Planning Techniques with Limited Liability Companies
Limited liability companies, or “LLCs” for short, have become the predominant form of liability limiting entity for a variety of situations. The LLC is a relatively new business structure authorized by state statute. The LLC is chiefly inspired by the GmbH, a type of business organization in Germany, and by limitadas, a type of business organization available in many Latin American countries. The primary advantage an LLC provides over another common pass-through entity known as the Subchapter S corporation is its flexibility, given that LLCs have no restrictions on who can be a member, as well as the fact that members of an LLC can have different rights depending upon their class of ownership.
In the United States, the first limited liability company act appeared in Wyoming in 1977 as special interest legislation for an oil company. In 1980, the Internal Revenue Service issued a private letter ruling to an LLC formed under Wyoming LLC Act indicating that the IRS would treat the LLC as a partnership for federal tax purposes. However, later that year, the IRS proposed regulations that would deny partnership classification to any business entity in which no member bore personal responsibility for the entity’s liabilities. In 1982, Florida adopted an LLC act modeled on Wyoming’s LLC Act. Due to uncertainty over the tax treatment of LLCs, no other states introduced LLC legislation until after 1988. In 1988, the IRS issued a revenue ruling stating that it would treat a Wyoming-style LLC as a partnership for tax purposes. By 1996, nearly every state had enacted an LLC statute.
When I entered law school in the Fall of 1998, a recent IRS regulatory change made LLCs the hot topic in business law. The change was the IRS’ introduction in 1997 of the “Check-the-Box” Regulations, a series of regulations that for the first time allowed single-member LLCs. These single-member LLCs were “disregarded” for Federal income tax purposes, meaning that not only was there no separate entity tax to be paid, but there was also no need to file a separate return for the LLC (as is the case with the Subchapter S corporation where one files an 1120S for the entity and issues K-1s to each shareholder who pay tax on their pro rata share of the corporation’s profits). Following the introduction of the “Check-the-Box” rules, every state amended its LLC statute to allow for single member LLCs.
And the rest, as they say, was history. The single member LLC has become perhaps the most useful planning tool for a number of situations. Owners of rental real estate can compartmentalize liability for each property owned within a separate single member LLC, and in turn each single member LLC is owned by a holding company LLC with all income from the operations flowing up to the individual owners. Restaurant businesses can do the same thing, with each location contained within a separate LLC. Other businesses can use separate single member LLCs to create business divisions (with the single member LLCs being treated as wholly-owned subsidiaries).
As I was finishing up my last semester of law school in 2000, I had the opportunity to learn about the history of LLCs and their uses from Professor Daniel Kleinberger. Professor Kleinberger helped write Minnesota’s LLC statute and is the co-author of Limited Liability Companies: Tax and Business Law, one of the foremost treatises on LLC law in the United States. I took my run at positing the use of LLCs as an alternative means of effecting a business separation where a tax-free spin-off under Section 355 of the Internal Revenue Code could not be accomplished. I’ve posted the paper over on the Articles page for those interested.
Over the years, I’ve spoken and written about LLCs on numerous occasions. I even devoted my very first Legal Minute on the Real Estate Radio Hour to the use of LLCs to own investment real estate. My partner, Earl Cohen, and I will again present, this time on “Advanced LLC Issues”, in Bloomington, Minnesota on May 17 at a program sponsored by the National Business Institute. I’ll be talking about fidcuiary obligations in LLCs and ethics issues for their advisors. If you’re an attorney, a CPA or a financial advisor, I would encourage you to attend as continuing education credits are available. You can find more information on the program here.
In the early days of LLCs, the knock on them by many practitioners was that they were “too new”, meaning that there was not much legal precedent on the books as to how various issues would or could be handled, and thus too much uncertainty existed as to what result would arise from the use of an LLC as opposed to a more established form of entity such as a corporation. Now, with LLCs in existence for over thirty years, and with an entire generation of business lawyers such as myself trained on the nuances of these entities, LLCs will continue to predominate the business entity landscape.