Limited Liability Companies Are Replacing Partnerships

While some worry about revenue loss, states latch on to advantages of LLCs

THE greeting, ``Howdy, partner,'' may always have a home on the range, but in business offices, partners could someday be scarcer than buffalo.

That day is still well in the future, but proponents of limited liability companies contend that, in time, the LLC will virtually replace the traditional business partnership and its corporate counterpart, the S-corporation.

``The development of LLCs is one of the most significant revolutions in business law,'' says David Neufeld, a Washington lawyer and executive director of the Association of Limited Liability Companies.

LLCs are a hybrid form of business organization, blending characteristics of both partnerships and corporations. For federal (and, in most cases, state) income-tax purposes, the owners of an LLC - called members - are treated as partners: All income, losses, and deductions of the business are passed through to the members and are not recognized at the enterprise level. (In contrast, corporations are taxed on gains, and stockholders pay a second tax on dividends and other corporate distributions.)

However, like corporate stockholders or limited partners, members of an LLC are shielded from personal liability for the acts or debts of the business. Ordinary business partners, including the ``general'' partners in limited partnerships, face unlimited personal liability.

Fewer restrictions on investors

LLCs bear some similarities to S-corporations, authorized by the Internal Revenue Code, whose shareholders also avoid double taxation and enjoy limited liability. But LLCs have fewer restrictions on the number and kind of people and entities that can invest in the business than S-corporations have, and thus have greater flexibility in raising capital.

Enthusiasm for LLCs has swept through the states like a prairie fire since 1988, when the Internal Revenue Service ruled that LLCs formed under a 1977 Wyoming statute would be taxed like partnerships.

Today, 37 states have enacted LLC statutes, and legislation is pending in the remainder. Thousands of LLCs have been created.

Not all states are leaping onto the bandwagon, however. Lawmakers in such major commercial states as California, New York, Pennsylvania, and Massachusetts are taking a go-slow approach. The chief concern among legislators and government officials in these states is the potential loss of tax revenue from corporations.

``In states authorizing LLCs, the only businesses that really need to be C-corporations [corporations subject to taxation under the Internal Revenue Code and most state revenue laws] are companies that want to be publicly traded,'' says Frederick Herberich, general counsel of the Massachusetts Department of Revenue (DOR).

At the request of the Massachusetts legislature, the DOR has tried to estimate the revenue consequences of an LLC statute. The calculations are difficult, Mr. Herberich says, because it is hard to predict how many startup businesses would take advantage of the law and how many existing companies would convert to LLCs. Nonetheless, the DOR has concluded that the state would suffer ``some'' loss of revenue, Herberich says.

A recent study by New York state revenue officials reached a similar conclusion.

``Given Massachusetts' budget crunch, lawmakers aren't eager to propose a bill that would cost the state even $10,'' says Kathleen Parker, a Boston tax lawyer who helped draft the LLC bill.

Annual fee for LLCs

Some legislators in Massachusetts, as in New York, California, and other states, favor an annual fee for LLCs to help offset projected revenue losses. Proponents of LLCs counter that such fees would put the levying states at a competitive disadvantage.

Indeed, competition among states to attract business and jobs almost ensures that all states will enact LLC legislation sooner rather than later, advocates say.

``I've seen ads in a Massachusetts newspaper encouraging people here to come to [neighboring] New Hampshire to form LLCs,'' says Kevin Long, a Boston accountant and chairman of the state-tax committee of the Massachusetts Society of Certified Public Accountants, which supports the LLC bill. ``If Massachusetts waits until everyone is setting up LLCs in other states, it will miss the boat.''

One danger is that states without LLC laws will treat LLCs formed in other states as partnerships without limited liability. For this reason, Ms. Parker says, to date the form has been utilized mainly by businesses that operate only in a single state. But with the rapid spread of LLC laws, the interstate risk is diminishing.

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