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Effective Use of Limited Liability Companies in Georgia:
An Overview of Their Characteristics and Advantages


Charles R. Beaudrot, Jr.
Morris, Manning & Martin, L.L.P.
1600 Atlanta Financial Center
3343 Peachtree Road, N.E.
Atlanta, Georgia 30326
(404) 233-7000
crb@mmmlaw.com

The term "limited liability company" has been confusing to many, lawyers and lay people alike, because it triggers two distinct mental associations, (1) with the limited partnership, and (2) with a company or corporation. In fact, these associations are intended, because a limited liability company ("LLC") is an entity which partakes of characteristics of both a limited partnership and a corporation. Like limited partnerships, limited liability companies which qualify (as discussed below) will be accorded pass-through taxation on their income. Like corporations, the liability of all members and managers -- those who hold ownership interests in, and/or who manage, the limited liability company -- is absolutely limited to the extent of their investment in the entity. It is this duality that drove the development of limited liability companies, and which advocates for their use in many situations.

The purpose of this outline is to review the historical development of this new form of entity, including its adoption by Georgia; the principal characteristics of a limited liability company, with relevant comparisons to the characteristics of other forms of entity, including C and S corporations and limited partnerships; the manner in which a limited liability company may qualify for partnership (flow-through) taxation for federal and state purposes; various legal and operational issues implicated by limited liability companies and their resolution in the Georgia Limited Liability Company Act; and general planning issues in the effective utilization of a Georgia limited liability company.

Historical Background and Legislative History

A. History

The history of Limited Liability Companies has been traced back to the German Gesellschaft mit beschranter Haftung ("GmbH"). The first domestic statute providing for the creation of a "limited liability company" (hereinafter referred to as "LLC") was created by statute in Wyoming, in 1977. The original genesis for such entities is unclear, although they apparently were initially developed for use as ownership vehicles for the oil and gas industry. Although the Internal Revenue Service (the "IRS or "Service") issued a Private Letter Ruling to one Wyoming LLC stating that it would be treated as a partnership for tax purposes, the Service contemporaneously issued Proposed Regulations to deny partnership classification to any organization where no individual had liability for the debts of the organization. Due to unfavorable commentary on the Regulations, these were withdrawn in 1982, and the IRS instituted a study to review the proper classification of LLCs.

Florida followed Wyoming in enacting its own LLC Act in 1982, which was generally modeled on the Wyoming Act (although permitting LLCs greater flexibility). However, due to continuing uncertainty both as to the manner in which LLCs would be classified for tax purposes by the Service, as well as whether the liability protection provisions would be effective, few businesses availed themselves of the opportunity to form LLCs in either Wyoming or Florida. Only in 1988, when the Service concluded that the standing partnership classification Regulations should be applied to LLCs -- i.e., that limited liability alone should not preclude classification of an LLC as a partnership -- did it issue Revenue Ruling 88-76, which concluded that a Wyoming LLC formed under the default provisions of that Act would be classified as a partnership, and thereby afforded single-level taxation. Issuance of this Revenue Ruling signaled the viability of this new form of entity. A swift response at the state level followed to this and to the subsequent adoption of the "Check-the-Box" entity classification regulations. Since 1988 all 50 states and the District of Columbia have enacted LLC statutes.

B. Motivations Behind Legislation.

The explosion in interest in LLC's is driven by both tax and business considerations. 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.

LLCs are in large measure a response to limitations on the availability of S corporations for federal and state tax purposes:

  1. LLCs are not limited, like S corporations, to one class of shareholder;
  2. LLCs are not limited, like S corporations, generally to U.S. individuals (and estates, certain trusts, charitable foundations and ESOPs) as shareholders;
  3. LLCs can have preferred interests and participating debt;
  4. LLCs are not limited, like S corporations, to 75 shareholders;

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.

Another impetus behind LLC's has been the attractiveness of these entities to professionals who wish to limit their professional liability to their own negligence while avoiding so called "vicarious," "collateral" or "derivative" liability for the errors and omissions of their colleagues.

Finally, there can be little question that LLC's are in part attractive because of the lingering stigma attached to partnerships as the vehicles through which so much of the real estate collapse of the late 1980's was experienced.

C. Legislative Drafting Process.

Georgia's legislation on LLCs was conceived and drafted by a committee composed of members of the Atlanta Bar Association's Business and Finance and Tax Law Sections and the State Bar of Georgia Corporate and Banking Law Section. In its work, the Committee drew heavily on the ABA prototype LLC Act as well as other states' LLC legislation.

Georgia's LLC legislation was enacted in a two-step process. First, during 1991-92, the committee drafted the Foreign Qualification of LLCs Act. This was introduced to the Georgia General Assembly, through the sponsorship of Representative Thurbert E. Baker and with the endorsement of the Atlanta Bar Association. This Act, which enabled foreign LLCs to qualify to do business in Georgia, was signed into law on April 16, 1992, with an effective date of July 1, 1992. Second, through 1992 and into 1993, the drafting committee developed a comprehensive LLC Act for all LLCs organized or operating in Georgia. This Act was introduced and passed by the Georgia General Assembly at its 1993 session. The Georgia LLC Act was signed into law by Governor Miller on April 5, 1993, with an effective date of March 1, 1994. The Georgia LLC Act is contained in Title 14, Chapter 11 of the Official Code of Georgia Annotated.

Principal Characteristics of Georgia LLCs

A. Types of LLC Statutes

Many of the early LLC statutes, such as the Wyoming Statute (Wyoming Statutes 17-15-100, et seq.) were what are referred to in the literature as "bullet proof" statutes. That is to say, an LLC organized under one of such statutes would always constitute an association taxable as a partnership for federal income tax purposes under the entity classification rules then in effect. In addition to the Wyoming statute, other initial "bullet proof" statutes included the initial versions of the Colorado, Virginia, Nevada and West Virginia LLC statutes.

The subsequently enacted statutes tended to opt for the greatest possible flexibility in the creation of LLC's. These "flexible" statutes, such as those of Delaware, Florida, Kansas, Texas, Maryland and Oklahoma, permit parties to structure their LLC in such a fashion so as to be taxable as either a partnership or a corporation for federal tax purposes. Although the greater flexibility of these statutes made it possible to address business needs with great particularity, it also created opportunities for professional foot faults, not only through inadvertently failing to achieve the desired partnership tax status, but also as to issues of entity governance.

Recently some states which had "bullet proof" statutes, such as Colorado, have enacted revised "flexible" statutes. The National Conference of Commissioners has also prepared a form Uniform Limited Liability Company Act which was approved in August of 1994 and may well lead to greater standardization at the state level.

The adoption of the liberalized "Check-the-Box" entity classification rules, discussed in greater detail below, has caused many states to revise their statutes to move to the "flexible" model and, in some cases, to cause their LLC entities to bear more similarity to corporations than was initially the case.

B. Principles Underlying Georgia Statute.

  1. Election: The Georgia LLC statute falls decidedly into the "flexible" model. In working with the Georgia LLC Act, it is helpful to keep in mind several overriding principles that guided the drafting effort:
    1. Freedom of Contract. The first principle that the drafters used in preparing the Georgia statute was to endorse, to the fullest extent possible, freedom of contract. In only a relatively few cases are statutory strictures mandatory. In almost all cases, the rights of the parties can be varied by agreement.
    2. Elaborate and Specific Statutory Default Rules. As a counterpoise to this desire for contractual flexibility, however, was a desire for clarity of the governing rules where the parties did not formalize their agreements. A number of members of the committee, based upon years of practice in the partnership area, expressed concerns about the uncertainty of so many legal issues affecting partnerships. Such uncertainties can result both because of failure by the parties to reach, or articulate, a meeting of the minds or because of basic ambiguities in the law of partnerships. Accordingly, the statute provides clear and often elaborate default rules in the absence of an agreement to the contrary.
    3. Requirement of Written Agreement.To avoid the serious proof difficulties that can arise from oral agreements in complex business relationships, a third overriding principle is that in order for the parties to avail themselves of freedom of contract with respect to their LLC, their decisions must be evidenced in writing in the governing instruments for the LLC. Thus, use of the Georgia LLC act places a premium on the drafting and implementation of a well written agreement.
  2. Parallel Existing Rules for Other Entities. Finally, because of the desire to facilitate use of the new statute by Georgia practitioners, where possible, analogous provisions of the Georgia Business Corporation Code, Georgia Revised Uniform Limited Partnership Act ("GRULPA") and Georgia version of the Uniform Partnership Act ("UPA") were liberally borrowed from and incorporated into the new statute.

C. Adaptation of Rules Applicable To Other Entities.

In the process of constructing a new form of entity, which at various times partakes of characteristics of a limited partnership, a general partnership or a corporation, the drafters of the Act confronted several instances where the conventions of one business form had to be chosen over the other (e.g., organization of an LLC follows the corporate model in that the Articles of Organization of an LLC may be signed by a non-member where the Certificate of Limited Partnership must be signed by all the General Partners.) The drafters also imported conventions into LLC's of one business form, where no analogous provision existed with respect to the other form (e.g., detailed corporate-style derivative actions were included, although only a limited right exists for partners in a limited partnership). Although generalizations are treacherous, generally, Georgia LLCs will more closely resemble in documentation and matters of governance a limited partnership (or in some cases a joint venture) than a C corporation or an S corporation

The primary difference between a Georgia LLC and a Georgia limited partnership is that the limited partnership is managed by one or more general partners who are personally liable for the obligations and debts of the partnership. In a Georgia LLC no member has personal liability. In states other than Georgia another critical difference between LLCs and limited partnerships is the degree of participation or control permitted to be exercised by limited partners (i.e., little or none) as compared to LLC members.

D. Salient Characteristics of a Georgia LLC.

  1. Types of Business. A Georgia LLC may be formed for any lawful purpose. Unless the articles of organization or a written operating agreement provide a more limited purpose, the LLC is presumed to be to empowered to engage in any lawful business in which corporations for profit, professional corporations, limited partnerships or general partnerships formed in Georgia may engage. Thus, professionals are permitted to practice in the form of LLCs. The ramifications of this decision are discussed in greater detail at Section VI below. O.C.G.A. § 14-11-201 also makes clear that if there is another provision of law, for example, a banking statute, that requires an entity to be organized in a special way or precludes an entity from being organized as an LLC, such special provision controls.
  2. Formation and Governing Instruments. The key documents for purposes of the Georgia LLC statute are the Articles of Organization and the Operating Agreement. The Articles of Organization for an LLC is analogous to, and similar in form to, the limited partnership certificate filed in order to create a limited partnership For many LLC's, the Operating Agreement is analogous to and will generally be similar in content and form to a joint venture or limited partnership agreement. In the case of LLCs in which management is delegated to one or more managers, the Operating Agreement may also include provisions similar to corporate bylaws or shareholder agreements.

Georgia LLCs may be formed by one or more organizers, by filing articles of organization with the Secretary of State, which articles contain the name(s) of the organizers, the name of the LLC, as reserved with and approved by the Secretary of State as distinguishable (and which must contain the words "limited liability company" or "limited company" or L.L.C., LLC, L.C. or LC). Unlike a limited partnership, here the LLC follows the corporate model. The Articles can be signed by anyone. LLC's must also maintain a registered office and agent, the mailing address of the LLC, the name and address of a registered agent, and provide other information required by the Secretary of State, but this does not have to be included in the Articles of Organization.

Thus, the Articles of Organization need be only a skeletal document. Indeed, the Secretary of State's office has expressed a strong preference in the drafting process to keep the filing requirements to a minimum. Under the statute as originally enacted, the Articles needed to include the latest date on which the LLC was to dissolve. This requirement was deleted by amendment prior to the March 1, 1994 effective date.

Although not required, examples of provisions that might be included in the Articles of Organization would be a provision designating managers, if the LLC is to be manager managed, specific restrictions on the authority of members or managers or special requirements with respect to the execution or delivery of documents in order to bind the LLC. There is nothing in the statute that precludes issues of importance from being included in the Articles of Organization. And in some cases, inclusion of key provisions as a form of public record may be advisable, as is routine with corporate practice. However, other than the name, which must comply with O.C.G.A. §14-11-207, (i.e. must not be confusingly similar to another entity), nothing else is required by the statute.

Although they could be included in the Articles of Organization, a Georgia LLC's governance provisions generally will appear in its Operating Agreement. The Operating Agreement will generally be a much more detailed instrument. Although the Operating Agreement may be oral or written, in most instances the statutory default rules apply unless overruled in the Articles of Organization or a written Operating Agreement. Parties may well not want the statutory default rules for reasons discussed in more detail below, therefore a written Operating Agreement is of paramount importance.

E. Capital Contributions/Finance.

As with both Georgia corporations and Limited Partnerships, an LLC member's capital contribution may take many forms, including cash, property, promissory notes or services rendered or to be rendered. As with limited partnerships, an LLC may issue ownership interests for various quanta of consideration, and discrimination between or within classes of interests is permissible and achievable through the use of special allocations and distribution preferences.

The drafters made no effort to define how such contributions are accounted for as such determinations are generally driven by tax and accounting considerations not susceptible to statutory resolution. To be enforceable, an obligation to make capital contributions must be in the Articles of Organization, the Operating Agreement or another writing. An LLC may, but is not required to, issue interest certificates. O.C.G.A. §14-11-403 provides for allocations of profits and losses, as distinguished from distributions. These will often be largely driven by tax considerations. It should be noted that in the absence of a written Operating Agreement, profits and losses are allocated on a per capita basis.

Distributions are addressed separately in the statute in part to highlight (what every tax attorney knows) that income and cash often have little to do with one another, and are discussed in greater length below. The most important point for the practitioner to note is that distributions are also shared on a per capita basis unless otherwise agreed to in the written operating agreement.

F. Management, Duties and Indemnification.

By statutory default, a Georgia LLC is managed by its members unless the Articles of Organization or written Operating Agreement vest management in an manager or managers selected by a majority of members. A manager's rights and authority to so manage an LLC must be set forth in the governing documents, as well as any restrictions thereon. If the LLC is managed by its members, then each member functions as an agent of the LLC whose actions will be binding on the LLC. If, however, a manager or managers are provided for, then such manager functions as agent of the LLC, to the exclusion of members (acting solely in their capacity as such). This is yet another example as to why a written operating agreement is essential.

In a manager-managed LLC, managers may often function as do a corporate board of directors. In LLC's which follow the joint venture model, the manager or managers may more closely resemble a managing partner model. If an LLC is instead member-managed, it may more closely resemble a general partnership (and some Georgia limited partnerships), where every partner participates in management. In every case, the individuals controlling the business entity will be deemed agents of such entity.

Members and managers of an LLC are not liable to the LLC or each other if their management actions are believed in good faith to be in the best interests of the LLC, subject to a prudent person standard of care. A member is not liable to a manager-managed LLC or any other member solely by reason of acting in the capacity as a member. Subject to the provisions of governing documents, an LLC may expand, restrict or eliminate any duties and liabilities of members or managers, except that the LLC may not indemnify members or managers for intentional misconduct or knowing violations of law, or for transactions triggering the receipt of personal benefits in violation of an existing operating agreement. Corporate directors and general partners in limited partnerships are both subject to duties and indemnification provisions similar to those imposed on managing managers and members of an LLC. The thinking of the drafters in this regard was that any attempt to limit the duties of members or managers of an LLC further might be held to be contrary to public policy and would force the courts to develop an ad hoc response through unnecessary litigation. By adopting this well understood standard, the courts should be dissuaded from creating more open ended standards through litigation.

In an effort to address some of the concerns that have historically arisen as to matters of title in the real estate area, O.C.G.A. §14-11-302 provides a procedure under which a copy of an LLC's articles of organization may be filed with the superior court clerk of the county where real property belonging to the LLC is located. In such case, the limitations on authority of members or managers contained in the Articles of Organization are conclusively presumed in favor of the LLC. The intention here is to create a document analogous to partnership statements often seen under the UPA.

Another borrowing from the corporate code are rules to ensure that transactions in which members or managers have interests which conflict with the interests of the LLC are to be approved by disinterested persons. This is another instance where the parties may vary that limitation under their written operating agreement. Before doing so, however, a drafter should consider whether the drafter wishes to abandon the statutory safe harbor that these provisions create, and the well understood principles that derive from the corporate code model, in favor of the uncertainty of individualized agreements.

Under the statutory default, most management decisions can be made by a majority vote of the members or managers (depending on which group has management authority). Certain other decisions, however, require unanimous approval. In either case, in the absence of a written operating agreement to the contrary, all such determinations are made on a per capita vote basis. This is yet another example of the critical importance of a written operating agreements for LLCs in order to vary from this rule.

G. Limited Liability.

The members, managers, agents and employees of a Georgia LLC are not liable for the debts, obligations or liabilities of the LLC. Like corporate shareholders or limited partners, members may be held liable to their organization to the extent of funded capital contributions, but are not subject to enforcement of creditors' claims against the LLC (apparently including any right to enforce agreed upon contributions of members that are not specifically enforceable under the terms of the governing documents). General partners, on the other hand, remain personally liable for all partnership debts and obligations.

Any limitation on liability of LLC managers and members must be read in conjunction with the provision of the Georgia LLC Act that provides that the Act is not intended to alter any law applicable to the relationship between a person rendering professional services and a person receiving those services, including liability arising out of those services. The ramifications of this rule are discussed at greater length in Section VI below.

H. LLC Interests/Admission of Members.

An LLC membership interest is composed of two elements: (1) the economic rights (and liabilities) associated with an interest, and (2) the participation, management and control rights associated with an interest. Each of these components may be uniquely delineated for each separate interest in an LLC. Under the statute, the economic rights pertaining to any LLC membership interest may be transferred without the prior consent of other members under the Act, subject to contrary provisions in governing documents. However, unanimous approval of the members -- unless the governing documents stipulate a lesser required vote -- is required for an economic interest owner or an unaffiliated individual to become a member of the LLC.

This dichotomy in LLC interests and restrictions on transferability follows the familiar rules applicable to limited partnership interests. This lack of free transferability is not typical of corporate shares, although it is often imposed contractually in closely held businesses. Indeed imposing restrictions on transferability of interest is generally a critical element of achieving the desired tax results for S corporations due to external restrictions on who or what can own such interests.

I. Transfer of Interests.

An LLC interest is deemed personal property and economic rights are freely assignable unless otherwise agreed. The actual transfer of interests occurs under the same provisions of the governing documents as the admission of new LLC members.

J. Distributions.

Subject to the statutory default provision of per capita distributions, a Georgia LLC may allocate distributions to its members in any manner, but such allocations must be in the Articles of Organization or a written Operating Agreement to be given effect. The governing documents may also provide when, prior to dissolution of the LLC, members may receive distributions. Unless otherwise provided, no member has the right to a distribution in any form other than cash.

Distributions must be made subject to dual equity and balance sheet and solvency tests. At first blush one may question the inclusion of this provision in the statute. The reason is, that on balance, it was felt by the drafters to be a matter of prudent policy and of benefit to use of the LLC form. The statute in effect creates a special limitation on actions to reclaim wrongful distributions. It may well limit the applicable remedies under which such distributions can be attacked by creditors.

The statutory scheme of distributions in LLCs is similar to that of a partnership, where the partnership agreement allocations are discretionary, and unlike that of a corporation, where every share within a single class or series must be treated equally, or pro rata in accordance with stock holdings.

K. Events of Dissociation and Dissolution.

O.C.G.A. §14-11-405 provides the standards for disassociation which can trigger dissolution and, ultimately, liquidation of an LLC. Initially, this provision was of great importance to ensure that the LLC obtained treatment as a partnership for federal tax purpose. However, the statutory default of liquidation on dissociation could be varied by contract. Prior to the adoption of the "Check-the-Box" regulation, this flexibility incorporated in the statute, although desirable for business purposes, could have resulted in an LLC failing this critical test and inadvertently being taxed not as a partnership, but a corporation. As discussed below, since "Check-the-Box," this is no longer a significant risk.

The Georgia LLC Act provides by default that certain events, including the death, bankruptcy, redemption or removal of a member, result in the dissociation of a member. Initially, disassociation also included voluntary withdrawal. This was important because an LLC was dissolved when certain specified events occurred, including -- again, subject to contrary agreement in the Articles of Organization or a written operating agreement -- the dissociation of a member, unless within 90 days of the event of dissociation the other members vote to continue the LLC. If during this 90 day period dissolution was not averted and the LLC continued , then the LLC commences "winding up" in the same manner as a partnership does with marshaling of assets, payment of creditors and distribution of the balance of assets to the members in accordance with the agreement. Only after this process has been completed does an LLC file a certificate of termination. Thus, LLCs were like partnerships with respect to dissolution. Rather than marking the end of existence as an entity, as is the case with corporations, dissolution of an LLC indicates the commencement of the winding up process.

In 1999, the legislature amended the Act to alter these default rules and to bring the statute more in line with the Check-the-Box regulations. Although no changes were made to the rules involving assignability, prior amendments which had deleted voluntary withdrawal as an event triggering dissociation and dissolution (the so-called "Hotel California" approach) were confirmed. More importantly, other statutory modifications provide that a modified corporate style of continuity of life is now the default treatment for LLCs. That is to say, for LLCs formed after July 1, 1999 unless otherwise provided in the written operating agreement, the LLC will not dissolve until the dissociation of the last remaining member. This last provision was designed to deal with the difficulty that would arise in the situation where the only member of an LLC had died or was incompetent and there would be no mechanism for the dissolution and winding up of the company. With the proliferation of single member LLCs, this was becoming a very real potential issue. By providing the statutory default, the difficulty is avoided.

The Georgia Act also provides for judicial and administrative dissolution of an LLC, where it is either not reasonably practicable to carry on the LLC's business in accordance with its governing documents, or where the LLC has failed to comply with Secretary of State requirements. These provisions are, again, analogous to those applied to corporations. One advantage of the limited liability company statute are the provisions of O.C.G.A. §§14-11-606 through 14-11-608. These give the dissolving limited liability company a procedure for barring claims, both known and unknown, against the dissolved LLC within a relatively short period of time.

L. Dissenters Rights/Inspection Rights/Derivative Actions.

The Georgia LLC Act provides a default rule of unanimous approval of members for certain fundamental actions (i.e., dissolution, merger, or sale of substantially all assets, admission of members, amendment of Articles of Organization or written operating agreement, reduction in capital and approval of distributions). This requirement may be varied in the Articles or Written Operating Agreement.

Unless otherwise provided in the Articles of Organization or written Operating Agreement, dissenters' rights are afforded to LLC members who are opposed to any fundamental action of the LLC which will otherwise be approved, whereby the member in question demands and obtains payment of the fair value of its interest. Formal dissenters' rights procedures are established in the Act. These procedures are adapted from and generally follow the corporate statute.

The right to inspect the organization's operational, accounting and tax records is also separately available to LLC members, upon reasonable request, although a formal right to an accounting is not required by the Act. Nevertheless, the governing documents may provide for the imposition of penalties on members or managers who fail to perform in accordance with the terms of the LLC's governing documents.

If certain preconditions regarding a formal written demand and lapse of time are met, members of an LLC have the right to commence a derivative action in the right of the LLC to recover a judgment in its favor. The court in which such an action is brought may dismiss the action if it determines that certain qualified parties have concluded such action would not be in the best interests of the LLC. This detailed procedure is adapted directly from the Georgia Corporate Code and is much more detailed than the rules applicable to limited partnerships. Unlike dissenter's rights, this right to derivative action cannot be varied by contract.

M. Foreign LLCs.

The registration of foreign limited liability companies in Georgia is governed by O.C.G.A. §14-11-701 et seq. The provisions are substantially similar to the corporate and partnership filing requirements.

N. Mergers and "Conversions".

In general, Georgia LLCs are permitted to merge with (or into) other domestic and foreign business entities, other than a corporation, provided that the statute governing the other form of entity permits such mergers and a written agreement is executed by the constituent parties. The merger provisions were paired by conforming changes to GRULPA, regarding limited partnerships and the Corporate Code, has been amended to permit mergers with LLCs.

Other provisions have been made for a corporation or limited partnership simply to elect to become an LLC by filing a certificate of election with the Secretary of State. Indeed, O.C.G.A. § 14-11-212 of the LLC Act is one of the most original and creative ideas in recent LLC drafting. This provision of the statute, which originated with the Chairman of the committee, Bob Bryant, permits various existing entities to elect LLC status by simply filing a certificate of election with the Secretary of State. This extremely flexible approach has made the utilization of the new Act extremely simple for many existing businesses, particularly for professionals and existing firms that wish to avail themselves of this new form of business.

For partnerships, conversion to LLC status, although it may trigger gain, generally will be a non-taxable event. Practitioners should remember, however, that electing LLC status can have extraordinary tax consequences to a corporation and its shareholders. Such an election will be treated as the liquidation of the corporation -- a transaction potentially triggering taxable gain to the electing corporation, and the corporation's shareholders.

O. Other Administrative Matters.

LLC's must file annual registration with the Secretary of State by LLCs similar to the filings for Georgia corporations and limited partnerships. Fees for various flings are contained in O.C.G.A. §14-11-1101.

Georgia and Federal Income Taxation of LLCs.

The primary tax goal of an LLC is qualification and taxation as a partnership. The obvious benefit to taxation as a partnership, rather than as a corporation, is that partnerships are not deemed to be separate taxable entities. The taxable income, loss, credits and deductions of a partnership flow through to its partners, who report such items on their own returns to the extent they are utilizable. On the other hand, corporations are taxed twice on their income: once at the entity level, at corporate rates, and again to shareholders when they receive distributions to the extent such distributions exceed shareholder capital contributions or are deemed dividends. A secondary benefit to taxation as a partnership is the LLC's ability to allocate these same items of income, loss, credits and deductions specially among its members.

A. Federal Classification Controls.

The Georgia LLC Act specifies that both Georgia and foreign LLCs will be classified as partnerships for Georgia tax purposes unless classified otherwise for federal tax purposes, in which case the LLC's federal tax classification will carry through for Georgia purposes. Therefore, the federal classification is crucial.

B. Check-the-Box.

In 1995, the IRS and the Treasury Department announced in Notice 95-14 a proposal to simplify the classification Regulations to allow taxpayers to treat domestic unincorporated business organizations as partnerships or as corporations on an elective basis. This proposal was quickly tabbed with the moniker of "Check-the-Box." After publication, the Treasury continued to pursue this goal, even in the face of some criticism from the tax bar as to the authority, if not the wisdom, of the proposed changes These changes were made final, effective January 1, 1997.

  1. Historical Perspective

    Prior to implementation of Check-the-Box, the classification regulations were based on the historical differences under local law between partnerships and corporations. With the onset of the LLC revolution, many states had revised their statutes to a degree that partnerships and other unincorporated organizations could possess characteristics that had 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, had been modified to provide that no partner is liable for all of the debts of a partnership which had made an LLP election. Similarly, almost all states had enacted statutes allowing the formation of limited liability companies. These entities had been designed to provide liability protection to all members and to otherwise resemble corporations in many operating respects, 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 was that even prior to the final implementation of the Check-the-Box rules, it was clear taxpayers could generally achieve partnership tax classification for a non-publicly traded organization that was virtually indistinguishable from a corporation in operational respects. Taxpayers and the Service, however, continued to expend considerable resources on the tax classification of domestic unincorporated business organizations. In addition, small unincorporated organizations oftentimes did not have sufficient resources and expertise to apply the classification regulations to achieve the desired tax classification.

    Under the Check-the-Box approach proposed by the IRS, taxpayers were to be permitted 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 had two or more members and an objective to carry on business and divide the gains, unless the organization's classification were determined under another Code provision. For example, an organization that was treated as a partnership, but which was 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 was 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.

    Initially, the Check-the-Box proposal declined to address the application of these concepts to two issues of recurrent interest: one member LLCs and foreign entities. Final regulations did however address these issues with interesting ramifications.
  2. The Final Regulations
    The final regulations implementing Notice 95-14 (lovingly referred to as the "Check-the-Box" Regulations) were published December 18, 1996 as TD 8697, with an effective date of January 1, 1997. They generally follow the outline of Notice 95-14 and the subsequent proposed regulations, but with some extremely important and interesting refinements.
    1. Consequences of Change in Statutes
      It should be noted that Notice 95-14 stated 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. The final "Check-the-Box" Regulations continued this approach. This can result in significant tax liability, particularly in instances where existing corporations elect to convert to LLC status, thus triggering significant tax liability for the corporation and its shareholders
    2. Eligible Entity.
      Under Check-the-Box, any business entity that is not required to be treated as a corporation for federal tax purposes (an entity which is referred to in the Regulations as a "Eligible Entity") may choose its classification under the rules of Section 301.7701.3. These rules generally provide that an Eligible Entity with at least two members can be classified as either a partnership or an association taxable as a corporation, and that an Eligible Entity with a single member can be classified as an association taxable as a corporation or can be disregarded as an entity separate from its owner. Such disregarded entities are now referred to in certain quarters of the Tax Bar as "Nothings".
    3. Default Rules
      In order to provide Eligible Entities with the classification rules they would generally choose, the Check-the-Box Regulations provide default classification rules that generally aim to match taxpayers’ expectations, and thus reduce the number of elections that will actually be needed. It is not necessary to do anything to receive this default treatment -- it is automatic.
      (1) Per Se Corporations. The regulations contain a number of entities which are referred to as so-called "per se" corporations. These include any entity organized as a corporation under state law, certain banking organizations, organizations wholly owned by a state, organizations that are taxable as corporations under the provision of the Code other than Section 7701(a)(3) (for example, publicly traded partnerships) and, most importantly for the international practice, an extensive list of certain organizations formed under the laws of various foreign jurisdictions. There is a special grandfather rule contained in Section 301.7701.2(d) for entities which have at all times been taxed other than as a corporation for the taxable year including May 1996 and certain other restrictions. In addition, if such an entity suffers a tax termination under Section 708(b)(1)(B), the foreign entity will lose the benefit of the grandfather rule and become taxable as a corporation.
      (2) Non-Corporations. The default rule for domestic entities other than corporations is that a newly formed Eligible Entity will be classified as a partnership if it has at least two members or it will be disregarded as an entity separate from its owner if it has a single owner.
      (3) Foreign Entities. The default rule for foreign entities is based on whether the members have limited liability. Thus, a foreign Eligible Entity (i.e. not on the per se corporation list) will be classified as an association taxable as a corporation if all of the members have limited liability. The regulations eschew guidance as to what constitutes limited liability for these purposes. On the other hand, a foreign Eligible Entity will be classified as a partnership if it has two or more members and at least one member does not have limited liability. The entity will be disregarded as an entity separate from its owner if it has a single owner and that owner does not have limited liability. Finally, the default classification for an existing entity is the classification that the entity claimed immediately prior to the effective date of the regulations. That classification continues until the entity elects to change its classifications by means of an affirmative election or loses the benefit of the grandfather rule.
    4. Filing Elections
      An Eligible Entity may affirmatively elect its classification on Form 8832 - Entity Classification Election (a new form). The form will need to be signed by each member of the entity or any officer, manager or member of the entity which is authorized to make the election and who represents to having such an authorized an penalties of perjury. The election will not be accepted unless it includes all of the required information, including the entity’s taxpayer identifying number.

      If an entity chooses not to avail itself of the default rules, the applicable election must be made for the first year of the tax return which cannot be more than seventy-five (75) days prior to the date of the election.

    5. The World After Check-the-Box
      The Check-the-Box Regulations have proven extremely significant, both for federal tax and state law planning purposes. For instance, there has been noticeable movement in the direction of converting many existing corporate subsidiaries into one member LLC subsidiaries of a parent corporation. This can obviate the need for the entire applicability of the Consolidated Return Rules, in many circumstances obviating SRLY or CRCO limitations, while preserving limited liability for the division. Especially in settings where the deemed liquidation of the subsidiary entity into the new single member LLC can be accomplished in a non-taxable 332 transaction, the ramifications can be startling.

      One issue that will be interesting to monitor will be the impact of the integration of the financial reporting systems for such multi-division single entity taxpayers with classical doctrines of "piercing the corporate veil" and other state law issues associated with this structure. Other interesting issues arose in the employment and withholding tax areas and in the whole issue of FEIN numbers generally for such disregarded entities, none of which have been addressed, others of which remain unsettled.

      Ironically, the liberalization of the Check-the-Box rules proceeded in tandem with the liberalization of the S corporation rules. Although the LLC continues to enjoy many advantages over the S corporation, perhaps its greatest negative aspect from the point of view of choice of entity is in the area of corporate reorganizations, since, by definition, LLCs which are taxable as partnerships cannot constitute corporations for purposes of the reorganization provisions. Thus, the choice of S corporation versus LLC continues to be a complex one. Indeed, in many circumstances, the optimal entity may actually be a more complex hybrid which takes the form of an LLC with multiple corporate members, some or all of which may be S corporations.

      In Georgia, the Check-the-Box rules have permitted liberalization of the LLC statute. Now LLCs in Georgia have a form of quasi corporate continuity of life by default. That is to say that the dissolution of the company only occurs by default in Georgia in the event of the dissociation of the last remaining member. Thus, the so called "Hotel California" approach to voluntary disassociation applies. That is to say that a member of an LLC can no longer voluntarily withdraw or be entitled to receive, by virtue of such withdrawal, any payment from the company. LLCs in Georgia are now thus placed essentially on par with corporations as to matters of equity ownership.

Special Georgia Legislative Concerns.

During the legislative process, two issues emerged that caused concern to the legislature and required specific responses from the drafting committee.

A. "Piercing the Veil".

During drafting, it was generally assumed the courts would ultimately formulate doctrines using historic common law principles as to when the limitation on liability of members can be pierced, principles generally referred to in the corporate context as "piercing of the corporate veil". Certain legislators expressed a desire to make such doctrines explicitly applicable to LLCs. In order not to unduly chill the use of LLC's, the language which now appears at O.C.G.A. §14-11-314, second sentence was added to make clear that the general laws with respect to the disregarding of legal entities apply. However, because of the informal nature of LLCs, the language also makes clear that the failure to observe formalities are not germane for this purpose. In this particular therefore, LLCs enjoy an advantage over corporations.

B. Classification of LLC Interest as Securities.

Another legislative concern raised was whether ownership interests in LLCs constitute securities. Under general principles, an interest in a general partnership is usually not a security. On the other hand, an investment contract or a limited partnership interest generally is a security. Because of the variety of businesses and circumstances that are anticipated to adopt the LLC form, in response to concerns expressed by Representatives Groover, Barnes and sponsor Baker, language which now appears as O.C.G.A. §14-11-1107(n) makes clear that the general test for the determination of whether LLC interests constitute securities will continue to apply. In this regard, the consensus of both legislators and practitioners was that it was wise to rely on general principles to answer this question.

Thus, whether an LLC interest will constitute a security under these tests will require a case by case analysis. Therefore, practitioners will need to consider carefully the securities implications of each formation. At least with respect to member managed LLCs, however, there is an excellent argument that such interests do not constitute securities.

LLCs And Professionals.

Although not every state's limited liability company statute permits professionals to organize as LLCs, the Georgia Act does allow professionals to elect to practice in this form. Specifically adverted to in the preamble to the Act, this general legislative intent is codified at §14-11-107(f):
The laws of this state relating to the establishment and regulation of professional services are amended and superseded to the extent such laws are inconsistent as to form of organization with the provisions of this chapter and are deemed amended to permit the provision of professional services within this state by limited liability companies.

In the face of the broad statutory grant, whether a group of professionals may also organize as (or elect the status of) an LLC depends upon the licensing authority that regulates that profession. Subsection (g) of § 14-11-1107 provides that permission to organize a professional practice as an LLC is subject to the rules of each profession’s governing board.

Each profession must confront this issue individually. For example, the accounting profession was a moving force behind the enactment of the LLC Act, and the LLC Act specifically addresses changes to permit use of this entity by accountants. However, the State Board of Accountancy was slow to promulgate amendments to its regulations explicitly to permit accountants to use the LLC form. By amendments to the rules of the State Bar adopted by Supreme Court on July 15, the Supreme Court specifically sanctioned the use of LLCs by attorneys.

By its terms, the LLC Act shields the professional from personal liability for the errors and omissions of the professional’s colleagues—so-called vicarious, derivative or collateral liability—unless some other statute or principle of law requires a contrary result. However, the terms of the statute do not alter the liability of a professional for personal malpractice. Thus, use of an LLC will not protect the professional with respect to his or her own errors and omissions. The same result follows in an LLP. While a partner in an LLP is not personally liable for the debts, obligations or liabilities of the LLP or another partner that were incurred, created or assumed while the partnership is an LLP, the LLP Amendments make clear that the professional retains liability for such professional's own malpractice.

  1. Comparison of LLCs, LLPs and PCs in Georgia
    The ability to combine the benefit of limited liability with the flexibility of partnership taxation makes both the LLC and the LLP formats attractive to many professionals. When deciding whether to organize as a professional corporation ("PC") or as an LLC or LLP, the professional should base the decision on issues of corporate governance and tax considerations. On questions of vicarious professional liability, in Georgia the PC, LLC and LLP stand on substantially equivalent grounds. A PC protects its shareholders from vicarious professional liability in the same way that an LLC protects its members or an LLP its partners.

    The LLC Act is substantially broader than the PC statute. The PC statute specifically limits the use of the PC form to certified public accountants, architects, chiropractors, dentists, professional engineers, land surveyors, lawyers, psychologists, medical and surgical physicians, optometrists, osteopaths, podiatrists, veterinarians, registered professional nurses, and harbor pilots; professions not listed may not use the PC statute.

    Another contrasting feature is the simplicity with which a professional firm may elect to come under the LLC Act as compared with the detailed requirements of the PC statute. For example, the LLC Act includes no limitation on purpose and no requirement that at least one member be a licensed professional. Similarly, there is no requirement under the LLC Act that the name of the entity reflect professional corporation or association status, and there is no restriction on ownership of an LLC. Although the LLC Act limits the power to substitute transferees as members, the operating agreement can be drafted to provide otherwise.

    LLPs enjoy some, but not all of these advantages. Although as general partnerships LLPs have no specific requirements or limitations on who may be a partner, other statutory and regulatory restrictions on non-professional owners continue to apply. Moreover, as partnerships, LLPs are subject to the vast body of existing case law and the rules applicable to general partnerships. This may be advantageous or disadvantageous, depending upon the issue and the position one is asserting.

B. Other Considerations For Professionals Before Electing LLC or LLP Status in Georgia

At first glance, there is little to be lost and much to be gained for any professional firm electing LLC status. The simplicity and flexibility of organization and operation suggest that this is a viable alternative for all professionals and virtually any service industry where there are substantial risks for claims growing out of alleged errors and omissions. LLPs represent somewhat of a halfway house for these purposes. Although they provide the characteristic of limited liability, they must still operate under the general partnership statute for most purposes.

Before electing LLC or LLP status, the professional should consider certain collateral issues.

  1. Importance of Written Operating Agreement.

    Professionals electing LLC status should be aware of certain consequences of electing LLC status without a written agreement. In the absence of a written operating agreement, the LLC format generally opts for (1) unanimous consent as to certain fundamental matters of firm governance, (2) dissolution in the event of dissociation of a member, and (3) per capita voting, per capita distributions and per capita allocations of profits and losses. In reality, few professional firms intend to operate on this basis. Imagine the surprise of a professional firm electing LLC status without a written operating agreement when a member not intended to have a veto will not approve a fundamental action, or asserts rights to financial accommodations upon withdrawal from the firm that are inconsistent with the unwritten agreement among the members
    As general partnerships, LLPs require no written agreement and some statutory default rules may be varied orally. Thus, for firms that have neglected to reduce their partnership agreement to writing and do not wish to remedy that situation, the LLP option may be a more practical alternative.


  2. Availability of Cash Method of Accounting for Tax Purposes.

    Another issue of particular concern to professionals is whether professional LLCs and LLPs are required to adopt the accrual method of accounting for tax purposes. It appears that where properly structured, a professional firm organized as an LLC or LLP will be able to use the cash method of accounting for tax purposes.


  3. Self-Employment Taxes.

    The question of the applicability of self-employment taxes to LLCs, an issue of concern by professionals considering whether to use an LLC, continues to be an issue, although it seems likely that professional LLCs should be on essentially the same footing as general partnerships. Because an LLP is a form of general partnership, the rules regarding self-employment taxes that are applicable to general partnerships should apply equally to LLPs.


  4. Alteration of the Scope of Duties.

    One subtle point that professionals electing LLC status should keep in mind is the potential for altering the scope and nature of duties of one member to another by virtue of status as a member of the firm. In a general partnership, all partners owe duties -- often characterized as fiduciary duties -- to the firm and to other partners. In a member-managed LLC, all of the members have the duties imposed by LLC Act § 14-11-305, which imposes director-style duties on all members. In a manager-managed LLC, however, member status alone imposes no duty on members to other members. Although such members may have certain duties by virtue of their status as employees, the nature and scope of such duties will depend upon the nature and scope of employment.

    Therefore, drafters of professional LLC operating agreements may wish to articulate the scope of the commitment of each member to the firm and impose express duties on the members. The operating agreement could address issues such as presentation of business opportunities to the LLC and whether practice outside the LLC is permitted. Amendments to the LLC Act that become effective July 1, 1995, expressly contemplate such contractual delineation of duties. It should be noted that these issues are substantially the same as those that currently confront professional firms organized as PCs.

    This is one area where the LLP is an arguably superior vehicle for the professional firm, because the duties applicable to general partners continue to apply to partners in an LLP.


  5. Authority to Bind Firm.

    In member-managed LLCs (that is, LLCs that do not state in their articles of organization that they are manager-managed), the authority of members to bind and act for the entity is explicitly established by statute. In manager-managed LLCs (that is, LLCs that state in their articles that they are manager-managed), however, nonmanager-members have no authority to bind the firm. Accordingly, a professional firm may wish to be "manager-managed" in the internal sense only -- that is, certain members or groups of members (or designated nonmembers) have contractually specified management powers within the firm -- and retain (by not providing for manager management in the articles) the members' agency authority vis a' vis third parties. The point is brought home when one considers the authority of members of the firm to sign opinions for the firm.

    On the other hand, this consideration is one in which the LLC may present an advantage over LLPs. Because of the power of any member of a general partnership to bind the firm, to the possible detriment of the other partners, providing for manager management in the articles of organization may present an attractive way to limit the power of non-manager members to bind the firm.


  6. Errors and Omissions Planning Considerations.

    One of the more subtle and potentially more important issues in use of the LLC or LLP forms by professionals is the extent of protection these statutes afford in issues associated with defending potential malpractice actions. One "advantage" of the current rule that all members of a general partnership are liable for the errors and omissions of every other member is that, in the event of a claim, there is typically no conflict of interest between the alleged tortfeasor and the other partners in the defense of the case. However, because both an LLC and an LLP permit a member to avoid vicarious liability for the errors and omissions of co-members, the risk that the other members may insist on indemnification by the firm from the alleged tortfeasor creates a significant risk of conflict between the firm and the named individual professional defendant.

    Issues also arise with regard to inter-member indemnification. For example, to what extent should members of a firm’s opinions committee receive explicit indemnification if they are held personally liable for negligent failure to supervise? Similarly, what about a member who, through the firm’s internal procedures, reviews another member’s work but does not detect an error?

    The presence of errors and omissions insurance further complicates the issue. The question of whether the firm can or should claim indemnification from the alleged tortfeasor as to either the deductible under the policy, or a loss in excess of the policy limits, creates a serious risk of conflict between the alleged tortfeasor and the firm. In many cases, the importance of a united defense may well outweigh the possibly illusory benefits of a claim against the tortfeasor for the deductible and/or the excess loss over the policy limits. A related issue is the extent to which the firm agrees to obligate itself to defend and indemnify the alleged tortfeasor during the pendency of the litigation.


  7. Firm Name.

    The name of an LLC must be distinguishable on the records of the Secretary of State from the name of any other corporation, LLC, or limited partnership name. Moreover, the name, as adopted, must include the words "limited liability company," "limited company," "LLC," or "LC" (with or without periods), or abbreviations thereof. Unless required by the applicable governing board for the profession, the name need not indicate the nature of the professional firm.

    Although an LLP must include the words "limited liability partnership", "L.L.P." or "LLP" in its name, because the LLP election is made by recording an election with the Clerk of a Superior Court, there is no requirement that the name not conflict with other names on the Secretary of State's records.


  8. Ability to Impose Forfeitures on Withdrawing Members.

    The LLC Act explicitly states that, under a written operating agreement that so provides, members can impose forfeitures and penalties on members for specified reasons, which could include withdrawing wrongfully or engaging in post-withdrawal competition. In the professional context, it is likely that this provision will be invoked frequently to justify severe financial consequences for withdrawing members who compete with the former firm. Given the express terms of the LLC Act, these consequences should be enforceable in the case of professional LLCs other than law firms. Ethical and public policy issues make it unclear whether this result will be sustained as to lawyers. The question is whether such clauses will be viewed as imposing a restriction on the practice of law, which is generally viewed as void as a matter of public policy, or as a compensatory adjustment to a withdrawing member’s share, in which case it could be sustained.

    This is one instance where the choice between LLPs an LLCs is clear. Although there is statutory authorization for imposition of an offset for actual provable damages for wrongful withdrawal from a partnership, the general partnership statute lacks the LLC Act's express sanction of imposing severe consequences on withdrawing members.

Although lawyers in Georgia are permitted to organize as LLCs (and are permitted to make the LLP election), until recently the consequences of this decision in terms of obtaining limitations on liability were less clear for them than for other professionals. As noted above, the LLC Act and the LLP Amendments by their terms limit the liability of individual members for the firm's and other members' contractual obligations. The LLC Act and LLP Amendments by their terms similarly protect lawyers from personal liability for legal malpractice suits arising from actions of other firm members -- so called "vicarious" or "derivative" liability.

This latter issue was clouded, however, by the language of the leading Georgia case addressing this issue with regard to lawyers. The problem arose from the meaning and scope of the Supreme Court's treatment of the Georgia Professional Corporation Act in First Bank v. Trust Co. v. Zagoria.

It was possible to read Zagoria narrowly for the proposition that a lawyer in a law firm could not use the corporate shield to insulate himself or herself against claims arising from fraudulent acts of a co-professional in matters involving firm accounts that the lawyer had been (or should have been) in a position to monitor. Thus, the holding of the case could be justified as imposing liability under a "negligent supervision" theory. Under this analysis, a lawyer would be vicariously liable for the fraudulent acts of a co-professional in cases where the lawyer's negligent failure to supervise gave rise to actual fraud by the co-professional. Unfortunately, although sound as a matter of policy, this reading was dubious in light of the breadth of the language of the opinion, provoked no doubt by the Court's justifiable outrage at such conduct by a member of the bar. Most people read the case for the broader proposition that a member of a law firm was always personally liable for the professional misconduct of other lawyers in the firm.

Fortunately, this cloud over the use of LLCs and LLPs cast by Zagoria was eliminated by two developments in July of 1996. The first was Henderson v. HSI Financial Services, Inc. (Sup. Ct. of Ga., July 1, 1996) which explicitly overruled Zagoria. The second was the order of the Supreme Court dated July 15, 1996 approving amendments to the Rules and Regulations for the Organization and Government of the State Bar of Georgia and parallel revisions to the Ethical Considerations and Directory Rules specifically sanctioning the practice of law by Georgia lawyers in either the LLC or LLP. The combination of these two developments makes it clear that lawyers are now on the same footing with other professionals who use LLCs and LLPs.

State Tax Issues

Another important issue in the use of limited liability companies, and indeed all flow through entities, is state tax planning. Although the majority of states which address the issue have concluded that LLCs will be taxed for state law purposes as the same as under applicable federal principles, certain states, for instance, Tennessee and Texas, impose significant entity level taxes on LLCs. Moreover, the taxation of flow-through entities generally in a multi-state context is extremely complex and rife with difficulties and uncertainties. See generally, Robert N. Kozub and James T. Collins, 2000 Multi-State Tax Guide To Pass Through Entities, Panel Publishers, a division of Aspen Publishers, Inc. (2000). This complexity, however, should not deter the use of these entities where, and as often the case, the tax benefits are overwhelmingly positive for the utilization of flow through entities.

Conclusion

The Georgia LLC statute presents significant planning opportunities for businesses and professionals. As one of the most flexible state statutes, Georgia is an excellent jurisdiction in which to form and operate an LLC.
 

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