This article appeared in the June1994 issue of The Louisiana Bar Journal. It may be cited as Frederick R. Parker, Jr., Classification of Louisiana Limited Liability Companies for Income Tax Purposes and Related Drafting Considerations, 42 Louisiana Bar Journal 21 (June 1994). Reprinted by permission of the Louisiana State Bar Association.

*Frederick R. Parker, Jr. is a board-certified tax attorney in Shreveport, where his practice emphasizes tax planning and tax controversy matters. He received his BA and MBA from Northeast Louisiana University, his JD from LSU Law School, where he was a member of the Louisiana Law Review, and his LLM (in taxation) from New York Univesity School of Law. Parker also is a certified public accountant and serves as an adjunct member of the faculty at LSU-Shreveport, where he teaches corporate and partnership taxation.

One of the most significant developments to arise from the 1992 session of the Louisiana Legislature was the enactment of the Louisiana Limited Liability Company Law.¹ This new form of unincorporated business entity (the LLC) affords a previously unavailable combination of business and tax planning opportunities by allowing the entity to be treated as a partnership for tax purposes while bestowing limited liability upon all of its owners. This article summarizes the most significant income tax considerations attendant to the drafting of the documents necessary to organize and govern the operations of a Louisiana LLC. Because the tax treatment of an LLC and its members flows from the classification of the entity as a corporation or as a partnership for tax purposes, the article focuses first upon this pivotal determination. The discussion then shifts to some of the more subtle tax possibilities of which careful practitioners also should be aware.

Wyoming pioneered the development of the LLC form of business entity in the United States in 1977. More than 10 years later, the Internal Revenue Service issued an administrative ruling, which, based upon an analysis of the legal characteristics of the Wyoming entity, held that a Wyoming LLC would be treated as a partnership for tax purposes.² Because the Louisiana LLC statute affords much greater flexibility than does the Wyoming law in terms of the entity's structure, however, members of a Louisiana LLC may not rely upon the IRS's holding in the Wyoming ruling and will have to independently establish the character of their entity for tax purposes.³ Further, the flexibility provided under the Louisiana LLC law presents a variety of unanticipated tax implications. It, therefore, is important for the Louisiana practitioner to focus critically on the relevant tax-sensitive facts when structuring this new form of business entity.

The significance of how a business entity is characterized for tax purposes cannot be overstated. If the investors in a limited liability company desire to avoid the burden of the income tax at the entity level (and the attending scheme of double taxation typically associated with doing business in the corporate form), they will have to structure their new business entity in such a way as to ensure its treatment as a partnership for tax purposes. Although an LLC does not constitute a "corporation" under state law (because the formal requirements for incorporating have not been satisfied), the IRS, nevertheless, will treat certain business associations as corporations for tax purposes, thereby invoking the plethora of adverse tax consequences attending the corporate form of business venture. The test the IRS employs for determining the tax character of an unincorporated business association is derived from the analysis applied in the jurisprudence, and is set forth in Treas. Reg. Section 301.7701-2(a).

The regulations first set forth the following six characteristics which all corporations customarily possess:

* associates;

* profit motive;

* continuity of life;

* centralized management;

* free transferability of interests; and

* limited liability.

Because the first two characteristics (associates and profit motive) are common to both corporations and non-corporate entities, the regulations focus on the remaining four, which only corporations generally possess. The regulations then adopt the test used by the courts in determining whether an unincorporated entity should be taxed as a corporation: in general, an entity must possess at least three of the four corporate characteristics before it will be treated as an association subject to the corporate tax provisions of the Internal Revenue Code (the Code). An entity possessing only two of these characteristics will be treated as a partnership for tax purposes, and thus will avoid tax at the entity level. An analysis of the Louisiana LLC law in light of these characteristics follows.

Continuity of Life

The regulations provide that an entity will be found to lack the corporate characteristic of "continuity of life" if the death, insanity, bankruptcy, retirement, resignation or expulsion of any member will cause the entity to dissolve. The regulations further provide that the ability of the remaining members to continue the business organization by a majority vote upon the occurrence of one of these events will not lead to the conclusion that the entity possesses this corporate characteristic.

The Louisiana LLC law tracks the treasury regulation analysis by providing, in general, that the death, interdiction, withdrawal, expulsion, bankruptcy or dissolution of a member (or the occurrence of any other event terminating a membership interest in the LLC) will operate to dissolve the entity unless, within 90 days after the event occurs, the LLC is continued by the unanimous written consent of the remaining members (and, if membership is reduced to one, at least one new member is admitted). Thus, in the absence of any provision to the contrary in the articles of organization or the operating agreement, the Louisiana law will operate to prevent a finding that a Louisiana LLC possesses the corporate characteristic of continuity of life.⁴

Centralized Management

With respect to the second characteristic typically associated with the corporate form of entity, the regulations provide that centralized management exists where the exclusive authority to make management decisions has been vested in fewer than all of the entity's members. Although the Louisiana law gives the LLC the choice either to be managed by its members or to be managed by one or more managers, management will be vested in the members in the absence of any express grant of authority to the contrary in the governing documents. Accordingly, unless those documents expressly delegate management authority to a group of managers comprised of fewer than all of the LLC's members, the Louisiana law should prevent a finding that the entity possesses the characteristic of centralized management.⁵

Free Transferability of Interests

The third corporate characteristic the regulations focus upon deals with whether members are free to transfer their interests in the entity. According to the regulations, a business entity will be found to possess the corporate characteristic of "free transferability of interests" if the members who own substantially all of the interests have the right, without the consent of the other members, to transfer their membership interests to one who is not then a member of the entity. The regulations further provide that a finding of free transferability of interests may be made only if the members are able to freely confer all of the attributes associated with their interests, including the right to share in profits and the right to participate in management.

The Louisiana LLC law permits the articles of organization or the operating agreement to set forth the extent to which a membership interest in the entity will be assignable. The law further provides that, in the absence of any express provision in the governing documents concerning the transferability of a membership interest, an interest will be assignable, although the transferee will be entitled to receive only the distributions to which his transferor would have been entitled and will not become a member or be entitled to exercise any of the rights of a member unless the other members unanimously consent to his admission. Thus, in the absence of any express provision to the contrary in the governing documents, a Louisiana LLC will be found to lack the corporate characteristic of free transferability of interests because a member's right to transfer all of the attributes of his interest is limited by law.⁶

Limited Liability

The final characteristic which the treasury regulations focus upon is that of "limited liability." According to the regulations, an organization will be found to possess the characteristic of limited liability if, under local law, no member will be personally liable for the entity's debts or obligations. As a general rule, no member of a Louisiana LLC will be liable for any of the entity's debts, obligations or liabilities. Louisiana limited liability companies, by definition, will be found to possess this final corporate characteristic.⁷

The analysis set forth above leads to the conclusion that the Louisiana LLC, as defined by statute, should be treated as a partnership for income tax purposes because it possesses only one of the four characteristics typically associated with corporations (limited liability). Further, since an entity generally must possess at least three of the four characteristics, those organizing a Louisiana LLC should be able to structure their entity by creating either continuity of life, free transferability of interests or centralized management without jeopardizing treatment of the LLC as a partnership for tax purposes. In light of the great flexibility provided under Louisiana law in terms of the entity's structure and the significantly differing tax consequences that may attend the character of the entity which ultimately results, however, it is important for those organizing a Louisiana LLC to carefully consider which of these characteristics is to be treated differently than the treatment accorded under the statute and to be sure of the tax character of the entity they create.

One important restriction in the Louisiana statute is the requirement that a Louisiana LLC have at least two members.⁸ While some states authorize single-member LLC's (which should be able to obtain authority to do business in Louisiana),⁹ it is difficult to conceive of a single-member company being treated as a partnership for tax purposes. The incongruity arises from two perspectives. First, the definition of a "partnership" in the Code precludes the characterization of a one-person entity as a partnership.¹⁰ The same result follows under the treasury regulation analysis set forth above. A single-member LLC cannot practically avoid a determination that it possesses the corporate attributes of free transferability of interests and centralized management. Together with limited liability, the entity likely would be found to possess three of the four corporate characteristics and thus would be treated as an association taxable as a corporation.¹¹

While the determination of which form of entity a client will find most advantageous must always be made on an individual basis, taxpayers often will find an LLC structured as a tax partnership to be the entity of choice. As noted above, however, the IRS may, in certain circumstances, seek to reclassify as a corporation an entity which the owners intended to be treated as a partnership. Any such reclassification could be disastrous to the entity and its owners because of the potential for double taxation and the acceleration of income associated with the corporate form.

Further, because the classification of an entity as a corporation for tax purposes turns upon the existence of at least three of the four characteristics traditionally associated with the corporate form of venture, and in light of the great flexibility in structure afforded under the Louisiana Limited Liability Company Law, practitioners must carefully consider which of these characteristics the entity being created will possess. Because a Louisiana LLC created under the provisions of the law without modification will possess only the characteristic of limited liability, the governing documents of an LLC may provide that the entity will possess any one of the three remaining corporate attributes (continuity of life, centralized management or free transferability of interests) without jeopardizing the availability of partnership treatment for tax purposes. It is somewhat anomalous that this flexibility provided under the law, when combined with the possibility of future changes the members may desire in the entity's structure, poses the greatest potential for reclassifying an LLC as a corporation. The careful drafter, therefore, must keep the tax character of the entity in mind not only when initially preparing the LLC's organizational documents, but also throughout its existence. The tax consequences attending a mid-stream change in character could be devastating, particularly when the change occurs unexpectedly and after the completion of transactions that were structured based upon the assumption that the entity would be treated as a partnership for tax purposes.

The possibility of changing the tax character of an LLC in mid-stream exists not only in the context of an affirmative decision by the members to revise the rules governing the company's operations. This possibility also may arise in an unexpected manner. The most obvious example of this subtle possibility exists in the context of the death of a member in a two-member LLC where there exists no special provision in either the articles of organization or in the operating agreement in terms of the rights of a deceased member's successors-in-interest. In the absence of any provision in the governing documents to the contrary, the deceased member's membership in the company would terminate, and his heirs or legatees would be treated as assignees entitled only to the distributions to which the deceased member would have been entitled; they would not be entitled to exercise any of the rights the decedent previously possessed as a member of the LLC. Accordingly, the membership of the company would have been reduced to one at the moment of the deceased member's death.

The Louisiana LLC law provides that in the absence of any provision in the governing documents to the contrary, an LLC will terminate upon the death of a member unless, within 90 days after the date of death, the remaining members unanimously consent to continue the company's existence and, if membership is reduced to one as a result of the death, at least one new member is admitted.¹²

Accordingly, the analysis of the tax consequences flowing from the death of one member in a two-member LLC depends upon whether a new member is admitted within 90 days after the date of the former member's demise.

On the one hand, the statute is clear that the entity dissolves upon the death of the member in this scenario if no new member is admitted within the 90-day period.¹³ No obvious tax complications arise from this dissolution, however, which arguably should be treated simply as any other liquidation of a partnership.

On the other hand, a very significant, yet subtle, distinction arises when the entity is continued by the admission of a new member within the critical 90-day period. Because the deceased member's interest would have terminated upon his death (with his heirs or legatees being entitled only to the rights of assignees), membership in the entity would have been reduced to one at the moment of death. The statutory rule further provides that an LLC's existence will not be disrupted if the surviving member consents to the continuation of the entity and admits at least one new member within the 90-day period. The suspensive nature of this statutory condition related to the term of the LLC raises a serious question concerning the tax character of the entity during the interim. Because the existence of the entity continues in such circumstances, the insulation from liability the remaining member enjoys under the law would not be disrupted even during the period between the date of the first member's death and the admission of the additional member. Accordingly, the LLC would continue to possess the corporate characteristic of limited liability throughout this interim. Also, because the entity would have only one member during this period, it would be difficult to argue that the LLC lacked the corporate characteristics of centralized management and free transferability of interests during the interim. It follows that the IRS might seek to recharacterize an LLC in such circumstances as an association taxable as a corporation during the period of time between the death of the first member and the admission of the new member.

Any such reclassification would raise a number of significant tax issues beyond the basic concern of subjecting the income earned during the interim period to taxation both at the entity and the member levels. The first critical concern involves the manner in which the former tax partnership would have become a corporation for tax purposes. Although there are several possible scenarios under which the deemed incorporation could be considered as having occurred, the most plausible involves a deemed transfer by the members of their "partnership" interests to the "corporation" in exchange for stock, followed by a deemed liquidation of the former tax partnership into the new "corporation." The taxability of this deemed incorporation and subsequent partnership liquidation would have to be tested under the requirements of sections 351 and 731 of the Code.¹⁴

The next issue involves the availability of an election by the corporation to be taxed under the provisions of subchapter S of the Code. Recall that, in the absence of any provision to the contrary in the governing documents, the successors to the deceased member's interest in the LLC by law would possess only the right to receive any distributions to which their transferor would have been entitled and they would not be entitled to any other rights possessed by a member. Because S corporations may have only one class of stock, however, the availability of the election would turn upon a determination of whether the membership rights of the heirs or legatees of the deceased member, as limited by law, would be deemed to represent a prohibited separate class of stock.¹⁵

Further, while a determination that the "corporation" would be eligible for an election under subchapter S would permit the company to eliminate some of the adverse tax consequences flowing from corporate tax treatment, it by no means would afford the elimination of all of them. The most drastic of these unavoidable consequences would arise under the scenario where an additional member is timely-admitted to an LLC with substantially-appreciated assets.

Recall that an LLC generally will continue in existence upon the death of a member (and, in the setting under discussion, upon the corresponding reduction of the membership to one) as long as the remaining member consents to continue the entity and admits at least one additional member within 90 days after the former member's death. Also recall that the "deemed incorporation" analysis rests upon the assumption that a one-person limited liability entity would constitute a corporation for tax purposes because it would be seen as possessing three out of the four attributes traditionally associated with corporations (limited liability, centralized management and free transferability of interests). Just as the entity would have come to possess the latter two of these attributes only upon the death of the first member (by virtue of the membership having been reduced to one), so, too, would the entity be seen as having shed itself of these latter attributes upon the admission of an additional member. Thus, just as the LLC would have been transformed into a "corporation" for tax purposes upon the reduction of its membership to one, it just as easily would have reassumed the character of a tax partnership upon the admission of an additional member within the critical 90-day period (the entity thereupon possessing only the corporate attribute of limited liability).

Would this conversion of the character of the entity from a corporation to a partnership for tax purposes represent the converse of the deemed incorporation hypothesized above (i.e., a deemed liquidation)? If so, the tax consequences of the "liquidation" also would have to be analyzed under the corporation provisions of the Code, leading to the very unfavorable result of any built-in gain being recognized to the "corporation" concurrently with the admission of an additional member. At the very least, this would result in the unnecessary acceleration of income (where an election under subchapter S is available). The consequences would be even more severe if an S election were not available; in that case, gain would be recognized twice upon the deemed liquidation: once to the corporation, again to the members. In either instance, these adverse tax consequences would be solely the result of a lack of planning at the initial drafting stage.

It is not a foregone conclusion that the IRS would employ the analysis set forth above to recharacterize an LLC upon the temporary reduction of the entity's membership to one. Admittedly, the analysis may be considered excessively technical. The risk of such a recharacterization, nevertheless, is more than theoretical.¹⁶ Accordingly, careful practitioners may want to be sure to provide in their LLC's governing documents that membership never will be reduced to one even momentarily. This may be accomplished in any number of ways, ranging from the provision in the governing documents for the automatic admission into membership of a deceased member's heirs or legatees, to simply calling for the automatic termination of the entity upon the occurrence of any event that would reduce the entity's membership to one.

As a general rule, an LLC created under the Louisiana Limited Liability Company Law without modification should be treated as a partnership for tax purposes because it would possess only one of the four characteristics traditionally associated with corporations. Accordingly, an LLC should avoid tax at the entity level, with all of its earnings being taxed only to the members. Because the Louisiana law provides a great deal of flexibility concerning the manner in which the entity may be structured, however, practitioners must carefully consider the tax effects of any decision to structure an LLC in any manner that differs from that provided in the statutory framework. Further, practitioners must keep these considerations in mind not only when drafting the initial governing documents, but also throughout the term of the company's life because mid-stream changes in structure may give rise to unexpected and undesirable tax consequences. Finally, because of the inherent tax risks associated with certain events that could reduce the company's membership to one, but which are beyond the control of the company or its members, practitioners may want to consider drafting the governing documents in such a way as to eliminate any possibility that membership in the entity could ever be reduced to one.

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