Research Paper on "Optimal Business Forms for Taxation Purposes"

Research Paper 21 pages (5934 words) Sources: 20 Style: Chicago

[EXCERPT] . . . .

optimal business forms for taxation purposes in recent years has compelled many businesses to form limited liability companies (LLCs) or S Corporations. Both of these alternatives provide some measures of preferential treatment depending on the unique circumstances of the entities involved, but LLCs in particular have emerged as the alternative of choice for many companies of all sizes and types. The growing popularity of the LLC to the exclusion of the S Corporation is due in large part to the additional flexibility it affords its members in their governance structures and level of participation in the operation of their business, the avoidance of double taxation and the built-in tax and restrictions on the types of owners and class of stock associated with S Corporations, but the LLC alternative is not without its downsides, including most especially a lack of jurisdictional uniformity. Despite this and other considerations, this study shows that the limited liability company provides practitioners and businesses alike a number of advantages that make it worthy of consideration when searching for optimal business solutions.

An Examination of the Similarities and Differences between a Limited Liability Company (LLC) and an S Corporation: Formation, Tax Basis, Liquidations and Dissolutions

Introduction

The combination of corporate and partnership forms that are provided by a limited liability company (LLC) has make this an attractive alternative for a growing number of businesses of all sizes and types due in large part to the taxation advantage is affords as well as the flexibility it provides in structuring business governance. This paper provides a review of the relevant peer-reviewed and scholarly literature concerning the similarities and differences between limited liability companies (LLC) and S Corporations in regards to formation, tax basis, liquidations and dissolutions of each type of entity. A summary of the research in these areas and important findings are presented in the conclusion.

Review and Analysis

Limited Liability Company

Unlike a traditional corporation or partnership, a limited liability company or LLC is formed pursuant to "articles of organization" rather than either "articles of incorporation" or a partnership agreement, and is an unincorporated business that, by definition, provides limited personal liability to its owners who are termed "members."

In addition, when organized and administered properly, LLCs are taxed as partnerships with the taxable income being reported on the members' own federal income tax returns and taxed at each member's marginal income tax rate.

The LLC framework came into being following changes to the tax laws that made limited liability companies more attractive based on the favorable tax treatment they provided which resulted in their adoption by a majority of state legislatures.

As Pollack points out, though, "It would be a gross overstatement to say that in this case the federal tax laws developed to 'serve' the needs or demands of private economic interests."

The setting was right for the introduction of LLCs because there was growing concerning among practitioners, businesses and investors alike about the need for better corporate structures to protect and preserve their resources. For instance, Pollack points out that, "Businesses and individual investors turned away from the traditional business corporation and began to use alternative business entities, such as partnerships and common law creations (e.g., the Massachusetts business trust), precisely because of the more favorable tax results that could be achieved through such entities."

Not surprisingly, then, LLCs have become the alternative of choice for a growing number of enterprises, but their adoption is not without some consequences. For example, since their introduction, LLCs have compelled companies to restructure their operations to accommodate the new regulatory guidance from the IRS.

Nevertheless, despite these and other considerations involving their implementation and administration, LLCs have become increasingly popular for a growing number of practitioners and businesses in recent years. For instance, according to Pollack, "Law and accounting firms favor the limited liability company for the benefits it offers to both clients and themselves."

Likewise, Goodman (2007) emphasizes, "LLCs are the most versatile entity from an income tax standpoint. LLCs can generally elect between being classified as a disregarded entity or partnership on the one hand, or a corporation on the other. . . . LLCs open up new possibilities in structuring mergers and acquisitions."

In reality, though, LLCs are certainly not a recent phenomenon. In fact, limited liability companies were originally recognized as an alternative business entity as early as 1977 by the Wyoming legislature.

In this regard, Dylla reports that, "LLCs were first allowed in 1977 under the statutes of the state of Wyoming. After the IRS ruled in 1988 (in Revenue Ruling 88-76) that companies meeting the Wyoming requirements would be taxed as partnerships for federal income tax purposes, a large number of states passed similar legislation."

It required some time for practitioners to become sufficiently familiar with LLCs for them to gain credibility and widespread acceptance, but this process was facilitated by the promulgation of Revenue Ruling 88-76. According to Dylla, "This ruling announced that [a]n unincorporated [business] organization operating under the Wyoming Limited Liability Company Act [was] classified as a partnership for federal [income] tax purposes....:"

In its ruling, the IRS identified six primary corporate characteristics of LLCs as follows: (1) associates, (2) an objective to carry on business and divide the gains therefrom, (3) continuity of life, (4) centralization of management, (5) liability for corporate debts limited to corporate property, and (6) free transferability of interests"; in addition, the IRS added that "if an unincorporated organization possesse[d] more corporate characteristics than noncorporate characteristics, it constitute[d] an association taxable as a corporation."

In the event the unincorporated organization failed to achieve a majority of the corporate characteristics through a preponderance of the evidence, the entity would be taxed as a partnership.

This preferential tax treatment resulted in a number of state legislatures enacting their own LLC legislation, a process that resulted in the National Conference of Commissioners on Uniform State Laws (CCUSL) crafting a uniform LLC act. As a result, Dylla reports that, "In 1996, NCCUSL promulgated the Uniform Limited Liability Company Act (ULLCA). This act was the first generation of uniform state laws pertaining to limited liability companies drafted by NCCUSL. ULLCA was largely influenced by the Revised Uniform Partnership Act, the 1985 Revised Uniform Limited Partnership Act, and the Model Business Corporation Act."

Shortly after ULLCA was introduced, the Internal Revenue Service provided even more favorable tax treatment for LLCs with the approval of the "check the box" rules that made LLCs "an even more attractive entity option."

According to Dylla, "Beginning in 1997, with the adoption of what has become known as the 'check the box' rules, the preponderance of corporate characteristics test of Revenue Ruling 88-76 was eliminated along with the requirement to include certain language within the operating agreement in order to bulletproof the entity."

The adoption of the "check the box" protocol meant that businesses now enjoyed the alternative to be taxed as a partnership/pass-through entity or as an incorporated entity, almost entirely irrespective of how the business organization was structured. In addition, the "check the box" protocol simplified the operating agreement making the new rules more attractive to practitioners and businesses due to its enhanced flexibility to structure the business organization based on its real-world needs and operating environment from a relationship perspective.

Furthermore, the protocol made it possible to create a pass-through tax entity that has all four corporate characteristics built into the organization's documents.

The growing preference for limited liability companies, though, also created a concomitant issue for practitioners and businesses with respect to uniformity.

In this regard, Ribstein reports that, "Prior to 1996, nearly every state had its own LLC statute, resulting in significant variation in the applicability and enforcement of LLC law throughout the country."

The Uniform Limited Liability Company Act (ULLCA), though, did not resolve the issue of uniformity across jurisdictions, an issue that became even more problematic in hindsight because in most cases, states had already passed their own versions that either mirrored best practices in most states or otherwise involved variations that made subsequent legislative remedies more difficult and more expensive to enact. In this regard, Ribstein notes that, "Unfortunately, the promulgation of ULLCA did not solve the problem of variability in LLC law, in large part because it was introduced after most jurisdictions had already legislatively addressed LLCs."

In response to the lingering differences between LLC laws in the states in which it had been approved, the National Conference of Commissioners on Uniform State Laws approved and recommended that all states should adopt the Revised Uniform Limited Liability Company Act (RULLCA).

To date, a number of states have adopted the RULLCA while others in the process of reviewing it for their own jurisdictions. According to Ribstein, "The introduction of a new uniform act is significant because it enters the legal scene at a time when LLCs are widely considered to be the "go-to' entity."

This growing popularity of the RULLCA has fueled interest in the LLC for a wider array of business types. In… READ MORE

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