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Limited Liability Companies: Best of Both Worlds

Last September, California joined 46 other states which recognize the limited liability company (LLC), one of the most innovative form of business association currently available in this country. First introduced in 1977, LLCs have gained increasing acceptance and popularity following an IRS determination that the entity would be treated as a partnership for federal income tax purposes. The LLC combines the most favorable features of both partnership and corporate structures. Like partnerships, they offer organizational flexibility and tax benefits, including tax-free status at the organization level. And like corporations, they shield all owners from personal liability.

Unlike limited partnerships, where partners must relinquish their right of management and control to gain protection from personal liability, LLC "members" may participate in the operation of the business. Further, LLCs do not require any interest comparable to a general partner, with its unlimited liability status. Thus, they avoid much of the down-side typically associated with partnerships. At the same time, they preserve the favorable tax treatment enjoyed by partnerships because they pass profit and loss directly through to each owner's individual personal income. Thus, the double taxation, which frequently burdens corporate income, is avoided. Since LLCs avoid many corporate formalities and tax code restrictions on numbers and types of shareholders, they are even attractive alternatives to the S Corporation. Overall, the LLC seems to combine the most attractive characteristics of all other business forms.

The single greatest disadvantage to the LLC, at this time, is legal uncertainty. Since they are creatures of the jurisdictions in which they are formed, subtle differences among the various state codes will inevitably lead to legal challenges. There simply is not enough case law involving LLCs to gauge how the courts will interpret and apply these laws. Further, since several states still do not recognize LLCs, their status in some jurisdictions is uncertain. The organizational limits required to avoid corporate taxation could lead to other problems as well.

The IRS follows a simple maxim: "If it looks like a corporation, tax it like a corporation." Four factors are examined, and if three or more bear corporate characteristics, an LLC will "look like a corporation." One factor, limited liability, is inherent to the LLC form. Thus, it is critical to avoid at least two of the remaining corporate traits.

When a person entity, or narrow group holds continuing, exclusive and unilateral authority to make management decisions, the corporate characteristic is present. A member-managed LLC generally will not have this characteristic because, when member-managers behave more like general partners in a partnership than like the shareholders of a corporation, management tends to become less centralized. However, this is a flexible and prickly issue. Sometimes it can be difficult to distinguish between centralized and non-centralized management, so facts and circumstances tests might come into play.

When all attributes of ownership, including rights to vote, act on behalf of the LLC, share in the profits, etc., can be transferred without restriction, the corporate characteristic is manifested. Typically, however, LLC statutes ensure that member interests are not freely transferable by requiring that at least a majority of the non-transferring members consent to any transfer. The California Act, for example, provides that a membership interest may be transferred only with the unanimous consent of members, unless the articles of organization or operation agreement provide otherwise.

A business organization lacks continuity of life if it is required to dissolve upon the death, insanity, bankruptcy, retirement, resignation, expulsion, or other event of withdrawal of an equity owner. Such language appears in most LLC statutes as an organizational requirement. However, a business continuation option can be included in the articles of organization, which, if properly drafted, will allow non-withdrawing members to continue the business after dissolution without affecting continuity of life.

In time, the LLC will become a very popular business form with significant tax and non-tax advantages. Competent legal and tax counsel should be obtained to establish an LLC. Please call my office if you have any questions or if I can help you in any other way.

Issue 2

IRS More Willing Than Ever to Settle for Partial Tax Payment

The Internal Revenue Service instituted a major policy change regarding Offer in Compromise agreements (OICs) in 1992. An OIC binds the IRS and taxpayer to a negotiated settlement of delinquent tax liability. Liens are removed and collection activities cease. Unlike earlier years, the IRS now actively encourages such settlements. This new attitude toward the OIC is expected to reduce the backlog of account receivables and offer troubled taxpayers a fresh start.

The IRS has long held the authority to compromise tax debts. But the Service's unbudging attitude toward collection often impeded delinquent taxpayers. The processing requirements for OICs were slow and cumbersome. Now, however, the IRS has adopted an official policy of compromise and accommodation. Consequently, the number of accepted offers during Fiscal Year 1993 was nearly four times higher than 1992 and continues to rise.

When collection may be accomplished without undue hardship, the Service remains unbudging. However, where collection appears difficult or unlikely, taxpayers may have opportunities to settle with the IRS for substantially less than the full amount owed. IRS statistics reveal that in an average OIC settlement, taxpayers pay only 15 cents on the dollar.

IRS acceptance criteria consider the taxpayer's assets, living expenses, and likely future cash flow streams, including employment opportunities based on age, education and prior work experience. But even if rejected, submitting an OIC has advantages. While a properly drafted OIC awaits review, the IRS will stop collection efforts, affording the taxpayer a stay of nine months or longer.



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