APPLICATIONS OF THE LIMITED LIABILITY COMPANY
IN ESTATE ADMINISTRATION
CHARLES E. HAMILTON
Charles E. Hamilton, P.C.
890 West Price Road
Brownsville, TX. 78520-8702
4TH ANNUAL ADVANCED DRAFTING:
ESTATE PLANNING AND PROBATE
Houston, Texas
November 11-12, 1993
Table of Contents
| I. | RED FLAGS: SOME INDICATORS FOR CONSIDERATION OF A LLC | 4 |
| II. | OVERVIEW OF THE LLC | 4 |
| A. History and Growth | 4 | |
| B. Terminology | 4 | |
| C. Classification of the LLC as a Partnership or a Corporation for Income Tax Purposes. | 4 |
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| D. Franchise Tax.. | 5 |
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| III. | FORMING THE LLC | 5 |
| A. Reservation of Name | 5 |
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| B. The Articles of Organization | ||
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1. NAME 2. DURATION 3. PURPOSE 4. REGISTERED ADDRESS 5. INITIAL MANAGERS OR MEMBERS 6. ORGANIZERS 7. REQUIRED PROFESSIONAL LLC PROVISIONS 8. SIGNATURE OF ORGANIZER(S) 9. FILING FEE 10. OPTIONAL PROVISIONS |
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| IV. | RECENT REVISIONS TO THE LLC ACT | |
| V. | KEY ISSUES IN MOLDING THE LLC FOR ESTATE USE | |
| A. Formation of the LLC | ||
| B. Operation of the LLC | ||
| C. Distributions from the LLC |
APPLICATIONS OF THE LIMITED LIABILITY COMPANY IN ESTATE ADMINISTRATION
Stylistic Note: The term "LLC" is used throughout this paper to refer to the Texas Limited Liability Company.
I. RED FLAGS: SOME INDICATORS FOR CONSIDERATION OF A LLC
Before actually discussing the Texas Limited Liability Company, it will be helpful to have in mind two fact situations which you might well face next week on your return to your office. Assume that you are representing a bank or individual with substantial net worth. In the first hypothetical, your client has been nominated as the independent executor of a substantial estate, but one of the principal assets of the estate is an unincorporated display sign business. It is profitable, but its operation involves substantial risk of claims. Your client would like to serve as executor, but is concerned about risks of the business.
The second hypothetical situation assumes that your prospective executor is faced with the operation of a relatively placid apartment rental business, but that a child already owns a minority interest in the real estate and the remainder was co-owned by the decedent and his brother. Your client is concerned about getting into an ownership posture where there may be joint and several liability and a lack of practical control.
In the first situation, the primary concern is limitation of liability. In the second, potential lack of control is added to the concern over limitation of liability.
The Texas Limited Liability Company is a statutory form of business which has the limited liability characteristic of a corporation, while authorizing a very broad variety of forms of organization. These forms extend from a very simple entity similar to a sole proprietorship with limitation of liability, through the partnership format, to a corporate style of entity with unlimited life, depending on the organizational form chosen by the organizers (and their attorney).
The LLC is of recent origin in Texas, the original Texas Liability Company Act having been adopted in 1992, Tex. Rev. Civ. Stat. Ann. art. 1528n. Major revisions to the LLC Act were adopted by the 73rd Legislature and became effective on September 1, 1993, Ch. 215, Tex. Session Laws 1993, 73rd Legislature, Regular Session. These revisions clarified and substantially extended the utility of the LLC. Citations below are to Ch. 215, unless otherwise noted.
The initial LLC Act was discussed in Rogers and Stinebaugh, Limited Liability Companies, Texas Bar Journal 666 (July, 1992). For a more technical discussion of LLC formation and tax issues, see Fijoleh et al., Texas Limited Liability Companies, 7 Tex. Real Estate Rep. 4 (1991) 37.
The number of states authorizing the LLC form of entity has grown rapidly, from eight states in early 1992, Rogers and Stinebaugh 666, to 31 states in June 1993, with authorizing legislation pending in California, New Jersey, and New York. Jurisdictions which have already adopted the LLC include Delaware, Illinois, and Florida. Jan M. Rosen, The Many Advantages of a Hybrid Company, The New York Times, June 19, 1993 p34, col. 1.
For reasons which are unknown to the author and seem to have no basis in good sense, the Texas form of the LLC has adopted terminology for the ownership and management of the LLC which is completely different from the terminology used for corporate organizations. There are close parallels between the two structures, and the attorney will spend a fair amount "translating" terms for the client and for other interested persons, such as bank officers. At this point there seems to be little hope that the legislature will reconsider, so definitions of terms are in order.
The LLC is initiated by filing Articles of Organization, which are directly analogous to corporate articles of incorporation. The owners of the LLC will ordinarily be the Members, who may function as shareholders or as partners, depending on how their roles are defined in the organizational documents. Management of the LLC may be reserved to the members, or the Articles may specify Managers, who will ordinarily be analogous to the directors of a corporation. Finally, the LLC is permitted but not required to have officers.
C. Classification of the LLC as a Partnership or a Corporation for Income Tax Purposes
A key issue which must be faced early on in the organization of the LLC is that the LLC may be organized so that it is taxable as a partnership or alternatively it may be organized as an association subject to the rules of corporate taxation (Rev. Rul. 88-76, 1988-2 CB 360). The primary reason for qualifying the LLC as a partnership is the conduit theory of partnership taxation. Under partnership treatment, the LLC is not a taxable entity; instead, the profits and losses are passed through to the individual members.
The leading ruling in this area is Revenue Ruling 88-76, 1988-2 CB 360, in which the Internal Revenue Service considered a limited liability company organized under the Wyoming statute. The IRS followed the usual rules governing the classification of nonincorporated entities as partnerships or as associations subject to corporate taxation, and ruled that it was the former. The Wyoming limited liability company was found not to have continuity of life or free transferability of interests and thus was classified as a partnership rather than a corporation. This decision turns on an analysis of Treas. Reg. § 301.7701-2. Under this analysis, six characteristics distinguish an association taxable as a corporation from other associations. These are:
● Associates.
● The objectives of carrying on the business and dividing the resulting gains.
● Continuity of life.
● Centralization of management.
● The liability of associates for corporate debts is limited to corporate property.
● Free transferability of interests in the association.
Since both corporations and partnerships have will associates and will seek to carry on business and divide the gains, the remaining four characteristics will be determinative and if a majority, i.e., more than two, of these remaining characteristics are found to exist, the association will be subject to the rules of corporate taxation.
Under Treas. Reg. § 301.7701-2(b)(1), an organization has continuity of life if the death, insanity, bankruptcy, retirement, resignation, or expulsion of a member will not terminate the organization. Under Treas. Reg. § 301.7701-2(e), an organization will be found to have free transferability of interests if each member may transfer his or her interest to an outsider with the consent of the other members. On the other hand, free transferability does not exist if each member can assign his or her interest in profits but cannot transfer the right to participate in the management of the organization.
A more recent letter ruling reached a similar result in Ltr. Rul. 9219022. There, careful draftsmanship saved the day. The state statute provided that dissolution would occur on the death, bankruptcy, retirement, etc. of a member, but permitted continuation if all members agreed under a right stated in the articles of organization, or in the organization's operating agreement. The IRS was not compelled to decide the issue of whether they would accept an agreement for continuation contained in the operating agreement, since the operating agreement actually provided that dissolution would occur unless ALL the remaining members agreed to continue.
As will be seen from the discussion of the Texas LLC Act, classification of a LLC as a partnership is not at all automatic due to the very broad latitude provided by that act, and careful draftsmanship is indicated.
A Texas Limited Liability Company is subject to the Texas Franchise Tax. ---(CITATION)---
This is, by one measure, equivalent to an annual tax of 4.5% on the company's assets, and would foreclose the use of the LLC as a simple vehicle for real estate holdings in many cases. Consider, however, whether the LLC would make an appropriate general partner for a limited partnership. If the LLC is not classified as a corporation, it appears under the reasoning of Larson v. Commissioner, 66 Tax Ct. 159 (1976) that the limited partnership would also not be classified as a corporation, absent other factors, and thus that the restrictive capitalization and management rules of Rev. Proc. 72-13, 1972-1 C.B. 735 would not apply. The further restrictions of Rev. Proc. 74-17, 1974-1 C.B. 438, setting conditions to be satisfied before a limited partnership will be ruled not to be taxable as a corporation, should be relatively easy to satisfy, notably, that the general partners' interests in each material item of income, gain, loss, deduction, or credit, are at least 1% of each item at all times during the partnership, not counting interests held as limited partners. If the LLC/general partner's interest were reduced to 1%, then the effective franchise tax on the entire holdings would drop to approximately 0.045%. This technique should be pursued with caution, as it has apparently not been expressly ruled upon.
Formation of the LLC parallels the procedures for formation of a small business corporation, with the reservation of the name, execution and filing of the articles of organization, and adoption of the regulations and usual items of initial business by the members (or by the managers, if so provided in the articles). Elementary forms promulgated by the Secretary of State follow the Act.
A reservation of a name for the LLC may be made by filing the reservation with the Secretary of State. Art. 2.04, Texas Limited Liability Company Act (hereafter, "the Act"). References are to the Act, unless otherwise noted. If the name is available, the reservation is effective for 120 days, and may be transferred to any other person or LLC by filing a notice with the Secretary of State, specifying the name and address of the transferee. The filing fee for the reservation of name is $25.00, and the fee for filing a notice of transfer is $10.00. Art. 9.01 (A)(7) and (8).
B. The Articles of Organization
The required contents of the Articles of Organization are set out in Article 3.02, Section A, as follows:
The name of the LLC. For LLCs formed after September 1, 1993, the name must either contain the words "Limited Liability Company" or "Limited Company," or the abbreviations "L.L.C.," "LLC," "LC," or "L.C." The word "Limited" may be abbreviated as "Ltd." or "LTD" and the word "Company" may be abbreviated as "Co."
The period of duration, which may be perpetual. Prior to the 1993 amendments, the maximum period of duration was 30 years. Interestingly enough, Treas. Reg. § 301.7701-2(b)(1), which defines the conditions which constitute continuity of life, does not require that the organization's governing document define a finite life span for the organization. Your provision of a period of duration might be helpful, should the IRS reconsider this point, and the sample documents specify a duration of 25 years.
The purpose for which the LLC is organized, which the Act specifically provides may include the transaction of any or all lawful business for which LLCs may be organized under the Act.
The address of the initial registered office, and the name of its initial registered agent at that address. Note that the address of the registered agent must be identical to that of the registered office of the LLC. Art. 2.05 A.(2).
5. INITIAL MANAGERS OR MEMBERS
If the LLC is to have a manager(s), a statement to that effect, with the name and address of the initial manager(s). If there will be no managers, then a statement to that effect is required, with the name and address of the initial member(s). Note that if there is to be only one member and no managers, the resulting entity is a form of sole proprietorship with limited liability. Since there are no associates and no intent to divide the gains from the business, it appears that there is no association, and no corporate/partnership classification problem under Treas. Reg. § 301.7701-2. ***CITATION***
The name and address of each organizer.
7. REQUIRED PROFESSIONAL LLC PROVISIONS
Any provisions required by the new Part Eleven of the Act (Arts. 11.01-11.07), which authorizes professional limited liability companies. It is improbable that this would be needed in connection with the administration of an estate.
Any natural person 18 years or older, or any other person (without regard to place of residence, domicile, or organization) may act as an organizer by signing the articles of organization and delivering the original and one copy to the Secretary of State. Art 3.01. Note that the articles are not required to be notarized, and that they may be executed by any legal person, including an entity.
The fee to the Secretary of State for filing the articles is $200.00. Art. 9.01 A.(1).
While not required by the Act to be part of the articles of organization, the very broad variety of organizational forms permitted by the Act virtually dictates that the careful draftsman will supply some of the details of the organizational structure in the articles. The following list is not exhaustive, but it suggests points which you may wish to consider.
● Provisions that the death, insanity, bankruptcy, retirement, resignation, or expulsion will effect a dissolution of the LLC, unless all of the remaining members elect to continue the organization.***TRACK REGS*** Note that under Art. 6.01, the necessary conditions of termination will exist unless negatived by the regulations. Since the regulations may be freely amended by the members unless otherwise provided in the articles, Art. 2.09, a more conservative approach would be to specify the essential events of termination in the articles.
● Provisions limiting the transferability of interests in the LLC. Unless otherwise provided by the regulations, a membership interest is assignable, but the assignment of a membership does not entitle the assignee to membership rights. Art. 4.05. An assignee may become a member to the extent that the regulations provide, or if all members agree. Art. 4.07 A.
● Managers.
● Officers.
● Provisions for expulsion of a member.
IV. RECENT REVISIONS TO THE LLC ACT
V. KEY ISSUES IN MOLDING THE LLC FOR ESTATE USE