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 trusts
beneficial holders were not shielded from personal liability for
the trusts 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 LLCs 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
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 members
interest and a limited partners 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 partners 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
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 partners 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 LLCs income. [Rev Proc 95-10, 1995-1 CB
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 LLCs 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 LLCs
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 taxpayers 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 entitys members have limited liability,
the entitys 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 entitys 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
An LLC Without Anyones 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 members 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 statutes 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 taxpayers 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 members
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 Members Tax Basis
In An LLC Interest Calculated?
A members 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 members 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 members interest in an LLC is adjusted
from time to time as follows:
Increased by the members distributive
share of the LLCs income and tax-exempt income;
Increased by the members distributive
share of the LLCs deductions for depletion over the basis
of the property subject to depletion;
Increased by the members share of the
LLCs recourse (and, in some cases, qualified nonrecourse)
liabilities for which no other member is personally liable on;
Decreased by the members distributive
share of the LLCs losses and nondeductible expenses, which
are not properly chargeable to capital accounts; and
A members tax basis includes any portion
of the LLCs 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
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
Distributive Shares Of The LLCs 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:
The Liability Test. The member faces personal
liability for claims against the LLC.
The Authority Test. This requires that the
member have the authority to create binding contracts on behalf
of the LLC.
The Participation Test. Her the member must
participate more than 500 hours per year in the business of
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 members distributive share
to be taxed as a limited partners 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 partners to one of a limited partners.
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.
The Single Class of Interest Test. This test
only applies to members classified as general partners under
the Participation Test. If the members 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 members 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
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
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
Tax Basis And Capital Account?
At least three important distinctions may be made
between tax basis and capital accounts:
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.
Liabilities. A members tax basis in an
LLC may include all or a portion of the amount of the LLCs
liabilities. Because capital accounts reflect a members
gaross, not net, equity in the LLC, capital accounts do not
include a members allocable share of the LLCs liabilities,
even if the member has guaranteed the debt.
"Negative basis." A members
tax basis in an LLC interest cannot be negative. [IRC § 704(d)]
A members 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
LLCs 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 LLCs holding
period for the property is equal to the holding period of the
member that contributed the property. [IRC § 1223(2)]
Questions about Forming an LLC or Corporation?
Call NCP at 1-800-351-5111