By Robert C. Hackney
The Three Generic Legal Entity Forms
When we analyze the different kinds of entities it is best to start by thinking about three generic forms, or species, of legal entities.
Those general categories are:
1) corporations,
2) partnerships, and
3) limited liability companies
Limited liability companies are a relative new form of entity in the United States, although types of them have been formed in other countries for many years. The limited liability company is generally thought of as a hybrid which has some of the attributes of a corporation and some of the attributes of a partnership.
Other than the pure general partnership form, each of these entities is really nothing more than a creature created by a state statute. Therefore, in doing your analysis of which type of entity would be best for your particular situation, you not only must consider the tax and liability issues that are most significant, but must look to the particular state where you wish to create the entity to determine what the specific state law is in that particular state. Therefore, the following discussion must be viewed in its general form, and there may be variations from state to state that would have an effect upon your choice of entity.
Liability
Let’s begin by talking about the liability concerns relating to choosing the appropriate entity for your business. The goal of most business people in general, is to create a legal entity that will protect them from individual or personal liability. As we are all too aware, we live in a very litigious society and people who lose money are apt to file lawsuits. Generally, this occurs whether or not you have actually done anything wrong. In the event that you or your business faces a lawsuit, the typical business owner will have a great desire to avoid any personal liability with regard to any such situation.
The Corporate Form of Entity
If you create a corporate form for your business, the corporation would be liable for any act of its officers, agents, or directors if such act was negligent or wrongful and was done on behalf of the corporation. Generally, a shareholder, just by virtue of being a shareholder, would not be responsible for corporate obligations. Corporations are typically either taxed as C corporations or S corporations, and the S election requires an IRS filing of Form 2553. In an S corporation there are limitations placed on the type and number of shareholders permitted. For example, an S corporation cannot have more than 100 shareholders, and with a few exceptions, cannot have shareholders that are not individuals. An S corporation shareholder cannot be a foreign person or entity, so no Canadian friends or relatives, no Bahamian corporations, no middle east sheiks.
The Limited Liability Company Form of Entity
Similar to a situation involving a corporation and its officers and shareholders, the member or managers of a limited liability company would not have any liability for obligations of the limited liability company. Of course, the limited liability company itself, just as a corporation, would be liable for all of its own obligations. This form is generally preferred over a limited partnership, because unlike a general partner, a manager of a limited liability company has no exposure to liability. In addition, when using an LLC, there is only one entity to be concerned about, and that is the limited liability company itself. Since there is no separate general partner entity, the business does not have to have two sets of books, two tax returns and two of everything.
Also, from a liability perspective, one of the things that business people like about limited liability companies is that if a creditor of a member of a limited liability company obtains a judgment against that individual member, the creditor does not automatically become a member of the limited liability company. In that situation, the creditor becomes a mere “assignee” and the limited liability company is only subject to a “charging order”, which simply means that the creditor now only will get distributions if any are made and will be liable with respect to any taxable income of the limited liability company. This is a significant detriment to a creditor. It is a detriment particularly because a creditor may end up in a position where it receives taxable income for which it will be liable to pay taxes to the US Treasury and may receive no corresponding distribution of cash to pay the tax liability. Therefore, the creditor is already out the money that is owed on the judgment and then finds itself in the position where it not only has not received any money to satisfy the judgment but it now owes the government taxes based on the taxable income of the limited liability company and it has no money to pay those taxes. This situation is actually the same in a limited partnership.
The Limited Partnership Form of Entity
In the limited partnership form of entity there must be at least one general partner and one limited partner. In a limited partnership all the general partners are liable for all the obligations of the limited partnership and this liability is joint and several, which means that if there are three general partners each one would be liable for all of the debts of the limited partnership, they would not be liable on a pro-rata basis. In the limited partnership form of entity, unless a limited partner actually participates in the management of the company (which is against the rules) a limited partner will not be personally liable for obligations of the limited partnership. The only exception to this rule is that a limited partner is always liable for the amount of his investment in the limited partnership.
In a worst case scenario, it is possible that a limited partner may have to pay back a portion of the amount that they have contributed to buy their limited partnership interest if such amount was not yet fully funded by them or even in some cases where the amount was distributed back to them as a distribution from the limited partnership.
Business owners who use this form of entity for their business generally create another entity to act as the general partner. This entity that acts as the general partner could be a corporation or a limited liability company (it actually could be any type of entity but those are the two which are typically chosen). The general partner entity should not be an entity that has no assets i.e. simply a shell entity. To create a shell entity to act as the general partner would not only violate the IRS rules, but would subject the owners of that entity to personal liability. Therefore, for tax purposes it is typically required that the general partner have at least 1% in net worth of the total amount of contributions made to the limited partnership. This generally meets the IRS rules although it would be best for the general partner entity to have a more substantial net worth in order to avoid the possibility that the individuals could be held liable for these obligations.
Taxation Issues
In the business world there are really only two different forms of entities for tax purposes. Generically your entity is either a corporation or a partnership for taxation purposes. The IRS has a form that is referred to as the “check the box” form. In this form you designate whether or not you are a corporation or partnership for tax purposes. If you are in the real estate industry, for example, you would probably not desire your entity to be viewed as a corporation for tax purposes. This is primarily because you cannot transfer or remove any appreciated property from a corporation without incurring a tax liability. Even an S corporation has problems which are insurmountable when you are dealing with real estate because you cannot allocate different amounts among the shareholders.
In an S Corporation there is an additional problem that the losses are limited to the amount of the money that the shareholder has “at risk” which means that the amount they have invested plus any amount of loans for which the shareholder is directly liable.
Partnership Taxation
In areas such as real estate, partnership tax law is much more favorable than corporation tax law. Therefore, it is advisable in nearly every case for the entity that you choose for your real estate transaction to be treated as a partnership for tax purposes. Most commonly in this situation your entity will either be a limited liability company or a limited partnership. Under partnership tax law it is possible to allocate distributions and taxable gains and losses differently among the members. In other words, there can be various classes of membership interests in a limited liability company or a limited partnership. While the tax rules with regard to “special allocations” are somewhat complex, they provide a mechanism for a business to create different classes and hence different incentives for different investors. Another excellent benefit of partnership taxation is that for legal entities that own real estate, members can have “basis” for portions for debt that is incurred. The result of this is that it could allow a member to claim losses from the property that are in excess of the cash that they have invested. This is not possible under corporation taxation rules. Under partnership law there is the concept of “qualified non-recourse debt” which is a special rule which does not exist in the world of corporate taxation. While the general rule in partnership tax and corporate tax is the same i.e. the investors limited to losses equal to the amount that they are at risk, there is this one exception in partnership taxation. Therefore, if there is non-recourse debt related to the property and it meets the definition of “qualified non-recourse debt,” and the debt has been incurred in relation to rental real estate, a member of an LLC or a partner in a limited partnership can include their portion of the non-recourse debt in their basis. If they do this, they could conceivably get losses in excess of the amount of cash that they have actually invested.
Special Allocations
With regard to special allocations, you should keep in mind that the law requires that these allocations have “substantial economic effect” which generally means that there must be a good business reason for the allocation. Obviously, you could not allocate all of the gain to one group of partners and all of the losses to another because that would simply too obvious that is was being done for purely tax reasons and not for legitimate business purposes. What this does however, is create the ability for a business owner to create separate classes with preferred returns to different classes of partners and differentiation with regard to allocations for different classes based on their risk involved in the transaction, amount invested or other factors. For example, one small class of partners may be required to sign on recourse debt and in exchange for that would receive a substantial preferred return before any other partners received any distributions.
Hybrid Partnership Forms
Since the creation and acceptance of limited liability companies, many states have proceeded to create other hybrid entities which are treated as partnerships for tax purposes but have somewhat different forms. For example, in Florida, in addition to limited partnerships, limited liability companies and partnerships there are also limited liability partnerships and limited liability limited partnerships the last two being referred to a LLPs and LLLPs.
The Series LLC
Delaware has recently created a new entity called the Delaware Series LLC. This concept allows one LLC to create a number of different series or units under the same LLC entity. The idea is that each different series or unit can own distinct assets and can incur liabilities separate from the other units and can even have different managers and different members. This is a reaction to the existing law because until now most people in the real estate industry and other business people who own real estate would create a separate LLC for each parcel of real estate. This keeps each of the properties separated legally and keeps each property away from creditors of the other properties.
Delaware is seeking to simplify the administrative aspects of having a variety of different LLCs for different projects. As created by Delaware, you could have five different real estate projects, for example, and have each one in a different series or unit of the same LLC. Each project would have its own loans and debts which would be separate from the others and there would be really no crossover in liability between the different series or units. This concept certainly reduces complication and reduces some of the expenses involved in maintaining a number of different and separate limited liability companies.
The only problem with this concept at the present time is that if you have a Delaware Series LLC and you are operating in a state where the state law does not provide for a creation for a Series LLC, then the law of that state may not recognize the Delaware LLC and the limitation on the crossover between the units as it relates to liabilities.
Since the inception of the Series LLC in Delaware, a number of other states have adopted the same or similar legislation.