In previous reports, I've made frequent mention of family limited partnerships (FLP) as asset protection devices. However, some commentators claim that a newer form of entity may offer greater asset protection benefits, with a number of other advantages over FLPs. 

The Limited Liability Company (LLC) is a relatively new form of legal entity that combines most of the best features of a corporation a limited partnership and a general partnership. 

According to the May/June, 1996 issue of the Limited Liability Company Reporter, all of the 50 states have adopted enabling laws. 

Here is a summary of the key differences between a LLC and other forms of business.

Any partnership losses of a limited partner may not be deductible by a limited partner because of the passive activity loss tax rules. However, if a member of a LLC is an "active participant" in the LLC, any losses should be deductible by the member - but that's likely to be an issue that will vary with the facts for each member of a LLC. (It took the IRS 200 pages to define "active participation" in a business entity, but the practical distinction is whether you devote more than 500 hours a year as a manager or member of the entity.)

While you can avoid double taxation with an S corporation, the LLC isn't subject to the numerous tax law restrictions and limitations that apply to S corporations. A major problem with S corporations is that the shareholders must be individuals or certain types of trusts (as provided in tax code section 1361). With a LLC, the business can be partly owned by a trust that can provide substantial flexibility in arranging the distribution of income or the eventual distribution of the family business. In addition, the LLC doesn't require quite as much operating formality as a corporation. The LLC also offers some partnership tax benefits not available to an S corporation. One is the ability to include entity level debt in computing the tax basis of the interest in the entity. Another is the opportunity to "step up" the tax basis of assets in a LLC at death without paying income taxes on the unrealized appreciation. 

The 1996 tax law that was passed in late August, 1996 included some provisions that will make the S corporation less of a problem, but it's too early to tell whether those changes will radically change the comparative appeal of the LLC versus the S corporation. In addition, the creditors of anyone who owns a majority of the stock in an S corporation can secure control of the S corporation, thereby making the FLP or LLC more attractive for asset protection purposes.

One way to avoid taxes on a conversion is to form a LLC as a second entity and to then exchange some of the assets of the corporation for an interest in the LLC. Then, the LLC can operate a division of the business of the corporation or can market a new product line.

Gideon Rothschild agreed and added that the LLC offers no advantage over a FLP because the FLP can give greater control to "Dad" as the general partner. It's more difficult for one partner to have total control of a LLC. In addition, he pointed out that the FLP offers more certainty with respect to valuation discounts.

Except in a few states, a LLC must have at least two partners, so you can't be a one person LLC as you can with corporations in many states. (However, any legal entity can be a member of a LLC, so the other partner of your LLC could be your own corporation.) 

Professionals, like accountants, doctors and lawyers, can't avoid professional liability with a corporation. The same basic principle applies to a LLC. (However, the LLC does protect each member from liability for the errors or omissions of other members.)

Most states will treat the LLC as a partnership, just as the IRS does. However in the states where the LLC is not yet a recognized legal entity, the tax treatment by the state is uncertain. In a few states, the LLC is subject to a franchise tax, like a corporation, even though those states have adopted a LLC statute. 

For many types of businesses, it's important to be able to use the cash method of accounting. Tax code section 448 prohibits tax shelters from using the cash method of accounting. A "syndicate" is one of a number of business forms that is assumed to be a tax shelter - unless all of the members are active in the management of the LLC. Where this matter is critical to a business, it may be necessary to get an advance ruling from the IRS. 

A limited partner's distributed share of partnership profits is not subject to the self employment tax, whereas the profits of a general partner are subject to this tax. Since the LLC can have either active members or passive members, the test of whether the profits are subject to the S.E. tax will most likely be based on the degree of involvement by each member in the business of the LLC. 

IRS Regulation 301.7701-2(b) says that an entity lacks continuity of life if the death, insanity, bankruptcy, retirement, resignation, or expulsion of any member of the entity results in the dissolution of the entity - even though the remaining members agree to continue the entity's existence following the dissolution. In Revenue Ruling 93-91, the IRS concluded that the consent of a majority of the remaining members (when permitted by state statute) to continue the entity would not result in the entity having continuity of life, like a corporation. 

However, if a member takes bankruptcy to protect some of his or her personal assets from the claims of creditors, that could force a dissolution of the LLC. The bankrupt member's share of the assets would then become available to his or her creditors. Thus, it seems that the asset protection benefits of the LLC could be lost if bankruptcy were necessary. The LLC member must then choose between the protection of bankruptcy or the protection afforded by the LLC. 

Terry Coxon suggested that it might be possible to avoid this conflict with a buy/sell agreement that requires bankrupt members to make a first offer of their interest to other members, but he acknowledged that this is an untested idea. It occurs to me this would be beneficial to the other LLC members, but would not provide asset protection for the member who must resort to bankruptcy. 

For an operating business, the LLC is certainly worth serious consideration. For estate planning and the protection of the passive investments of a family, it may not be as useful as a FLP.

Further details about protecting your assets from future lawsuits  are available in our subscriber's web site. Changes in the tax laws and various federal and state laws affecting various asset protection devices are provided in our monthly newsletter on Asset Protection Strategies.

NOTICE: This Information is intended only for educational purposes and may be regarded as controversial by some legal experts. Readers should consult with a qualified  professional who is familiar with their specific financial and tax circumstances before adopting any ideas that are discussed in this article.

About the author:

Vernon Jacobs is a CPA/CLU who works as a tax author and consultant. . He  sponsors and moderates a free discussion group on asset protection and offshore topics.  His email address is vkj@rpifs.com.  He can be reached by phone or fax at (913) 362-9667.

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