The LLC envelope.

• Author: Evans, F. Owen, III
• Position: Limited liabilites company, asset protection and federal tax benefits

For those intending to form a closely held operating business in Florida, the entity of choice, in most cases, will be a limited liability company that elects to be taxed as a Subchapter S corporation. We refer to this entity as the LLC envelope.

Following the issuance of "check-the-box" regulations in 1997, eligible entities (1) (including eligible LLCs) have been able to select their classification for federal tax purposes under an elective regime. Eligible entities, such as the LLC envelope, may elect to be taxed as a corporation, an S corporation, a partnership, or, in the case of single-member LLCs, a disregarded entity. As a result, since 1997 practitioners have been able to select the best combination of state law attributes and federal tax treatment to achieve an entity structure suited to the particular needs of a business. This flexibility changes the entity selection process from one driven first by considerations of federal tax law to one driven first by considerations of state law. Reversing the traditional analysis sequence provides greater entity design flexibility. However, few practitioners appear to have recognized this advantage. (2)

The LLC envelope constitutes a hybrid structure that marries the benefits of an LLC (a function of state law) with those of an S corporation (a function of federal tax law). This marriage achieves three principal benefits: 1) protection of the owners' interests in the company from their personal liabilities ("asset protection"); 2) protection of the assets of the owners from the liabilities of the enterprise ("limited liability"); and 3) the lowest federal employment tax (3) liability for owners employed by the business. The LLC envelope is the only Florida entity that provides all three of these benefits.

While providing the above-out-lined benefits, the LLC envelope also avoids a new and serious problem faced by many C corporations (particularly professional and other personal service corporations) as a result of the recent case Pediatric Surgical Assoc., P.C. v. Comm'r, T.C. Memo. 2001-81. Pediatric held that profits derived from associate physicians in a medical practice were corporate profits and could only be distributed to shareholder physicians of the C corporation as dividends, thus imposing two layers of tax on the profits generated by the associates.

This article will discuss the asset protection, limited liability, and federal tax benefits of the LLC envelope, analyze those situations where the LLC envelope would not be a good choice, and outline certain material considerations which impact the process and decision to convert an existing entity into an LLC envelope.

Asset Protection Benefits

The LLC is a creature of state law, and, as a result, its benefits derive from Florida statutory authority. (4) Among the most material of those benefits is the protection provided by F.S. [section] 608.433(4), which safeguards the membership interest of an LLC owner from loss by limiting a creditor to the remedy of a "charging order." While a charging order provides a creditor with the rights of an assignee, which entitles a creditor to receive distributions to which the debtor-owner would otherwise have been entitled, the debtor-owner will continue to own its membership interest in the LLC and, otherwise, operate its business without interference from the creditor. The creditor cannot vote on business matters, inspect or copy business records, nor exercise any of the debtor-owner's rights with respect to the management of the business. Conversely, the owners of a corporation (both S and C) have no similar benefit, as their creditors are not limited in their remedies to a charging order. As a result, shares of stock are subject to levy and loss to shareholder-creditors, who may thereafter exercise control over the business to the same extent as was exercised by the debtor-shareholder, including the right to manage or liquidate the business. Accordingly, the Florida LLC provides a distinct measure of "asset protection," while the Florida corporation provides none.

Some commentators believe that, in addition to constituting a nominal remedy, the charging order may actually be a detriment to its holder. They argue that a creditor who utilizes a charging order to obtain the rights of an assignee is treated as a partner for federal income tax purposes. (5) While these commentators only address assignees of "partnership interests," the same logic ought to be applicable to creditors utilizing a charging order to obtain the rights of an assignee of a member of an LLC taxed as an S corporation, since an S corporation is also a flow-through entity. (6) As a result, if an LLC taxed as an S corporation earns income, which is allocated but not distributed to the owners, the creditor with the charging order may recognize phantom income. No similar detriment exists for the creditor of a shareholder.

Thus, the charging order limitation mandated by state law may provide the advantage of both asset protection for the debtor-owner and potentially unfavorable tax treatment for the creditor. This combination of state law benefits (which limit a creditor's remedies to a charging order) and federal tax law detriments (which may subject the holder of a charging order to phantom income) arm the LLC owner-debtor with an advantage over his or her creditors, thereby potentially enabling the LLC owner-debtor to settle disputes with them more favorably.

It should be noted, however, that clients who desire these asset protection benefits should be encouraged to form an LLC with at least two members. In In Re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003), the bankruptcy court, interpreting a Colorado charging order statute that is similar to Florida's statute, held that a creditor of a member...