Tcl - Limited Liability Companies: Structuring Members' Economic Rights - Business Law Newsletter
| Publication year | 2005 |
| Pages | 73 |
| Citation | Vol. 34 No. 8 Pg. 73 |
2005, August, Pg. 73. TCL - Limited Liability Companies: Structuring Members' Economic Rights - Business Law Newsletter
August 2005
Vol. 34, No. 8 [Page 73]
Business Law Newsletter
Limited Liability Companies: Structuring Members' Economic Rights
by James R. Walker
This column is sponsored by the CBA Business Law Section to apprise members of current information concerning substantive law. It focuses on business law topics for the Colorado practitioner, including, but not limited to, issues surrounding antitrust, bankruptcy, business entities, commercial law, corporate counsel, financial institutions, franchising, nonprofit entities, securities law, and small business entities.
David P. Steigerwald of Sparks Willson Borges Brandt & Johnson, P.C., Colorado Springs - (719) 475-0097, dpsteig@sparkswillson.com; Rob Fogler of Kamlet Shepherd & Reichert LLP - (303) 825-4200, rfogler@ksrlaw.com
This month's article was written by James R. Walker, Denver, a partner with Rothgerber Johnson & Lyons LLP - (303) 628-9510, jwalker@rothgerber.com.
The LLC challenges today's business lawyer to properly make use of a host of accounting principles that impact an LLC member's economic returns. This article describes these important concepts and the federal and state law limits on LLC deal-making.
The limited liability company ("LLC"), which once was considered a newfangled hybrid with an uncertain future,1 has emerged as a preeminent private business entity.2 The flexible LLC is designed to offer co-owners freedom from personal liability,3 the opportunity to manage the business directly, and favorable tax benefits of a partnership.4 These rules pass income through to the LLC members without any separate taxation.5
Nevertheless, even with all the advantages of an LLC and its acclaimed status, many practitioners are hesitant to use the LLC structure. Its flexibility demands that practitioners have a working knowledge of deal-making possibilities and the means used to achieve these goals. The LLC's flexibility regarding governance and alternative economic results challenges today's business lawyer to properly apply basic accounting rules that bear economic consequences for LLC members.
This article focuses on structuring LLC economic rights and the federal and state law limitations on economic decision-making. This article is designed to help today's business lawyers understand the heart of the economic matter.
Formation Issues and Capital Accounts
Unlike an investor in the corporate world, each LLC member is expected to bargain separately for economic rights. These separate rights include profit- and loss-sharing and the right to receive cash or property distributions either currently or on liquidation of the LLC. The most important measure of an LLC member's economic rights is his or her capital account. The capital account represents a member's contractual right to receive cash or property. Capital accounts are required under federal income tax law,6 although Colorado's LLC statute does not address them.
When a member contributes property to the LLC, a critical and necessary negotiation will be the amount credited to the member's capital account. The amount should be the result of a careful negotiation between the contributing member and the other LLC members.
As noted, Colorado's LLC statute does not address this critical deal-making point. With its corporate and partnership origins, Colorado's substantive LLC law does not even address capital accounts. Colorado's LLC Act7 simply mandates that a written operating agreement or a statement of the manager of the LLC sets forth:
[t]he amount of cash and a description and statement of the agreed value of other property or service contributed by each member and which each member has agreed to contribute in the future. . . .8
In effect, this requirement opens the door to inserting capital account principles into an LLC operating agreement. The requirement also serves as the basis for integrating critical federal partnership tax law principles into the business deal.
In contrast to the state law's minimal standard, the federal income tax law provides detailed guidelines regarding capital accounts.9 Through lengthy regulations, the Internal Revenue Service ("IRS") has established rules, known as the "704(b) regulations," regarding both the creation and maintenance of a member's capital account, including many tax-specific adjustments to account balances.10 These IRS regulations, which are discussed in the balance of this article, even mandate "deficit restoration."11 A fundamental review of these rules follows.
Allocation and
Colorado's LLC Act permits broad freedom to establish each member's separate share in the LLC's income. Such arrangements should be set forth in the LLC operating agreement. There is some restraint to contractual freedom in the federal income tax law.12 Nevertheless, careful documentation will allow members to establish their economic rights with the comfort that the IRS will respect their deal-making.
The federal income tax law allows members to allocate income, gain, loss, deduction, or credit as they may agree. This deal-making freedom is found in the tax statute itself, with an instruction that "the distributive share of income, gain, loss, deductions and credit shall, except as otherwise provided, be determined by the partnership agreement."13
Redetermination by the IRS
The federal tax law contains an outward limit for allocations. If the LLC's economic arrangements do not have "substantial economic effect," the IRS may redetermine a member's allocations. Such redetermination, which is also referred to as "reallocation," overrides the business deal and realigns allocations in accordance with each member's interest in the LLC, taking into account all facts and circumstances.14 In other words, the federal taxing authority may disregard the business deal.
The authority of the IRS to reapportion allocations has caused significant uncertainty for practitioners and LLC members. This has led some LLC members to insert a deficit makeup obligation in an operating agreement, in an attempt to reduce the risks of reallocation.15 Such a clause,16 however, often is not necessary and may do more harm than good.
Despite concerns about an IRS reallocation, the real risk may be slight because the IRS can reallocate only in accordance with the member's interest in the LLC. Therefore, many...
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