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INTRODUCTION

The Limited Liability Company ("LLC") is a new form of business organization that came into existence on September 30, 1994 by the California Limited Liability Act. LLC's are hybrids between partnerships and corporations. Like corporations, the LLC's members enjoy "liability shields." However, LLC's are unincorporated so like partnerships, they are not double taxed. Thus, the LLC simultaneously enjoys both the tax benefits of a partnership and the liability protection of a corporation

PARTNERSHIPS, CORPORATIONS, AND THE LLC

The LLC is said to be a hybrid of a partnership and a corporation. Thus, in order to understand the significance of the LLC, you must first know a little bit about the advantages and disadvantages of partnerships and corporations.

Partnerships

A partnership iseasy to form. All it requires is two people to decide that they want to work together. No comjplicated applications are required and nothing has to be filed with the Secretary of State. The partnership is a relatively simple orgaqnization and the partners can do what they want in handling the money, running the organization, making decisions, etc. There really is no separateness between the partnership and the partners. Therefore, partnerships are only taxed once but when there is liability by the partnership, the individual partners' own assets are at risk.

Corporations

A corporation, on the other hand, is a much more complex organization. It is a completely separate entity from its shareholders. For example, the individual shareholders can't take money from the corporation whenever they want. It is not their money, it's the corporation's. THerefore, since the corporation and the shareholders are separate, they must both pay taxes. This is why it is said that corporations must pay double taxes. However, since the corporation is completely separate, when there is liability, only the corporation can be sued and the assets of the individual shareholders are safe.

The Hybrid -- LLC

Now there is the possibility of creating an organization that is somewhere in the middle between a partnership and a corporation. This is the LLC.

A partnership has no separateness from its partners. This is what allows it to be taxed only once. On the other hand, a corporation must be separate from its shareholders. This is what allows it to enjoy the "liability shield." The LLC is in the middle -- it must be both separate and non-separate at the same time. This is a delicate line to balance.

THE BALANCE

Classification of the LLC for Income Tax Purposes

The LLC will always enjoy the limited liability protections of corporations. But as for the "partnership" aspect of the LLC, this is not automatic, but is a trait that must be proven to the IRS before the partnership tax benefits can be received. In other words, the IRS must be convinced that the LLC is organized and run like a partnership, not a corporation. The determination of whether the IRS will classify your organization as a partnership or a corporation for tax purposes will be determined by examining the following four "corporate" characteristics: 1) limited liability; 2) continuity of life (the organization continues after the death, withdrawal, resignation, expulsion, bankruptcy or dissolution of a member); 3) centralized management (the organization is managed by all the members and every member is an agent of the organization for the purpose of its business and affairs); and 4) free transferability of interests (interests freely transferrable -- the transfer does not have to be approved by members).

All LLC's will have the corporate characteristics of 1) limited liability, above. Thus, the important considerations are the last three characteristics -- continuity of life, centralized management, and free transferability of interests. The LLC can have only one of these remaining three "corporate" chacteristics and still enjoy the tax benefits of a partnership. But, if the LLC has more than one of these last three "corporate" characteristics, the IRS will deem it to be a corporation for tax purposes and your company will have to pay double taxes.

What happens if the LLC fails to obtain a partnership classification from the IRS?

If the LLC fails to qualify for partnership tax status then, like a corporation, it will be taxed twice -- once when the LLC earns the taxable income and then a second time when the LLC makes distributions to its members. But in addition to the double taxation, the LLC will likely have to pay substantial penalties for late filing of corporate returns, underreporting of taxes, and underpayment of taxes. Why? Because the LLC will have operated under the assumption that it was going to be taxed as a partnership. Thus, it would not have filed a corporate income tax return and would not have paid any corporate income tax. Moreover, if the LLC incurred losses during that period, the members would have likely taken improper deductions of those losses on their individual returns.

Accordingly, care must be taken in structuring the LLC at the outset to assure that the IRS will classify it as a partnership for income tax purposes.

FORMATION AND OPERATION OF THE LLC

The members

The LLC brings with it a new term. The equity owners are called "members." Members are analogous to shareholders in a corporation or to partners in a partnership.

Articles of Organization

A document known as the "articles of organization" must be filed with the Secretary of State. These articles typically must contain 1) the name of the LLC, 2) the type of business to be conducted, 3) the names of the initial members, 4) the capital contributed by initial members, 5) the duration of the LLC, 6) the conditions under which new members may be admitted, and 7) the right of members to continue the LLC upon the occurrence of certain events. Thus, in its formation, the LLC is like a corporation because it must file some rather complex documents with the Secretary of State.

Operation

The members of the LLC may, but are not required to, adopt a governing agreement which is commonly called the "operating agreement" or the "regulations." The members may reserve all management powers to themselves, or they may appoint managers who may or may not be members. However, it should be noted that if any member attempts to assign his/her interest in the LLC, the transferee will acquire no say in the management of the enterprise unless it is approved by the other members. Thus, inits operations, the LLC is like a partnership because it allows flexibility in the management of its day to day affairs.

CONCLUSION

The LLC is not for every organization. It is for small businesses containing investments by corporations. It is for alien investors who want to have only one level of taxation. It is for businesses with potential uninsurable risks. It is for businesses that expect to have a stable group of investors together for along time. It is for companies with tax write-offs in the early years for research and development. It is for groups where policies are determined by all investors and not just centralized management. It is for individuals wanting to decrease the value of their estates by holding a non-controlling interest. And finally, it is for people who want the tax benefits of a partnership and the liability protection of a corporation.