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Tax Issues for LLCs & LLPs


By Charles R. Beaudrot, Esquire
Morris, Manning & Martin, LLP
crb@mmmlaw.com
404.504.7753

A. Introduction

What Are Limited Liability Companies?

  1. A limited liability company ("LLC") is an unincorporated entity which limits the liability of its owners (generally known as members) and the persons who run it (generally known as managers) to their investments in the enterprise.
  2. The concept of LLCs continues to evolve. To date, 48 states and the District of Columbia have enacted LLC legislation which varies widely from state to state. The two states which have not passed LLC legislation are Vermont and Hawaii, though bills are pending. New state developments occur almost daily.
  3. An LLC is sometimes described as, and is perhaps best analogized to, a limited partnership with no general partner. Like all generalizations, this one should not be pushed too far.

Why Are Limited Liability Companies Attractive?

The existence of LLCs is driven by both tax and business considerations.
  1. Flow Through Tax Treatment. The goal is to have an entity which has the corporate characteristic of limited liability and which has flow through tax characteristics, such that income is taxed only once, i.e. at the owner level, not twice, as is the case with regular corporations, at both corporate level and owner level.
  2. Advantage over S Corporations. LLCs are in large measure a response to limitations on the availability of S corporations:
    1. LLCs are not limited, like S corporations, to one class of shareholder.
    2. LLCs are not limited, like S corporations, to U.S. individuals (and estates and certain trusts) as shareholders.
    3. LLCs can have preferred interests and participating debt.
    4. LLCs are not limited, like S corporations, to 35 shareholders.
    5. LLCs can hold control (i.e., own 80% or more) of a corporation without losing their flow through tax status.
      6. It is questionable if there would be a need for LLCs if Subchapter S corporations truly were taxed like partnerships and could operate with the flexibility of partnerships.
    6. c. Avoid Partnership Stigma. LLCs avoid the "stigma" associated with partnerships because of the collapse of the real estate syndication industry after the 1986 Tax Reform Act that created the Internal Revenue Code of 1986.
    7. Relative Simplicity. LLCs are simpler to organize than traditional limited partnerships, particularly those with corporate general partners.

What Are The Principal Characteristics of Limited Liability Companies?

  1. Limited Liability. LLCs limit the liability of their members and managers, similar to the method by which corporate shareholders and officers have limited liability.
  2. Non-corporate Nature. LLCs are not subject to restrictions on finance and management. There is no obligation to pay dividends or requirement that management be by a board of directors. In this regard they are more similar to partnerships.
  3. Participation and Control. Most LLC statutes permit management directly by the members without loss of limited liability. Alternatively, the entities may provide for centralized management by persons designated as managers by agreement.

Who Will Use LLC's?

Prime candidates include:
  1. Real estate ownership entities.
  2. Entities which would otherwise operate as S corporations but cannot qualify (e.g., those with foreign investors, corporate or trust investors, or holders of preferred stock).
  3. Technology joint ventures and research and development entities.
  4. Health care entities (MSOs, IPAs, etc.) which need flexibility and flow through tax treatment.
  5. Closely held investment and hedge funds.
  6. Start-up entities with venture capital financing.
  7. Closely held family businesses that need flexibility in operation.
  8. Professional firms.

B. Federal Income Tax Classification Of LLCs

The Regulations which address classification of entities for tax purposes provide that an unincorporated organization will be characterized as a partnership and not as an association taxable as a corporation so long as it possesses no more than two of four "corporate" characteristics: (a) continuity of life, (b) centralization of management, (c) limited liability, and (d) free transferability of interests. Equal weight is given to each of these four characteristics. Therefore, an LLC will be treated as a partnership for federal tax purposes if it lacks at least two of these four characteristics.

The Internal Revenue Service has issued Rev. Proc. 95-10 which specifies the conditions under which the IRS will consider a ruling request with respect to the classification of a domestic or foreign LLC as a partnership for federal tax purposes. It is important to note that Rev. Proc. 95-10 applies for advance ruling purposes only. Therefore, the failure to meet its requirements does not necessarily mean that the LLC will not be classified as a partnership for federal tax purposes. Thus, if an LLC meets the requirements of the Regulations for being treated as a partnership, it does not matter that the LLC does not meet all of the guidelines in Rev. Proc. 95-10. However, Rev. Proc. 95-10 is widely perceived as containing what are as a practical matter safe harbor's for LLC classification.

There are two types of LLC statutes: "bulletproof" and "flexible". A bulletproof statute is one that will cause any LLC formed under it to lack at least two of the four corporate characteristics. A bullet proof statute thus ensures that an LLC will always be classified as a partnership for federal tax purposes. A bullet proof statute generally provides that (1) certain events will always lead to a dissolution of the LLC unless the remaining members unanimously consent to continue the LLC, and (2) the assignee of an LLC interest cannot be admitted as a substitute member without the unanimous consent of the other members. An LLC formed under a bulletproof statute will always lack both continuity of life and free transferability of interests.

A number of revenue rulings have been issued for states that have bulletproof statutes. Each holds that an LLC formed under such a bulletproof act will be classified as a partnership for federal tax purposes. Each ruling turns upon the conclusion that the LLC lacks both free transferability of interests and continuity of life. In all cases the LLC acts required unanimous consent to permit these.

A flexible statute on the other hand allows variations with respect to (1) the events that will cause a dissolution of the LLC; (2) the vote required to continue an LLC after the occurrence of a dissolution event; or (3) the vote necessary to admit a transferee as a member. An LLC formed under a flexible statute may be classified as either a corporation or a partnership, depending upon how the documents are drafted.

The clear trend among legislation is to opt for flexible statutes. The Georgia statute is an example of such a flexible statute.

Rev. Rul. 93-38 was the first published ruling addressing a flexible statute. There the IRS ruled that a Delaware LLC will be classified as a corporation or partnership depending upon the terms of its limited liability company agreement, because the statutory provisions of the Delaware LLC act that affect the relevant characteristics may be modified by agreement. A number of subsequent revenue rulings involving states with flexible statutes have held the same.

1. Continuity of Life

Under the Regulations, continuity of life exists "if the death, insanity, bankruptcy, retirement, resignation or expulsion of any member will not cause a dissolution of the organization." On the other hand, if an organization is dissolved upon the happening of one of these events to any member (a "dissolution event"), continuity of life does not exist. Thus, the Regulations provide that a limited partnership lacks continuity of life if a dissolution event to a general partner causes a dissolution of the partnership, even though the dissolution may be avoided either by all of the remaining general partners agreeing to continue the partnership, or by at least a majority in interest of the remaining partners (both general and limited) agreeing to continue the partnership.

Rev. Proc. 94-46 provides a safe harbor to be used to determine a "majority in interest" for purposes of Regulation § 301.7701-2(b)(1). A "majority in interest" of the remaining partners means the remaining partners who own a majority of the profits interests and a majority of the capital interests owned by all remaining partners. "Profits" are determined and allocated based on any reasonable estimate of profits from the date of the dissolution event to the projected termination of the partnership, taking into account present and future allocations of profits under the partnership agreement that is in effect as of the date of the dissolution event. "Capital" is determined as of the date of the dissolution event. If capital accounts are determined and maintained through the date of the dissolution event in accordance with the capital account rules of Regulation § 1.704-1 (b)(2)(iv), then capital determined as of the date of the dissolution event represents the capital account balances determined on that date.

The Regulations provide that continuity of life does not exist if the occurrence of any of the dissolution events to any member causes dissolution of the organization. In a limited partnership, the occurrence of a dissolution event to a limited partner need not result in a dissolution of the partnership so long as the occurrence of such an event to a general partner causes a dissolution of the partnership. Thus, in an LLC with member-managers, by analogy, it should be possible to limit dissolution to the occurrence of a dissolution event to a member-manager, rather than to all of the members, without having continuity of life.

For advance ruling purposes, Rev. Proc. 95-10 provides:
If the members of the LLC designate or elect one or more members as managers and the controlling statute, or the operating agreement pursuant to the controlling statute, provides that the death, insanity, bankruptcy, retirement, resignation, or expulsion of any member-manager causes a dissolution of the LLC without further action of the members, unless the LLC is continued by the consent of not less than a majority in interest of the remaining members, the Service will generally rule that the LLC lacks continuity of life. For purposes of the preceding sentence all the member-managers must be subject to the specified dissolution events. For example, if the LLC is managed by A, B, and C, it must be provided that a dissolution event with respect to A, B, or C will dissolve the LLC, and not a dissolution event with respect to only one of the named managers (i.e., a dissolution event only with respect to A but not B or C).


For purposes of Rev. Proc. 95-10, "majority in interest" has the same meaning as in Rev. Proc. 94-46. Generally, Rev. Proc. 95-10 requires that the member-managers in the aggregate, during the entire existence of the LLC, must own at least a 1 percent interest in each material item of the LLC's income, gain, loss, deduction, and credit, and must maintain a minimum capital account balance equal to the lesser of 1 percent of total positive capital account balances or $500,000.

If the LLC members do not designate managers and the controlling LLC statute or operating agreement provides that a dissolution event to any member dissolves the LLC without further action of the members, unless the LLC is continued by the consent of not less than a majority in interest of the remaining members, the IRS generally will rule that the LLC lacks continuity of life, provided that all members are subject to the specified dissolution events.

Rev. Proc. 95-10 also provides that if the controlling LLC statute or operating agreement provides that less than all of the dissolution events with respect to the member-managers or members dissolves the LLC, the IRS will not rule that the LLC lacks continuity of life unless it is established in the ruling request "that the event or events selected provide a meaningful possibility of dissolution."

Rev. Proc. 95-10 contains considerably more stringent guidelines for classifying an LLC as a partnership than the classification rules contained in the Regulations. If an LLC satisfies the tests contained in the Regulations, it should be classified as a partnership notwithstanding its failure to meet all the guidelines contained in Rev. Proc. 95-10. Still, careful practitioners will wish to adhere to the Rev. Proc. 95-10 guidelines where this does not undue violence to the business deal of the parties.

The Georgia LLC Act provides that, subject to any contrary provision in the articles of organization or a written operating agreement, a Georgia LLC will be dissolved ninety days after any event of dissociation with respect to a member (other than voluntary withdrawal), unless within such ninety-day period the LLC is continued by the written consent of all the other members or as otherwise provided in the articles of organization or a written operating agreement. An event of dissociation is "an event that causes a person to cease to be a member, as provided in Code Section 14-11-601". Thus, under the default rule, a Georgia LLC will lack continuity of life. This can be varied in the Articles of Organization or a written operating agreement for the LLC. Thus, it is possible for a Georgia LLC to have the attribute of continuity of life.

2. Centralization of Management

An organization has centralized management if any person (or any group of persons that does not include all members) has continuing, exclusive authority to make the management decisions necessary to the conduct of the organization's business, which authority does not require ratification by members of the organization. The Regulations state that the persons who are vested with such management authority resemble the board of directors of a corporation in powers and functions. The Regulations further state that for centralization of management to exist, the managers must have sole authority to make management decisions.

The Regulations provide that limited partnerships subject to a statute corresponding to either the Uniform Limited Partnership Act or the Revised Uniform Limited Partnership Act generally do not have centralized management, but that centralized management exists if limited partners own substantially all of the interests in the partnership. There is no bright-line test to determine when limited partners will be considered to own substantially all of the partnership interests of a limited partnership.

With respect to LLCs, Rev. Proc. 95-10 states that if the controlling LLC statute or operating agreement provides that the LLC is managed by the members exclusively in their membership capacity, the IRS generally will rule that the LLC lacks centralized management. On the other hand, if the members of an LLC designate or elect one or more members as managers of the LLC, the IRS will not rule that the LLC lacks centralized management unless the member-managers own at least 20 percent of the total interests in the LLC. Even if this ownership test is satisfied, the IRS will also consider other relevant facts and circumstances in determining whether the LLC lacks centralized management. Of particular concern to the IRS is the issue of direct or indirect member control of the member-managers. If either the member-managers are subject to periodic elections by the members or, the nonmanaging members have a substantially unrestricted power to remove the member-managers, the IRS will not rule that the LLC lacks centralized management.

For principles of agency law, management of an LLC is vested in the members unless the articles of organization provide that management of the LLC is vested in one or more managers, who need not be members. If a Georgia LLC's Articles do not vest management of the LLC in one or more managers, then
every member is an agent of the limited liability company for the purpose of its business and affairs, and the act of any member, including, but not limited to, the execution in the name of the limited liability company of any instrument for apparently carrying on in the usual way the business and affairs of the limited liability company of which he or she is a member, binds the limited liability company, unless the member so acting has, in fact, no authority to act for the limited liability company in the particular matter, and the person with whom he or she is dealing has knowledge of the fact that the member has no such authority. O.C.G.A. § 14-11-301(a) (1994).


The Georgia statutory presumption is that members of an LLC are like partners in a general partnership: each Member is presumed to have authority with the power to bind the LLC. The Regulations provide with respect to Partnerships that
because of the mutual agency relationship between members of a general partnership subject to a statute corresponding to the Uniform Partnership Act, such a general partnership cannot achieve effective concentration of management powers and, therefore, centralized management. Usually, the act of any partner within the scope of the partnership business binds all the partners; and even if the partners agree among themselves that the powers of management shall be exclusively in a selected few, this agreement will be ineffective as against an outsider who had no notice of it.


Conceptually, this same rationale should extend to LLCs formed under the Georgia LLC act when the articles of organization do not provide that management of the LLC is vested in one or more managers. If an LLC's articles of organization do not vest management in one or more managers, but the LLC's operating agreement provides that one or more members will manage the LLC, this should not necessarily result in centralized management under the Regulations. Caution should be taken in relying on this approach, however, as it appears under Rev. Proc. 95-10 and previously published private ruling that the service's view here may be more functional than technical.

3. Limited Liability

Under the Regulations, an organization has limited liability if, under local law, no member is personally liable for the debts or claims against the organization. Personal liability means that "a creditor of an organization may seek personal satisfaction from a member of the organization to the extent that the assets of such organization are insufficient to satisfy the creditor's claim." The Regulations provide that personal liability exists with respect to each general partner of a general partnership. In the case of an organization formed as a limited partnership, however, personal liability does not exist with respect to a general partner when such general partner does not have substantial assets (other than its interest in the partnership) which can be reached by the partnership's creditors and when the general partner is merely a "dummy" acting as an agent of the limited partners.

Virtually all of the current LLC statutes (including Georgia's) provide that members and managers of an LLC are not liable for the debts or obligations of the LLC, although some states allow an LLC's governing agreement to provide for personal liability. An LLC will thus almost always possess the corporate characteristic of limited liability.

The LLC Act provides that no member, manager, agent, or employee of an LLC will be liable for the debts, obligations, or liabilities of the LLC solely by reason of being a member, manager, agent, or employee of the LLC. In addition, the LLC Act does not provide express authority allowing members to assume personal liability for the obligations of the LLC. Thus, an LLC formed in Georgia should have the corporate characteristic of limited liability.

4. Free Transferability of Interests

For tax classification purposes, an organization has "free transferability of interests" if every member, or those members owning substantially all of the interests in the organization, may, without the consent of the other members, substitute for himself or herself a person who is not a member of the organization. The Regulations state that for this power of substitution to exist in the corporate sense, the member must be able, without the consent of other members, to confer upon a substitute member all of the attributes of the member's interest in the organization. If a member can assign the member's interest in the profits of the organization without the consent of the other members, but needs the consent of the other members to assign the rights to participate in the management of the organization, then free transferability of interest does not exist. If each member can transfer the member's interest to a person who is not a member only after having offered the interest to the other members on a fair market value first refusal basis, the Regulations treat this as modified form of free transferability. Including a right of first refusal in an operating agreement must be carefully considered. If an LLC has limited liability and centralized management, this modified corporate characteristic could tip the scales in favor of the LLC being classified as an association taxable as a corporation. On the other hand, mere economic interests may be subjected to this kind of restriction without incurring substantial risk.

In an LLC with both member-managers and nonmanager-members, it may be possible to provide that nonmanager-members may substitute another person for themselves with the consent of only the member-managers. For example, in PLR 9210019 (Dec. 6, 1991), the interests in a Texas LLC were held to be not freely transferable where nonmanager-members needed only the consent of the sole member-manager to transfer their interests. In addition, the unrestricted right of a member to transfer an interest to a limited class of "permitted transferees" (e.g., family members and affiliated or controlled entities) should not result in free transferability where it would not otherwise exist.

Rev. Proc. 95-10 provides that in manager-managed LLCs, if under the applicable statute or operating agreement members owning more than 20 percent of all interests in the LLC's capital, income, gain, loss, deduction, and credit, cannot confer upon a nonmember all the attributes of the member's interests in the LLC without the consent of not less than a majority of the nontransferring member-managers, the IRS will generally rule that the LLC lacks free transferability of interests. Rev. Proc. 95-10 requires generally that such member-managers in the aggregate, during the LLC's entire existence, must own at least a 1 percent interest in each material item of the LLC's income, gain, loss, deduction, and credit, and must maintain a minimum capital account balance equal to the lesser of 1 percent of total positive capital account balances or $500,000. Thus, a properly constructed LLC would not have free transferability of interests if members owning 21 percent of the LLC's interests were prohibited from transferring their interests without the consent of a majority of the nontransferring member-managers, even though members owning 79 percent of the LLC's interests could transfer all of their rights in their interests without any consent.

If an LLC is member-managed (as opposed to manager-managed), members owning more than 20 percent of all interests in the LLC cannot transfer to a nonmember all the attributes of the member's interests in the LLC without the consent of not less than a majority of the nontransferring members, the IRS will generally rule that the LLC lacks free transferability of interests. Consent of a majority includes either a majority in interest (as described in Rev. Proc. 94-46), a majority of either the capital or profits interests in the LLC, or a per capita majority. The IRS will not rule that an LLC lacks free transferability of interests unless the power to withhold consent constitutes a meaningful restriction on the transfer of the interests. In this regard, Rev. Proc. 95-10 specifically states that a power to withhold consent to a transfer is not a meaningful restriction if the consent may not be unreasonably withheld. Therefore, as a precaution, practitioners should not include such a clause which prevents a member from unreasonably withholding consent to a transfer in an LLC operating agreement.

Under most LLC statutes, including Georgia's, unless otherwise provided in the articles of organization or operating agreement, a member may assign its interest in an LLC to a nonmember without consent of the other members. In such a case, however, the assignee will not acquire all the attributes of the assigning member's interest unless all the remaining members consent to the transfer. Accordingly, though economic participation may be made freely assignable interests in LLCs formed under the LLC Act are not freely transferable unless their articles of organization or operating agreement provide otherwise.

B. One-Member LLCs and Lack of Separate Interests

1. One Member LLC's

Unlike most LLC statutes, Georgia's LLC Act does not expressly require at least two members to form an LLC. Thus, a one-member LLC will be recognized under the Georgia LLC Act. Classification of a one-member LLC will be for federal tax purposes is unsettled, although it appears unlikely that a one-member LLC will be classified as a partnership. The IRS has repeatedly expressed concern and uncertainty about classification of one member LLC's.

Not surprisingly, Rev. Proc. 95-10 states that the IRS will consider a ruling request from an LLC only if the LLC has at least two members. Moreover, if an LLC is issued a favorable ruling under Rev. Proc. 95-10 and the LLC subsequently has only one member, the letter ruling will cease to be effective "because the LLC's status as a partnership for federal tax purposes terminates as of the relevant date specified in § 708 and § 736." One reason a published ruling on the Georgia LLC Act has not been issued by the IRS is because the Georgia LLC Act allows one-member LLCs. Until this issue is resolved, an LLCs should be formed with at least two members.

2. Separate Interests.

Even when an LLC has at least two members, the relationship of those members to each other may affect application of the classification standards. For instance, in Rev. Rul. 77-214, the IRS held that a GmbH owned by two wholly-owned domestic subsidiaries of a U.S. corporation would be classified as an association taxable as a corporation. The IRS concluded that the GmbH possessed the corporate characteristics of free transferability of interests and continuity of life because the theoretical limitations on free transferability and dissolution were in fact illusionary because of the common control of both entities. Thus, because the IRS had already concluded that the GmbH had the corporate characteristics of limited liability and centralization of management, the GmbH was classified as an association taxable as a corporation.

This highly troubling ruling was modified and superseded by Rev. Rul. 93-4, in which the IRS stated that "the presence or absence of separate interests is not relevant to the determination of whether an entity possesses continuity of life." However, the IRS defended the application of the separate interest theory to the characteristic of free transferability, stating that "[t]o lack free transferability, the possibility of an impediment to transfer must exist. Because all the members of the GmbH are commonly controlled, consent to transfer is not meaningful, and Rev. Rul. 77-214's conclusion on free transferability of interests is reaffirmed." Interestingly, the ruling goes on to state that if the memorandum of association in Rev. Rul. 77-214 had either completely prohibited transfers or provided that the transfer of an interest would cause the dissolution of the GmbH, the GmbH would have lacked free transferability of interests. Thus, in these types of situations it is wise to prohibit transfers absolutely and to make attempted transfers in event of dissolution.

C. Conversion Of Existing Entities

The advantages of operating in LLC form will cause the members of many existing entities to consider converting into LLCs. The LLC Act provides a fairly simple procedure whereby partnerships and corporations can so convert by filing a certificate of election with the Secretary of State. In addition, under the current Georgia Act, a partnership or corporation can merge into an LLC with the LLC as the survivor. However, there are serious tax issues attendant to such conversions and mergers. The issue is particularly acute for corporations.

1. Conversion of a Partnership into an LLC

Because an LLC is treated as a partnership for federal income tax purposes, the tax rules that govern conversion of a general partnership into a limited partnership (and vice versa) should also govern when an existing partnership converts or merges into an LLC. In Rev. Rul. 84-52, the IRS ruled that the conversion of a general partnership into a limited partnership would be viewed as a contribution by the partners of their general partnership interests to the limited partnership in exchange for interests in the limited partnership. This deemed contribution would not result in gain recognition to a contributing partner under Code § 721, except to the extent such exchange results in a deemed distribution from the partnership in excess of the partner's basis in his or her partnership interest. The IRS also ruled that the conversion would not be treated as a termination of the existing partnership for tax purposes, and that there would be no change in the holding period for any partnership interest in the partnership.

In several private letter rulings the IRS applied Rev. Rul. 84-52 to the conversion of a partnerships into an LLC. Then, in Rev. Rul. 95-37, the IRS issued a published ruling holding that the federal income tax consequences described in Rev. Rul. 84-52 apply to the conversion of a domestic partnership into a domestic LLC, regardless of the manner in which the conversion is achieved under state law. In addition, the ruling specifically states that the resulting LLC will not need to obtain a new taxpayer identification number.

Remember that if a limited partnership with substantial recourse liabilities converts to an LLC, the general partners may have gain recognition. Under Code § 752 (b) a reduction in a partner's share of the partnership's liabilities is treated as a distribution of cash to the partner. If the distribution is larger than the partner's tax basis in his or her partnership interest, then such excess will be taxable under Code § 731. Prior to conversion, the general partners of a limited partnership generally will be allocated all the recourse debt. If such debt becomes nonrecourse as a result of the conversion, the general partners will be allocated only a pro rata portion of such debt. If the reduction in a general partner's share of such liabilities exceeds his or her tax basis, taxable income will result.

One way to ameliorate this result is for general partners to agree to continue to be personally liable for the limited partnership's debt after its assumption by the LLC. This may not always be necessary, however, since under state law a general partner usually will not be relieved of liability for prior acts or debts of the limited partnership upon its conversion.

2. Conversion of a Corporation into an LLC

The conversion of an existing corporation into a Georgia LLC may be accomplished by a variety of techniques. If it is a corporation, it can be merged into an LLC. Alternatively, the corporation's assets could be contributed to the LLC in return for membership interests which would then be distributed to the shareholders in complete liquidation of the corporation or the corporation could distribute its assets in complete liquidation, and the shareholders could then contribute their undivided interests in the assets to the LLC in exchange for membership interests in the LLC or the corporation elect LLC status under O.C.G.A. § 14-11-212. Because the corporate reorganization provisions of Code § 368 apply only where all of the parties to the reorganization are corporations, the merger of a corporation into an LLC will not be tax-free. Such a merger will be recharacterized as a complete liquidation of the merged corporation.

When a corporation completely liquidates, IRC § 336 provides that the corporation will be required to recognize gain or loss as if its assets were sold at their fair market value. The provisions of Code § 336 apply to S corporations as well as C corporations. A corporation merging or converting into an LLC may thus recognize significant income when the corporation owns appreciated assets. Thus, there will only be one level of tax in such a situation. However, the conversion will trigger immediate tax on any such gain.

In addition, each shareholder of a corporation that merges or converts into an LLC will be required to recognize gain on the distribution (or deemed distribution) to such shareholder to the extent that the fair market value of the property received exceeds the shareholder's basis in the stock surrendered. With an S corporation, the gain recognized by the corporation (net of any tax paid on built-in gain recognized in the liquidation) will increase the shareholder's basis in his or her stock, so that the gain will not be recognized again on the exchange of stock for property pursuant to the liquidation.

As a practical matter, the tax costs of merging or converting a corporation with appreciated assets into an LLC will often be so high that it will prevent such merger or conversion.

D. Election To Be Treated As A Partnership

The IRS and the Treasury Department announced in Notice 95-14 that they are considering simplifying the classification Regulations to allow taxpayers to treat domestic unincorporated business organizations as partnerships or as corporations on an elective basis. The Treasury has continued to restate its intentions to pursue this goal although these rules have as of this writing still not been finalized.

The existing classification regulations are based on the historical differences under local law between partnerships and corporations. Many states have revised their statutes to a degree that partnerships and other unincorporated organizations may possess characteristics that have traditionally been associated with corporations, thereby narrowing considerably the traditional distinctions between corporations and partnerships. For example, some partnership statutes such as Georgia's LLP legislation have been modified to provide that no partner is liable for all of the debts of partnership which has made an LLP election. Similarly, almost all states have enacted statutes allowing the formation of limited liability companies. These entities are designed to provide liability protection to all members and to otherwise resemble corporations, while generally qualifying as partnerships for federal tax purposes. See, e.g., Rev. Rul. 88-76, 1988-2 C.B. 360.

One consequence of the narrowing of the differences between corporations and partnerships is that taxpayers can achieve partnership tax classification for a non-publicly traded organization that is virtually indistinguishable from a corporation. Taxpayers and the Service, however, continue to expend considerable resources in the tax classification of domestic unincorporated business organizations. In addition, small unincorporated organizations may not have sufficient resources and expertise to apply the current classification regulations to achieve the tax classification they desire.

Under the approach proposed by the IRS, taxpayers would be able to elect to have unincorporated business organizations treated as partnerships or as corporations for federal tax purposes. This election would apply to all such organizations that have two or more members and an objective to carry on business and divide the gains, unless the organization's classification is determined under another Code provision. For example, an organization that is treated as a partnership, but which is publicly traded and taxed as a corporation under IRC § 7704, would continue to be taxed as a corporation. All affirmative elections would be prospective from the date the election is filed or a later date designated in the election, and retroactive elections would not be permitted. The election would have to be executed by all members of the organization and would be binding on all members thereafter, until superseded by a subsequent election.

Notice 95-14 states that an election to change the classification of an organization would have the same federal tax consequences as a change in classification under current law. For example, if an organization classified as a corporation elected to be classified as a partnership, the election would be treated as a complete liquidation of the corporation and the formation of a new partnership. As discussed above, this could result in significant tax liability to the corporation and its shareholders.

If a newly formed organization does not make an affirmative classification election, the default classification generally would be for the organization to be treated as a partnership. This would not apply to organizations that are in existence on or before the effective date of the revised Regulations, which organizations would retain their current classification unless an affirmative election to be classified differently is filed.

Notice 95-14 also states that the IRS and Treasury are considering simplifying the classification rules for foreign organizations in a manner consistent with the approach described for domestic organizations, but notes that a number of special considerations that arise in the foreign area must be taken into consideration.

While the simplified approach described in Notice 95-14 might not be seen as a good development for most tax practitioners, businesses will find this to be a welcome improvement to the classification Regulations.

E. Federal Income Taxation Of LLC Members

1. Overview

If an LLC is treated as a partnership for federal income tax purposes, the entity itself will not be subject to federal income tax. Instead, each member will be taxed on the member's allocable share of the LLC's taxable income. Generally, the character of an item of income or loss will be the same for a member as it is for the LLC. Each member of an LLC must take into account the member's distributive share of an LLC's income and loss as determined by the LLC's operating agreement, unless the operating agreement does not provide for such allocations or such allocations under the operating agreement do not have "substantial economic effect," in which case such member's distributive share will be determined in accordance with the member's interest in the LLC. In addition, income, gain, loss, and deductions with respect to contributed property must be allocated among the members to take account of any difference between the tax basis of the property and its fair market value at the time of contribution. A member will be entitled to deduct its share of an LLC's tax losses to the extent of the tax basis in its LLC interest. Any loss in excess of such tax basis may be carried over indefinitely and deducted, subject to various limitations (e.g., passive activity and at-risk rules), in any subsequent year in which the tax basis in such member's LLC interest is increased above zero.

Generally, no gain or loss is recognized to either the contributing member or the LLC on a member's contribution of property to the LLC. Similarly, no gain or loss is generally recognized by the LLC or the distributee member on the distribution of property to such member, except to the extent that any money distributed exceeds the tax basis of such member's LLC interest immediately before the distribution. On a sale of an LLC interest, the selling member will recognize gain or loss based on the difference between the amount realized and the member's tax basis in its interest.

2. Tax Basis in LLC Interest

In general, the initial tax basis of a member who acquires an LLC interest from the LLC will be equal to the amount of money and the tax basis of any property that the member contributes to the LLC in exchange for such interest. The tax basis thus determined will be increased by such member's share of the LLC's liabilities, by its share of the LLC's income, and by any subsequent capital contributions. The member's tax basis will be reduced (but not below zero) by the member's share of LLC distributions and losses and also by any decrease in such member's share of the LLC's liabilities.

IRC § 752 embodies the statutory rules for sharing LLC liabilities. That Section provides that any increase in a partner's share of a partnership's liabilities, or any increase in a partner's individual liabilities by reason of assuming a partnership's liabilities, will be considered a contribution of money by such partner to the partnership. Conversely, any decrease in a partner's share of a partnership's liabilities, or any decrease in a partner's individual liabilities by reason of a partnership assuming such liabilities, will be considered a distribution of money to the partner by the partnership. Unfortunately, the statute does not provide for the manner in which a partner's share of liabilities will be determined. Instead, one must look to the Regulations.

The § 752 Regulations treat all liabilities as either recourse or nonrecourse. A partnership liability is a recourse liability to the extent that any partner (or a person related to that partner) bears the economic risk of loss for that liability. A partner's share of a recourse partnership liability equals the portion of that liability, if any, for which that partner or a related person bears the economic risk of loss with respect to such liability. Basically, a partner is treated as bearing the economic risk of loss for a partnership liability to the extent that the partner or related person would be obligated to make a contribution or payment with respect to a partnership liability (and would not be entitled to be reimbursed for the contribution or payment by another partner, a person related to another partner, or the partnership), if the partnership constructively liquidated. The following events are deemed to occur in a constructive liquidation: (1) all of the partnership's liabilities become due and payable in full; (2) with the exception of property contributed to secure a partnership liability, all of the partnership's assets (including money) become worthless and have a value of zero; (3) the partnership disposes of all of its assets in a fully taxable transaction for no consideration (other than relief from liabilities for which the creditor's right to repayment is limited solely to one or more assets of the partnership); (4) all items of income, gain, loss, and deduction for the year are allocated among the partners; and (5) the partnership completely liquidates.

A partnership liability is a nonrecourse liability to the extent that no partner or related person bears the economic risk of loss for that liability. A partner's share of the nonrecourse liabilities of a partnership equals the sum of the amounts determined under the following three tiers: first, the partner's share of "partnership minimum gain" determined pursuant to Code § 704 (b) and the Regulations thereunder; second, the amount of any taxable gain that would be allocated to such partner under Code § 704 (c) principles if the partnership disposed of all partnership property subject to one or more partnership nonrecourse liabilities in full satisfaction of such liabilities and for no other consideration; and third, such partner's share of any partnership nonrecourse liabilities in excess of those allocated pursuant to the first two tiers, as determined in accordance with such partner's share of partnership profits taking into account all facts and circumstances relating to the economic arrangement of the partners.

3. Capital Accounts and Their Role in LLC Taxation

The partnership agreement may specify the partners' interests in profits for purposes of allocating excess nonrecourse liabilities, provided the interests so specified are reasonably consistent with valid allocations under the § 704 (b) Regulations of some other significant item of partnership income or gain. The Regulations also provide an alternative under which excess nonrecourse liabilities may be allocated among the partners in accordance with the manner in which it is reasonably expected that the deductions attributable to those nonrecourse liabilities will be allocated. Excess nonrecourse liabilities are not required to be allocated under the same method each year.

It is important to recognize that a member's interest in an LLC is separate and distinct from the member's capital account. A capital account is basically a measure of a member's equity in an LLC. Computation of the capital account begins with the amount of money and the fair market value (not the tax basis) of other property contributed by such member to the LLC (net of liabilities secured by such contributed property that the LLC is considered to assume or take subject to under IRC § 752), and is increased by the member's share of the LLC's income and gain. The member's capital account is decreased by the amount of money and the fair market value of property (again, not the tax basis) distributed to such member (net of liabilities secured by such distributed property that such member is considered to assume or take subject to under Code § 752), and such member's share of the LLC's losses, deductions, and nondeductible expenditures.

A member's capital account does not reflect such member's share of the LLC's liabilities except to the extent that such liabilities are actually assumed by the member and the creditor is aware of such assumption and can directly enforce the member's obligation. Thus, while there will be an increase in the member's tax basis in its LLC interest for the increase in the member's share of the LLC's liabilities, generally there will be no corresponding increase in the member's capital account.

The Regulations also permit an adjustment to the members' capital accounts to reflect the revaluation of LLC property on the LLC's books, provided that the adjustments are made principally for a substantial nontax business purpose either (1) in connection with a contribution or distribution of money or other property (other than a de minimis amount) as consideration for the acquisition or relinquishment of an interest in the LLC; (2) under generally accepted industry accounting practices, provided that substantially all of the LLC's property (excluding money) consists of stock, securities, commodities, options, warrants, futures, or similar instruments that are readily tradable on an established securities market; or (3) in connection with a liquidation of the LLC. Such adjustments must be based on the fair market value of LLC property on the date of adjustment and must reflect the manner in which the unrealized income, gain, loss, or deduction inherent in such property (that has not been previously reflected in the capital accounts) would be allocated among the members if there were a taxable disposition of such property for such fair market value on that date. The members' capital accounts must be subsequently adjusted for book depreciation, depletion, amortization, and gain or loss with respect to the booked-up value of the property. The members' distributive shares of tax depreciation, depletion, amortization, and gain or loss with respect to the property must also be determined to take into account the resulting book/tax disparity according to the rules of Code § 704(c). Generally, under IRC § 704(c), certain tax allocations must be made to the contributing member with respect to the difference between the book value (fair market value) of contributed property and its tax basis, so that the difference between tax basis and book value at the time of contribution is ultimately recognized by the contributing member.

4. Allocation of Profits and Losses

Each member of an LLC must take into account the member's distributive share of all items of the LLC's income, gain, loss, deduction, and credit for federal income tax purposes. In general, an LLC's operating agreement determines a member's distributive share of these items, unless the agreement does not provide for such allocations or such allocations under the agreement do not have "substantial economic effect," in which case such member's distributive share of these items will be determined in accordance with its interest in the LLC, taking into account all facts and circumstances. If the operating agreement provides for the allocation of such items to a member, the Regulations state that there are three ways in which such allocation will be respected under IRC § 704 (b) and the Regulations thereunder: the allocation can have substantial economic effect; the allocation can be in accordance with the member's interest in the LLC, taking into account all facts and circumstances; or, the allocation can be deemed to be in accordance with the member's interest in the LLC.

5. Substantial Economic Effect

The determination of whether an allocation to a member has substantial economic effect is a two-part analysis: first, the allocation must have economic effect, and second, the economic effect must be substantial. In order for an allocation to have economic effect, it must be consistent with the underlying economic arrangement of the members -- if there is an economic benefit or burden that corresponds to an allocation, the member to whom the allocation is made must receive such economic benefit or bear such economic burden.

Generally under the Regulations, an allocation will have economic effect if, and only if, throughout the full term of the LLC, the operating agreement provides that (1) the members' capital accounts will be maintained in accordance with the Regulations; (2) positive capital account balances will determine the distribution of an LLC's assets in liquidation of the LLC (or any member's interest in the LLC); and (3) each member will be required to restore any deficit in his or her capital account that remains after the distribution of liquidation proceeds, and such amount will be paid to creditors of the LLC or distributed to other members in accordance with their positive capital account balances. If the first two requirements are met but the member to whom an allocation is made is not required to restore a deficit balance in its capital account, such allocation will be considered to have economic effect to the extent such allocation does not cause or increase a deficit balance in such member's capital account (in excess of any limited amount of such deficit that such member is obligated or deemed to be obligated to restore), provided there is a "qualified income offset" provision in the operating agreement. Such an allocation will be considered to have economic effect under what the Regulations refer to as the alternate test for economic effect. A qualified income offset is a provision that requires a member who unexpectedly receives an adjustment, allocation, or distribution described in the Regulations that causes or increases a deficit balance in such member's capital account (in excess of any limited amount of such deficit that such member is obligated or deemed to be obligated to restore), to be allocated income and gain in an amount and manner sufficient to eliminate such deficit balance as quickly as possible. Because most LLCs will not require any of their members to restore negative capital account balances, an operating agreement will need to include a qualified income offset provision.

The Regulations provide that, in general, the economic effect of an allocation will be "substantial" if there is a reasonable possibility that the allocation will substantially affect the dollar amounts that the partners will receive, independent of tax consequences. If an allocation has economic effect, but the economic effect is not substantial, such allocation must be based on the members' interests in the LLC.

The Regulations contain a safe harbor test in regard to losses and deductions attributable to nonrecourse debt secured by partnership property ("nonrecourse deductions"). Allocations of nonrecourse deductions cannot have substantial economic effect because the creditor alone bears any economic loss attributable to those deductions. Thus, nonrecourse deductions must be allocated in accordance with the members' interests in the LLC. The Regulations provide that allocations of nonrecourse deductions will be deemed to be made in accordance with the members' interests in the LLC so long as the following four requirements are met: (1) Capital accounts are properly maintained in accordance with the § 704 (b) Regulations, liquidating distributions are required to be made in accordance with positive capital account balances, and members with deficit capital account balances have a deficit restoration obligation or the operating agreement contains a qualified income offset; (2) the operating agreement provides for allocation of nonrecourse deductions in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant LLC item attributable to the property securing the nonrecourse debt; (3) the operating agreement contains a "minimum gain chargeback"; and (4) all other material LLC allocations and capital account adjustments under the operating agreement are recognized under the § 704 (b) Regulations. Allocations of nonrecourse deductions not qualifying under this safe harbor must be made in accordance with the members' overall economic interests in the LLC, as determined under the Regulations.

The 704(c) regulations are extraordinarily complex and must be studied carefully in many situations.

6. At-Risk Rules

IRC § 465 provides that in the case of individuals and certain closely held C corporations, a loss from certain activities is allowable only to the extent the taxpayer is at-risk for such activity at the close of the taxable year. The at-risk rules apply to all activities engaged in by a taxpayer in carrying on a trade or business or for the production of income.

A taxpayer is at-risk with respect to an activity to the extent of (1) the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity, plus (2) amounts borrowed for use in the activity to the extent the taxpayer is personally liable for the repayment of such amounts, or has pledged property, other than property used in such activity, as security for the debt (to the extent of the net fair market value of the taxpayer's interest in such pledged property). In addition, a taxpayer is considered at-risk with respect to the taxpayer's share of any "qualified nonrecourse financing" that is secured by real property used in the activity. Qualified nonrecourse financing is any financing (1) that is borrowed by the taxpayer from a qualified person (i.e., generally an unrelated entity actively engaged in the business of lending money), or that represents a loan from any federal, state, or local government or instrumentality thereof (or is guaranteed by any federal, state, or local government or instrumentality thereof), with respect to the activity of holding real property; (2) with respect to which no person is personally liable for repayment; and (3) which is not convertible debt. A member's share of any qualified nonrecourse financing is determined on the basis of that member's share of LLC liabilities incurred in connection with such financing, within the meaning of Code § 752.

If an LLC is engaged in an activity that is subject to the at-risk rules, the at-risk limitation is applied at the member level, not at the LLC level. Thus, some members may be subject to the at-risk rules while others are not. Each member is required to determine the amount he or she has at-risk in the LLC at the end of each taxable year. Generally, a member will be at-risk for the amount of money and the tax basis of other property contributed to the LLC by such member, plus amounts borrowed by the LLC for which such member is either personally liable for the repayment thereof or has pledged property (other than its LLC interest or assets owned by the LLC) as security for the loan, to the extent of the fair market value of such pledged property. In addition, if a member is contractually obligated to make additional contributions to the LLC, such member may be entitled to increase its at-risk amount by a portion of the LLC's liabilities, provided they are the types of liabilities that would increase the members at-risk amount if he or she were a general partner in a partnership. A member's share of LLC profits will increase its amount at-risk .

If a member's share of the LLC's loss for a taxable year is less than the amount it has at-risk at the end of such year, the deduction for such loss is not limited by Code § 465. However, the member must then reduce the amount considered at-risk by the amount of the loss that has been deducted, and the reduced at-risk amount is carried over to the next taxable year.

If a member's share of an LLC's loss for a taxable year is greater than the amount at-risk, the deduction in that year is limited to the amount at-risk at the end of the year, and the amount at-risk is reduced to zero. The member's share of the LLC's loss that is not allowable as a deduction by reason of Code § 465 in any taxable year may be carried over and deducted in succeeding taxable years to the extent its at-risk basis has increased above zero.

When a member's at-risk basis is reduced below zero at the end of any taxable year (for example, by distributions to such member), the member will recognize income to the extent the at-risk basis is reduced below zero. This recapture income, however, is limited to the excess of the losses previously allowed to such member over any amounts previously recaptured, and will be treated as a deduction allocable to the activity for the first succeeding taxable year.

It is important to note that the at-risk limitation does not affect the tax basis of a member's interest or the amount of gain or loss realized by a member; it merely limits the amount of loss that may be deducted by a member in a particular year.

7. Passive Activity Rules

Individuals, estates, trusts, closely held C corporations, and personal service corporations are subject to the passive activity rules of IRC § 469, which generally prohibit those taxpayers from using losses from passive activities to offset nonpassive income. A passive activity loss is the amount by which a taxpayer's passive activity deductions for the taxable year exceed his or her passive activity gross income for the year. A passive activity generally is (1) any activity that involves the conduct of a trade or business and in which the taxpayer does not materially participate, and (2) any rental activity, regardless of the extent to which the taxpayer participates, except for interests in rental real estate owned by certain real estate operators. In addition, an individual who "actively" participates in a rental real estate activity of which he or she owns at least a 10 percent interest may use up to $25,000 of passive losses per year to offset nonpassive income; however, this amount is reduced by 50 percent of the taxpayer's adjusted gross income in excess of $100,000.

In applying the passive loss rules, a taxpayer's income and losses are separated into three categories or baskets: (1) passive income; (2) portfolio income (e.g., interest, dividends, and certain royalties); and (3) active income (e.g., salary and wages). Losses from passive activities are allowed to the extent of the taxpayer's passive income, and they cannot be used to offset either portfolio income or active income. Credits arising with respect to passive activities may be used to offset tax attributable to net passive income. Disallowed passive losses and credits are carried over and used to offset future passive income and tax attributable thereto. Upon the fully taxable disposition of the taxpayer's entire interest in a passive activity, all suspended losses (but not credits) attributable to that activity can be used without regard to the passive loss limitation.

"Material participation" in an activity is defined as active involvement in the operations of the activity on a regular, continuous and substantial basis. Generally, an individual is treated as materially participating in an activity for a taxable year if he or she meets one of the following seven tests:
  1. the individual participates in the activity for more than 500 hours during such year;
  2. the individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals for such year;
  3. the individual participates in the activity for more than 100 hours during the taxable year, and that participation is not less than that of any other individual for such year;
  4. the activity is a significant participation activity for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;
  5. the individual materially participated in the activity for any five taxable years during the ten immediately preceding taxable years;
  6. the activity is a personal service activity, and the individual materially participated for any three preceding taxable years; or
  7. based on all the facts and circumstances, the individual participates on a regular, continuous and substantial basis during such taxable year.


A limited partner will not be treated as materially participating in the activities of a limited partnership unless specifically permitted by the Regulations. The IRS has issued temporary Regulations which provide that a limited partner will be deemed to materially participate by qualifying under tests (1), (5), or (6) above. Thus, a limited partner either must participate for more than 500 hours or must have materially participated during five of the last ten years or, if the activity is a personal service activity, any three preceding years. By contrast, an S corporation shareholder will be deemed to materially participate by satisfying any of the seven tests.

The determination of whether an activity will be a passive activity is a complex and relatively uncharted area. For a discussion of these complexities see Bryant, Jones & Beaudrot, Georgia LLC/LLP Handbook ppgs. 128 to 132.

8. Accounting Methods

Under Code § 446 (c), a taxpayer generally may use either the cash method or the accrual method of accounting. Code § 448 (a), however, precludes a "tax shelter" from using the cash method of accounting. A tax shelter is any of the following entities: (1) any enterprise" (other than a C corporation), if at any time interests in such enterprise have been offered for sale in any offering required to be registered with any federal or state agency having the authority to regulate the offering of securities for sale; (2) any "tax shelter" as defined in Code § 6662 (d)(2)(C)(ii); and (3) any "syndicate" within the meaning of Code § 1256 (e)(3)(B). Although not apparent on first blush, this statute can be read as applying to many LLC's.

The IRS has issued several private letter rulings dealing with this issue. In Priv. Ltr. Rul. 9321047 (Feb. 25, 1993), a cash-method law firm operating as a general partnership decided to convert into an LLC. First, the IRS found that the LLC was not an "enterprise" so long as it did not offer interests in itself for sale in an offering required to be registered, which the law firm represented it had never done and would never do. The IRS also found that the LLC was not a "syndicate," noting that this issue depends on how the LLC's members are classified and how its losses are allocated. The IRS found that the members of the LLC were not limited entrepreneurs, based on the law firm's representations that all of the members of the LLC would continue to engage in the practice of law and that all of the members would be required to vote in order for the LLC to take certain actions. Subsequent private letter rulings have included similar representations. Although not discussed, the IRS apparently did not view members of the LLC as being limited partners simply because they would have limited liability.

Finally, the IRS found that the LLC was not a "tax shelter" within the meaning of Code § 6662 (d)(2)(C)(ii), based on the law firm's representations that the partners would participate in the management of the LLC, that the LLC would be organized to engage in the practice of law, and that the LLC would not be organized for any federal income tax avoidance motive. Thus, the IRS ruled that the law firm could retain the cash method of accounting after it converted to an LLC.

In Priv. Ltr. Rul. 9415005 (Jan. 10, 1994), the IRS also allowed a law firm converting into an LLC to retain the cash method of accounting, but did not base the ruling on the members' active participation in firm management activities. The IRS found that for purposes of Code § 461 (i)(3)(A), the law firm would not be an enterprise so long as it did not offer interests in itself for sale in any offering required to be registered. The IRS also found that the LLC would not be a syndicate, although no representations were included in the ruling concerning management or the active participation of members; however, based on representations that the firm consistently reported taxable income rather than a loss, the IRS ruled that the LLC would not be a syndicate for any year in which it does not incur losses. The IRS declined to determine whether the LLC would be a tax shelter as defined in Code § 6662 (d)(2)(C)(ii), but did find that the LLC would not be treated as a tax shelter under that Code Section solely as a consequence of its organizational structure as an LLC.

9. Self-Employment Tax

In computing net earnings from self-employment, the distributive share of any item of income or loss of a limited partner (other than guaranteed payments) is excluded. This exclusion was added because of the concern that investors might use limited partnerships as a means to become insured for Social Security benefits, undermining the basic principle of the Social Security program that benefits are designed to partially replace lost earnings from work. Thus, if all LLC members are treated as limited partners, regardless of participation in the business, all of the LLC's income or loss would be excluded from self-employment tax.

On December 28, 1994, the IRS issued proposed Regulations which provide generally that a member's net earnings from self-employment include the member's distributive share (whether or not distributed) of income or loss from any trade or business carried on by an LLC. However, a member of an LLC is treated as a limited partner for purposes of the exclusion in Code § 1402 (a)(13) if (1) the member is not a manager of the LLC, (2) the entity could have been formed as a limited partnership rather than an LLC in the same jurisdiction, and (3) the member could have qualified as a limited partner in that limited partnership under applicable law. If there are no designated or elected managers of the LLC who have continuing exclusive authority to manage the LLC, then all of the members will be treated as managers, even if some members have greater management authority than others.

State Tax Considerations

An area of increasing importance for planning in the use of LLC's is state tax characterization. Although most states treat LLC's for state tax purposes the same as for federal purposes, there are notable exceptions. For example, Florida subjects LLC's to its Florida corporate tax while Texas applies its corporate franchise tax to LLC's. Similarly, as number of states now impose entity level withholding on distributions to non-resident owners of LLCs, see, e.g. O.C.G.A. § 48-7-129.

11. Tax Considerations for LLPs

As discussed in Chapter One of Part Two, an LLP is a general partnership that records a limited liability partnership election. The principal difference between a Georgia general partnership that is an LLP and one that is not, is that a partner in a LLP is liable only for such partner's own errors, omissions, negligence, malpractice, wrongful acts, incompetence or misconduct. A Georgia LLP will lack continuity of life because it will be dissolved "[b]y the express will or withdrawal of any partner . . .", and this cannot be varied by agreement. A Georgia LLP should also lack centralized management. In most situations a general partnership will also lack free transferability of interests, although this can be modified by agreement. A Georgia LLP would appear to possess a modified form of the corporate characteristic of limited liability since each partner is liable for his or her own errors, omissions, negligence, malpractice, wrongful acts, incompetence and misconduct. The IRS takes the position that this will not be enough for the partnership to lack limited liability. Thus, a Georgia LLP should always be classified as a partnership for federal tax purposes.

12. Other Tax Issues

Most of the partnership tax rules discussed above will apply to LLPs in the same manner that they apply to LLCs, with the possible exceptions of the passive activity rules and self-employment tax. Concerning the passive activity rules, while an LLC interest arguably would be limited partnership, interest for purposes of the material participation test, because the liability of a partner in a Georgia LLP is not limited to a determinable fixed amount, there is a substantial argument to the contrary.

With respect to self-employment tax, Code § 1402(a) provides that "net earnings from self-employment" include an individual's "distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member. . . ." Code § 1402(a)(13) excludes from the definition of net earnings from self-employment the distributive share of any item of income or loss of a limited partner, other than guaranteed payments under Code § 707(c). Thus, a limited partner will not be subject to self-employment tax.

Under the proposed Regulations, it appears that a partner in a Georgia LLP could be considered to be a limited partner for purposes of the self-employment tax. The proposed Regulations provide that a member of an LLC will be treated as a limited partner if the three tests contained therein are met. A member is any person who owns an interest in an LLC, and an LLC is defined as an organization formed under a law that allows limitation of the liability of all members for the organization's debts and other obligations within the meaning of Regulation § 301.7701-2(d), and is classified as a partnership for federal tax purposes. As discussed in Chapter Three of this Part, it appears that the IRS's position is that an LLP will have limited liability under Regulation § 301.7701-2(d). Thus, if an LLP is treated as a partnership for federal tax purposes (which it should be), and a partner meets the three tests contained in the proposed Regulations, it is possible that partners will be treated as a limited partner for self-employment tax purposes.
 

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