The second-generation limited liability company.

• Author: Elwood, William E.
• Position: Taxation

The observation that "[t]he only constant in the world of business is change" is nowhere truer than in the realm of business structures. The early part of the 1990s saw the limited liability company or LLC emerge from the status of an obscure curiosity to the mainstream of respectable business entity alternatives. Now, new Treasury regulations and amended state laws have set the stage for a new or second generation of limited liability companies that promise both greater tax certainty and improved organizational flexibility.

The LLC's popularity and rapid acceptance have been driven by the status of LLCs as "hybrid entities" that marry in one entity the most desired characteristics of both corporations and partnerships. It is a distinct category of legal entity with a separate legal personality under state law. The applicable rules, usually set forth in the state's limited liability company act, shield the LLC's owners (and managers) from the debts and liabilities of the entity, just as state corporation laws shield shareholders. The LLC is nonetheless treated as a partnership for federal (and most state) income tax purposes, thereby avoiding the burden of double taxation of its income (at the enterprise level and again when distributed as dividends).

The First-Generation LLC

Although the combination of corporate and partnership attributes made early LLCs desirable, effective utilization posed a number of challenges for the typical corporate enterprise.

First and foremost of the difficulties was the level of uncertainty in federal tax treatment. The Internal Revenue Service had ruled that a limited liability company could be classified as a partnership in Rev. Rul. 88-76, 1988-2 C.B. 360, and similarly in a series of subsequent private letter rulings. Under those rulings, however, achieving partnership or flow-through treatment depended upon each LLC's ability to separately meet the then current IRS classification tests, as set forth in old Treas. Reg. [sections] 301.7701-2.

The old regulations provided four criteria for determining entity classification. Each was a characteristic that the IRS viewed as indicative of corporate, rather than partnership, character. They were:

* Limitation of Liability

* Centralized Management

* Free Transferability of Interests

* Continuity of Life

An LLC seeking to be classified as a partnership by the IRS had to possess no more than two of the foregoing corporate characteristics. Any LLC with more than two corporate characteristics failed to meet the IRS test and was treated as an "association taxable as a corporation." Moreover, because of its nature, every LLC possessed the "corporate" characteristics of limited liability and thus came to the classification arena with one strike against it.

This classification problem made tax planning difficult. In addition, the need to satisfy the four-factor test restricted businesses' flexibility in negotiating business arrangements utilizing an LLC structure. For example, an LLC might seem the ideal vehicle for structuring a joint venture between two corporations, since the participants would want both flow-through tax treatment and protection from investor liability. In addition, joint venturers would typically prefer to structure the venture to avoid dissolution in the event one member were to withdraw or become bankrupt; if the joint venture was so structured, however, the LLC would possess a second corporate...