18 TASKS THAT TAX AND LEGAL PROFESSIONALS

SHOULD HANDLE IN ASSISTING CLIENTS TO FORM LLCs

INTRODUCTION

  1. Intended Addressees. This outline is intended primarily as a resource for tax and legal professionals engaged in assisting clients to form new businesses. (I will address these professionals in the outline in the second person - i.e., as "you.") However, I hope the list will also be useful to business people who want to understand the tax and legal issues inherent in forming new business entities.
  2. The "15 Key Issues." Readers of this outline may also wish to read another outline contained in this website – namely, the one entitled "15 KEY ISSUES IN WRITING A BUSINESS PLAN." That latter outline is intended to provide a comprehensive overview of what is involved in starting a new business. You can access that outline by clicking on the tab in this website marked "Starting New Businesses."
  3. The Assumption Underlying this Outline. The following outline generally assumes that in the business formation in question, you will have a single client, that the client’s business will require the use of only a single legal entity, and that the appropriate business organization form for that entity will be the LLC form. However, the outline may also be applied, with appropriate adjustments, in representing multiple clients, in forming multi-entity businesses and in forming corporations and other non-LLC entities.

 

 

OVERVIEW

1. IDENTIFY AND HANDLE ETHICAL ISSUES *

2. OBTAIN ALL RELEVANT BACKGROUND FACTS *

3. DETERMINE OPTIMAL NUMBER OF ENTITIES *

4. DETERMINE OPTIMAL NUMBER OF OWNERS. *

5. DETERMINE OPTIMAL FEDERAL INCOME TAX REGIMEN FOR FEDERAL INCOME TAX PURPOSES *

6. DETERMINE OPTIMAL FEDERAL INCOME TAX REGIMEN FOR SOCIAL SECURITY TAX PURPOSES *

7. DETERMINE OPTIMAL FEDERAL INCOME TAX REGIMEN FOR STATE TAX PURPOSES *

8. IF NECESSARY, RECONCILE TASKS 5-7 *

9. DETERMINE OPTIMAL STATE-LAW BUSINESS ORGANIZATION FORM FOR NON-TAX PURPOSES *

10. DETERMINE OPTIMAL STATE-LAW BUSINESS ORGANIZATION FORM FOR STATE TAX PURPOSES *

11. IF NECESSARY, RECONCILE TASKS 9 AND 10 *

12. DO A CHECK-THE-BOX ANALYSIS AND ANY NECESSARY RECONCILIATION OF TASKS 5 THROUGH 10 *

13. DETERMINE OPTIMAL BUSINESS ORGANIZATION LAW STATUTE *

14. DETERMINE OPTIMAL LLC MANAGEMENT STRUCTURE *

15. DETERMINE THE LLC TYPE THAT BEST DESCRIBES THE LLC IN QUESTION AND, ON THAT BASIS, DETERMINE THE BEST MODEL OPERATING AGREEMENT FOR USE IN FORMING THE LLC *

16. ADDRESS ALL RELEVANT BUSINESS ORGANIZATION LAW ISSUES *

17. ADDRESS ALL RELEVANT TAX ISSUES *

18. ADDRESS "MISCELLANEOUS" LEGAL AND NONLEGAL ISSUES IN THE ENTITY’S OPERATING AGREEMENT *

 

  1. IDENTIFY AND HANDLE ALL RELEVANT ETHICAL ISSUES

You should identify all relevant ethical issues in the LLC formation in question. These issues may include, among others:

    1. The issue of your own competence and that of other professionals handling the professional tasks involved in the LLC formation in question; and,
    2. If you represent two or more persons in the same LLC formation, the ethical issues that arise in joint representations.

Obviously, if you yourself are not competent to handle any particular issue in an LLC formation, you should either find another professional who possesses the necessary competence or, at the very least, you should advise your client that you will not be handling the issue.

  1. OBTAIN ALL RELEVANT BACKGROUND FACTS

You should ascertain from the client all facts about the client, the new business, and other matters that are likely to be relevant to your tasks. In particular, you should determine the purpose for which your client wishes to use the LLC, since this purpose is likely to have an important impact on the number of owners that the LLC should have, on its management structure and on its tax structure.

There are two main uses for LLCs – namely, as operating companies and as holding companies. In addition, there are two main uses for holding companies – namely:

  • To hold property in order to conserve it until its eventual disposition; and
  • To hold property for lease to other persons.

Holding companies may own personal property, real property or a mix of real and personal property. The type of property held by a holding company can have a major impact on its tax and legal structure.

  1. DETERMINE OPTIMAL NUMBER OF ENTITIES
  2. You should determine whether the new business should be conducted through a single entity or through multiple entities. (If a new business has or will reasonably soon have significant business assets, the optimal structure for it will often consist of an asset-holding entity and a separate operating entity.)

  3. DETERMINE OPTIMAL NUMBER OF OWNERS
  4. You should determine whether the LLC in question should have one owner or multiple owners. (If the LLC will have significant business assets, it should normally have at least two owners in order to maximize business asset protection.)

  5. DETERMINE OPTIMAL FEDERAL INCOME TAX REGIMEN FOR FEDERAL INCOME TAX PURPOSES
  6. You should determine the optimal federal income tax regimen for the LLC in question for federal income tax purposes. The choice will usually be among four types of federal income taxation – sole proprietorship taxation and taxation under Subchapter K or S.

  7. DETERMINE OPTIMAL FEDERAL INCOME TAX REGIMEN FOR SOCIAL SECURITY TAX PURPOSES
  8. You should determine the optimal federal income tax regimen for the LLC in question for Social Security tax purposes. For professional LLCs, the best regimen is normally Subchapter S. For non-professional LLCs, the best regimen is often Subchapter K. However, the issue is complex and should be handled only by a professional with a thorough understanding of, among other things, Prop. Reg. §1.1402(a)-2, the Internal Revenue Code proposed regulation that determines the Social Security taxation of individuals who are members of LLCs taxable as partnerships.

     

  9. DETERMINE OPTIMAL FEDERAL INCOME TAX REGIMEN FOR STATE TAX PURPOSES
  10. You should determine the optimal federal income tax regimen for the LLC in question for state tax purposes. In most states this will be the same as the regimen that is optimal for federal income tax purposes. However, in other states, this may not be the case; and in New Hampshire, the federal income tax regimen of an LLC or other business entity will be irrelevant to its state taxation.

     

  11. IF NECESSARY, RECONCILE TASKS 5-7
  12. If necessary, you should reconcile the outcomes of Tasks 5 through 7. For example, for a particular LLC, the optimal federal income tax regimen for federal income tax purposes may be Subchapter K but, for Social Security tax avoidance purposes, it may be Subchapter S. The task then becomes that of determining which is more important to the client on a short- and long-term basis – avoiding federal income taxes or avoiding Social Security taxes.

  13. DETERMINE OPTIMAL STATE-LAW BUSINESS ORGANIZATION FORM FOR NON-TAX PURPOSES
  14. You should determine the optimal state business organization form for non-tax purposes. For most entities in most states, this will be the LLC form. However, in some states – e.g., California, Florida, Nebraska, Pennsylvania and Texas – the limited partnership form or other non-LLC business organization forms may be optimal.

     

  15. DETERMINE OPTIMAL STATE-LAW BUSINESS ORGANIZATION FORM FOR STATE TAX PURPOSES
  16. You should determine the optimal state-law business organization form for the entity on state and multi-state tax grounds. In a few states – e.g., California, Florida and Texas – the LLC form may be best from a business organization law viewpoint, while a general or limited partnership may be best from a state tax viewpoint.

  17. IF NECESSARY, RECONCILE TASKS 10 AND 11
  18. If necessary, you should reconcile Tasks 10 and 11. See second sentence in comments under Task 10.

  19. DO A CHECK-THE-BOX ANALYSIS AND ANY NECESSARY RECONCILIATION OF TASKS 6-11
  20. You should do a Check-the-Box analysis, and, on the basis of this analysis, you should do any necessary reconciliation of Tasks 6 through 11. For example, it is possible that your determination of the best business organization form for a particular business from a business organization law viewpoint may be the business corporation form (e.g., because of the near-term possibility of a public offering); but if the best federal income tax regimen for the business is partnership taxation, the Check-the-Box Regulations will not permit the use of a business corporation.

  21. DETERMINE OPTIMAL LLC Act
  22. You should determine the optimal U.S. or non-U.S. LLC act for the LLC in question. The choice is usually between one’s home state LLC Act and the Delaware LLC Act. However, a non-U.S. act may be best if asset protection is a significant objective of the client.

     

  23. DETERMINE OPTIMAL LLC MANAGEMENT STRUCTURE

You should determine the optimal management structure for the LLC.

  1. Single-member LLCs owned by individuals. In the case of single-member LLCs owned by individuals, the choice is usually between:
    1. A simple member-management structure; and
    2. A simple manager-management structure.
  2. Single-member LLCs owned by entities. In the case of single-member LLCs owned by entities, the best choice is usually a simple manager-management structure.
  3. Multi-member LLCs. In the case of multi-member LLCs, the choice is usually among:
    1. A simple general partnership management structure;
    2. A complex general partnership management structure;
    3. A simple manager-controlled limited partnership management structure;
    4. A simple member-controlled limited partnership management structure;
    5. A complex member-controlled limited partnership management structure;
    6. A simple corporate management structure; and
    7. A complex corporate management structure.

 

  1. DETERMINE THE LLC TYPE THAT BEST DESCRIBES THE LLC IN QUESTION AND, ON THAT BASIS, DETERMINE THE BEST MODEL OPERATING AGREEMENT FOR USE IN FORMING THE LLC
  2. On the basis of number of their members, their management structure, and their federal tax regimen, there are 14 main types of LLCs; and there are a total of 36 main types of LLC operating agreements. A critical step in any LLC formation is to determine the LLC type that the LLC in question most resembles and, on that basis, to determine the best model operating agreement for the LLC.

     

  3. ADDRESS ALL RELEVANT BUSINESS ORGANIZATION LAW ISSUES

You should identify all business organization law issues relevant to your client, assist your client in negotiating these issues, and reflect the resolution of the issue in the LLC’s operating agreement.

There are six main types of LLC business organization law issues:

  1. "Introductory" issues (such as issues about the LLC’s name and fiscal year);
  2. Financial issues (including issues concerning capital contributions, allocations, distributions and buy-sell arrangements);
  3. Management issues (including issues about voting and agency authority);
  4. Member dissociation issues (including issues about member resignations and expulsions);
  5. Fiduciary issues (including manager duties of loyalty and care); and
  6. "Miscellaneous" issues (including, for example, issues as to the best manner in which to resolve disputes among LLC members).

In a well-drafted LLC operating agreement for a manager-managed multi-member LLC formed to conduct a relatively high-stakes enterprise, it will often be useful to address the above issues in 32 separate sections comprising 100 or more subsections. Some of the relevant 32 sections will be highly detailed "long-form" sections; others will be very brief short-form sections. Often it will be helpful to the client for you to address in one or more planning memorandums the best way to address the specific issues covered in these sections.

  1. ADDRESS ALL RELEVANT TAX ISSUES
  2. In negotiating and drafting the operating agreement of the LLC, you should handle all income tax issues, Social Security Tax issues and state tax issues relevant to your clients and the LLC. These issues will vary depending on which of the principal types of federal income tax regimens you choose for the LLC in question on the basis of the tax choice-of-entity task described in the above Tasks 5 through 8.

     

  3. ADDRESS "MISCELLANEOUS" LEGAL AND NONLEGAL ISSUES

In negotiating and drafting the operating agreement, you should handle all "miscellaneous" legal and nonlegal issues relevant to your clients and the entity – i.e., all issues other than business organization law and tax issues. These may include, for example, real estate issues, federal and state securities law issues, and intellectual property issues.

 

 

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