 1988 Revenue Ruling and the drafting of theUniform Limited Liability Company Act (ULLCA) in 1994, the IRS has shownmore acceptance and favorable tax treatment of the LLC. Conclusion Since Wyoming adopted the first LLC statute in 1977, business law hasundergone massive changes. [vii] Ibid. Another advantage of LLCs is that their organization allowstheir members to limit their liability for all debts or claims against thecompany. The NCCUSL drafted the relevant sections of RUPA in 1995 after moststates had already adopted LLP statutes, and consequently, it serves as agood example of what is included in such statutes. tit. [c] Ibid. Accordingly, Schorr argues that an LLC organized under a statutewith such a provision may be viewed as an attractive "special purposevehicle" to be used in structured finance, monetization or factoringtransactions, now typically set up using off-shore vehicles, or DelawareBusiness Trusts.[clxx] He also maintains that given these conditions, anLLC would be an ideal entity to issue debt securities or short-termcommercial paper for business financing transactions.[clxxi] Nonetheless, LLCs still provide more protection against vicariousliability than do LLPs. [lxxvii] RUPA, § 1 1(f), notes accompanying. However, LLC statutesdo often provide that a member may not transfer his or her membershipinterest without the consent of a significant percentage interest of theremaining members. § 1.1367-1(c). [clxiii] Ibid. [cvi] 26 C.F.R. [lxxiii] Ibid. Notice 95-14, 1995-14 I.R.B. [ciii] Ibid. [lxxxiii] Ibid. [xix] Ibid., §§ 2 3(a)(1)-(4). [xxxix] Ibid. [cxxxi] Burke, 326-327. [cxxii] Peddie, Internet. And each organization shoulddetermine that its state of organization does recognize one-member LLCs ifthe information would be relevant to its organization. Instead, the newregulations allow an LLC to choose whether it wishes to be taxed as apartnership or a corporation simply by filing an IRS Form 8832 and"checking the box" as to what kind of taxable entity it wants to be.[xxx]These new regulations also allow one-member LLCs to be treated as a soleproprietorship rather than as a corporation for tax purposes.[xxxi] Generally, the 1997 regulations provide that the IRS will treat anybusiness entity formed after the enactment of the new provisions, excludingcorporations and, in most cases, banks, as a partnership unless its memberselect to be treated as a corporation.[xxxii] An existing eligible entitycan elect non-corporate status by filing Form 8832 and specifying the dateon which the election is to become effective.[xxxiii] A one-member non-corporate entity such as a one-member LLC will not be treated as an entityseparate from its owner unless the owner elects corporate tax treatment.Thus, the IRS will treat a sole proprietorship that becomes an LLC as asole proprietorship and an LLC set up by a corporation will be treated as abranch or division of the corporation rather than as a separate legalentity.[xxxiv] Thus, under the UCLLA as amended, there is very little reason for anybusiness with more than one owner to operate as a partnership without theprotection of limited liability.[xxxv] Also, following the new IRSregulations, most of the states will drop the requirement that an LLC haveat least two members.[xxxvi] Consequently, it generally makes good businesssense for almost any sole proprietor to become an LLC, since the IRS willignore the existence of the LLC and continue to treat its income as beingearned by a sole proprietorship. Nonetheless, Peddie argues that the 1996 amendments to Subchapter Shave increased the availability of flow-through taxation for manycorporations, including banks.[cxlii] He also maintains that businessplanners will now be able to consider using the S corporation as a vehiclefor holding wholly-owned subsidiaries.[cxliii] This is a significant factbecause it means business planners must consider the viability of the Scorporation as amended versus the LLC. Ann. Rev. Stat. [iii] Michael Jenkins, "Everything You Ever Wanted to Know (AndProbably More) About Limited Liability Companies and Limited LiabilityPartnerships." Internet. [xliii] ULLCA, § 3 3(b). [xlvi] Ibid., § 4 2(a). 2 . al., 188. 7. [xci] Goforth, 115 . 95-1 , 1995-3 I.R.B. [xxxviii] ULLCA, § 3 3(a). [lviii] Goforth, 1143. Gary Bishop, "The Uniform Limited Liability Company Act:Summary & Analysis." The Business Lawyer 51 (November 1995): 56. § 1366(b); Burke, 327. Revenue Rulings Rev. Rul. This will be discussed infurther detail in the section titled "S Corporations." [xxxvi] Ibid. [xxvii] Ibid. Generally, RUPA's LLPprovisions amended the act to deal with four major issues: (1) the scope ofa partner's liability shield; (2) the voting requirement to become an LLP;(3) the effect of becoming an LLP on the partnership agreement; and (4) theannual filing requirement. [cxxiii] 26 U.S.C.A. [cxlvii] Ibid., 2 3. [cxxvi] H.R. RUPA notes that the unanimous vote default rule reflectsthe significance of a partnership becoming a limited liabilitypartnership.[lxxxii] Where the agreement includes several amendment votesdepending on the nature of the amendment, each member's contributionobligations will determine what vote is required because those obligationsare the most affected by the amendments.[lxxxiii] Most states currentlyconsider the required vote to become an LLP to be an ordinary partnershipdecision requiring only majority consent.[lxxxiv] RUPA advises that each partner should consider his or her own personalliability when deciding whether to form an LLP.[lxxxv] Should partnershipassets be insufficient to indemnify a partner for an LLP obligation, eachpartner forfeits a right to receive contributions from other partners inexchange for being relieved of the obligation to contribute to the personalliability of other partners.[lxxxvi] Each partner's decision should bebased on the size and business of the partnership, the number of partners,the amount of insurance, and the relative risk of each partner's businesspractice compared to fellow partners.[lxxxvii] RUPA adopts the voterequired to amend the partnership agreement in special and general cases toallow for these varying interests.[lxxxviii] RUPA section 3 6(c) provides that when a partnership becomes an LLP,limited liability applies despite any inconsistent provisions of thepartnership agreement existing immediately before the vote to become an LLPwas taken. [xlviii] Ibid., § 4 7. now recognize an entity called the LLP.[lxi] Inaddition, the National Conference of Commissioners on Uniform State Laws(NCCUSL) amended the Revised Uniform Partnership Act (RUPA) to includelimited liability provisions.[lxii] For ease of discussion, this paper willrefer primarily to the LLP provisions of the Revised Uniform PartnershipAct (RUPA). [cxliv] Ibid. Code of Federal Regulations 26 C.F.R. For example, traditional partnerships offered limited liability totheir limited partners.[xii] However, a limited partnership was required tohave at least one general partner who was fully liable for the debts of thebusiness. [ii] Ibid. (December 1992). For example, some states prevent professional serviceorganizations from forming as LLPs. [clxvii] Ibid. Michael Jenkins, anattorney and CPA who drafts software to aid businesses in forming their ownlimited liability business structures, claims that LLCs now offer smallbusinesses a "very attractive new alternative that every small business,including the smallest home-based business, should now consider."[xi]Jenkins notes that LLCs resemble and are usually taxed as partnerships butthey offer the advantages of limited liability formerly reserved only forcorporations. [lxxx] Gorforth, 1146 citing e.g., Del. In other cases, a business entity with more than oneclass of stock will not be able to elect S corporation status. [lix] Keatinge, 159. [cxxvii] Peddie, Internet. National Conference of Commissioners on Uniform State Laws,Revised Uniform Partnership Act (RUPA) § 3 6 (1997). [clv] Goforth, 1151. [xiii] Ibid. 1996). H.B. §§ 1361-1379 (1958, as amended). Code Ann. Karen Burke notes that this provision is intended to deny Scorporations the benefits of provisions applicable to C corporations whenit would be inconsistent with pass-through treatment.[cxix] Thus, Burke notes, S corporations combine the advantages of corporatebusiness form with those of a single-level income tax. [xxv] Bishop, 57. However, in recentyears, with the adoption of uniform laws to guide states in the creationand amendment of their statutes, the laws are beginning to take on someconsistency. [xxix] Ibid., citing 1995-14 I.R.B. [cl] Ibid., 2 4. [cliv] Keatinge et. S corporation status may be preferable to an LLC forprofessional firms because profits not paid out by an S corporation assalary are not be subject to self-employment tax. It states that partners in aTexas LLP are not liable for: errors, omissions, negligence, incompetence, or malfeasance committed in the course of the partnership business by another partner or a representative of the partnership not working under the supervision or direction of the first partner at the time the errors, omissions, negligence, incompetence, malfeasance occurred, unless the first partner: (a) was directly involved in the specific activity in which the errors, omissions, negligence, incompetence, or malfeasance were committed by the other partner or representative; or (b) had notice of knowledge of the errors, omissions, negligence, incompetence, or malfeasance by the other partner or representative at the time of the occurrence.[lx] Subsequently, Louisiana enacted an LLP statute and currently all 5 states and Washington, D.C. Thus, the creation of laws governing LLPsand LLCs has been haphazard and often inconsistent. [lxxii] Ibid., §§ 1 5(d), 1 3(e). Tex. [cvii] Keatinge et. al. 1996). http://www.roninsoft.com/llc.htm. [cix] Rev. Rul. [clxix] Ibid. [xxii] Ibid. Gen. [x] Jenkins, Internet. [xviii] Ibid., §§ 2 3(a) an (b), 2 5(a)(3). [ix] Ibid. Ann. § 1361(a)(1). (St. [xvi] Ibid., §§. [cxlviii] Ibid., 161. Peddie, Richard Byron, "Small Business Job Protection Act Creates NewOpportunities For S Corporations." Internet,http://www.frascona.com/resource/rbp497sb.htm. 1994). § 7-6 -144(2) (Bradford Cum. Articles, Law Reviews Bishop, Gary. Ann. Laws § 7-16-3 (Supp. Internet. No. [xcvii] RUPA, § 3 6(c), comments following. The conversion to an LLC may also have burdensometax consequences for an organization. [lxxxi] RUPA, § 1 1(b). [cxxxvii] Ibid. [clxvi] Ibid. Goforth, Carol, "Limiting the Liability of General Partners in LLPs:An Analysis of Statutory Alternatives." Oregon Law Review. [xcix] Ibid., § 4 1(c). [cviii] Ibid. tit. 273, 1993). [xxiv] Ibid., § 3 3(c). No. [clxxii] Ibid. Tit. [lxxix] Ibid., § 1 1(g). Goforth points out that Rhode Island expressly excludesfrom the permissible purposes of LLCs the provision of professionalservices. Revenue Procedures Rev. Proc. Therefore, the required vote equals the vote required to amendthe partnership agreement.[lxxxi] When the agreement is silent, the votemust be unanimous. [xxiii] § 2 3(a)(7). [lvii] Ibid. [lvi] Ibid. [cxvi] Peddie, Internet. [cxlvi] Keatinge et. [ci] Keatinge et. [xxviii] Ibid. al., 16 . [xlii] Ibid., 6 . [cxxxvi] Burke, 327. [cxxviii] Ibid. Rev. Civ. [lxxvi] Ibid. note that among the rules that appear todevelop differently for partnerships and LLCs include worker's compensationand Housing and Urban Development lending regulations.[cl] Regarding realestate in particular, because registration constitutes a change in theexisting organization rather than a transformation to a new organization,it provides greater assurance the change to an association providinglimited liability will not trigger due on sale and real estate transfertaxes.[cli] However, an LLP is not as flexible as an LLC because an LLP must beorganized for profit, must have at least two members, and is subject todissolution on the dissociation of a member to the same extent as a generalpartnership.[clii] Nonetheless, many professional firms have traditionallyoperated in the partnership format and may be reluctant to alter theirways.[cliii] Generally, an LLP is subject to the same internal rules as ageneral partnership except with respect to contributions andindemnification.[cliv] In addition, Goforth notes that there are problems with the otheroptions available to professional-service providers. Art. [lxii] National Conference of Commissioners on Uniform State Laws,Revised Uniform Partnership Act (RUPA) § 3 6 (1997) [lxiii] RUPA § 1 1(d). 13. H.B. However, thepartners may subsequently amend the partnership agreement again toreestablish contribution obligations.[xc] The LLP is a business form that would seem particularly attractive toservice-oriented partnerships.[xci] Many such partnerships are composed ofprofessionals such as attorneys, accountants or medical practitioners.Since the liability explosion of the mid-198 s, the accounting industry wasseeking a way to limit vicarious liability, particularly for large, multi-state firms.[xcii] In the case of law firms, a partner or associatenegligently commits professional malpractice and other partners, includingthose who specialize in different areas of the law or have differentclients or work out of different branches, were held personally liable forsuch malpractice.[xciii] Thus, the wave of personal liability imposed on partners inprofessional partnerships for misconduct of others over whom they had nocontrol was the driving force behind the LLP legislation.[xciv] Goforthnotes also that the same fact patterns that affected the accounting andlegal professions could arise in many non-professional service-orientedpartnerships. [cxiii] 26 U.S.C.A. § 5 -15(B)(Michie 1994). [cxxxv] Generally, the cost of acquiring an asset. 6 (Supp. [xxxv] Ibid. [lv] Kanovsky, 4 9. No. [clxiv] Ibid. 278, Tex. Corp. Supp. Thus, Karen Burke notes that LLCs may undermine the viability ofSubchapter S. § 7-6 -144(2) (Bradford Cum. 75 (1996): 1143. [cxl] Burke, 349. [lxxxiv] Ibid., comment accompanying section. [lxvii] Goforth, 1145,citing e.g., Ariz. Thus, service organizations in suchstates may prefer to remain as professional associations or limited orgeneral partnerships. [xxxiv] Ibid. The organization must alsopay a required filing fee. [cxxx] Ibid., § 1363(b). [cxlix] Ibid., 2 3. [xiv] National Conference of Commissioners on Uniform State Laws,Uniform Limited Liability Company Act (1996). (December 1992). However, some state barassociations initially have expressed some reservations about thelimitation of liability for professional service organizations. Carol Goforth, "Limiting the Liability of GeneralPartners in LLPs: An Analysis of Statutory Alternatives." Oregon LawReview. Section 1 1(2) defines an at-willcompany as any LLC other than a term company. She contends that theinflexibility of this corporate form makes it less than ideal for manyservice firms.[clvii] Goforth also notes that the LLC is also subject to some drawbacks.First, LLCs may be subject to special fees, taxes, or restrictions that maymake them unsuitable or undesirable for certain businesses.[clviii] Shedemonstrates, for example, that some states still preclude all or someprofessionals from utilizing the LLC form of business.[clix] Additionally,there may be other problems with the LLC business form because it is so newand some issues such as securities law treatment and various tax issueshave not been fully dealt with.[clx] Also, Brian Schorr notes that while S corporations, LLPs, and LLCs allallow for federal pass-through tax treatment, a LLC is more flexible andhas certain advantages compared to an LLP or an S corporation.[clxi] Forexample, all members of an LLC may actively participate in the managementof an LLCs business. [lii] ULLCA, § 1 3(a). Code Ann. Comments accompanying section. Partners may challenge the abuse ofauthority for purposes of establishing the liability of the culpablepartners but may not effect the liability shield as to third parties.Likewise, third parties may not challenge the existence of the liabilityshield because the decision to file the statement lacked the propervote.[lxxviii] Generally, in most states and under RUPA, the filing of a statement ofqualification establishes that a partnership has satisfied all conditionsprecedent to the qualification of the partnership as a limited liabilitypartnership.[lxxix] However, in several states, achieving LLP status isconditioned upon maintaining certain required levels of insurance or beingable to demonstrate a minimum level of financial responsibility.[lxxx] RUPA section 1 1(b) provides that the decision to become an LLP is amajor partnership event equivalent to an amendment of the partnershipagreement. [lxxxvii] Ibid. However, Jenkins notes there are situations where certaincorporate tax advantages may outweigh such disadvantages, as in the case ofS corporation status. [cxli] Ibid. Consequently,the primary effect of its liability shield is to sever a partner's personalliability to contribute to the partnership when partnership assets areinsufficient to cover its indemnification obligation to a partner whoincurs a partnership obligation in the ordinary course of the partnership'sbusiness.[c] In a partnership, each partner has an obligation to indemnify eachother partner for obligations rising out of the partner's simple negligenceor for which the partner is responsible.[ci] Each partner who is directlyliable as a result of that partner's negligence or responsibility as a"responsible partner" may look to all the partners for indemnification inthe event of a simple mistake or some other personal liability.[cii] As aresult, each responsible partner may have the added security of having theindividual assets of his or her partners as additional protection against amassive claim.[ciii] However, in an LLP, each partner gives up this rightto look to the other partners for indemnification.[civ] Tax Treatment of LLPs As were LLCs, LLPs also come under Notice 94-14, by which the TreasuryDepartment allowed most unincorporated associations to elect to be treatedas partnerships or corporate associations at the election of themembers.[cv] LLPs qualify rather easily under the Treasury Regulations[cvi]because they are required to carry on a business as co-owners for a profitand have at least two members.[cvii] Further, the Regulations provide thata general partnership subject to a statute corresponding to the RUPA willlack all four of the corporate characteristics.[cviii] Revenue Ruling 95-55 noted that where the partners had not agreed tobe liable for any of the LLP's obligations, the LLP had the corporatecharacteristic of limited liability even though each partner remainedliable for any negligent or wrongful act committed by that partner or anyperson under that partner's direct supervision and control in renderingprofessional services.[cix] The LLP, however, lacked the corporatecharacteristic of centralized management because the mutual agencyrelationship between the partners precluded effective concentration ofmanagement powers.[cx] Finally, the LLP lacked continuity of life becausethe LLP could have dissolved without violation of the partnership agreementby the express will of any partner where no definite term or particularundertaking was specified or in violation of the agreement by the expresswill of any partner at any time.[cxi] The LLP lacked three of the fourcorporate characteristics and therefore would be taxed as apartnership.[cxii] S Corporation An S corporation is defined as a "small business corporation" forwhich a Subchapter S election is in effect.[cxiii] One of the biggestdrawbacks to forming a corporation has been that corporations are requiredto pay taxes on any profits and the shareholders also pay taxes upon thedistribution of dividends.[cxiv] Thus, corporations are subject to "doubletaxation." Subchapter S of the IRC[cxv] eliminates the federal income taxlevied against certain qualifying small business corporations by taxing Scorporations under partnership rules. 6 §1546(a)(Supp. Paul: West Publishing, 1996): 317. He argues that this feature makesthe LLC particularly attractive for family businesses that desire controlto be preserved within the family or among certain family members, forprofessionals, and for businesses controlled by investor groups interestedin maintaining control of the business.[clxix] Also, certain LLC statutes specifically provide that creditors ofmembers may not reach LLC assets in satisfaction of members' personalclaims. [clix] Ibid. Consequently, to ensure partnership status, LLCs had to ensurethey lacked at least two of the three remaining corporate characteristics,i.e., continuity of life, free transferability of interests, andcentralized management. [clxxi] Ibid. Bibliography Uniform Laws National Conference of Commissioners on Uniform State Laws, UniformLimited Liability Company Act (1996). Carol Goforth states that RLLLPs raise thesame issues as LLPs because an LLLP is a limited partnership where thegeneral partners have the same personal liability protections as generalpartners in an LLP. 7. [xlv] ULLCA, § 4 3(a). 1996); Del. §§ 1361-1379 (1958, as amended). [lxi] Some states have also recognized a registered limited liabilitylimited partnership (RLLLP). § 1.1367-1. LLCs now remove that requirement.[xiii] For ease of discussion, this paper will discuss the Uniform LimitedLiability Company Act adopted by the National Conference on Commissionerson Uniform State Laws.[xiv] Organizing an LLC An LLC is a legal entity distinct from its one or more memberowners.[xv] Its members may create an LLC for any lawful purpose bydelivering its articles of organization to the office of the Secretary ofState or similar state official for filing.[xvi] Filing the articles by theSecretary of State serves as conclusive proof that all conditions necessaryfor the creation of the LLC have been satisfied.[xvii] These articles mustset forth certain information and must be signed by a person organizing theLLC.[xviii] The articles organizing a LLC must include the name of the company,the address of its designated office, the name and address of its initialservice agent, and the name and address of each organizer.[xix] Thearticles should also specify that the organization is being created for aspecified term or the company will be created as an at-will company.[xx]Section 1 1(19) of the ULLCA defines a "term company" as an LLC in whichits members have agreed to remain members until a certain length of timespecified in the articles expires. [cxxxix] Reg. Michael Jenkins claimsenthusiastically that it may soon become standard practice for any form ofbusiness, including sole proprietorships, partnerships or corporations, tocreate separate LLCs for any new and additional business ventures so thatthe failure of the new venture does not devastate the entire company.[cxlv]However, LLCs remain inappropriate for closely held firms because of thestate filing requirement. [cxxxiv] Ibid. [v] Ibid. In short, the sole proprietorship gainsthe benefits of limited liability without any increase in its federal taxcompliance chores or any changes in its tax liability.[xxxvii] The liability shield of an LLC has several components. [clvii] Ibid. [cxxix] 26 U.S.C.A. Ibid. [cxlv] Jenkins, Internet. Currently, only Massachusetts and Washington, D.C. [clxx] Ibid. [cxii] Ibid. Jenkins advises, however, that a change from corporateto non-corporate status would be the equivalent of a corporate liquidation,with potential capital gains or other taxable income resulting at both thecorporate and owner level at the time of such a change. [lx] Tex. So any member will remain liable for personal obligations such aconduct that violates the duty of care,[xlv] for unpaidcontributions,[xlvi] for false statements in filed records,[xlvii] and forcertain unlawful distributions.[xlviii] Closely Held Firms Larry Ribstein, Professor of Law at George Mason University School ofLaw, argues that the filing requirement for LLCs serves to discourage theadoption of limited liability status for closely held corporations.[xlix]The filing requirement allows the state to retain control over the form ofthe company's organization. [lxxxv] Ibid., prefatory comments. These forms of organization have been popular sincetheir inception and the IRS's recent rulings indicate that it hasrecognized the LLC as an accepted form of organization. 13. Del. Internet. Schorr argues that this feature makes the LLC anespecially attractive business entity for start-up businesses,entrepreneurial businesses with active investors, professional firms, jointventures, and other undertakings where participants seek a high degree ofmanagerial participation without assuming unlimited liability.[clxii] But an LLC can also be structured to provide for centralizedmanagement by a small number of members or managers, and is therefore idealfor passive investments such as investment partnerships and commoditypools, as well as real estate, oil and gas, and theatricalinvestments.[clxiii] The advantages of an LLC over an S corporation wouldseem to be great in such cases, given the relatively stringent restrictionson S corporations discussed above. IRS Notices I.R.S. Ibid., § 2 6(a). al., 197. [cxviii] Ibid., § 1371(a). [xcviii] Ibid. [xxvi] Ibid., citing 1995-3 I.R.B. [cxliii] Ibid. [cxiv] Peddie, Richard Byron, "Small Business Job Protection ActCreates New Opportunities For S Corporations." Internet,http://www.frascona.com/resource/rbp497sb.htm. [cli] Ibid. Ann § 29-244E (West Supp. Corp. This is commonly known as "flow-through" taxation.[cxvi] Thus, Subchapter S[cxvii] is intended to minimize federal income taxconsiderations in deciding whether to conduct a business as a corporation,a partnership, or other entity. [xlvii] Ibid., § 2 9. [xcvi] Keatinge, 186. Va. Burke, Karen, Federal Income Taxation of Corporations andStockholders. (St. Code Ann. Income from an Scorporation's business operations will generally be subject to a singleshareholder-level tax, which is less burdensome than the double-level taximposed on C corporations.[cxx] Subtitle C of the recently enacted SmallBusiness Job Protection Act[cxxi] has liberalized the qualifications for "Scorporations." The result is an expansion of the opportunities and ways inwhich S corporations can be used.[cxxii] Historically, corporations could qualify as S corporations if they hadno more than 35 shareholders, all shareholders were natural persons,estates, and qualifying trusts, no shareholders were nonresident aliens,and the corporation had only one class of stock.[cxxiii] To qualify underthe Subchapter, corporations had to affirmatively elect to be treated as Scorporations by filing Form 2553.[cxxiv] The one-class-of-stock requirementwas intended to ensure that each share of stock represented an equal sharein the profits and assets of the corporation.[cxxv] The 1996 amendments to Subchapter S now allow for a maximum of 75shareholders.[cxxvi] They also allow an S corporation to own up to 1 percent of the stock of a subsidiary, an increase from the 8 percent limitin the previous law.[cxxvii] The Act also relaxes the restrictions on theownership of S corporations by trusts by allowing trusts to hold Scorporation stock and to "spray" S-corporation income among thoseindividuals who are beneficiaries of the trust.[cxxviii] An S corporation's income or loss flows through to a shareholder'staxable year in which the corporation's taxable year ends.[cxxix] Taxableincome of an S corporation flows through to the shareholders and iscalculated as is that of an individual, with some modifications.[cxxx]Under section 1366(a)(1), each shareholder must report his share of thecorporation's separately and non-separately stated items of income, loss,deduction or credit.[cxxxi] Separately stated items are those that couldaffect the tax liability of different shareholders differently based ontheir tax situations.[cxxxii] All other items are combined at the corporatelevel and passed through to shareholders as an item of non-separatelystated net income or loss.[cxxxiii] Each of a shareholder's items istreated as if it were in the hands of the corporation.[cxxxiv] In an S corporation, a shareholder's basis[cxxxv] in the stock anddebt is important in determining the amount of losses and deductions thatcan be passed through as well as the tax treatment of stock, and repaymentor retirement of debt.[cxxxvi] Generally, a shareholder's basis in stockfor the purposes of an S corporation is the amount of cash or the value ofany property contributed to the S corporation, less any liabilities towhich the cash or property is subject.[cxxxvii] Section 1367(a)(1)increases a shareholder's stock basis by separately and non-separatelystated items.[cxxxviii] Section 1367(a)(2) decreases the stock basis byitems of loss and deduction, including corporate distributions and expenseitems that cannot be capitalized and are not deductible to the corporationin calculating its income.[cxxxix] The principal advantages of an S election are that income frombusiness operations or liquidation will generally be subject to only asingle shareholder level tax.[cxl] An S corporation is less flexible than apartnership with respect to income or loss, but it does offer limitedliability through its corporate form.[cxli] However, the advent of LLCs,LLPs, and LLLPs would seem to offer most of the advantages of an Scorporation without the restrictions on stock requirements and membershiplevels. This distinction issignificant because it affects a member's right to require the LLC topurchase her interest when she dissociates from the company. Generally, a corporation that electsSubchapter S (S corporation) is comparable to a partnership for federalincome tax purposes because the entity's income and losses generally passthrough directly to the shareholders without being separately taxed at theentity level.[cxviii] Section 1371(a)(2) provides that an S corporation inits capacity as a shareholder of another corporation is treated as anindividual. [xvii] Ibid., § 2 2(c). [lxiv] Goforth, 1145. [clx] Ibid. [xxxvii] Ibid. He advises that acorporate business entity should consult a tax adviser before making such achange because the tax consequences can be severe in certain situations. [lxxiv] Ibid. Cal. Ribstein notes that corporation statutes andcase law have historically limited the enforceability of variations fromthe corporate standard for close corporations.[l] In particular, such lawshave limited the power of closely held firms to remove power from the boardof directors through their voting agreements. [cxv] 26 U.S.C.A. LLCs undoubtedly offer great benefits to start-up companies andnumerous other business entities that seek to organize but who need tolimit their liability. § 1.1367-1(b). [liv] Robert Keatinge, Allan Donn, George Coleman and ElizabethHester, "Limited Liability Partnerships: The Next Step in the Evolution ofthe Unincorporated Business Organization." The Business Lawyer 51 (November1995): 174. Ribstein, Larry, "Limited Liability and Theories of the Corporation."Maryland Law Review 5 (1991): 92. However, in 1997, the IRS adopted the "check-the-box" positionexpressed in Revenue Notice 95-14,[xxix] which gave companies less of anincentive to rely on the liability sections of the UCLLA. [cxix] Karen Burke, Federal Income Taxation of Corporations andStockholders. [vi] Brian Schorr, "Limited Liability Companies: Features and Uses."The CPA Journal Online. § 1366(a); Burke, 325. [lxv] Ibid. Now, even morerecently, the limited liability partnership (LLP) is also available.Generally, limited liability business structures allow two benefits:limited legal liability and passthrough tax treatment.[ii] This paper willconsider the tax and legal advantages of the LLC and the LLP versus themore traditional S corporation.Limited Liability Corporations Beginning with Wyoming in 1977 and ending with the Hawaii legislaturein 1996, all 5 states have adopted limited liability company (LLC)laws.[iii] In 1988, the IRS published Revenue Ruling 88-76, whichclassified a Wyoming LLC as a partnership for federal income taxpurposes.[iv] Subsequently, the IRS issued a number of private letterrulings that treated limited liability companies as partnerships.[v]However, the IRS laid down complex requirements that LLCs had to follow ifthey were to avoid being subject to corporate income taxes. H.B. http://www.roninsoft.com/llc.htm. [lxx] RUPA, § 1 1(d). Treasury Regulations Reg. [cxvii] Ibid. [xliv] Bishop, 6 . 1997). [cxxxiii] Burke, 327. Code § 15 49(e) (West Supp.1997); Colo. Rev. Civ. 1994). 6132b (amendedTex. [cxxv] Burke, 319. For example, she notesthat the significant restrictions on S Corporations may render thatalternative unattractive as well.[clv] For example, current rules limit Scorporations to no more than seventy-five shareholders, all of whom must beindividuals who are citizens of the United States.[clvi] In addition, an Scorporation is limited to one class of stock. R.I. 1994). [xxxi] Ibid. [cxi] Ibid. Organizing an LLP As with an LLC, the first step toward organizing as an LLP requiresthe partnership to file a statement of qualification or other form ofapplication with an appropriate state official and register as anLLP.[lxiii] Carol Goforth notes that the filing requirement is consistentwith the general statutory approach toward other forms of businessenterprises that offer owners limited personal liability.[lxiv] Generally,business entities that offer at least some owners limited liability such asLLPs and LLC can only be formed by filing a statement of qualification withthe state.[lxv] RUPA requires that the statement contain the name of the partnership,the street address of the partnership's chief executive office, a statementthat the partnership elects to be a limited liability partnership, and thedeferred effective date, if relevant.[lxvi] A number of states require thata renewal application must be filed annually to continue LLP status.[lxvii]In these states, the liability protections offered by the LLP areterminated if an LLP does not file its annual renewal.[lxviii] However, notall states require an annual filing.[lxix] RUPA provides that a partnership's status as an LLP remains effectiveuntil it is revoked by a vote of the partners or it is canceled by theSecretary of State for the failure to file an annual report or pay therequired annual fees.[lxx] The NCCULS specifically chose not to adopt theannual filing requirement on the basis that such a requirement could meanan operating partnership could have "gaps" in its shield, which wouldcomplicate determinations as to when a partnership obligation belongs tothe shielded LLP or the unshielded partnership.[lxxi] Consequently, RUPA,along with an apparent minority of state statutes, preserves the LLP statusand the partners' liability shield unless the LLP status is revoked by thepartners or canceled by the Secretary of State.[lxxii] In such cases, thepartnership could apply for retroactive resurrection of LLP status with acorrective filing within two years of the breach.[lxxiii] Thus, a partnership that dissolves but whose business is continuedunder a business continuation agreement retains its status as a limitedliability partnership without the need to refile a new statement.[lxxiv]Also, limited liability partnership status remains even though apartnership may be dissolved, wound up, and terminated.[lxxv] Consequently,even after a partnership is terminated, the former partners are notpersonally liable for partnership obligations incurred while thepartnership was an LLP.[lxxvi] Section 1 1(f) provides that once a statement of qualification isexecuted and filed, the partnership assumes the status of a limitedliability partnership. Laws § 7-16-3 (Supp. Gen. [civ] Ibid. [cxlii] Peddie, Internet. [lxxv] Ibid. [clxviii] Ibid. The statute holds that this status is intended to beconclusive with regard to third parties dealing with thepartnership.[lxxvii] It is not intended to affect the rights of partners.For example, a properly executed and filed statement of qualificationconclusively establishes the limited liability shield described in section3 6(c). 7. [xv] ULLCA § 2 1. No. Code § 15 49(e) (West Supp. 1996). [xi] Ibid. [xl] Bishop, 59. Schorr also advocates that the flexibility in allocating income, gain,and loss in a partnership is a significant of an LLP.[clxiv] Because Scorporations are limited in the classes of stock they can hold, an LLC canbe of particular use in place of an S corporation where more than one classof ownership interest is desired.[clxv] Thus, members of an LLC candistinguish between equity interests of employees, investors who are non-managers, or investor who are managers based on the future success of theLLC, a segment of the LLC's business, or the realization of profit or lossupon sale of the LLC or its business.[clxvi] While Schorr argues that an LLC is also an ideal entity for businesseswhere the owners desire to restrict transfer of the ownershipinterests,[clxvii] an LLC is still not an ideal structure for a closelyheld firm that requires tight control of management. [clvi] Ibid. [cliii] Goforth, 1151. [cxxxii] 26 U.S.C.A. Supp. [lxviii] Ibid. These will be discussed in more detail in thefollowing discussion.
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