Recent legislative and tax developments are changing the scene, however, providing many more attractive options than the traditional corporation vs. limited partnership decision. The IRS has relaxed its attitude to the extent that non-corporate entities are given the right to elect the kind of tax treatment they prefer. The traditional lines of demarcation between types of business entities are being blurred through a proliferation of limited liability entities. Finally, if the initial choice of business entity no longer functions optimally, an entity may be easily converted to a different type of organization, without an interruption of business. All of these factors are making business organization decisions more creative and challenging.
New IRS ApproachCheck-the- Box Tax Treatment
Choices are opened up by the IRSs new (effective January 1, 1997) Check-the-Box regulations (Treasury Regulations 301.7701-3). Traditionally, the IRS has engaged in complicated tests to determine whether a business entity was, in actuality, a separate taxable entity (a corporation) or an unincorporated association which was transparent for tax purposes. The IRS typically looked to see if the business entity had certain corporate characteristics:
i. continuity of life;
ii. centralized management;
iii. limited liability ; and
iv. free transferability of ownership interests.
If an entity had more than two of the corporate characteristics, the IRS treated it as a corporation, regardless of the manner in which it was organized under State law. The resultant determination had real monetary impact, since a corporations income can be subjected to double taxation. First, a corporation is taxed on its income at corporate rates. The same income is taxed again, at the shareholders individualized rates, when it is distributed to the shareholders as a dividend. Another detriment is that a corporation may not pass tax benefits through to its owners, as is permitted for unincorporated associations.
Double taxation and loss of tax benefits has always been the penalty you had to pay if you walked too near the line in setting up an unincorporated limited liability entity. No more! Now the IRS allows most unincorporated businesses with two or more owners (Eligible Entities) to elect tax treatment as either a partnership or as an association (which will be taxed like a corporation) by checking the relevant box on IRS Form 8832, Entity Classification Election. If an Eligible Entity fails to file an IRS Form 8832, it is automatically deemed a partnership.
An unincorporated entity with only one owner (such as a single-member limited liability company) may also affirmatively elect to be treated as an association (corporate tax treatment); otherwise, the entity will be treated as a sole proprietorship or as a branch or division of the owner.
Of course, there are some circumstances where taxation as a corporation is still mandated. These include:
i. a business entity organized under federal, state or Indian tribal statute which refers to the entity as being incorporated, or as a corporation, body corporate or body politic;
ii. an association under Treasury Regs 301.7701- 3;
iii. a joint stock company or joint stock association;
iv.an insurance company;
v. a state-chartered banking entity, if any of its deposits are insured under the Federal Deposit Insurance Act;
vi. a business entity which is wholly owned by a state or a state political subdivision;
vii. a business entity that is taxable as a corporation under an Internal Revenue Code provision
other than Code Section 7701(a)(3) [this encompasses any publicly traded business under Code Sec. 7704]; and
viii. certain foreign entities.
Form 8832 elections are effective on the date specified in the Form or, if no effective date is specified, on the date of filing. The effective date may be no earlier than January 1, 1997, and cannot be more than 75 days prior to, or more than 12 months after the date the Form 8832 is filed. If an Eligible Entity elects to change its classification, it may not elect to change its classification again for 60 months after the elections effective date.
The Check-the-Box election provides a welcome reliability of tax treatment for the unincorporated business entity. It will be interesting to see whether corporations whose structure was dictated by the necessity of a liability shield, will now explore new hybrid organizational options so that pass-through taxation can be achieved.
Limiting Liability
Hybrid Business Entities
The statutory creation of hybrid business entities such as limited liability companies and registered limited liability partnerships, has provided new choices for hands on owners where previously only a corporation was considered, due to liability potential. These entities have the advantage of limiting the personal liability of all of the owners to their investments in the business (as in a corporation), while allowing the flexibility of management and allocations of profits and losses which are more often seen in partnerships, but without the limitation upon owners participation in management which is inherent in a limited partnership.
Limited Liability Companies
The limited liability company (LLC) is governed by the Texas Limited Liability Company Act (Vernons Ann. Civ. St. art. 1528n). LLCs were the original attempt to provide the equivalent of a corporations liability shield to all owners, while permitting pass-through tax treatment by carefully limiting the entity to only two corporate characteristics (Usually continuity of life and free transfer of ownership interests are denied to an LLC.)
An LLC is composed of one or more members, who may be individuals or any kind of domestic or foreign business entity. Management may be reserved to the members or may be allocated in whole or in part to one or more managers. The LLC may additionally have officers, so that, if desired, its organizational structure may mimic the corporate trilogy of shareholders-board of directors-officers. The skeletal business structure is set out in articles of organization (filed with the Secretary of State of Texas) and may be fleshed out in regulations (the LLC equivalent of bylaws - sometimes called operating agreements in other States). Regulations are not mandatory, however, and the regulation of the LLC may arise through usage and custom.
LLCs have an advantage in that the management structure may be as formal or as informal as is desired by the members, and the machinery of the entitys management is usually contained in the regulations, which is not a public document. This management flexibility and privacy make the entity as attractive a vehicle for family businesses as it is for sophisticated arms-length investors.
While LLCs provide the liability shield of a corporation to all of its members and managers in a manner similar to that of an S-Corporation, they are not hampered by the restrictions which are placed upon the ownership of S-Corporations. An LLC has far more flexibility in ownership requirements, structure and management than an S-Corporation is permitted. For example, LLCs have no citizenship requirement, no limitation on the number of owners, no limitation to only one class of shares, and no limitation on the ownership of other corporations. Finally, members of an LLC may be persons which would be barred from ownership in an S-Corporation (non-citizens, trusts, partnerships, corporations).
Unfortunately for the popularity of LLCs, the Texas Legislature has chosen to subject them to franchise taxation in the manner of corporations. This has resulted in the LLC being less advantageous a vehicle for real estate investments than was originally envisioned.
Professional Limited Liability Companies
A variant of the LLC is the professional limited liability company (PLLC) which is governed by Articles 11.01-11.07 of the Texas Limited Liability Company Act. The PLLC is organized for the sole and specific purpose of rendering professional service and has as its members only professional individuals or professional entities. A professional service means any type of personal service that requires obtaining a license, permit, certificate of registration or other legal authorization to provide that service. Professional individuals are individuals who are licensed or otherwise authorized to render the same professional service as is the PLLC, either within Texas or any other jurisdiction. A professional entity is a person (including non-profit corporations and unincorporated non-profit associations), other than an individual, that renders the same professional service as the PLLC, but only through partners, members, shareholders, managers, directors, associates, officers, employees, or agents who are themselves professional individuals or professional entities. Some of the types of professionals who might utilize PLLCs are architects, attorneys-at-law, certified public accountants, dentists, doctors, physicians, public accountants, surgeons or veterinarians.
A PLLC may render professional service in Texas only through members, managers, officers, employees or agents who are professional individuals or professional entities authorized to render the professional service in Texas. A person who is not a professional individual or a professional entity may not be a member, manager or officer of the PLLC, and a membership interest in the PLLC may not be transferred to a person who is not a professional individual or professional entity.
PLLCs shield their members against general commercial liability. Liability for malpractice situations is handled differently. Malpractice liability will lie against the person who rendered the faulty service and against the PLLC, jointly and severally, but other members, managers, officers, employees or agents of the PLLC are not liable. If the malpracticing person is a professional entity, then that entitys partner, member, shareholder, manager, director, associate, officer, employee or agent who committed the malpractice is also jointly and severally liable.
Registered Limited Liability Partnerships
If a general partnership or a limited partnership registers with the Secretary of State as a registered limited liability partnership (RLLP) under Section 3.08 of the Texas Revised Partnership Act (TRPA) (Vernons Ann. Civ. St. art. 6132b), then, except as provided in Section 3.08(a)(2), a partner is not individually liable, directly or indirectly, by contribution, indemnity or otherwise, for debts and obligations of the RLLP which are incurred while the entity is a RLLP. This is an expansion of liability limitation to eliminate partners personal liability for the RLLPs contractual obligations. The statutory change became effective September 1, 1997, and does not affect obligations under a contract existing before the effective date.
Section 3.08(a)(2) sets out the circumstances under which a RLLP partner may have personal liability. A partner is not individually liable, directly or indirectly, by contribution, indemnity or otherwise, for debts and obligations of the RLLP arising from errors, omissions, negligence, incompetence or malfeasance (collectively, the Bad Acts) committed while the entity is a RLLP and during the course of the RLLP business by another partner or an agent, servant or employee of the RLLP who was not working under the supervision or direction of the first partner unless the first partner:
. was directly involved in the specific activity in which the Bad Acts were committed; or
. had notice or knowledge of the Bad Acts at the time of occurrence and then failed to take reasonable steps to prevent or cure the Bad Acts.
The RLLP liability limitations do not affect the following:
. the liability of the RLLP to pay its debts and obligations out of RLLP property;
ii. the liability of a partner, if any, imposed by law or contract independently of the partners status as a partner in the RLLP; or
iii. the manner in which service of citation or other civil process may be served in an action against the RLLP.
The above liability limitations as to a RLLP prevail over any other provision of the TRPA relating to partnership liability, charging partners with the debts and obligations of the partnership and partners obligations regarding contributions and indemnities.
In order to become an RLLP, a partnership must file with the Secretary of State an application stating (i) the name of the partnership; (ii) the partnerships federal tax identification number; (iii) the street address of the partnerships principal office in Texas and outside Texas, as applicable; (iv) the number of partners at the date of application; and (v) in brief, the partnerships business. The application must be executed by a majority-in-interest of the partners or by one or more partners authorized by a majority-in-interest of the partners. Two copies of the application must be filed, with a $200 filing fee for each partner.
A RLLP must either (i) carry at least $100,000 of liability insurance of a kind that is designed to cover the Bad Acts, or (ii) provide $100,000 in funds specifically designated and segregated for the satisfaction of judgments against the RLLP based upon the Bad Acts, by depositing such funds in trust or in bank escrow of cash, bank certificates of deposit, or U.S. Treasury obligations, or a bank letter of credit or insurance company bond. The Secretary of State is not required to confirm a RLLPs compliance with this requirement.
If the RLLP is in compliance with this requirement, then the requirements of the provision shall not be admissible or in any way made known to a jury in determining an issue of liability for or the extent of a debt or obligation or damages. If the RLLPs compliance is in dispute, then compliance must be determined separately from the trial or proceeding to determine the RLLPs debt or obligation in question, its amount, or partner liability. The burden of proof of compliance is on the person claiming the limitation of liability under the registration.
Registered Foreign
Limited Liability Partnerships
The 1997 Legislature added a new Article 10 to TRPA, providing registered limited liability partnership treatment in Texas for foreign limited liability partnerships which are qualified to do business in Texas. The law of the state or country of formation applies to the organization and internal affairs of a registered foreign limited liability partnership (RFLLP), and to the liability of partners for obligations of the RFLLP. A foreign limited liability partnership cannot be denied qualification to do business in Texas because of discrepancies between the laws under which it is organized and those of Texas. However, with respect to its activities in Texas, a RFLLP is subject to the provisions of Section 3.01 of TRPA, which sets out the general powers of a partnership.
Conversions
Possibly with the intention of facilitating the use of such hybrid business organizations, the 1997 Legislature passed Senate Bill No. 555 (effective September 1, 1997) which, among many other updating changes, amends most of the business organization acts to permit a new kind of business transaction - the conversion.
Conversion is a technique for changing an entitys business organization without the necessity for a merger or for a transfer of assets to a newly-formed entity and subsequent dissolution of the old entity. The old organization is referred to as the converting entity and the new organization is referred to as the converted entity. A plan of conversion is adopted and articles of conversion are generally filed with the Secretary of State to effect the change.
A conversion is distinct from a merger in that a conversion may only be from an existing business organization to a newly formed different type of business organization. If the both entities are pre-existing and operating, then a merger is the appropriate method of effecting a change of organization.
Entities eligible to be converting entities or converted entities include corporations, limited or general partnerships, limited liability companies, real estate investment trusts, joint venture, joint stock companies, cooperatives, associations, banks, trusts, insurance companies and other legal entities, whether organized for profit or not.
Conversions may also take place across state or national boundaries. If the converting entity is a foreign one (organized under the laws of a state other than Texas or another country), then a conversion may occur:
i. for a foreign corporation, limited liability company, limited partnership, or partnership - if conversion is permitted by the laws of state or country in which the entity is organized;
ii. for a foreign entity not covered by (i) aboveif conversion is either permitted by the laws of the state or country of organization, or by the constituent documents of the foreign entity that are not inconsistent with the laws of the state or country of organization; and
iii. the converting foreign entity takes all action required by such laws and constituent documents.
If the converted entity is to be a foreign one, then the conversion must be permitted by, or not inconsistent with, the laws of the state or country in which the converted entity is to be incorporated, formed or organized, and the incorporation, formation or organization must be accomplished in accordance with such laws. A foreign converted entity is deemed to have appointed the Secretary of State of Texas as its agent for service of process in a proceeding to enforce any obligation or the rights of dissenting owners of the converted entity.
A plan of conversion must include:
i. the names of the converting entity and the converted entity;
ii. a statement that the converting entity is continuing its existence in the organizational form of the converted entity;
iii. the type of entity that the converted entity is to be and the state or country under the laws of which the converted entity is to be incorporated, formed or organized;
iv. the manner and basis of converting ownership interests from the converting entity into ownership interests or securities of the converted entity; or any combination thereof; and
v. if the converting entity and the converted entity are not both domestic, or are not both the same type of organization, then in an attachment or exhibit, the organizational documents of the converted entity (ie., articles of incorporation or organization, or certificate of limited partnership) must be provided.
The plan of conversion may also include other provisions concerning the conversion which are not inconsistent with law, such as the initial bylaws, regulations, or partnership agreement of the converted entity.
If a plan of conversion has been adopted (and is not abandoned), the converting entity executes articles of conversion and files them with the Secretary of State; if the converting entity and the converted entity are both general partnerships, however, articles of conversion are not required. Articles of conversion set out:
i. either the plan of conversion or a statement certifying:
a. the name, state or country of incorporation, formation and organization of the converting entity and the organizational form of the converted entity;
b. that a plan of conversion has been approved;
c. that an executed plan of conversion is on file at the principal place of business of the converting entity (stating the address thereof), and that one will be on file from and after the date of conversion, at the principal place of business of the converted entity (stating the address thereof); and
d. that a copy of the plan of conversion will be furnished on written request, without cost, to any owner of the converting or the converted entity, by the converting entity, before conversion, or by the converted entity, after conversion.
ii. if the converting entity is a domestic corporation, then the number of shares outstanding (and, if any class or series of shares is entitled to vote as a class, the designation and number of outstanding shares of such class or series) and the voting record for and against the plan (and showing the vote of any class or series entitled to vote as a class); otherwise, a statement that the approval of the plan of conversion was duly authorized by all action required by the laws under which the converting entity was organized and by its constituent documents; and
iii any other statements or information that may be required by any law to which the converting entity or the converted entity is subject, or which either chooses to include in the articles. [This is a provision of the Texas Limited Liability Company Act, but is not included in the other organization acts - although the Secretary of State probably will not reject articles of conversion which contain extraneous information.]
A conversion takes effect upon the Secretary of Statess issuance of a certificate of conversion. When the converting entity and the converted entity are both general partnerships, however, the conversion becomes effective in accordance with the provisions of the plan of conversion.
When a conversion takes effect:
i. the converting entity continues in existence, without interruption, but in the organizational form of the converted entity;
ii. all rights, title and interests to all real estate and other property owned by the converting entity continue to be owned by the converted entity, without reversion or impairment, without any further act or deed, and without a transfer or an assignment having occurred, but subject to any existing liens or encumbrances;
iii. all liabilities and obligations of the converting entity continue to be liabilities and obligations of the converted entity, without impairment by reason of the conversion;
iv. all rights of creditors and other parties against the owners of the converting entity, in such capacity, which are in existence as of the effective time of the conversion will continue in existence as to those liabilities and obligations, and may be pursued by such creditors and obligees as though the conversion did not occur;
v. no substitution of parties is necessary in any proceeding pending by or against the converting entity or its owners, in such capacity;
vi. the ownership interests in the converting entity that are to be converted into ownership interests or securities of the converted entity, are so converted, and the former owners of the converting entity have only the rights set out in the plan of conversion, except that former shareholders of a domestic corporation additionally have the rights set out in Article 5.11 of the Texas Business Corporation Act (relating to rights of dissenting shareholders);
vii. if the converting entity and the converted entity are both domestic business corporations, domestic general partnerships, or domestic limited partnerships, the converted entity is treated as though it was the survivor of a merger with the converting entity.
If, after the effectiveness of the conversion, an owner of the converted entity would be liable under applicable law, in such capacity, for the debts or obligations of the converted entity, then such owner is liable for the debts and obligations of the converting entity that existed before the conversion took effect, only to the extent that such owner:
i. agreed in writing to be liable for such debts or obligations;
ii. was liable under applicable laws, prior to the effectiveness of the conversion; or
iii. by becoming an owner of the converted entity, becomes liable under applicable law for the existing debts and obligations of the converted entity.
The tax consequences of a conversion are dependent upon the form of the converting entity and the converted entity and whether, under the IRS Check -the-Box Regs, the conversion effects a change from an association tax treatment to a partnership tax treatment, or vice versa.
The new concept of conversion has been incorporated into the Texas Business Corporation Act (see Art. 5.17 -5.20), the Texas Limited Liability Company Act (see Art. 10.08 - 10.11), the Texas Revised Limited Partnership Act (see Section 2.15), and The Texas Revised Partnership Act (see Sections 9.05 and 9.06).
Conclusion
It will be interesting to see whether established businesses whose structures were originally dictated by the IRS corporate characteristics test, and the desire to limit owner liability, now explore the options created by the hybrid business entities currently available. The new statutes facilitating conversions from one type of entity to another provide an opportunity for creative fashioning of business organizations, maximizing protection for the owners and minimizing tax consequences.
Tamea A. Dula has been Board Certified in Commercial Real Estate Law since 1989, and is a Maintaining Member of the College of the State Bar of Texas. She is currently a Senior Assistant City Attorney for the City of Houston, dealing primarily with acquisitions and sales of real property interests. Prior to joining the Citys Legal Department in 1994, Ms. Dula practiced with the Federal Deposit Insurance Corporation and with a private law firm. She is a graduate of the University of Houston Law Center, where she was an editor of the Houston Law Review.