BUSINESS
ORGANIZATIONS 101
WHAT BUSINESS
ENTITY MAKES SENSE FOR YOUR FIRM?
by
Richard M.
Colombik, JD, CPA
Richard
M. Colombik & Associates, P.C.
One Pierce
Place #460E
Itasca,
Il. 60143
www.colombik.com
630-250-5700
- Introduction
- Uses By the Professions
- LLC Basic Advantages
- Use of a Single-Member
LLC
- Co
- To Hold Real
Estate
- To Hold Tangible
Personal Property or Intangible Assets
- As an Estate
Planning Vehicle
- To Hold Life
Insurance Policies
- Asset Protection
Tool
- Piercing the
LLC Veil
- Limited Liability
Partnerships (LLPs)
- Introduction
Illinois
Limited Liability Companies (?LLC?) are governed by 805 ILCS 180/1-1. The Limited
Liability Company Act (?LLCA?).
An LLC
is a separate legal entity and requires certain procedural steps be
followed. First, the LLC organizer(s) must file articles of organization
(the LLC counterpart to a corporation?s Articles of Incorporation)
with the appropriate state agency (generally, the Secretary of State).
The articles of organization must contain: the name and address of the
principal place of business of the LLC; its period of duration; the
business purpose (ordinarily, language to the effect of for the transaction
of any or all lawful business for which limited liability companies
may be organized under the Limited Liability Company Act); the registered
agent?s name, the registered agent?s address; the name(s) and address(es)
of the initial LLC?s manager(s) or members; and a statement indicating
that the LLC is managed by managers; the names and addresses of each
organizer; and any other provision the members/managers elect to include.
Before
the articles of organization can be filed, however, a name must be chosen
and approved by the Secretary of State (the purpose of this approval
is to prohibit the use of the same or similar names by two different
business entities). An LLC must contain the words ?Limited Liability
Company? or the abbreviations ?L.L.C.? or ?LLC? after its
name to indicate that it is an LLC. The name must not contain
any of the following words or abbreviations: ?Corporation,? ?Corp.,?
?Incorporated,? ?Inc.,? ?Ltd.,? ?Co.,? ?Limited Partnership,?
or ?L.P.?.
Next, an
operating agreement should be prepared listing the rights and duties
of all of the members. Here, as well as in the company minutes
if so adopted after the LLC?s formation, is the appropriate place
for language to be included governing business succession and ownership
interest transfer restrictions. Even though more expensive than
a corporation, the costs associated with forming an LLC are relatively
minimal in relationship to the asset protection features inherent in
a properly drafted operating agreement in addition to statutory protection.
- Uses by the Professions1
Because
professionals typically have conducted business in unincorporated forms,
they have faced unlimited liability for obligations arising from their
professional practices. Those who have incorporated their practices
may have encountered income tax problems (including double taxation
of income when operating as a C corporation if one does not zero out
their earnings and the lack of flexibility in ownership and operation
as an S corporation) and nontax problems (including administrative costs
and the view that operation in incorporated form is either ?unprofessional?
or impractical). LLC?s appear to avoid these problems.2
As a result,
LLC structures had become the focal point of professionals, including
accountants and lawyers, seeking protection from unlimited liability
while avoiding double taxation and the need to incorporate. A
number of states have provisions specifically allowing professionals
to practice as LLC?s.3 Though the new rage appears to be
the usage of LLP?s!
Nonetheless,
there are important unresolved questions concerning multistate practice
by professional LLC?s, including the issue of cross-border protection
from liability and the difficulty for multistate firms to meet state
regulatory or statutory restrictions.4 In order to
be a member of a professional service LLC, the member typically must
be authorized by law to provide the professional services for which
the LLC was formed. Under the LLC statutes of some states, it
is required that all members of a professional LLC be authorized to
practice in the particular state in which the LLC is organized. Under
the legislation of some states, members need be authorized only by the
law of the state in which they actually render services.
As described
below, the potential impact of LLC acts in general and the LLC in particular:
- accountants,
- attorneys, and
- other professionals
practicing in Illinois merits consideration.
Attorneys
and Law Firms:5
On April 1, 2003, the Illinois
Supreme Court issued an amendment to Supreme Court Rule 721 and created
Rule 722, authorizing limited liability legal practice.6
The Rules were in response to a joint petition filed by the Chicago
Bar Association and Illinois State Bar Association in March 2002 requesting
that the Court amend the Rules to allow lawyers practicing in limited
liability entities to be protected from unlimited vicarious liability
under certain circumstances. The Rules took effect July 1, 2003.
The Rules eliminate mandatory vicarious liability of law firm partners
for malpractice committed by other firm lawyers not in their control.
The centerpiece of the Rules is a quid pro quo permitting lawyers with
an equity interest in professional corporations, professional associations,
limited liability companies, and registered limited liability partnerships
to avoid vicarious liability as long as the firm maintains adequate
insurance or other proof of financial responsibility.
A minimum level of insurance
under the rules is $ 100,000 per claim and $ 250,000 annual aggregate,
times the number of lawyers in the firm, and insurance need not exceed
$ 5,000,000 per claim and $ 10,000,000 annual aggregate. As a
result, the Rules improve clients? ability to recover for malpractice.
While every other state allows limited liability practice in some form,
only 11 require insurance as a condition of limited liability.
Illinois is now one of twelve states that clearly express an interest
in putting clients? interests first and the interests of their attorneys
in making a living in a competitive environment at a disadvantage versus
other licensed professionals.
Additional provisions of the Rules protecting clients are that partners
remain fully liable for their own malpractice and that of lawyers under
their direct supervision and control, partners remain jointly and severally
liable for amount of insurance deductible unless proof of financial
responsibility is provided in the amount of the deductible, and law
firm assets remain liable for malpractice committed by any firm lawyers.
The American
Institute of Certified Public Accountants (AICPA) was among the first
professional organizations to recognize the potential viability of the
LLC as a practice vehicle on a profession-wide basis. Before 1992,
the AICPA prohibited the practice of accountancy in any form other than
as a proprietorship, a partnership, or a professional corporation whose
characteristics corresponded to AICPA Code of Professional Conduct Rule
505. The rule was amended in January 1992 by an overall majority
of members of the AICPA voting on the issue, and Rule 505 as revised
allows members to select any organizational form, including the LLC,
to better serve accountants' needs in connection with limiting their
exposure to liability and facilitating their ability to establish multi-state
practices in order to better serve clients who operate in more than
one state.
Most of
the LLC acts enacted to date have not explicitly authorized or approved
of use of LLC?s by accountants; however, as a statutory matter this
does not appear to be necessary as long as they are not explicitly precluded
from using LLC?s. Indeed, the majority of LLC acts remain silent
on this point. A Kansas Attorney General's opinion7
has authorized the use of LLC?s by accountants, but other states,
including Illinois, have not explicitly issued rulings or attorneys
general's opinions regarding such usage.
In Illinois,
the practice of public accounting is governed by statute.8
A person, either individually or as a member of a partnership or an
officer of a corporation, may be deemed to be in practice under the
Illinois Public Accounting Act. 225 ILCS 450/8. The practice of
public accounting without licensure with the Illinois Department of
Professional Regulation is a Class B misdemeanor. 225 ILCS 450/7, 450/28(a).
The Illinois Public Accounting Act was amended by P.A. 88-36, effective
January 1,1994, to permit the practice of public accounting in limited
liability company form. 25 ILCS 450/8. The LLC must make application
to the Department of Professional Regulation for licensure and pay the
requisite fee. 225 ILCS 450/13.
In Illinois,
the Illinois Society of Certified Public Accountants has actively sought
to remove regulatory restrictions that might preclude the practice of
accountancy via the LLC form. It is anticipated that in light of the
amendments to the Illinois Public Accounting Act many accountants will
utilize the LLC as a form of business, and it is unlikely that the Illinois
Supreme Court will invalidate this form of organization or prevent limitation
of accountants? liability. Although use of the LLC is unlikely
to protect a member from personal liability for his or her own malpractice,
there is a good likelihood that the LLC form will protect a member of
an accounting firm from vicarious personal liability for malpractice
committed by a co-owner unlike the case for lawyers, discussed above.
Since accountants can utilize LLC?s in Illinois, it is anticipated
that most accounting firms will explore the structure, using a cost-benefit
analysis in their deliberations. Accountants likely to give serious
thought to using the LLC format are those who are engaged in practices
prone to malpractice and/or bankruptcy (i.e., those who prepare certified
audits for publicly traded companies, those who provide tax advice and/or
tax return preparation, and those involved in audits of industries such
as savings and loans and banks that have been relatively prone to potential
professional liability litigation in the event of the bankruptcy or
collapse of their audited clients).
The typical
disadvantages of using LLC?s also apply to professionals, including
the filing fees and related costs of formation and operation, which
are substantially higher than those of the general partnership form;
the lack of law in interpreting many of the provisions that must be
utilized in the firm's operating agreement; and the uncertain protection
that LLC?s provide with respect to shielding a member from practice
liability (such as malpractice) that arises due to actions of other
members or employees of the firm. In addition, there are certain
tax issues relating to operating as an LLC when one is in a professional
practice, including a question of the ability to retain the cash method
of accounting rather than being forced into the accrual method, with
potentially disastrous tax consequences.
On the
basis that every member actively practiced the profession and had voting
rights on numerous matters affecting the firm?s governance and operation,
the IRS has indicated in two Private Letter Rulings a willingness to
permit professional service LLC?s to use the cash method of accounting.
See PLRs. 9321047, and 9328005. It is by no means clear that medium-
or large-sized firms will be willing to permit all their members to
participate in firm management to the extent permitted in the aforementioned
letter rulings. Therefore, professionals would be prudent to seek
letter rulings for their own protection absent a Revenue ruling or regulation
promulgated on point.9
The so-called
[?Final 4?] national accounting firms have chosen to operate as
limited liability partnerships (LLPs) rather than as LLC?s.
It is understood that this choice was based on numerous factors, including
the inability of professionals to operate as LLC?s in a few states,
the relative ease of registering as an LLP and remaining uncertainties
as to the deductibility under §736 of payments to redeem the interests
of members of an accounting firm LLC. Accounting firms doing business
in Illinois or adjoining states are free to practice in LLC or LLP form,
and small and medium-sized Illinois accounting firms use both types
of formats.
However,
a cost-benefit analysis may cause many service providers to determine
that operation in partnership or corporate form is preferable, particularly
if the perceived magnitude and risk of personal liability are minor.
- LLC Basic Advantages
Because
of their flexibility and relative simplicity, the LLC is well suited
for both start-up businesses and more mature businesses. LLC?s
have several advantages:
- LLC?s provide
greater management flexibility than corporations. For instance,
corporations are required to have a formal structure with directors
and corporate officers. LLC?s are simply run by the members or managers.10
- LLC?s provide
greater flexibility with regard to income distribution than do corporations.
When corporations pay dividends, those profits must be distributed evenly
on a dollar per share basis. LLC?s may distribute income as
desired.
- If a small business
is interested in "pass-through" taxation, then LLC?s have
an advantage over S Corporations with regard to ownership flexibility.
All shareholders of S Corporations must be citizens or permanent residents
of the United States and there may be no more than 75 shareholders in
total. LLC?s do not have these restrictions, again allowing
greater operating flexibility.
- Caveat: LLC
distributions, unless structured properly pursuant to its operating
agreement are generally subject to self-employment tax, whereas, dividends
on S corporations are not.
- Erosion of charging
order protection via judicial foreclosure against a member?s interest
D. Use of a Single-Member
LLC
A single-member
LLC?s provides considerable flexibility for its owner. Individuals
forming a new business may choose to forego the liability of operating
the business as a sole proprietorship, or the forming a corporation
to own the business, by creating a single-member LLC which would own
and operate the business and assets. The single-member LLC provides
advantages over partnerships with a single equity source because a single-member
LLC eliminates the need to have two or more owners and this may result
in fewer costs by avoiding the need for creation of more than one legal
entity to act as ?partners.? Additionally, single-member LLC?s
may be used to own multiple divisions of a business or multiple real
properties with ownership is vested in a single-entity.
A disadvantage
of a single member LLC is that such an entity files a schedule C, when
owned by an individual or otherwise disregarded entities for income
tax purposes. For individual reporting schedule C taxpayers have a higher
audit incidence than non-schedule C taxpayers.11
- To Hold Real
Estate
Owning,
developing and operating commercial real estate may be a liability-prone
business. The owners of real estate can limit their liability
with a LLC. However, LLC owners may not be fully exculpated from
real estate liabilities using an LLC. In many instances, lenders
may require LLC members to personally guarantee loans.
LLC?s
may own, operate, and lease as a landlord, real estate. 805 ILCS 180/1-30(3)
and (4). The LLC is not required to disclose its member?s identity
unless they are also the LLC organizers or managers. 805 ILCS 180/5-5(a)(4),
(5) and (7).
Management
of Real Estate: Investors in real estate joint ventures may
seek to obtain limited liability by becoming a limited partner.
However, limited partners risk losing their protection against liability
if they participate in control and management of a limited partnership.
See 805 ILCS 210/303. Alternatively, an LLC will give the same
investor the benefit of limited liability and the ability to manage
the business. For example, a firm owning several real estate projects
may form a LLC to own each project separate and apart from ownership
of the other projects.12 This structure may have the
effect of isolating liabilities to a given project or property.13
LLC?s
also may be used in connection with like-kind exchanges intended to
qualify under I.R.C. §1031. The general rule requires that the
party who transferred the exchange property must receive replacement
property received in an exchange. This requirement may create
issues in that the transferor of the exchange property may wish to insulate
itself from personal liabilities in connection with the exchange property,
perhaps because of the different nature of the replacement property
or because for historical reasons the exchange property had been vested
in the transferee rather than in a single-purpose limited liability
entity such as a corporation, limited partnership, or LLC.
A LLC will
be disregarded as a separate entity for income tax purposes, and the
replacement property may be received by an LLC whose single member is
the transferor of the exchange property, thereby permitting both completion
of a like-kind exchange under I.R.C. § 1031 and limited liability for
the transferor as a member in the LLC that receives the replacement
property. Additionally, under very limited circumstances, the
IRS has permitted the use of a two-member LLC to be treated as a disregarded
entity and thereby complete an exchange when the second member does
not have an interest in profits or losses of the LLC but instead has
been inserted into the LLC?s organizational structure for control
purposes. See, e.g., PLR 199911033.
(See G.
In Lieu of Corporate Subsidiaries: below: regarding minimizing
potential environmental liability).
- To Hold Tangible
Personal Property or Intangible Assets
Intangibles:
Where a corporation has many businesses and one of its businesses is
a high-risk business, the corporation?s shareholders could establish
an LLC to carry on the high-risk business that would otherwise have
been carried on by the corporation. The corporation leases the use of
its fixed assets and licenses its intangibles to the LLC at fair market
value rentals and payment of license fees. In addition to the
LLC receiving the rentals and license fees, the corporation could use
existing contracts, inventory and outstanding accounts receivable to
capitalize the LLC. The LLC thereafter generates all future income
of the high-risk business that would have otherwise gone to the corporation.
This structure may isolate corporate assets from potential LLC future
creditors.
- CAVEAT: Be
sure to have counsel review fraudulent conveyance and fraudulent transfer
statutes prior to any such transfer.
- As an Estate
Planning Vehicle
The
Family LLC: LLC?s have not yet been the subject of voluminous
IRS or court rulings relative to estate planning. The IRS, however,
has indicated that gifts of a limited partnership interest qualify
for the annual gift tax exclusion as a gift of a present interest.14
As an LLC when formed is taxed as a partnership, there is no authority
that a contrary position would be taken with regard to an LLC. Further
most LLC statutes are derived in great part from limited partnership
statute. For example the concept of restricting creditor attachment
to a charging order is generally utilizing language form the Uniform
Limited Partnership Act as adopted on a statewide basis.
Therefore, taxpayers can consider using LLC?s to increase the amount
of property transferred via the annual gift exclusions and lifetime
transfer exemptions. This is due to the ability to obtain discounts
on the value of property contained within a LLC or a family limited
partnership, FLP.
An example
of an estate planning technique may consist of gifts of ownership interests
in a LLC to family members or to a trust for the family member?s benefit.
Since the LLC interest is being transferred, rather than a direct ownership
in the underlying assets, discounts for lack of marketability, lack
of control and minority interest discounts are generally available.
As long as the donor does not retain impermissible control over the
gift, any appreciation, as well as the gifted asset will generally not
be included within the transferor?s estate
Any type
of trust can be a member of an LLC, as opposed to ownership restrictions
placed upon shareholders within S corporations. Additionally,
valuation discounts for lack of marketability and control can reduce
the potential gift tax on business interests gifted to family members.
In the FLP scenario, which should be equally applicable to LLC?s,
generally allows a combined discount of 35% of an assets value within
a LLC, based upon recent court rulings.15
LLC?s
formed between family members for estate planning or income-shifting
strategies can be utilized to provide special classes of ownership such
as preferred and subordinated interests in capital, profit and cash
flow. For example, using multi-classes of ownership creates a
method in which cash flows can go to a donor during their lifetime while
providing substantial asset growth for the donees benefit. However,
assuming that I.R.C. §2701 is applicable to an LLC in the same manner
and method as to a partnership, IRC § 2701 must be understood.
In essence,
the partnership rules hold that I.R.C. §2701 applies to an LLC if an
individual transfers an interest in the LLC to or for the benefit of
a family member, while retaining a liquidation, put, call, conversion,
or distribution right and the interest transferred is not of the same
class or proportionally the same as the retained interest. Thus,
to avoid triggering the application of I.R.C. §2701, care must be exercised
when contemplating creating different classes of interests. Conversely,
if different classes of interests are created, they should be limited
to differences in the right to vote or manage the LLC as they should
not cause §2701 to apply.
Not
all is lost: It is still possible to use an LLC to transfer
some value without creating differing classes of distribution rights
and liquidation preferences that I.R.C. §2701 was designed to prohibit.
For example, a family can create a member-managed LLC, where a senior
member can receive compensation for managing the LLC. This appears
to be one method of acceptable income shifting for LLC?s and partnerships
that may not trigger I.R.C. §2701.
Still another
wealth shifting method is to receive lease payments from a LLC.
Leasing has been a traditional income shifting technique used as an
income tax planning device. A leasing agreement works as an estate
freezing techniques also. See C. As a Valuation ?Freeze? Entity
above.
Additionally,
though the annual gift exclusion likely applies to LLC?s, these transfers
must be analyzed in the context of estate tax law and retained interests.
Specifically, IRC § 2036 transfers with retained life estates and IRC
§ 2038 revocable transfers that may include gifts made prior to death
in a transferor?s estate, applicable to LLC transfers. Particularly
§ 2036 appears to be the new tool of the IRS to attack transfers with
retained interest.
Retained
Interests: This is an issue specifically raised in a family-held
LLC, where an older member is also a designated manager. The general
rule is that management powers retained by a general partner are subject
to strict fiduciary duties imposed by state law. As a direct result
of those fiduciary duties, such as the duty of loyalty and care, the
prevailing view is that this authority is not treated as a retained
interest includable in the taxable estate. Two letter rulings have held
that the power that a general partner retains with respect to the partnership
interests he transfers to junior family members should not cause those
transferred interests to be subject to estate tax inclusions within
either I.R.C. §2036 or I.R.C. §2038.
These rulings relied on the rationale of US v. Byrum, 408 U.S.
125 (1972), which held that the stock transferred by a controlling shareholder
to an irrevocable trust was not includable in his estate because the
decedent had a fiduciary duty to the corporation and to the minority
shareholders as a controlling shareholder and member of the board of
directors.
Arguably,
in an LLC, member-managers may also have a strict fiduciary duty imposed
by state law to other members, therefore, analogous to Byrum,
an LLC interest transferred to other family members should not be subject
to either I.R.C. §2036 or I.R.C. §2038 by reason of the control rights.
However, the landscape has drastically changed with the holding in
Estate of Strangi v. CIR, 115 T.C. 478, (2000), aff'd in part and
remanded in part, 293 F. 3d 279, (5th Cir. 2002), on remand, T.C. Memo.
2003-145, 2003.
In Strangi,
the Tax Court eliminated all estate tax discounts for a family limited
partnership that was created and the assets transferred within three
years of the decedent?s death. The Court held, as it had
in prior cases, that § 2036(a)(1) required this result. However,
the Court then went on to reach the alternative holding that § 2036(a)(2)
also precluded the estate from claiming a discount. However, the
alternative holding in Strangi appears to be based on a misreading
of the Supreme Court?s Byrum decision and is inconsistent with
the Service?s own published guidance.17
- the possession or
enjoyment of the transferred property; or
- the right to the
income from the transferred property.
Given the
statute's disjunctive structure, the courts (although the Supreme Court
has not yet spoken to the question) have understandably made clear that
the retained ability to enjoy or possess property need not be legally
enforceable. Thus, if the possession or enjoyment of
transferred property is retained under an implied understanding or agreement
that a decedent would not have been able to enforce under state law,
inclusion is nevertheless required.
In contrast,
section 2036(a)(2) applies only where a decedent has retained the right
to control the beneficial enjoyment of transferred property. An
important question arising under this provision is whether the decedent?s
retained practical control is sufficient to trigger estate inclusion
where state law imposes certain constraints that narrow the scope of
the decedent?s power. It was precisely this question that the
Supreme Court addressed in Byrum. The Service itself has
read Byrum as establishing the proposition that the provision
is applicable only where the decedent retained a legally enforceable
right.
Under this
reading, if the decedent?s ability to control is circumscribed by
a fiduciary duty owed to an unrelated or related minority interest,
the decedent cannot be viewed as having retained a legally enforceable
right. Byrum can also be read as strongly implying
that the retained ability to cause the liquidation of an entity is too
speculative to serve as a predicate for estate tax inclusion.
Nevertheless, in Strangi, the Tax Court concluded, as part of
its alternative holding, that the fiduciary duty that the decedent had
owed to family members should be disregarded and that his ability to
cause liquidation was sufficient to trigger § 2036(a)(2). The
Strangi reading of § 2036(a)(2) flies in the face of the IRS?s
previous reading of Byrum.
In TAM
9131006, the Service concluded that § 2036(a)(2) did not apply to a
family limited partnership even though the decedent, as general partner,
had the ability to control partnership distributions to limited partner,
donees, and all partners were related to the decedent.
It predicated its conclusion on the decedent?s fiduciary duty.
In doing so, the court cited Estate of Gilman v. CIR, 65 T.C.
296 (1976) and Byrum, and made no reference to the fact that
the decedent?s fiduciary duty was owed exclusively to family members.
Additionally,
the Service appears to have endorsed Byrum in a published ruling
as well. In Rev. Rul. 81- 15, 1981-1 C.B. 457, the Service invoked
the Byrum fiduciary-duty analysis and concluded that § 2036(a)(2)
did not apply in the case of corporate stock where a decedent had retained
voting rights even though the only shareholders were the decedent and
a family trust created by the decedent. Mysteriously, the Strangi
court made reference to the TAM, dismissing it on the grounds that it
held no weight as a precedent, but it then failed to mention the revenue
ruling, despite the mandate that the Service is obligated to respect
its published rulings in Tax Court litigation.22
In Strangi,
the court concluded that the decedent?s ability to vote with others
to cause a liquidation constituted sufficient control to invoke § 2036(a)(2).
The court further held that the fiduciary duty the decedent had owed
to his family members did not adequately constrain his retained right
to vote on liquidation or distributions23 and therefore,
should be disregarded.24 Granted, it is comprehensible
that the Court wished to establish a set of laws that will end abusive
family partnerships, yet neither Strangi conclusion follows given
Byrum, Rev. Rul. 73-143, Rev. Rul. 81-15 and Congress?s ratification
of Byrum?s perceived understanding.25
- Given Strangi?s
§ 2036(a)(2) holding, existing partnerships and LLC?s should seriously
consider restructuring their agreements relative to any retained interests.
- As for structuring
new partnerships and LLC?s, Strangi itself suggests a straightforward
method for avoiding its § 2036(a)(2) holding. If other family
members also contribute assets to the LLC at its formation in exchange
for LLC interests and each receives a LLC interest equal in value to
their contribution, Strangi suggests the potential to treat the
transaction as a ?pooling.? If it qualifies, § 2036?s bona
fide sale exception would preclude § 2036(a)(2) from applying at the
death of any contributing member. In structuring an LLC to qualify
as a pooling, care must be taken in drafting the operating agreement.
26
Consideration
should be given to placing an LLC interest in a grantor retained annuity
trust (GRAT) or a grantor retained unitrust (GRUT).
Under a
Grantor Retained Annuity Trust ("GRAT"), a grantor transfers
assets into an irrevocable trust while retaining a current income interest
from the trust for a specified period of time.27
Concurrently, the grantor must transfer a remainder interest in the
trust property to the individuals to whom he intends to pass the assets
upon his death.28 Normally, such a transfer would subject
the transaction to substantial federal gift taxes. However, by
structuring the current income interest as a fixed payment annuity,
§ 702 (?Special Valuation Rules in Case of Transfers of Interests
in Trusts?) permits the transfer to occur at least partially tax-free.29
Because the payments, if properly planned, will expire prior to the
grantor?s death, the remainder interest vests with the trust?s beneficiaries
prior to the grantor?s death and the assets have effectively been
removed from the estate. Moreover, any appreciation in value of
the assets after the date of transfer to the trust is entirely removed
from the estate.30 Any return on the assets in excess
of the annuity payments inures to the remainder interest free of any
gift taxes. However, as a grantor trust, the full value of the
trust? income remains taxable to the grantor until the expiration
of the annuity period.
The GRUT
differs from the GRAT only in that the annual annuity payment is calculated
as a percentage of the annual value of the trust, rather than as a fixed
amount.31
A GRAT
is optimal when it produces the income necessary to fund the annuity
payments without any diminution in amount. An LLC taxed as a partnership
is quite the opposite. This should usually be a good asset to
fund a GRAT. Note that a partnership, and by extension an LLC
taxed as a partnership, can receive basis adjustments under I.R.C. §743
and I.R.C. §754. Those adjustments are only available if the
asset is purchased or upon death via a step up in basis under I.R.C.
§1014. This might make the gifting of an LLC interest to a GRAT
or GRUT less desirable if the asset has a low basis.
CAVEAT:
The Service takes the position that if there is a transfer of an interest
to an assignee and if the assignee of an interest cannot vote on liquidation,
it is a lapse subject to I.R.C. §2704(a). FSA 200049003.
Furthermore, if the restriction on liquidation was to be disregarded
under I.R.C. §2704(b), which provides for applicable restrictions to
be disregarded when they effectively limit the ability of the partnership
to liquidate in a more restrictive fashion than state law, then an interest
which is disregarded for purposes of I.R.C. §2704(b) should also be
disregarded for purposes for I.R.C. §2704(a). See FSA 200049003.
- To Hold Life
Insurance Policies
Using LLC?s
in lieu of an irrevocable insurance trust adds flexibility for controlling
and holding policy proceeds versus the constraints generally contained
within an irrevocable insurance trust. However, when a LLC invests
in life insurance policies important beneficiary and transfer for value
concerns must be understood.
The issues
explored in relation to corporate-owned insurance must also be addressed
in the context of partnership or LLC owned life insurance. The IRS?s
position on partnership owned life insurance is set forth in Rev. Rul.
83-47, 1983-2 C.B. 158. Rev. Rul. 83-47 analyzes two situations
regarding partnership-owned life insurance:
- insurance on a partner?s
life is payable to the partnership, and
- where the insurance
is payable to a third party for a non-partnership purpose.
In PLR
200017051, the IRS ruled that the general partners of a family limited
partnership that owns policies insuring their separate and joint lives
do not have incidents of ownership with respect to the partnership-held
policies by reason of their general partnership interests. As
the partnership agreement prohibited general and limited partners from
participating in the exercise of any incident of ownership with respect
to any policy insuring his or her life, no incidence of ownership were
present.
- NOTE: Proper
drafting of the partnership agreement in this instance was the key
Similarly,
in PLR 200111038, the IRS ruled that an insured couple did not possess
§ 2042(2) incidents of ownership in three survivorship policies on
their lives that a trust they created planned to transfer to a limited
partnership. The trust, which benefited one spouse?s parents
and the spouses? children, was to receive limited partnership interests
in exchange for the policies. The couple also planned to contribute
cash to the partnership in exchange for limited partnership interests.
Additionally, another trust created by the couple planned to contribute
cash in exchange for general partnership interests.
The limited
partnership, as policy owner, planned to name itself as beneficiary.
The partnership would own other assets in excess of the policies face
amount and would continue the historic trust investment activities including
contributing the policies. The IRS noted that the limited partners
could not exercise control over the partnership?s business, management,
or investment decisions, could not vote on or take part in the partnership?s
management and operations, could not participate in the partnership?s
day to day affairs, and could not sign for or bind the partnership.
In Knipp
Est. v. Commissioner,32 a partnership owned insurance
policies on the life of a deceased partner, which were payable to the
partnership. The court held that the partnership, not the decedent,
possessed the policies incidents of ownership. Therefore, the insurance
proceeds were not includable in a deceased partner?s gross estate.
The IRS acquiesced in Knipp since inclusion of the policy?s
face value in the decedent's gross estate ?would have resulted in
unwarranted double taxation of a substantial portion of the proceeds.
This was due to inclusion of the decedent's proportionate share of the
partnership interest which was increased by the receipt of the policy
proceeds. This however, still resulted in reduced estate taxation,
due to valuation discounts present in the LLC or limited partnership
structure.
Knipp
based its decision on an entity theory of partnership, that is, the
partnership, as an entity, possessed the policy?s incidents of ownership.
That view is contrary to the aggregate theory of a partnership endorsed
by Rev. Rul. 83-147, that a partnership is merely a collection of individuals.
Regardless of the IRS?s rationale, the result of acquiescence in
Knipp is recognition that insurance payable to a partnership should
properly be taken into account for federal estate tax purposes only
to the extent it affects the valuation of the decedent?s partnership
interest.
In Rev.
Rul. 83-147, the decedent owned a one-third interest in a partnership
which owned an insurance policy on the decedent's life, payable to his
child. Had a corporation, rather than a partnership, been involved,
the corporation?s incidents of policy ownership would not have been
attributed to the decedent, since such attribution occurs only when
an insured, decedent owns more than 50 percent of the voting stock of
the corporation.33
The IRS
took a different view in the partnership context. Viewing the
partnership as an aggregate of individuals, rather than a separate entity,
the IRS found that the partners as individuals held the ownership rights
in a partnership-owned policy. Thus, the IRS ruled that the decedent,
in conjunction with the other partners, possessed incidents of ownership
in the policy.
Under Rev.
Rul. 83-147 reasoning, the size of the decedent?s proportionate partnership
interest is irrelevant; inclusion in the gross estate results in every
case where partnership-owned insurance on the life of a partner is payable
to a third party.34
Under the
general rule, the proceeds of a life insurance policy received by a
beneficiary are excluded from his gross income. IRC § 101(a).
An exception to this general rule is when there is a ?transfer
for a valuable consideration?. IRC § 101(a)(2). This rule is
known as the ?transfer for value? rule. Where there has been
a transfer for a valuable consideration, the amount excluded from gross
income will be limited to the amount of the consideration paid plus
the premiums subsequently paid by the transferee.35
While the
transfer of a life insurance policy for estate planning purposes is
ordinarily intended as a gift,36 in a business purpose context,
the transfer of a life insurance policy is generally not intended as
a gift. In business, there will generally be a ?transfer for
a valuable consideration.? Issue. If the §101(a) exclusion
from gross income for the proceeds of a life insurance policy is to
be preserved, the transfer must fall within one of the two exceptions
to the ?transfer for value? rule.
The first
exception is where the transferee?s basis is determined by reference
to the transferor?s basis. The second exception provides that
a ?transfer for value? will not destroy the §101(a) exclusion ?if
such transfer is to the insured, to a partner of the insured, to a partnership
in which the insured is a partner, or to a corporation in which the
insured is a shareholder or officer.?37
The transfer
of a life insurance policy in the business context frequently involves
a policy which is intended to fund the buyout of an insured?s interest
in the business entity. In this context, it is well established
that a ?cross-purchase agreement? can easily be converted into an
?entity purchase or a redemption agreement,? but that the reverse
may be difficult to accomplish. Several private letter rulings
have approved a technique which may permit a conversion from an ?entity
purchase? to a ?cross-purchase.? PLR 9012063 and 9239033.
The IRS
has also approved the transfer of a life insurance policy to an irrevocable
trust, where the trust and the insured were partners in a long-standing
partnership. See PLR 9235029.
Query,
whether the transfer for value rule will be avoided if insurance policies
are transferred to a partnership created for that express purpose?
In PLR
9309021, a corporation was the owner of insurance policies on the lives
of its two shareholders. The shareholders planned to form a partnership,
the only purpose of which appears to have been to ?engage in the purchase
and acquisition of life insurance policies on the lives of its partners.?
The IRS ruled favorably on the following rulings requested by
the taxpayer:
- The partnership
will qualify as a ?partnership? for federal income tax purposes.
- The transfers of
the life insurance policies from the corporation to the partnership
qualify under the exception to the transfer for value rule under §101(a)(2)(B).
- Proceeds of the
policies distributed to one of the partners under an insurance contract
on the life of the other partner would not be included in the gross
income of the recipient partner.
The only
issue seriously dealt with in PLR 9309021 was the qualification of the
new entity as a ?partnership? for federal income tax purposes.
This issue involved an analysis of the four characteristics ordinarily
found in a corporation. After finding that the entity did, in
fact, qualify as a ?partnership? for federal income tax purposes,
the IRS ruled favorably on the other two ruling requests with little
discussion. PLR 9309021 provides a blueprint for the conversion
of a corporate redemption arrangement to a cross-purchase agreement;
care must be given to the transaction.38
- NOTE: Good
drafting from a tax lawyer can save the day!
CAUSE
FOR CONCERN: Rev. Proc. 98-3, added to the no-rule area to indicate
that, in certain situations where a life insurance policy is transferred
to an unincorporated organization, the IRS will not rule on: (1) whether
the organization will be treated as a partnership under §§761 and
7701; or (2) whether the transfer will be exempt from the transfer for
value rules of §101 if substantially all of the organization's assets
consist, or will consist, of life insurance policies on the lives of
the members. This no-rule policy was retained in Rev. Proc. 2000-3,
and Rev. Proc. 99-3, which superseded Rev. Proc. 98-3.39
In Rev.
Proc. 2003-3, the IRS continued its absolute no-rulings policy on this
issue. This no-ruling policy indicates that the IRS will no longer
follow the result in PLR 9309021. Thus additional caution in structuring
partnerships for the sole purpose of transferring life insurance policies
is advisable.
In PLR
200017051, a husband and wife established not only a partnership but
also a limited liability company. Husband had established two
life insurance trusts, one in 1984 that held only a policy on his life
and one in 1988 that held two second-to-die policies on the joint lives
of the husband and wife. Husband also had established a third
trust (Trust 3), which over the years made unsecured loans to the insurance
trusts for premium payments, evidenced by interest-bearing demand promissory
notes. Husband made similar loans to the trusts. Husband,
wife, and Trust 3 later formed a LLC, with the trust contributing cash,
securities, and real estate in exchange for membership units with limited
participation rights. Husband and wife contributed cash in exchange
for all the membership units with the authority to control the company.
On the same day, husband and wife, as general partners, and Trust 3,
as a limited partner, formed a family limited partnership (?FLP?).
Wife contributed cash, husband contributed cash and the insurance trusts?
promissory notes, and Trust 3 contributed cash, marketable securities,
its interest in LLC, and the trusts? promissory notes. The stated
purposes of both LLC and FLP include managing and controlling the family?s
assets and restricting the rights of non-family members from acquiring
an interest in the assets.
FLP plans
to demand payment on the promissory notes, which the insurance trusts
will satisfy by transferring the insurance policies to FLP. If
a policy?s value, determined under Treas. Reg. § 25.2512-6, is greater
than the balance due under the notes then the trusts will withdraw cash
value from the policy in sufficient amount to make the interpolated
terminal reserve value (plus the proportionate premium amount extending
beyond the proposed date of transfer) of the policies equal to the balance
due. As the new owner of the transferred policies, FLP will designate
itself as the beneficiary of the policies and will pay all of the policy
premiums.
The IRS
concluded that the transfers of the policies by the insurance trusts
to FLP will be a transfer for valuable consideration because the transfers
are for an amount equal to the value of each trust's interest in the
policies and will discharge debt obligations that are enforceable under
state law and are valid debt obligations for federal income tax purposes.
The IRS then ruled that the transfer will satisfy the requirements of
§101(a)(2)(B) and the amounts that FLP will receive under these contracts
upon the deaths of husband and wife will be excluded from gross income
because the transferee will be FLP, which is a partnership for federal
tax purposes, and all of the insured?s under the policies to be transferred
will be partners of FLP at the time the policies are transferred.40
- Asset
Protection Tool
An LLC
is extremely advantageous in that it provides tax flexibility and significant
asset protection. Owner(s) of a corporation are referred to as shareholder(s)
whereas owner(s) of LLC interests are referred to as member(s). The
asset protection feature for LLC?s works in two regards. One
regard is inside out protection, which provides the same protection
as does a regular corporation in terms of preventing a creditor, inside
the entity from pursuing an owner?s personal assets to pay off business
debt.
The other
protection is outside in protection which prohibits any individual owner?s
personal creditors, outside the LLC, from seizing company assets, inside
the company, or becoming owner-members of the LLC itself (against the
will of the existing owner-members). This protection is derived
from and is in accord with the protection afforded limited partners
in a limited partnership.
Unlike
a corporation, where a judgment creditor can seize a shareholder?s
stock interest and take control of the entity, when enforcing claims
against an LLC member, most state statutes limit judgment creditors
to obtaining a ?charging order.? A charging order is an order
to attach the ?economic interest? of a member against income from
the LLC that is actually distributed to the member. The ?charged?
interest does not entitle the creditor to become a voting member of
the company, and if income is not actually distributed, no payments
would be made to the creditor.
A charging
order is essentially a lien upon a debtor?s distributional interest
held by a judgment creditor. In most states this order is the
only statutory remedy to a creditor who has and is trying to enforce
a judgment against a member in a properly established and maintained
limited liability company. The statute and language is the same
restriction that applies to enforcement of a judgment against a limited
partner in a partnership. This provides a statutory basis and
case law to determine the effects of a charging order.
Specifically,
a charging order entitles a creditor to attach a member?s income interest
and receive income actually distributed. A creditor, however,
does not assume any of the rights and responsibilities of a member.
Furthermore, since a creditor attaches an income interest, whether income
is distributed or not, the creditor may be taxed on income that has
not been received. This is the same law that applies to other
members of an income interest in other pass-through entities (partnerships
and S-Corporations) for income tax purposes.
A creditor
armed with a charging order against a debtor?s membership interest
has the same rights as an assignee of the interest: the right to attach
a member?s economic benefits. Profits and distributions by the company
are examples of economic benefits. It does not, however, include the
right to attach the company?s underlying assets. It also does not
include the ability to force a sale of the member?s interest or even
to vote for such action at the company level. This is different
from the same situation involving a corporation, where a creditor may
seize the debtor?s shares of stock and if his ownership level is sufficient,
actually end up owning the corporation.
In addition,
there are other drawbacks for a creditor that seizes a member?s interest.
For example, the company may have a provision in its operating agreement
that prohibits someone from becoming a member unless there is unanimous
consent from the other members. Absent such an affirmative vote
by the other members (which for obvious reasons is highly unlikely)
the creditor may never become an LLC member and hence won?t ever be
able to have any control over or real influence in the company.
A provision
also may be present in the articles of organization that requires the
remaining members to purchase the interest of a charged member at a
predetermined price. The price could be a fair market value price
or at a price less than fair market value (if this lesser value
approximates the value of the pro rata share of the company?s asset
value in the event of a liquidation). Hence, through careful preliminary
drafting, it is possible for LLC members to prohibit third parties (especially
judgment creditors) from becoming, or even from wanting to become, members.
Rather, the creditor may wish to settle with the debtor for a smaller
sum of money then is owed. Therefore, we recommend inserting language
to this effect into an LLC Operating Agreement.
Moreover,
creditors with no right to cash flows will likely not want to have an
economic interest in the LLC. For example, even though a partnership
had a provision prohibiting an assignee from becoming a substitute limited
partner without the consent of the general partners (and the general
partners did not in fact consent), an assignee was nevertheless treated
as a limited partner for income tax purposes due to his dominion and
control of the interest. This ultimately meant that the assignee
reported a distributive share of any income, gain, loss, deduction,
and credit available to that interest in the amounts applicable to that
interest as if that person were an actual substitute limited partner.
(Rev. Rul. 77-137, 1977-1 C.B. 178; see also Evans v. Commissioner,
54 T.C 40 (1970) (Tax Court held that the assignee of a partnership
interest was taxable as a partner because he held a capital interest
in the partnership as defined in Treas. Reg.
§ 1.704-1(e)(1)(v))).
This poses
obvious problems for a creditor-taxpayer that must report and pay applicable
taxes on a distributive share of income that was not actually distributed.
This party could wait for years until his claim is satisfied if the
company in question is not cooperative and unsympathetic to his situation.
Moreover, the threat or the imposition of adverse tax consequences is
a strong negotiation factor relative to settling a personal debt.
Another
major problem for a creditor with a charging order is that the debtor,
not the creditor, still retains any company managerial powers held prior
to the charge. It is a possibility that in the operating agreement,
or perhaps as part of the judgment between the debtor and the creditor
that the debtor may be required to exercise any remaining (nontransferable)
interests and rights in the company to the benefit of the creditor and
his newly acquired economic interest. Yet, such a scenario is
unlikely as it may be interpreted to expand the statutory judgment limitations.
(Rev. Rul. 77-137).
The Illinois
Limited Liability Company Act differentiates between membership interests
and distributional interests. The term ?distributional interest?
means all of a member?s interest in distributions by the LLC.
805 ILCS 180/1-5. ?Membership interest? is defined as
a member?s rights in the LLC, including the member?s right to receive
distributions of the LLC?s assets. A member is neither an owner,
co-owner nor holder of a transferable interest in LLC property.
805 ILCS 180/30-1(a). Conversely, a distributional interest in
a LLC is personal property and it may be transferred in whole or in
part. 805 ILCS 180/30-1(b). However, the transfer of a distributional
interest does not entitle the transferee to become or exercise any of
the rights of a member. The transferee would only be entitled
to receive the distributions to which the transferor would have been
entitled. 805 ILCS 180/30-5. The transferee of a distributional
interest is eligible to become a member if and to the extent that the
transferor gives such right as authorized by the operating agreement
or upon the consent of all other members. 805 ILCS 180/30-10(a).
A transferee
who does not become a member is not entitled to participate in the management
of the LLC?s business, have access to information concerning the company?s
dealings, or to inspect or copy any of the company?s records.
805 ILCS 180/30-10(d). A transferee who does not become a member
will be entitled to distributions to which the transferor would be entitled
as well as, upon dissolution and winding up of the LLC?s business,
the right to the net amount otherwise distributable to the transferor.
805 ILCS 180/30-10(3).
Currently
there are twelve states, California, Colorado, Delaware, Hawaii,
Illinois, Montana, Nevada, South Carolina, South Dakota, Virginia,
and West Virginia, where the court may order a foreclosure of a lien
on a distributional interest subject to the charging order. If
a creditor is not satisfied by the charging order, he could move for
judicial foreclosure. At the foreclosure sale, a third party could
buy the distributional interest and receive an assignment of that interest.
The funds from the sale would go to the creditor. The purchaser
at the foreclosure sale has the rights of a transferee.
In Illinois,
it is statutorily provided that an assignee of a partner?s interest
may seek dissolution by a court under specified circumstances, 805 ILCS
205/32(2), yet it has been held that such an assignee has no legal interest
in the dissolution of a partnership.41
- Piercing the
LLC Veil
Piercing
the LLC veil is an area of law that is best described as murky or undefined..
Moreover, there is little, if any, guidance on point in Illinois.
However, a brief review of case law reveals Illinois court looking for
persuasive support to hold that LLC members should be held liable under
the common law doctrine of piercing the corporate veil seems probable.
Many jurisdictions
follow the ?alter ego? test to determine whether to hold shareholders
personally liable for the debts of the corporation. The
alter ego test emphasizes that piercing the corporate veil is appropriate
where public policy interests are best served, such as protecting private
rights, and where the corporation fails to remain a separate legal entity
apart from its owners, the shareholders. In order to pierce the
corporate veil in the Illinois courts, there must be:
- such unity of interest
that the separate identity of the corporation on one hand and the shareholder
or officer on the other no longer exist and
- circumstances in
which adherence to the fiction of a separate corporate existence would
be fraudulent, unjust, or inequitable.44 In making
this determination, courts consider the following variables:
- inadequate capitalization;
- the failure to issue
stock and
- to observe corporate
formalities;
- the non-payment
of dividends;
- the insolvency of
the debtor corporation;
- the non-functioning
of other corporate officers or directors;
- the absence of corporate
records, and
- the amount of control
of the dominant stockholders.45
805 ILCS 180/10-10. Liability
of members and managers
Sec. 10-10. Liability of members and managers. (a) Except as otherwise
provided in subsection (d) of this Section, the debts, obligations,
and liabilities of a limited liability company, whether arising in contract,
tort, or otherwise, are solely the debts, obligations, and liabilities
of the company. A member or manager is not personally liable for a debt,
obligation, or liability of the company solely by reason of being or
acting as a member or manager.
(b) (Blank).
(c) The failure of a limited liability company to observe the usual
company formalities or requirements relating to the exercise of its
company powers or management of its business is not a ground for imposing
personal liability on the members or managers for liabilities of the
company.
(d) All or specified members of a limited liability company are liable
in their capacity as members for all or specified debts, obligations,
or liabilities of the company if:
(1) a provision to that effect is contained in the articles of organization;
and
(2) a member so liable has consented in writing to the adoption of the
provision or to be bound by the provision.
The United
States Bankruptcy Court for the Northern District of Illinois held in
Securities Investor Protection Corporation v. R.D. Kushnir & Co.,
examining Section 10-10, stated ?[i]t would seem from the foregoing
that ?members? or ?managers? of an Illinois limited liability
company cannot be held liable for the mere failure to observe corporate
formalities or repayment, but nothing in the statute bars piercing of
the ?corporate veil? for other grounds on which that may be done
for ordinary corporations.?46
The Court
in Securities Investor Protection Corporation explains the ?[a]lthough
generally true that corporations are distinct legal entities separate
from their officers, shareholders, and directors, Illinois may allow
the corporate veil to be pierced to avoid injustice. The corporate
form may be disregarded when (1) there is such unity of interest and
ownership that the separate personalities of the corporation and the
individual no longer exist; and (2) the continued adherence to the fiction
of a separate corporate existence would sanction a fraud or promote
injustice.?47
Conclusion:
The limited case law from Illinois and other jurisdictions suggests
the conclusion that the corporate piercing law shall be applied to Illinois
LLC?s. Therefore, Illinois courts will likely apply the typical
?alter ego? analysis, minus the ?lack of corporate formalities?
factor which is statutorily provided for, in holding LLC members personally
liable for the debts of the LLC.
- Limited Liability
Partnerships (LLPs)
A registered
limited liability partnership is a form of business entity established
by statute in 1994 within the framework of the Uniform Partnership Act.
The Uniform Partnership Act contains provisions under which an existing
partnership may become a registered limited liability partnership.
805 ILCS 205/8.1 The Uniform Partnership Act applies to registered limited
liability partnerships except where the particular statutes pertaining
to those partnerships are inconsistent with the Act. 805 ILCS
205/6(2). The primary distinction of a registered limited liability
partnership is the limitation of the joint and several liability of
partners found in a general partnership under the Act. 805 ILCS
205/15.
It is this
ability to limit liability for the malpractice and misdeeds of one?s
co-owners while retaining the simplicity of operation and favorable
tax treatment of a partnership that makes the LLP attractive to many
businesses. For professionals using a traditional partnership,
the protection from malpractice liability provided by a LLP greatly
outweighs the expense of maintaining the registration.
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