In an article in the previous issue by Mr. Gary Orlando, a fact pattern was set out concerning a medical doctor's practice. In Mr. Orlando's article the use of a corporation, limited liability company and a limited liability partnership was discussed. The purpose of this discussion is to build upon Mr. Orlando's article by comparing the limited liability company with other entities.
A Limited Liability Company ("LLC") is neither a corporation nor a partnership, but rather a new form of business entity that is formed under, and governed by, its own organic law. Notwithstanding their separate state-law status, however, LLCs resemble corporations and partnerships in various respects.
LLCs are like corporations in that their members, like shareholders, are protected from the debts, obligations and liabilities of the LLC, even if they participate in the management of the business. LLCs differ from corporations that are taxed under Subchapter C of the Internal Revenue Code of 1986, as amended (the "Code"), in that they will be treated as partnerships, and therefore pass-through entities for federal income tax purposes, if they are properly structured. The income of a "C corporation" is potentially subject to double taxation under the Code: the income is taxable to the corporation when it is earned, and it is taxable to the corporation's shareholders when it is distributed to them in the form of dividends. In the case of an LLC that is structured as a partnership for federal income tax purposes, income earned by the LLC is not taxable to the LLC itself, but rather such income is deemed to "flow through" the LLC to its members for purposes of federal income taxation. For purposes of the Texas Franchise Tax, however, LLCs are treated like corporations rather than partnerships (which are currently exempt from the tax).
Corporations that select "small business corporation" status under Section 1361 of the Code, commonly called "S corporations," also enjoy the dual benefits of pass-through treatment for federal income tax purposes and limited liability for their shareholders. Section 1361 of the Code, however, imposes significant restrictions on the ownership of S corporations. In addition, S corporations cannot have more than one class of stock (other than classes that differ only in voting rights), and therefore lack the flexibility afforded by the partnership allocation rules.
LLCs resemble general and limited partnerships in a number of respects. If the organizational documents of the LLC are properly drafted, the LLC will be classified as a partnership for federal income tax purposes and will be subject to the same partnership tax rules that apply to state-law partnerships. The principal difference between an LLC and a state-law partnership is that none of the members or managers of the LLC will have personal liability for the duties, obligations and liabilities of the LLC unless they voluntarily assume such personal liability in the regulations or in other documents, such as a guarantee. The general partners of a general or limited partnership, by contrast, have such personal liability as a matter of law. The Texas Revised Partnership Act establishes the general rule that "all partners are liable jointly and severally for all debts and obligations of the partnership unless otherwise agreed by the claimant or provided by law." This rule of joint and several liability is applicable to the general partners of a limited partnership.
Recent legislative developments in Texas have modified, but not eliminated, the rule of joint and several liability of general partners. The most significant change was the advent of registered Limited Liability Partnerships" ("LLPs"). If a Texas general or limited partnership files an annual registration with the Texas Secretary of State as an LLP, pays the requisite filing fee, and complies with certain insurance and name requirements, the partnership's general partners will enjoy a qualified form of limited liability. Specifically, a general partner will not be personally liable for debts and obligations of the partnership arising from errors, omissions, negligence, incompetence or malfeasance ("errors") committed while the partnership is an LLP and in the course of the partnership business by another partnership or representative of the partnership, unless the first partner (a) supervised or directed the errant partner or representative, (b) was directly involved in the specific activity in which the errors were committed, or (c) had notice or knowledge of the errors at the time of occurrence and then failed to take reasonable steps to prevent or cure the errors. Registration of the partnership as an LLP, however, does not absolve the general partners from other types of liability, such as contractual liability.
Despite these legislative developments, the fact remains that the general partners of Texas general and limited partnerships, even those that register as LLPs, cannot escape joint and several liability for many types of partnership liabilities. LLCs, by contrast, require none of the members or managers to subject themselves to such personal liability.
The members of an LLC do resemble the limited partners of a limited partnership in that neither members nor limited partners are personally liable for the entity's liabilities. There is an important caveat, however, to the rule of non-liability of limited partners: if they participate in the control of the partnership's business, they are liable (like general partners) to persons who transact business with the partnership reasonably believing, based upon a limited partner's conduct, that the limited partner is a general partner. The Texas Revised Limited Partnership Act contains an extensive "safe harbor" list of activities that are deemed not to constitute participation in the control of partnership business. Despite the breadth of this and the other safe harbor provisions, however, there presumably exist some actions that, if undertaken by limited partners, could be construed as constituting participation in the control of the business. The members of an LLC, by contrast, are subject to no such limitations on their liability to participate in the control or management of the LLC's business. Indeed, the Texas Limited Liability Company Act contemplates that LLCs which do not have managers will be managed directly by their members.
The foregoing discussion illustrates some of the principal differences between LLCs on the one hand, and C corporations, S corporations, general partnerships and limited partnerships on the other hand. Selection of the proper entity will have the effect of maximizing the tax benefits permitted under the Internal Revenue Code and provide protection of personal assets. Part of the answer to the question "Are Your Assets Protected?" is in selecting the proper entity in which to conduct your business. The use of a corporation, partnership or LLC is not restricted to one's professional practice, but may also be used in the conduct of other businesses such as the ownership and leasing of real or personal property and creation of a management entity. Selection of the proper entity can also aid an individual in shifting income to family members and reducing an individual's taxable estate. Discussion of personal estate questions, such as the use of a family limited partnership, a tax-planned will and trusts, will be addressed in the last article in this series.
Published in the Greater Houston Edition of M.D. News, March 1997
Are Your Assets Protected? Part III
The information provided in this article is not legal advice to any reader. Neither the transmission nor the receipt of this article creates an attorney-client relationship. The opinions expressed in this article may not be those of the firm.