Also in this Issue:
-Estate Planning with Family
Partnerships and LLCs
-Real Estate Investment Using
LLCs: Not Always a No-Brainer
-LLCs: Assessing the Tax Pros
and Cons
Welcome!
Welcome to the inaugural issue of the DDR&S Springboard, our newsletter for clients and friends of the firm. Through the Springboard we hope to provide you with useful and interesting information on a variety of topics of importance to you. Each issue will have a central theme around which the firm will prepare a series of short articles related to our areas of expertise. This first edition is about Limited Liability Companies, or LLCs, and we hope you enjoy it.
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The information contained in The Springboard is general, and while it is intended to present useful background material to our clients and friends, it is not legal advice and should not be relied upon in any specific instance or for any specific matter. Please consult with your counsel prior to making any decisions or taking any action in respect of the matters discussed in The Springboard.
LIMITED LIABILITY COMPANIES:
AN INTRODUCTION AND GENERAL OVERVIEW
by Andy Dudnick dudnick@ddrs.com
Many of you have created or at least heard about California’s newest form of business entity - the Limited Liability Company, commonly referred to as the LLC. The LLC combines the best of both worlds of partnerships and corporations: like a partnership it has pass-through tax treatment, and freedom to configure management and financial interests pretty much any way you like; as in a corporation the owners (called “members”) have limited liability, that is, (generally speaking) no liability for the obligations of the business.
Setting up an LLC is easy: first, you prepare and file Articles of Organization with the California Secretary of State, pay a $70 filing fee, and an $800 minimum franchise tax (which, unlike a corporation, should NOT be paid when you file the Articles if you want the LLC to be treated like a partnership for tax purposes). Then, you prepare and have all the members sign an Operating Agreement, a written document which looks like the bylaws of a corporation and the partnership agreement of a limited partnership rolled into one. (You could have an oral Operating Agreement but that approach is generally foolish: people’s memories tend to differ on important issues like profit allocations when things aren’t written down.) One other thing to remember: in addition to the $800 per year franchise tax for the privilege of doing business in California, LLCs pay an annual “tax” based on gross revenues, not net profits. The tax currently can be as high as $4500 per year if annual revenues meet or exceed $5,000,000.
Here are some practical tips to keep in mind when thinking about using an LLC for your next business:
Licensed professionals cannot use LLCs as the business entity through which they perform services. This includes, for example, brokers, dog groomers, doctors, contractors, accountants, architects, engineers, and yes, even lawyers. Also, banks, insurance companies, trust companies, and for the most part non-profits cannot use the LLC form.
California does not permit single owner LLCs. Even though the tax law recently changed in California to allow pass through treatment to single member LLCs, the LLC business statutes still have not caught up. (There are situations in which a single owner LLC could provide significant benefits, and in these situations the LLC can be formed in a state that permits single-member LLCs, and then qualified to do business in California; however, this technique has certain risks associated with it which must be considered before employing it).
The LLC may not be useful for a new high-tech growth company because it can not use incentive stock options or other tax-favored employee stock acquisition plans, and the inevitable conversion from an LLC to a corporation when the company goes public can be expensive and burdensome. In addition, if the exit strategy for the company involves a stock acquisition by a “big fish” (which is perhaps the most common form of acquisition employed these days), the use of tax-free exchange reorganization rules is not possible.
Converting an existing corporation (S or C) into an LLC raises two potential problems: first, the conversion is treated as a taxable liquidation (even if you use a statutory merger) and second, you will need to check all of the company’s agreements (with the landlord, the bank, customers, suppliers, etc.) to determine if you need consent to transfer the contracts into the LLC.
Quick comparison to limited partnerships (LPs) and S corporations: like an LP, LLCs have pass-through tax treatment, flexibility in management and financial structuring, and limited liability for limited partners; unlike an LP, in which at least one partner (the general partner) must have unlimited liability, no LLC members are required to do so; and to preserve limited liability for limited partners, limited partners can not take an active role in the business, but LLC members may. Like an S Corporation, LLCs have pass-through tax treatment, and limited liability for owners; unlike an S Corporation, LLC has greater flexibility in structuring ownership and financial matters (for example, allocations and distributions disproportionate to capital invested; more than one class of ownership permitted, an unlimited number of owners, and any person or entity can be an owner), and the LLC “tax” on gross receipts is different from the 11ž2% franchise tax imposed by California on S Corps.
Raising capital for a business formed as an LLC has pros and cons. The advantages include increased flexibility in structuring the economic relationship among owners, and permitting owners (unlike limited partners) to participate actively in the business without losing the protection of limited liability. The disadvantages include the status of LLC membership interests as securities (unless ALL members are actively engaged in the management); the newness and uncertainty associated with membership might scare some potential investors away (when such investors are used to dealing with, say, the more developed and better understood rules of limited partnerships and corporations); the uncertain treatment of LLCs and the liability of members under federal statutes such as federal bankruptcy, antitrust, and environmental laws; a less beaten path towards an exit strategy (such as going public or selling the business); and a lack of familiarity among some banks, title companies and other financial institutions which might impose greater due diligence requirements on an LLC.
In sum, LLCs are a new and useful form of entity for California businesses, combining the advantages of partnerships and corporations. They are, however, not for everybody or for every situation. Prospective investors and lenders may be skittish, so raising money may be more difficult. A different kind of tax, based of gross receipts, not net income, applies. You can’t use incentive stock options, the time-honored coin of the Silicon Valley realm. The bottom line is this: in many cases using an LLC makes a lot of sense, but it is rarely a “no-brainer”, and often requires a careful and thoughtful analysis of your particular situation.
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