By: Craig A. Taylor, Attorney

Transcription

1 WHEN A LIMITED LIABILITY COMPANYIS THE BEST CHOICE By: Craig A. Taylor, Attorney Carruthers & Roth, P.A. 235 N. Edgeworth Street Greensboro, NC Telephone: (336) Fax: (336) cat@crlaw.com INTRODUCTION The limited liability company ("LLC") has become one of the most popular choices of entity for all kinds of businesses in all kinds of industries. LLCs offer great flexibility in capital structure - convenient for startup businesses with creative management and capitalization models. LLCs afford liability protection that equals - and in some states, may even exceed - the protection offered by older forms like corporations and limited partnerships. This makes LLCs an attractive investment vehicle for asset protection planning for individuals and large organizations. Last but certainly not least, LLCs generally elect to be taxed as partnerships, creating significant tax efficiencies and planning opportunities. This makes LLCs particularly attractive in the real estate and financial industries. This paper will focus on the fact patterns that work best with LLCs, discuss how to structure and document LLCs in those contexts, and point out some common pitfalls and mistakes in the use and structure of LLCs. I. Limited Liability Companies - an Overview. LLCs can be set up as very basic and simple business forms, or they can be highly customized, complex entities. The great flexibility of the LLC is its greatest asset, but that same flexibility can create a trap for owners lacking knowledgeable legal, tax, and accounting advisors. At its most basic level, an LLC is a business organizational form that offers limited liability protection to its owners. An LLC will be treated as a partnership for tax purposes unless it elects to be taxed as a corporation. Therefore, an LLC combines the limited liability protection of corporations with the tax advantages and structural flexibility of partnerships. 1

2 A. Formation. In almost every state, an LLC is formed by filing Articles of Organization with the Secretary of State. In North Carolina, the filing fee is $125. B. Annual Reports. Most states require LLCs to file annual reports with an annual fee. In North Carolina, the annual fee is $200. Currently, there is no annual franchise tax liability for LLCs in North Carolina. Some states (notably California) do impose franchise taxes on LLCs. C. Limited LiabilifJl. Business entities can be exposed to liability for many different kinds of claims. For example: 1. Vicarious Liability For Acts of Employees; 2. Vicarious Liability For Acts of Partners/Co-Owners; 3. Accidents on the Premises --"Slip and Fall" Cases; 4. Workmen's Compensation Claims; 5. Breach of Contract Actions (Lease Agreements, Employment Agreements); 6. CommercialjFinancial Obligations (Debt Obligations); 7. Employment Discrimination; and 8. Product Liability and Environmental Contamination Cases. In order to guarantee limited liability protection to its owners, the LLC must be validly formed and operated as a separate legal entity. Thus, as with corporations, certain corporate law type formalities must be observed. Thus, in order to prevent the piercing of the corporate LLC veil, the LLC must be treated as a distinct separate legal entity separate and apart from the business affairs of the owners. Therefore, separate books and records must be kept to track business affairs ofthe LLC. Generally, if the LLC owners comply with these formalities, personally owned assets of the LLC members won't be subject to claims of third parties against the LLC. There are a few exceptions to the liability shield offered by LLCs. First, the separateness of the legal entity will be disregarded in those extreme circumstances where owners have treated the business as an extension of themselves or have structured the corporate form to defraud creditors or other third parties such that a basic injustice would be served by recognizing the corporate form. This is known as "piercing the corporate veil." 2

3 Second, business owners are always liable for their own personal actions, even if the action is connected with the business of the LLC. For example, an LLC does not provide a shield for the tortious or negligent conduct of the business owner; and LLC owners are often required to provide personal guaranties of the LLCs debts or performance of business obligations (such as leases, bank debts, or employment agreements). D. Ownership and Management ofan LLC. The owners of an LLC are called "members" rather than partners or shareholders. A person becomes a member by being named as such in the Articles of Organization, acquiring an interest in the LLC or by unanimous consent of the other members. Unless otherwise agreed, the LLC will be "member managed" which means that the members of an LLC manage the LLC by majority rule with one vote each, regardless of economic contribution or ownership percentage. This is the same "one partner, one vote" rule found in a partnership. In a member-managed LLC, it is possible to give members voting power tied with their economic contributions or ownership interests. This is a convenient way to provide for rule by majority in interest rather than a per capita majority. As an option, an LLC can be "manager managed". This means that the members are not necessarily managers, but that a person or group of persons is designated to "run" the LLC. The members must specifically agree to this arrangement either by designating managers in the Articles of Organization or in the LLC Operating Agreement. The concept of "managers" is similar to the concept of a Board of Directors of a corporation. Managers function like a combination of Board of Directors and corporate officers. As such, management decisions are made by the majority of the managers (like a Board of Directors), but managers also, acting alone, have the power to bind the LLC and take actions on its behalf (much like corporate officers). An LLC operating agreement can also create officer positions (such as Presidents, Vice Presidents, Treasurers, and so on) and vest in those positions powers and duties similar to those traditionally vested in corporate officers. E. Operating Agreements. The North Carolina LLC law provides a "default" set of rules outlining the rights of managers and members, but the owners of the business will almost always wish to vary this by agreement. One such default rule is the "one member, one vote" rule - almost every business wishes to instead operate on votes based on a "majority in interest." In order to establish the rights, obligations and responsibilities of the members and managers, the parties to an LLC must enter into a written operating agreement setting out the members' specific rights, obligations 3

4 and duties. Note that in Delaware and some other states, these agreements are called "limited liability company agreements." F. Lack ofprecedent Governing LLCs. Because LLCs have been available for less than twenty years (as opposed to well over a hundred years for corporations), the courts have not had an opportunity to hear and decide many cases relating to LLCs. Therefore, the body of case law governing LLCs is more limited than for corporations, and the parties must look to the statute and the express terms of the operating agreement for guidance. Also, the Internal Revenue Code does not take into account the state law differences between LLCs and traditional partnerships, which can lead to confusing results. This is especially notable in the rules governing tax basis arising from debt, and in recourse vs. nonrecourse liabilities. II. Taxation Characteristics of Limited Liability Companies As discussed above, an LLC will be treated as a partnership for tax purposes unless it elects a different treatment. As a result, the application of the partnership income tax rules generally will apply to LLCs. A. Pass Through Income Taxation. LLCs are not subject to a separate level tax on LLC income. Instead, items of income and loss of the LLC are passed through to the members and taxed at their individual tax rates. I.R.C. Section 702(a). Therefore, as with S corporations, income from the LLC will be subject to income tax at the members' individual tax rates (which may exceed the C corporation tax rates). B. No Double Taxation on LLC Income. Under I.R.C. Section 731(a)(1), LLC distributions will cause gain recognition to the distributee-member only to the extent that the actual amount of cash distributed exceeds that member's adjusted income tax basis in his membership interest. As with S corporations, as LLC income is earned and is taxed to the members at their individual rates, the members' adjusted income tax basis in their LLC interests will be increased by each member's distributive share of LLC income. I.R.C. Section 705(a)(1). Therefore, once the members pay tax on their LLC income, the members generally can then withdraw these earnings out of the LLC free of additional income taxes. 4

5 C. Deductibility ofoperating Losses. As with S corporations (but unlike C corporations), members of an LLC are allowed to deduct losses of the LLC on their personal returns. I.R.C. Section 702(a)(7). However, as with S corporations, LLC members may not deduct LLC losses in excess of the member's adjusted income tax basis in his LLC interest. I.R.C. Section 704(d). However, in contrast to S corporations, with LLCs, each member is entitled to take his or her pro rata share of LLC debts into account in determining that member's deductibility of LLC losses. I.R.C. Section 752(a). This is true even where the LLC indebtedness is attributable to loans from outside third parties. D. In-Kind Distribution ofappreciated Property. The most unique tax characteristic of LLCs results from the fact that, in general, no gain or loss is recognized on the distribution of appreciated property from an LLC to one or more LLC members. Under I.R.C. Section 731(a)(1), a distribution to an LLC member will cause gain recognition only to the extent that actual cash received exceeds that member's adjusted income tax basis in his or her LLC interest. For this reason, whenever it is anticipated that the business entity will hold potentially appreciating assets (such as real estate), it is usually advisable to structure the business entity as an LLC in light of the possibility that the members may wish to distribute this property in-kind to one or more of the members. E. No Limitations on Capital Structure. Unlike the case with S corporations, there are no limitations on the business structure of an LLC. Thus, unlike S corporations, LLCs may: 1. be a member of an affiliated group (i.e. an LLC may own more than 80% of another corporation); 2. have an unlimited number of owners; 3. have nonresident aliens as members; 4. have individuals, partnerships, corporations, other LLCs, estates or any types of trusts as LLC members. 5

6 F. No One Class ofstock Rules. Under I.R.C. Section 1361(b)(1)(D), an S corporation may only issue one class of stock. This generally means that equity interests in an S corporation may not confer unequal rights to distribution and liquidation proceeds. With LLCs, however, the LLC members are free to allocate items of income and gains in any manner agreed to by the members, and for tax purposes these allocations will be respected as long as they have "substantial economic effect." I.R.C. Section 704. This generally means that LLC members are free to create various classes of LLC membership interests which confer varying rights to LLC distributions. G. Intangibles Tax and Franchise Tax. In North Carolina, LLCs do not pay franchise tax (instead the LLC must pay a $200 filing fee with its annual payment). Also, LLC members are not required to pay intangibles tax on LLC membership interests. Some states, notably California, do subject LLCs to franchise taxes. H. Fringe Benefit Issues for Members ofan LLC. Since an LLC is taxed as a partnership, LLC members generally are not permitted to exclude from their gross income the value of certain valuable fringe benefits that may be paid on their behalf by the LLC- in particular, group health and life insurance. This may result in a "double tax" on theses fringe benefits provided by the LLC, since the income earned to pay these LLC fringe benefits will have already been taxed once to the LLC members on their individual schedule K-1's as part of their proportionate share of the LLC earnings. As with S corporations, this is another significant limitation of the LLC arrangement when compared to C corporations. If these fringe benefits are paid to a member as part of a compensation package for services rendered to the LLC, the payments are treated as guaranteed payments to the member and can be deducted by the LLC. I.R.C. Section 707(c) and Rev. Rul Subject to several limitations, the LLC member may be able to deduct all or part of the income from health insurance fringe premium payments. I.R.C. Section 162(1). However, the income is not deducted for purposes of calculating self-employment tax. I.R.C. Section 162 (l) ( 4 ). The LLC member's deduction of health insurance fringe premium payments is limited to the member's "earned income" derived from the LLC, meaning the remuneration the member receives in the form of a guaranteed payment in return for his or her services to the LLC. I.R.C. Section 162(l)(2)(A); I.R.C. Section 401(c)(2)(A). This itemized deduction is not a "miscellaneous" itemized deduction. I.R.C. Section 67(b)(6); I.R.C. Section 67(d)(2). Pending legislation suggests that this 6

7 itemized deduction may be used in calculating an increased tax or the alternative minimum tax. American Jobs Act of 2011, H.R.12.IH, Title IV, Subtitle A (adding Section 69 to the Internal Revenue Code). I. Employment Taxes on LLC Income. In general, since an LLC is a partnership for tax purposes, all income earned by the LLC will be subject to employment taxes, even for members who do not participate in the business at all. There are some exclusions to this rule. 1. Exclusion For Rental Real Estate Activities. Where the LLC's income is derived from rental real estate, the LLC income will be exempt from employment taxes. I.R.C. Section 1402(a)(1). 2. LLC Members Who Are Like Limited Partners. Also, members who are equivalent to "limited partners" will not be subject to self-employment tax on their share of LLC income. I.R.C. Section 1402(a)(13). As noted below, it will often be difficult to distinguish the members who are "general partners" from members who are "limited partners." However, for protection from the self-employment tax, it may be appropriate to recite some self-serving language in the LLC Operating Agreement where it is clear that certain members will be providing no services and will not participate in management decisions. The Internal Revenue Service recently issued some clarification on this issue, proposed Treas. Reg (a)-2(h). This proposed regulation provides that members will be treated as limited partners for purposes of Section 1402(a)(13) if (a) the member has no personal liability for debts of the LLC; (b) has no authority to contract on behalf of the LLC; (c) does not participate in the partnership's trade or business for more than 500 hours per year the LLC could have been formed as a limited partnership and the member would have qualified as a limited partner; and (d) the member does not provide substantial services to an LLC that is in the business of health, law, engineering, architecture, accounting, actuarial science, or consulting. The significance of classification as a limited partner is that the member's share of the LLC's earnings will not be subject to self employment tax. Under these rules, any person who is formally designated as a manager of the LLC will be subject to self employment tax, unless there is some other exception (such as rental real estate). However, even if a member is not officially a manager (a non-manager member), the income will still be subject to self employment tax ifthe member performs functions which would disqualify the member from treatment as a limited partner; for instance where he or she participates so extensively in the management of the business that the non-manager member would be deemed to be a general partner of a North Carolina limited partnership. Professional firms are essentially disqualified entirely. 7

8 Members engaged in the typical operating business will be affected by this rule. For members who are below the Social Security wage base (2011- $106,800), this represents an enormous additional tax of 15.3%. Even for those above this base, there will be an additional 2.9% tax for the recently uncapped Medicare portion. Example 1. A and B each own 50% ofa successful business that is operated by both A and B. The business generates $400,000 in total income, or $200,00 to each of A and B. A and Bare advised that they can justify paying themselves a salary of $90,000 each. In an S corporation, A and B can avoid Medicare tax on the nonwage portion ($220,000, or $110,000 each). If the business were operated as an LLC, this amount would be subject to Medicare tax, resulting in an additional tax of $3,190. Example 2. A is a 100% owner ofa "manager-managed" LLC. The LLC is a non-professional operating business that generates $300,000 in income per year. For estate planning purposes, A gives 5% interests in the LLC to each of his four children. The children are not managers and do not participate in the business. Under the proposed regulations, the children's share of LLC income will not be subject to employment taxes. III. LLCs as the Solution to Common Business Structures A. Real Estate Business Entities: LLCs are the Entitv ofchoice. Owners of real estate business ventures may face potential liability exposure for certain types ofliabilities such as: - commercial and trade obligations; - "slip and fall" liability; and - environmental tort liability. Therefore, owners of real estate business ventures usually should avail themselves of the limited liability protection offered by LLCs. LLCs are virtually always the choice of entity option for real estate business ventures: LLC members may take LLC debts into their outside tax basis in determining the deductibility of operating losses. Since most commercial real estate projects are highly leveraged and generate large depreciation deductions, this often greatly accelerates the realization of tax benefits. 8

9 LLCs are never subject to more than one level of tax on operating income or capital gains. Moreover, the employment tax and fringe benefit disadvantages of LLCs are minimized, since LLC income from rental real estate activities will always be exempt from self-employment taxes and these LLCs almost never offer fringe benefits to members. Importantly, appreciated assets always may be contributed and distributed in-kind from an LLC without the recognition of any taxable gain. This allows great flexibility in the structure of a real estate business, as new LLCs may be formed and receive contributions and distributions of appreciated real estate to accommodate new financing and capital opportunities. This feature may also facilitate Section 1031like kind exchanges. 1. "Promotes" or "Carried Interests". LLCs are attractive to real estate developers because partnership taxation facilitates equity-based compensation. These programs are known in the industry as "promotes" or "carried interests", and to tax professionals as "profits interests." These arrangements often convert some of the developer's compensation from ordinary income to capital gains. Corporations can grant equity-based compensation in the form of stock options. However, these programs are of limited use if there is no public market for the stock. Further, they may not be as effective in allowing capitals gains rates on compensation income. Finally, these programs are complex to implement and manage. Carried interests in LLCs can be easily implemented with straightforward language in the LLC's operating agreement, and existing revenue rulings give clear guidance in this area. Under Revenue Procedure 93-27, an interest in an LLC taxed as a partnership will be a "profits interest" if the recipient member would not receive a distribution if the LLC sold its assets at fair market value and liquidated immediately after the grant of the interest. Generally speaking, then, a profits interest can be established if (i) the LLC's operating agreement requires that liquidating distributions be made in accordance with the members' capital accounts; (ii) the member receiving a profits interest has a zero capital account on the date of grant; and (iii) the fair market value of the LLC's property is reflected in the capital accounts of the other members. The LLC may "book up" capital accounts to reflect fair market value when admitting a new member for this purpose. Revenue Procedure provides that the grant of a nonvested LLC interest is a nontaxable event unless the recipient member makes an election under Section 83(b) to recognize income. 9

10 Example 3: A and Beach own 50% ofalphabeta, LLC. Originally, A and B each contributed $20,000 to the LLC, thus each has a $20,000 capital account. The fair market value of the LLC's real estate increases to $100,000 with a basis of $40,000 and no liabilities. The LLC admits C as a 1/3 member. Prior to his admission, C had been a long term employee of the LLC. C will not be required to contribute any capital to the partnership for his interest, so his initial capital account will be $0. The operating agreement provides that liquidating distributions will be made in accordance with capital accounts. For Cto have a "profits interest", the LLC must either (a) book up the capital accounts of A and B to $50,000 each (reflecting the fair market value of the property) immediately before admitting C; or (b) amend the LLC agreement to provide that A and B are entitled to the first $100,000 of distributions upon liquidation ofthe LLC. Example 4: Investor and Developer make a deal to develop a shopping center. Investor will invest $1,000,000. Developer will be responsible for managing the development and construction process. The parties form Shops on the Park, LLC. Developer's capital account is $0, and her membership interest percentage is 10%. Investor's capital account is $1,000,000 and his membership interest is 90%. The operating agreement provides that liquidating distributions will be made in accordance with capital accounts. Shops on the Park, LLC acquires real estate worth $2,000,000 by borrowing $1,500,000, paying $500,000 in cash, and reserving $500,000 in cash for construction expenses. Developer has a profits interest. 2. Tiered Distribution Provisions. Because LLC's have great flexibility in capital structure, it is possible to create distribution formulas customized to meet the goals of all kinds of real estate investors and developers. This would be impossible in an S corporation, with its one class of stock rules. It would be cumbersome in a C corporation, because it would require the issuance of multiple classes of stock with highly customized characteristics, and this would be memorialized in the articles of incorporation - a document on file with the state and available to the public. Many sophisticated real estate investors use tiered distribution provisions to tie the developer's distributions to the investor's receipt of a stated internal rate of return on its investment. For example, the distribution provisions might state that all operating cash flow is distributed to the investor until the investor has received a 10% IRR; then 90% to the investor/10% to the developer until the investor has 10

11 received a 15% IRR, then 80% to the investor/20% to the developer until the investor has received a 18% IRR, and so on. Also, distributions of proceeds from the sale or refinancing of the LLC's property are generally distributed 100% to the investor until the investor has received a full return of capital (often with an additional preferred return or IRR formula), then divided between the investor and developer in an agreed percentage. 3. Rentals to Related Operating Business Successful non-real estate businesses often decide to stop renting office, warehouse, or production space and purchase real estate to occupy. The owners of the business should almost always create a separate LLC to purchase the real property. First, the owners will generally have significant equity in the real estate from the beginning (especially now that lenders are requiring 15% to 25% cash downpayments before they will consider acquisition and upfit loans). The owners hope that equity will grow over time as the property appreciates. This valuable asset should not be in the same entity as the operating business - if it is, the equity will be subject to claims of the business's creditors should the business fail or be subject to a major lawsuit. Second, placing real estate in a separate LLC facilitates lending. The real estate lender may require the borrower to enter into financial covenants and other performance obligations that might be burdensome for the operating company. Moreover, if the real estate will ever be financed by a mortgage that will be sold to Fannie Mae, Freddie Mac, or a private conduit lender, the lender may require that the real estate be owned by a special purpose entity. Third, placing the real estate in a separate LLC is tax efficient. The operating business will pay rent to the LLC. This produces tax deductions for the operating business. The rental income to the real estate LLC will not be subject to FICA or selfemployment tax. Additional tax savings may be realized by having the LLC acquire furniture, fixtures and equipment for lease to the operating business. The rental LLC may also generate tax losses from depreciation and amortization. Tax losses of the LLC will be considered passive losses, and will not be available to offset against the income of owners who are active in the business. However, if the business entity has passive owners who also own an interest in the real estate LLC, the LLC's tax losses may be available to offset the income of those owners. Finally, as discussed above, LLCs have flexible capital structures and appreciated assets can be contributed and distributed from LLCs without significant tax impacts. This can open up valuable planning opportunities for the business 11

12 owners that might not be available if the real estate were inside the operating company. B. [oint Ventures Using LLCs. As the cost of research and development for new technologies and exploration for new resources increases, businesses (even competitors) may decide to pool their resources. These business ventures can take many forms. Some widely-recognized examples include agreements between American and Asian automobile companies to jointly develop new automotive designs and share manufacturing facilities, ventures between petroleum companies to develop new oil or gas fields, and arrangements among consortiums of aerospace companies to develop new military airplanes. Out of the public eye, smaller companies may form joint ventures to develop new technology or exploit new opportunities. The alternative energy industry often uses joint ventures for this purpose. Real estate development ventures between an investor and a developer are also examples of joint ventures. The key concept of a joint venture is to pool resources, technology, and know-how for a particular limited purpose, but to avoid (i) exposing the other operations of the joint venturers to liabilities of the venture itself or of the other party, and (ii) revealing proprietary technology or intellectual property of the joint venturers to the other parties, who may be their competitors. Joint venturers also often want to be assured that they can get their valuable property back if the venture doesn't go well, or after it has run its course. LLCs are the ideal form for joint ventures. LLCs allow joint venturers to contribute assets (which may include technology, appreciated real estate, or equipment) to a limited liability entity without incurring a taxable event, pursuant to IRC Section 721. When the venture has run its course, each party can usually receive distributions of its own property without triggering taxation, via IRC Section 731. Venturers often contribute very different types of property and have very different responsibilities. Thus, it is important to be able to design capital structures that appropriately compensate the venturers for their contributions and incent desirable performance of services. Again, LLCs are ideal because their flexible capital structure allows owners to create highly customized classes of membership interests. Example 5: Company A has developed a valuable patent for a new solar power technology and has key employees with the engineering knowledge to make it successful, but does not have a manufacturing facility. Company B is already in the solar business and has a manufacturing facility. Company B is willing 12

13 to manufacture and market the new technology, but does not want to pay a high licensing fee to Company A and take all the risk that the technology will not be successful. Company A wants to commercialize the technology and recover its $1,000,000 in R&D costs, but is concerned about losing its key employees to competitors. Company A and Company B form AB JV, LLC. Company A contributes the rights to the patent to AB JV, LLC and receives capital account credit equal to its $1,000,000 of R&D costs. Company A also subcontracts its engineers to AB JV, LLC for a fixed fee. Company B leases part of its manufacturing facility to AB JV, LLC, provides $1,000,000 to fund initial materials costs, and subcontracts its marketing staff to AB JV, LLC on a commission basis. The LLC agreement provides that Company B will receive a 7% preferred return on its $1,000,000 cash investment, payable monthly once AB JV, LLC hits certain revenue targets. Company A will not receive preferred return on its $1,000,000 capital account credit for R&D expenses. The venturers will divide cash distributions (after expenses, including the preferred return payments), but if AB JV, LLC hits certain revenue and profitability targets, Company A will receive a progressively greater share ofthe distributions. The LLC agreement provides that upon liquidation of the LLC, Company B will be entitled to a priority distribution of any available cash up to its accrued preferred return, and then the parties will split the remaining cash in accordance with their capital account balances. The patent rights will be returned to Company A. The LLC agreement contains restrictions on the ability of either company to hire away the employees of the other. C. Professional Organizations. 1. Why not C Corporation? There is a strong argument that most professional corporations should operate as C corporations. Professional organizations (law, architecture, accounting, healthcare, and so forth) generally do not have highly appreciated assets. With proper planning, most of the enterprise value of a professional organization can be appropriately treated as goodwill of the owners, thus preventing double C corporation taxation on goodwill in the event of a sale. Profits of professional C corporations are generated by the efforts of the owners and thus 13

14 are appropriately paid to the owners in the form of salary and bonuses. Therefore, there is rarely any significant net profit at the end of the year to be subject to the personal service corporation ("PSC") tax or C corporation double tax. Furthermore, unlike S corporations and LLCs, C corporations can pay fringe benefits to owners tax free. That said, a professional service C corporation must be carefully operated to prevent the application of the PSC rules. Most importantly, the owners must track their income and deductions throughout the year and be able to accurately establish the amount of corporate profit remaining at the end of the year so it can be paid to the owners as bonuses for their professional services. Professional service C corporation owners must also resist the temptation to be aggressive with their deductions. This is because accurate accounts of deductions are required to correctly calculate profit, as described above. If a later audit disallows deductions (such as for meals and entertainment or other items frequently challenged on audit), the calculation of profit will be off for that year. Therefore, the assessment will require the corporation to pay the 35% PSC tax on those undistributed profits, plus interest and perhaps penalties. Therefore, professional organizations operating as C corporations should have qualified in-house accounting departments or subcontract their bookkeeping out to a qualified CPA firm. If a PSC has trouble accurately tracking its profit, or if some or all of the owners have a tendency to cause the corporation to take aggressive or poorly documented deductions, the business may be better off choosing to operate as an S corporation or LLC. 2. Why Should a PSC Choose LLC OverS Corporation? If a C corporation is not the best choice, LLCs have three advantages over S corporations for professional service organizations: (a) the ability of LLC owners to include LLC debt in their basis for deducting tax losses and taking LLC distributions; (b) the LLC's ability to have multiple classes of membership interests; and (c) the Section 736 rules for retiring or deceased LLC members. a. Debt Problems. Professional corporations operating as S corporations can fall into a "phantom income" trap when they use debt to fund distributions to owners or expansion. Debt of an S corporation is not included in the shareholders' tax basis. Therefore, debt funded distributions often exceed the owners' basis in their S corporation stock Often, at the same time as owners are receiving debt-funded distributions in excess of basis, the S corporation is showing profitable operations for tax purposes, but the corporation's cash is being used for debt service. Thus, actual cash delivered to the owners is less than their taxable income, and in excess of their basis in the S corporation. This problem can occur in litigation-driven legal 14

15 practices that rely on operating lines of credit to fund expenses and owner's compensation in between sporadic infusions of cash from settlements. If debt is used to finance purchases of new equipment, bonus depreciation or expensing will reduce the owners' basis. In subsequent years, the expanded business from the new equipment will produce more taxable income, but some of the cash is being used for debt service, and profits from operations have not yet caught up to the earlier big deductions. Thus, cash available for distribution doesn't match up to the taxable income produced by the operation. This problem frequently occurs in medical practices where new diagnostic equipment is a significant income driver. If these same businesses operated as LLCs, the expansion debt would be included in the owners' basis. Properly managed, this can minimize or eliminate the matching and timing problems that result from debt ins corporations. b. Capital Flexibility. Compensation structures in professional firms are infinitely variable. C corporation and S corporation professional firms generally must use formulas to calculate compensation that matches up with corporate profit. This is necessary in C corporations to avoid the double tax and PSC tax, and in S corporations because ofthe PSC tax and one class ofstock rule. Professional firms operated as LLCs have the additional option of creating multiple classes of membership interests or making disproportionate distributions among members. This may be useful for steering extra compensation to senior members or strong performers, allowing wealthier members to fund capital improvements to the business via purchases of new membership interests with preferred returns, or making "buy ins" by new members less painful. o: Venture Capital Arrangements. Startup businesses, or established businesses seeking to fund big but risky expansions, often turn to the private equity and venture capital markets for capital. Since S corporations cannot have LLCs or other corporations as shareholders, businesses seeking capital will need to use the C corporation or LLC form. While some private equity firms advocate for and may even require C corporations, LLCs are used in many deals. Practitioners who prefer LLCs in private equity deals point to several advantages over C corporations: (i) one level of taxation on appreciated assets (including corporate goodwill and valuable technology) when the business is sold; (ii) ability to use basis from LLC debts to deduct early stage operating losses; 15

16 (iii) greater capital structure flexibility and privacy; and (iv) the ability to wrap the entire deal between the parties into an operating agreement, rather than the more-traditional set of over a dozen documents necessary to implement the typical C corporation deal. Further, in the event that the LLC desires to hold an initial public offering, it can generally convert to Ccorporation status without significant tax consequences. Some venture capital providers perceive that the while the LLC form may be better for the founders of the targeted investment company, the ultimate owners of the venture capital company do not want to be exposed to pass-through taxation from the target. This is especially true with the target is expected to be profitable but reinvest its profits in continued research and development or expansion, as this can generate taxable income to LLC members without a guarantee of distributions to defray the taxes. In these cases, some venture capitalists may form C corporation "blockers" to own their investment in the target LLC. Such a structure can grant the benefits of an LLC to the target founders while preserving some of the perceived benefits of a C corporation for the venture capital firm. E. Foreign Investors. If nonresident aliens will be equity owners in the business enterprise, the business arrangement cannot be structured as an S corporation. Instead, the business must be an LLC or C corporation. In most closely held businesses, other factors (such as avoiding two levels of tax) will tilt the analysis toward formation as an LLC. Professional services businesses, which can be better off as C corporations, almost never have nonresident alien equity owners. F. Estate Planning and Asset Protection Considerations. If the business owners contemplate that ownership interests in the business will be transferred to trusts or to family LLCs or limited partnerships for estate planning purposes, the business should be an LLC unless there is some reason to operate as a C corporation. S corporation shareholders cannot be LLCs or limited partnerships, and there are restrictions on the types of trusts allowed to own S corporation shares. Furthermore, LLCs are very useful as asset protection and estate planning vehicles in their own right. In many states, no one can become a full member of an LLC without the unanimous consent of the other members. This means that while a judgment creditor of an LLC owner might be able to foreclose on the LLC interest, the creditor would only be entitled to receive distributions from the LLC, and would not be able to vote or otherwise exercise the rights of a member (assuming a multi 16

17 member LLC in which the other members refuse to vote to admit the creditor as a member). In contrast, voting and management rights are not easily separable from corporate stock. A judgment creditor of a corporate stockholder could foreclose on the stock, and the other stockholders would not be able to block the creditor from exercising all the rights of a stockholder. If properly structured, therefore, LLCs can shield valuable assets from owners' creditors. This can at least make the LLC interest a very unattractive target and increase the owner's leverage in settlement negotiations. LLCs can be used to reduce the gift and estate tax burden on transfers of highly appreciated assets within families. These LLCs, often known as "Family LLCs" or "FLLCs", purchase or receive contributions of valuable assets from wealthy family members. Membership interests in the FLLCs are then given or sold to other family members (generally children of the original contributor). Appraisals supporting discounts to the value of these membership interests (usually for lack of marketability and lack of control) reduce the gift tax due on the transfer or the capital gains tax due on the sale. FLLC structures have been the subject of years of litigation in the Tax Court. As a result, there is a wealth of judicial precedent and guidance on best practices in forming and using FLLCs. FLLCs must be properly formed and structured with the guidance of qualified legal and tax advisors, and transfer valuations must be supported by reasonable, good faith appraisals conducted by qualified appraisers. FLLCs must be operated as separate entities, and financial transactions with family members and affiliates must be conducted at arm's length under reasonable business terms. Under these circumstances, FLLCs are legitimate and effective vehicles for the tax-efficient transfer of wealth between generations. However, improperly structured FLLCs or flawed appraisals will result in the imposition of significant assessments, interest, and penalties. IV. When are LLCs Not Appropriate? Limited liability companies are not the best choice for every business or every business owner. In particular, LLCs are often not the best choice for small business owners operating active businesses in rented facilities - for example, restaurants, retail establishments, non-professional service firms, or small professional service firms. For these types of businesses, LLCs have several disadvantages when compared to corporations. First, as outlined above, fringe benefits purchased by the LLC on behalf of the owners are included in the owners' income, creating a "double tax" on the funds used to pay for these benefits. LLC members must be careful to include these fringe benefits as 17

18 part of a documented compensation package so that the LLC can deduct the expense and avoid the double tax. In C corporations, fringe benefits are deductible by the C corporation and are not included in the owners' gross income. Second, unless an LLC member qualifies as a "limited partner" for purposes of the regulations under Section 1402, 100% of the income of the LLC passed through to the member's K-1 will be subject to self-employment tax. Generally, in small non-real estate businesses, all of the owners are active in the business and will not qualify as deemed "limited partners" for purposes of the special Section 1402 exclusion. If the owners' income from the LLC will be below the Social Security wage base (2011 =$106,800), they will be subject to a 15.3% tax on all of their pass-through income. Even if their income is above the Social Security wage base it will still be subject to a 2.9% Medicare tax. For this reason, many small business owners who should realistically expect to have incomes below the Social Security wage base can save significantly in self-employment and Medicare taxes by forming an S corporation. Third, under state law, corporations are generally more simple to understand and operate than LLCs. The corporate form has been around for well over 100 years, and the corporate statutes and jurisprudence in most states provide a comprehensive set of fairly intuitive default rules. These rules often protect minority shareholders. Therefore, even if the owners never bother to implement stockholder agreements, there is a body of law to give structure to the business and protect the owners from each other. LLC statutes, in contrast, are extremely open-ended, and there is little judicial precedent regarding their operations. Some LLC statutes provide counter-intuitive rules (i.e., per capita voting instead of voting in proportion to ownership). Further, LLC statutes have very few default rules, and most provide that operating agreements can be verbal leaving LLC owners vulnerable to disputes that are difficult to reconcile. Fourth, partnership taxation is also generally considered to be more complex than S corporation and C corporation taxation. Business owners without a strong financial background may have difficulty dealing with the complexities of the partnership tax rules. For all of these reasons, advisors who work with entrepreneurs in the small business world often advocate for S corporations for these businesses. Although LLCs are growing in popularity for even the largest businesses (Chrysler is currently a limited liability company, for example), many advisors feel that C corporations are still the best choice for large organizations. The corporate form of governance, with its separation of powers between a board of directors and executive officers, is time-tested and well-suited to large organizations. Corporate accounting methods are more familiar to lenders and equity analysts who may work with these larger organizations. As businesses grow to the point that a public offering of equity interests is considered, C corporation status becomes almost mandatory. 18

19 As outlined above, there are compelling reasons for professional organizations to operate as C corporations. V. The Ongoing Role ofprofessional Advisors in the Entity Selection Process. Because of the significant ramifications the choice of entity decision will have upon the future success, profitability and viability of the business enterprise, the client's professional advisor team (attorneys, CPAs, accountants, return preparers, and others) must play an active and ongoing role in advising the client on the choice of entity selection process. LLCs are not appropriate for every business or every business owner. From the advisor's perspective, advising a new business owner on selecting a business entity form requires the advisor to "look into the crystal ball." In advising his or her clients, the advisor must recognize and anticipate the impact that future changes may have on the choice of entity decision. A. Tax Law Changes. Because the choice of entity decision often is made based upon tax considerations, the advisor must always be mindful of the impact of future tax law changes on the choice of entity decision. This is especially true when Congress acts to change personal and corporate income tax rates. For example, some tax reform advocates propose elimination or reduction of the "carried interest" rules that are beneficial to LLC service partners. If enacted, this proposal would remove a significant benefit enjoyed by LLCs in some situations. In addition, Congress has sporadically considered various acts outlawing or limiting valuation discounts in the FLLC context, and the IRS continues to challenge FLLC valuations and formation issues in court. Practitioners who use FLLCs for estate planning and asset protection must keep a close eye on Congressional and Tax Court activity. B. Changes in the Nature ofthe Client's Business. The choice of entity decision may also be affected by changes in the client's business. In the initial choice of entity decision-making process, clients may be focused on income tax issues. But as their businesses grow and mature, employment tax and estate tax considerations may arise. C. Changes in Business Operations. In the early stages of business formation, clients may be focused on how the choice of entity will affect their businesses on a day-to-day ongoing basis. However, as new business issues arise (such as the issuance of stock to new investors, the 19

20 possible sale of the business, or the buy-out of a business partner), the business advisor must periodically re-evaluate the choice of entity decision. D. The Client Who Fails to Keep the Advisor Informed. In many cases, changes in the business may arise by the unilateral act of the business owner without the advice and consultation of the advisory team. For example, clients may fail to consult their advisors prior to making a critical business decision, such as: 1. Acquiring real estate; 2. Purchasing the assets of another business; and 3. Acquiring corporate-owned life insurance. E. Summary. In light of all these issues, professional advisors must always be mindful that the choice of entity decision is not merely a question that arises in the business formation phase. In any of the situations described above, where there has been a substantial change in the tax laws or the specific activities of the business enterprise, the advisor must re-evaluate whether yesterday's choice of entity decision is still appropriate for today or tomorrow. Indeed, the choice of entity question must be constantly re-evaluated and readdressed on an ongoing basis. In some cases, the business owner must even consider converting the business to a new entity form or perhaps restructuring the business arrangement. CONCLUSION. Limited liability companies are an excellent choice of entity for many businesses. For a business to take advantage of all the benefits of LLCs, however, the business owner must have well-informed tax and legal advisors. Open-ended state LLC statutes and complex and evolving tax laws can make LLCs a trap for business owners who do not have qualified advisors (or who fail to work closely with their highly qualified advisors). Successful operation of an LLC requires (i) a well-drafted operating agreement; (ii) a proactive plan for compensation of owners to minimize compensation-related tax impacts; (iii) commitment by the business owner to consult legal and tax advisors before making significant business decisions involving the LLC; and (iv) regular review to make sure that the operating agreement has not become outdated by changes in the business pr its assets or by changes in applicable law. 20