Working With LLCs and FLPs: A Practitioner's Guide to Limited Liability Companies and Family Limited Partnerships

By Thomas F. Commito

This book is the most comprehensive, easy-to-read discussion of LLCs and FLPs you'll find anywhere. This edition will help you effectively address the insurance needs of LLCs and FLPs--from estate planning and mergers to valuation and benefits planning. Includes an entire new chapter on obtaining discounts for estate tax purposes, as well as new information on valuation, partnerships, and case analysis.Here are a few of the subjects covered in Working with LLCs and FLPs:Check-the-box rules for entity Allocation of Profits How to form and operate LLCs and FLPs Conversions of other business forms to LLCs Benefit planning for LLCs and FLPs General provisions, powers, and formation of LLCs Buy sell agreements Securities, bankruptcy and other federal law issues About the AuthorThomas F. Commito is Vice-President -- Business and Industry Development of the Lincoln Financial Group. He holds a J.D. from Boston College and an advanced degree in law and taxation from Boston University Law School. He is a well-known industry speaker and has spoken at meetings of the AALU, NAIFA, and MDRT and the SFSP. He is the author of more than 50 articles on insurance and taxation published in Life Insurance Selling, Financial Planning, National Underwriter, and dozens of others. Order Working with LLCs and FLPs, 2nd Edition today and gain in-depth knowledge and understanding of the complex issues surrounding LLCs and FLPs. You will have a tremendous advantage when selling to these hot business segments.

• Language: English
• Publisher: The National Underwriter Company
• Release date: Jan 15, 2013
• ISBN: 9781938130212

Book preview

ISBN 978-1-938130-21-2

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. — From a Declaration of Principles jointly adapted by a Committee of The American Bar Association and a Committee of Publishers and Associations.

Copyright © 2000

The National Underwriter Company

Second Edition

All rights reserved.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior written permission of the publisher.

Printed in the United States of America

Dedication

To my father, Ado Commito, who has been an educator his entire life.

Preface and Acknowledgements

This second edition has been expanded to include the law of Family Limited Partnerships and Family Limited Liability Companies. Thus, the material on estate planning has been significantly expanded since the first edition. Likewise, the position of LLCs has dramatically changed. At the writing of the first edition they were new and somewhat strange. As of this edition they have become a business entity of choice in many situations. Likewise, the creativity of estate planners has expanded their application greatly.

This first edition of this book grew out of a series of lectures presented to the Estate Planning Track of the American Society of CLU & ChFC. I would like to thank all of the insurance and financial planning professionals who provided feedback on that presentation, as well as their observations and comments on the first edition.

I would also like to thank Ed Berube when he headed up CIGNA’s Life insurance marketing efforts and Wes Thompson who heads up Lincoln Financial Distributors as President & CEO for all the support they provided for both the first and second editions.

The staff of the National Underwriter Company were extremely helpful and considerate during the writing and editing of this book.

Finally, the love of my wife, Jean, as well as my daughters, Kristin, Sarah, and Maura, provided the support without which this book would not have been written.

About the Author

Thomas F. Commito is Vice President, Business & Industry Development, Lincoln Life Distributors of the Lincoln Financial Group. He is a graduate of Cornell University. He received his law degree (J.D.) from Boston College Law School and an advanced degree in law and taxation (LL.M.) from Boston University Law School. He also holds the CLU and ChFC designations.

He is licensed to practice law in Massachusetts and Vermont. In 1996, he was actively involved in the development and passage of the Vermont Limited Liability Company Act.

A well known industry speaker, he has been a featured speaker at numerous annual meetings of AALU, NALU (currently NAIFA) and the American Society National Conferences (currently Society of Financial Services Professionals), as well as MDRT. He has also been the Chairman and Moderator for numerous video teleconferences of the American Society of CLU & ChFC (currently Society of Financial Services Professionals).

Tom currently serves on the Closely Held Business Committee and also the Personal Service Organization Committee for the Section of Taxation of the American Bar Association; the Insurance Industry Committee for the Section of Antitrust of the American Bar Association; the Estate and Business Planning Committee of the AALU and the Charitable Planning Subcommittee of the AALU.

He is the author of over 50 articles on insurance and taxation. His material has appeared in the Journal of the American Society of CLU & ChFC, Life Association News, Life Insurance Selling, The National Underwriter, Broker’s World, Financial Planning, Estate & Financial Planners Quarterly, as well as Senior Golf, Dental Practice & Finance and Family Business. Tom currently serves as an Assistant Editor for the Journal of the American Society of CLU & ChFC.

Table of Contents

Dedication

Preface and Acknowledgements

About the Author

Chapter 1: INTRODUCTION

A Brief History

Applicable Law

Fundamental Characteristics

Family Limited Partnership (FLP)

Terms

Chapter 2: FEDERAL INCOME TAXATION: CLASSIFICATION ISSUES

Introduction

Historical Background

Check-the-Box Regulations

The Impact of the New Regulations

An Exciting Concept: Single Member LLCs Under the New Regulations

Chapter 3: FEDERAL TAX ISSUES: OPERATING THE LLC OR FLP

Overview

Formation

Pass Through of Income and Expenses

Allocations

Current Distributions

Liquidation Distributions

Some Special Tax Concerns

Passive Activity Loss Rules

At Risk Rules

Transfers of Property in Satisfaction of Debt

Self Employment Income

Partnership Audit Issues

Chapter 4: COMPARISON OF LLCs AND OTHER BUSINESS FORMS

Introduction

LLCs Versus Corporations

Formation

Capital Structure

Organizational Structure

Ownership Structure

Limited Liability

Entity Characterization

Taxation

Distributions

Withdrawals

Termination

LLCs Versus S Corporations

S Corporation as a Corporation

Formation

Capital Structure

Taxation

Basis and Deductibility of Losses

Employment Taxes

Miscellaneous

LLCs Versus General Partnerships

Formation

Finance

Withdrawals

Dissolution

Miscellaneous

LLCs Versus Limited Partnerships (Including FLPs)

Overview

Management

Chapter 5: THE STATUTORY FRAMEWORK

Overview

General Provisions

Nature of Business

Powers

Name

Formation

Who May Form an LLC?

Articles of Organization

The Operating Agreement

Management

Authority to Bind

Duties of Members and Managers

Indemnification

Financial Matters

Contributions

Allocation of Profits and Losses

Distributions

Dissolution

Winding-Up or Continuing the Business

Specific State Statutes

Chapter 6: BUY SELL AGREEMENTS

Overview

IRC Section 736 – The Gatekeeper

IRC Section 736(b)

IRC Section 736(a) Payments

Ascertaining Whether a Payment is an IRC Section 736(a) or IRC Section 736(b) Payment

The IRC Section 754 Election

Cross Purchase Arrangements

Life Insurance

Drafting the Buy Sell Agreement

Chapter 7: EMPLOYEE BENEFIT PLANNING

Qualified Plans

Nonqualified Deferred Compensation Benefits

Medical and Health Insurance

Group Term Life Insurance

Split Dollar Plans

Business Owned Life Insurance

Fringe Benefits

Chapter 8: SECURITIES, BANKRUPTCY AND OTHER FEDERAL LAW ISSUES

Securities Law

Bankruptcy Law

Foreign LLCs and Interstate Commerce

Chapter 9: MERGERS AND CONVERSIONS

Overview

Terminology and State Statutes

Merger of Corporations and LLCs

Conversions of Partnerships

Professional LLCs

Chapter 10: ESTATE PLANNING

Valuation

Chapter 14

Liquidation Rights

Minority Discounts

Income Tax Considerations

The Family Limited Liability Company

Asset Protection

Medicare and Medicaid Planning

LLC Versus a Trust

The Life Insurance LLC

The Family LLC Versus the Family Limited Partnership

Chapter 11: VALUATION

Overview

The Nature and History of the Business

Economic Conditions

Financial Condition

Earnings

Cash Flow

Goodwill

Comparables

Reconciling the Various Factors

Discounts for a Minority Interest

Discount for Lack of Marketability

Conclusion

Chapter 12: DISCOUNTS

Overview

The Structure of the Transaction

The Minority Discount

Lack of Marketability

New Discount Theories: Potential Loss of a Key Employee

New Discount Theories: Potential Captial Gains Taxtion

New Discount Theories: Poor Portfolio Divesity

Current Developments: Separate Interests

Current Developments: Non-Application of Section 2704(b)

Appendix A: REVENUE PROCEDURE 95-10

Appendix B: REVENUE RULINGS AND LETTER RULINGS

Revenue Ruling 95-37

Revenue Ruling 93-12

Revenue Ruling 59-60

Letter Ruling 9538022

Appendix C: DELAWARE CODE ANNOTATED

Appendix D: SAMPLE OPERATING AGREEMENT

Appendix E: CHECK-THE-BOX REGULATIONS

Appendix F: COMPARISON OF BUSINESS ENTITIES

Chapter 1: INTRODUCTION

This new, second edition updates the first volume that dealt with Limited Liability Companies and expands its contents to include Limited Partnerships, specifically Family Limited Partnerships. The reason for this is that the two subjects – Limited Liability Companies and Limited Partnerships – are so closely related that coverage in a single volume makes a great deal of sense. The second reason, and one that will be emphasized a number of times, is that the LLC is really a super form of the limited partnership. In a limited partnership there must be at least one general partner. That individual has personal liability – meaning that their personal assets are subject to creditor attachement – if the partnership does not have enough assets to satisfy the claim. In an LLC, the equivalent of the general partner, called the member manager, does not incur any personal liability. It is this enhancement which makes the LLC both so popular and also so similar to the limited partnerships.

Limited Partnership law is fairly old. The original act, the Uniform Limited Partnership Act, was drafted in 1916. It has been adopted by most states, though each state has generally made some customizations. In 1976, the National Conference of Commissioners on Uniform State Laws adopted the first revision of the Uniform Limited Partnership Act. The 1976 Act is known as the Revised Uniform Limited Partnership Act or RULPA. The 1976 Act was intended to modernize the prior uniform law while retaining the special character of limited partnerships as compared with corporations. Among the goals of the Act is the maintenance of a degree of flexibility in defining the relations among the partners that is not available in the corporate form. A hallmark of limited partnership law is the relative uniformity among the states. This is to be contrasted with LLC’s where little uniformity between state law exists. It is also important to note that the drafters of the Uniform Limited Partnership Act are currently proposing changes known as Re-RULPA which would bring the law of Limited Partnerships and Limited Liability Companies as virtually the same. For this reason, we will focus more on LLC law than on Limited Partnership law. For our purposes, we will assume that Limited Partnership state law is similar to LLC law. For taxation purposes, there should be no difference between LLC and Limited Partnership law.

The limited liability company (LLC) is the first major development in the law of business organizations since the rise of the corporation in the late nineteenth century. There has been tremendous growth in state enabling statutes in the 1990s. Only a mere handful of enabling statutes existed in 1990, whereas all states now have enabling legislation. Concomitant with state enabling legislation has been the corresponding increase in the number of businesses utilizing this form. Obviously, a critical question is – why has this growth occurred? Another way of phrasing the same question is – why are these entities so attractive?

First and foremost, as the name implies, a limited liability company provides limited liability to all of its members. In this respect it resembles a corporation. In most situations, if the corporation is sued, the assets of its individual owners (the stockholders) are insulated from attachment by corporate creditors. This is true whether the liability occurs as a result of a business dealing (contract) or as a result of an injury (tort). Second, the vast majority of LLCs operate like a partnership. This characteristic has two advantages. First, the partnership form offers extreme flexibility in operation. The owners can tailor the LLC as they see fit. Second, the partnership form can offer taxation advantages, most notably the idea that there is only a single level or tier of taxation. Viewed comprehensively, there is no other form of business entity that offers so many positive attributes.

A Brief History

The LLC form of doing business has been around for many years. The basic structure of this type of business entity is to allow business owners to formulate a business as they see fit through a valid contract. Surrounding this structure is the state statutorily providing insulation of the owner’s personal assets as being beyond the scope of business creditors. This arrangement has been known for many years in such civil law countries as Brazil¹ and Germany.² Interestingly, there are a number of precursors to LLCs in the United States. In the late nineteenth century, Pennsylvania, Michigan and a few other states permitted partnership associations where the owners were not held personally liable for the obligations of the business. The Internal Revenue Service (IRS) has classified these partnership associations at different times as a partnership³ and as an association taxable as a corporation.⁴ In 1977, after the IRS issued its ruling classifying a partnership association as a partnership, Wyoming adopted the first statute creating an LLC.⁵ However, at that time the tax status of this entity was extremely murky.

In late 1980, the IRS issued a proposed regulation⁶ that basically held that no entity could be classified as a partnership if all of its owners had limited liability.⁷ This proposed regulation met with a number of negative comments. Finally, in late 1982, the IRS announced that it was withdrawing the proposed regulation and would commence a study to examine the whole issue of taxation of partnership associations.⁸ Shortly thereafter, Florida became the second state to adopt LLC legislation, essentially using the Wyoming statute as a model.⁹ Finally, after six years of study the IRS issued an announcement to the effect that the status of a limited liability company, in and of itself, would not prevent it from being classified as a partnership.¹⁰ This was soon followed by a revenue ruling that held a Wyoming LLC to be classified as a partnership. The rise of the LLC as a viable concept can be traced to the date that Revenue Ruling 88-76 was published.¹¹ This was followed by a number of private letter rulings that reinforced the concept that an LLC could be taxed as a partnership.¹² As a result of these positive developments, publicity for LLCs increased.¹³ Correspondingly, four additional states adopted LLC legislation in 1991. This increased to eleven more in 1992 and eighteen more in 1993.

Finally, in the year 2000 all 50 states have enabling legislation. As states continued to adopt enabling legislation, the IRS had the opportunity to review a number of the various state statutes. This was done in a series of both published and private rulings. These rulings, which were generally most favorable, spurred other states to adopt statutes, which in turn led to more favorable IRS rulings. In January, 1995 the IRS issued Revenue Procedure 95-10 in order to eliminate the volume of ruling requests.¹⁴ This pronouncement was designed to be the Bible for establishing the rules whereby everyone would understand what would be needed to establish an LLC that would be taxed either as a partnership or a C corporation. Finally, the IRS issued check-the-box regulations which greatly simply the process.¹⁵

Applicable Law

One of the few difficulties in working with LLCs is the fact that there is no uniform law governing them. To prevent confusion in many commercial areas, the National Conference of Commissioners on Uniform State Laws (NCCUSL) has proposed uniform laws that the states have adopted. For example, as discussed earlier both limited and general partnerships are governed by the uniform laws, which have been adopted in all United States jurisdictions. This ensures uniformity in legal principles that a person must learn and that apply everywhere. While there may be minor differences from state to state, on the whole, once a person learns the uniform law, he can effectively work in any state that has adopted that law. In this respect, there is no need to learn the differences of each state law.

The LLC area has grown so rapidly that in order not to be left out the states adopted statutes that were all different. Indeed, most states adopted statutes before the NCCUSL even had an opportunity to prepare a draft proposal of a uniform law. The net result is that no two LLC statutes are exactly the same. Those interested in LLCs must study and understand the enabling statute for their particular state. Further compounding the issue is that some states have sought to gain competitive advantage over other states in the hope of increasing revenues from filing fees when an LLC is formed. This has resulted in some states modifying their LLC statutes even though the statute may have been on the books for only a few years. While it is possible to discuss major aspects of LLC formation and operation, it is impossible to cover every state statute’s nuance. Again, the individual must study the statute for each particular state.

This is not to say that a uniform LLC law will not occur. In 1992, a subcommittee of the Business Law Section of the American Bar Association completed a prototype statute. This prototype formed the basis for subsequent LLC legislation in Louisiana, Arkansas, Maine and Indiana. Likewise, the NCCUSL has also promulgated a uniform law. This law is the basis for the recently enacted legislation in Vermont.

Fundamental Characteristics

While each item discussed in this section will be discussed in much greater detail later in this book, it is important to point them out at this juncture so that one may understand the appeal of LLCs. A widely accepted definition of an LLC is that it is a non-corporate business that provides its members with limited liability and allows them to participate actively in the entity’s management.¹⁶ This definition has three key elements, namely: non-corporate elements, limited liability, and active participation.

Non-Corporate Elements. The LLC is not a corporation. It is wrong to refer to an LLC as a limited liability corporation. There are two key elements that distinguish an LLC from a corporation. The first distinction occurs in the areas of capital and finance. Most states impose rigorous requirements on capitalization of corporations. The capital interest must be displayed in the form of a stock certificate. These rules further require that dividends must be paid only out of corporate surplus. None of these rules apply to LLCs. Ownership interests, the disbursement of funds, capital structure and most other financial items are governed by a contract among the LLC owners. These provisions are not imposed by state law. This allows great flexibility in creating an LLC. It is this flexibility (and freedom from state-imposed rules and regulations) which has made LLCs appealing to entrepreneurial businesses. Likewise, there is usually less paperwork and filings required in order to form an LLC. For example, corporations generally must file by-laws with the appropriate state agency, but there is no similar requirement for an LLC.

The second non-corporate element is probably the most important as far as all of the tax reasons for forming an LLC as opposed to another business entity. The LLC is not treated as a separate tax-paying entity. The LLC will generally be treated as a partnership for federal tax purposes. As such, it will file only an informational return.¹⁷ The income subject to tax will all pass through to the individual members. Thus, there is only one level or tier of taxation, which occurs at the owners’ level.

Limited Liability: Corporations have historically been the only business organization to provide total limited liability for all of its owners. What this means is that if a corporation is sued, whether it be in contract or tort, the personal assets of the owners are immune from attachment by whomever holds a judgment against the corporation. The LLC replicates this concept. All other business organizations generally have at least one individual who is personally liable for the debts and obligations of the business.

Active Participation: LLCs may operate like a partnership, in that all members may participate in the operation of the LLC. The members can do so without losing their limited liability status. In a limited partnership, there is a trade-off between limited liability and participation. If one participates, he loses limited liability. If one wants limited liability, he must not participate in the management of the limited partnership. An LLC member may have both limited liability and participation. On the other hand, an LLC may be structured similarly to a corporation, in that management is vested in the hands of a board similar to a corporation’s Board of Directors. This allows some members to not participate in the operational control of the LLC. One of the strengths of an LLC is that this choice is purely optional. The members who form the LLC can choose the structure that suits them best.

Family Limited Partnership (FLP)

A Family Limited Partnership is a most interesting vehicle. They were originally designed in the 1950’s to allow for the splitting of income. At that time, income could be split among family members. Over time, this issue became less important because of a general lowering of income tax rates for all. In addition, Congress passed a provision known as the Kiddie Tax. This provision applies only to interest and dividend income of a child under age 14. As a result, even a gift, either directly or in a partnership, of the assets that produced the income will not effectively shift the income to the child. It will be taxed at the parent’s rates.¹⁸ This provision, along with the lower rates has made the FLP no longer an income tax planning entity.

Just as the FLP was fading from view for income tax planning purposes, it became transformed into an estate planning vehicle. The reason for this is the availability of discounts. If an individual gives a piece of property to another, it is taxed for estate or gift tax purposes at fair market value. However, if the property is first put into an FLP and then gifts are made of the units of the partnership the property is discounted for federal tax purposes, since the partnership interest will have restrictions, which reduce the property’s value. The utilization of an FLP and discounts is fully covered in Chapter 12.

Terms

Like in all other human endeavors, there is a set of special terms that apply to LLCs. Fortunately, the number of special terms is small. Below is a list of some of the most important applicable terms.

Member: an owner of an LLC interest; similar to a shareholder in a corporation.

Member-Manager: a member-manager is analogous to a corporate shareholder who is on the Board of Directors. This term implies an owner (member) who also sets policy similar to that of a corporate director (manager). Generally, owners in an LLC are classified as either members or member-managers. A member is a passive owner, while a member-manager is an active owner. An LLC may be composed of all members, all member-managers, or some members and some member-managers.

Bulletproof: an LLC statute that forces the LLC to be taxed as a partnership. Early statutes, such as the original Wyoming statute, were bulletproof. If the LLC complies with the statute it will be taxed as a partnership for federal tax purposes.

Flexible: the vast majority of modern statutes are flexible in nature. This means that under the state statute the LLC may be taxed either as a corporation or a partnership for federal tax purposes. Usually, there is little to be gained in being taxed as a corporation. If one wants to be taxed as a corporation, he should just form a corporation. Under flexible statutes, care must be utilized in order to make sure the LLC is taxed as a partnership. This is generally a tightrope balancing act. One generally wants the most flexibility and the most ease in running the business, but still wants to be classified as a partnership.

Conversion: generally, this is when a partnership elects LLC status. Most states allow the partnership to simply file a document requesting LLC status. It is usually not necessary to start from scratch and file all the documents as a new, start-up LLC. Terminology here is confusing. Some states call the converted partnership a limited liability partnership or LLP. Some call the partnership a revised limited liability partnership or RLLP. Still others call it simply an LLC, just like a new, start-up LLC.

Limited Liability Partnership: approximately 37 states now have limited liability partnership statutes. In general, these states have taken the Uniform Limited Partnership Act (ULPA) and included limited liability for all partners.¹⁹ In many respects this results in an entity similar to early LLCs in that the entity must be classified as a partnership because of inflexible operating rules and little opportunity for the owners to create operating rules outside those dictated by statute. As such, this legislation is useful for a partnership that wants to convert from an entity where one or more partners have unlimited liability. Rather than having to completely redo all the paperwork, these states allow the partnership to convert to an LLC-type organization. Since under these conversion statutes the entity is still technically a partnership, it is called an LLP or limited liability partnership. In general, one forming a new entity will prefer the flexibility of being an LLC and will usually not choose to form an LLP over an LLC.

Limited Liability Vehicle: a number of people are using this term as an umbrella to cover the various terminologies used in different states. It encompasses LLCs, LLPs, RLLPs, Professional LLCs, etc. The tax treatment of all of these entities is virtually the same and they all work in essentially the same manner. The term limited liability vehicle is a good term since it includes all of the sub-terms set out above and eliminates trying to keep track of all the different terms used in various jurisdictions.

Professional LLC: a number of states have special rules for professionals such as accountants, lawyers, or insurance agents who wish to form an LLC. Some states simply call this professional organization an LLC. Other states call it a PLLC or professional limited liability company, while a few others call it a professional limited liability partnership or PLLP. Other states have no special rules for professional organizations and they are simply covered under the regular LLC statute. In any case, a professional LLC operates just like a regular LLC. Special rules and the question of liability are discussed in further detail in Chapter 9.

Default Statute: the modern approach to state statutes is to allow the members of an LLC to create their own operating rules and structure through an operating agreement. If they fail to cover a particular point (either intentionally or unintentionally) then the statute comes into play and provides the missing piece or pieces. The statute’s provisions become operative only if the contract among the members of the LLC does not cover an item that is covered by the default provisions of the governing statute.

Footnote References

1. See Let. Rul. 8003072, which discusses a limited organization under Brazilian law.

2. See Let. Rul. 8221136, which discusses a German LLC.

3. Let. Rul. 7505290310A.

4. Let. Rul. 7102100370A.

5. W.S.A. §§17-15-101 to -143.

6. Former Prop. Reg. §301.7701-2.

7. Apparently the IRS was concerned more about close corporations, and making sure that they would be taxed as corporations. See Letter Ruling 7921084, which held that a close corporation could never be classified as a partnership.

8. IR-82-145 (12/16/82).

9. F.S.A. §§608.401 to 608.514.

10. Announcement 88-76, 1988-18 IRB 44.

11. 1988-2 CB 360.

12. Among these rulings are Let. Ruls. 9119029, 9030013, 9029019, 9010027, 8937010.

13. See for example, Tannenbaum, J.A. States Are Sanctioning New Form of Business, The Wall Street Journal, July 17, 1992 at page B1.

14. 1995-1 CB 501. The Revenue Procedure was actually made public on December 28, 1994 under 26 C.F.R. 601.201.

15. The regulations are discussed extensively in Chapter 2.

16. Keatinge, R.R., et al, The Limited Liability Company: A Study of the Emerging Entity, Business Lawyer, Volume 47, Number 2 (Feb., 1992) at page 384.

17. Usually IRS Form 1065. Information from this form is disbursed to each individual member of the LLC. This is done through giving each member a Schedule K-1. In all aspects this is analogous to a partnership.

18. IRC Sec. 1(g).

19. See Louisiana (LSA-RS §9:3431, et seq.); Texas (Texas R.U.L.P.A. at T.R.C.S.A. Art. 6132b-3.08(1)); District of Columbia (D.C. Code §41-151.1 et seq.).

Chapter 2: FEDERAL INCOME TAXATION: CLASSIFICATION ISSUES

Introduction

As was discussed previously, an LLC may be taxed either as a corporation or a partnership. Likewise, even though a partnership is a partnership for state law purposes, it also may be classified as a corporation or partnership for taxation purposes. In virtually all situations the choice will be to tax the LLC and the Limited Partnership as a partnership. Not only does a partnership offer more flexibility, it also allows for only one level of taxation. Prior to 1986, a corporation could distribute appreciated property to its shareholders and avoid paying capital gains tax at the corporate level.¹ The Tax Reform Act of 1986 eliminated this exception so that in virtually all situations involving corporate distributions there is a double tax. The corporation first pays tax on income when it is received. Then, when the proceeds are distributed to the shareholders there is a second tax, which is paid by the shareholders. Generally, the corporation does not get a deduction when it distributes proceeds to the shareholders.² Thus, there are two complete taxes – one at the corporate level and another at the shareholder level. A partnership, on the other hand, is not a taxable entity. It is merely a passthrough where all of the tax effects at the partnership level are reflected in the personal tax returns of the partners.³ This can result in substantial tax savings, as demonstrated in the following example.

Example: Acme Corporation has a piece of capital gains property that has a basis of $0. The corporation sells this property for $1,000 and distributes the net proceeds, after tax, to Irv Investor, a shareholder. Assuming that both Acme and Irv are in the top marginal brackets respectively, what is the net proceeds after tax left in Irv’s hands?

Now let us assume everything is the same, except that Acme is a partnership:

Besides being a much easier calculation, the single tier of taxation represented by the partnership results in a very substantial tax savings. The amount retained through the partnership tax treatment is almost double the tax treatment that occurs because of the double taxation occurring through the corporation.

Historical Background

The classification of business entities for taxation purposes has a long, and somewhat complicated history. For many years, it was among the most complicated problems facing a person who wished to create an LLC or an FLP. Fortunately, new regulations, known as the Check-the-Box regulations have ameliorated the problem. A brief overview of the prior structure and format of business classification may be useful. The Internal Revenue Code contains a plethora of different taxation schemes for different types of business entities.⁵ The most important and most common entity classification problem involves the difference between a partnership and a corporation. Obviously, corporations are taxed as corporations under the Internal Revenue Code. For this purpose, the Supreme Court basically established the rules for classification purposes. It said that a corporation is a legally formed entity under state corporate law organized to carry out a legal business.⁶ However, business organizations that are not legally incorporated may be taxed as an association. An association is an organization whose attributes require that it be taxed as a corporation rather than another type of organization such as a trust or a partnership. In Morrissey v. Commissioner, the Supreme Court held that a trust could be classified as an association and hence taxable as a corporation.⁷ The key to this treatment was that the trust possessed the attributes of a corporation. The tests of Morrissey were later modified and enhanced in a series of regulations. These regulations once were critical to the assessment of whether an organization will be taxed as a partnership or a corporation.⁸

These former regulations identified six characteristics that are normally found in corporations. These are:⁹

• associates;

• an objective to carry on a business;

• continuity of life;

• centralized management;

• limited liability;

• free transferability of interests.

The meaning of each of these characteristics was the subject of much case law and IRS rulings and regulations.

As LLC statutes sprang up in the states, the IRS began addressing the question of whether an LLC could be taxed as a corporation or a partnership on a state by state basis in revenue rulings. Then the IRS issued Revenue Procedure 1995-10, 1995-1 CB 501, creating safe harbor rules for having an LLC taxed as a partnership. Finally, the IRS issued the check-the-box regulations, which essentially allow an individual to simply choose the method of taxation desired, whether as a partnership or a corporation.

Check-the-Box Regulations

There were many problems with regards to classification under prior law. Fortunately, the former system was discontinued and a new system instituted that is much more efficient. On March 29, 1995, the IRS announced that it was considering a simple and radical alternative to the former classification test system.¹⁰ This new approach would allow individuals to simply choose which form of taxation they desire, regardless of the criteria involved. Under this approach, all unincorporated businesses would be taxed as partnerships, unless they check-the-box to be taxed as a corporation on an IRS form. On May 13, 1996, the IRS issued new regulations outlining this check-the-box concept.¹¹ These regulations met with almost unanimous approval, and were finalized for entities created on or after January 1, 1997.¹² The structure of the new regulations is in essence a flow diagram. By a process of elimination, one is able to reach the point of electing a certain organization classification.

Under the explanation section of the new regulations, it is pointed out that many states have revised their statutes to provide that partnerships and other unincorporated organizations may possess characteristics that traditionally have been associated with corporations, thereby narrowing considerably the traditional distinctions between corporations and partnerships, under local law.¹³

The explanation then points out that this blurring of traditional classification issues has resulted in the need for more and more sophisticated legal assistance to obtain the desired taxation result. As stated in the new regulations, small business organizations may lack the resources and expertise to achieve the tax classification they want under current classification regulations.¹⁴

To alleviate these problems, the new regulations state "[i]n light of these developments, Treasury and the IRS believe that it is appropriate to replace