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Limited Liability Companies (LLC’s)

California has become the forty-sixth state to enact legislation enabling creation of limited liability companies (“LLC’s”). A new star has been added to California’s firmament of business entities and business lawyers are excited about it.

Advantages

Briefly, an LLC is an entity designed to combine the best features of corporations and partnerships. It has the following advantages:

Limited Liability. All members of an LLC enjoy protection from its creditors, even though they may actively participate in the LLC’s business.

No Entity-Level Taxation. An LLC is ordinarily taxed as a partnership, imposing a single level of taxation on its members. Transfers to and from the LLC may be tax-free.

Operational Flexibility. An LLC is governed by an operating agreement which is virtually unlimited in the terms it may contain. It may be managed by its members, which seems to be a likely scenario, or managed by non-members. The operating agreement may dispense with formal procedures, such as the annual meetings required of corporations.

Financial Flexibility. The operating agreement may allocate income and distributions in virtually any fashion. Thus, the rigidity of corporate allocations are avoided. It is the only entity allowing partnership-like special allocationsand complete limited liability.

Even More Flexibility. Unlike S corporations, there are no particularized requirements as to who may be a member of an LLC in order for it to qualify for its tax benefits. Members may receive their interest in an LLC in exchange for money to be paid in the future or services to be rendered in the future, in addition to the contributions corporations and limited partnerships must receive for an interest: money, property, antecedent debt, or services previously performed.

Formation

An LLC is formed when its Articles of Organization have been executed and filed with the California Secretary of State’s office. The Articles of Organization are a Secretary of State one page form. An LLC may have one or more members at the time of formation and its members are required, either before or after filing the Articles of Organization, to enter into an operating agreement, which may be written or oral and may be as simple as an agreement among the members to form the LLC. The name of the LLC must include the words “Limited Liability Company”, or the abbreviation “LLC”. The word “Limited” may be abbreviated to “Ltd.” and the word “Company” may be abbreviated to “Co.”

Generally, filing fees are more moderate than those pertaining to corporate formation, but there is an annual fee based on gross income each year (which may be as much as four thousand five hundred dollars ($4,500.00) if gross income exceeds five million dollars ($5,000,000.00)). It is difficult to compare an LLC’s fees to those imposed on corporations, and other entities which pay taxes based on net income, without an income projection. However, annual fees are deductible for income tax purposes.

Potential Uses

LLC’s make particular sense where limited partnerships have previously been used, such as the single asset real estate entity and other stationary investments. In such cases, they avoid the need of a general partner to be liable for all the enterprise’s debts while preserving the flow-through of tax benefits and enabling special allocations which such limited partnerships have typically preferred. However, certain practitioners avoid LLC’s for build and sell real estate projects due to the fee based on gross income, which would include the project’s selling price. In such cases a limited partnership may be preferable, with perhaps an LLC as the general partner.

They are also useful in lieu of S corporations, avoiding the eligibility restrictions of S corporations, the one class of stock rule, the rigidity of corporate formality and income allocation, and limitations on shareholders. LLC’s make particular sense in joint ventures between existing corporations or other entities, since management activity will not impose unlimited liability and no extra level of taxation is created.

Unfortunately, the present California Act precludes the use of LLC’s for the practice of professions, including medicine, accounting, and law. Limited Liability Partnerships are available to law and to accounting practices. The LLC may also have disadvantages in the estate planning area. Member interests may not qualify for minority valuation discounts as limited partnership interest do. Finally, there are troubling IRS regulations indicating that a member with management rights may have to pay self employment taxes on profit allocations, even if the member is a passive investor. Bills are presently pending to remedy these problems however.

Because of the apparent advantages of LLC’s over most other entities, they must be the first entity to consider when forming a new business venture. It may also make sense to convert existing entities into an LLC, especially existing pass-through entities. However, there can be adverse tax consequences when a C corporation holding appreciated property is converted to an LLC, or when an S corporation is converted to an LLC in certain circumstances.