The Limited Liability Company (LLC) is a popular form of business entity. A creature of state law, virtually all states, including New York, have enacted LLC statutes. The principal allure of the LLC is the liability protection it affords its members. LLCs are also endowed with favorable federal tax attributes.
Why then does not every business convert to an LLC? In fact, many have. Many that have not are concerned that the personal liability protection offered in-state may not be recognized out-of-state. In addition, potential conflict of laws questions may arise with respect to how and whether courts of one state will interpret another state’s LLC statute.
Another difficulty in LLC status is getting there: while a start-up venture can easily choose LLC status, converting a C or S corporation to LLC form may entail prohibitive tax cost, since a corporation liquidation is required. A welter of administrative requirements must also be complied with in order to elect LLC status for a new or an existing entity. Of all existing entities, partnerships can most easily make the transition to LLC form. Favorable basis rules make the LLC a particularly attractive form for real estate investments.
Mere compliance with state law does not assure that the LLC will attract favorable partnership tax rules under the Code. If the LLC has too many corporate characteristics, the IRS may seek to tax the entity as a C corporation. To be taxed as a partnership under federal tax law, Treasury Regulations provide that the LLC must lack two of the following four corporate attributes: (1) limited liability; (2) continuity of life; (3) free transferability of interests; and (4) centralized management.
By definition an LLC will not lack limited liability. It must therefore lack two of the three remaining corporate attributes in order to be taxed as a partnership under federal tax law. In order to obviate the possibility of failing this test, many states have enacted so-called “bulletproof” statutes. In these states, qualifying for partnership taxation is merely a matter of the LLC agreement being in compliance with the state’s LLC statute.
Other states, recognizing that the LLC need only lack two of the three remaining corporate characteristics (recall that the LLC will by definition fail to lack the corporate attribute of limited liability), permit the LLC to modify the “default” operating agreement so as to choose which corporate characteristics it will lack. New York is such a state. The danger posed in “flexible” states is that arrangements thought adequate to comply with the regulations may not suffice. This could result in the LLC losing its right to be taxed as a partnership under the Code.
It is important to remember that the determination of whether an LLC is eligible to be taxed as a partnership under the Code has little bearing on the status of the LLC under state law. That is, even if the entity fails to achieve favorable partnership tax status under the Code, it may nevertheless be a completely viable LLC under state law. In this case, only the entity’s right to be taxed as a partnership — and not the liability protection afforded its members — will have been lost.
What are the drawbacks to operating in the LLC form? To enjoy the favorable partnership tax rules, the LLC must lack at least two corporate characteristics. For some business ventures, this limitation may prove significant. Another problem with the LLC form is that although most states have enacted LLC statutes, it remains unclear how an out-of-state LLC will fare in courts of another state. Taxation of LLCs by states also varies widely, with some states taxing LLCs as C corporations, some as S corporations, and some as neither.
Most often, if an LLC is taxed as a partnership under federal tax law, the state in which the LLC operates will also accord flow-through status to the entity for state tax purposes. Not always, however: Florida, for example, taxes LLCs as C corporations, even though Florida accords flow-through status to S corporations.
New York imposes no entity level tax on LLCs similar to the one imposed on S corporations. Instead, New York imposes an “annual fee,” which is the greater of $325 or 50 times the number of employees, but not to exceed $10,000. New York City may also impose annual fees on LLCs with NYC source income.
In order to validly form or convert to LLC status in New York, compliance with various legal requirements must also be achieved:
¶ An operating agreement must be drafted, and it must contain allocations of income, gain, loss, deduction and credit. It must also define the rights and obligations of each LLC member. The operating agreement must also be consistent with the Articles of Organization required to be filed with the Secretary of State.
¶ Notice must be made by publication of the LLC’s existence. This requirement, unique to New York, may involve significant cost.
¶ Contracts, leases, insurance policies, and other legal documents must be reviewed in order to determine whether converting to LLC form would violate preexisting legal obligations.
¶ Bank accounts must be closed, and then reopened in the name of the LLC. The word “LLC” must also appear in the entity’s name, as well as on its letterhead.
Seventeen states, including New York have now enacted Limited Liability Partnership (LLP) statues. LLPs, strongly resemble LLCs. LLPs improve on the LLC form in a few important respects, most having to do with ease of converting existing entities. However, while an LLC may be composed of any members, only licensed professionals may operate in LLP form. Notably, a professional partnership wishing to convert to LLP form need not even draft a new operating agreement in New York, since the LLP statutes permits use of the firm’s existing partnership agreement.
While the professional in his individual capacity will still be subject to suit for torts committed by himself or his agent, the LLP member will not be held personally liable for the debts, obligations, or liabilities of the LLP. This treatment is considerably more favorable than that accorded to members under many other states’ LLP statutes in that the New York statute does not stop at negligent or wrongful acts, but extends coverage to contractual obligations of the LLP.