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Do All States Recognize The LLC?

All 50 states and the District of Columbia have authorized the organization of LLCs in their jurisdiction. Vermont, Massachusetts and Hawaii were the last states to enact LLC acts.

Most LLC acts recognize LLCs formed in other states ("foreign" LLCs), and provide for the registration of the foreign LLC to do business in the state.

What Happens If An LLC Conducts Business In A State That Does Not Recognize Foreign LLCs, Or If The State Questions A Specific Attribute Or Does Not Allow An LLC To Conduct The Specific Business Of The Foreign LLC?

No direct legal precedents answer this question. The concern is demonstrated by Thompson V. Schimitt [274 SW 554, 560, 561 (Tex 1925)], an old case, which addresses the conduct of business by a Massachusetts business trust in Texas. At that time, Texas did not statutorily recognize the business trust entity. The result of that case was disastrous for the owners of the trust. The Texas Supreme Court held that, because the Texas legislature had not authorized the use of a Massachusetts business trust as a legal form of business organization, the trust’s beneficial holders were not shielded from personal liability for the trust’s liabilities due to public policy.

Before the New York LLC Act was adopted, a federal district court in New York "suggested" that the law of the place of origin of an LLC would apply if the LLC was properly organized. This court was analyzing a Lebanese LLC doing business in New York. [Abu-Nasser v Elders Futures, Inc, No 88 Civ 7906, 1991 US Dist LEXIS 3794 (SDNY Mar 28, 1991)] The court thus implied that the foreign LLC would be respected as an LLC in New York; however, the court did not have to reach this conclusion.

Many recent LLC statues provide that the courts in other states should respect their law, but that technically has limited effect. [Merrill, "Treatment of Oregon Limited Liability Companies in States Without Limited Liability Company Statutes," 73 Ore L Rev 43 (1994)]

It is also necessary to review the LLC acts in states where the LLC’s business will be conducted to ensure that those states recognize foreign LLCs, that is, those formed in other states, especially if the LLC is conducting a professional practice, insurance business, or other highly regulated business that may not be authorized in a state that otherwise allows other foreign LLCs to do business.

Can Any Person Or Entity Own An Interest In An LLC?

Yes. Generally, any legally recognized "person" may own an interest in all LLC except a professional LLC in which the ownership rules are more restrictive due to state law, licensing authority rules, or other regulations; however, the relevant LLCact should be consulted. For example, the Missouri statue provides that any person may own an interest in an LLC and defines "person" to include individuals, partnerships, domestic or foreign limited partnerships, domestic or foreign LLCs, domestic or foreign corporations, trusts, business trustee, real estate investment trusts, estates, and other associations or business entities. [Mo Rev Stat 347.015(15)] Uniform Act Sections 201 and 101(18) expand this definition by adding "government, government subdivision agency or instrumentality, or any other legal or commercial entity."

What Are The Differences Between An LLC And A
Limited Partnership (LP)?

LLCs and LPs are very similar. Both must be structured and operated careful ensure that they are taxed as partnerships for federal income tax purposes. However, there are several significant distinctions.

General Partner Liability. While a limited partnership is not subject to the tax code ownership restrictions of an S corporation, a limited partnership must have a least one general partner who or which is able for all of the debts of the partnership. In contrast, all of the members of an LLC normally are protected from personal liability, as are limited partners. It is important to note, however, that both an LLC member’s interest and a limited partner’s interest are subject to charging orders against that interest obtainable by creditors of the debtor member. Several cases have held that the UPA permits the foreclosure of a limited partner’s interest. [Madison Hills, Ltd Partnership II v Madison Hills, Inc, 35 Conn App 81, 644, A2d 363 (1994); Centurion Corp v Crocker Nat Bank, 208 Cal App 3d 1, 255 Cal Rptr 794 (1989); but see Nigiri v Lotz, 216 Ga App 204, 453 SE 2d 780 (1995)]

The general partner owes limited partners the duties of loyalty and care. In terms of duty of care, courts have been willing to borrow the business judgment rule from corporate law and apply it in limited partnership contexts. [Levine v Levine, 184 AD 2d 53 (1992] Some model acts apply a similar standard. [UPA 21; RUPA 404] Unless the partnership agreement provides otherwise, the same standards will apply to limited partnerships. [See UPA 6(2); RULPA 1105] Given that general partners in a partnership and managers in an LLC serve approximately the same function, courts arguably should apply the same standard to the manager of an LLC. However, courts may find that limited partners may require more protection because, by definition, they have limited management rights whereas the members of an LLC have more participation rights in management and greater control over the conduct of the LLC manager. [Ribstein and Keatinge on Limited Liability Companies, 9.09]

Participation in Management. The participation of limited partners in the management of a limited partnership can result in a loss of limited liability protection for that limited partner. [RULPA 303] No similar restriction exists on the ability of LLC members to participate in the management of the LLC. All LLC members can participate in the management and control of the LLC, as members or as managers. [Uniform Act 301]

RULPA has been revised, and the revision adopted by several states allows greater participation by limited partners in the management of the limited partnership.

For example, the Delaware RULPA allows a limited partner to exercise any poer authorized in the partnership agreement or other written agreement. [Del Code Ann tit 6, 17-302] The Georgia version of RULPA is even more liberal; it flatly states that a limited partner does not lose limited liability as a result of participating in the management or control of the business. [Ga Code Ann 14-9-3-3].

Nevertheless, LLCs provide greater control, limited liability to all members, and are simpler to form and maintain.

The degree of participation in management has an impact on the degree fiduciary duties that partners in a limited partnership and LLC members have between each other. Since limited partners do not have management rights, the degree of fiduciary duties owed by them to others is not as great as that of members in a LLc. For example, limited partners may not be required to alert partners of a business opportunity which has a bearing on partnership operations. [In re Villa West Associates, 193 BR 587 (D Kan 1996) (acquisition by limited partner of partnership indebtedness which reduces that partner’s liability on a guarantee relative to other partners without alerting other partners of the opportunity was not a breach of fiduciary duty)]

To satisfy the minimum interest test, the general partners collectively must have at least a one percent interest "in each material item of partnership income, gain, loss, deduction, or credit…at all times during the existence of the partnership, and the partnership agreement must expressly so provide." The limited partnership does not violate this representation by temporary lapses in compliance and failures to comply due to conformance with Code Section 704(b) or 704(c). Revenue Procedure 89-12 [1989-1 CB 798] reduces the minimum interest test for limited partnerships with total capital contributions exceeding $50 million.

Revenue Procedure 89-12 also provides that, the general partners taken together must maintain a minimum capital account balance equal to the lesser of: one percent of the total positive capital account balances of the limited partnership, or $500,000. A general partner does not have to satisfy this test, if the general partner renders or will render substantial services to the partnership in his, her, or its capacity as a general partner, apart from services for which they are compensated with Code Section 707 (c) guaranteed payments.

Because an LLC by statute has the corporate characteristic of limited liability (as defined by the IRS), only in certain circumstances, prior to the effectiveness of the "check-the-box" rules, was any member of an LLC required to represent that it had a minimum net worth or was entitled to a prescribed minimum allocation of the LLC’s income. [Rev Proc 95-10, 1995-1 CB 501]

How Many Owners (Members) Are Needed To Form An LLC?

Some states authorize one-member LLCs. The IRS in 1997 implemented "check-the-box" regulations, which allow single-member LLCs to be treated as sole proprietorships for taxation purposes. Such entities will thus be subject to pass-through taxation, as would a sole proprietorship. [Treas Reg 301.7701-1(a)(4)]

It is also possible to have two members, even though they are related. Trusts or corporation can be a member as well as individuals. Thus, it is possible to have an LLC between an individual and a corporation in which that individual owns, stock, or between an individual and a trust that benefits the individual. The "check-the-box" regulations allow substantial leeway in choosing the method by which the LLC will be taxed. [Treas Reg 301.7701-3]

Do The State LLC Statutes Allow A Foreign LLC
To Do Business In The State?

Yes, every state LLC statutes provides for the operation of business within its state by foreign LLCs. Generally, the laws of the LLC’s home jurisdiction will control the organization and internal affairs of the LlC. State statutes differ on the liability of members; some statutes provide that the LLC’s home jurisdiction will determine liability, while other states provide that a foreign LLC is not entitled to any greater privileges than those available to domestic LLCs. Other states impose specific requirements on foreign LLCs to ensure that residents dealing with the foreign LLCs have adequate protection. [See, e.g., Wash Rev Code 24.12.310 (foreign LLCs providing professional service must meet financial responsibility requirements or members face personal liability)] Most states provide that a foreign LLC will not be denied foreign registration because of any differences in the laws of the home state and foreign jurisdiction.

If No "Check-The-Box" Election Is Made, What Are The Default Rules For Domestic Entitles, Foreign Entities, And Existing Entitles?

Domestic Entities. Unless the regulations require classification as a corporation, a newly formed domestic entity will automatically be classified as a partnership for tax purposes if it has two or more members, unless an election is filed to classify the entity as an association (and thus, taxable as a corporation); no affirmative action need to be taken by the entity to ensure partnership classification. Similarly, if that entity has a single member, it will not be treated as an entity separate from its owner for federal tax purposes unless an election is filed to classify that organization as an association. Comments to the Final Regulations indicate that an entity is not under single member ownership even if all the owners are under common control. [16 Fed Reg 66584 (Dec 18, 1996)] These default rules were aimed at matching the taxpayer’s expectation and reducing the number of elections that would need to be filed. Although no elections is required to be filed, a newly formed domestic entity may wish to file an election for protective purposes. A protective election is useful if there is doubt whether the entity is domestic or foreign. Foreign entities face different default rules under the "check-the-box" regulations so it may be advantageous for a new entity to protect itself with an election from a possible reclassification.

Foreign Entities. An entity is foreign if it is not organized pursuant to United States law or the law of any state or the District of Columbia. [Treas Reg 301.7701-1(d)] A foreign entity will be classified as a corporation if it is designated as a "per se" corporation by the regulations. [See Treas Reg 301.7701-2(b)(8) If one or more of a foreign entity'’ members has personal liability, the entity will be classified as a partnership if it has two or more members, or it will be disregarded as a separate entity if it has a single owner. [Treas Reg 301.7701-3(b)(2)(i)(A), (B)] Conversely, if all of the entity’s members have limited liability, the entity’s default classification will be that of an association. Under the "check-the-box""regulations, a member of a foreign entity has personal liability if that member is liable for all or part of an entity’s debts and obligations based solely on the controlling statute or law pursuant to which the entity is organized, or if protection from personal liability is optional under the applicable law, the entitly'’ organizational documents provide for personal liability. [Treas Reg 301.7701-3(b)(2)(ii)]

Existing entities. Entitles in existence before January 1, 1997 (the effective date of the final "check-the-box" regulations) that choose to retain their current classification would not be required to file an election. Rather, those entities would retain the classification claimed under the prior regulations, except that, if an eligible entity with a single owner claimed to be a partnership under the prior regulations, the entity would be disregarded as an entity separate from its owner under this default rule. However, it is important to check the applicable state LLC statues since some states do not allow a one-member LLC.

A foreign entity is considered such an existing entity only if its classification immediately before the effective date of the regulations is relevant to any person for federal tax purposes; other foreign entities formed before the effective date of these regulations would be considered new entities at the time that their federal tax classification became relevant and, therefore, would be required to file a classification election or be classified under the general default rule described above.

What Type Of Property Can Be Contributed To An LLC In Exchange For A Membership Interest In An LLC?

The LLC acts are not uniform in this respect. Many LLC acts allow members to contribute almost anything of value in exchange for an interest, including cash, property, the right to use property, services performed or an agreement to perform services in the future, or a promissory note or other obligation to contribute capital in the future. However, some states limit capital contributions to cash or property [Fla Stat Ann 608.4211; Wyo Stat 17-15-115]; other states specifically prohibit the issuance of an interest in exchange for a promissory note or services to be rendered at a later date [SD Codified Laws Ann 47-34-19]; and still others do not permit services to be contributed in exchange for an interest in an LLC. [Neb Stat 21-2614]

Can A Member Assign His Or Her Interest In
An LLC Without Anyone’s Consent?

In many cases yes, although the transferee will be an assignee and not a member. Only members can vote and exercise other rights of members, but an assignee, like a member, may receive distributions of cash or property.

While a member in an LLC generally can transfer an LLC interest in whole or in part, the Operating Agreement, Articles, or statute may limit this power. Some state LLC acts prohibit a member from transferring that member’s own interest without the consent of all of the other members. Consent may be inferred by a failure to object to a transfer, and the failure to follow formalities by one individual, such as signing and amended Operating Agreement, may not be raised as objection by another member at a later date. [In re DeLuca (Broyhill v DeLuca), 194 BR 65 (ED Va 1996)] Many of the newer statutes require only majority consent, or allow the members to alter the statute’s requirement for unanimous consent. In addition, any attempted transfer may be void if: (1) right-of-first-refusal restrictions in the Articles or Operating Agreement have not been complied with, or (2) a transfer of an interest in a professional LLC is attempted to a person or entity not licensed or otherwise eligible for membership.

To ensure that the LLC does not have the corporate characteristic of free transferability of interest, the Articles and the Operating Agreement should either mirror the statutory requ8irement, or if that can be altered, should require the approval of at least a majority in a nonmember.

In conclusion, while it may be possible to transfer the interest to someone without the consent of the other members, the transferee of that interest will not be a member unless the transferee has satisfied the statutory and any other requirements to obtain the status of a member.

What Is Tax Basis?

Basis is a tax concept that determines whether any taxable disposition of property creates a recognized gain or loss. It can be summarized as the amount of cash or the fair market value of property a person actually has invested in another piece of property, which may be adjusted by several factors. A taxpayer is, absent an exception, generally subject to tax on the sale or exchange of property unless the cash or fair market value of property received exceeds that taxpayer’s tax basis in the property transferred. Basis also can relate to other basis or values. For example, property inherited from a decedent generally has a basis equal to its fair market value at the date of death or alternate valuation date; a done gnerally inherits the basis of a living donor.

For an LLC taxed as a partnership, basis is important because members can deduct certain losses of an LLC allocated to them to theextent of their tax basis in their LLC interest, subject to limitations discussed below. [IRC 704(d)] A member’s tax basis in an LLC interest can never be less than zero; although one often hears the term ‘negative basis,’ the term actually means a deficit capital account, which can trigger tax (often depreciation recapture) upon sale, foreclosure, gift, or other nondeath transfer.

How Is A Member’s Tax Basis In An LLC Interest Calculated?

A member’s tax basis in an LLC interest initially is equal to the amount of cash and adjusted tax basis of property contributed by that member to the LLC in exchange for the LLC interest. [IRC 722] If the member purchased the interest from another member, the purchasing member’s tax basis initially would be equal to the amount of cash or fair market value of property transferred in exchange for the interest. [IRC 742, 1101]

A member’s interest in an LLC is adjusted from time to time as follows:

  1. Increased by the member’s distributive share of the LLC’s income and tax-exempt income;
  2. Increased by the member’s distributive share of the LLC’s deductions for depletion over the basis of the property subject to depletion;
  3. Increased by the member’s share of the LLC’s recourse (and, in some cases, qualified nonrecourse) liabilities for which no other member is personally liable on;
  4. Decreased by the member’s distributive share of the LLC’s losses and nondeductible expenses, which are not properly chargeable to capital accounts; and

5. Decreased by any distributions to the member.

[IRC 705, 722, 752; Treas Reg 1.752-2(e)(1), 1.704-2-(b)(4)]

A member’s tax basis includes any portion of the LLC’s liabilities, unless (1) the debt is nonrecourse to that member and another member is personally liable for all of the debt, or the debt is not qualified [IRC 752], or (2) the member is not at risk. [IRC 465]

Does An LLC File A Federal Income Tax Return?

Yes, unless it is a one-member LLC taxed as a sole proprietorship. The LLC, if taxed as a sole proprietorship, files on Schedule E of the Form 1040, the personal tax return, and if taxed as a partnership, is required to file Form 1065 (Partnership Tax Return) annually. Form 1065 is only an informational return, and the LLC must issue a separate Form K-1 to each individual member, which separately state specific items that may be treated differently by each individual member. [IRC 702] For example, the LLC must itemize capital gains and losses, charitable contributions, dividends, and foreign taxes.

Can Employees of an LLC Participate in an ESOP Adopted By A Corporation That Owns An Interest In The LLC?

No. While the employees of all corporations in a controlled group of corporations may participate in the ESOP of any of the corporations, al LLC, classified as a partnership for tax purposes, connot be a member of a controlled group of corporation. [IRC 409(1)(4); GCM 39880; Ltr Rul 9236042 (in which the Irs ruled that the employees of a partnership could not participate in an ESOP maintained by a corporation that owned an interest in the partnership)]

Are Members Subject To Self-Employment Tax On
Distributive Shares Of The LLC’s Income?

In 1997, the Treasury withdrew its proposed regulations submitted in 1994 regarding classification of members of unincorporated entities as either general or limited partners, and offered a new set of proposed regulations in their place.

Under the 1997 proposed regulations, an LLC member will be classified as a limited partner unless one of four tests is met in which case the member will be a general partner. The four tests are:

    1. The Liability Test. The member faces personal liability for claims against the LLC.
    2. The Authority Test. This requires that the member have the authority to create binding contracts on behalf of the LLC.
    3. The Participation Test. Her the member must participate more than 500 hours per year in the business of the LLC.
    4. The Personal Services Test. The member must provide greater than a de minimi amount of services on behalf of the business of the LLC, and the business must involve the areas of health, law, engineering, architecture, accounting, actuarial science, or consulting.

In a departure from the 1994 proposed regulations, the 1997 regulations permit a member’s distributive share to be taxed as a limited partner’s distributive share under certain circumstances. The 1997 proposed regulations set forth two alternative tests which may serve to reclassify a distributive share of a general partner’s to one of a limited partner’s. They are;

    1. The Two Classes of Interest Test. This test applies to distributive shares with respect to a second class of interest which may be held by an individual who is otherwise classified as a general partner. This class of interest is also required to be held by individuals who qualify as limited partners and the rights and obligations with respect to the second class of interest must be identical. Note that this test does not apply to a member treated as general partner by virtue of the Personal Services Test.
    2. The Single Class of Interest Test. This test only applies to members classified as general partners under the Participation Test. If the member’s rights and obligations with respect to that interest are identical to that of other members classified as limited partners and those other members have a "substantial continuing interest" in the LLC, the member’s distributive share will be taxed as one of a limited partner and not of a general partner. The regulations provide that 20 percent ownership of a particular class of interest constitutes a substantial continuing interest. For purposes of the test, members’ interest may be identical even though one is classified as a general partner who provides services to the LLC and the other s as limited partners who do not.

Neither the Code nor the regulations expressly purport to limit the reclassification of a distributive share from one flowing to a general partner to one flowing to a limited partner on the basis of whether the payment is guaranteed instead of payment that is merely remuneration for services. A careful practitioner, however, may provide for regulation which attempts to distinguish between compensation for services and returns on capital.

The 1997 proposed regulations have been accompanied by intense criticism on the ground that they eliminate the benefits of being a limited partner in state law limited partnerships. As a result, Congress has prohibited the issuance of any further regulations and has suspended the effectiveness of the 1997 proposed regulations until July 1, 1998. [Taxpayer Relief Act of 1997, PL No 105-34, 935] This criticism on the basis of limited partnership concerns may be somewhat misguided because (1) limited liability companies have replaced the use of limited partnerships in may instances, and (2) the application to limited partnerships is, in reality, extremely limited. The very nature of limited partnerships provides limited liability to limited partners and prevents limited partners from binding the partnership. Thus, the only practical applications would be to those limited partnerships who have at least one member who spends more than 500 hours in the business of the limited partnership and has a second class of interest with differing rights and obligations than the limited partners and to those limited partners in a service partnership. Another possible application of the new regulation would be the extremely rare instance where all members of a limited partnership participate more than 500 hours which would result in the treatment of all of them as limited partners instead of general partners for purposes of the distributive share.

What Is The Difference Between A Member’s
Tax Basis And Capital Account?

At least three important distinctions may be made between tax basis and capital accounts:

  1. Basis versus fair market value. If a member acquires an interest in an LLC by contributing property other than cash, the tax basis in the LLC interest is equal to the tax basis in the property contributed. The capital account, however, is equal to the fair market value of the property contributed.
  2. Liabilities. A member’s tax basis in an LLC may include all or a portion of the amount of the LLC’s liabilities. Because capital accounts reflect a member’s gaross, not net, equity in the LLC, capital accounts do not include a member’s allocable share of the LLC’s liabilities, even if the member has guaranteed the debt.
  3. "Negative basis." A member’s tax basis in an LLC interest cannot be negative. [IRC 704(d)] A member’s capital account, however, can be negative, and, as discussed above, is often called "negative basis" in common parlance, although technically it does not exist. Commonly, negative basis is caused by depreciation deductions allocated in excess of basis.

What Are The Tax Consequences To An LLC
Upon The Contribution Of Property?

An LLC does not recognize gain or loss upon receipt of property, including cash, in exchange for an interest in the LLC. [IRC 721 (a)] This rule apples whether property is contributed to the LLC upon formation or to an existing and operating LLC. Property, in this context, includes, but is not limited to, cash, tangible and intangible personal property, accounts receivable, licenses, patents, contract rights, and installment notes. The LLC’s basis in the contributed property equals the adjusted basis of the property in the hands of the member at the time of the contribution. [IRC 723] Additionally, the LLC’s holding period for the property is equal to the holding period of the member that contributed the property. [IRC 1223(2)]

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