I. Can the business entity operate as a limited liability company?A. Under the laws of most states, banks, insurance companies, and similar businesses are required to be organized as corporations and cannot be organized as LLCs.
B. Some states prohibit LLCs from engaging in other businesses, such as providing professional services.
II. Is an LLC desirable given the characteristics of the owners and the nature of the business?A. How do the advantages and disadvantages of an LLC stack up for this particular entity? An LLC will not be the right form of entity in all situations, and each of the perceived advantages and disadvantages of an LLC should be analyzed for the business under consideration.1. The primary advantages of an LLC are as follows:a. All members and managers enjoy limited liability (unlike a general partnership or limited partnership).
b. There is more flexibility to tailor management than any other form of entity—an LLC may be member-managed (partnership structure) or manager-managed (corporate or limited partnership structure).
c. All members may participate in management without loss of limited liability (unlike a limited partnership).
d. There are no limitations on the number or type of persons that may be members (unlike an S corporation).
e. There can be different types of equity interests held by various owners, allowing income, loss or other tax items to be allocated disproportionately to members (special allocations) and allowing disproportionate distributions to members (unlike an S corporation).
f. An LLC is ordinarily taxed as a partnership for federal income tax purposes, thus avoiding a double tax on its income (unlike a C corporation).
g. As an entity taxed as a partnership, an LLC avoids taxable gain when it dissolves and distributes its assets to its members (unlike an S corporation or C corporation).
h. The members of an LLC do not generally recognize gain when the LLC dissolves and distributes its assets to its members (unlike a C corporation).
2. The primary disadvantages of an LLC are as follows:a. State level filings are required for the organization and continued operation of an LLC (unlike a general partnership).
b. Qualification is required for doing business in other states (unlike a general partnership).
c. An LLC may be dissolved on the death, disability, or withdrawal of a member unless the LLC purchases the member’s interest (unlike an S corporation or C corporation).
d. While the economic interests of members in an LLC are generally transferable, state law often prevents transfers of a member’s voting rights and right to inspect business records (unlike an S corporation or C corporation).
e. Transfer of interests in an LLC may be subject to securities law regulation (unlike a general partnership).
f. Tax-favored fringe benefits, such as employer-paid medical insurance, group term life insurance, and cafeteria plans, are unavailable to LLC members (unlike a C corporation).
g. Income allocated to LLC members is often classified as net earnings from self-employment subject to federal self-employment tax (unlike an S corporation).
h. An LLC may be subject to state taxes, including franchise taxes and corporate income taxes (unlike a partnership).
B. What effect will the conversion have on a future sale or other disposition of the business?1. Unlike a C corporation, sale of the assets of an LLC will result in only a single level of tax.
2. Unlike a corporation, sale of 50 percent or more of the members’ interests in the LLC within twelve months will result in termination of the LLC for federal income tax purposes (but this may not have substantial adverse consequences).
3. Unlike a corporation, an LLC may not participate in a tax-free corporate reorganization, and this may limit the interest of public companies in acquiring the business. An LLC may, however, participate in tax-free divisions and also tax-free acquisitions involving LLCs or other noncorporate entities.
4. Unlike a corporation, an LLC can generally be liquidated income tax-free, even if it has assets with a value in excess of their basis.
III. What are the possible consequences of or roadblocks to the conversion?A. What are the tax consequences?1. If the entity to be converted is a corporation, the conversion will be a taxable transaction.a. If a corporation is to be converted to an LLC, it must dissolve and liquidate. A corporate liquidation is treated for tax purposes as if the corporation sold its assets to its shareholders. From the shareholders standpoint, it is treated as a taxable sale or exchange of their stock to the corporation. Even if dissolution and liquidation is not required as a matter of state law, the corporation will be deemed to have dissolved and liquidated for federal income tax purposes.
b. If the corporation is a C corporation, there will be two levels of potential tax. If the corporation is an S corporation, there will be one level of tax.
c. The tax costs of conversion of a corporation to an LLC may not be undue if the value of the corporation’s assets is not substantially greater than their tax basis, or if the corporation or its shareholders have loss carryovers sufficient to shelter all or part of the gain on liquidation from tax.
d. The termination of the existence of the corporation may involve loss of valuable tax attributes, including such things as the ability to defer gain on installment sales and involuntary conversions, fiscal year elections, favorable depreciation methods, holding periods of assets, unused tax credits, and unused net operating losses and capital losses.
2. If the entity to be converted is a general partnership or a limited partnership, the conversion will not ordinarily be taxable. However, it may be advantageous to structure it as assets-up transaction (which can involve a tax to the partners) in order to increase the tax basis of partnership property.
3. The value of interests in an LLC may be less than the value of comparable interests in a general or limited partnership, so a conversion can limit the gift and estate tax consequences of interfamily transfers.
B. What are the business and transactional consequences?1. The conversion may violate due-on-sale clauses, prohibitions on lease assignments, or other contractual restrictions to which the converting entity is a party.
2. There will be transactional costs of making the conversion, particularly if the converting entity is dissolved and liquated and assets must be transferred from the converting entity to its owner and from the owners to an LLC.
3. Creditors, suppliers, insurers, and other third parties will need to be notified of the conversion, particularly if a partnership or limited partnership is converted to an LLC and limited liability for all owners is created. Members may be required to personally guaranty business obligations.
4. Stationery, invoices, signs, and other written materials will need to be changed to reflect the new form in which the business is organized.
5. Existing agreements, structures, and safeguards between business owners, such as buy-sell agreements and shareholder voting agreements, will need to be replaced with provisions in the LLC’s organizational documents.
B. Some states prohibit LLCs from engaging in other businesses, such as providing professional services.
II. Is an LLC desirable given the characteristics of the owners and the nature of the business?A. How do the advantages and disadvantages of an LLC stack up for this particular entity? An LLC will not be the right form of entity in all situations, and each of the perceived advantages and disadvantages of an LLC should be analyzed for the business under consideration.1. The primary advantages of an LLC are as follows:a. All members and managers enjoy limited liability (unlike a general partnership or limited partnership).
b. There is more flexibility to tailor management than any other form of entity—an LLC may be member-managed (partnership structure) or manager-managed (corporate or limited partnership structure).
c. All members may participate in management without loss of limited liability (unlike a limited partnership).
d. There are no limitations on the number or type of persons that may be members (unlike an S corporation).
e. There can be different types of equity interests held by various owners, allowing income, loss or other tax items to be allocated disproportionately to members (special allocations) and allowing disproportionate distributions to members (unlike an S corporation).
f. An LLC is ordinarily taxed as a partnership for federal income tax purposes, thus avoiding a double tax on its income (unlike a C corporation).
g. As an entity taxed as a partnership, an LLC avoids taxable gain when it dissolves and distributes its assets to its members (unlike an S corporation or C corporation).
h. The members of an LLC do not generally recognize gain when the LLC dissolves and distributes its assets to its members (unlike a C corporation).
2. The primary disadvantages of an LLC are as follows:a. State level filings are required for the organization and continued operation of an LLC (unlike a general partnership).
b. Qualification is required for doing business in other states (unlike a general partnership).
c. An LLC may be dissolved on the death, disability, or withdrawal of a member unless the LLC purchases the member’s interest (unlike an S corporation or C corporation).
d. While the economic interests of members in an LLC are generally transferable, state law often prevents transfers of a member’s voting rights and right to inspect business records (unlike an S corporation or C corporation).
e. Transfer of interests in an LLC may be subject to securities law regulation (unlike a general partnership).
f. Tax-favored fringe benefits, such as employer-paid medical insurance, group term life insurance, and cafeteria plans, are unavailable to LLC members (unlike a C corporation).
g. Income allocated to LLC members is often classified as net earnings from self-employment subject to federal self-employment tax (unlike an S corporation).
h. An LLC may be subject to state taxes, including franchise taxes and corporate income taxes (unlike a partnership).
B. What effect will the conversion have on a future sale or other disposition of the business?1. Unlike a C corporation, sale of the assets of an LLC will result in only a single level of tax.
2. Unlike a corporation, sale of 50 percent or more of the members’ interests in the LLC within twelve months will result in termination of the LLC for federal income tax purposes (but this may not have substantial adverse consequences).
3. Unlike a corporation, an LLC may not participate in a tax-free corporate reorganization, and this may limit the interest of public companies in acquiring the business. An LLC may, however, participate in tax-free divisions and also tax-free acquisitions involving LLCs or other noncorporate entities.
4. Unlike a corporation, an LLC can generally be liquidated income tax-free, even if it has assets with a value in excess of their basis.
III. What are the possible consequences of or roadblocks to the conversion?A. What are the tax consequences?1. If the entity to be converted is a corporation, the conversion will be a taxable transaction.a. If a corporation is to be converted to an LLC, it must dissolve and liquidate. A corporate liquidation is treated for tax purposes as if the corporation sold its assets to its shareholders. From the shareholders standpoint, it is treated as a taxable sale or exchange of their stock to the corporation. Even if dissolution and liquidation is not required as a matter of state law, the corporation will be deemed to have dissolved and liquidated for federal income tax purposes.
b. If the corporation is a C corporation, there will be two levels of potential tax. If the corporation is an S corporation, there will be one level of tax.
c. The tax costs of conversion of a corporation to an LLC may not be undue if the value of the corporation’s assets is not substantially greater than their tax basis, or if the corporation or its shareholders have loss carryovers sufficient to shelter all or part of the gain on liquidation from tax.
d. The termination of the existence of the corporation may involve loss of valuable tax attributes, including such things as the ability to defer gain on installment sales and involuntary conversions, fiscal year elections, favorable depreciation methods, holding periods of assets, unused tax credits, and unused net operating losses and capital losses.
2. If the entity to be converted is a general partnership or a limited partnership, the conversion will not ordinarily be taxable. However, it may be advantageous to structure it as assets-up transaction (which can involve a tax to the partners) in order to increase the tax basis of partnership property.
3. The value of interests in an LLC may be less than the value of comparable interests in a general or limited partnership, so a conversion can limit the gift and estate tax consequences of interfamily transfers.
B. What are the business and transactional consequences?1. The conversion may violate due-on-sale clauses, prohibitions on lease assignments, or other contractual restrictions to which the converting entity is a party.
2. There will be transactional costs of making the conversion, particularly if the converting entity is dissolved and liquated and assets must be transferred from the converting entity to its owner and from the owners to an LLC.
3. Creditors, suppliers, insurers, and other third parties will need to be notified of the conversion, particularly if a partnership or limited partnership is converted to an LLC and limited liability for all owners is created. Members may be required to personally guaranty business obligations.
4. Stationery, invoices, signs, and other written materials will need to be changed to reflect the new form in which the business is organized.
5. Existing agreements, structures, and safeguards between business owners, such as buy-sell agreements and shareholder voting agreements, will need to be replaced with provisions in the LLC’s organizational documents.
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