After many delays and disappointed expectations, the Massachusetts Limited Liability Company Act is finally effective, permitting a limited liability company (“LLC”) to be formed under the laws of the Commonwealth, and allowing LLCs wherever formed to do business in Massachusetts with reasonably certain legal consequences. (As part of the same legislation, Massachusetts now also permits limited liability partnerships, which is of particular interest to professional firms.) All but two states — Vermont and Hawaii — have LLC statutes in effect, eliminating what was a major obstacle to using this form of business entity. While the relevance of this type of entity to most enterprises has been greatly overstated in many articles in the press, use of an LLC does make sense in appropriate situations, and certain types of start-ups and existing businesses should examine closely the pros and cons of becoming an LLC in this new legal environment.
The LLC is a relatively new type of business entity in the United States, though it is similar to such foreign entities as the German GmbH, the French SARL and the Central and South American limitada. An LLC is usually described as a hybrid form of business entity, sharing features of both the partnership and the corporation. Most importantly, an LLC can easily be made to qualify for pass-through treatment under federal (and Massachusetts) income tax rules as a partnership, and it has important advantages over the other available forms of pass-through business entities. An LLC affords all the flexibility of a partnership, while offering the liability protection of a corporation. Unlike an S corporation (but like a partnership), an LLC isn’t limited to 35 owners, and its owners (called “members”) can include corporations, partnerships, other LLCs, pension funds, trusts, and nonresident aliens. It can have multiple classes of ownership interest, and its income and losses can be allocated among its members under the same rules that apply to partnerships. Unlike a limited partnership, which must have at least one general partner, and whose limited partners risk general liability if they participate in the control of the business, none of the members of an LLC have general liability (except for their own wrongful acts and their personal guarantees of the LLC’s obligations), regardless of how the business is controlled.
While an LLC is undoubtedly the best choice of entity in many situations, to date there hasn’t been the stampede to form LLCs that many practitioners had predicted. There are many reasons why this has been the case. Of particular importance to high tech businesses is the negative reaction of many venture capital funds. This is due in part to certain undesired tax results (i.e., “unrelated business income tax” problems) that may be created for pension funds and other tax-exempt investors in a business entity taxed as a partnership. There is also a natural desire to stick with the familiar, and with what has been well-tested. In addition to the many practical questions involved in operating with a relatively novel form of business entity, there are many questions about how the partnership tax rules will be applied to LLCs, and about how courts will interpret the LLC statutes.
In any case, with some exceptions LLCs are likely to be recommended only for start-up businesses. For most existing corporations, whether pass-through S corporations, or taxable C corporations, a major obstacle to converting to an LLC is the gain that would be triggered by the deemed transfer of assets, including goodwill and other intangible assets. And, most existing partnerships would have little, if anything, to gain from converting.
In a later article, we will explore these and related issues in greater detail.