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 [email protected]

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

28 office; (3) change the LLC s name to alter the LLC designation or to add a geographical attribution; and (4) restate the articles by filing Form LLC-5.30 to integrate into a single instrument all provisions in effect from prior filings. 805 ILCS 180/15-1(c)(2) and 180/5-15. B. MANAGEMENT DECISION-MAKING The LLC Act provides that each member has equal rights in the management and conduct of the LLC s business in a member-managed LLC, and each manager has equal rights in the management and conduct of the LLC s business in a manager-managed LLC. 805 ILCS 180/15-1(a)(1) and 180/15-1(b)(1). These rights are not in proportion to the amount of the members contributions or the number of his membership interests. Instead, each member has equal rights. The LLC Act provides that most decisions of the LLC are made by a majority vote of the members in a member-managed LLC and by a majority vote of the managers in a manager-managed LLC. 805 ILCS 180/15-1(a)(2) and 180/15-1(b)(2). However, the following decisions require the consent of all members: 1) The amendment of the operating agreement. 2) The amendment of the articles of organization, except that a majority of the managers of an LLC may make some minor changes (See section above on Amendments to the Articles of Organization. 3) The compromise, as among members, of an obligation of a member to make a contribution to the LLC or return money or other property paid or distributed in violation of the LLC Act. 4) The making of interim distributions, including the redemption of an interest. 5) The admission of a new member. 6) The use of the LLC s property to redeem an interest subject to a charging order. 7) The consent to dissolve the LLC. 8) A waiver of the right to have the LLC s business wound up and the LLC terminated after the LLC has dissolved but not wound up its business. 9) The merger of the LLC with another entity. 10) The sale, lease, exchange, or other disposal of all, or substantially all, of the company s property with or without goodwill. IMPLEMENTING AN LLC 20

29 805 ILCS 180/15-1(c). Actions requiring the consent of members or managers may be taken without a meeting. 805 ILCS 180/15-1(d). Members and managers also may appoint a proxy to vote or otherwise act for the member or manager by signing an appointment instrument, either personally or by the member or manager s attorney-in-fact. 805 ILCS 180/15-1(e). The default rules provided by the LLC Act give each manager or member equal voting rights rather giving them voting rights in proportion to their contributions to the LLC. These default rules may not produce a desirable result if some members have contributed substantially more to the LLC than others. Thus, the LLC s organizers likely will want to provide in the operating agreement different rules for the management of the LLC than those provided by the LLC Act. C. SINGLE MEMBER LLCs LLCs can be formed with only one member. 805 ILCS 180/5-1(a). One-person LLCs are often used to provide limited liability to individuals who would otherwise operate their business as a sole proprietorship or would hold real estate in their individual capacity. The member of a one-person LLC in particular should ensure that he does not act in such a way that would cause him to lose the limited liability protections that the LLC offers. For example, the member should not commingle his personal funds with those of the LLC or treat the LLC s assets as his own. (See Section below on Limited Liability of Members and Exceptions.) In practice, a single member of an LLC often does not execute an operating agreement to govern his relationship with the LLC. However, even in single-member LLCs, it is advisable for the member to do so to avoid inadvertently being bound by terms stated in other documents. This may happen because the LLC Act provides a list of documents that are considered legally equivalent to an operating agreement in a single member LLC even if the member did not intend the documents to have the same effect as an operating agreement. These documents include: (1) any writing as to the LLC s affairs signed by the sole member; (2) any written agreement between the member and the LLC as to the LLC s affairs; and (3) any oral or written agreement between the member and the LLC as to the LLC s affairs if the LLC is managermanaged. 805 ILCS 180/15-5(c). In addition, it is advisable for a single member of an LLC to execute an operating agreement to allow the LLC to indemnify and to defend the LLC member to the full extent permitted by law if the LLC member is sued for his conduct relating to the LLC. Absent such a provision, the LLC would not necessarily be allowed to use its assets for the personal benefit of the member. IMPLEMENTING AN LLC 21

30 D. FOREIGN LLCs A foreign LLC is an LLC that is organized under the laws of a jurisdiction other than Illinois. Foreign LLCs cannot transact business in Illinois unless the LLC files an application for admission with the Secretary of State, and the LLC is subject to monetary penalties and other consequences if it fails to do so. 805 ILCS 180/45-5(a) and 180/45-45(d). The Secretary of State may revoke the LLC s right to transact business in Illinois upon the occurrence of certain events, and the LLC may reinstate its admission after its revocation by satisfying certain requirements. 805 ILCS 180/45-35 and 180/ Similarly, an Illinois LLC that transacts business in states other than Illinois and in foreign countries is a foreign LLC with respect to these states and countries. Just like a foreign LLC that transacts business in Illinois must comply with Illinois rules governing foreign LLCs, an Illinois LLC that transacts business in other states and countries must comply with the rules governing foreign LLCs effective in those states and countries. If the LLC has not complied with the legal requirements for doing business in a state, the state may prohibit the LLC from instituting a lawsuit in the state, require the LLC to pay penalties, and impose other adverse consequences. Transaction of Business in Illinois. Except for certain foreign LLCs transacting an insurance business, a foreign LLC cannot transact business in Illinois unless it files an application for admission to do so with the Illinois Secretary of State. 805 ILCS 180/45-5(a). This requirement raises the question of the meaning of the statutory term transact business. If the LLC s activities in Illinois do not constitute the transaction of business in Illinois, then the LLC does not need to file an application, but if the LLC s activities do constitute the transaction of business in Illinois then the LLC does need to file an application. The LLC Act contains a specific statutory provision that helps an LLC determine whether or not its Illinois activities constitute the transaction of business. The LLC Act states that the following activities in Illinois do not constitute the transaction of business: 1) Maintaining, defending, or settling any proceeding; 2) Carrying on activities concerning internal company affairs; 3) Maintaining bank accounts; 4) Maintaining offices, agencies, trustees or depositaries for the LLC s own securities; IMPLEMENTING AN LLC 22

31 5) Selling through independent contractors; 6) Soliciting or obtaining orders if orders require acceptance outside Illinois; 7) Owning real or personal property; 8) Conducting an isolated transaction completed within 120 days; or 9) Having a member or manager who is an Illinois resident. 805 ILCS 180/ Application for Admission. In order to obtain the right to transact business in Illinois, a foreign LLC must file an application for admission to transact business with the Illinois Secretary of State. A regular, foreign LLC files Form LLC-45.5 and pays a $500 filing fee. 805 ILCS 180/50-10(b)(1). A series, foreign LLC files Form LLC-45.5(S) and pays a $750 filing fee. A series LLC also must file a certificate of designation on Form LLC and pay a $50 filing fee for each series of the LLC. The application for admission to transact business in Illinois contains the following: 1) The LLC s name and the name under which it proposes to transact business; 2) The jurisdiction and date of the LLC s formation and the period of its duration; 3) A certificate from the foreign state s official that the LLC is in existence and a copy of the LLC s articles of organization authenticated by the foreign state s official; 4) The name and address of its Illinois registered agent; 5) The address of the office required to be maintained in the state of organization or if no requirement, then the LLC s principal place of business; 6) The purpose for which the LLC was organized and proposes to conduct business in Illinois and the date upon which the LLC first conducted business in Illinois; 7) A statement of whether the LLC is managed by member(s) or manager(s); 8) A statement that the LLC appoints the Secretary of State as its agent for service of process if an Illinois agent is not maintained or cannot be found; and 9) For series LLCs, notice that the liabilities of the LLC are limited to being satisfied from the assets of the series and that a certificate of designation shall be filed. 805 ILCS 180/45-5(a). IMPLEMENTING AN LLC 23

32 The name under which the foreign LLC transacts business in Illinois must be available for use to a LLC in Illinois. If the name the LLC uses to transact its business in Illinois is different from the name used for its formation, then the LLC must file an assumed name application Form LLC ILCS 180/ A foreign LLC must maintain a registered agent and registered office in Illinois. The registered agent must be an individual who resides in Illinois, an Illinois corporation, or a foreign corporation having a place of business in and authorized to do business in Illinois. 805 ILCS 180/45-30(1). To maintain its admission to transact business in Illinois, a foreign LLC must file an annual report on Form LLC-50.1(F) and pay a $250 filing fee. 805 ILCS 180/45-30(c) and 180/50-10(b)(11). If the foreign LLC is a series LLC, the LLC must pay an additional fee of $50 for each series to file its annual report. Consequences of Failing To Be Admitted. If a foreign LLC transacts business in Illinois without being admitted to do so, the LLC is liable for the filing fees and penalties for late filings that otherwise would have been imposed. In addition, if the LLC fails to be admitted within 60 days after it commences Illinois business, the LLC is liable for a penalty of $2,000 plus $100 for each month of business. A foreign LLC that has not been admitted to transact business in Illinois also appoints the Secretary of State as its agent for process and it cannot maintain a civil action in an Illinois court. The Attorney General also may bring an action to restrain the LLC from transacting business in Illinois. However, a foreign LLC s failure to be admitted to transact business does not impair the validity of any contract or act or prevent the LLC from defending a civil action in Illinois. 805 ILCS 180/ Revocation of Admission. The Illinois Secretary of State may revoke a foreign LLCs admission to transact business in Illinois if: 1) The LLC fails to: a. File its annual report or pay any fees or penalties; b. Appoint and maintain registered agent within 60 days after agent s notice of resignation; c. File a report upon change in the name or address of the registered agent; d. File any amendment to its application for admission; or IMPLEMENTING AN LLC 24

33 e. Renew its assumed name, or apply to change its assumed name, when the LLC may only transact business within the State under its assumed name. or 2) The LLC makes a misrepresentation in a document submitted under LLC Act; and 3) The LLC has failed to correct the violation after Secretary of State has given the LLC 60 days notice and 120 days have passed from the notice date. 805 ILCS 180/ Reinstatement and Withdrawal of Admission. A foreign LLC may reinstate its admission to transact business in Illinois after it has been revoked by filing an application for reinstatement Form LLC The LLC also must file all reports due and pay all fees and penalties. 805 ILCS 180/ A Foreign LLC may withdrawal is admission to transact business in Illinois by filing an application for withdrawal Form LLC ILCS 180/ E. SPECIAL RULES FOR REGULATED PROFESSIONALS An LLC cannot be formed for the practice of certain professions unless certain requirements are satisfied as follows: Accountancy: Architecture: A majority of the financial interests and voting rights in the LLC must be held by persons licensed as a public accountant in some state. 225 ILCS 450/14(b)(2). All members of the LLC, whether licensed or not, must actively participate in the firm. The LLC must require that all members comply with the rules promulgated under the Illinois Public Accounting Act, and the LLC must designate to the Department of Professional Regulations in writing an individual licensed under the Illinois Public Accounting Act who is responsible for the proper registration of the firm. 225 ILCS 450/14.3. The LLC must obtain a license from the Department of Professional Regulation and pay a $120 fee. 225 ILCS 450/13. Two-thirds of the LLC s members must be licensed under the laws of any state to practice architecture, professional engineering, land surveying, or structural engineering. The person having the architectural practice in Illinois in his IMPLEMENTING AN LLC 25

34 charge must be a member of the LLC and must hold a license to practice architecture under the Illinois Architecture Practice Act. The LLC must register with the Illinois Department of Professional Regulation and pay a $75 fee. 225 ILCS 305/21(b). Dentistry: All members and managers must be licensed dentists under the Illinois Dental Practice Act. 805 ILCS 180/1-25(3). Engineering: The LLC must designate a managing agent in charge of professional engineering activities in Illinois who maintains a license to practice professional engineering in Illinois and is a full-time employee of the LLC. The LLC must register with the Illinois Department of Professional Regulation and pay a $75 fee. 225 ILCS 325/23(a) and (b). Insurance: Law: If the LLC carries on a business as a member of a group including incorporated and individual unincorporated underwriters, the Director of Insurance must find that the group meets the requirements of subsection (3) of Section 86 of the Illinois Insurance Code. If insolvent, the is subject to liquidation by the Director of Insurance under Article XIII of the Illinois Insurance Code. 805 ILCS 180/1-25(2). The LLC must satisfy specific requirements and obtain a certificate of registration from the Supreme Court of Illinois. See a detailed discussion in the section below. Professional land surveyors: The LLC must designate a managing agent in charge of land surveyor activities in Illinois who maintains a license to practice professional land surveying in Illinois and is a full-time employee of the LLC. The LLC must register with the Illinois Department of Professional Regulation and pay a $75 fee. 225 ILCS 330/25(a) and (b). Real estate brokers: Every manager of the LLC must hold a license as a real estate broker and every member and employee who acts as a salesperson or leasing agent for the LLC must hold a license as a real estate broker, salesperson, or leasing agent. No individual salesperson or leasing agent or group of them may directly or indirectly control more than forty-nine percent of the ownership in the LLC. The LLC must obtain a license from the Office of Banks and Real Estate and pay a $125 fee. 225 ILCS 454/5-15(a), (d) and (e). Medicine: All members and managers must be licensed to practice medicine under the Medical Practice Act of 1987 and all organizers must be licensed to practice medicine or law. 805 ILCS 180/1-25(4) and 180/5-1(a). IMPLEMENTING AN LLC 26

35 Structural engineering: The LLC must designate a managing agent in charge of structural engineering activities in Illinois who maintains a license to practice structural engineering in Illinois and is a full-time employee of the LLC. The LLC must register with the Illinois Department of Professional Regulation and pay a $75 fee. 225 ILCS 340/19(a) and (b). Additional restrictions exist for other professions. A professional who establishes an LLC for a client to practice a regulated profession always should check the statutes and rules governing the particular profession to ensure that the profession is allowed to be practiced by an LLC and to ensure that all other applicable requirements have been satisfied. The Illinois Department of Financial and Professional Regulation maintains a website at that contains detailed information concerning the licensing requirements for all professions. LLCs Formed for the Practice of Law. An LLC formed for the practice of law must first obtain a certificate of registration from the Supreme Court of Illinois. Il. Supreme. Ct Rule 721(c). An application for registration can be obtained by calling (217) or from the website under the headings Supreme Court of Illinois and Application for Certificate of Registration to Practice Law as an entity under Supreme Court Rule 721. The registration fee is $50 and the annual renewal fee is $40. The LLC must post its certificate of registration at its premises. Il. Supreme Ct Rule 721. An LLC cannot obtain a certificate of registration to practice law unless all of the following conditions are satisfied: 1) Each member and manager is licensed to practice law; 2) Each person who is engaged in the practice of law and who is an employee of the LLC is licensed to practice law; 3) At least one member is an Illinois bar member and practices law in Illinois; 4) Each member and manager is a member of the bar of each jurisdiction in which the person practices; and 5) No disciplinary actions are pending against any member or manager. Il. Supreme. Ct Rule 721(a). Failure to obtain a certificate is grounds for the Illinois Supreme Court to terminate or suspend the right of the LLC to practice law or otherwise to discipline it. Il. Supreme Ct Rule 721(b). In addition, the failure to obtain a certificate causes the LLC s members to lose the limited liability protections afforded by Illinois Supreme Court Rule 721, which limits a member s liability for the malpractice committed by other members. Ford Motor Credit Co. v. Sperry, 214 Ill.2d 371, IMPLEMENTING AN LLC 27

36 388, 827 N.E.2d 422, 432, 292 Ill. Dec. 893, 903 (2005). A failure to obtain the certificate does not prevent the LLC from collecting fees for its services. Storto v. Becker, 341 Ill. App. 3d 337, 345, 792 N.E.2d 384, 391, 275 Ill. Dec. 153, 160 (2 nd Dist. 2003). F. LIMITED LIABILITY OF MEMBERS AND EXCEPTIONS A member or manager of an LLC is generally not personally liable for the LLC s debts, obligations, or liabilities. 805 ILCS 180/10-5(a). However, important exceptions to this general rule exist under both the common and statutory law. Under the common law, personal liability may arise if (1) there is a unity of interest and ownership such that the separate personalities of the LLC and the individual no longer exist; and (2) the continued adherence to the fiction of a separate corporate existence would sanction a fraud or promote injustice. In re Kreisler, B.R. 331 B.R. 364, 379 (N.D. Ill. 2005). If an individual commingles his funds or assets with those of the LLC or treats the LLC s assets as his own, this suggests that there is a unity of interest and ownership between the LLC and the individual. In making the second determination, courts generally consider the following factors: (1) inadequate capitalization; (2) the failure to issue membership interests; (3) the nonpayment of distributions; (4) the insolvency of the entity; (5) the non-functioning of the managers or officers; (6) the absence of company records; (7) commingling of funds; (8) diversion of assets from the LLC by or to a member; (9) failure to maintain arm s length relationships amount related entities; and (10) whether the LLC is a façade for the operation of the dominant shareholder. Jacobson v. Buffalo Rock Shooters Supply, Inc. 278 Ill.App.3d 1084, 1088, 664 N.E.2d 328, 331, 215 Ill. Dec. 931, 934 (3 rd Dist. 1996). The LLC Act expressly alters prior common law by stating that the failure of an LLC to observe company formalities or requirements for exercise of company powers or management does not result in personal liability. 805 ILCS 180/10-10(c). Pursuant to statute, members and/or managers of an LLC also are personally liable as follows: 1) By Agreement: A member is personally liable if the articles of organization so provide and the member has consented to be bound to it (805 ILCS 180/10-10(d)); 2) For Causing Unlawful Distributions: A member or manager is personally liable to the LLC for the amount by which a distribution by the LLC to its members exceeds the amount that could have been lawfully distributed if the member or manager votes for or assents to the unlawful distribution and the member or manager breached his fiduciary duties or duty of good faith and fair dealing to the LLC (805 ILCS 180/25-35(a)); 3) For Receiving Unlawful Distributions: A member is personally liable to the LLC for the amount by which the distribution received by the member exceeds the amount that IMPLEMENTING AN LLC 28

37 could have been lawfully distributed to the member if he knew that the distribution was unlawful. (805 ILCS 180/25-35(b)); 4) For Professional Malpractice: A member of an LLC that provides regulated professional services many be personally liable by virtue of the laws governing the profession; and 5) For Breach of Fiduciary or Other Duties: A manager or member who breaches his fiduciary duties or duty of good faith and fair dealing owed to the LLC and/or the members is personally liable for his breaches (805 ILCS 180/15-3); and 6) For Inappropriate Acts During Dissolution: A member or manager who, with knowledge of the LLC s dissolution, subjects the LLC to liability by an act that is not appropriate for winding up the LLC s business is personally liable to the LLC for resulting damages (805 ILCS 180/35-7(b)). Members and Managers Liability for Unlawful Distributions. A member of a member-managed LLC or a member or manager of a manager-managed LLC who votes for or assents to a distribution is personally liable for the distribution if (1) the distribution violates the LLC Act, the articles of organization, or the operating agreement; and (2) the member or manager breached the fiduciary duties or duty of good faith and fair dealing that he owes to the LLC pursuant to the LLC Act. 805 ILCS 180/25-35(a). The member s and manager s liability is only for the amount of the distribution in excess of the amount that could have been lawfully distributed. Id. In addition, a member of a manager-managed LLC is liable for a distribution if (1) the distribution violates the LLC Act, the articles of organization, or the operating agreement; and (2) the member knew the distribution was made in violation of one of them. 805 ILCS 180/25-35(b). The member s liability is limited to the amount of the distribution received by the member in excess of the amount that could have been lawfully distributed pursuant to the LLC s Acts financial standards. Id. A member or manager who is liable for an unlawful distribution may compel contribution from all other members or managers who are also personally liable for the unlawful distributions pursuant to the rules set forth above. 805 ILCS 180/25-35(c). Liability for Professional Services. Professional regulations governing certain regulated professions impose personal liability on professionals who render professional services through an LLC despite the limited personal liability that the LLC Act affords to an LLC s members and managers. Specifically, the IMPLEMENTING AN LLC 29

38 regulations often impose personal liability on a professional for claims arising from the professional services that the professional and/or others render through the LLC. For example, the professional regulations governing the practice of public accounting and law impose personal liability to a certain extent on CPAs and lawyers who practice in an LLC. Professional regulations do not cause the professionals to be personally liable for the debts and obligations of the LLC that do not arise directly from the LLC s rendering of professional services. The Practice of Public Accounting. Rule 505 of the AICPA Code of Professional Conduct and similar rules governing public accountants require that Certified Public Accountants remain responsible, financially and otherwise, for attest work performed to protect the public interest. Because the LLC Act provides for limited liability of all members and managers of an LLC, an LLC that performs public accounting attest work must add provisions to its articles of organization and/or operating agreement that provide for the personal liability of the Certified Public Accountants to comply with Rule 505. The Practice of Law. The professional rules governing the practice of law provide that practicing law in an LLC or other entity that normally provides its owners with limited personal liability does not alter a lawyer s personal liability for claims arising from the performance of professional services by the lawyer or by any person under his direct supervision and control. Supreme Ct Rule 722(c). See also 805 ILCS 180/55-2. Similarly, practicing law in an LLC or other entity does not change the lawyer s personal responsibility for his violations of the standards of professional conduct governing lawyers. Supreme Ct Rule 721(b). However, practicing law in an LLC or other limited-liability entity does permit a lawyer to take certain actions that limit his personal liability for claims arising from the performance of professional services by other lawyers and employees of the entity that the lawyer does not supervise or control. Supreme Ct Rules 721(d) and 722(b). In particular, a lawyer will not be personally liable for the acts of other members and other persons arising out of the performance of professional services by the entity if the entity maintains minimum insurance or proof of financial responsibility. Supreme Ct Rules 721(d) and 722(b). Minimum insurance requires the maintenance of an annual insurance policy with coverage of $100,000 per claim and $250,000 in the aggregate for wrongful conduct in the policy period and previous six years times the number of lawyers practicing in the entity, but in no event greater than $5,000,000 per claim and $10,000,000 in the aggregate annually. Supreme Ct Rule 722(b)(1). Proof of financial responsibility requires that the entity to maintain funds that are specifically designated and segregated for the satisfaction of any judgments against the entity, and any of IMPLEMENTING AN LLC 30

39 its owners or employees, entered by an Illinois court, arising out of wrongful conduct. Supreme Ct Rule 722(b)(3). The amount of the funds must be no less than the required annual aggregate for minimum insurance and maintained in the form of (1) a deposit in a trust or in a bank escrow of cash, bank certificates of deposit, or U.S. Treasury obligations; (2) bank letter of credit; or (3) a surety bond. Id. Even if the entity maintains minimum insurance, the entity s owners are still jointly and severally liable up to the amount of the deductible amount unless the entity also has provided proof of financial responsibility in a sum no less than the amount of the deductible. Supreme Ct Rule 722(2). If minimum insurance or proof of financial responsibility is not maintained, the articles of organization of an LLC that engages in the practice of law must provide, and in any event the members shall be deemed to agree, that the members are jointly and severally liable for the acts of members and other employees arising out of the performance of professional services by the LLC. Supreme Ct Rule 721(d). Members and Managers Liability for Breach of Fiduciary and Other Duties. In a member-managed LLC, the LLC s members owe fiduciary and other duties to the LLC and to its other members. 805 ILCS 180/15-3(a)-(c). In a manager-managed LLC, the managers owe fiduciary and other duties to the LLC. 805 ILCS 180/15-3(g). The members of a manager-managed LLC do not owe any duties, except that members who exercise the authority of a manager in the management and conduct of the LLC s business pursuant to the operating agreement of a manager-managed LLC do owe duties. 805 ILCS 180/15-3(g)(1) and (3). A manager is relieved of his duties to the extent of the managerial authority delegated to the members by the operating agreement. 805 ILCS 180/15-3(g)(4). Finally, a person winding up the LLC s business as the personal or legal representative of the last surviving member owe the same duties as the member. 805 ILCS 180/15-3(f). A member s or manager s duties include the fiduciary duties of loyalty and duty of care and the duty of good faith and fair dealing. 805 ILCS 180/15-3(b)-(d). The duty of loyalty requires the fiduciary to (1) account for and hold as trustee any property, profit or benefit derived by the fiduciary in the conduct of the LLC s business or derived from use of the LLC s property, including the appropriation of an opportunity of the LLC; (2) to act fairly when dealing with the LLC in the conduct of the LLC s business as or on behalf of an adverse party; and (3) to refrain from competing with the LLC in the LLC s business. 805 ILCS 180/15-3(b). In the conduct of winding up the LLC s business, the fiduciary s duty of care is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law. 805 ILCS 180/15-3(c). The duty of good faith and fair dealing requires the member or manager to discharges his duties and exercise his rights relating to the LLC consistent with the obligation of good faith and fair dealing. 805 ILCS 180/15-3(d). IMPLEMENTING AN LLC 31

40 The LLC Act expressly provides that a member or manager does not violate his duties merely because his conduct furthers his own interest. 805 ILCS 180/15-3(e). In addition, the LLC Act expressly allows members and managers to consider in discharging their duties the effect of any action (including a change in control) upon employees, suppliers, customers, and communities, and to consider all other pertinent factors. 805 ILCS 180/ Standing to Sue. An LLC member may sue the LLC or another member to enforce the member s operating agreement rights, the member s LLC Act rights, and the member s rights arising independently of the member s relationship to the LLC. 805 ILCS 180/15-20(a). In addition, a member may bring a derivative action on behalf of the LLC to enforce the LLC s rights where the member cannot allege an injury distinct from the injury to the LLC. To bring a derivative action, the member must show that (1) the LLC s members or managers with authority to sue have refused to sue or that an effort to cause them to sue is not likely to succeed; and (2) the member was a member at the time of the subject transaction or became a member through a person who was a member at the time. 805 ILCS 180/40-1 and 180/40-5. If successful, the court may award the member reasonable expenses, including attorney s fees, and shall direct the member to remit the proceeds to the LLC. 805 ILCS 180/ LLC s Liability for a Member s or Manager s Acts. An LLC s liability for the acts of its members and managers is determined by principles of agency as codified in the LLC Act. An LLC is liable for wrongful acts and omissions (such as tortuous conduct) of a member or manager acting in the ordinary course of the LLC s business or with the LLC s authority. 805 ILCS 180/ An LLC is bound by a member s or manager s acts (such as entering into a contract) when the member or manager has either actual or apparent authority to act on behalf of the LLC pursuant to principles of agency. 805 ILCS 180/13-5. The LLC Act provides different rules of agency for member-managed and manager-managed LLCs. In a member-managed LLC, each member has actual authority to bind the LLC if the member s act is authorized by the other members. Each member has apparent authority to bind the LLC if the member s act is to carry on, in the ordinary course, the LLC s business or business of the kind carried on by the LLC. 805 ILCS 180/13-5(a)(1). The LLC is not bound if the member had no actual authority to act and the person with whom the member was dealing knew or had notice that the member lacked authority. Id. In manager-managed LLCs, each manager has actual authority to bind the LLC if the manager s act is authorized. Each manager has apparent authority to bind the LLC if the manager s act is to carry on, in the ordinary course, the LLC s business or business of the kind carried on by the IMPLEMENTING AN LLC 32

41 LLC. 805 ILCS 180/13-5(b). Members in manager-managed LLCs do not have apparent authority to bind the LLC. Id. In both member-managed and manager-managed LLCs, different rules of agency apply to the transfer of real property. Unless the articles of organization limit their authority, 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 person who gives value without knowledge of the person s lack of authority. 805 ILCS 180/13-5(c). Finally, the rules of agency in both types of LLCs differ after the LLC s dissolution and after a member s dissociation. After dissolution, the LLC is bound by a member s or manager s act that (1) is appropriate for winding up the LLC s business; or (2) that would have bound the LLC before dissolution, if the other party to the transaction did not have notice of the dissolution. 805 ILCS 180/35-7(a). For a period of two years after a member s dissociation without the LLC s winding up, the LLC is bound by the dissociated member s act that would have otherwise bound the LLC if the other party to the transaction reasonably believed that the dissociated member was then a member and did not have notice of the member s dissociation. 805 ILCS 180/ G. PROPERTY TRANSFERS TO AND FROM MEMBERS LLC members typically make contributions to the LLC. In exchange, LLC members hold a membership interest in the LLC that entitles them to receive any interim and final distributions made by the LLC and to be reimbursed by the LLC for certain expenses incurred. A member may transfer his LLC membership interest to another voluntarily and his interest may be subject to the rights of his creditors. Contributions. To become an LLC member, a person or entity typically makes a contribution to the LLC. The contribution may be in the form of cash, property, or services rendered. 805 ILCS 180/20-1. The contribution also may be in the form of a promissory note or other obligation to contribute cash, property, or services. Id. A member s obligation to make the agreed-upon contribution is not excused by death, disability or other inability to perform. 805 ILCS 180/20-1(c). If the member does not contribute the required property or services, the member is obligated at the option of the LLC to contribute money equal to its value. Id. A creditor who relies on a member s obligation to contribute to the LLC can enforce the member s contribution obligation. 805 ILCS 180/20-5(d). The LLC must keep at its principal place of business a list of each member s contribution. 805 ILCS 180/1-40(a)(1). IMPLEMENTING AN LLC 33

42 Reimbursements. An LLC is obligated to reimburse a member for payments made and liabilities incurred by the member in the LLC s ordinary course of business or for the preservation of the LLC s business or property. 805 ILCS 180/15-7(a). In addition, an LLC is obligated to repay a member for advances the member makes to the LLC. 805 ILCS 180/15-7(b). An LLC also must pay the member interest from the date that the member made the payments or advances. 805 ILCS 180/15-7(c). An LLC is not required to pay a member remuneration for services performed by the member for the LLC other than for winding up the LLC, unless otherwise provided by the operating agreement, a contract, or the common law. 805 ILCS 180/15-7(d). Interim Distributions. If an LLC makes interim distributions to its members, the distributions must be in equal shares to the LLC s members unless the operating agreement otherwise provides. 805 ILCS 180/25-1(a). This default rule can lead to extremely inequitable results if the members contributions are disproportionate. Therefore, a professional drafting an operating agreement should ensure that the LLC s method for making interim distributions is expressly delineated in the operating agreement unless the LLC desires for each member to receive equal interim distributions. An LLC cannot make interim distributions to its members if (1) the LLC would not be able to pay its debts as they become due; or (2) the LLC s total assets would be less than its total liabilities and the amount of members preferential rights if the LLC were dissolved. 805 ILCS 180/25-30(a). The LLC Act provides detailed rules as to how to perform the calculation for whether an LLC is permitted to make an interim distribution. 805 ILCS 180/25-20(b)-(e). IMPLEMENTING AN LLC 34

43 LLC s Final Distribution of Assets. When the LLC winds up its operations, its assets are applied and distributed in the following order: 1) First, the LLC s assets are applied to discharge obligations to creditors, including members who are creditors. 2) Second, the LLC s assets are applied to return all members contributions that have not previously been returned. 3) Third, the LLC s assets are distributed to its members in equal shares. 805 ILCS 180/ As with interim distributions, the default rule providing for the members to receive final distributions in equal shares after the contributions of all members have been returned can lead to extremely inequitable results. Therefore, a professional drafting an operating agreement should ensure that the LLC s method for making final distributions is expressly delineated in the operating agreement unless the LLC desires for each member to receive equal final distributions. Voluntary Transfer of a Member s Distributional Interest. The right of a member to receive his appropriate share of the interim and final distributions of an LLC, if any, is called the member s distributional interest. A member has no absolute right to receive any distributions, has no interest in the LLC s property, and has no right to receive a distribution in kind. 805 ILCS 180/25-1(b) and 180/30-1. A member entitled to receive a distribution has rights of a general, unsecured creditor. 805 ILCS 180/ A member s distributional interest is personal property that may be transferred in whole or in part. 805 ILCS 180/30-1(b). The operating agreement may provide that the distributional interest may be evidenced by a certificate and may provide for the transfer of any interest represented by the certificate. 805 ILCS 180/30-1(c). A transferee of a member s distributional interest has no absolute right to become a member and is not entitled to participate in the LLC s management or access its records. 805 ILCS 180/30-5 and 180/30-10(d). A transferee may become a member only if the transferor gives the transferee this right in accordance with the operating agreement or all other members consent. 805 ILCS 180/ A transferee is entitled to received, in accordance with the transfer, interim and final distributions that the LLC makes. 805 ILCS 180/30-10(e)(1) and (2). A transferee also may seek a judicial determination that it is equitable to dissolve the LLC. 805 ILCS 180/30-10(e)(3). A transferor of his distributional IMPLEMENTING AN LLC 35

44 interest is not released from liability to the LLC under the operating agreement or the LLC Act even if the transferee becomes an LLC member. 805 ILCS 180/30-10(c). If the transferee becomes a member of the LLC, the transferee is liable for the transferor s contribution obligation and to return any unlawful distributions made by the transferor. 805 ILCS 180/30-10(b). However, the transferee is not obligated for the transferor member s liabilities unknown to the transferee at the time the transferee becomes a member. Id. When forming an LLC, the LLC s members should consider whether they want to provide in the operating agreement exit strategies that permit, and/or require, members to withdraw from the LLC and transfer their membership interests. The LLC Act provides for certain procedures for a member to disassociate from the LLC and to require the LLC to purchase his membership interest. (See Section below on Dealing with a Member s Dissociation.) If the members want to eliminate this right or set forth additional procedures for the withdrawal, they should do so in the operating agreement. LLC members are given a great degree of liberty in crafting these procedures. The provisions that professionals generally use for corporations can also be used for LLCs. For example, the operating agreement may restrict the transfer of a membership interest to third parties, contain a buy-sell agreement, require a member s interest to be redeemed by the LLC or purchased by another member, provide a right to sell shares if other shares are sold (co-sale rights), provide a right of first refusal for membership interests offered for sale, and/or provide the right to cause a minority member to sell its interest when the majority votes to do so (drag along rights). Where relevant, the operating agreement also should provide a set price or a method to determine the price for the transfer of the member s membership interest. In addition, the members may wish to ensure in the operating agreement that their membership interests are not diluted by the LLC s subsequent sale of additional membership interests. Often this is accomplished by giving members the right to purchase the additional interests offered in proportion to their existing interest in the LLC prior to any sale by the LLC of the interests to others. Transfer of a Member s Distributional Interest to Creditors. A court may charge the distributional interest of a member or a member s transferee to satisfy judgments against the member or his transferee. 805 ILCS 180/30-20(a). The court s charging order is a lien on the distributional interest and the court may order the interest to be foreclosed. 805 ILCS 180/30-20(b). The distributional interest may be redeemed by the judgment debtor, by another member, or by the LLC if the operating agreement permits. 805 ILCS 180/30-20(c). Importantly, creditors of an LLC member are limited to the remedy of a charging order to enforce their interest in a member s distributional interest. This means that the creditor does not have any control over or voting rights in the LLC. Rather, the creditor only has an IMPLEMENTING AN LLC 36

45 economic interest in the LLC. Because a creditor attaches an income interest, an argument can be made that the creditor must pay tax on income allocated to the interest even if no distributions have been paid to the creditor. Thus, the member s interest may create a tax liability for the creditor, and therefore, be undesirable to the creditor. H. SECURITIES LAW COMPLIANCE The securities laws apply only to interests that are considered securities. A security exists if a person contributes money, property, or services to a company in exchange for an interest in the company by which the person expects to make a return. Securities include both debt and equity securities. A membership interest in an LLC generally constitutes a security subject to the federal and state securities laws. The securities laws impose two types of obligations on an LLC in connection with the sale of LLC membership interests. First, the antifraud provisions of the securities laws require the LLC to make full and fair disclosure of information relating to the membership interests to purchasers. Second, the registration provisions require the LLC to register the membership interests with federal and/or state governmental bodies unless an exemption from registration applies. Duty of Fair and Full Disclosure The duty of full and fair disclosure is independent of the duty to register the LLC membership interests. Thus, even if an exemption from registration exists, an LLC must ensure that no false or misleading information is provided to purchasers of the membership interests and no information is omitted from disclosure that makes the information that is disclosed false or misleading. For private offerings, LLCs typically provide investors with a business plan and an Offering Memorandum or Private Placement Memorandum prepared by an attorney and an accountant containing detailed information about the LLC and the LLC s membership interests. Among other things, the Memorandum discloses the terms of the offering and the risks associated with it to investors. The LLC may also attach documents relating to the LLC as exhibits to the Memorandum. LLCs that do not want to incur the expense of preparing a formal Memorandum often choose to provide potential purchasers instead with all of the documents that the LLC has in its possession that relate to the LLC and the membership interests. For example, the LLC provides the investors with the terms sheet for the offering, operating agreement, articles of organization, financial records, and contracts of the LLC. If the LLC relies exclusively on this IMPLEMENTING AN LLC 37

46 later method, the LLC substantially increases its risk of being subjected to a claim for securities fraud, and therefore, this method is not recommended in most circumstances. When an LLC sells its membership interests in a public offering involving public solicitation and general advertising, the LLC generally must prepare and provide to investors a prospectus. A prospectus is a very detailed, complex document and its contents are proscribed by law. Federal Securities Registration. LLCs that offer their membership interests for sale must file a registration statement with the securities with the Securities and Exchange Commission to register the offering unless an exemption from registration applies. There are at least six common registration exemptions, which are discussed below. A practitioner should remember that the existence of a federal registration exemption does not exempt the LLC from its duty of providing to purchasers full and fair disclosure of information relating to the membership interests. Similarly, a federal registration exemption does not necessarily exempt the LLC from having to register the securities pursuant to state securities laws or to file a notice of the sale with federal and state regulatory bodies. Intrastate Offering Exemption. Section 3(a)(11) of the Securities Act of 1933, 15 U.S.C. 77c(a)(11), exempts from federal registration securities offerings by an issuer that are considered to take place entirely within one state. This exemption was intended to apply only to securities issuances that are genuinely local in character, which represent local financing by local businesses carried out through local investment. To qualify for this exemption, a limited liability company issuing membership interests must meet each one of these three requirements: 1) The LLC must be organized in the state where it is offering the membership interests; 2) The LLC must be doing business in that state; and 3) The LLC must make offers and sales of the membership interests only to residents of that state. The interstate exemption does not depend on the dollar value of the offering or the number or characteristics of the purchasers. If a purchaser resells any of the membership interests to a person who resides outside the state within a short period of time after the LLC s offering is complete (usually a period of nine months), the exemption may be lost with respect to the entire transaction. In order to provide issuers with confidence as to whether the three requirements for the intrastate exemption have been satisfied, the Securities and Exchange Commission IMPLEMENTING AN LLC 38

47 promulgated Rule 147, 17 CFR , providing a safe harbor rule. Satisfaction of the tests stated in Rule 147 and compliance with the additional obligations set forth in the Rule will ensure the issuer that the intrastate offering exemption applies. However, it is possible that securities offerings that do not meet the tests set forth in Rule 147 may still qualify for the intrastate offering exemption. Rule 147 provides that an issuer will be considered to be doing business within a state for the purpose of determining whether the second requirement for the intrastate offering exemption is satisfied if: 1) The issuer derived at least 80 percent of its gross revenues and those of its subsidiaries on a consolidated basis from the operation of a business or of real property located in, or from the rendering of services within, the state; 2) For its most recent fiscal year, if the first offer of any part of the issue is made during the first six months of the issuer s current fiscal year; or 3) For the first six months of its current fiscal year or during the twelve month fiscal period ending with such six month period, if the first offer of any part of the issue is made during the last six months of the issuer s current fiscal year; 4) Provided, however, that this provision does not apply to any issuer which has not had gross revenues in excess of $5,000 from the sale of products or services or other conduct of its business for its most recent twelve month fiscal period; 5) The issuer had at the end of its most recent semi-annual fiscal period prior to the first offer of any part of the issue, at least 80 percent of its assets and those of its subsidiaries on a consolidated basis located within the state; 6) The issuer intends to use and uses at least 80 percent of the net proceeds to the issuer from sales made pursuant to Rule 147 in connection with operating a business or of real property, purchasing real property located in, or rendering services within the state; and 7) The principal office of the issuer is located within the state. Similarly, Rule 147 provides that the residency of offerees and purchasers of the security are determined as follows for the purpose of determining whether the third requirement for the intrastate offering exemption is satisfied: 1) A corporation, partnership, trust or other form of business organization is a resident of a state if, at the time of the offer and sale to it, it has its principal office within the state. 2) An individual is a resident of a state if the individual has, at the time of the offer and sale to him, his principal residence in the state. IMPLEMENTING AN LLC 39

48 3) A corporation, partnership, trust or other form of business organization which is organized for the specific purpose of acquiring part of an issue offered pursuant to Rule 147 is not a resident of the state unless all of the beneficial owners of the organization are residents of the state. Rule 147 also places the following additional restrictions on the securities and obligations on the issuer when securities are offered pursuant to the Rule 147 safe harbor: 1) Limitation on out-of-state resales. During the period in which securities that are part of an issue are being offered and sold by the issuer, and for a period of nine months from the date of the last sale by the issuer of the securities, all resales of any part of the issue, by any person, must be made only to persons resident within the state. 2) Certificate Legend. The issuer must place a legend on the certificate or other document evidencing the security stating that the securities have not been registered under the Act and setting forth the limitation on resale stated above. 3) Stop Transfer Orders. The issuer must direct stop transfer instructions to the issuer s transfer agent, if any, with respect to the securities, or, if the issuer transfers its own securities, make a notation in the appropriate records of the issuer. 4) Purchaser Representation. The issuer must obtain a written representation from each purchaser as to his residence. 5) Disclosure of Limitations. The issuer must disclose in writing, in connection with any offers for sale or sales, the limitations on resale, the provisions required to be stated in the certificate legend, and the instructions to be sent to the transfer agent or noted in the issuer s records. Private Offering Exemption Without Regard to the Offering s Dollar Amount. Section 4(2) of the Securities Act of 1933, 15 U.S.C. 77d(2), exempts from federal registration securities offerings by an issuer that do not involve a public offering. To qualify for this exemption, the following requirements must be met: 1) The purchasers of the securities must: a. Be sophisticated investors, which means that they have enough knowledge and experience in finance and business matters to evaluate the risks and merits of the investment, or the issuer reasonably believes that the purchasers come within this description; b. Have access to the type of information normally provided in a prospectus; and c. Agree not to resell or distribute the securities to the public. IMPLEMENTING AN LLC 40

49 2) The issuer cannot use any form of public solicitation or general advertising in connection with the offering. The precise limits of this exemption are uncertain. In general, the requirements are more likely to be satisfied if the number of purchasers is small and their relationship to the company and its management is close. To provide greater certainty, the Securities and Exchange Commission promulgated Rule 506, 17 CFR , as part of Regulation D to provide another safe harbor rule. Rule 506 specifies objective standards that an issuer can rely on to determine if the requirements of the private offering exemption have been satisfied. Rule 506 states that if the following standards are satisfied, then the private offering exemption applies: 1) The securities are sold only to accredited investors and up to thirty-five other purchasers who, either alone or with a purchaser representative, are sophisticated investors ; 2) Non-accredited investors are advised that the securities have not been registered under the Act and, therefore, cannot be resold unless they are registered under the Act or unless an exemption from registration is available; 3) The issuer exercises reasonable care to assure that the purchasers are not underwriters, which may be demonstrated by: a. Reasonable inquiry to determine if the purchaser is acquiring the securities for himself or for other persons; b. Written disclosure to each purchaser prior to sale that the securities have not been registered under the Act and, therefore, cannot be resold unless they are registered under the Act or unless an exemption from registration is available; and c. Placement of a legend on the certificate or other document that evidences the securities stating that the securities have not been registered under the Act and setting forth or referring to the restrictions on transferability and sale of the securities; 4) The issuer does not use any form of public solicitation or general advertising in connection with the offering; 5) The non-accredited investors receive disclosure documents that are generally the same as those used in registered offerings and include disclosures of certain non-financial statement information and financial statement information, which include at a minimum an audited balance sheet and other audited statements depending on the size of the offering; IMPLEMENTING AN LLC 41

50 6) Any information that is provided to accredited investors is made available to the nonaccredited investors as well; 7) The issuer is available to answer questions by prospective purchasers; and 8) The issuer files with the Securities and Exchange Commission five copies of a notice on Form D, 17 CFR 239.5, no later than 15 days after the first sale of the securities. An accredited investor under the Securities Acts includes the following: 1) A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; 2) A natural person with a net worth of at least $1 million; 3) A manager or executive officer of the company selling the securities; 4) A business in which all the equity owners are accredited investors; 5) A bank, insurance company, registered investment company, business development company, or small business investment company; 6) An employee benefit plan, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million; 7) A charitable organization, business trust, corporation or partnership with total assets in excess of $5,000,000; and 8) A trust with assets of at least $5 million, not formed to acquire the securities offered, and whose purchases are directed by a sophisticated person. Private Offerings Not Exceeding $1,000,000. Rule 504 of Regulation D, 17 CFR , exempts from federal registration certain private offerings that do not exceed $1,000,000. To qualify for this exemption, the following requirements must be met: 1) The offering does not exceed the amount of $1,000,000 in a 12-month period; 2) The issuer does not use any form of public solicitation or general advertising in connection with the offering; 3) The securities are restricted and the purchasers cannot sell the securities without registration or an applicable exemption; IMPLEMENTING AN LLC 42

51 4) The issuer exercises reasonable care to assure that the purchasers are not underwriters, which may be demonstrated by: a. Reasonable inquiry to determine if the purchaser is acquiring the securities for himself or for other persons; b. Written disclosure to each purchaser prior to sale that the securities have not been registered under the Act and, therefore, cannot be resold unless they are registered under the Act or unless an exemption from registration is available; and c. Placement of a legend on the certificate or other document that evidences the securities stating that the securities have not been registered under the Act and setting forth or referring to the restrictions on transferability and sale of the securities; 5) The issuer files with the Securities and Exchange Commission five copies of a notice on Form D, 17 CFR 239.5, no later than 15 days after the first sale of the securities; and 6) The issuer is not a blank check company with an unspecified business or an investment company required to be registered under the Investment Company Act of This exemption may also be used for an offering involving public solicitation and advertising and the securities will not be restricted from resale under the following circumstances: 1) The issuer registers the offering exclusively in one or more states that require a publicly filed registration statement and delivery of a substantive disclosure document to investors; 2) The issuer registers and sells in a state that requires registration and disclosure delivery and also sells in a state without those requirements, so long as the issuer delivers the disclosure documents; or 3) The issuer sells exclusively according to state law exemptions that permit general solicitation and advertising, so long as the issuer sells only to accredited investors. Private Offerings Not Exceeding $5,000,000. Rule 505 of Regulation D, 17 CFR , exempts from federal registration certain private offerings that do not exceed $5,000,000. To qualify for this exemption, the following requirements must be met: 1) The offering does not exceed $5,000,000 in a 12-month period; 2) The issuer is not an investment company; IMPLEMENTING AN LLC 43

52 3) The securities are sold to an unlimited number of accredited investors and up to 35 other persons who do not need to satisfy any sophistication or wealth standards; 4) Non-accredited investors are advised that the securities have not been registered under the Act and, therefore, cannot be resold unless they are registered under the Act or unless an exemption from registration is available; 5) The issuer exercises reasonable care to assure that the purchasers are not underwriters, which may be demonstrated by: a. Reasonable inquiry to determine if the purchaser is acquiring the securities for himself or for other persons; b. Written disclosure to each purchaser prior to sale that the securities have not been registered under the Act and, therefore, cannot be resold unless they are registered under the Act or unless an exemption from registration is available; and c. Placement of a legend on the certificate or other document that evidences the securities stating that the securities have not been registered under the Act and setting forth or referring to the restrictions on transferability and sale of the securities; 6) The issuer does not use any form of public solicitation or general advertising in connection with the offering; 7) The non-accredited investors receive disclosure documents that are generally the same as those used in registered offerings and include disclosures of certain non-financial statement information and financial statement information, which include at a minimum an audited balance sheet and other audited statements depending on the size of the offering; 8) Any information that is provided to accredited investors is made available to the nonaccredited investors as well; 9) The issuer is available to answer questions by prospective purchasers; and 10) The issuer files with the Securities and Exchange Commission five copies of a notice on Form D, 17 CFR 239.5, no later than 15 days after the first sale of the securities. Offerings to Accredited Investors. Section 4(6) of the Securities Act of 1933, 15 U.S.C. 77d(6), exempts from registration securities offerings to accredited investors if the following criteria are satisfied: 1) None of the securities are sold to non-accredited investors; IMPLEMENTING AN LLC 44

53 2) The total offering price is less than $5 million; 3) The issuer does not use any form of public solicitation or general advertising in connection with the offering; and 4) The issuer files with the Securities and Exchange Commission five copies of a notice on Form D, 17 CFR 239.5, no later than 15 days after the first sale of the securities. Small Offerings. Section 3(b) of the Securities Act of 1933, 15 U.S.C. 77c(b), authorizes the Securities and Exchange Commission to issue Regulations that exempt from federal registration securities offerings by an issuer that involve a small amount of capital. Pursuant to this authority, the Securities and Exchange Commission promulgated Regulation A exempting from registration certain small public offerings that satisfied the following criteria: 1) The offering cannot exceed $5 million in any 12-month period; 2) The issuer files an offering statement on Securities and Exchange Commission Form 1-A with the Commission for review, consisting of a notification, offering circular, and exhibits; 3) The issuer provides purchasers with an offering circular that is similar in content to a prospectus; and 4) The issuer is not a blank check company with an unspecified business or an investment company required to be registered under the Investment Company Act of Unlike certain other exemptions, securities offered pursuant to Regulation A are not restricted from resale and may be freely traded in the secondary market after the offering. Offerings executed pursuant to Regulation A are similar to offerings executed with full registration. However, Regulation A offerings do have the following advantages over full registration: 1) The financial statements are simpler and do not need to be audited; 2) There are no Exchange Act reporting obligations after the offering unless the company has more than $10 million in total assets and more than 500 members; 3) The issuer may choose among three formats to prepare the offering circular, one of which is a simplified question-and-answer document; and 4) The issuer may determine if there is adequate interest in the securities by general solicitation and advertising (but not solicitation or acceptance of money) before going through the expense of filing an offering statement with the Securities and Exchange Commission. IMPLEMENTING AN LLC 45

54 State Securities Registration LLCs must not only comply with the federal securities laws, but also the securities law of all states from which, and to which, the LLC intends to offer its membership interests to investors. State securities laws are called blue sky laws and vary substantially between states. The Illinois Securities Law of 1953, 815 ILCS 5/1 et. seq., requires an LLC that issues membership interests to register the membership interests pursuant to Section 5 of the Act and to file an annual notification pursuant to Section 3 of the Act. Section 4 of the Act sets forth exemptions to these requirements, and the six most common of these exemptions are discussed below. Private Offering Exemption. Section 4G of the Act exempts from registration any offer, sale or issuance of a security, whether to Illinois residents or non-residents, where: 1) All sales of the security to Illinois residents within the preceding 12-month period have been made to not more than 35 investors or have involved an aggregate sales price of not more than $1,000,000, (excluding the investors and the dollar value of securities sold to investors in transactions for which another exemption applies); 2) The security is not offered or sold by means of general advertising or general solicitation in Illinois; 3) No commission, discount, or other remuneration exceeding 20% of the sales price of the security, if sold to a resident of this State, is paid or given directly or indirectly for or on account of the sales; and 4) The issuer files an Illinois Form 4G Report of Sale or a U.S. Securities and Exchange Commission Form D with the Illinois Securities Department and pays a $100 filing fee. The Form 4G Report of Sale or Form D must be filed on or after the date of the first sale made to an Illinois resident, but no later than 12 months after the date of the first sale. The filing covers a 12 month period. If sales occur for more than 12 months, another filing must be made and filing fee paid. If the securities have been offered pursuant to a federal registration exemption that requires the issuer to file U.S. Securities and Exchange Commission Form D with the Commission, then the issuer can file Form D with the Illinois Securities Department in place of Form 4G. Accredited Investor Exemption. IMPLEMENTING AN LLC 46

55 Section 4H of the Act exempts from registration any offer, sale or issuance of a security if the securities are not sold by means of any general advertising or general solicitation in Illinois and the securities are sold to the following: 1) A natural person who has, or is reasonably believed by the issuer to have, a net worth or joint worth with that person s spouse of $1,000,000 excluding the value of a principal residence; 2) A natural person who had, or is reasonably believed by the issuer to have, an income or joint income with that person s spouse, in excess of $200,000 in each of the two most recent years and who reasonably expects, or is reasonably expected to have, an income in excess of $200,000 in the current year; or 3) Any entity in which at least 90% of the equity interest is owned by persons who satisfy a requirement stated in (1) or (2). Preorganization Subscription Exemption. Section 4M of the Act exempts from registration any offer, sale or issuance of a security if the following conditions are satisfied: 1) The securities are sold pursuant to a preorganization subscription prior to the organization of the issuer; 2) The number of subscribers does not exceed 25; and 3) No commission or other remuneration is paid or given directly or indirectly for or on account of the sales of the securities or if any commission or other remuneration is paid, the securities are not offered or sold by any means of general advertising or general solicitation in Illinois. Controlling Person Exemption. Section 4O of the Act exempts from registration any offer, sale or issuance of securities if the following conditions are satisfied: 1) The sale is for the direct or indirect benefit of the issuer or of a controlling person; 2) The securities sold, together with securities already owned by the purchaser, constitute 50% or more of the equity interest of the issuer; 3) The number of purchasers is not more than 5; and IMPLEMENTING AN LLC 47

56 4) No commission, discount or other remuneration exceeding 15% of the aggregate sale price of the securities is paid or given directly or indirectly for or on account of the sales. Large Investment Exemption. Section 4R of the Act exempts from registration any offer, sale or issuance of securities if the following conditions are satisfied: 1) The securities are sold to a person who purchases at least $150,000 of the securities being offered; 2) The purchaser s total purchase price does not, or it is reasonably believed by the issuer that the purchase price does not, exceed 20 percent of the purchaser s net worth, or if a natural person a joint net worth with that person s spouse, for one or any combination of the following: and a. Cash; b. Securities for which market quotations are readily available; c. An unconditional obligation to pay cash or securities for which quotations are readily available, which obligation is to be discharged within five years of the sale of the securities to the purchaser; or d. The cancellation of any indebtedness owed by the issuer to the purchaser; 3) The Security is not offered or sold by means of any general advertising or general solicitation in Illinois. Insider Exemption. Section 4S of the Act exempts from registration any offer, sale or issuance of securities if the securities are sold to a person who is a manager or executive officer of the issuer. IMPLEMENTING AN LLC 48

57 III. ADVANCED LLC TAX ISSUES A. CHECK-THE-BOX CLASSIFICATION SYSTEM An LLC is an eligible entity under the check the box classification rules under Treasury Regulation (a). As a result, an LLC can elect how it will be taxed. The LLC is required to make its tax elections at certain times. Tax Elections. Under the Code, the default rule is that a single-member LLC is disregarded as an entity separate from its owner and treated like a sole proprietorship. A multi-member LLC is treated like a partnership. Pursuant to Section 761(a) of the Code, certain partnerships are permitted to elect to be excluded from the partnership tax provisions in the Code contained in Subchapter K and to have their partners treated as the direct owners of the partnership s assets for tax purposes. This election is not available to LLC because the LLC is a separate and distinct entity from its owners. Therefore, the LLC must be considered to be the owner of its property and not the LLC s members. 26 U.S.C By filing IRS Form 8832, a single-member or a multi-member LLC can opt out of the flow-through tax default rules and be taxed as a separate entity like a corporation instead. The LLC can further make the Subchapter S election to be taxed like an S corporation by filing IRS Form 2553 if the specified requirements from making this 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 the LLC files Form 2553 to make the S election, the LLC will be deemed to have made the election to be T H E T U C K E R F I R M L L C 1723 North Halsted Street Chicago, Illinois [email protected] (312)

58 taxed as a corporation, and the LLC does not need to file Form 8832 to make that election. Treasury Regulation (c)(1)(v)(C). Election Deadlines. The election to be taxed as a corporation is effective on the date specified by the LLC in its Form 8832, which cannot be more than 75 days prior to, or more than 12 months after, the date the form is filed. Once the LLC makes an election to be taxed as a corporation, the LLC generally cannot change its tax classification again during the sixty months after the effective date of the election. This sixty-month rule does not apply if the previous election was made by a newly formed LLC and was effective on the date of the LLC s formation. Treasury Regulations (c)(1)(iv). To make the Subchapter S election, an LLC files Form 2553 prior to the 15 th day of the third month in the year for which the LLC desires to be taxed as an S corporation. 26 U.S.C. 1362(b)(1). Once made, the election remains in effect until it is terminated by: (1) the revocation of the election by the LLC, (2) the failure of the LLC to satisfy the requirements for making the election, or (3) the LLC s having accumulated earnings and profits and passive investment income that exceeds twenty-five percent of the LLC s gross receipts for a period of three years. 26 U.S.C. 1362(d). Once the LLC s Subchapter S election has terminated, the LLC cannot make the election again before its fifth taxable year after the first taxable year for which the termination was effective. There are tax consequences when an LLC changes its tax elections, and therefore, the LLC should ensure that it is aware of these consequences before it makes a change. See Treasury Regulation (g). For example, if an LLC changes from being taxed like a C corporation to being taxed like an S corporation or a partnership, then distributions that are made of earnings that were accumulated when the LLC was taxed like a C corporation are subject to tax as if they were dividends. B. TAX FORMS AND NUMBERS. An LLC and its members file different federal and state tax returns depending on the tax election that the LLC has made. An LLC also may need to obtain a federal and state tax number. ADVANCED LLC TAX ISSUES 50

59 Federal Tax Forms. A single-member LLC that is disregarded as an entity separate from the member, files no separate tax return. The member reports the LLC s income, deductions, gains, losses and other tax items on the member s individual income tax return, Form The LLC s income and expenses are reported on Schedule C or Schedule E for rental real estate activities. An LLC treated as a partnership files Form 1065, U.S. Partnership Return of Income, to report its activities. The LLC issues K-1s on Schedule K-1, Form 1065 to its members to report the members allocations of the LLC s income, deductions, gains, losses and other tax items. Members report their allocations from the LLC on their individual tax returns, Form LLCs owned exclusively by a husband and wife teams in Illinois are treated as a partnership rather than a sole proprietorship, and therefore, they must file IRS Form An LLC that has elected to be taxed as a C corporation files its income tax return on Form 1120, U.S. Corporation Income Tax Return. The LLC issues 1099 s to its members to report any distributions made to them. Members report distributions they receive from the LLC on their individual tax returns, typically Form If the LLC has current or accumulated earnings, the distributions are reported as dividends on Form 1040, Schedule B. If the LLC has no current or accumulated earnings and profits, then the distributions first reduce the members basis in their membership interests. Any distributions in excess of the basis are treated as capital gains and are reported on Form 1040, Schedule D. An LLC that further elects to be taxed as an S corporation files its income tax return on Form 1120-S, U.S. Income Tax Return for an S Corporation. The LLC issues K-1s on Schedule K-1, Form 1120-S to its members to report the members allocation of the LLC s income, deduction, gains, losses, and other tax items. Members report their allocations from the LLC on their individual tax returns, Form Income and expenses are reported on Schedule E. State Income Tax Returns. A single-member LLC that is disregarded as an entity separate from the member, files no separate Illinois state income tax return. An LLC that is treated as a partnership also files no separate Illinois state income tax return, but it files an Illinois partnership replacement tax return on Form IL An LLC that elects to be taxed as a C corporation files its Illinois state income and replacement tax return on Form IL An LLC that elects to be treated as an S corporation files no separate Illinois state income tax return, but it files an Illinois small business corporation replacement tax return on Form IL-1120-ST. The members of an LLC file their Illinois state income tax returns on Form IL-1040 irrespective of the federal tax election that the LLC has made. The members pay Illinois state income taxes ADVANCED LLC TAX ISSUES 51

60 based on the member s federal adjusted gross income, which includes the LLC s income, deductions, gains, losses, and other tax items. Federal Employee Tax Identification Number. An LLC must obtain a Federal Employee Identification Number ( FEIN ) if the LLC is taxed as a corporation or a partnership, the LLC s bank requires the number, the LLC has employees, or the LLC is subject to excise or alcohol, tobacco and firearm taxes. An LLC member or his authorized agent can obtain an FEIN for the LLC by filing IRS Form SS-4 with the IRS. If the form is mailed to the IRS, it taxes about four to six weeks to receive the FEIN. If the form is faxed to the IRS at (859) , it taxes about four business days to receive the FEIN. An LLC member or his authorized agent may also call 1 (800) and obtain the FEIN by providing orally the information contained on the SS-4 form. For an authorized agent to obtain the FEIN by phone, the agent also must fax the completed SS-4 form containing the written authorization for the agent to obtain the FIEN or have a member orally authorize the agent to obtain the FEIN during the call. Finally, an LLC member or his authorized agent can obtain an FEIN for the LLC on the internet by going to the website and clicking on Employer ID Numbers under Topics. Illinois Business Tax Number. An LLC must obtain an Illinois Business Tax Number ( IBT no. ) if it has Illinois employees or is subject to Illinois sales and/or use tax. An LLC can obtain an IBT number by filing REG-1, Illinois Business Registration Application, with the Illinois Department of Revenue. An LLC also can obtain an IBT number on the Illinois Department of Revenue s website at If the LLC does not apply for an IBT number, the LLC eventually will receive one automatically from the Illinois Department of Revenue as a result of filing its articles of organization with the Secretary of State. C. FEDERAL INCOME TAX DIFFERENCES The treatment of the LLC for federal income tax purposes will depend on whether the LLC chooses to be disregarded as an entity or treated as a partnership, elects to be taxed as a C corporation, or further elects to be taxed as an S corporation. If the LLC elects to be treated as a partnership, the tax rules that are set forth in Subchapter K of the Code will apply to all federal income tax matters. If the LLC elects to be taxed as a corporation, the LLC will be taxed ADVANCED LLC TAX ISSUES 52

61 pursuant to the rules applicable to corporations set forth in Subchapter C of the Code. If an LLC elects to be taxed as an S corporation, the LLC will be taxed pursuant to the rules specifically applicable to S corporations set forth in Subchapter S of the Code. Basically, this means that the LLC s income and loss will flow through to, and be taxed only to, the LLC s members like in a partnership. The rules applicable to C corporations set forth in Subchapter C of the Code will apply to all matters other than those specifically set forth in Subchapter S. There are significant differences in how an LLC will be taxed depending on whether the LLC elects to be subject to the rules in Subchapter K, Subchapter C, or Subchapter S. Some of these differences are outlined below. Federal Taxation of Income. Pursuant to Subchapter K and Subchapter S, an LLC s income and loss flow through to the LLC s members. Only the LLC s members pay federal income taxes on the LLC s income and loss. The LLC itself will not pay federal income taxes. Pursuant to Subchapter C, an LLC will pay federal tax at a rate up to 34% on its income and loss, and the LLC s members will also pay tax personal income tax on any distributions they receive from the LLC. Loss Offsets. Pursuant to Subchapter K and Subchapter S, an LLC s losses are allocated to the LLC s members. Therefore, the members may be able to offset the losses against their other personal income. However, a member s ability to deduct or offset a loss is subject to various limitations such as the passive activity loss rules under Code Section 469 and the at risk limitations under Code Section 465, and the amount of their tax basis in their membership interests. Pursuant to Subchapter C, an LLC s losses are available to offset only the income of the LLC itself in the form of net operating loss carryovers and carrybacks. 26 U.S.C Alternative Minimum Tax. Pursuant to Subchapters K and Subchapter S, an LLC is not subject to the alternative minimum tax ( AMT ). However, the LLC s members will take their share of AMT items allocated from the LLC into account when computing their personal AMT liability. Pursuant to Subchapter C, an LLC is subject to the AMT. ADVANCED LLC TAX ISSUES 53

62 Contributions of Appreciated Property. Pursuant to Subchapters K, an LLC s members generally can transfer appreciated property to the LLC in exchange for a membership interest without having to recognize a gain on the property provided that the LLC is not an investment company. 26 U.S.C (See section below on Members Contributions to the LLC.) Pursuant to Subchapters C and S, an LLC s member can transfer appreciated property to the LLC without recognizing a gain only if certain requirements are met. 26 U.S.C Generally, the member must own at least 80% of the LLC s membership interests after the transfer for gain not to be recognized. Id. Distributions of Appreciated Property. Pursuant to Subchapters K, an LLC generally can transfer appreciated property to the LLC s members without gain recognition by the LLC or its members. Pursuant to Subchapter C, an LLC s transfer of appreciated property to one of its members will require gain recognition by the corporation and by the member. Pursuant to Subchapter S, an LLC s transfer of appreciated property to one of the LLC s members will require gain recognition by the LLC but not by the LLC s member. Debt. The members of an LLC generally do not bear the economic risk of loss with respect to the LLC s debt. Nevertheless, for an LLC that chooses to be treated as a partnership, an LLC s members may include a portion of the the LLC s debt in computing the tax basis of their membership interest in the LLC. An increase of a member s share of the LLC s debt is treated as a contribution of money to the LLC by the member. 26 U.S.C. 752(a). A decrease in the member s share of the LLC s debt is treated as a distribution of money to the member. 26 U.S.C. 752(b). For certain types of debt, a LLC member s share of the debt is the loss that the LLC member would bear after all LLC capital is exhausted to satisfy the debt. This allocation method is used for debt if: 1) The member (or related person) guaranteed repayment of the LLC s debt. 2) The member (or related person) made a loan directly to the LLC. 3) The member remained liable for recourse debts of a predecessor entity. ADVANCED LLC TAX ISSUES 54

63 4) The member guaranteed payment of at least 25% of the total interest which will accrue on a nonrecourse debt. 5) The member provided property as collateral security for the debt. For all other debt of the LLC, a member s share of the LLC s debt will be allocated among the LLC s members in the manner that nonrecourse liabilities are allocated to partners in a partnership. A member s share of the LLC s debt equals the sum of the following allocation tiers for the debt: 1) The member s share of the LLC s minimum gain, which is the excess of nonrecourse debt over the book value of the property securing the debt pursuant to Code Section 704(b). 2) The member s share of the Code Section 704(b) minimum gain, which is the gain if the LLC disposed of all LLC property subject to one or more nonrecourse liabilities of the LLC in full satisfaction of the liabilities and for no other consideration; 3) The member s share of the remaining debt of the LLC as determined in accordance with the member s share of the LLC s profits. 26 C.F.R (a). The ability of an LLC s member to include his share of LLC debt in the basis of his membership interest enables the member to claim more tax deductions, absorb more losses, and withdraw more money from the LLC on a tax-free basis. Pursuant to Subchapters C and S, an LLC s members do not include any portion of the LLC s debt in their basis of their membership interests. Pursuant to Subchapter S, an LLC s members can use their basis in loans they make to the LLC for loss deduction purposes. 26 U.S.C. 1366(d)(1)(B). Allocations. Pursuant to Subchapter K, an LLC may flexibly allocate income, gain, loss, deduction or credit among the LLC s members provided that the allocations have substantial economic effect. 26 U.S.C. 704(b). Pursuant to Subchapter S, an LLC must allocate income, gain, loss, deduction and credit to the LLC s members based on their proportionate share of the LLC s membership interests. Pursuant to Subchapter C, no allocations are made to the LLC s members. ADVANCED LLC TAX ISSUES 55

64 Fringe Benefits. For an LLC subject to Subchapter K, amounts paid by the LLC to the LLC s employees for fringe benefits (such as for health insurance and group term life insurance) are deductible by the LLC subject to certain restrictions. The amounts paid by the LLC for the fringe benefits typically are excluded from the gross income of the LLC s employees. However, employees who are members of the LLC must include the fringe benefits in their gross income. For an LLC subject to Subchapter C, employee fringe benefits are deductible by the LLC subject to certain restrictions. The amounts are excluded from the gross income of the employees even if the employees are members of the LLC. For an LLC subject to Subchapter S, employee fringe benefits are deductible by the LLC subject to certain restrictions. The amounts are excluded from the gross income of employees who are not members of the LLC or who own less than 2% of the membership interests of the LLC. 26 U.S.C. 1372(a). The amounts are included in the gross income of all employees who own 2% or more of the membership interests of the LLC.. 26 U.S.C. 1372(a)(2). Accounting Method. For an LLC subject to Subchapters K and S, the accounting methods of the LLC s members will not affect the LLC s choice of accounting methods. An LLC is allowed to use the cash method of accounting subject to a few exceptions. An LLC may not be permitted to use the cash method if the LLC has a C corporation as a member. 26 U.S.C However, an LLC with a C corporation member will be permitted to use the cash method if the LLC has average annual gross receipts of $5 million or less for the prior three years, is in the farming business, or the C corporation is a personal service corporation. Id. An LLC also may not be permitted to use the cash method of accounting if the LLC constitutes a tax shelter pursuant to Code Section 461(i)(3). Id. Finally, the LLC may not be permitted to use the cash method if the LLC must maintain inventories under Code Section 471. Id. An LLC subject to Subchapter C may not use the cash method of accounting if it has five million dollars of receipts or more. 26 U.S.C. 448(b)(3). Tax Year. Pursuant to Subchapter K, an LLC s tax year must conform to the tax year or years of its members. The LLC must adopt the tax year of a member who owns more than 50% of the LLC s profits and capital interests. 26 U.S.C. 706(b)(1)(B). If there is no such member, then the LLC must adopt the tax year of all members who own at least 5% of the LLC s profits and ADVANCED LLC TAX ISSUES 56

65 capital interests. Id. If none exist, then the LLC must adopt either the calendar year or any other year resulting in the minimum deferral. 26 C.F.R (b). An LLC subject to Subchapter C has a great deal of discretion in selecting its taxable year. The LLC can use its annual accounting period as its taxable year if it is a calendar year or a fiscal year. 26 U.S.C. 441(b). Pursuant to Subchapter S, an LLC may choose as its tax year a year ending December 31 or any other accounting period for which the LLC can establish a legitimate business purpose other than the deferral of income to the LLC s members. 26 U.S.C Accumulated Earnings and Personal Holding Company Taxes. An LLC subject to Subchapter K is not subject to the 15% accumulated earnings tax of Code Section U.S.C The LLC also is not subject to the 15% personal holding company tax of Code Section U.S.C. 542(a). An LLC subject to Subchapters C or S is subject to the accumulated earnings tax and the personal holding company tax. 26 U.S.C. 532 and 542(a). D. CONTRIBUTIONS OF PROPERTY A member s contribution of property to an LLC in exchange for a membership interest in the LLC gives rise to many tax issues. A determinate must be made as to the taxation of the contribution, the tax basis of the membership interest, the applicability of exceptions to the general rules, the allocation of any built-in gain, the holding period of the membership interest, and the taxation of contributed services. These issues are discussed below with respect to LLCs that are taxed as a partnership pursuant to Subchapter K. Tax-free Contributions and Carryover Basis. If an LLC chooses to be treated as a partnership for tax purposes, the LLC and its members generally do not recognize a gain or loss when property is contributed by the members in exchange for the LLC s membership interests. 26 U.S.C. 721(a). This rule applies to property contributed to members not only when the LLC is initially formed, but also during the LLC s life. Id. This rule also applies irrespective of the number of membership interests the contributing LLC member holds. Id. ADVANCED LLC TAX ISSUES 57

66 A member s tax basis in the contributed property is preserved by the LLC. 26 U.S.C The member s tax basis in his LLC membership interest is equal to his basis in the property contributed. However, any gain that is recognized on the contribution by virtue of the contribution being made to an LLC that is an investment company is added to the LLC s basis in the property and the member s basis in his membership interest. 26 U.S.C (See section below on Contributions to Investment Companies.) Exceptions to Not Recognizing Gain on Contributions. There are at least four exceptions to the rule that a gain will not be recognized on a member s contribution of property to an LLC. Disguised Sale. If a member contributes property to an LLC and then the LLC issues a distribution to the member, the transaction may be deemed to be a disguised sale of the property to the LLC. 26 U.S.C. 707(a)(2)(B). As a result, the contributing member must recognize the gain or loss on the property upon contribution of the property to the LLC. Id. If the member s contribution to the LLC and the distribution by the LLC are simultaneous, then the transaction is deemed to be a disguised sale if the LLC would not have made the distribution but for the contribution of the property by the member. Id. If the contribution and distribution are not simultaneous, then the transfers are rebuttably presumed to be sales under a multi-factor test. 26 C.F.R (c). Distributions within two years of a contribution are presumed to be part of a sale, but a distribution subject to entrepreneurial risk generally will not be treated as part of a disguised sale. Id. Disguised Exchange. If a member contributes property to an LLC and the LLC distributes other property to the member within seven years of the contribution, the transaction will be deemed to be a disguised exchange of the property and the contributing member will be required to recognize the built-in gain on the contributed property. 26 U.S.C. 704(c)(1)(B) and 737. (See section below on recognition of Built-In Gains.) ADVANCED LLC TAX ISSUES 58

67 Contribution of a Right to Use Property. If a member contributes a right to use property to the LLC rather than ownership of the property in exchange for a membership interest, then the transaction is treated as a lease or a license. The member reports the consideration that the member receives from the LLC as rent, and the LLC deducts the amount of the rent only when the recipient reports it as income. However, if there will be little or no value to the property after the end of the LLC s period of use, then a member s contribution of the right to use the property may be treated as a contribution of the ownership of the property. Contributions to Investment Companies. If a member makes a contribution to an LLC that is deemed to be a contribution to an investment company then the contribution is taxable. 26 U.S.C. 721(b). A contribution to an LLC constitutes a contribution to an investment company if (1) more than 80% of the value of the LLC s assets immediately after the receipt of the contribution consists of money, stocks and corporate securities, options, foreign currencies, derivatives, interests in precious metals, regulated investment companies, REIT s, publicly traded partnerships, common trust funds and any other entity convertible into any of these assets, and (2) the contribution causes the member s investment portfolio to be diversified. 26 C.F.R (c)(1). A member s portfolio is not diversified as a result of transfers of identical assets to the LLC by other members or by a member s contribution of a portfolio that is already diversified. Id. If the member s contribution is a contribution to an investment company, then the member must recognize gain on appreciated property contributed to the LLC, but the member will not be allowed to recognize any loss that exists on the contributed property. 26 U.S.C. 721(b). The basis of the contributed property in the hands of the LLC and the basis of the member s LLC membership interest will be increased by any gain recognized upon the contribution. 26 U.S.C Recognition of Built-in Gains. The built-in gain on contributed property is the gain represented by the difference between the fair market value and the basis of the property when the property was contributed to the LLC. A member who contributes appreciated property to an LLC is responsible for the built-in gain on the property when the gain is realized by the LLC. 26 U.S.C. 704(c). When the LLC disposes of the property and recognizes the gain on it, the built-in gain will be allocated only to the member who contributed the property to the LLC. Id. However, the LLC may disregard this rule if the disparity between the basis and value of the property is less than 15% of the basis and $20,000 in the aggregate. 26 C.F.R (e). ADVANCED LLC TAX ISSUES 59

68 The LLC also is required to allocate tax depreciation on the property to the noncontributing LLC members up to the book depreciation and allocate any excess to the contributing member. 26 C.F.R (b)(1). Ceiling rules limit the amount of built-in gain and depreciation allocable to the contributing member to the gain and depreciation actually recognized by the LLC. 26 C.F.R (b)(1). For tax purposes, curative allocations of other income or loss are permitted to offset any book-tax disparity remaining after application of the ceiling. 26 C.F.R (c). Remedial allocations also are allowed to eliminate distortions created by the ceiling. 26 C.F.R (d). The allocation of the built-in gain to the contributing member cannot be avoided by distributing contributed property to another member. If the contributed property is distributed to another member within seven years of its contribution, then the contributing member still recognizes the built-in gain (limited to the actual gain recognized by the LLC). 26 C.F.R (c)(1)(B). In addition, the contributing member must recognize any unrealized built-in gain if the LLC distributes any other property to the contributing member within seven years of the initial contribution. 26 U.S.C Holding Period. In general, the LLC s holding period for property contributed to an LLC includes that period that the property was held by the contributing member. 26 U.S.C. 1223(2). Similarly, the contributing member s holding period for his LLC interest includes the period that he held the property that he contributed. Id. These rules are called tacking rules and may be significant due to the advantageous tax treatment of capital gains recognized upon the sale of capital assets held for more than one year. The tacking rule does not apply to the holding period for the member s membership interest if the property contributed was inventory, not a capital asset, or Section 1231 property (ordinary income generating assets). 26 U.S.C. 1223(1). The tacking rule still does apply to the LLC s holding period of the contributed property even if the tacking rule does not apply to the holding period for the member s membership interest. 26 U.S.C. 1223(2). If an LLC member contributes assets to the LLC that have different holding periods, then the member s LLC interest will have a split holding period based on the relative values of the assets contributed. 26 C.F.R Character of Property. The character of the income, gain, deduction or loss realized upon the disposition of contributed property is determined based on the purpose for which the property is held at the ADVANCED LLC TAX ISSUES 60

69 time of its disposition by the LLC. The contributing member s use of the contributed property before contributing it to the LLC is not considered. However, ordinary income property is prevented from being converted to capital gain property and capital loss property is prevented from being converted to ordinary loss property through contributions to the LLC. 26 U.S.C This restriction applies to unrealized receivables, inventory items for five years after their contribution, and property with a built-in capital loss at the time of its contribution. Id. E. CONTRIBUTIONS OF SERVICES If a member contributes services to the LLC in exchange for a membership interest, the member is taxed on the contribution if the member receives a capital interest from the LLC and is not taxed on the contribution if the member receives a profits interest from the LLC. The theory behind this treatment is that an LLC member who receives a capital interest in the LLC has received property from the LLC for his services. An LLC member who receives a profits interest in the LLC may or may not receive anything for his services depending on whether the LLC is profitable in the future. Capital Interest. There are many factors considered in determining whether the member has received a capital interest or not. However, the focus is on the member s rights to receive a distribution when the member s interest or the LLC itself is liquidated. The IRS has defined a capital interest in a partnership as an interest that would give the holder a share of the proceeds if the partnership s assets were sold at fair market value and then the proceeds were distributed in complete liquidation of the interest. This determination is generally made at the time of grant of the partnership interest. Rev. Proc , 26 C.F.R This same analysis applies to LLCs. If the interest is contingent on the satisfaction of certain conditions, it is not considered a capital interest and no compensation will result until the condition is satisfied. See, e.g., U.S. v. Frazell, 88 T.C (1987). If the member receives a capital interest, then the LLC deducts or capitalizes as appropriate the amount of the capital interest provided to the member. The member recognizes income for the value of the capital interest the member receives from the LLC. The value of the capital interest will depend on whether the services have been rendered already or will be rendered in the future as well as whether the services are to be deducted or capitalized by the LLC. The member s capital account will reflect the value of his capital interest. ADVANCED LLC TAX ISSUES 61

70 Profits Interest. If the member receives a profits interest in the LLC in exchange for contributing services to the LLC, the member generally will not be immediately taxed on the contribution. The IRS has defined a profits interest as one that is not a capital interest. Rev. Proc , 26 C.F.R The member receiving a profits interest has an initial capital account balance of zero. The member realizes taxable income as the LLC allocates income to the member, which allocation may even include subsequent appreciation of the LLC s assets. The income allocated to the member retains the same character as is realized by the LLC, such as long-term capital gain or tax-exempt income if realized as such by the LLC. There are at least three specific exceptions to the rule that a member receiving a profits interest in exchange for the contribution of services to an LLC is not taxed. A contribution in exchange for a profits interest is taxed if (1) the member sells his profits interest within two years of its receipt; (2) the profits interest provides the member with a predictable stream of income from the LLC; or (3) the profits interest is in an LLC that is publicly traded. Rev. Proc , 26 C.F.R All of these profits interests are relatively easy to value and not particularly speculative, and therefore, they subject the member to tax on the contribution. The LLC Act provides that each member has an equal interest in the allocations and distributions of the LLC irrespective of the amount of his capital account. Thus, unless this default rule is altered by the LLC s operating agreement, a member who contributes services likely will be deemed to receive a capital interest and will be subject to tax on its receipt. Thus, a professional forming an LLC should take care in drafting the operating agreement to ensure that the member receives the type of interest and is taxed as intended. Unvested Profits Interest. If a member contributes services to an LLC in exchange for an unvested profits interest, the service provider will be taxed as if he is a member who received his profits interest on the date of its initial grant rather than on the subsequent vesting date if certain conditions are satisfied. The first condition is that the LLC treats the service provider as a member from the date of grant. The second condition is that the service provider takes into account his distributive share of the LLC s income, gain, loss and deduction for the entire period the interest is held. The third condition is that no compensation deduction is claimed by the LLC for the interest at the times of its granting or its vesting. The fourth condition is that all other conditions set forth in Rev. Proc are otherwise satisfied. See Rev. Proc It is not necessary for a Section 83(b) election to be filed in connection with the receipt of a nonvested profits interest. Id. ADVANCED LLC TAX ISSUES 62

71 F. FORMATION TAX ISSUES In addition to the tax issues relating to contributions from an LLC s members, other tax issues arise when an LLC is formed. Some of these issues include when depreciation begins and when organizational expenses and start-up expenditures are deducted. Depreciation. An LLC s first year for depreciation will begin when its business or investment activity begins and not sooner. Organizational Expenses. An LLC may deduct up to $5,000 of the expenses it incurs for the organization of the LLC in the year that the LLC begins irrespective of whether the LLC chooses to be taxed as a partnership or a corporation. 26 U.S.C. 709 and 26 U.S.C Any remaining organizational expenses are amortized over 180 months, beginning with the month in which the LLC s business begins. Id. The $5,000 amount is reduced to the extent that organizational expenses exceed $50,000, regardless of when they are incurred. Id. Syndication expenses are not considered organizational expenses and are not eligible to be deducted or amortized. Id. Start-up Expenses. An LLC also may deduct up to $5,000 of the expenses it incurs for the start-up and investigation of the LLC s business in the year that the LLC begins irrespective of whether the LLC chooses to be taxed as a partnership or a corporation. 26 U.S.C Any remaining start-up expenses are amortized over 180 months, beginning with the month in which the LLC s business begins. Id. The $5,000 amount is reduced to the extent that start-up expenses exceed $50,000, regardless of when they are incurred. Id. ADVANCED LLC TAX ISSUES 63

72 G. DISTRIBUTIONS AND ALLOCATIONS An LLC s members will be taxed on the distributions they receive from the LLC if the LLC elects to be taxed as a C corporation, and the LLC s members will be taxed on the allocations of tax items they receive from the LLC if the LLC chooses to be taxed as a partnership or a S corporation. An LLC has the flexibility to allocate its tax items to its members disproportionately. However, the allocations will only be respected for tax purposes if certain conditions are satisfied. Taxation of Distributions or Allocations. If an LLC is taxed as a C corporation, then the LLC pays federal and state income taxes on its income and loss. The LLC s members only pay income taxes if they receive distributions from the LLC. To the extent of the LLC s accumulated earnings and profits, the distributions are taxed to the LLC s members as dividends. Distributions in excess of the LLC s accumulated earnings first reduce the LLC members basis in their membership interest and then are taxed as a gain from the sale of their membership interest. If the LLC is treated as a partnership or S corporation, then the LLC itself pays no federal or state income tax. The LLC s members pay income taxes on the LLC s income, gain, loss, deductions, and credits that are allocated to them by the LLC. The items allocated to the members by the LLC will retain the tax characteristics that they had in the hand of the LLC. 26 U.S.C. 702(b). The LLC s members also pay income taxes on distributions they receive from the LLC that exceed the LLC member s adjusted basis in their membership interest. 26 U.S.C. 731(a) and 1368(b). An LLC is not required to make any cash distributions to its members. As a result, the LLC s members may be required to pay taxes as a result of the LLC s operations, but the LLC members may not have received payments from the LLC to enable them to pay the tax. Thus, LLC operating agreements often require the LLC to make distributions to members that at least cover the member s tax liability generated from the LLC s allocation of income to the member. Flexibility in Allocations. An LLC can provide in its operating agreement that allocations of tax items to its members will be made disproportionately. To determine whether a particular allocation method minimizes the members taxes, the LLC should first estimate the amount of its income and loss for each year for an extended period of time. The LLC s members should then provide information on ADVANCED LLC TAX ISSUES 64

73 their personal tax situation. Helpful information includes the members anticipated marginal tax rates and the anticipated amount and character of other income and/or loss that the members anticipate having in each year in the future. By analyzing this information and considering applicable tax rules such as the passive activity loss limitations and at-risk rules, the LLC should be able to determine which members can reap tax benefits from the LLC s disproportionate allocations. Respect of Allocations. An LLC s allocations of tax items to its members will be respected for tax purposes only if the allocations either have substantial economic effect or they are in accordance with the members interests in the LLC. 26 U.S.C An LLC s allocations have the required substantial economic effect if the following three conditions are satisfied: 1) The LLC maintains capital accounts that require the members accounts to reflect the value of contributed and distributed properties as well as income and losses flowing through to the LLC s members in accordance with the Section 704(b) Treasury Regulations; 2) The LLC makes all liquidating distributions in accordance with the positive capital account balances of members; and 3) The LLC requires each member with a deficit capital account balance to restore the deficit amount upon liquidation of the LLC, which is known as a deficit restoration obligations or DRO, or the LLC has a qualified income offset provision in its operating agreement, in which case the allocations will be respected to the extent that they do not create excess negative capital account balances of the LLC s members. 26 C.F.R (b)(2)(ii)(b)(3) and (b)(2)(ii)(d). H. SELF-EMPLOYMENT TAX Although there is some uncertainty with respect to the liability of LLC members for self-employment taxes, authorities generally agree that if an LLC member participates in the management of the LLC, the member must pay self-employment taxes on both the guaranteed payments that the member receives from the LLC and the member s distributive share of the LLC s income and loss. ADVANCED LLC TAX ISSUES 65

74 Rates. Self-employment tax is comprised of two separate taxes. The first part is a tax for old age, survivor, and disability insurance (OASDI) in the amount of 12.4% and the second part is a tax for hospital insurance (HI) in the amount of 2.9%. The amount of the self-employment tax mirrors the employment taxes on wages paid to an employee. There is a cap on the earnings subject to the OASDI tax, which is $94,200 in There is no cap on earnings subject to the HI tax. To report self-employment income, an individual files Schedule SE of Form Self-employment Earnings. Self-employment tax is paid on net earnings from self-employment as defined in the Code. 26 U.S.C. 1402(a). Net earnings from self-employment include (1) the gross income derived by an individual from a trade or business carried on by an individual; and (2) the individual s distributive share of income or loss from any trade or business carried on by a partnership of which he is a member. 26 U.S.C. 1402(a). Net earnings from self-employment exclude earnings received for the performance of service by an individual as an employee. 26 U.S.C. 1402(c)(2). The employer and employee pay employment taxes on employee wages that are equivalent to the self-employment tax paid by self-employed individuals. Net earnings from self-employment also exclude the following types of earnings: 1) Rentals from real and personal property unless the rentals are received in a trade or business as a real estate dealer; 2) Interest and dividends unless they are received in a trade or business as a dealer of securities; and 3) Gains and losses from the sale of capital assets. 26 U.S.C. 1402(1)-(3). Application to Partners. For general partners in a partnership, self-employment earnings include payments received by the partner for services rendered to the partnership or for the use of capital by the partnership provided that the payments are determined without regard to the income of the partnership ( guaranteed payments ). 26 C.F.R (a)-1(b). A general partner s self-employment ADVANCED LLC TAX ISSUES

75 earnings also include the partner s distributive share (whether or not distributed) of the partnership s income or loss. 26 U.S.C. 1402(a). These rules apply equally to general partners who activity participate in the partnerships business and who do not. Norwood v. Commissioner of Internal Revenue, No , 2000 WL (T.C. March 13, 2000). A limited partner s self-employment earnings do not include the partner s distributive share of the partnership s income or loss except for guaranteed payments received by the partner as remuneration for services he actually rendered for the partnership. 26 U.S.C. 1402(a)(13). In short, a general partner pays self-employment taxes on his guaranteed payments and his distributive share of the partnership s income and loss. A limited partner pays self-employment taxes only on the guaranteed payments he receives for his services. Application to LLC Members. If the LLC has elected to be taxed as a C corporation, then the LLC s members do not pay self-employment tax on distributions they receive from the LLC as shareholders even if they actively participate in the corporation s business. This is because the LLC s business is deemed to be carried on by the LLC and not by its shareholders, and therefore, distributions to shareholders do not represent gross income derived by the shareholders from a business carried on by the shareholders. See 26 U.S.C. 1402(a). Of course, the LLC and the LLC s members will pay employment taxes on any wages an LLC member receives for services he performs as an employee of the LLC. The rules with respect to self-employment taxes that apply to members of an LLC that chooses to be treated as a partnership will also apply to members of an LLC that has elected to be treated as an S Corporation. See 26 C.F.R (a)-1(b). However, these rules are currently uncertain. In 1994, the IRS issued proposed regulations guidance on self-employment taxes in the form of proposed regulations. These regulations provided two requirements to be satisfied for a member of an LLC to be treated as a limited partner for purposes of self-employment tax. First, the LLC member must lack the authority to make management decisions, and second, the LLC must have been able to be organized as a limited partnership in the same state, and the member must have qualified as a limited partner. See Treas. Reg , 62 C.F.R In 1996, the IRS withdrew the 1994 proposed regulations and issued new proposed regulations to better define the issue without the need to look to state law classifications. Id. The new regulations set forth one standard to be used both for limited partners in limited partnerships and LLC members in LLCs to determine whether the individual qualified for treated as a limited partner for purposes of self-employment taxes. Under the 1996 proposed regulations, a limited partner or an LLC member was treated as a limited partner for self-employment tax purposes unless he: (1) had personal liability for the debts and claims of ADVANCED LLC TAX ISSUES 67

76 the entity by reason of being a partner or member, (2) had authority to contract on behalf of the partnership under state law; or (3) participated in the entity s business for five hundred hours or more during the tax year. In addition, under the 1996 proposed regulations, an individual would not be treated as a limited partner if he provided services as part of an entity in which substantially all of the activities of the entity involved the performance of services in the fields of law, health, engineering, architecture, accounting, actuarial science, or consulting. The IRS s 1996 proposed regulations were severely criticized and Congress prohibited the IRS from finalizing them prior to July 1, To date, the IRS has not finalized these or any other regulations and Congress has not enacted any legislation on the issue. Therefore, there is some uncertainty as to whether LLC members must pay self-employment taxes on their distributive shares of the LLC s income and loss. However, authorities generally agree that if an LLC member participates in the management of the LLC, the member should pay self-employment taxes on their distributive shares. S Corporation as the Manager. LLCs may be structured to minimize the self-employment tax liability of its members. One such structure is a manager-managed LLC with the manager being an S corporation. The S corporation then employs the LLC s member(s) to provide services to the LLC and pays them a fair wage upon which the S corporation and the employees pay employment taxes. In this structure, Because the members do not technically participate in the management of the LLC other than as employees of the S corporation, the LLC s members may not be subject to self-employment taxes on their distributive shares of the LLC s income and loss. I. ILLINOIS STATE TAXES. Illinois State Income Tax. LLCs that elect to be taxed like C corporations are subject to an entity-level state income tax of 4.8% of the entity s net income, and their members 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). Flow-through entities, including partnerships, S corporations, and LLCs that have chosen to be taxed like them, 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). ADVANCED LLC TAX ISSUES 68

77 Illinois State Personal Property Replacement Taxes. Single-member LLCs that elect to be treated as a sole proprietorship do not pay Illinois state personal property replacement taxes. LLCs that have elected to be taxed as a partnership or S Corporation are subject to an entity-level 1.5% Illinois personal property replacement tax based on net income. 35 ILCS 5/201(c) and (d). Certain investment flow-through entities are exempt from this tax. 35 ILCS 5/205(b). LLCs that elect to be taxed as C corporations 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 annual report and paid to the Secretary of State along with the corporation s annual report filing fee. 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(11). ADVANCED LLC TAX ISSUES 69

78 IV. OPERATING AS AN LLC A. DRAFTING THE OPERATING AGREEMENT AND STATUTORY LIMITATIONS The LLC Act allows LLC members to enter into an operating agreement to regulate the internal affairs of the company and to govern the relationship between the members, managers, and the LLC. 805 ILCS 180/15-5(a). Absent an operating agreement, the provisions of the LLC Act serve as the default provisions establishing these rules. The operating agreement typically contains terms that would be found in the by-laws and shareholder agreements of a corporation. The operating agreement usually does the following: 1) Specifies the management, governance, and tax plans for the LLC; 2) Describes the contributions of members and the powers and responsibilities they have; 3) Provides for circumstances such as withdrawal, removal, or death of a member; and 4) Provides the methods of distributions and allocations to members. The LLC Act allows members considerable flexibility in the provisions contained in the operating agreement. However, the LLC Act prohibits the operating agreement from altering certain provisions of the LLC Act. 805 ILCS 180/15-5(b). The LLC s operating agreement cannot: 1) Restrict rights of a person, other than a manager, member, or transferee of a member s distributional interest, under the LLC Act; 2) Reduce a member s fiduciary duties, except it may: T H E T U C K E R F I R M L L C 1723 North Halsted Street Chicago, Illinois [email protected] (312)

79 3) Identify specific activity types that do not violate these duties, if not manifestly unreasonable; and 4) Specify the number of members or disinterested managers that may authorize or ratify, after full disclosure of all material facts, a specific act or transaction that otherwise would violate these duties. 5) Reduce the obligation of good faith and fair dealing for mangers and members, except that it may determine the standards by which performance of the obligation is to be measured, if not manifestly unreasonable; 6) Unreasonably restrict a member s right to information or records; 7) Vary the right to expel a member if the member engages in conduct that is wrongful, in breach of the operating agreement or fiduciary duties, or that makes it not reasonably practicable to carry on the LLC s business; 8) Vary the requirement that the LLC s business be wound up if an event occurs that makes is unlawful to continue the LLC s business or a member has obtained a judicial decree requiring wind up; or 9) Restrict the power of a member to dissociate, except that it may determine whether dissociation is wrongful and may eliminate or vary the obligation of the LLC to purchase the dissociated member s distributional interest. Id. B. ANNUAL REPORT AND OTHER REQUIRED DOCUMENTS An LLC is required to file an annual report with the Illinois Secretary of State and to maintain certain records at its principal place of business. 805 ILCS 180/50-1(a). The filing fee for an LLC s annual report is $ ILCS 180/50-10(b)(11). Series LLCs must pay an additional filing fee of $50 for each series in a series LLC. A standard LLC files its annual report on Form LLC-50.1(D) for domestic regular and series LLCs. An LLC s filing fees for its annual reports are fixed and apply regardless of the amount of capital of the LLC. The annual filing fee for an LLC is often lower than for a C corporation with high paid-in-capital. This is because a C corporation must pay a fixed filing fee of $75 for its annual report plus an annual franchise tax of.1% of the corporation s stated and paid-in-capital of the corporation, subject to a minimum of $25. Therefore, the annual filing fee for an LLC with $1 million in capital is $250 whereas the annual filing fee for corporation with $1 million in capital is $1,075. OPERATING AS AN LLC 71

80 Finally, an LLC is required to maintain the following records at its principal place of business named in the articles of organization or other reasonable location specified in the operating agreement: 1) A list of the name and address of each member, the description and amount contributed to the LLC by the member, and the date on which each became a member; 2) The articles of organization and any powers of attorney under which documents have been executed; 3) The LLC s federal, state, and local income tax returns and reports for the three most recent years; 4) The current operating agreement and any amendments to it; and 5) Any financial statements of the LLC for the three most recent years. 805 ILCS 180/1-40(a). These records may be inspected and copied at the request and expense of any member. 805 ILCS 180/1-40(b). C. PROPER PROCEDURES FOR MERGERS AND CONVERSIONS A merger is a transaction in which two or more entities combine and only one of them legally survives. A conversion is a transaction in which an entity changes from one entity type to another. The LLC Act contains specific provisions that govern mergers and conversions with respect to LLCs. Effect of a Merger. An LLC may be merged with, or into, one or more LLCs, corporations, partnerships, or other entities if permitted under the law governing the other entity or entities. 805 ILCS 180/37-20(a). To execute a merger, a plan of merger is prepared and approved and articles of merger are filed. 805 ILCS 180/37-20(b) and (e). The effect of a merger is that the separate existence of each entity merged terminates except for the one entity that survives. 805 ILCS 180/37-30(a)(1). The merger vests in the surviving entity all property, debts, liabilities, obligations, actions, proceedings, rights, privileges, OPERATING AS AN LLC 72

81 immunities, powers, and purposes. 805 ILCS 180/37-30(a)(2)-(3), (5). A member of an LLC surviving entity is liable for all obligations of a party to the merger for which the member was personally liable before the merger. 805 ILCS 180/37-30(e). An LLC that is merged into another entity is not required to wind up its business in order to merge. 805 ILCS 180/37-30(f). Plan of Merger. A plan of merger must state the following information: 1) Each entity s name; 2) The surviving entity s name; 3) The surviving entity s type; 4) The merger s terms and conditions; 5) The manner and basis for converting the interests of each party into interests of the surviving entity and/or into money or other property; and 6) The surviving entity s principal place of business address. 805 ILCS 180/37-20(b). Approval of the Plan of Merger. For an Illinois LLC to merge, the plan of merger must be approved by all of the members or by the number of members specified in the operating agreement. 805 ILCS 180/37-20(c)(1). For a foreign LLC to merge, the plan of merger must be approved by the vote required by the law of the state in which the LLC is organized. 805 ILCS 180/37-20(c)(1). If an LLC is merging with an entity that is not an LLC, the plan of merger must also be approved properly by that entity. For a partnership or Illinois limited partnership to merge with an LLC, the plan of merger must be approved by all of the partners or by the number specified in the partnership agreement. 805 ILCS 180/37-20(c)(3). For any other entity, the plan of merger must be approved by the vote required for approval of a merger by Illinois law or other state in which the entity is organized. 805 ILCS 180/37-20(c)(4). If there is no requirement, then the plan of merger must be approved by all of the owners of interests in the entity. Id. Articles of Merger. OPERATING AS AN LLC 73

82 A merger is effective only when articles of merger are filed on Form LLC with the Illinois Secretary of State by each entity that is a party to the merger after approval of the plan of merger. 805 ILCS 180/37-20(e). The articles of merger states: 1) The name and jurisdiction of formation for all entities; 2) For each LLC, the date articles of organization were filed; 3) A statement that a plan of merger has been approved and signed by each entity and a copy of the plan as approved by any corporation; 4) The name and address of the surviving entity; 5) The merger s effective date; 6) If an LLC is the surviving entity, any changes in its articles or organization that are necessary; 7) If the mergers involves a foreign LLC, the jurisdiction and date of filing of the LLC s initial articles of organization and the date when its application for authority to do business was filed; and 8) If the surviving entity is not an LLC, an agreement that the surviving entity may be served with process and is subject to liability for the obligations of any LLC previously subject to suit in Illinois and the enforcement under the LLC Act of the right of members of any LLC to receive payment for their interest against the surviving entity. 805 ILCS 180/37-25(a). The filing fee for the articles of merger is $100 plus $50 for each entity merged in excess of two. 805 ILCS 180/50-10(b)(13) Effect of Conversions. A partnership or limited partnership may be converted to an LLC if the law governing the partnership permits it. 805 ILCS 180/37-10(a). To execute a conversion, an agreement of conversion is prepared and approved and an articles of organization is filed. 805 ILCS 180/37-10(b) and (d). The effect of a conversion is that the partnership ceases to exist, and the LLC is for all purposes the same entity that previously existed. 805 ILCS 180/37-10(e) and 180/37-15(a). All property, debts, liabilities, obligations, pending actions, rights, privileges, immunities, powers, and purposes vest in the LLC. 805 ILCS 180/37-15(b). All of the partners continue as LLC members. 805 ILCS 180/37-15(b)(5). A general partner remains liable as a partner for an obligation incurred by the partnership before the conversion. 805 ILCS 180/37-10(g). OPERATING AS AN LLC 74

83 A limited partner remains liable only to the extent the limited partner was liable for an obligation incurred by the limited partnership before the conversion. Id. Agreement of Conversion and its Approval. The agreement of conversion should include a statement of the terms and conditions of the conversion of the partnership interests into LLC interests and/or the cash or other consideration paid. 805 ILCS 180/37-10(c). The agreement must be approved by all of the partners or by the partners required in the partnership agreement. 805 ILCS 180/37-10(b). Articles of Organization. After the agreement of conversion is executed and approved, the LLC must file an articles of organization. 805 ILCS 180/37-10(d). In addition to the regular items, the articles of organization must contain a statement of the following: 1) That the partnership was converted to an LLC; 2) The partnership s former name; 3) The number of votes cast by the partners entitled to vote on the conversion, and the number or percentage required to approve it; and 4) For a limited partnership, a statement that the certificate of limited partnership shall be canceled on the conversion date. Id. The filing fee for this statement is $ ILCS 180/50-10(b)(14). D. DEALING WITH A MEMBER S DISSOCIATION Practitioners are generally familiar with the concept of dissolution through their dealings with other types of entities. The dissolution of an LLC relates to process by which the LLC s business is wound up and the LLC is terminated. The LLC Act introduces a separate concept called dissociation that is distinct from dissolution and is unique to the LLC. A dissociation refers to the voluntary or involuntary withdraw of a member from an LLC. Certain events trigger a member s dissociation. Once a dissociation occurs, certain rights and obligations arise. OPERATING AS AN LLC 75

84 Events that Cause a Member s Dissociation. The events that cause a member s dissociation from the LLC are: 1) The receipt of notice by the LLC of the member s express will to withdraw; 2) Transfer of all of the member s distributional interest, except for security purposes or a court charging order not foreclosed; 3) An event or the member s expulsion as specified in the operating agreement; 4) The member s expulsion by the other members unanimous vote if: a. It is unlawful to carry on the LLC s business with the member; b. Substantially all of the member s distributional interest has been transferred, except for security purposes or a court charging order not foreclosed; c. A corporate member has dissolved, had is charter revoked, or had its right to conduct business suspended and it is not corrected within 90 days after the LLC gives notice; or d. A partnership or LLC member has dissolved and is winding up. 5) The member s expulsion by judicial determination upon application by the LLC or another member because the member: a. Engaged in wrongful conduct that adversely affected the LLC s business; b. Willfully or persistently breached the operating agreement or a fiduciary duty; or c. Engaged in conduct relating to the LLC s business that makes it not reasonably practicable to carry on the LLC s business with the member. 6) The member has: a. Become a debtor in bankruptcy or executed an assignment for the benefit of creditors; or b. Acquiesced in the appointment of a trustee, receiver, or liquidator of the member or the member s property or failed to have the appointment vacated or stayed within 90 days if the appointment was without the member s acquiescence. 7) An individual member has: a. Died; OPERATING AS AN LLC 76

85 b. Had a guardian or general conservator appointed; or c. Been judicially determined to be incapable of performing duties. 8) A trust or trustee member or an estate or personal representative of an estate member has distributed its rights to receive the LLC s distributions; or 9) A member not an individual, estate or trust (other than a business trust) has had its existence terminated. 805 ILCS 180/ A Member s Power and Legal Right to Dissociate. A member of a manager-managed LLC cannot dissociate from the LLC unless the operating agreement provides. 805 ILCS 180/35-50(a). In contrast, a member of a member-managed LLC can dissociate from the LLC, rightfully or wrongfully, by giving notice. Id. The member s dissociation is wrongful only if it breaches an express operating agreement provision. 805 ILCS 180/35-50(b). If the member s dissociation is wrongful, the member is liable to the LLC and other members for damages caused by the dissociation. 805 ILCS 180/35-50(c). If the LLC does not wind up, damages must be offset against distributions due the member. 805 ILCS 180/35-50(d). Effect of a Member s Dissociation. Upon a member s dissociation, the member ceases to be a member and is treated as a transferee of a member, except that a member who has not wrongfully dissociated can participate in the LLC s winding up. 805 ILCS 180/35-55(b)(1). The member s fiduciary duties terminate except that the member s duty of loyalty (except for the duty not to compete) and the member s duty of care continue on matters arising before dissociation. 805 ILCS 180/35-55(b)(3). Upon a member s dissociation, the LLC is required to purchase the dissociated member s distributional interest if the dissociation does not result in a dissolution and winding up of the LLC. 805 ILCS 180/35-55(a). The purchase price is the fair value of the distributional interest on the dissociation date. 805 ILCS 180/35-60(a). The operating agreement may fix the price and terms, and if the LLC defaults, the member may have the LLC judicially dissolved and wound up. 805 ILCS 180/35-60(c). Damages for wrongful dissociation and all other amounts the dissociated member owes the LLC must be offset against the purchase price. 805 ILCS 180/35-60(f). OPERATING AS AN LLC 77

86 The procedure for the LLC s purchase of the dissociated member s distributional interest is established by the LLC Act. 805 ILCS 180/ The LLC is required to deliver a purchase offer to the dissociated member not later than 30 days after the dissociation. 805 ILCS 180/35-60(b). The offer must include a statement of the LLC s assets and liabilities as of the dissociation date, the LLC s latest balance sheet and income statement, if any, and an explanation of how the payment amount was calculated. Id. If the LLC and the dissociated member do not make a purchase agreement for the dissociated member s interest within 120 days after dissociation, the member may sue to enforce the purchase within another 120 days. 805 ILCS 180/35-60(d). The court will determine the fair value of the member s distributional interest, considering going concern value, other purchase agreements, court-appointed appraiser recommendations, legal constraints on the LLC, and other factors. 805 ILCS 180/35-65(a)(1). The court will then specify the terms of the purchase, which may include installment payments, subordination to the LLC s other creditors, security for a deferred purchase, a covenant not to compete or other restriction on a dissociated member, and other terms. 805 ILCS 180/35-65(a)(2). Finally, the court will require the dissociated member to assign his interest to the LLC upon receipt of the purchase price. 805 ILCS 180/35-65(a)(3). After the dissociated member delivers the assignment, the dissociated member has no further claim against the LLC, its member, officers, or managers other than a claim to any unpaid balance of the purchase price and a claim under any agreement with the LLC or its members that the court does not terminate. 805 ILCS 180/35-65(b). If the purchase is not completed as ordered, the LLC must be dissolved upon application and the dissociated member has the same rights and priorities in the LLC s assets as if the sale had not been ordered. 805 ILCS 180/35-65(c). If a party to the proceeding acted arbitrarily, vexatiously, or not in good faith, the court may award reasonable expenses, including attorneys fees, and expert expenses. 805 ILCS 180/35-65(d). The finding may be based on the LLC s failure to make an offer to pay or to purchase the interest. Id. Interest must be paid on the amount awarded from the dissociation date to the date of payment. 805 ILCS 180/35-65(e). E. GUIDING CLIENTS THROUGH DISSOLUTION In contract to dissociation, dissolution of an LLC causes the LLC to cease to exist as a legal entity. Dissolution is triggered by certain specified events. Once one of these events occurs, the LLC must follow procedures to wind up its business operations, deal with outstanding claims, distribute its assets, and file articles of dissolution with the Secretary of State. Events Causing Dissolution. OPERATING AS AN LLC 78

87 An LLC is required to wind up its business and dissolve as a legal entity (1) upon an event specified in the operating agreement as requiring dissolution, (2) on the consent of the number of members specified in the operating agreement as required to cause dissolution, or (3) upon an event that makes it unlawful for the LLC s business to be continued. 805 ILCS 180/35-1(1)-(3). Dissolution upon a specified event or by consent can be avoided if the members and any dissociated members unanimously waive the requirement that the LLC dissolve. 805 ILCS 180/35-3(b). In addition, dissolution upon the dissociation of the last member can be avoided if within six months (1) the last member s personal representative agrees to continue the LLC until the personal representative or designee of the last member is admitted as a member; or (2) the operating agreement specifically provides for the admission of a member after there is no longer a remaining member and a member is admitted. 805 ILCS 180/35-3(c). A court may also order the LLC to dissolve if a transferee of a member s interest requests the LLC s dissolution and the court determines that it is equitable to wind up the LLC s business. 805 ILCS 180/35-1(5). A member s dissociation from the LLC does not require the LLC to dissolve. However, a court may order the LLC to dissolve on application by a current or dissociated member if the court determines that: 1) The LLC s economic purpose is likely to be unreasonably frustrated; 2) A member has engaged in conduct relating to the LLC s business that makes it not reasonably practicable to carry on the LLC s business with that member; 3) It is not otherwise reasonably practicable to carry on the LLC s business in conformity with the articles of organization and the operating agreement; 4) The LLC failed to purchase the member s distributional interest after the member dissociated himself; or 5) The managers or members in control of the LLC have acted or will act in a manner that is illegal, oppressive, or fraudulent with respect to the member. 805 ILCS 180/35-1(4). Finally, the Illinois Secretary of State may administratively dissolve an LLC if (1) the LLC fails to file its annual report or any other report within 180 days of its due date or the LLC fails to appoint an Illinois registered agent within 60 days of its former agent s resignation; and (2) the Secretary of State has sent a notice of delinquency to the LLC allowing it 120 days to correct the default. 805 ILCS 180/ After an administrative dissolution, an LLC may be reinstated by filing an application for reinstatement Form LLC-35.40, filing all reports that are due, and paying all fees and penalties. 805 ILCS 180/ OPERATING AS AN LLC 79

88 Winding Up the LLC s Business. After an event causing the LLC s dissolution occurs, the LLC must wind up its business. This process may be done by any member who has not wrongfully dissociated or the last member s legal representative. 805 ILCS 180/35-4(a)-(b). The Circuit Court also may order judicial supervision of the winding up process. Id. The LLC s business may be preserved as a going concern for a reasonable time after dissolution but before winding up. Disposing of the LLC s Claims. During the dissolution process, an LLC should undertake steps to dispose of known and unknown claims against the LLC as provided for in the LLC Act. To dispose of known claims against the LLC, the LLC may send known claimants a notice of the dissolution in writing stating: 1) The information required to be included in a claim; 2) The mailing address for claims; 3) The deadline for the claim s receipt, which may not be less than 120 days after the notice s receipt; and 4) The statement that the claim will be barred if not received by the deadline. 805 ILCS 180/25-45(a)-(b). The claimant s claim is barred if (1) the claim is not received by the deadline; or (2) the claim is received by the deadline, rejected by the LLC, and the claimant does not commence a proceeding to enforce the claim within ninety days after notice of the rejection. 805 ILCS 180/25-45(c). To dispose of unknown claims against the LLC, the LLC may request the presentation of claim by publishing notice: 1) At least once in a newspaper of general circulation in the county of the principal office in Illinois, or if none of the designated office; 2) Describing information required to be contained in a claim and stating the mailing address where a claim is to be sent; and 3) Stating that a claim is barred unless a proceeding to enforce the claim is commenced within five years. 805 ILCS 180/25-50(a)-(b). OPERATING AS AN LLC 80

89 Claims are barred if the claimant did not receive written notice for a known claim, the claimant s claim was timely sent to the LLC but not acted on, or the claimant s claim is contingent or based on an event occurring after the dissolution date. 805 ILCS 180/25-50(c). Claims that are not known and not barred by the procedures described above may be enforced against a dissolved LLC to the extent of its undistributed assets or, if the LLC s assets have been distributed, against a member to the extent of the member s proportionate share of the claim or his distribution, whichever is less. 805 ILCS 180/25-50(c) Distribution of the LLC s Assets. Upon the LLC s dissolution, the LLC s assets must be distributed in accordance with certain priorities. 805 ILCS 180/ (See section above on Property Transfers to and from Members.) Articles of Dissolution. In order to complete the dissolution process, the LLC must file articles of dissolution Form LLC with the Secretary of State and pay a $100 filing fee. 805 ILCS 180/35-15 and 180/50-10(b)(3). The articles of dissolution must state that: 1) All of the LLC s debts, obligations, and liabilities have been paid and discharged or that adequate provision has been made therefore; 2) All of the LLC s remaining property and assets have been distributed among its members; and 3) There are no suits pending or that adequate provision has been made to satisfy any judgment. (805 ILCS 180/35-15(1)-(4).) OPERATING AS AN LLC 81

90 V. SERIES LLCs A. FORMATION A series LLC is formed by filing with the Secretary of State an articles of organization for the LLC and a certificate of designation for each series and by providing for the series in the operating agreement. Articles of Organization A series LLC files its articles of organization on Form LLC-5.5(S) and pays a $750 filing fee. Articles of organization for a series LLC contain the same information as for a standard LLC except that the series LLC must provide notice that the liabilities of the series are limited to being satisfied from the assets of the series. 805 ILCS 180/37-40(b). A statement providing this notice is preprinted on the series LLC articles of organization form. The form states: The operating agreement provides for the establishment of one or more series. When the company has filed a Certificate of Designation for each series, which is to have limited liability pursuant to Section of the Illinois Limited Liability Company Act, the debts, liabilities and obligations incurred, contracted for or otherwise existing with respect to a particular series shall be enforceable against the assets of such series only, and not against the assets of the Limited Liability Company generally or any other series thereof, and unless otherwise provided in the operating agreement, none of the debts, liabilities, obligations and expenses incurred, contracted for or otherwise existing with respect to this company generally or any other series thereof shall be enforceable against the assets of such series. T H E T U C K E R F I R M L L C 1723 North Halsted Street Chicago, Illinois [email protected] (312)

91 Certificate of Designation. In addition to filing an articles of organization, a series LLC also must file on Form LLC a certificate of designation for each series established within the LLC and pay a $50 filing fee for each certificate. 805 ILCS 180/37-40(d). Certificates of designation for each series may be filed by the limited liability company or by any manager, person, or entity designated in the operating agreement for the limited liability company. 805 ILCS 180/37-40(d). The certificate of designation states (1) the LLC s name, (2) whether the LLC is established in Illinois or in another state, (3) the name of the series, and (3) a statement that the LLC s registered agent and office shall be the agent and office for the series. 805 ILCS 180/37-40(d). The name of the series must contain the entire name of the LLC and be distinguishable from the names of the LLC s other series. Id. If the management of the series is different from the management of the LLC, the certificate of designation must state the names and address of the managers or the members who will manage the series. Id. A series of an LLC will be deemed to be in good standing as long as the LLC is in good standing. 805 ILCS 180/37-40(e). However, the series will not have the additional limited liability protection that series LLCs afford unless a certificate of designation has been filed by the series. 805 ILCS 180/37-40(b). Operating Agreement The series in a series LLC must be established in the LLC s operating agreement. 805 ILCS 180/37-40(a). A series can be defined in many different ways. The LLC Act states that a series may provide for different members, managers, or LLC interests having separate rights, powers, or duties with respect to specified property or obligations of the LLC or profits and losses associated with specified property or obligations. Id. A series also may have a separate business purpose or investment objective. Id. Rather than establishing specific series from the LLC s inception, a series LLC s operating agreement may provide for the establishment of series or additional series in the future. Id. With respect to the management of the series LLC, the operating agreement may provide that a series will be managed by either the member or members associated with the series or by a manager or managers chosen by the members of the series. 805 ILCS 180/37-40(h). If the operating agreement does not specify the management of the series, the series management is vested in the members associated with the particular series. Id. The operating agreement may grant to all or certain of the members or managers of the series the right to vote separately or with any group of the members or managers associated with the series on any matter. 805 ILCS 180/37-40(i). In the alternative, the operating agreement may provide that a member or the members of the series have no voting rights. Id. In order for each series to have limited liability, the operating agreement of the series LLC must specifically provide for this. 805 ILCS 180/37-40(b). The operating agreement should SERIES LLCs 83

92 explicitly state that the debts, liabilities, and obligations incurred, contracted for, or otherwise existing with respect to a particular series shall be enforceable against the assets of such series only, and not against the assets of the LLC generally or any other series of the LLC. In addition, the operating agreement should state that none of the debts, liabilities, obligations, and expenses incurred, contracted for, or otherwise existing with respect to the LLC generally or any other series of the LLC shall be enforceable against the assets of such series. Id. B. CONVERSION A standard LLC can be converted into a series LLC without first dissolving the standard LLC. The conversion is accomplished by amending the standard LLC s articles of organization to provide for a series LLC. The members of the standard LLC must authorize the conversion by unanimous vote. 805 ILCS 180/15-1(c)(2). Once authorized, the standard LLC should file an articles of amendment on Form LLC-5.25 with the Secretary of State to amend its articles of organization. The articles of amendment should be drafted so as to cause the final articles of organization to contain the provisions stated on the articles of organization Form LLC-5.5(S), which is the form used to form a series LLC initially. In particular, the articles of amendment must contain a provision stating that series exist and that they have limited liability if the series LLC desires this limited liability. The filing fee for articles of amendment that convert a standard LLC to a series LLC is $400. The Secretary of State calculates this fee as the $150 fee regularly charged for filing an articles of amendment plus $250 representing the difference in the fee for filing an articles of organization for a series LLC as compared to a standard LLC. Despite the Secretary of State s method for calculating the filing fees, only the articles of amendment is filed to accomplish the conversion and not a new articles of organization. C. REPORTS Like a standard LLC, a series LLC must file an annual report with the Secretary of State. A domestic standard LLC files its annual report on Form LLC-50.1(D). The Secretary of State has not created the form that will be used for a series LLC to file its annual report. However, the Secretary of State has indicated that the annual report will be one document rather than a separate document for each series. The filing fee for an LLC s annual report is $250 plus $50 for each series if the LLC is a series LLC. 805 ILCS 180/50-10(11). These filing fees are fixed and apply regardless of the amount of capital of the LLC. Id. SERIES LLCs 84

93 D. CONDITIONS FOR LIMITED LIABILITY The limited liability protection that series LLCs offer for the assets of each series of the LLC is not automatic. Rather, certain conditions must be satisfied in order for the series LLC to obtain this limited liability protection. 805 ILCS 180/37-40(b). These conditions are the following: Id. 1) The LLC s operating agreement must create series and explicitly provide for limited liability for the series; 2) Separate and distinct records must be maintained for each series; 3) Each series assets must be held (directly or indirectly, including through a nominee or otherwise) separately; 4) Each series assets must be accounted for separately; 5) Notice of the limited liability must be contained in the LLC s articles of organization; and 6) The series must file a certificate of designation with the Secretary of State. The LLC Act also specifies circumstances that will not cause a series LLC to lose its additional limited liability protection. 805 ILCS 180/37-40(b). A series LLC does not lose its limited liability if the LLC and any of its series consolidate their operations as a single taxpayer or are treated as a single business for purposes of qualifying to do business in Illinois or another state. Id. In addition, the LLC Act states that the LLC and any of its series may work cooperatively or contract jointly without losing their limited liability protection. Id. E. OPERATING A series with limited liability is generally treated like a separate legal entity in conducting its business. 805 ILCS 180/37-40(b). A series should use its own name to contract, hold title to assets, grant security interests, sue and be sued, and otherwise conduct its business. Id. The provisions in the LLC Act will apply to each separate series in the same manner that they apply to a standard LLC as a whole. 805 ILCS 180/37-40(j). Any event in the LLC s operating agreement or the LLC Act that causes a manager or member to cease being a manager or member of a series will not cause the manager or member to cease being a manager or member of the LLC in general. 805 ILCS 180/37-40(k). SERIES LLCs 85

94 The business of a series can be wound up and the series can be dissolved without causing the dissolution of the limited liability company as a whole. 805 ILCS 180/37-40(m). F. TAXATION Series LLCs may be taxed as one entity or multiple entities. Federal tax law rather than state business law determines the existence of an entity for tax purposes. Whether a series LLC is taxed as one or more entities will depend on the characteristics of the series. A series LLC likely will be taxed as one entity if its series have common economic interests and activities, ownership, and decision making. However, if the series differ substantially with respect to these items, then the LLC likely will be taxed as multiple entities. The IRS has held in a private letter ruling that each series of a Delaware business trust would constitute a separate entity for tax purposes. IRS Private Letter Ruling, No , 1994 WL (Sept. 2, 1994.) In this situation, each series was to have a distinct investment objective and invest in a portfolio of securities in which no other series would have an interest. Each holder of an interest in the trust was to invest in one or more series and his rights and economic interests were limited to, and determined only with respect to, the particular series in which he invested. Id. The IRS has not issued any specific guidance on the taxation of series LLCs, and therefore, there is a great deal of uncertainty in this area. What is certain is that the tax consequences of a series LLC being taxed as one entity as compared to multiple entities are substantial. This aspect of the series LLC provides the tax planner with many opportunities and challenges. SERIES LLCs 86

95 VI. ETHICS IN DEALING WITH LLCs A. ETHICAL STANDARDS AND CIVIL LIABILITY As with any engagement, a professional must not only comply with the ethical standards set by his profession, but also ensure that he is not negligent in performing his services. Professionals who are not lawyers also should be particularly careful not to engage in the unauthorized practice of law. Professionals who are not attorneys may attempt to advise individuals on the formation and maintenance of an LLC. The danger of doing this is that the professional could be deemed to be engaged in the unauthorized practice of law. Illinois courts have defined the practice of law broadly to be the giving of advice or the rendition of any sort of service which requires the use of any degree of legal knowledge or skill. If the advice offered or service provided requires more than ordinary business intelligence, it constitutes the practice of law. In general, if a person is merely filling out forms for a company, this is not considered the practice of law. However, if the person performs a legal analysis of the facts relating to the company and advises the company on how to proceed, this constitutes the unauthorized practice of law. T H E T U C K E R F I R M L L C 1723 North Halsted Street Chicago, Illinois (312)

96 B. THE ROLE OF THE ATTORNEY AS ADVISOR IN LLC FORMATION The procedures that an attorney should follow in forming an LLC for a client are extensive. The attorney should first determine whether the LLC is the most appropriate entity for the client s operations, considering the differences among the different entity types. (See the section above Factors to Consider in Choosing the Right Entity.) The attorney also should ensure that the LLC Act and any other applicable statutes governing the client s industry allow for the client to operate as an LLC. In addition, the attorney should ensure that all of the specific requirements for the client to be allowed to operate as an LLC are satisfied. (See the section above on Special Rules for Regulated Professionals.) Once the attorney has determined that an LLC is desirable and permissible, the attorney should draft the articles of organization for the LLC. (See section above on Drafting the Articles of Organization.) Most importantly, the attorney should draft the operating agreement for the LLC. (See section above on Drafting the Operating Agreement and Statutory Limitations.) Although an attorney may wish to start the drafting process by using a standard form operating agreement, an attorney should not allow the form to substitute for the attorney s good independent analysis and advice, considering fully the nature of the LLC s business and its structure. During the drafting process, the attorney should meet several times with the key members of the LLC to determine how the LLC will be structured and operated. For example, the attorney should discuss what each member will contribute to the LLC, how decisions for the LLC will be made, what each member will receive from the LLC, and how a member will withdraw from the LLC. The attorney should ensure that the operating agreement is consistent with the member s understanding as to how the LLC will be structured and operated. If an attorney skips this important step, the members often operate the LLC in a manner that is independent of and often inconsistent with the operating agreement. This creates a situation in which it becomes nearly impossible to sort out the legal rights and obligations of those involved in the event that a conflict arises in the future. The attorney may also need to draft employment and/or independent contractor agreements for the members and/or managers who will be providing services to the LLC. Finally, the attorney should ensure that the LLC complies with all applicable securities laws. An attorney often forms an LLC and then stops providing services to the client relating the LLC s setup. By doing so, the attorney not only fails to serve his client well, but also misses the opportunity for earning additional fees for providing essential services for the ongoing maintenance of the LLC. At a minimum, an attorney should ensure that either the attorney or the LLC files its annual report when due every year. The attorney may also wish to consult with ETHICS IN DEALING WITH LLCS 88

97 his LLC clients to ensure that the LLC is in compliance with its other ongoing legal obligations and to determine if anything has changed with the LLC that would require changes to the LLC s filings with the Secretary of State or to the LLC s internal documents. For example, the attorney should ensure that the LLC has maintained its registered agent in Illinois and has the records that it is required to keep on file. In addition, the attorney may inquire as to whether the LLC s name, members and/or managers, registered agent, principal place of business, operations or governance has changed. If so, the attorney may inform the LLC that certain of these changes may require changes to the LLC s filings and internal documents and offer to provide services to make any required changes. Many businesses exist that provide standard forms to the public for forming LLCs or that provide services to fill out these forms for the LLC without the involvement of an attorney. These businesses often charge very small amounts to their customers for providing these documents and services. For example, many companies charge only several hundred dollars for forming an LLC. An attorney may face an uphill battle to convince a client that it is not in the client s best interest to form an LLC solely by using standard forms. Instead, the attorney may elect to cut his fees and to provide fewer services to his client to tailor the LLC s documents to the LLC s business. However, the attorney should remember that regardless of the amount of the fee charged, the attorney still has unlimited personal liability for any malpractice claim that arises from his services. The attorney should think carefully about whether providing bad service and incurring substantial risk is worth the small fee. An attorney may determine that a client who is not willing to pay for the attorney doing all of the tasks necessary to properly form and maintain an LLC should make other arrangements for forming his LLC. C. AVOIDING CONFLICTS OF INTEREST When dealing with an LLC, an attorney may represent the LLC itself and/or one or more of the LLC s members individually. If the attorney represents only one person or entity, then no issues arise as to a potential conflict of interest by the attorney. Thus, if an attorney is retained to form an LLC, the attorney may wish to represent only the LLC to avoid potential conflicts of interests. The attorney also should take steps to protect himself against any potential claims of an improper conflict of interest. For example, the attorney should send an engagement letter to his client stating precisely the identity of his client and also stating that the attorney is not representing any other entity or persons involved. The attorney also may send an appropriate letter to any others involved in the situation to avoid any inference by them that the attorney is representing them, especially if they are not represented by an attorney. In providing his services, the attorney should ensure that he at all times is acting for his client and not for any other entity or person. Finally, the attorney should ensure that he is paid by his client and not from any other entity or person. ETHICS IN DEALING WITH LLCS 89

98 If the attorney chooses to represent two or more persons or entities in dealing with an LLC, then potential conflicts of interest may arise. The Rules of Professional Conduct state that an attorney cannot represent a client if the representation of that client will be directly adverse to another client or be materially limited by the attorney s responsibilities to another client unless (1) the attorney reasonably believes that his representation of the client will not be adversely affected and that there will be no adverse effect on his relationship with the other client; and (2) each client consents after disclosure. In addition, when the attorney s representation of multiple clients in a single matter is undertaken, the disclosure must include an explanation of the implications of the common representation and the advantages and risks involved. Thus, if the attorney chooses to represent multiple clients in forming an LLC or otherwise dealing with an LLC, the attorney should ensure that he complies with these rules. D. CONFIDENTIAL INFORMATION FROM A REPRESENTATION In dealing with an LLC, attorneys and accountants also should be careful not violate the duties of confidentiality that they owe to their clients. The Illinois Rules of Professional Conduct prohibit a lawyer, during or after termination of a professional relationship with a client, to use or reveal a confidence or secret of the client known to the lawyer unless the client consents after disclosure. Accountants owe their clients a similar duty. Thus, a lawyer or accountant who deals with LLCs first should ensure that he or she has clarified who his or her client is. It is possible that the lawyer s or accountant s client is the LLC entity, the LLC s members or both, provided that the representation is not prohibited by the rules on conflicts of interest. Only by identifying his client, can the lawyer or accountant ensure that he or she is not disclosing information improperly to individuals and/or entities other than his or her client. ETHICS IN DEALING WITH LLCS 90

99 VII. MASTERING ESTATE PLANNING ISSUES A. USING AN LLC TO HOLD AND TRANSFER REAL PROPERTY LLCs are used frequently to hold real property and to carryout like-kind exchanges of real property. Reasons to Hold Real Property in an LLC. The LLC Act expressly authorizes LLCs to own, operate, and lease as a landlord real estate. LLCs are often used by owners of real estate to insulate the owner from personal liability, to protect the owner s identity, and to obtain certain tax advantages. Owners of real estate who own multiple properties can form separate LLCs to hold each property so that liability is isolated to the given property. Owners also can form a series LLC and hold title to each property in a separate series of the LLC so that liability is isolated to the given property. As long as no grounds exist for piercing the LLC s veil, this strategy is effective. (See Section above on Limited Liability of Members and Exceptions.) Holding title to real estate in an LLC also may assist an individual in keeping the individual s name from the public. Unless the member is also an organizer or manager of the LLC, the member s name will not appear in the public records of the Secretary of State provided that the LLC is manager-managed. T H E T U C K E R F I R M L L C 1723 North Halsted Street Chicago, Illinois (312)

100 Finally, an LLC may provide tax advantages to a real estate owner that are not available through other entity types. If an LLC chooses to be taxed as a partnership, then the member s contribution to the LLC and the LLC s distribution to the member of appreciated real estate generally do not cause either the member or the LLC to recognize a taxable gain on the appreciation. In contrast, if an LLC elects to be taxed as a C corporation or an S corporation, a taxable gain is recognized on the contribution and distribution of appreciated real estate unless the member has at least an 80% ownership interest in the LLC as set forth in Section 368(c) of the Code. 26 U.S.C. 368(c). In addition, in an LLC that elects to be taxed as a partnership, a member s share of the LLC s debt increases the member s tax basis in his LLC interest. The increased basis gives the member a greater ability to deduct losses generated by the LLC. If the LLC elects to be taxed as a C corporation or S corporation, the member s tax basis in his LLC interest is not increased by the member s share of the LLC s debt. Because the member s basis is lower, the member will not be able to deduct as many losses because deductions in excess of the member s basis will be prohibited by the at-risk limitations. Like-Kind Exchanges. Use of an LLC to hold real estate does not limit a real estate owner s ability to carryout a likekind exchange under Section 1031 of the Code. To carry out a like-kind exchange, the same party who transferred the exchange property must generally receive the replacement property in the exchange. However, a single-member LLC will be disregarded as a separate entity from the member for income tax purposes; and therefore, the replacement property may be received by an LLC whose single member is the transferor of the exchange property. See IRS Ruling, No , 1998 WL 57886, (Feb. 13, 1998.) In addition, under some circumstances, the IRS has permitted the use of a two-member LLC to be treated as a disregarded entity to complete the exchange. This has been allowed when the second LLC member does not have an interest in income or loss of the LLC but is a member of the LLC only for control purposes. See IRS Ruling, No , 1999 WL , (Mar. 19, 1999.) B. AN LLC AS A VALUATION FREEZE ENTITY If a donor owns an asset that the donor would like to gift to a donee, the donor may use an LLC to maximize the amount of property that can be transferred subject to the annual gift tax exclusion and the lifetime transfer exemption, and hence, minimize gift and estate taxes. The donor would contribute the property to an LLC and then gift the LLC s membership interests to the donee rather than gift the asset directly to the donee. For this strategy to succeed in MASTERING ESTATE PLANNING ISSUES 92

101 minimizing tax, the LLC membership interests must qualify as present interests and be subject to valuation discounts. LLC Membership Interests As Present Interests. For an LLC membership interest to qualify for the annual gift tax exclusion and lifetime transfer exemption for estate tax purposes, the LLC membership interest must constitute a present interest. A present interest exists if the donee has the immediate and unconditional right to the use, possession, or enjoyment of the gifted property or the income from it. 26 U.S.C. 2503(b). The IRS has held that certain limited partnership interests constitute present interests that qualify for the annual gift tax exclusion and lifetime transfer exemptions. Internal Revenue Ruling, No , 1994 WL (Apr. 15, 1994.) It is possible for LLC membership interests to constitute present interests as well. However, there is only one published situation in which the IRS has considered the issue. In Hackl v. Commissioner of the Internal Revenue, the Seventh Circuit Federal Court of Appeals held that the gifted LLC membership interests at issue did not constitute present interests. 335 F.3d 664 (7 th Cir. 2003). The Court s holding was based on the facts that (1) the LLC s operating agreement prohibited the members from selling their membership interests absent manager approval, (2) any purchaser did have a right to become a member or to participate in the LLC s business, (3) the members had no right to compel distributions from the LLC or to withdraw their capital accounts, and (4) the LLC anticipated generating losses and making no distributions to its members for a number of years. Id. Accordingly, a donor must ensure that an LLC s operating agreement provides for greater current rights than the rights present in Hackl to cause gifted LLC membership interests to constitute a present interest that qualifies for the annual gift tax exemption and life time transfer exemption. Valuation Discounts Assuming that an LLC is structured such that its membership interests constitute present interests, a taxpayer may be able to minimize taxes by causing the value of the gifted LLC membership interests for tax purposes to be less than the member s proportionate share of the value of the LLC s assets. For example, if a donor owns an asset with a fair market value of $100,000 and gifts twelve percent of the asset directly to the donee, the gift s value would be $12,000 if no valuation discounts applied and would be equal to the annual gift tax exemption. If the donor contributes the asset to an LLC, the donor may be able to gift a higher percentage of the membership interests than twelve percent and still have the gift s value be equal to the annual gift tax exemption. This would occur if there are more valuation discounts that apply to a gift of the LLC s membership interests than apply to the asset directly. Thus, the donor could gift more property without tax. MASTERING ESTATE PLANNING ISSUES 93

102 The value of LLC membership interests may be discounted for tax purposes for conditions such as the lack of marketability, lack of control, and minority interest discounts. Valuation discounts have been permitted on interests in a family limited partnership up to forty percent of the value of the partnership s assets. Estate of Jones v. Commissioner, 116 T.C. 121, 139, 2001 WL (2001). Thus, gifting LLC membership interests subject to valuation discounts can substantially minimize gift and estate taxes. Similarly, tax advantages may be obtained by fixing the value of a member s LLC interest at below its fair market value by inserting bona fide provisions in the operating agreement to freeze the value of the membership interest at a certain level. For example, the operating agreement may provide for the remaining members of the LLC to buy the membership interest of the member who dies at a price determined by a formula or fixed amount that is below the fair market value. These provisions may be used to determine the value of the membership interest for estate tax purposes if the price formula is arm s length and other conditions are met. When LLC interests are given to family members, the taxpayer should take care to ensure that Section 2701 of the Code does not apply to the transaction. Section 2701 generally provides that transfers of assets between certain family members will be ignored for gift and estate tax purposes if the transferor retains an interest in the asset transferred. Section 2701 may apply to the transfer of an LLC interest if the transfer is made to a family member, while retaining a liquidation, put, call, conversion, or distribution right and the interest transferred is not of the same class or proportionally the same as the retained interest. Thus, to avoid triggering Section 2701, different classes of interests in an LLC should be created and transferred carefully. C. HOLDING LIFE INSURANCE POLICIES IN AN LLC An LLC can hold a life insurance policy on a member that is either payable to the LLC or to a third-party for a purpose unrelated to the LLC. When an LLC holds a life insurance policy that is payable to the LLC on the death of an LLC member, the LLC likely possesses the policy s incidents of ownership. Thus, when the member dies, the insurance proceeds are likely taken into account for federal estate tax purposes only to the extent that they increase the value of the decedent s membership interest in the LLC. The policy s face value may not be included in the decedent s gross estate. Otherwise, double taxation would result to the decedent because the proceeds of the policy increase the value of the decedent s LLC member interest, which is included in his estate. See Knipp Est. v. CIR, 25 T.C. 153 (1955), aff d on another issue, 244 F.2d 436 (4 th Cir. 1957). Thus, the LLC s holding of the policy and receipt of the insurance proceeds may reduce estate tax if valuation discounts exist that can be applied to the decedent s membership interest. MASTERING ESTATE PLANNING ISSUES 94

103 In contrast, when an LLC that is taxed as a partnership holds a life insurance policy on a member that is payable to a third party, the face amount of the policy likely must be included with the gross estate of the member upon his death. See Revenue Ruling D. USING AN LLC FOR PROJECTS LLCs can be used advantageously to carry out subsidiary operations, risky operations, joint venture projects, or venture capital projects. Corporate subsidiaries. A company s use of an LLC as a subsidiary rather than another type of entity has certain advantages. Unlike corporations, an LLC is not required to designate directors and officers. Thus, the company could just name the parent as the manager of the LLC and avoid the added complication of having a board and officers. The LLC also is not required to follow formalities in its management to preserve its limited liability. Finally, an LLC that is wholly owned by the parent company will be disregarded as an entity separate from its parent for federal income tax purposes if the LLC chooses this tax treatment. Therefore, the LLC will not be required to file a separate tax return. Risky Projects. A company can form an LLC as a wholly owned subsidiary and use it to carry out risky operations of a company to insulate the liability from the operations from the rest of the company s business. For example, a company may lease its fixed assets or license its intangibles to an LLC at the fair market rent and license fee. The LLC then uses the assets to carry out the risky business operations and pays the company the rent and license fee. Thus, the LLC, and not the company, would be liable for claims resulting from the business operations carried out by the LLC. The rent and license fees paid by the LLC to the company and the leased assets would be insolated from claims arising from the LLC s risky operations. However, before implementing this structure, it is important to review the fraudulent conveyance and fraudulent transfer statutes for limitations that may apply. MASTERING ESTATE PLANNING ISSUES 95

104 Joint Venture Projects. Joint venture projects by two companies are often carried out through a corporate subsidiary. The companies traditionally join together to form a third corporation for the joint venture. However, this requires appointing a separate board of directors and officers and following other required corporate formalities. A separate board of directors and officers for the joint venture is often unnecessary given that the companies already have a board of directors and officers in place for each company. In contrast, the two companies can form an LLC to carry out the joint venture project. With an LLC, the companies are not required to appoint a board of directors and officers or to follow other corporate formalities if they are unneeded in the joint venture. Venture Capital Projects. LLCs and series LLCs also may be used by venture capitalists. An LLC provides venture capitalists with the ability to segment business operations and to allocate income and loss flexibly among investors. The venture capitalists who finance many small businesses can minimize the number of separate legal entities that need to be maintained by carrying out each different business within a separate series of the series LLC. In an LLC, the venture capitalists also can provide for a simple management structure for businesses for which a more complex structure is unnecessary. However, if it is anticipated that a venture project will engage in an initial public offering, an an LLC is generally not preferred. To have ownership interests traded on a major securities exchange, the entity would need to be a C corporation. LLCs cannot be converted into a C corporation without being dissolved. MASTERING ESTATE PLANNING ISSUES 96