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Working with Limited Liability Companies and
Limited Liability Partnerships


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

I. 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, 47 states and the District of Columbia have enacted LLC legislation which varies widely from state to state. The three states which have not passed LLC legislation are Vermont, Massachusetts and Hawaii, though bills are currently pending in Hawaii and Massachusetts. 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.


II. 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.


    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.


  3. 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.


  4. Relative Simplicity. LLCs are simpler to organize than traditional limited partnerships, particularly those with corporate general partners.


III. 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.


IV. Federal Income Tax Classification.

  1. Classification as a Partnership. In order to be taxed as a partnership (i.e., one level of tax) under the applicable regulations (Treas. Reg. §301.7701-2(a)(1)-(3)), an entity cannot have more than two of the four corporate characteristics of (i) limited liability, (ii) continuity of life, (iii) centralization of management, and (iv) free transferability of interest.

    Since an LLC will always have limited liability, an LLC must therefore lack at least two of the remaining three characteristics.

    1. Continuity of Life. Dissolution can be statutorily mandated on the death, withdrawal or consent of a member. Most statutes provide for reinstatement or continuation upon the consent of the members, however. A requirement of majority consent is sufficient to create such restriction.
    2. Centralization of Management. Generally, centralization of management can be avoided by permitting all members to participate in management.
    3. Free Transferability of Interest. This can be avoided statutorily or by agreement restricting transfer of management rights (as opposed to financial rights) unless the LLC members consent to such transfer.


  2. Two or More Members. Because of the rule a partnership must have at least two partners, it would appear an LLC must always have two members or owners to secure partnership status. See Treas. Reg. §1.708-1(b)(1)(i). Recent comments from the IRS suggest that this rule is not absolutely certain.


  3. IRS Authority.

    1. Published Ruling and Policies. Rev. Rul. 88-76, 1988-2 C.B. 360, addressed the classification of an LLC created under the Wyoming statute (the first state to create LLCs) for tax purposes. The ruling holds that a Wyoming LLC statutorily lacks continuity of life and free transferability of interest, and, hence, qualifies as a partnership for tax purposes, under the classification regulations. The IRS has subsequently issued a number of published rulings and particularly important, a Revenue Procedure articulating the Service's position on a number of key issues. Rev. Proc. 95-10, IRB 1995-3 (January 17 1995)
    2. No Automatic Qualification. Although the IRS has demonstrated that it is willing to treat an LLC as a partnership, LLCs must independently demonstrate that they lack at least 2 of the relevant corporate characteristics, either by statute or by operation of the applicable agreement.


V. Major Tax Features.

  1. Partnership Rules Apply. As a partnership for federal tax purposes, an LLC is taxable as a partnership under normal partnership tax rules. It files a Form 1065.


  2. Taxable as Partnership for Georgia Tax Purposes. Because definitions of Georgia taxable income follow federal income for tax purposes, an LLC will be taxable as a partnership in Georgia. See, O.C.G.A. §48-7-27 and §48-7-24. The Georgia LLC statute which is effective March 1, 1994 provides for this result explicitly.


  3. Non-Recognition on Formation. In general, there is no gain or loss on formation of an LLC by contribution of cash or property under I.R.C. §721. Contributions of services can result in ordinary income to the contributor unless the interest received is a profits interest only.


  4. Allocation of Profits and Losses. LLC members are allocated tax profits and tax losses in accordance with the terms of the agreement and subject to the normal tax rules. In the absence of agreement, the general rules of I.R.C. §704 and the regulations thereunder apply.


  5. Allocation of Liabilities and Basis. Since liabilities of an LLC are generally nonrecourse for tax purposes, the I.R.C. §§704 and 752 rules and the accompanying regulations governing liability allocations and basis apply.


  6. Passive Activity and "At Risk" Rules. The passive activity loss limitations applicable to partnerships generally would apply to LLCs. Similarly, the I.R.C. §465 "at risk" rules apply.


  7. TEFRA Rules. LLCs with at least 10 members are subject to the unified audit procedure and must have "tax matters" partners in accordance with the TEFRA rules.


VI. Status of LLCs in Georgia.

  1. Foreign Qualification Statute. Georgia enacted in 1992 a qualification statute requiring foreign LLCs to qualify to do business and recognizing that liability will be governed by the law of the organizing state.


  2. Comprehensive Legislation. A comprehensive statute providing for the creation of Georgia LLCs was prepared by a drafting committee composed of members of the Tax Section and the Business and Finance Section of the Atlanta Bar. This project was adopted and endorsed by the Corporate and Banking Law Section of the State Bar and was an official State Bar bill in the 1993 session sponsored by Representatives Thurbert Baker and Terry Coleman. The Bill, after relatively minor modifications, passed and was signed into law by Governor Miller with an effective date of March 1, 1994. The Georgia Limited Liability Company Act appears at O.C.G.A. § 14-11-100 et seq.


VII. Who Will Use LLCs?

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. Closely held investment and hedge funds.
  5. Start-up entities with venture capital financing.
  6. Closely held family businesses that need flexibility in operation.
  7. Professional firms.


VIII. What Are Limited Liability Partnerships?

  1. Status in Georgia. Limited liability partnerships are general partnerships which have elected the status of a limited liability partnership. Georgia currently recognizes and registers foreign LLPs. O.C.G.A. § 14-8-44 et seq.

    The general rule is that partners in a general partnership are liable, to the full extent of the partner's personal assets, for acts or omissions of the other partners. An LLP reverses this fundamental characteristic. Under the Georgia LLP amendments, which will become effective July 1, 1995, a partner is not liable for any obligation of the partnership or another partner that was incurred, created or assumed while the partnership is a Georgia LLP.


  2. Differences from Other States. To date, although some 18 states have passed LLP legislation, other than Georgia, only Minnesota (and New York as to professionals) has a statute which limits the partners from liability for both tort and contract. In most states, only tort liabilities are covered.


  3. Election to Become LLP. Under the Georgia amendments creating Georgia LLPs (a copy of which is attached) the election to become a limited liability partnership is about as simple as possible. It requires a simple filing with the office of the superior court. Perhaps most importantly, in Georgia the election remains in effect until cancelled. There is no annual renewal or fee, with no concomitant risk of inadvertent loss of status.

    The firm must include in its name the words "limited liability partnership" or the abbreviation "LLP" or the designation "L.L.P."

IX. Comparisons of LLCs and LLPs

Given Georgia's extremely broad LLP legislation, the question may become which should be chosen as between an LLC or LLP.

In making these choices, the following items should be considered:
  1. The Importance of Written Operating Agreement. A written agreement is virtually essential for an LLC, not necessarily for an LLP.


  2. Remedies on Wrongful Withdrawal. Partnerships have a limited remedy for wrongful withdrawal. LLCs have statutorily sanctioned authority for imposing severe consequences on a withdrawing member.


  3. Alteration of Scope of Duties. In an LLP, all partners owe duties, often characterized as fiduciary duties, to the firm and other partners. In a member-managed LLC, the members have the duties imposed by the LLC Act Section O.C.G.A. § 14-11-305 which imposes director style duties on the members. In a manager-managed LLC, however, member status alone imposes no duties on the members to other member. Although members may have duties by virtue of their status as employees, the nature and status of such duties will depend on the scope and articulation of those duties in an agreement.


  4. Authority to Bind in Firm. In member-managed LLCs and in LLPs, each member can bind the firm. In manager-managed LLCs, however, non-manager members do not have this authority. The managers must affirmatively delegate this authority through creation of officers or through other actions authorizing non-managers to act for the company. This can be a positive or negative consideration for a business.


  5. Carryover of Existing Law. Both an advantage and disadvantage for an LLP is it carries over existing law regarding general partnerships. That is to say issues involving payments to a withdrawing partners, fiduciary duties and other partnership law apply to LLPs. LLCs permit substantially greater freedom of contract, at least in certain key areas, than LLPs which are governed by the Uniform Partnership Act.

X. Frequently Asked Questions and Answers Regarding Use of LLCs in Georgia.

The following questions are some of those frequently asked on LLCs. Many of these topics deserve an extensive discussion. The "answers" are included only to alert the practitioner to certain issues and to give him or her a start on the analysis.

QUESTION:
How do you perfect a security interest in an LLC interest?

ANSWER:
 A limited liability company interest consists of contract rights. Accordingly, the method for perfecting a security interest should be the same as that for general intangibles. Note, however, that it is possible for an LLC to issue certificates representing interests. In that case the secured party should take possession of the certificate along with an appropriate transfer instrument designed to have the same effect as a stock power. The practitioner should also consider requiring that its security interest be noted on the LLC's books and that the LLC agree not to effect transfers of the pledged interest.

QUESTION:
When lending to an LLC, how should a lender attempt to establish the proper authority?

ANSWER:
The lender should examine the articles of organization to determine whether the entity is manager-managed. A statement to that effect will negate the inherent agency authority of the members. If there is no such statement, each member has authority to bind the LLC, so the signature of any member should be sufficient. It would be prudent to obtain a representation (in the loan documents or in a separate certificate) that the member signing is in fact a member. If the articles of organization state that the entity is manager-managed, each manager has authority to bind the LLC so the signature of any manager should be sufficient. Again, it would be prudent to obtain a representation that the signing manager is in fact a manager. Although it is not required, the customary procedure of obtaining an "incumbency" certificate -- signed by a member or manager who is not the signatory on the loan documents and attesting that the member or manager signing the loan documents is who she says she is -- likely will be followed. Further, it would be wise to examine a certified copy of the operating agreement to confirm the identity and scope of authority (to the extent established by the operating agreement) of the member or manager signing the loan documents.

QUESTION:
Can a lender foreclose on an LLC interest?

ANSWER:
Since a security interest can be granted and perfected in a limited liability company interest, the secured party should be able to exercise any remedies otherwise available in the event of a default. The LLC's governing instruments should be studied carefully, however, to determine the effect of a "foreclosure". The transfer, or purported transfer, of an LLC interest to a lender in a foreclosure proceeding could result in dissolution of the entity, a forfeiture or mandatory repurchase of the interest, or other contractual remedies established by the governing instruments of LLC. These should be examined, therefore, as part of any loan transaction.

QUESTION:
Can a nonmember-manager of an LLC be a tax matters partner?

ANSWER:

No. The tax matters partner must be a member. The Code defines "tax matters partner" as the general partner designated as such or the general partner with the largest profits interest if there is no designated general partner. Although an LLC has no general partner, it would appear that any member of an LLC should qualify as a general partner for this purpose to the extent such member has the right to participate in the LLC's management. It is good practice to designate the tax matters partner in the operating agreement and to provide procedures for removing and replacing the tax matters partner.

QUESTION:
Which forms does an LLC use to file tax returns?

ANSWER:
Assuming that it is properly classified as a partnership for tax purposes, an LLC will use IRS Form 1065 (U.S. Partnership Return of Income) for federal tax purposes and Georgia Form 700 (State of Georgia Partnership Income Tax Return) for Georgia purposes.

QUESTION:
If a partnership converts to an LLC, does it need a new tax identification number?

ANSWER:
No. Under the applicable revenue rulings, the conversion is not treated as a termination of the existing partnership.

QUESTION:
Will the IRS give the tax identification number of an LLC over the telephone to a nonmember?

ANSWER:
No. However, the SS-4 form can be completed by the organizer. The number will be mailed to the address indicated in the application or a member or manager can call in. The fax number is (404) 455-2660, but you need signature authorization if you are faxing. Call (404) 455-2480 to get the tax identification number after it has been faxed.

QUESTION:
How is title to real estate held in an LLC? How does an LLC establish authority for purposes of conveying real estate?

ANSWER:
Title to real estate is held in the entity itself. Authority would be established by reference to the operating agreement and the articles of organization (see the response to Question 2, above).

QUESTION:
Is an LLC interest a "security"?

ANSWER:
This issue is complex. The practitioner should start by reviewing the discussions in Carter G. Bishop & Daniel S. Klienberger, Limited Liability Companies -- Tax and Business Law ¶¶ 11.01-04 (1994), and Larry E. Ribstein and Robert R. Keatinge, Limited Liability Companies §§ 14.02-.03 (1994) ("Ribstein and Keatinge"). The courts will likely apply an "investment contract" analysis to the issue of whether an interest in an LLC is a security. See SEC v. W. J. Howey Co., 328 U.S. 293, 298-99 (1946) (An investment contract is "a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party . . .") At one end of the spectrum is a closely held LLC that is member-managed and in which each member actively participates in management. Under an investment contract analysis, interests in such an enterprise should not be "securities." At the other end of the spectrum, an LLC clearly may be used as a vehicle for a public offering of interests to passive investors. In those circumstances, such interests would likely constitute "securities." There is a substantial area between the extremes, and the careful practitioner will study the relevant case law and likely will proceed on the assumption that the interest is a security unless the facts are quite close to the closely held, member-managed LLC, where all managers participate actively in management.

QUESTION:
Can an LLC issue "stock"?

ANSWER:
Ownership interests in an LLC can be called stock, shares, units or any other name that is appealing to the parties. LLC interests may also be certificated. However, the interests are not the equivalent of corporate stock. The careful practitioner may wish to avoid the use of the term "stock", particularly when the members will include passive, relatively unsophisticated investors, because of its potential for misleading members as to the nature of the entity.

QUESTION:
Can an LLC issue certificates for its shares?

ANSWER:
Yes, but refer to Question 10 for some of the issues associated with doing this.

QUESTION:
Can an LLC issue incentive stock options?

ANSWER:
No. Incentive stock options may only be issued with respect to stock in an entity that is a corporation for federal tax purposes. Assuming an LLC qualifies as a partnership for tax purposes, it cannot meet this standard. However, an LLC may grant options or other rights to acquire interests in the LLC. The tax treatment of such options or rights can be quite complex, particularly if the options are granted in exchange for services.

QUESTION:
How is an LLC treated for bankruptcy filing purposes?

ANSWER:
The answer is uncertain. For a discussion of the application of the bankruptcy laws to LLCs see generally, Ribstein and Keatinge ¶ 14.04. It appears that the corporate rather than the partnership bankruptcy rules will govern how a limited liability company files for bankruptcy under the Federal Bankruptcy Code. Although the Bankruptcy Code does not specifically address LLCs, the definition of "corporation" for purposes of the Bankruptcy Code includes "a partnership association organized under a law that makes only the capital subscribed responsible for the debts of such association." 11 U.S.C. § 101(9)(A)(ii). The question remains open as to whether members or managers would then be considered "insiders" for purposes of the provisions of the Bankruptcy Code. Under the Bankruptcy Code, the officers and directors of a corporation and the general partners of a partnership are considered insiders. Id. § 101 (3)(B). Whether an LLC is treated as a corporation or a partnership, the LLC itself should qualify to be a debtor under either Chapter 7 or Chapter 11 of the Bankruptcy Code.

QUESTION:
Does conversion of a corporation or partnership to an LLC under O.C.G.A. § 14-11-212 trigger liability for real estate transfer tax in connection with the recording of any deed?

ANSWER:
There is little law on this subject. A widely circulated memorandum of the Department of Revenue Real Estate Transfer Tax Division indicates that there would be no transfer tax on a deed ancillary to a merger, which suggests that there should be no real estate transfer tax due on a conversion of a corporation or partnership to an LLC. At least one Georgia general partnership has converted to a Georgia LLC without incurring any transfer tax in Gwinnett County. Along with a quitclaim deed, an Affidavit Regarding Title to Real Property was filed which, among other things, recited O.C.G.A. § 14-11-212(c)(5) in its entirety. In addition, in Section E of the Real Estate Transfer Tax Declaration was typed: "Non-taxable. Filed solely to reflect partnership election of limited liability company status per O.C.G.A. § 14-11-212."
 

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