The ABCs of LLCs

Limited Liability Companies Offer New Option for Rural Businesses

Donald A. Frederick
Program Leader, Law, Policy & Governance USDA Rural Business-Cooperative Service

Editor's Note: Opinions expressed in this article are those of the author. They do not reflect official policy of the U.S. Department of Agriculture, the Department of the Treasury, or any other government agency. When making business and tax decisions, readers should consult a professional tax advisor or tax attorney.

I n recent years, every state has enacted laws enabling businesses to operate in a new form known as the limited liability company (LLC). Recent changes in the way the Internal Revenue Service (IRS) treats LLCs for tax purposes has increased their appeal. This article discusses the characteristics of an LLC, provides some background on their evolution, compares them to other ways of structuring a business, and looks at opportunities they offer rural residents and their cooperatives.

What is an LLC?

    The LLC is a legal structure for organizing a business that provides its owners with the limited liability of a traditional corporation and the single tax treatment of a partnership. The owners are called members, as in a cooperative. Under a typical state law, an LLC is created by filing articles of organization, comparable to a corporation's articles of incorporation, with the appropriate state official. Member rights and obligations are set out in an operating agreement, similar to a partnership agreement or corporate bylaws. The operating agreement covers issues such as management, voting rights, allocation of income and losses, transfer of interests, and withdrawal.

Several key traits identify an LLC:

• An LLC is a state-approved, unincorporated association. Sometimes an LLC is referred to as a "limited liability corporation." This is incorrect. The fact that it is not a corporation is crucial to its qualifying for single tax treatment.
• Owners, managers, and agents are protected from personal liability for debts and other obligations of an LLC by state law.
• Earnings (and losses) pass through to the owners for federal income tax purposes under IRS administrative rules. The Internal Revenue Code doesn't contain any provision for LLCs that is comparable to Subchapter T for cooperatives.
• Similar single tax treatment is generally available at the state level. Exceptions exist, so anyone interested in forming an LLC should check carefully in each state where the LLC is subject to taxation to see how it will be taxed.

    While thee LLC is a relatively new for of business organization in the United States, it has been used in Europe and South America since the 19th century. For example, the suffix ''Gmbh'' after a company name identifies a German LLC; "S.A.R.L." a French LLC; and "E.P.E." a Greek LLC. In South America, an LLC is referred to as a "Limitada."

    The story of LLCs here begins in 1960 when the IRS adopted rules, commonly called the Kintner regulations, for classifying unincorporated, multi-owner businesses for tax purposes. IRS identified what it referred to as "corporate characteristics." They were (1) continuity of life, (2) centralized management, (3) limited liability for owners, and (4) unrestricted transferability of ownership interests. If a business had 3 or more of these traits, IRS considered it a corporation for tax purposes. If it had 2 or less, it was treated as a partnership.

    This approach worked relatively well for 17 years, primarily because no one attempted to create an unincorporated business structure that provided the owners with broad limited liability. This changed in 1977, when Wyoming enacted the first limited liability company act in the United States.

    The Wyoming law created a dilemma for IRS. It had to decide whether limited liability was so fundamental to the concept of being a corporation that an organization where all owners had limited liability must always be classified as a corporation for tax purposes. IRS studied the issue for 11 years. This created a period of dead time in the evolution of LLCs as the other states waited for IRS to rule on the tax status of Wyoming LLCs.

    Finally, in 1988, IRS decided no one corporate characteristic, including limited liability, should be accorded greater weight than the others in classifying a business for tax purposes. Therefore, as with any other unincorporated business, an LLC qualified for tax treatment as a partnership if it had two or less of the four corporate characteristics.

    This stimulated the states to enact so-called "bullet-proof' LLC statutes. They limited an LLC to not more than 2 corporate characteristics. For example, the Virginia law defined an LLC as "an unincorporated association, without perpetual duration...." It also provided "an assignee of an interest in a limited liability company may become a member only if the other members unanimously consent."

    As a Virginia LLC was expressly barred from having "continuity of life" or "free transferability of interests," it had to qualify for partnership tax status under the Kintner regulations. Therefore, its access to single tax treatment was "bullet-proof" in that it couldn't be "shot down" by IRS agents and auditors.

    This opened the door to use of LLCs by sophisticated taxpayers, including some cooperatives who developed LLCs with other cooperative and noncooperative firms to carry out joint ventures. But the process of organizing diverse rural residents into a cohesive business unit within the confines of the Kintner regulations was pretty daunting. Many people were left with the Hobson's choice of b corporabng to achieve limited liability or forming their business as a partnership to qualify for single tax treatment.

IRS "Check the Box" Regulations

    A new set of tax rules frees all taxpayers from having to choose between limited liability or single tax treatment. On January 1, 1997, IRS abandoned the Kintner regulations and adopted a self-classification approach for determining the tax status of unincorporated businesses. The new rules are commonly called the "check the box" regulations because they permit most unincorporated businesses to choose whether to be taxed as a partnership or a corporation. Most don't even have to do that much. They are automatically given the status they want. (This discussion applies only to businesses formed in the United States. The rules where a foreign firm is involved are more complex and beyond the scope of this article.)

    The new regulations list entities that have no choice but to be treated as corporations for tax purposes. This includes businesses organized under a state, federal or tribal law that describes or refers to them as incorporated or a corporation. Virtually all existing cooperatives are covered, as they are organized pursuant to a state cooperative or general business incorporation law. Corporate tax status is also mandated for insurance companies and a state-chartered business conducting banking activity that has any deposits insured under the Federal Deposit Insurance Act or a similar federal statute.

    Any other business with two or more owners may choose to be taxed as a partnership or a corporation. A single-owner business can elect to be treated as a corporation, or simply disregarded as an entity separate from its owner. For example, a cooperative conducting an activity through a single-member LLC can treat the LLC as a division for tax purposes. All tax consequences relating to the LLC will be included in the cooperative's tax return. A single individual who forms an LLC is taxed as a sole proprietorship unless he or she chooses corporate status.

    The new regulations provide for default classification. Firms existing on January 1, 1997, are assigned the same classification they had under prior law. Multi-owner firms organized on or after January 1 are assigned partnership status. Single-owner businesses are presumed to want to be disregarded as separate entities.

    If a business wants to change its classification, it does so by filing IRS form 8832. Once an election is made to change tax status, it can't be changed again for 5 years without IRS approval. Some experts have suggested the new rules should be called the "don't check the box" regulations because, in truth, most businesses will want the status they are assigned and should do nothing. Unless a business wants to change it classification, filing a form 8832 is neither necessary nor recommended.

    The states are responding to the "check the box" rules by amending their LLC laws to remove restrictions designed to insure compliance with the old Kintner regulations. For example, Virginia has amended its law to remove the requirement that all other members must agree before an interest in an LLC can be transferred. Now the members are free to set out their own rules on transferring interests in the articles of organization or the operating agreement.

LLCs vs. Other Business Forms

    The LLC gives its member-owners substantial flexibility in designing financial and governance structures compared to other business forms. When this is combined with single tax treatment and limited liability for members, the total package is an attractive option to people forming businesses. This section compares key differences between LLCs and other options.

• Sole proprietorship-An LLC offers limited liability for the owner, protection not available to a regular sole proprietorship. While some states require multiple owners to form an LLC, they are gradually amending their laws to authorize one-member LLCs.
• Partnership-Both a partnership and a multi-owner LLC are generally permitted pass-through, single tax treatment under Subchapter K of the Internal Revenue Code. An LLC provides limited personal liability for all members, regardless of the extent of their involvement in managing the venture. In a partnership, at least one partner actively involved in managing the operation usually is personally liable for its obligations.
• General Business Corporation-Income of a general business corporation is taxed twice, at the corporate level when earned and at the owner level when distributed. An LLC qualifies for single tax treatment; all income and losses pass through to the members. Also, members of an LLC need not comply with corporate formalities such as annual meetings, keeping minutes, and electing directors and officers.
• Subchapter "S" Corporation-Some closely held corporations are eligible for single tax treatment under Subchapter S of the Internal Revenue Code. To qualify, they must comply with restrictions on the number and type of members and can't have more than one class of stock. An LLC has no such limitations.
• Cooperative-An LLC can't delay the pass-through of earnings to its members; there is no equivalent to "non-qualified" retains for an LLC. But LLC members can allocate earnings and losses and assign votes among themselves as they see fit.

    The emergence of LLCs has interesting implications for persons involved in business organization. These include:Fewer new businesses will form as partnership or Subchapter "S" corporations. The LLC offers better liability protection than a partnership and more governance flexibility than an "S" corporation.

• Many existing partnerships will convert to LLCs. Under many state laws, this conversion is not a significant event. For example, Virginia law provides "a general or limited partnership that has been converted (into an LLC) shall be deemed for all purposes the same entity that existed before the conversion." The IRS takes the same approach. It has held that the conversion of a partnership into an LLC is a nontaxable event.
• Some corporations will convert to LLCs. However, this is generally treated as a liquidation of the corporation. Tax liability can arise, for example, if property held by the corporation has appreciated in value. This will discourage some corporations from changing to LLC status.

Impact on Cooperative Development

    Even before IRS adopted the "check the box regulations," the LLC was proving a popular vehicle for established cooperatives to organize joint ventures with other cooperative and noncooperative firms. On the marketing side, an LLC could be used by a cooperative and a commercial firm to develop a new branded product. The cooperative might provide raw produce to the LLC which manufactures it into a finished product under license from the commercial food company and sells it to third parties.

    On the supply side, a cooperative could form an LLC with a chemical company to produce fertilizer. The LLC sells the fertilizer to both firms, which then resell it to their members and customers, respectively.

    The cooperatives involved in these ventures aren't concerned about perpetual existence or limits on transferability of interests. The LLC members are few in number and comfortable working with each other. They are confident that if the venture isn't successful it can be dissolved without undue harm to any participant. If they wish to continue the venture beyond the time period set in the articles of organization, they can simply amend the articles to provide for a longer life.

    The implications for new and developing cooperatives, and those who work with them, may depend on how they respond to this new tool. The following simplified example illustrates how the LLC might be used to expand opportunities for local people to form businesses to help themselves.

    Example-Allen, Barbara, and Carl, three fruit growers, want to start a packing and shipping business. They need financial support and Donna, a dentist in their community with no ties to farming, is interested in helping finance the venture.

    The four of them decide to form the business, each taking a 25 percent interest. However, since Donna is putting up most of the start-up capital, she would like to receive the bulk of any tax losses occurring in the venture's first two years and a guaranteed annual return of 10% on her investment.

    Discussion-As they search for the proper business structure, the group might well discard a partnership as it doesn't provide total liability protection and a general business corporation because it isn't eligible for single tax treatment.

    This business plan might be difficult to do as a Subchapter S corporation. Donna's ownership interest would likely constitute a prohibited second class of stock. This would deprive the venture of single tax treatment.

    The deal would also be difficult to do as a traditional cooperative. Donna, a non-producer, could not have a voting interest. Also, earnings are not being allocated on the basis of use.

    This arrangement can be easily organized as an LLC. All that is required is a properly prepared "organization agreement."

    But let's assume the three producers like the cooperative approach of distributing margins on the basis of use. They would probably be free to divide their share of the earnings among themselves on the basis of fruit provided while Donna got her 25-percent share each year (or more if necessary to meet her minimum return requirement).

    Think about your response to this question, "Is this a cooperative?" If you can comfortably answer yes, then you should have little trouble envisioning how the LLC model might contribute to solving perhaps the most pressing problem facing cooperatives, raising adequate equity capital. Like transferable delivery rights, if properly structured, the LLC can facilitate cooperative growth through adequate capitalization without subverting accepted cooperative characteristics.

    One last thought. If this group felt it needed the limited antitrust protection available under the Capper-Volstead Act, it would have to limit voting participation to producers. But it could still form as an LLC, allocate earnings on some basis other than use, and qualify as a Capper-Volstead association with single tax status. The word "cooperative" never appears in Capper-Volstead. It covers an "association" of producers with one-member one-vote or an 8-percent limit on dividends that does a majority of its business with members.

Why Isn't Everyone Using LLCs?

    If the LLC has so much to offer, it is fair to ask why every possible business isn't changing to LLC status. There are good reasons not to rush into an LLC.

• Lack of a body of law on issues such as liability, governance, and member rights-While an LLC may sound good in the abstract, no body of administrative and judicial rulings exist to offer guidance when difficult questions concerning organization and operation of an LLC arise. When early users of LLCs have problems, they will bear the cost of being test cases to establish the detailed rules for conducting business as an LLC.
• Tax problems of conversion from the corporate form-As mentioned above, conversion of a corporation into an LLC can be a complex event for tax purposes. Again, as conflicts arise between corporations wanting to change and IRS, the first to do so will run the risk of becoming embroiled in administrative proceedings over issues without established precedents.
• Other legal issues are not resolved in all states, and may be treated differently, at least in the short run, by different states. For example, an existing business may have entered into a contract that forbids it from assigning its rights and responsibilities to any other entity States may take different attitudes toward whether converting an existing business to an LLC is an assignment of that contract to another entity, requiring the consent of the other parties to the agreement.

    Some business consultants are calling the combination of state laws authorizing LLCs and the IRS "check the box" tax rules the most important developments in business formation since the advent of the general business corporation. Whether this becomes a fact will take many years to determine. But certainly the LLC is becoming a popular vehicle for organizing businesses. It will be both a tool of cooperatives and potent competition for the cooperative form of doing business. It offers both challenges and opportunities to rural residents and their advisers as we plan together to position rural businesses for a prominent place in the 21st Century.

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