What Business Entity Makes Sense For Your Firm

A.  Introduction

Illinois Limited Liability Companies (“LLC”) are governed by 805 ILCS 180/1-1. The Limited Liability Company Act (“LLCA”).

An LLC is a separate legal entity and requires certain procedural steps be followed. First, the LLC organizer(s) must file articles of organization (the LLC counterpart to a corporation’s Articles of Incorporation) with the appropriate state agency (generally, the Secretary of State). The articles of organization must contain: the name and address of the principal place of business of the LLC; its period of duration; the business purpose (ordinarily, language to the effect of for the transaction of any or all lawful business for which limited liability companies may be organized under the Limited Liability Company Act); the registered agent’s name, the registered agent’s address; the name(s) and address(es) of the initial LLC’s manager(s) or members; and a statement indicating that the LLC is managed by managers; the names and addresses of each organizer; and any other provision the members/managers elect to include.

Before the articles of organization can be filed, however, a name must be chosen and approved by the Secretary of State (the purpose of this approval is to prohibit the use of the same or similar names by two different business entities). An LLC must contain the words “Limited Liability Company” or the abbreviations “L.L.C.” or “LLC” after its name to indicate that it is an LLC. The name must not contain any of the following words or abbreviations: “Corporation,” “Corp.,” “Incorporated,” “Inc.,” “Ltd.,” “Co.,” “Limited Partnership,” or “L.P.”.

Next, an operating agreement should be prepared listing the rights and duties of all of the members. Here, as well as in the company minutes if so adopted after the LLC’s formation, is the appropriate place for language to be included governing business succession and ownership interest transfer restrictions. Even though more expensive than a corporation, the costs associated with forming an LLC are relatively minimal in relationship to the asset protection features inherent in a properly drafted operating agreement in addition to statutory protection.

B.  Uses by the Professions

Because professionals typically have conducted business in unincorporated forms, they have faced unlimited liability for obligations arising from their professional practices. Those who have incorporated their practices may have encountered income tax problems (including double taxation of income when operating as a C corporation if one does not zero out their earnings and the lack of flexibility in ownership and operation as an S corporation) and nontax problems (including administrative costs and the view that operation in incorporated form is either “unprofessional” or impractical). LLC’s appear to avoid these problems.

As a result, LLC structures had become the focal point of professionals, including accountants and lawyers, seeking protection from unlimited liability while avoiding double taxation and the need to incorporate. A number of states have provisions specifically allowing professionals to practice as LLC’s. Though the new rage appears to be the usage of LLP’s!

Nonetheless, there are important unresolved questions concerning multistate practice by professional LLC’s, including the issue of cross-border protection from liability and the difficulty for multistate firms to meet state regulatory or statutory restrictions. In order to be a member of a professional service LLC, the member typically must be authorized by law to provide the professional services for which the LLC was formed. Under the LLC statutes of some states, it is required that all members of a professional LLC be authorized to practice in the particular state in which the LLC is organized. Under the legislation of some states, members need be authorized only by the law of the state in which they actually render services.

As described below, the potential impact of LLC acts in general and the LLC in particular:

1. accountants,
2. attorneys, and
3. other professionals practicing in Illinois merits consideration.

Attorneys and Law Firms:

On April 1, 2003, the Illinois Supreme Court issued an amendment to Supreme Court Rule 721 and created Rule 722, authorizing limited liability legal practice. The Rules were in response to a joint petition filed by the Chicago Bar Association and Illinois State Bar Association in March 2002 requesting that the Court amend the Rules to allow lawyers practicing in limited liability entities to be protected from unlimited vicarious liability under certain circumstances. The Rules took effect July 1, 2003.

The Rules eliminate mandatory vicarious liability of law firm partners for malpractice committed by other firm lawyers not in their control. The centerpiece of the Rules is a quid pro quo permitting lawyers with an equity interest in professional corporations, professional associations, limited liability companies, and registered limited liability partnerships to avoid vicarious liability as long as the firm maintains adequate insurance or other proof of financial responsibility.

A minimum level of insurance under the rules is $ 100,000 per claim and $ 250,000 annual aggregate, times the number of lawyers in the firm, and insurance need not exceed $ 5,000,000 per claim and $ 10,000,000 annual aggregate. As a result, the Rules improve clients’ ability to recover for malpractice. While every other state allows limited liability practice in some form, only 11 require insurance as a condition of limited liability. Illinois is now one of twelve states that clearly express an interest in putting clients’ interests first and the interests of their attorneys in making a living in a competitive environment at a disadvantage versus other licensed professionals.

Additional provisions of the Rules protecting clients are that partners remain fully liable for their own malpractice and that of lawyers under their direct supervision and control, partners remain jointly and severally liable for amount of insurance deductible unless proof of financial responsibility is provided in the amount of the deductible, and law firm assets remain liable for malpractice committed by any firm lawyers.

Accountants:

The American Institute of Certified Public Accountants (AICPA) was among the first professional organizations to recognize the potential viability of the LLC as a practice vehicle on a profession-wide basis. Before 1992, the AICPA prohibited the practice of accountancy in any form other than as a proprietorship, a partnership, or a professional corporation whose characteristics corresponded to AICPA Code of Professional Conduct Rule 505. The rule was amended in January 1992 by an overall majority of members of the AICPA voting on the issue, and Rule 505 as revised allows members to select any organizational form, including the LLC, to better serve accountants' needs in connection with limiting their exposure to liability and facilitating their ability to establish multi-state practices in order to better serve clients who operate in more than one state.

Most of the LLC acts enacted to date have not explicitly authorized or approved of use of LLC’s by accountants; however, as a statutory matter this does not appear to be necessary as long as they are not explicitly precluded from using LLC’s. Indeed, the majority of LLC acts remain silent on this point. A Kansas Attorney General's opinion has authorized the use of LLC’s by accountants, but other states, including Illinois, have not explicitly issued rulings or attorneys general's opinions regarding such usage.

In Illinois, the practice of public accounting is governed by statute. A person, either individually or as a member of a partnership or an officer of a corporation, may be deemed to be in practice under the Illinois Public Accounting Act. 225 ILCS 450/8. The practice of public accounting without licensure with the Illinois Department of Professional Regulation is a Class B misdemeanor. 225 ILCS 450/7, 450/28(a). The Illinois Public Accounting Act was amended by P.A. 88-36, effective January 1,1994, to permit the practice of public accounting in limited liability company form. 25 ILCS 450/8. The LLC must make application to the Department of Professional Regulation for licensure and pay the requisite fee. 225 ILCS 450/13.

In Illinois, the Illinois Society of Certified Public Accountants has actively sought to remove regulatory restrictions that might preclude the practice of accountancy via the LLC form. It is anticipated that in light of the amendments to the Illinois Public Accounting Act many accountants will utilize the LLC as a form of business, and it is unlikely that the Illinois Supreme Court will invalidate this form of organization or prevent limitation of accountants’ liability. Although use of the LLC is unlikely to protect a member from personal liability for his or her own malpractice, there is a good likelihood that the LLC form will protect a member of an accounting firm from vicarious personal liability for malpractice committed by a co-owner unlike the case for lawyers, discussed above. Since accountants can utilize LLC’s in Illinois, it is anticipated that most accounting firms will explore the structure, using a cost-benefit analysis in their deliberations. Accountants likely to give serious thought to using the LLC format are those who are engaged in practices prone to malpractice and/or bankruptcy (i.e., those who prepare certified audits for publicly traded companies, those who provide tax advice and/or tax return preparation, and those involved in audits of industries such as savings and loans and banks that have been relatively prone to potential professional liability litigation in the event of the bankruptcy or collapse of their audited clients).

The typical disadvantages of using LLC’s also apply to professionals, including the filing fees and related costs of formation and operation, which are substantially higher than those of the general partnership form; the lack of law in interpreting many of the provisions that must be utilized in the firm's operating agreement; and the uncertain protection that LLC’s provide with respect to shielding a member from practice liability (such as malpractice) that arises due to actions of other members or employees of the firm. In addition, there are certain tax issues relating to operating as an LLC when one is in a professional practice, including a question of the ability to retain the cash method of accounting rather than being forced into the accrual method, with potentially disastrous tax consequences.

On the basis that every member actively practiced the profession and had voting rights on numerous matters affecting the firm’s governance and operation, the IRS has indicated in two Private Letter Rulings a willingness to permit professional service LLC’s to use the cash method of accounting. See PLRs. 9321047, and 9328005. It is by no means clear that medium- or large-sized firms will be willing to permit all their members to participate in firm management to the extent permitted in the aforementioned letter rulings. Therefore, professionals would be prudent to seek letter rulings for their own protection absent a Revenue ruling or regulation promulgated on point.

The so-called [“Final 4”] national accounting firms have chosen to operate as limited liability partnerships (LLPs) rather than as LLC’s. It is understood that this choice was based on numerous factors, including the inability of professionals to operate as LLC’s in a few states, the relative ease of registering as an LLP and remaining uncertainties as to the deductibility under §736 of payments to redeem the interests of members of an accounting firm LLC. Accounting firms doing business in Illinois or adjoining states are free to practice in LLC or LLP form, and small and medium-sized Illinois accounting firms use both types of formats.

However, a cost-benefit analysis may cause many service providers to determine that operation in partnership or corporate form is preferable, particularly if the perceived magnitude and risk of personal liability are minor.

C.  LLC Basic Advantages

Because of their flexibility and relative simplicity, the LLC is well suited for both start-up businesses and more mature businesses. LLC's have several advantages:

• LLC's provide greater management flexibility than corporations. For instance, corporations are required to have a formal structure with directors and corporate officers. LLC's are simply run by the members or managers.

• LLC's provide greater flexibility with regard to income distribution than do corporations. When corporations pay dividends, those profits must be distributed evenly on a dollar per share basis. LLC's may distribute income as desired.

• If a small business is interested in “pass-through” taxation, then LLC's have an advantage over S Corporations with regard to ownership flexibility. All shareholders of S Corporations must be citizens or permanent residents of the United States and there may be no more than 75 shareholders in total. LLC's do not have these restrictions, again allowing greater operating flexibility.

• Caveat: LLC distributions, unless structured properly pursuant to its operating agreement are generally subject to self-employment tax, whereas, dividends on S corporations are not.

• Erosion of charging order protection via judicial foreclosure against a member's interest

D.  Use of a Single-Member LLC

A single-member LLC's provides considerable flexibility for its owner. Individuals forming a new business may choose to forego the liability of operating the business as a sole proprietorship, or the forming a corporation to own the business, by creating a single-member LLC which would own and operate the business and assets. The single-member LLC provides advantages over partnerships with a single equity source because a single-member LLC eliminates the need to have two or more owners and this may result in fewer costs by avoiding the need for creation of more than one legal entity to act as partners. Additionally, single-member LLC's may be used to own multiple divisions of a business or multiple real properties with ownership is vested in a single-entity.

A disadvantage of a single member LLC is that such an entity files a schedule C, when owned by an individual or otherwise disregarded entities for income tax purposes. For individual reporting schedule C taxpayers have a higher audit incidence than non-schedule C taxpayers.

E.  To Hold Real Estate

Owning, developing and operating commercial real estate may be a liability-prone business. The owners of real estate can limit their liability with a LLC. However, LLC owners may not be fully exculpated from real estate liabilities using an LLC. In many instances, lenders may require LLC members to personally guarantee loans.

LLC's may own, operate, and lease as a landlord, real estate. 805 ILCS 180/1-30(3) and (4). The LLC is not required to disclose its member's identity unless they are also the LLC organizers or managers. 805 ILCS 180/5-5(a)(4), (5) and (7).

Management of Real Estate: Investors in real estate joint ventures may seek to obtain limited liability by becoming a limited partner. However, limited partners risk losing their protection against liability if they participate in control and management of a limited partnership. See 805 ILCS 210/303. Alternatively, an LLC will give the same investor the benefit of limited liability and the ability to manage the business. For example, a firm owning several real estate projects may form a LLC to own each project separate and apart from ownership of the other projects.¹² This structure may have the effect of isolating liabilities to a given project or property.

LLC's also may be used in connection with like-kind exchanges intended to qualify under I.R.C. §1031. The general rule requires that the party who transferred the exchange property must receive replacement property received in an exchange. This requirement may create issues in that the transferor of the exchange property may wish to insulate itself from personal liabilities in connection with the exchange property, perhaps because of the different nature of the replacement property or because for historical reasons the exchange property had been vested in the transferee rather than in a single-purpose limited liability entity such as a corporation, limited partnership, or LLC.

A LLC will be disregarded as a separate entity for income tax purposes, and the replacement property may be received by an LLC whose single member is the transferor of the exchange property, thereby permitting both completion of a like-kind exchange under I.R.C. § 1031 and limited liability for the transferor as a member in the LLC that receives the replacement property. Additionally, under very limited circumstances, the IRS has permitted the use of a two-member LLC to be treated as a disregarded entity and thereby complete an exchange when the second member does not have an interest in profits or losses of the LLC but instead has been inserted into the LLC's organizational structure for control purposes. See, e.g., PLR 199911033.

(See G. In Lieu of Corporate Subsidiaries: below: regarding minimizing potential environmental liability).

F.  To Hold Tangible Personal Property or Intangible Assets

Intangibles: Where a corporation has many businesses and one of its businesses is a high-risk business, the corporation's shareholders could establish an LLC to carry on the high-risk business that would otherwise have been carried on by the corporation. The corporation leases the use of its fixed assets and licenses its intangibles to the LLC at fair market value rentals and payment of license fees. In addition to the LLC receiving the rentals and license fees, the corporation could use existing contracts, inventory and outstanding accounts receivable to capitalize the LLC. The LLC thereafter generates all future income of the high-risk business that would have otherwise gone to the corporation. This structure may isolate corporate assets from potential LLC future creditors.

• CAVEAT: Be sure to have counsel review fraudulent conveyance and fraudulent transfer statutes prior to any such transfer.

G.  As an Estate Planning Vehicle

The Family LLC: LLC's have not yet been the subject of voluminous IRS or court rulings relative to estate planning. The IRS, however, has indicated that gifts of a limited partnership interest qualify for the annual gift tax exclusion as a gift of a present interest.14 As an LLC when formed is taxed as a partnership, there is no authority that a contrary position would be taken with regard to an LLC. Further most LLC statutes are derived in great part from limited partnership statute. For example the concept of restricting creditor attachment to a charging order is generally utilizing language form the Uniform Limited Partnership Act as adopted on a statewide basis. Therefore, taxpayers can consider using LLC's to increase the amount of property transferred via the annual gift exclusions and lifetime transfer exemptions. This is due to the ability to obtain discounts on the value of property contained within a LLC or a family limited partnership, FLP.

An example of an estate planning technique may consist of gifts of ownership interests in a LLC to family members or to a trust for the family member's benefit. Since the LLC interest is being transferred, rather than a direct ownership in the underlying assets, discounts for lack of marketability, lack of control and minority interest discounts are generally available. As long as the donor does not retain impermissible control over the gift, any appreciation, as well as the gifted asset will generally not be included within the transferor's estate

Any type of trust can be a member of an LLC, as opposed to ownership restrictions placed upon shareholders within S corporations. Additionally, valuation discounts for lack of marketability and control can reduce the potential gift tax on business interests gifted to family members. In the FLP scenario, which should be equally applicable to LLC's, generally allows a combined discount of 35% of an assets value within a LLC, based upon recent court rulings.

LLC's formed between family members for estate planning or income-shifting strategies can be utilized to provide special classes of ownership such as preferred and subordinated interests in capital, profit and cash flow. For example, using multi-classes of ownership creates a method in which cash flows can go to a donor during their lifetime while providing substantial asset growth for the donees benefit. However, assuming that I.R.C. §2701 is applicable to an LLC in the same manner and method as to a partnership, IRC § 2701 must be understood.

In essence, the partnership rules hold that I.R.C. §2701 applies to an LLC if an individual transfers an interest in the LLC to or for the benefit of a family member, while retaining a liquidation, put, call, conversion, or distribution right and the interest transferred is not of the same class or proportionally the same as the retained interest. Thus, to avoid triggering the application of I.R.C. §2701, care must be exercised when contemplating creating different classes of interests. Conversely, if different classes of interests are created, they should be limited to differences in the right to vote or manage the LLC as they should not cause §2701 to apply.

Not all is lost: It is still possible to use an LLC to transfer some value without creating differing classes of distribution rights and liquidation preferences that I.R.C. §2701 was designed to prohibit. For example, a family can create a member-managed LLC, where a senior member can receive compensation for managing the LLC. This appears to be one method of acceptable income shifting for LLC's and partnerships that may not trigger I.R.C. §2701.

Still another wealth shifting method is to receive lease payments from a LLC. Leasing has been a traditional income shifting technique used as an income tax planning device. A leasing agreement works as an estate freezing techniques also. See C. As a Valuation ?Freeze? Entity above.

Additionally, though the annual gift exclusion likely applies to LLC's, these transfers must be analyzed in the context of estate tax law and retained interests. Specifically, IRC § 2036 transfers with retained life estates and IRC § 2038 revocable transfers that may include gifts made prior to death in a transferor's estate, applicable to LLC transfers. Particularly § 2036 appears to be the new tool of the IRS to attack transfers with retained interest.

Retained Interests: This is an issue specifically raised in a family-held LLC, where an older member is also a designated manager. The general rule is that management powers retained by a general partner are subject to strict fiduciary duties imposed by state law. As a direct result of those fiduciary duties, such as the duty of loyalty and care, the prevailing view is that this authority is not treated as a retained interest includable in the taxable estate. Two letter rulings have held that the power that a general partner retains with respect to the partnership interests he transfers to junior family members should not cause those transferred interests to be subject to estate tax inclusions within either I.R.C. §2036 or I.R.C. §2038.These rulings relied on the rationale of US v. Byrum, 408 U.S. 125 (1972), which held that the stock transferred by a controlling shareholder to an irrevocable trust was not includable in his estate because the decedent had a fiduciary duty to the corporation and to the minority shareholders as a controlling shareholder and member of the board of directors.

Arguably, in an LLC, member-managers may also have a strict fiduciary duty imposed by state law to other members, therefore, analogous to Byrum, an LLC interest transferred to other family members should not be subject to either I.R.C. §2036 or I.R.C. §2038 by reason of the control rights. However, the landscape has drastically changed with the holding in Estate of Strangi v. CIR, 115 T.C. 478, (2000), aff’d in part and remanded in part, 293 F. 3d 279, (5th Cir. 2002), on remand, T.C. Memo. 2003-145, 2003.

In Strangi, the Tax Court eliminated all estate tax discounts for a family limited partnership that was created and the assets transferred within three years of the decedent’s death. The Court held, as it had in prior cases, that § 2036(a)(1) required this result. However, the Court then went on to reach the alternative holding that § 2036(a)(2) also precluded the estate from claiming a discount. However, the alternative holding in Strangi appears to be based on a misreading of the Supreme Court’s Byrum decision and is inconsistent with the Service’s own published guidance.

§ 2036(a)(1) applies where the decedent has retained either:

1. the possession or enjoyment of the transferred property; or
2. the right to the income from the transferred property.

Given the statute’s disjunctive structure, the courts (although the Supreme Court has not yet spoken to the question) have understandably made clear that the retained ability to enjoy or possess property need not be legally enforceable. Thus, if the possession or enjoyment of transferred property is retained under an implied understanding or agreement that a decedent would not have been able to enforce under state law, inclusion is nevertheless required.

In contrast, section 2036(a)(2) applies only where a decedent has retained the right to control the beneficial enjoyment of transferred property. An important question arising under this provision is whether the decedent’s retained practical control is sufficient to trigger estate inclusion where state law imposes certain constraints that narrow the scope of the decedent’s power. It was precisely this question that the Supreme Court addressed in Byrum. The Service itself has read Byrum as establishing the proposition that the provision is applicable only where the decedent retained a legally enforceable right.

Under this reading, if the decedent’s ability to control is circumscribed by a fiduciary duty owed to an unrelated or related minority interest, the decedent cannot be viewed as having retained a legally enforceable right. Byrum can also be read as strongly implying that the retained ability to cause the liquidation of an entity is too speculative to serve as a predicate for estate tax inclusion. Nevertheless, in Strangi, the Tax Court concluded, as part of its alternative holding, that the fiduciary duty that the decedent had owed to family members should be disregarded and that his ability to cause liquidation was sufficient to trigger § 2036(a)(2). The Strangi reading of § 2036(a)(2) flies in the face of the IRS’s previous reading of Byrum.

In TAM 9131006, the Service concluded that § 2036(a)(2) did not apply to a family limited partnership even though the decedent, as general partner, had the ability to control partnership distributions to limited partner, donees, and all partners were related to the decedent. It predicated its conclusion on the decedent’s fiduciary duty. In doing so, the court cited Estate of Gilman v. CIR, 65 T.C. 296 (1976) and Byrum, and made no reference to the fact that the decedent’s fiduciary duty was owed exclusively to family members.

Additionally, the Service appears to have endorsed Byrum in a published ruling as well. In Rev. Rul. 81- 15, 1981-1 C.B. 457, the Service invoked the Byrum fiduciary-duty analysis and concluded that § 2036(a)(2) did not apply in the case of corporate stock where a decedent had retained voting rights even though the only shareholders were the decedent and a family trust created by the decedent. Mysteriously, the Strangicourt made reference to the TAM, dismissing it on the grounds that it held no weight as a precedent, but it then failed to mention the revenue ruling, despite the mandate that the Service is obligated to respect its published rulings in Tax Court litigation.²²

In Strangi, the court concluded that the decedent's ability to vote with others to cause a liquidation constituted sufficient control to invoke § 2036(a)(2). The court further held that the fiduciary duty the decedent had owed to his family members did not adequately constrain his retained right to vote on liquidation or distributions ²³ and therefore, should be disregarded. ²⁴ Granted, it is comprehensible that the Court wished to establish a set of laws that will end abusive family partnerships, yet neither Strangiconclusion follows given Byrum, Rev. Rul. 73-143, Rev. Rul. 81-15 and Congress's ratification of Byrum's perceived understanding.²⁵

Planning Around Strangi:

1. Given Strangi's § 2036(a)(2) holding, existing partnerships and LLC's should seriously consider restructuring their agreements relative to any retained interests.
2. As for structuring new partnerships and LLC's, Strangi itself suggests a straightforward method for avoiding its § 2036(a)(2) holding. If other family members also contribute assets to the LLC at its formation in exchange for LLC interests and each receives a LLC interest equal in value to their contribution,Strangi suggests the potential to treat the transaction as a pooling. If it qualifies, § 2036's bona fide sale exception would preclude § 2036(a)(2) from applying at the death of any contributing member. In structuring an LLC to qualify as a pooling, care must be taken in drafting the operating agreement.26

IRC §2702 Issues:

Consideration should be given to placing an LLC interest in a grantor retained annuity trust (GRAT) or a grantor retained unitrust (GRUT).

Grantor Retained Annuity Trusts (GRATs)

Under a Grantor Retained Annuity Trust (“GRAT”), a grantor transfers assets into an irrevocable trust while retaining a current income interest from the trust for a specified period of time.27 Concurrently, the grantor must transfer a remainder interest in the trust property to the individuals to whom he intends to pass the assets upon his death.²⁸ Normally, such a transfer would subject the transaction to substantial federal gift taxes. However, by structuring the current income interest as a fixed payment annuity, § 702 ('special Valuation Rules in Case of Transfers of Interests in Trusts) permits the transfer to occur at least partially tax-free.29 Because the payments, if properly planned, will expire prior to the grantor's death, the remainder interest vests with the trust's beneficiaries prior to the grantor's death and the assets have effectively been removed from the estate. Moreover, any appreciation in value of the assets after the date of transfer to the trust is entirely removed from the estate.30 Any return on the assets in excess of the annuity payments inures to the remainder interest free of any gift taxes. However, as a grantor trust, the full value of the trust? income remains taxable to the grantor until the expiration of the annuity period.

Grantor Retained UniTrusts (GRUTs)

The GRUT differs from the GRAT only in that the annual annuity payment is calculated as a percentage of the annual value of the trust, rather than as a fixed amount.31

A GRAT is optimal when it produces the income necessary to fund the annuity payments without any diminution in amount. An LLC taxed as a partnership is quite the opposite. This should usually be a good asset to fund a GRAT. Note that a partnership, and by extension an LLC taxed as a partnership, can receive basis adjustments under I.R.C. §743 and I.R.C. §754. Those adjustments are only available if the asset is purchased or upon death via a step up in basis under I.R.C. §1014. This might make the gifting of an LLC interest to a GRAT or GRUT less desirable if the asset has a low basis.

CAVEAT: The Service takes the position that if there is a transfer of an interest to an assignee and if the assignee of an interest cannot vote on liquidation, it is a lapse subject to I.R.C. §2704(a). FSA 200049003. Furthermore, if the restriction on liquidation was to be disregarded under I.R.C. §2704(b), which provides for applicable restrictions to be disregarded when they effectively limit the ability of the partnership to liquidate in a more restrictive fashion than state law, then an interest which is disregarded for purposes of I.R.C. §2704(b) should also be disregarded for purposes for I.R.C. §2704(a). See FSA 200049003.

H.  To Hold Life Insurance Policies

Using LLC's in lieu of an irrevocable insurance trust adds flexibility for controlling and holding policy proceeds versus the constraints generally contained within an irrevocable insurance trust. However, when a LLC invests in life insurance policies important beneficiary and transfer for value concerns must be understood.

Beneficiary Concerns:

The issues explored in relation to corporate-owned insurance must also be addressed in the context of partnership or LLC owned life insurance. The IRS's position on partnership owned life insurance is set forth in Rev. Rul. 83-47, 1983-2 C.B. 158. Rev. Rul. 83-47 analyzes two situations regarding partnership-owned life insurance:

1. insurance on a partner's life is payable to the partnership, and
2. where the insurance is payable to a third party for a non-partnership purpose.

In PLR 200017051, the IRS ruled that the general partners of a family limited partnership that owns policies insuring their separate and joint lives do not have incidents of ownership with respect to the partnership-held policies by reason of their general partnership interests. As the partnership agreement prohibited general and limited partners from participating in the exercise of any incident of ownership with respect to any policy insuring his or her life, no incidence of ownership were present.

• NOTE: Proper drafting of the partnership agreement in this instance was the key

Similarly, in PLR 200111038, the IRS ruled that an insured couple did not possess § 2042(2) incidents of ownership in three survivorship policies on their lives that a trust they created planned to transfer to a limited partnership. The trust, which benefited one spouse’s parents and the spouses’ children, was to receive limited partnership interests in exchange for the policies. The couple also planned to contribute cash to the partnership in exchange for limited partnership interests. Additionally, another trust created by the couple planned to contribute cash in exchange for general partnership interests.

The limited partnership, as policy owner, planned to name itself as beneficiary. The partnership would own other assets in excess of the policies face amount and would continue the historic trust investment activities including contributing the policies. The IRS noted that the limited partners could not exercise control over the partnership's business, management, or investment decisions, could not vote on or take part in the partnership's management and operations, could not participate in the partnership's day to day affairs, and could not sign for or bind the partnership.

Insurance Payable to or for the Benefit of the Partnership:

In Knipp Est. v. Commissioner, a partnership owned insurance policy on the life of a deceased partner, which were payable to the partnership. The court held that the partnership, not the decedent, possessed the policies incidents of ownership. Therefore, the insurance proceeds were not includable in a deceased partner’s gross estate. The IRS acquiesced in Knipp since inclusion of the policy’s face value in the decedent's gross estate “would have resulted in unwarranted double taxation of a substantial portion of the proceeds. This was due to inclusion of the decedent's proportionate share of the partnership interest which was increased by the receipt of the policy proceeds. This however, still resulted in reduced estate taxation, due to valuation discounts present in the LLC or limited partnership structure.

Knipp based its decision on an entity theory of partnership, that is, the partnership, as an entity, possessed the policy’s incidents of ownership. That view is contrary to the aggregate theory of a partnership endorsed by Rev. Rul. 83-147, that a partnership is merely a collection of individuals. Regardless of the IRS’s rationale, the result of acquiescence in Knipp is recognition that insurance payable to a partnership should properly be taken into account for federal estate tax purposes only to the extent it affects the valuation of the decedent’s partnership interest.

Insurance Payable to Third Party:

In Rev. Rul. 83-147, the decedent owned a one-third interest in a partnership which owned an insurance policy on the decedent's life, payable to his child. Had a corporation, rather than a partnership, been involved, the corporation’s incidents of policy ownership would not have been attributed to the decedent, since such attribution occurs only when an insured, decedent owns more than 50 percent of the voting stock of the corporation.

The IRS took a different view in the partnership context. Viewing the partnership as an aggregate of individuals, rather than a separate entity, the IRS found that the partners as individuals held the ownership rights in a partnership-owned policy. Thus, the IRS ruled that the decedent, in conjunction with the other partners, possessed incidents of ownership in the policy.

Under Rev. Rul. 83-147 reasoning, the size of the decedent’s proportionate partnership interest is irrelevant; inclusion in the gross estate results in every case where partnership-owned insurance on the life of a partner is payable to a third party.

Transfer for Value:

Under the general rule, the proceeds of a life insurance policy received by a beneficiary are excluded from his gross income. IRC § 101(a). An exception to this general rule is when there is a “transfer for a valuable consideration”. IRC § 101(a)(2). This rule is known as the “transfer for value” rule. Where there has been a transfer for a valuable consideration, the amount excluded from gross income will be limited to the amount of the consideration paid plus the premiums subsequently paid by the transferee.

While the transfer of a life insurance policy for estate planning purposes is ordinarily intended as a gift, in a business purpose context, the transfer of a life insurance policy is generally not intended as a gift. In business, there will generally be a “transfer for a valuable consideration.” Issue. If the §101(a) exclusion from gross income for the proceeds of a life insurance policy is to be preserved, the transfer must fall within one of the two exceptions to the “transfer for value” rule.

The first exception is where the transferee’s basis is determined by reference to the transferor’s basis. The second exception provides that a “transfer for value” will not destroy the §101(a) exclusion “if such transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer.”

The transfer of a life insurance policy in the business context frequently involves a policy which is intended to fund the buyout of an insured’s interest in the business entity. In this context, it is well established that a “cross-purchase agreement” can easily be converted into an “entity purchase or a redemption agreement,” but that the reverse may be difficult to accomplish. Several private letter rulings have approved a technique which may permit a conversion from an “entity purchase” to a “cross-purchase.” PLR 9012063 and 9239033.

The IRS has also approved the transfer of a life insurance policy to an irrevocable trust, where the trust and the insured were partners in a long-standing partnership. See PLR 9235029.

Query, whether the transfer for value rule will be avoided if insurance policies are transferred to a partnership created for that express purpose?

In PLR 9309021, a corporation was the owner of insurance policies on the lives of its two shareholders. The shareholders planned to form a partnership, the only purpose of which appears to have been to “engage in the purchase and acquisition of life insurance policies on the lives of its partners.” The IRS ruled favorably on the following rulings requested by the taxpayer:

1. The partnership will qualify as a “partnership” for federal income tax purposes.
2. The transfers of the life insurance policies from the corporation to the partnership qualify under the exception to the transfer for value rule under §101(a)(2)(B).
3. Proceeds of the policies distributed to one of the partners under an insurance contract on the life of the other partner would not be included in the gross income of the recipient partner.

The only issue seriously dealt with in PLR 9309021 was the qualification of the new entity as a “partnership” for federal income tax purposes. This issue involved an analysis of the four characteristics ordinarily found in a corporation. After finding that the entity did, in fact, qualify as a “partnership” for federal income tax purposes, the IRS ruled favorably on the other two ruling requests with little discussion. PLR 9309021 provides a blueprint for the conversion of a corporate redemption arrangement to a cross-purchase agreement; care must be given to the transaction.

• NOTE: Good drafting from a tax lawyer can save the day!

CAUSE FOR CONCERN: Rev. Proc. 98-3, added to the no-rule area to indicate that, in certain situations where a life insurance policy is transferred to an unincorporated organization, the IRS will not rule on: (1) whether the organization will be treated as a partnership under §§761 and 7701; or (2) whether the transfer will be exempt from the transfer for value rules of §101 if substantially all of the organization's assets consist, or will consist, of life insurance policies on the lives of the members. This no-rule policy was retained in Rev. Proc. 2000-3, and Rev. Proc. 99-3, which superseded Rev. Proc. 98-3.

In Rev. Proc. 2003-3, the IRS continued its absolute no-rulings policy on this issue. This no-ruling policy indicates that the IRS will no longer follow the result in PLR 9309021. Thus, additional caution in structuring partnerships for the sole purpose of transferring life insurance policies is advisable.

In PLR 200017051, a husband and wife established not only a partnership but also a limited liability company. Husband had established two life insurance trusts, one in 1984 that held only a policy on his life and one in 1988 that held two second-to-die policies on the joint lives of the husband and wife. Husband also had established a third trust (Trust 3), which over the years made unsecured loans to the insurance trusts for premium payments, evidenced by interest-bearing demand promissory notes. Husband made similar loans to the trusts. Husband, wife, and Trust 3 later formed a LLC, with the trust contributing cash, securities, and real estate in exchange for membership units with limited participation rights. Husband and wife contributed cash in exchange for all the membership units with the authority to control the company. On the same day, husband and wife, as general partners, and Trust 3, as a limited partner, formed a family limited partnership (“FLP”). Wife contributed cash, husband contributed cash and the insurance trusts’ promissory notes, and Trust 3 contributed cash, marketable securities, its interest in LLC, and the trusts’ promissory notes. The stated purposes of both LLC and FLP include managing and controlling the family’s assets and restricting the rights of non-family members from acquiring an interest in the assets.

FLP plans to demand payment on the promissory notes, which the insurance trusts will satisfy by transferring the insurance policies to FLP. If a policy’s value, determined under Treas. Reg. § 25.2512-6, is greater than the balance due under the notes then the trusts will withdraw cash value from the policy in sufficient amount to make the interpolated terminal reserve value (plus the proportionate premium amount extending beyond the proposed date of transfer) of the policies equal to the balance due. As the new owner of the transferred policies, FLP will designate itself as the beneficiary of the policies and will pay all of the policy premiums.

The IRS concluded that the transfers of the policies by the insurance trusts to FLP will be a transfer for valuable consideration because the transfers are for an amount equal to the value of each trust's interest in the policies and will discharge debt obligations that are enforceable under state law and are valid debt obligations for federal income tax purposes. The IRS then ruled that the transfer will satisfy the requirements of §101(a)(2)(B) and the amounts that FLP will receive under these contracts upon the deaths of husband and wife will be excluded from gross income because the transferee will be FLP, which is a partnership for federal tax purposes, and all of the insured’s under the policies to be transferred will be partners of FLP at the time the policies are transferred.

A complex solution to a complex issue!

I.  Asset Protection Tool

An LLC is extremely advantageous in that it provides tax flexibility and significant asset protection. Owner(s) of a corporation are referred to as shareholder(s) whereas owner(s) of LLC interests are referred to as member(s). The asset protection feature for LLC’s works in two regards. One regard is inside out protection, which provides the same protection as does a regular corporation in terms of preventing a creditor, inside the entity from pursuing an owner’s personal assets to pay off business debt.

The other protection is outside in protection which prohibits any individual owner’s personal creditors, outside the LLC, from seizing company assets, inside the company, or becoming owner-members of the LLC itself (against the will of the existing owner-members). This protection is derived from and is in accord with the protection afforded limited partners in a limited partnership.

Unlike a corporation, where a judgment creditor can seize a shareholder’s stock interest and take control of the entity, when enforcing claims against an LLC member, most state statutes limit judgment creditors to obtaining a “charging order.” A charging order is an order to attach the “economic interest” of a member against income from the LLC that is actually distributed to the member. The “charged” interest does not entitle the creditor to become a voting member of the company, and if income is not actually distributed, no payments would be made to the creditor.

A charging order is essentially a lien upon a debtor’s distributional interest held by a judgment creditor. In most states this order is the only statutory remedy to a creditor who has and is trying to enforce a judgment against a member in a properly established and maintained limited liability company. The statute and language is the same restriction that applies to enforcement of a judgment against a limited partner in a partnership. This provides a statutory basis and case law to determine the effects of a charging order.

Specifically, a charging order entitles a creditor to attach a member’s income interest and receive income actually distributed. A creditor, however, does not assume any of the rights and responsibilities of a member. Furthermore, since a creditor attaches an income interest, whether income is distributed or not, the creditor may be taxed on income that has not been received. This is the same law that applies to other members of an income interest in other pass-through entities (partnerships and S-Corporations) for income tax purposes.

A creditor armed with a charging order against a debtor’s membership interest has the same rights as an assignee of the interest: the right to attach a member’s economic benefits. Profits and distributions by the company are examples of economic benefits. It does not, however, include the right to attach the company’s underlying assets. It also does not include the ability to force a sale of the member’s interest or even to vote for such action at the company level. This is different from the same situation involving a corporation, where a creditor may seize the debtor’s shares of stock and if his ownership level is sufficient, actually end up owning the corporation.

In addition, there are other drawbacks for a creditor that seizes a member’s interest. For example, the company may have a provision in its operating agreement that prohibits someone from becoming a member unless there is unanimous consent from the other members. Absent such an affirmative vote by the other members (which for obvious reasons is highly unlikely) the creditor may never become an LLC member and hence won’t ever be able to have any control over or real influence in the company.

A provision also may be present in the articles of organization that requires the remaining members to purchase the interest of a charged member at a predetermined price. The price could be a fair market value price or at a price less than fair market value (if this lesser value approximates the value of the pro rata share of the company’s asset value in the event of a liquidation). Hence, through careful preliminary drafting, it is possible for LLC members to prohibit third parties (especially judgment creditors) from becoming, or even from wanting to become, members. Rather, the creditor may wish to settle with the debtor for a smaller sum of money then is owed. Therefore, we recommend inserting language to this effect into an LLC Operating Agreement.

Moreover, creditors with no right to cash flows will likely not want to have an economic interest in the LLC. For example, even though a partnership had a provision prohibiting an assignee from becoming a substitute limited partner without the consent of the general partners (and the general partners did not in fact consent), an assignee was nevertheless treated as a limited partner for income tax purposes due to his dominion and control of the interest. This ultimately meant that the assignee reported a distributive share of any income, gain, loss, deduction, and credit available to that interest in the amounts applicable to that interest as if that person were an actual substitute limited partner. (Rev. Rul. 77-137, 1977-1 C.B. 178; see also Evans v. Commissioner, 54 T.C 40 (1970) (Tax Court held that the assignee of a partnership interest was taxable as a partner because he held a capital interest in the partnership as defined in Treas. Reg. § 1.704-1(e)(1)(v))).

This poses obvious problems for a creditor-taxpayer that must report and pay applicable taxes on a distributive share of income that was not actually distributed. This party could wait for years until his claim is satisfied if the company in question is not cooperative and unsympathetic to his situation. Moreover, the threat or the imposition of adverse tax consequences is a strong negotiation factor relative to settling a personal debt.

Another major problem for a creditor with a charging order is that the debtor, not the creditor, still retains any company managerial powers held prior to the charge. It is a possibility that in the operating agreement, or perhaps as part of the judgment between the debtor and the creditor that the debtor may be required to exercise any remaining (nontransferable) interests and rights in the company to the benefit of the creditor and his newly acquired economic interest. Yet, such a scenario is unlikely as it may be interpreted to expand the statutory judgment limitations. (Rev. Rul. 77-137).

The Illinois Limited Liability Company Act differentiates between membership interests and distributional interests. The term “distributional interest” means all of a member’s interest in distributions by the LLC. 805 ILCS 180/1-5. “Membership interest” is defined as a member’s rights in the LLC, including the member’s right to receive distributions of the LLC’s assets. A member is neither an owner, co-owner nor holder of a transferable interest in LLC property. 805 ILCS 180/30-1(a). Conversely, a distributional interest in a LLC is personal property and it may be transferred in whole or in part. 805 ILCS 180/30-1(b). However, the transfer of a distributional interest does not entitle the transferee to become or exercise any of the rights of a member. The transferee would only be entitled to receive the distributions to which the transferor would have been entitled. 805 ILCS 180/30-5. The transferee of a distributional interest is eligible to become a member if and to the extent that the transferor gives such right as authorized by the operating agreement or upon the consent of all other members. 805 ILCS 180/30-10(a).

A transferee who does not become a member is not entitled to participate in the management of the LLC's business, have access to information concerning the company's dealings, or to inspect or copy any of the company's records. 805 ILCS 180/30-10(d). A transferee who does not become a member will be entitled to distributions to which the transferor would be entitled as well as, upon dissolution and winding up of the LLC's business, the right to the net amount otherwise distributable to the transferor. 805 ILCS 180/30-10(3).

Currently there are twelve states, California, Colorado, Delaware, Hawaii, Illinois, Montana, Nevada, South Carolina, South Dakota, Virginia, and West Virginia, where the court may order a foreclosure of a lien on a distributional interest subject to the charging order. If a creditor is not satisfied by the charging order, he could move for judicial foreclosure. At the foreclosure sale, a third party could buy the distributional interest and receive an assignment of that interest. The funds from the sale would go to the creditor. The purchaser at the foreclosure sale has the rights of a transferee.

In Illinois, it is statutorily provided that an assignee of a partner's interest may seek dissolution by a court under specified circumstances, 805 ILCS 205/32(2), yet it has been held that such an assignee has no legal interest in the dissolution of a partnership.41

J.  Piercing the LLC Veil

Piercing the LLC veil is an area of law that is best described as murky or undefined. Moreover, there is little, if any, guidance on point in Illinois. However, a brief review of case law reveals Illinois court looking for persuasive support to hold that LLC members should be held liable under the common law doctrine of piercing the corporate veil seems probable.

Many jurisdictions follow the “alter ego” test to determine whether to hold shareholders personally liable for the debts of the corporation. The alter ego test emphasizes that piercing the corporate veil is appropriate where public policy interests are best served, such as protecting private rights, and where the corporation fails to remain a separate legal entity apart from its owners, the shareholders. In order to pierce the corporate veil in the Illinois courts, there must be:

1. such unity of interest that the separate identity of the corporation on one hand and the shareholder or officer on the other no longer exist and
2. circumstances in which adherence to the fiction of a separate corporate existence would be fraudulent, unjust, or inequitable.44 In making this determination, courts consider the following variables:
   1. inadequate capitalization;
   2. the failure to issue stock and
   3. to observe corporate formalities;
   4. the non-payment of dividends;
   5. the insolvency of the debtor corporation;
   6. the non-functioning of other corporate officers or directors;
   7. the absence of corporate records, and
   8. the amount of control of the dominant stockholders.45

Illinois Law:

805 ILCS 180/10-10.Liability of members and managers

Sec. 10-10. Liability of members and managers. (a) Except as otherwise provided in subsection (d) of this Section, the debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company. A member or manager is not personally liable for a debt, obligation, or liability of the company solely by reason of being or acting as a member or manager.
(b) (Blank).
(c) The failure of a limited liability company to observe the usual company formalities or requirements relating to the exercise of its company powers or management of its business is not a ground for imposing personal liability on the members or managers for liabilities of the company.
(d) All or specified members of a limited liability company are liable in their capacity as members for all or specified debts, obligations, or liabilities of the company if:
(1) a provision to that effect is contained in the articles of organization; and
(2) a member so liable has consented in writing to the adoption of the provision or to be bound by the provision.

The United States Bankruptcy Court for the Northern District of Illinois held in Securities Investor Protection Corporation v. R.D. Kushnir & Co., examining Section 10-10, stated “[i]t would seem from the foregoing that ‘members’ or ‘managers’ of an Illinois limited liability company cannot be held liable for the mere failure to observe corporate formalities or repayment, but nothing in the statute bars piercing of the ‘corporate veil’ for other grounds on which that may be done for ordinary corporations.”

The Court in Securities Investor Protection Corporation explains the “[a]lthough generally true that corporations are distinct legal entities separate from their officers, shareholders, and directors, Illinois may allow the corporate veil to be pierced to avoid injustice. The corporate form may be disregarded when (1) there is such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist; and (2) the continued adherence to the fiction of a separate corporate existence would sanction a fraud or promote injustice.”

Conclusion: The limited case law from Illinois and other jurisdictions suggests the conclusion that the corporate piercing law shall be applied to Illinois LLC’s. Therefore, Illinois courts will likely apply the typical “alter ego” analysis, minus the “lack of corporate formalities” factor which is statutorily provided for, in holding LLC members personally liable for the debts of the LLC.

K.  Limited Liability Partnerships (LLPs)

A registered limited liability partnership is a form of business entity established by statute in 1994 within the framework of the Uniform Partnership Act. The Uniform Partnership Act contains provisions under which an existing partnership may become a registered limited liability partnership. 805 ILCS 205/8.1 The Uniform Partnership Act applies to registered limited liability partnerships except where the particular statutes pertaining to those partnerships are inconsistent with the Act. 805 ILCS 205/6(2). The primary distinction of a registered limited liability partnership is the limitation of the joint and several liability of partners found in a general partnership under the Act. 805 ILCS 205/15.

It is this ability to limit liability for the malpractice and misdeeds of one’s co-owners while retaining the simplicity of operation and favorable tax treatment of a partnership that makes the LLP attractive to many businesses. For professionals using a traditional partnership, the protection from malpractice liability provided by a LLP greatly outweighs the expense of maintaining the registration.