LIMITED LIABILITY COMPANIES

Transcription

1 A COMPREHENSIVE GUIDE TO LLC FORMATION AND OPERATION LIMITED LIABILITY COMPANIES THE TUCKER FIRM CORPORATE LEGAL COUNSEL 1723 North Halsted Street Chicago, Illinois tel general@thetuckerfirm.com

2 author Debra J. Tucker, Esq. CPA The Tucker Firm LLC 1723 North Halsted Street Chicago, Illinois (312) All rights reserved. These materials may not be reproduced or distributed to any other person without written permission from The Tucker Firm, LLC. This publication is designed to provide general information in regard to subject matter covered. It is sold with the understanding that the publisher and the author are not engaged in rendering legal, accounting, or other professional service. Although prepared by a professional, this publication should not be utilized as a substitute for professional service in specific solutions. If legal advice or other expert assistance is required, the services of a professional should be sought.

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4 about the author DEBRA J. TUCKER is an attorney and CPA who concentrates on representing businesses in civil litigation and defending accountants against claims. She has represented many large companies in complex litigation, including Office Depot, Exxon Mobile, Martin Marietta, Illinois Tool Works, Kraft Foods, Motorola, General Motors Acceptance Corporation, Skidmore Owings and Merrill, and Ameritech. She also has defended many large accounting firms, including PriceWaterhouseCoopers, Arthur Anderson, and Crowe Chizek. Debra is the founder of The Tucker Firm LLC. Debra frequently speaks and writes for organizations on legal topics. She has been a consistent instructor for the Illinois CPA Society, American Institute of Certified Public Accountants, and American Bar Association. She also has appeared as a legal expert on WGN-TV Chicago and FOX News. Debra received her Juris Doctorate with honors from The Law School of the University of Chicago. She is admitted to practice in the United States Court of Appeals for the 7th Circuit, the United States District Court for the Northern District of Illinois, Illinois State Courts, and several other courts around the country. She is an arbitrator for the Illinois Circuit Court and the NASD and a member of the American Bar Association. She formerly practiced law with the international law firm of Kirkland and Ellis in Chicago. Prior to practicing law, Debra received a Bachelor of Science in Accountancy from the University of Illinois at Urbana-Champaign, where she was a Robert W. Rogers and James Scholar. She obtained a perfect GPA of 5.0/5.0 and graduated Bronze Tablet, Summa Cum Laude, and Phi Beta Kappa. On the May 1990 CPA examination, Debra was awarded the Illinois Bronze Medal for achieving the third-highest score in Illinois, and she was awarded the National Elijah Watt Sells Award for obtaining one of the 108 highest scores nationally of the 68,050 examination candidates. Debra subsequently practiced as a CPA with PriceWaterhouse in New York City. Debra is a member of the Illinois CPA Society and American Institute of Certified Public Accountants, and she served on the American Institute of Certified Public Accountant s Special Committee on Financial Reporting.

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6 contents I. ENTITY SELECTION 1 A. History and Types of LLCs 1 B. The Illinois Limited Liability Company Act 2 C. Choosing the Right Entity 2 D. Who Should Use LLCs 13 II. IMPLEMENTING AN LLC 15 A. Drafting the Articles of Organization 15 B. Management Decision-Making 20 C. Single Member LLCs 21 D. Foreign LLCs 22 E. Special Rules for Regulated Professionals 25 F. Limited Liability of Members and Exceptions 28 G. Property Transfers to and from Members 33 H. Securities Law Compliance 37 III. ADVANCED TAX ISSUES 50 A. Check-the-Box Regulation 50 B. Tax Forms and Numbers 51 C. Federal Income Tax Differences 53 D. Contributions of Property 58 E. Contributions of Services 62 F. Formation Tax Issues 64 G. Distributions and Allocations 65 H. Self-Employment Tax 66 I. Illinois State Taxes 69 IV. OPERATING AS AN LLC 71 A. Drafting the Operating Agreement and Statutory Limitations 71 B. Annual Report and Other Required Documents 72 C. Proper Procedures for Mergers and Conversions 73 D. Dealing with a Member s Dissociation 76 E. Guiding Clients Through Dissolution 79

7 V. SERIES LLCs 83 A. Formation 83 B. Conversion 85 C. Reports 86 D. Conditions for Limited Liability 86 E. Operating 87 F. Taxation 87 VI. ETHICS IN DEALING WITH LLCs 88 A. Ethical Standards and Civil Liability 88 B. The Role of the Attorney as Advisor in LLC Formation 89 C. Avoiding Conflicts of Interest 90 D. Confidential Information from a Representation 91 VII. MASTERING ESTATE PLANNING ISSUES 92 A. Using an LLC to Hold and Transfer Real Property 92 B. An LLC as a Valuation Freeze Entity 93 C. Holding Life Insurance Policies in an LLC 95 D. Using an LLC for Projects 96

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9 I. ENTITY SELECTION A. HISTORY AND TYPES OF LLCs A limited liability company ( LLC ) is a separate legal entity that may be established pursuant to state law. The concept of an LLC originated in 1892 in Germany. In 1977, Wyoming was the first state in the United States to allow an LLC to be formed, and the other states subsequently followed suit. Today, LLCs are recognized as a valid entity structure in all fifty of the United States, and LLCs are commonly used. In August 1996, Delaware authorized the creation of series LLCs, which are a variation of standard LLCs. The states of Tennessee, Wisconsin, North Dakota, Iowa, Oklahoma, and Illinois subsequently authorized series LLCs. The Illinois series LLC legislation was enacted on August 16, ILCS 180/ An LLC s structure consists of one or more members who own interests in the LLC, which are called membership interests. An LLC may choose to be managed either by its member or members or by a manager or board of managers. Managers may or may not also be members. An LLC that elects to be managed by its member or members is called a member-managed LLC, and an LLC that elects to be managed by a manager or board of managers is called a manager-managed LLC. An LLC also may elect, but is not required, to have officers. In a series LLC, the LLC s assets may be divided into separate groups called series. Each series may have different members, managers, or membership interests, and they may have different rights, powers, or duties with respect to the series assets. The important implication of creating series in a series LLC is that the liabilities of a particular series are enforceable only against the assets of the particular series if certain conditions are satisfied. The assets contained in other series or the LLC generally are unreachable. This T H E T U C K E R F I R M L L C 1723 North Halsted Street Chicago, Illinois (312)

10 provides greater protection for assets than is afforded by other entity types without the formation of multiple separate entities. It is this feature that makes a series LLC very advantageous for many types of businesses. B. THE ILLINOIS LIMITED LIABILITY COMPANY ACT LLCs in Illinois are formed pursuant to the Illinois Limited Liability Company Act, 805 ILCS 180/1-1 et. seq. (the LLC Act ). The Illinois Act is based on the Uniform LLC Act. The Act is available on the website After entering the site, you can find the Act under the headings legislation and laws, Illinois compiled statutes, business, business organizations, limited liability companies, and Limited Liability Company Act. A copy of the Act can be accessed through the Secretary of State s website. The LLC Act codifies many rights and obligations relating to LLCs that are provided by the common law for other entities. For example, the LLC Act expressly identifies the fiduciary duties of an LLC s members whereas these duties arise from the common law for other entity types. Noticeably absent from the LLC Act are detailed provisions requiring that formalities be followed in the management of the LLC. For example, the LLC Act does not contain requirements for holding meetings of the LLC s members and does not provide for the appointment of officers or specify their duties. The LLC Act expressly provides that [u]nless displaced by particular provisions of this Act, the principles of law and equity supplement this Act. 805 ILCS 180/1-43. The LLC Act generally allows for an LLC s members to alter the provisions contained in the LLC Act, except with respect to certain specified issues. (See Section below on Drafting the Operating Agreement and Statutory Limitations.) C. CHOOSING THE RIGHT ENTITY The LLC is one of many types of entities that may be used to hold assets or to operate a business in Illinois. Other entity types include the sole proprietorship, general partnership, limited partnership, limited liability partnership, S Corporation, and C Corporation. The factors to consider in determining the most advantageous entity type include: (1) the number and character of the owners of the entity, (2) the extent of liability of the owners, (3) business restrictions, (4) formation and maintenance costs, (5) the flexibility in providing the owners with a return, (6) the flexibility in segmenting business operations, (7) the ability to raise ENTITY SELECTION 2

11 capital, (8) the credibility of the entity, and (9) tax differences. Number and Character of Owners. An LLC can be formed regardless of the number of owners (called members) of the LLC. 805 ILCS 180/5-1(b). Except for certain professions, an LLC also can be formed regardless of the character of the owners. (See Section below on Special Rules for Regulated Professions.) Thus, an LLC can be formed if there is one member or there are multiple members of the LLC. An LLC also can be formed if its members are legal entities rather than individuals or if its members are foreign citizens rather than United States citizens. In contrast, restrictions exist that prohibit other entity types from being used depending on the number and the character of the entity s owners. For example, a business cannot operate as a sole proprietorship if it has more than one owner. A partnership must have two or more owners. Like an LLC, C corporations can have one or more owners and the character of the owners are not restricted. S corporations have restrictions on both the number and the character of their owners. S corporations cannot have more than one-hundred shareholders and the shareholders cannot be partnerships, corporations, certain types of trusts, certain tax-exempt organizations, or individuals whose residence is not within the United States and who are not United States citizens. 26 U.S.C. 1361(b)(1). An LLC can hold shares of an S corporation without invalidating the corporation s Subchapter S election, at least if the LLC does not elect to be taxed as a corporation and the members of the LLC would otherwise qualify to be owners of the S corporation s shares directly. IRS Letter Ruling Liability of the Owners. The members of an LLC generally are not personally liable for the debts and obligations of the limited liability company, except in certain exceptional circumstances. (See section below on Limited Liability of Members and Exceptions.) An LLC s members do not lose their limited liability by participating in the management of the LLC or by failing to observe formalities in managing the LLC. 805 ILCS 180/10-10(a) and (c). In contrast, the owner of a sole proprietorship and the general partner(s) in a general partnership and in a limited partnership have unlimited personal liability for the debts and obligations of the company. Like the members of an LLC, limited partners of a limited partnership and partners in a limited liability partnership have limited liability. However, limited partners in limited partnerships lose their limited liability if they actively participate in the management of the limited partnership. The shareholders of an S corporation and C corporation generally have limited liability. Business Restrictions. ENTITY SELECTION 3

12 Almost all types of assets can be held and almost all types of businesses can be operated as an LLC. However, the LLC Act contains additional specific requirements if the LLC conducts the business of insurance, dentistry, or medicine. In addition, the regulatory bodies of certain other professional services place additional restrictions on LLCs that engage in regulated professions. (See section below on Special Rules for Regulated Professionals.) These same types of restrictions exist for providing professional services through other entity types. Formation and Maintenance Costs. An LLC is formed by filing an articles of organization with the Illinois Secretary of State and paying a five-hundred-dollar filing fee for a traditional LLC and a seven-hundred and fifty-dollar filing fee for a series LLC. A series LLC must pay an additional filing fee of fifty dollars for each series to file a certificate of designation for each series. Each year, an LLC must file an annual report with the Secretary of State and pay a two-hundred and fifty dollar filing fee. A series LLC must pay an additional fifty dollars for each series to file its annual report. In addition, Illinois LLCs that transact business in other states generally must register to do business in those states, and foreign LLCs that transact business in Illinois must register to do business in Illinois. An LLC typically incurs professional fees to file the required documents with the Secretary of State and to draft an operating agreement to govern its internal affairs. Professional fees are generally not incurred to draft bylaws or shareholders agreements for LLCs because provisions that are usually contained in these documents are integrated into the LLC s operating agreement. In contrast, a sole proprietorship is administratively simple to start. The owner of the sole proprietorship does not need to file documents with the Secretary of State to form a sole proprietorship or to file an annual report with the Secretary of State. However, if the sole proprietorship conducts business other than under the name of the sole proprietor, then the sole proprietorship must make an assumed name publication. Similarly, a general partnership is administratively simple to start. Typically, a partnership agreement is entered into, but this is not legally required. To form a limited partnership, a Certificate of Limited Partnership must be filed with the Secretary of State and a $150 filing fee must be paid. A limited partnership must file Biennial Renewal Reports with the Secretary of State and pay a $150 filing fee. To form a limited liability partnership, a Statement of Registration must be filed with the Secretary of State and a filing fee must be paid of $200 plus $100 for each partner above two up to a maximum of $5,000. Each year, the limited liability partnership must file an Application for Renewal with the Secretary of State and pay a $100 filing fee per partner up to a maximum of $5,000. A partnership typically incurs professional fees to file any required documents with the Secretary of State and to draft the partnership agreement to govern its internal affairs. ENTITY SELECTION 4

13 A C corporation and S corporation are formed by filing articles of incorporation with the Secretary of State. The filing fee is $150 plus initial franchise taxes in the amount of 0.15% of the amount of initial paid in capital (a $1.5 fee for each $1,000 of paid in capital), subject to a minimum amount of $25. Each year the corporation must file an annual report with the Secretary of State and pay a $75 filing fee and annual franchise taxes in the amount of 0.1% of the paid in capital of the corporation (a $1.0 fee for each $1,000 of paid in capital), subject to a minimum amount of $25. In addition, the corporation also typically incurs professional fees to file the required documents with the Secretary to State, to draft bylaws, a shareholder s agreement, and corporate resolutions. A corporation files a Subchapter S election with the IRS at no cost to be taxed as a flow-through entity and to be deemed an S corporation. Flexibility in Providing a Return. LLCs provide a great amount of flexibility in allocating the LLC s income and loss to the LLC s members. Although the LLC Act provides default rules for the distribution of the LLC s income and loss to the LLC s members, the members can alter these default rules by adopting provisions in the operating agreement. As long as the LLC s allocations of income and loss to its members have economic effect, they will be respected by the Internal Revenue Service ( IRS ) and may provide tax advantages to the LLC s members. Series LLCs provide even greater flexibility in allocating the LLC s income and loss to the LLC s members. Income and loss associated with the property of each series can be allocated easily to the members of each series and different allocation methods can be used for each separate series. Similar to an LLC, partnerships allow for flexibility in providing their owners with a return on their investment. However, C corporations and S corporations do not. In a C corporation, separate classes of stock must be created in order to treat owners differently with respect to distributions. S corporations are not permitted to have multiple classes of stock; and therefore, S corporations are extremely limited in their ability to give a priority return to certain owners. Flexibility in Segmenting Operations. LLCs allow a great deal of flexibility in segmenting a company s operations and assets. An LLC provides a company with a very simple and cost effective mechanism to operate a segment of its business. This is because LLCs are not required to have directors or officers, are not required to follow other corporate formalities, and can have any number of owners. In addition, contributions of property to an LLC by its members and distributions of property by the LLC to its members generally do not constitute taxable events if the LLC has elected flowthrough tax treatment. Thus, an LLC provides a company with a cost effective mechanism to transfer property in or out of business segments. ENTITY SELECTION 5

14 Series LLCs provide a company with even greater flexibility in segmenting its operations and assets. In a series LLC, a company can segregate its operations solely by forming separate series with limited liability within the overall LLC legal entity rather than forming multiple legal entities to limit liability. In contrast, it is not possible to isolate the assets and obligations of business segments within any other entity type such that the segments each have limited liability. Although business segments may be internally managed separately, the segments are treated as one entity for liability purposes. To obtain limited liability for each business segment, a separate legal entity would have to be established for each business segment. Ability to Raise Capital. An LLC structure provides only a limited ability for the entity to raise capital. Because most investors prefer to invest in an entity that offers limited liability, an LLC structure helps the business raise capital. A series LLC enhances a company s ability to raise capital because it allows a mechanism whereby investors may invest in some, but not all, of the operations of a company. However, LLC membership interests cannot be traded publicly on the major securities exchanges, and this limits an LLC s ability to raise capital. An LLC can be changed later to a C corporation to allow its ownership interests to be traded on an exchange. This process requires the LLC to be dissolved and the C corporation to be newly formed, and it may be complicated and costly. In addition, the newly-formed C corporation will not be able to immediately have its shares traded on a major securities exchange because the exchanges require a company to operate for a certain number of years before being traded on the exchange. Therefore, if a company anticipates going public in the near future, the company typically should not form as an LLC. A sole proprietorship is more limited than an LLC in its ability to raise capital, and typically it must rely on its sole proprietor to provide it s financing. Likewise, a general partnership s ability to raise capital is limited because individuals usually do not desire to invest in entities that do not offer limited liability. Limited partnerships, limited liability partnerships, and S corporations enhance a company s ability to raise capital because they offer owners limited liability. However, the restrictions on the number and character of an S corporation s owners limit an S corporation s ability to raise capital. C corporations offer the greatest ability to raise capital. The C corporation structure often is essential for the company s shares to be traded on the major securities exchanges. Often an entity that intends on having its ownership interests publicly traded in the future is established as an S corporation so that it can be taxed as a flow-through entity before it is publicly traded. When the company is ready to have its shares publicly traded, the company converts from an S corporation to a C corporation. This process involves changing the company s tax election ENTITY SELECTION 6

15 with the IRS and not the company s ownership and management structure. It is not complicated or costly. Credibility. In the past, LLCs were not recognized by the laws of all fifty states and few LLCs existed. Because the business community was not accustomed to dealing with LLCs, LLCs encountered difficulty in conducting their business and establishing credibility in the marketplace. Today, all fifty states recognize LLCs as a valid entity type and the entity form is widely utilized. Thus, LLCs have an easier time transacting business and establishing credibility in the business community today. Even though the business world has become more accustomed to LLCs, many legal uncertainties still exist with respect to LLCs. There are very few court decisions, IRS determinations, and other authority on issues relating to LLCs. As a result, it is often difficult to predict how legal issues will be resolved in the context of an LLC. Greater difficulty exists with respect to series LLCs. Very few states have enacted series LLC legislation. If the LLC intends on doing business in a state that has not enacted series LLC legislation, problems may arise. The LLC acts in most states expressly provide that issues relating to an LLC will be determined according to the laws of the sate in which the LLC was formed. Thus, a series LLC s structure and limitations on liability provided by the law of the state in which the LLC was formed should be respected in these states even if the state has not enacted series LLC legislation. However, this result depends on the specific provisions of the LLC act in effect in the particular state in which the LLC is doing business. Thus, if a company plans to do business in states other than Illinois, the company should first ensure that the series LLC will be respected in the other states. Because other entity types have been utilized for an extended period of time, transactions involving them are often easier and greater certainty exists with respect to legal issues relating to them. Tax Differences. One of the advantages of an LLC is that it offers a great degree of tax flexibility. An LLC can choose to be taxed like a sole proprietorship or partnership, a C corporation, or an S Corp subject to certain restrictions. Thus, an LLC generally can choose the tax treatment that provides the greatest tax advantage to the LLC and its owners given their specific circumstances. In contrast, sole proprietorships and partnerships must be treated as such for tax purposes and have no option to be taxed otherwise. Similarly, a C corporation is taxed as such and cannot elect to be taxed otherwise unless it meets the requirements for making the Subchapter S election. Most importantly, a C corporation cannot make the Subchapter S ENTITY SELECTION 7

16 election if it has multiple classes of stock, and multiple classes of stock are necessary to distribute income and loss to shareholders in proportions different from their ownership percentage. Therefore, an S Corporation does not provide any opportunity to minimize taxes by allocating income and loss to owners in a disproportionate, strategic manner. Differences exist in the federal income tax, federal self-employment tax, and Illinois states taxes for entities of different types and their owners. Federal Income Taxes. For federal income tax purposes, a single-member LLC can choose to be disregarded as an entity like a sole proprietorship or a multi-member LLC can choose to be treated like a partnership. In the alternative, an LLC with any number of members can elect to be taxed as a separate entity like a corporation. If a single-member LLC elects to be disregarded for tax purposes, the LLC s income and loss flows through and is taxed only to the LLC s member. If a multi-member LLC elects to be taxed as a partnership, the rules applicable to partnerships that are set forth in Subchapter K of the Internal Revenue Code ( Code ) apply to all federal income tax matters. The LLC s income and loss flows through and is taxed only to the LLC s members. Gain generally is not recognized on contributions of appreciated property to the LLC by the LLC s members or distributions of appreciated property by the LLC to the LLC s members. The member s basis in his LLC membership interest includes the member s share of the LLC s debt, which enables the member to claim more tax deductions, absorb more losses, and withdraw more money from the LLC on a tax-free basis. The LLC s members are not permitted to exclude from their gross income employee fringe benefits (such as medical payments and the cost of group term life insurance) paid for them by the LLC. The LLC is not be able to engage in the tax-free reorganizations specified for corporations in the Code. If the LLC elects to be taxed as a corporation, the LLC is taxed pursuant to the rules applicable to corporations set forth in Subchapter C of the Code. These rules require the LLC to pay income tax on its income and loss and also require the LLC s members to pay tax on distributions they receive from the LLC. This is referred to as the double tax because both the LLC and its members pay income tax arising from the LLC s income and loss. However, tax at the entity level can be avoided if the LLC pays all of its profits to its owners as wages each year. Gain is generally recognized by the LLC s members on contributions of appreciated property to the LLC by the LLC s members unless the contributing member controls at least 80% of the LLC. Gain also is recognized by the LLC and by the LLC s member on distributions of appreciated property by the LLC to the LLC s member. The member s basis in his LLC membership interest does not include the member s share of the LLC s debt. The LLC s members are permitted to exclude from their gross income certain employee fringe benefits paid for them by the LLC, and the LLC is able to engage in the tax free reorganizations specified for corporations in the Code. ENTITY SELECTION 8

17 An LLC that elects to be taxed as a corporation can further elect to be taxed as an S corporation if the requirements for making the Subchapter S election are satisfied. These requirements are that (1) the LLC has no more than 100 members, (2) the LLC s members are not partnerships, corporations, certain types of trusts, certain tax-exempt organizations, or individuals whose residence is not within the United States and who are not citizens, and (3) the LLC has only one class of membership interests. 26 U.S.C. 1361(b)(1). If an LLC elects to be taxed as an S corporation, the LLC is taxed pursuant to the rules specifically applicable to S corporations set forth in Subchapter S of the Code. The rules applicable to C corporations set forth in Subchapter C of the Code apply to all matters other than those specifically set forth in Subchapter S. Basically, this means that the LLC s income and loss is taxed like partnership income and loss, i.e. the income and loss flow through and are taxed only to the LLC s members. In addition, LLC s members who own 2% or more of the membership interests of the LLC are required to include in their gross income employee fringe benefits paid for them by the LLC. The LLC is treated as a regular C corporation with respect to most other federal income tax rules, such as corporate distributions, redemptions, liquidations, reorganizations, and the like. Gain generally is recognized by the LLC s members on contributions of appreciated property to the LLC by the LLC s members unless the contributing member controls at least 80% of the LLC. Gain is recognized by the LLC on distributions of appreciated property by the LLC to the LLC s members. The member s basis in his LLC membership interest does not include the member s share of the LLC s debt. However, for purposes of deducting losses, the LLC s member is able to include the amount of any debt that the LLC owes the member. The LLC is able to engage in the tax free reorganizations specified for corporations in the Code. For the most part, the tax treatment that is afforded to LLCs can be obtained by any other entity type that is taxed pursuant to the same subchapter of the Code pursuant to which the LLC chooses to be taxed. In other words, if it is advantageous for a single-member LLC to be disregarded as an entity, then the company can obtain the same tax advantages by operating as a sole proprietorship. If it is advantageous for a multi-member LLC to be taxed as a partnership pursuant to the tax rules in Subchapter K, then the company can obtain the same tax advantages by forming a partnership. Similarly, if it is advantageous for the LLC to elect to be taxed as a corporation pursuant to the tax rules of Subchapter C, then the company can obtain the same tax advantages by forming a C corporation. If it is advantageous for the LLC to be taxed pursuant to the tax rules in Subchapters S and the LLC satisfies the requirements for making the Subchapter S election, then the company can obtain the same tax advantages by forming an S corporation. ENTITY SELECTION 9

18 Federal Self-employment Tax. Individuals who are owners of an entity may be required to pay self-employment taxes in the combined amount of 15.3% on their earnings subject to a cap. A sole proprietor pays selfemployment tax on all of the sole proprietorship s income and loss. A general partner in partnerships pays self-employment tax on the guaranteed payments he receives from the partnership and his distributive share of the partnership s income and loss. A limited partner pays self-employment tax only on guaranteed payments he receives from the partnership as compensation for services he renders for the partnership. A member of an LLC that chooses to be disregarded as an entity, treated like a partnership, or an S corporation, pays self-employment tax on the guaranteed payments he receives from the LLC and his distributive share of the LLC s income and loss if the member participates in the management of the LLC. A member who does not participate in the management of the LLC pays self-employment tax only on guaranteed payments he receives from the LLC as compensation for services he renders to the LLC. A shareholder of a C or S corporation does not pay self-employment tax on any amounts distributed, or allocations of income or loss made, by the corporation to its shareholders by virtue of their ownership interest in the corporation. The corporation and the shareholders pay employment tax on any wages paid to the shareholder as an employee of the corporation, and a shareholder pays self-employment tax on any compensation he receives from the corporation for services rendered as an independent contractor to the corporation. Illinois State Income Tax. Sole proprietorships and single-member LLCs that elect to be treated like them do not pay an entity-level Illinois state income tax. Rather, the owners pay a personal income tax on the income and loss of the company at the rate of 3%. Flow-through entities, including partnerships, S corporations, and LLCs that have chosen to be taxed like them, also do not pay an entity-level income tax. Id. Their owners pay a personal income tax on income and loss flowed through to them at the rate of 3%. 35 ILCS 5/201(b)(2)(ii). C corporations and LLCs that elect to be taxed like them are subject to an entity-level state income tax of 4.8% of the entity s net income, and their owners also pay a personal income tax on distributions made to them by the entity at the rate of 3%. 35 ILCS 5/201(a), (b)(2)(ii), and (b)(8). ENTITY SELECTION 10

19 Illinois State Personal Property Replacement Taxes. Sole proprietorships and single-member LLCs that elect to be treated like them do not pay Illinois state personal property replacement taxes. Legal entities that have their income flowedthrough to their owners for income tax purposes are subject to an entity-level 1.5% Illinois personal property replacement tax based on net income. 35 ILCS 5/201(c) and (d). These entities include partnerships, S corporations, and LLCs that have chosen to be taxed like them. Certain investment flow-through entities are exempt from this tax. 35 ILCS 5/205(b). C corporations and LLCs that elect to be taxed like them are taxed at the rate of 2.5% rather than 1.5%. 35 ILCS 5/201(d). Illinois State Franchise Tax. An LLC is not subject to Illinois franchise taxes on its paid-in-capital even if it elects to be taxed as a corporation for federal income tax purposes. The Illinois franchise tax only applies to entities that are legally formed as corporations, including C corporations and S corporations. The tax is reported on the corporation s articles of organization and annual reports. It is paid to the Secretary of State in the amount of $1.5 per $1,000 of initial paid in capital and $1.0 per $1,000 of the annual paid in capital balance. An LLC pays a fixed annual report fee of $250 without regard to its paid-in-capital and without paying any franchise tax. 805 ILCS 180/50-10(b)(11). ENTITY SELECTION 11

20 General Tax Summary. TAX ITEM TYPE OF ENTITY AND LLCs THAT ELECT TO BE SIMILARLY TAXED Sole Proprietorship Partner-ship C Corp. S Corp. 1) Income and loss flows through to the owner(s) and federal and state income tax is paid only by the owner(s). 2) The company pays a federal and state income tax and the owner(s) pay personal income tax on distributions received from the entity. Yes Yes No Yes No No Yes No 3) Self-employment tax is paid by the owners on their distributive shares of the company s income and loss. Yes Yes, except for limited partners. Yes for LLC members who participate in management No No for S corps. Yes for LLC members who participate in management. 4) Gain is recognized on an owner s contribution of appreciated property. No No Yes, except for 80% owners Yes, except for 80% owners 5) The basis of an owner s ownership interest includes the owner s share of the company s debt. 6) Fringe benefits paid to employee owners are included in their taxable gross income. 7) Tax free corporate reorganizations specified in the Code can be executed. Yes Yes No No Yes Yes No Yes if 2% owners No No Yes Yes 8) Illinois Income Tax is paid by the entity No No Yes No 9) Illinois Personal Property Replacement Tax is paid on the company s income. No Yes, at 1.5% Yes, at 2.5% Yes, at 1.5% 10) Illinois Franchise Tax is paid on paid-in-capital. No No Yes for C corps. No for LLCs Yes for S corps. No for LLCs ENTITY SELECTION 12

21 Taxation of Series LLCs. Series LLCs may provide a company with tax advantages that are not obtainable through any other entity type. Series LLCs may be taxed as one entity or as multiple entities depending on the extent of the differences in the characteristics of each series. Thus, a tax planner has an additional dimension upon which to structure the LLC to afford the most favorable tax treatment for the LLC and its members. Other legal entities are always treated as one tax entity, and therefore, there is no opportunity to minimize taxes on the basis of the entity being treated as one or more tax entities. The treatment of a series LLC as multiple tax entities also could generate some unintended tax consequences if the LLC is not vigilant. Although a series LLC will operate in many respects like one entity, the LLC must remember that for tax purposes the series LLC may be treated as multiple separate entities. Therefore, the tax treatment of a transaction executed by a series LLC may be different than if the transaction were executed by a single tax entity. D. WHO SHOULD USE LLCs Whether a company should operate as an LLC depends on the objectives desired to be achieved by the business owners and how the LLC compares to other types of entities in its ability to meet those objectives. (See section above on Factors to Consider in Choosing the Right Entity.) Because of the flexibility that LLCs offer, LLCs are almost always able to satisfy all of the objectives of business owners without accompanying disadvantages. In certain circumstances, the LLC is the cheapest entity structure to achieve desired objectives, and there is at least one set of objectives that can only be satisfied by an LLC. Typically, small business owners desire limited personal liability and flow-through tax treatment for the company s income and loss. These objectives can be satisfied by an LLC, a limited liability partnership if there are at least two owners, or an S corporation if the requirements for making the Subchapter S election are satisfied. Depending on the circumstances, one of these alternatives may be more cost effective. The initial filing fee and the annual report fees for a limited liability partnership are higher than for an LLC if the business has three or more owners and is maintained for five or more years. The initial filing fee and the annual report fees for an S corporation are higher than for an LLC if the company has high paid-in-capital. Thus, the LLC is the most cost effective alternative to obtain limited liability and flow-through tax treatment if these circumstances exist. The LLC also is the most cost effective alternative to achieve limited liability for multiple segments of a company s assets or operations. To obtain limited liability for a business segment through an entity other than an LLC, separate legal entities must be established and maintained for each business segment. Initial filing fees and annual report fees would need to be paid for each separate legal entity. In addition, corporate formalities would need to be ENTITY SELECTION 13

22 followed for each separate legal entity. A series LLC is the most cost effective manner in which to achieve limited liability for multiple segments of a company. It is less expensive to form and maintain a series within a series LLC than it is to form and maintain a separate legal entity for each segment of the company. ENTITY SELECTION 14

23 II. IMPLEMENTING AN LLC A. DRAFTING THE ARTICLES OF ORGANIZATION Articles of Organization Form. An LLC is formed by filing articles of organization with the Illinois Secretary of State and paying a filing fee. 805 ILCS 180/5-1(a). A standard LLC files its articles of organization on Form LLC-5.5 and pays a $500 filing fee. 805 ILCS 180/50-10(b)(1). A series LLC files its articles of organization on Form LLC-5.5(S) and pays a $750 filing fee. A series LLC must also file a certificate of designation on Form LLC and pay a $50 filing fee to establish each series in the LLC. 805 ILCS 180/37-40(d). (See section below on Series LLC Formation Certificate of Designation.) The articles of organization must contain the following information: 1) The LLC s name and address of principal place of business; 2) The LLC s purposes; 3) The registered agent s name and registered office s address; 4) The names and addresses of the manager(s) for manager-managed LLCs or the names and addresses of the member(s) for member-managed LLCs; 5) Each organizer s name, address and signature; 6) The effective organization date not more than 60 days after filing, if it is not desired for the LLC to be formed on the filing date; T H E T U C K E R F I R M L L C 1723 North Halsted Street Chicago, Illinois (312)

24 7) The latest dissolution date and other agreed-upon events of dissolution, if any; 8) A statement limiting the members and/or managers authority to affect the LLC s interest in real property, if desired; 9) Any other provision for the regulation of internal affairs desired to be stated; 10) For LLCs that accept and execute trusts, a statement from the Office of Banks and Real Estate of compliance with the Corporate Fiduciary Act; and 11) For series LLCs, notice that the liabilities of the series are limited to being satisfied from the assets of the series. 805 ILCS 180/5-5(a). The LLC s Name. The LLC s name stated on its articles of organization must satisfy several requirements. 805 ILCS 180/1-10. The LLC s name must contain the terms limited liability company, L.L.C. or LLC ; and the LLC s name cannot contain terms that would indicate that the LLC is another type of entity, such as Corp., Ltd., L.P. or other similar terms. The LLC s name must contain the word trust if it is organized for the purpose of accepting and executing trusts; and the LLC s name cannot contain words implying authorization to be a corporate fiduciary, such as trust, trustee or fiduciary, unless the LLC complies with the Corporate Fiduciary Act. The LLC s name must be the name under which the LLC transacts business unless the LLC adopts an assumed name by filing Form LLC However, an LLC may use divisional designations or trade names as long as the LLC s name is also clearly disclosed. By filing Form LLC-1.20 and paying a fee of $30 per year, the LLC is permitted to use an assumed name until the next year ending in either 0 or ILCS 180/50-10(b)(9). The right to use the assumed name must be renewed thereafter for five year periods by filing Form LLC-1.20 and paying a $150 filing fee. 805 ILCS 180/50-10(b)(9). The LLC s name also must be distinguishable from names of existing Illinois LLCs and corporations, foreign LLCs and corporations admitted to do business in Illinois, and assumed and reserved names. The availability of a name can be checked by doing a search at the following website: The availability of a name also can be checked by calling (217) Names can be reserved for future use by an LLC for up to 90 days by filing an application to reserve a name on Form LLC-1.15 and paying a $300 filing fee. 805 ILCS 180/50-10(b)(4). Finally, the LLC s name must comply with all common law and other statutory laws on unfair competition, trade names, service names and any other right to the exclusive use of a name. IMPLEMENTING AN LLC 16

25 The Illinois Limited Liability Company Act also specifically prohibits an LLC from improperly using a name. 805 ILCS 180/1-20(h). An LLC cannot use a name other than its organized or assumed name on a sign or advertisement, and an LLC cannot advertise or list in a telephone directory an assumed or fictitious name that intentionally misrepresents where the LLC is located or operated. If the LLC improperly uses a name, it can be fined not less than $501 and not more than $1,000 for each violation, and each additional day of improper use constitutes an additional offense. LLC s Purposes. The LLC must state in its articles of organization the purpose for which it is formed. An LLC is allowed to state that its purpose is the transaction of any and all lawful businesses for which LLCs may be organized. 805 ILCS 180/5-5(a)(2). However, one disadvantage of this stated purpose is that it does not provide notice to potential entrants into the marketplace that the LLC s name is already in use in the particular type of business of the LLC. Thus, it is advisable to state that the purpose of the LLC is to operate the LLC s particular type of business and the transaction of any and all lawful businesses for which LLCs may be organized. By this method, potential entrants are on notice of the LLC s use of its name for this type of business and the LLC may expand its operations without exceeding its permitted purpose. Registered Agent. The LLC s registered agent must be an individual who resides in Illinois, an Illinois corporation, or a foreign corporation having a place of business in Illinois and authorized to do business in Illinois. If the agent is a corporation, the corporation must be authorized by its articles of incorporation to act as an agent. 805 ILCS 180/1-35(a). The LLC s registered agent may change the address of the LLC s registered office by filing Form LLC-1.36/1.37 with the Secretary of State and paying a filing fee of $ ILCS 180/1-35(b) and 180/50-10(b)(15). The registered agent may resign at any time by first mailing a notice to the LLC at its principal office. At least ten days after sending the notice of resignation to the LLC, the agent must file a notice of resignation on Form 1.35 with the Secretary of State and pay a $100 filing fee. 805 ILCS 180/50-10(b)(17). The resignation is effective on the date specified on the filed form, which cannot be more than thirty days from the date of its filing. The LLC must place a new registered agent on record within 60 days after a registered agent s notice of resignation. 805 ILCS 180/1-35. A CPA or an attorney establishing an LLC on behalf of a client may find it advantageous to act as the registered agent for the client. By doing so, the professional can ensure that the LLC stays in compliance with the ongoing requirements of the LLC Act. The professional may also find that his duties provide him with the opportunity to stay in close contact with his client relating to issues that arise over time and to provide additional professional services as needed. IMPLEMENTING AN LLC 17

26 However, a professional may not want to assume the responsibilities as agent for the client if the professional has no assurance that the professional will be able to locate the client and will be on good terms with the client in the future. It will be extremely difficult for the professional to satisfy his or her obligations as agent for the client if these conditions are not met. Management Structure. Prior to filing the articles of organization, the LLC must choose whether it will be managed by its members or by managers, who do not need to also be members. If an LLC has managers, they function similar to a Board of Directors of a corporation. The LLC Act provides that the LLC s managers, if any, are appointed, removed, or replaced by vote of a majority of the members. A manager holds office until a successor has been elected and qualified, unless the manager sooner resigns or is removed. 805 ILCS 180/15-1(b)(3). Whether an LLC is member-managed or manager-managed has at least three consequences. First, if the LLC is manager-managed, the identity of the LLC s members is not on file with the Secretary of State s office on the LLC s articles of organization for the public to see. Second, if the LLC is manager-managed, then members of the LLC who are not also managers are not subject to self-employment taxes on their allocations of profits from the LLC. Third, if the LLC is manager-managed, then members of the LLC who are not also managers do not have fiduciary duties to the LLC and they cannot dissociates themselves from the LLC by providing notice to the LLC. 805 ILCS 180/15-3(g)((1) and 180/25-50(a). LLCs are typically established as manager-managed LLCs. Organizers. The organizers of an LLC are akin to the promoters of a corporation who act prior to the LLC s formation to establish the LLC and its business. Each organizer must be over 18 years of age, but need not be a member of the LLC. 805 ILCS 180/5-1(a). Limitation of Authority and Internal Regulations. Provisions governing the LLC s internal affairs are typically set forth in the LLC s operating agreement and not in the LLC s articles of organization. However, if the provisions are stated in the articles of organization rather than in the operating agreement, then this provides effective legal notice of the stated provisions. Thus, an LLC may have an interest in stating certain provisions in the articles of organization rather than the operating agreement. The potential disadvantage of stating provisions in the articles of organization rather than in the operating agreement is that changes to the articles of organization require the LLC to pay a filing fee to the Secretary of State whereas changes to the operating agreement do not require a fee. IMPLEMENTING AN LLC 18

27 To satisfy these competing concerns, a professional may state in the articles of organization that an operating agreement exists that governs the internal affairs of the LLC, but not state the specific provisions that are contained in the operating agreement. By this method, the LLC gives the public notice that provisions exist, but the LLC does not need to pay a filing fee to the Secretary of State to change these provisions. By a particular rule stated in the LLC Act, an LLC is able to protect itself against unauthorized transfers of its real property by adding a provision to its articles of organization. The LLC Act provides that any member of a member-managed LLC or manager of a manager-managed LLC may sign and deliver any instrument transferring or affecting the LLC s interest in real property. The instrument is conclusive in favor of a person who gives value without knowledge of the person s lack of authority. If the LLC does not want its members and/or managers to have the authority to transfer its real property and wants to protect itself against unauthorized transfers, the LLC can state in its articles of organization that its members and/or managers do not have this authority. This restriction will be effective to prevent the transfer of the LLC s real property to a third party, even if the third party gives value for it. 805 ILCS 180/13-5(c). Filing Fee and Location. An LLC files its articles of organization with the Illinois Secretary of State unless it is a bank, in which case it files with the Commissioner of Banks and Real Estate or the federal banking regulator. 805 ILCS 180/5-5(b) and (d). Unlike corporations, LLCs are not required by state statute to record their articles of organization in the county in which they transact business. However, there may be other local requirements that apply to the LLC. The filing fees due to the Illinois Secretary of State must be paid by certified check, cashier s check, Illinois CPA s check, Illinois attorney s check, or money order payable to the Secretary of State. The articles of organization must be typewritten and submitted in duplicate. Amendments to the Articles of Organization. An LLC s articles of organization may be amended by filing an Articles of Amendment Form LLC-5.25 and paying a $150 filing fee. 805 ILCS 180/50-10(b)(2). Even though an LLC s registered agent and office are stated in the LLC s articles of organization, an LLC can change the LLC s registered agent and/or the registered office by filing Form LLC-1.36/1.37 and paying a $25 filing fee without amending its articles of organization. 805 ILCS 180/50-10(b)(15). Pursuant to a statement contained on Form LLC-5.25, changes in the LLC s members and/or managers are not required to be reported to the Illinois Secretary of State even though the names of the members or managers are stated on the LLC s articles of organization. Amendments to the articles of organization requires the unanimous consent of the members in member-managed LLCs and manager-managed LLC, except that a majority of the managers may (1) remove the name of a former manager; (2) remove the registered agent or registered IMPLEMENTING AN LLC 19