Originally published in January 2000.
a. Definition of New Hampshire Limited Liability Company ("LLC")
i. Definition found in New Hampshire LLC Act: Limited Liability Company formed under the laws of New Hampshire and having one or more members. NH RSA 304-C:1 V.
ii. An unincorporated business entity formed through a filing with the New Hampshire Secretary of State under NH RSA 304-C that provides its members with limited liability and allows them to participate actively in the entity's management.
b. Characteristics of an LLC
i. Hybrid of business corporation and partnership, has the liability protection afforded to corporations and can elect to be classified as a partnership for federal tax purposes.
ii. Unincorporated business entity – separate business entity formed under the statute governing LLCs and not subject to the requirements of a corporation (e.g., management structure, formalities, or rigid equity structure).
iii. May have one (1) or more members.
iv. LLC provides its members with limited liability.
v. Contractual flexibility – the New Hampshire LLC act has few mandatory rules, most rules governing an LLC are "default" rules which govern if not altered by the LLC's operating agreement. The members of an LLC have a large degree of latitude and flexibility with respect to the formation and operation of the LLC.
vi. Limited statutory formalities – the New Hampshire LLC act has few formalities regarding formation or operation of the LLC.
2. History of the LLC
a. History of the LLC Act
i. The first LLC act was adopted in Wyoming in 1977.
(1) Developed out of the demand by an oil company, Hamilton Brothers Oil Company ("Hamilton"), for a domestic entity that combined limited liability protection for the entity's owners and classification as a partnership for federal tax purposes.
(2) After the enactment of the Wyoming LLC Act, Hamilton sought a private letter ruling from the Internal Revenue Service ("IRS") confirming that a Wyoming LLC would be treated as a partnership for federal tax purposes.
ii. New Hampshire adopted its LLC statute, codified as NH RSA 304-C, in 1993.
iii. New Hampshire amended its LLC statute in 1997 in order to provide for single member LLCs.
b. History of Tax Treatment of LLCs
i. In 1980 the IRS issued a private letter ruling on the Hamilton matter confirming that an LLC would be treated as a partnership for federal tax purposes. Priv. Ltr. Rul. 8106082 (Nov. 18, 1980).
ii. At approximately the same time as it issued the private letter ruling on the Hamilton matter, the IRS issued proposed amendments to the partnership classification regulations that would automatically tax all LLCs as corporations for federal tax purposes. 45 Fed. Reg. 75, 709-75,710 (1980). The IRS later withdrew these proposed amendments.
iii. In 1988 the IRS issued Revenue Ruling 88-76 which provided that the presence of limited liability protection did not by itself mandate corporate taxation for unincorporated entities, thus, properly organized LLCs would be treated as partnerships for federal tax purposes.
iv. Prior to January 1, 1997, the IRS determined if an LLC should be taxed as a corporation or a partnership based on the six characteristics listed below (known as the "Kintner" tax classification regulations). The IRS held that these characteristics were found ordinarily found in a pure corporation and, taken together, distinguished a corporation from other entities. Treas. Reg. § 301.7701-2(a)(1983). If an LLC had five or more of the characteristics, it was classified as a corporation for federal tax purposes; if it has four or fewer characteristics, it was classified as a partnership. Thus, when forming an LLC prior to January 1, 1997, it was critical that these characteristics be addressed in a manner that ensured that the LLC would be characterized as a partnership for federal tax purposes:
(2) an objective to carry on business and divide the gains therefrom;
(3) continuity of life;
(4) centralized management;
(5) limited liability (i.e., liability for corporate debts limited to corporate property);
(6) free transferability of interest.
v. The IRS generated numerous private letter rulings and technical advice memorandums regarding the Kintner regulations until they were repealed in 1997 and replaced with the "check-the-box" regulations.
c. The Check-The-Box Regulations
i. In 1996 the IRS proposed the check-the-box rules, which became effective on January 1, 1997. Treas. Reg. § 301.7701-1 through § 301.7701-3.
ii. Check-the-box regulations allow the LLC to elect if it will be taxed as a partnership or a cooperation, or in the case of a single member LLC, as a disregarded entity.
iii. The election is made using IRS Form 8832.
3. Advantages of LLC
a. Single level of taxation.
b. Limited liability.
i. Courts have generally respected the LLC veil which protects the personal assets of the members and managers from the liabilities of the LLC.
ii. Although LLC are subject to far fewer statutory formalities than corporations, it is important that the members and manager of an LLC take reasonable step to prevent the "piercing of the LLC veil."
(1) Members should adopt an operating agreement.
(2) Pay annual fee ($100).
(3) LLC managers should not use the LLC to commit fraud or other serious misconduct.
(4) LLC should be adequately capitalized at all times.
(5) Separate ledgers and bank accounts should be established for the LLC.
(6) Member and managers of the LLC should refer to the LLC as an LLC.
(7) Members and managers should avoid engaging in any action with third parties that may imply that the member or manager is acting on his own behalf as an individual, rather than as an agent of the LLC.
(8) Adhere to the limited formalities set forth in the NH LLC act.
(a) List of the name and last known business, residence or mailing address of each member and manager;
(b) LLC's federal and state income tax returns; and
(c) A copy of the LLC agreement and certificate of formation.
c. Lack of formalities.
i. No requirement for annual meetings.
ii. No requirement to issue membership certificates to members.
d. Relatively easy to form.
e. Flexibility with respect to the organization of the management structure and operation of the LLC, including the allocation of profits and losses.
f. Members may participate in the management and operation of the LLC.
4. Disadvantages of LLC
a. Lack of familiarity with LLCs
i. LLCs are relatively new and some people are not familiar with LLCs.
ii. As LLCs are becoming more common this is far less of a problem.
b. Lack of uniformity of LLC law (e.g., Massachusetts does not recognize single member LLCs).
c. Undeveloped common law.
d. Flexibility of management and operation.
e. C-corporations generally preferred for public offering.
f. Medical insurance – expenses for medical insurance provided to employees is deductible by corporation under Internal Revenue Code § 162, however, this beneficial tax treatment is not available to medical insurance payments made by a partnership (or LLC being taxed as a partnership) for its partners. This disadvantage is mitigated by the fact that I.R.C. § 162(1) permits a self-employed person (including a partner) to deduct 60% of medical insurance premiums paid on his behalf in 2001. The amount of the deduction increase to 70% in 2002 and 100% in 2003 and thereafter.
5. LLC Act – NH RSA 304-C
a. Originally became effective in 1993, and was amended in 1997 in response to the check-the-box regulations and to provide for single member LLCs.
b. The statute has several rules that may not be altered by the members by agreement ("Mandatory Rules"), however the majority of the rules are default rules which may be altered by the members ("Default Rules") by written agreement. The alterations to the LLC Act's default rules are usually found in the LLC agreement.
c. Selected Mandatory Rules
i. LLC agreement must be in writing. NH RSA 304-C:1. VI.
ii. LLC shall not indemnify a member, manager or other person for:
(1) a liability of the person to the LLC; or
(2) damages incurred by the person for receiving an improper personal benefit in respect of the LLC. NH RSA 304-C:9 II.
iii. Members of an LLC shall be dissociated for the LLC if:
(1) they resign; or
(2) they are removed. NH RSA 304-C:27 I.
iv. No promise by a member to make a contribution to the LLC shall be enforceable against the LLC unless it is writing and signed by the member. NH RSA 304-C:37 I.
a. Certificate of Formation (RSA 304-C:12)
i. An LLC is formed by filing a Certificate of Formation with the Office of the New Hampshire Secretary of State. The form used is No. LLC 1.
ii. NH RSA 304-C:12 II requires the following information be included in all Certificates of Formation:
(1) The name of the LLC, which name shall contain the words "LLC" or the abbreviation "L.L.C." or similar abbreviation. See NH RSA 304-C:3.
(2) The nature of the primary business or purposes . See NH RSA 304-C:7.
(a) An LLC may be organized for any lawful purpose except banking, construction and maintenance of railroads, or the business of a trust, surety, indemnity or safe deposit company. NH RSA 304-C:7 I.
(3) The address of the registered office and the name and address of the LLC’s registered agent . See NH RSA 304-C:5.
(4) If circumstances so dictate, the Certificate of Formation must also contain the following information:
(a) If the management of the LLC is to be vested in a manager or managers, the Certificate must contain a statement to that effect. If the LLC is not being managed by managers, then the members are vested with the authority to manage the LLC, but that need not be recited in the Certificate. NH RSA 304-C:31 II.
(b) If the LLC is to have a specific date of dissolution, the Certificate must state such date.
(5) The Certificate must be dated and signed by a manager of any LLC which has a manager, or by a member of any LLC which does not have a manager. NH RSA 304-C:2 VI.
(6) The Certificate along with one exact or conformed copy and necessary filing fees must be delivered to the Office of the Secretary of State. NH RSA 304-C:2 VIII.
iii. The LLC is formed as of the effective time and date of the Certificate of Formation. The effective time and date of the Certificate of Formation is at the close of business on the date it is filed, or at the time specified in the document as its effective time on the date it is filed. NH RSA 304-C:11 I. A delayed effective time and date may be used provided it is no later than the ninetieth day after the date the Certificate if filed. NH RSA 304-C:11 II.
b. Statement pursuant to RSA 421-B:13 I-a.
i. In addition to the Certificate of Formation, a statement pursuant to RSA 421-B:13 I-a must also be filed. NH RSA 304-C:12 I. The statement must be in the form of Form LLC 1-A.
c. Filing Fees.
i. Certificate of Formation $35.00.
ii. Form LLC 1-A $50.00.
d. What Happens After Filing?
i. The Secretary of State will file the Certificate, assuming that it conforms to all requirements, and return to the person who filed it a copy of the original signed Certificate with an endorsement showing that it was “filed” and the filing date. NH RSA 304-C:15.
e. Additional Filing Requirements.
i. Each domestic LLC, except LLCs making returns to the insurance commissioner, must deliver to the Secretary of State for filing an annual report. NH RSA 304-C:80.
ii. The fees for such report shall be $100.00. NH RSA 304-C:81 I(d).
iii. The report and fee are due between January 1 and April 1 of each year. As with corporations, the forms are mailed out by the Secretary of State early each year.
f. Effect of Proper Formation.
i. RSA 304-C:25 provides that the debts, obligations and liabilities of the LLC, whether arising in contract, tort or otherwise, shall be solely the debts, obligations and liabilities of the LLC; and no member or manager of the LLC shall be obligated personally for any such debt, obligation or liability of the LLC solely by reason of being a member or acting as a manager of the LLC. This provision affords managers and members limited liability. Note, however, that a member or manager acting in that capacity may still be liable for tortious conduct or under contracts which he makes personally, for instance, liability from negligently injuring people or personal guaranties of LLC liabilities. Nevertheless, members will be shielded from personal liability for negligent acts of co-members and employees of the LLC and for contractual obligations that have not been personally guarantied.
g. Tax Classification Election
i. The entity classification is made by filing a Form 8823 with the IRS.
ii. The default rules provide that:
(1) an eligible entity, which includes LLCs, with two or more members is presumptively treated as a partnership.
(2) an eligible entity with a single owner is disregarded for federal tax purposes. If the owner is an individual, the single member LLC is treated as a sole proprietorship; if the owner is a corporation, the single member LLC is treated as a branch or division.
iii. An LLC is only required to file a Form 8823 if it desires to elect a classification other than the default classification.
7. Formalities of LLC Governance.
a. Generally, there are extremely few formalities of LLC governance required by RSA 304-C. Nonetheless, it may be best to organize the records of the LLC in a “corporate” record book, starting with the Certificate of Formation, followed by the LLC agreement if any, and records of votes or consents, if any. Practitioners have assumed that the limited liability of members will be attacked on bases similar to attacks on shareholders of corporations, and observation of minimal LLC formalities will serve as one leg of the argument against disregard of the entity.
b. LLC Agreements.
i. NH RSA 304-C provides for, but does not require, a written agreement among the members or adopted by the single-member of an LLC.
i. The consent of members or managers is required for certain actions, for instance merger, dissolution, or continuation, either under the statute or an LLC agreement. Although such consents need not be in writing (unless required by your agreement), for obvious reasons it is a good practice to document them as written consents or minutes of meetings.
i. Generally, meetings of members are not required. NH RSA 304-C:24 VIII does require that a meeting of members of a manager -managed LLC be held if the meeting is demanded by a member and such a meeting has not been held within the 240 days prior to the demand.
8. Securities Issues in Formation of LLCs.
a. Like other forms of business entities, LLCs and their formation and operation are affected by other laws. At least fleeting consideration has to be given to federal and states securities laws, in connection with the sale or issuance of membership interests in LLCs at the time of formation.
b. New Hampshire Securities Act
i. Under the New Hampshire Securities Act, RSA 421-B, in general, an interest in a LLC constitutes a security. NH RSA 421-B:2 XX(a) . That general rule applies regardless of whether the LLC is a single member LLC or what amounts to a small partnership among active participants in a business. The Securities Act provides a limited exception for LLC interests determined by the Secretary of State not to constitute securities and for LLC interests in professional limited liability companies. NH RSA 421-B:2 XX(b) .
ii. Securities (including LLC interests) must be registered with the Bureau of Securities Regulation or exempted from registration at the time of issuance, including issuance at formation of the LLC. Normally, there will be exemptions from registration that will apply to the issuance of LLC interests at formation. They are:
(1) NH RSA 421-B:17 II(k) exempts offers and sales made by an LLC having its principal office in New Hampshire if, after the sales, it will have no more than ten members (excluding institutional investors), b ut (i) all of those members must have purchased for investment, (ii) no commission may be paid, (iii) no advertising may be published, and (iv) all sales must be completed within 60 days of the date of formation. Advertising includes virtually any written communication concerning the membership interests or which is intended to be used to determine when to purchase the membership interests.
(a) Normally, NH RSA 421-B:17(k) is the exemption relied on when completing Form LLC 1-A. However, the four conditions noted in the preceding paragraph can easily preclude the use of that exemption.
(2) NH RSA 421-B:17 II(a) exempts from registration any sale of membership interests provided that no more than five sales are made by the LLC pursuant to that exemption within a twelve-month period. None of the additional conditions found in Section NH RSA 421-B:17 II(k) apply to a NH RSA 421-B:17 II(a) exemption, so this exemption is most frequently the alternative to Section 17 II(k) for the Form LLC 1-A.
c. Federal Securities Act
i. Like the New Hampshire Securities Act, the Federal Securities Act of 1933 generally requires registration or exemption of offers and sales of securities. However, it is a reasonably safe bet that LLC interests in a member-managed LLC in which all members actively participate in the business, will not constitute securities at all. Even in a manager-managed LLC (those interests are likely to constitute securities under federal law), an exemption from registration will almost certainly be available; and if the number of members is few and the solicitation of members is very private, it is likely that no filing with the SEC will be necessary.
d. Securities Laws of Other States
i. If LLC interest is being issued to residents of other states, the securities acts of those states will apply to the issuance. State laws vary with respect to offer and sale of LLC interests. Nonetheless, even in states in which LLC interests constitute securities; there are almost always exemptions from registration that are easily available. For most small LLC formations, those exemptions will be self-executing in most states.
a. The merger of an LLC is governed by NH RSA 304-C:18 through C:22.
b. An LLC may merge with or into another LLC, general partnership, limited partnership, or corporation.
c. Generally, the procedures to merge a LLC are substantially similar to the requirements for the merger of a corporation.
i. Voting Requirement
(1) Unless otherwise provided in the LLC Agreement, the merger agreement must be approved by more than 1/2 by number of the members. NH RSA 304-C:19.
ii. Agreement of Merger, which shall contain the following information (NH RSA 304-C:20):
(1) The name of each business entity that is a party to the merger and the name of the surviving business entity into which each other business entity merges;
(2) The terms and conditions of the merger;
(3) The manner and basis of converting the interests in each LLC and the shares of stock or other interests in each entity that is a party to the merger
(4) Such amendments to the formation documents that are to be effected by the merger, or that no such changes are to be effected; and
(5) Such other provisions relating to the merger as are deemed necessary or desirable.
iii. Certificate of Merger, which shall contain the following information (NH RSA 304-C:21):
(1) The name and jurisdiction of formation or organization of each business entity which is to merge;
(2) That an agreement of merger has been approved and executed by each business entity which is a party to the merger;
(3) The name of the surviving business entity;
(4) To the extent permitted by RSA 304-C:11 the future effective date and time of the merger (which shall be a date or time certain) if it is not to be effective at the close of business on the date of filing of the certificate of merger;
(5) That the agreement of merger is on file at a place of business of the surviving business entity, and the address of that place of business;
(6) That a copy of the agreement of merger will be furnished by the surviving business entity, on request and without cost, to any person holding an interest in any business entity which is to merge; and
(7) If the surviving entity is not a business entity organized under the laws of this state, a statement that such surviving business entity:
(a) Agrees that it may be served with process in this state in any proceeding for enforcement of any obligation of any business entity party to the merger that was organized under the laws of this state, as well as for enforcement of any obligation of the surviving business entity arising from the merger; and
(b) Appoints the secretary of state as its agent for service of process in any such proceeding, and the surviving business entity shall specify the address to which a copy of the process shall be mailed to it by the secretary of state.
iv. A merger takes effect upon the later of the effective date of the filing of the certificate of merger or the date set forth in the certificate of merger. NH RSA 304-C:21 II.
v. A certificate of merger shall constitute a certificate of cancellation for a LLC which is not the surviving business entity in the merger. NH RSA 304-C:21 IV.
vi. Dissenters' Rights - A member of a LLC is entitled to dissent from, and obtain payment of fair value of the member's LLC interest upon consummation of a plan of merger to which the LLC is a party or the consummation of a plan of conversion of the LLC to some other business entity. NH RSA C:22-b.
10. Conversion of a LLC (NH RSA 304-C:17)
a. A LLC may convert to a general partnership.
b. If the LLC agreement specifies the manner of authorizing a conversion of the LLC, the conversion shall be authorized as specified in the LLC agreement. If the LLC agreement does not specify the manner of authorizing a conversion of the LLC and does not prohibit a conversion of the LLC, the conversion shall be authorized in the same manner as is specified in the LLC agreement for authorizing a merger that involves the LLC as a constituent party to the merger.
c. If the LLC agreement does not otherwise provide, the conversion shall be authorized by the approval by more than 1/2 by number of the members.
a. A LLC is dissolved and its affairs shall be wound up upon the first to occur of the following (NH RSA 304-C:50):
i. The occurrence of events specified in a LLC agreement;
ii. Unless otherwise provided in the LLC agreement, the vote or written consent of a majority of the members; or
iii. The issuance of a notice of administrative dissolution under RSA 304-C:53, I or entry of a decree of judicial dissolution under RSA 304-C:51.
b. Distributions of Assets Upon Dissolution (NH RSA 304-C:58)
i. Prior to making any distributions of assets to any members and managers upon the winding up of a LLC, the LLC or any person or persons authorized to wind up the LLC's affairs shall first obtain a certificate of dissolution from the department of revenue administration in accordance with NH RSA 77-A:18.
ii. Upon the winding up of a LLC, the assets shall be distributed as follows:
(1) Payment, or adequate provision for payment, shall be made to creditors, including, to the extent permitted by law, members who are creditors in satisfaction of liabilities of the LLC;
(2) Unless otherwise provided in a LLC agreement, to members and former members in satisfaction of liabilities for distributions, and
(3) Unless otherwise provided in a LLC agreement, to members first for the return of their contributions and second respecting their LLC interests, in the proportions in which the members share in distributions.
c. Certificate of Cancellation (NH RSA 304-C:59)
i. After the dissolution of the LLC pursuant to RSA 304-C:50, the LLC shall file a certificate of cancellation with the secretary of state which shall set forth:
(1) The name of the LLC;
(2) The reason for filing the certificate of cancellation;
(3) The effective date (which shall be a date certain) of the certificate of cancellation if it is not to be effective upon the filing; and
(4) Any other information the members or managers filing the certificate shall deem proper.
12. Choice of Entity
a. Overview of Characteristics of New Hampshire business entities.
i. Sole Proprietorship.
(1) Owned and managed by one person.
(2) No direct statutory requirements or fees required in order to form or maintain a sole proprietorship. Because of the ease in forming it is the most prevalent form of business entity.
(3) Liability is unlimited, which means that all of the sole proprietor's assets, including personal assets are subject to claims by creditors and tort claimants. This issue may be mitigated by purchasing insurance.
(4) Management of the business is limited to managerial capacity of the sole proprietor.
(5) Relatively difficult to raise capital because the sole proprietor cannot sell interests in his business. Therefore, the only way for a proprietor to raise money is for the proprietor to invest his own capital or to borrow from a bank or other lender.
(6) Disregarded entity for tax purposes.
ii. General Partnership.
(1) Governed by RSA 304-A, Uniform Partnership Act.
(2) Defined as an association of 2 or more persons to carry on as co-owners a business for profit.
(3) No filing required to form a general partnership, and there are no annual fees required to maintain the partnership.
(4) Liability is joint and several among all partners for wrongful acts and omissions of any partner acting in the ordinary course, or for misapplication by any partner of money or property of a third person. Jointly liable for all other debts and obligations of the partnership.
(5) Management is shared by all the partners equally or as provided in the partnership agreement.
(6) Generally a written partnership agreement, which sets forth the rights and obligations of the partners, is adopted by the partners.
(7) Taxed as a flow-through entity for tax purposes.
iii. Registered Limited Partnership.
(1) Governed by RSA 304-A.
(2) Formation requires the filing of a registration with the Secretary of State. Registered Limited Liability Partnership must file an annual report and pay fee to Secretary of State.
(3) Liability of partners in a registered limited liability partnership: Partners are not liable, directly or indirectly, for the debts, obligations and liabilities of the partnership arising from omissions, negligence, wrongful acts, misconduct, or malpractice committed by another partner or employee, agent or representative of the partnership. A partner, however, cannot escape liability for his own wrongful acts or omissions or those of anyone under his direct supervision or control. A partner is also jointly liable for all other debts and obligations of the partnership.
(4) Management is shared by all of the partners equally or as set forth in the partnership agreement.
(5) Taxed as a flow-through entity for tax purposes.
iv. Limited Partnership.
(1) Governed by NH RSA 304-B, Uniform Limited Partnership Act.
(2) Defined as two or more persons, at least one of who is a general partner and one of who is a limited partner.
(3) Formation require the filing of a certificate of limited partnership with the Secretary of State, but no annual report is require to be filed.
(4) Liability of general partners: General Partner has the same liability as a partner in a general partnership. Liability of a limited partner is limited to the limited partner's capital contribution unless the limited partner is also a general partner or the limited partner participates in the control of the business.
(5) Management generally held equally in general partners. If limited partners participate in the management of the limited partnership they lose their limited liability protection.
v. S Corporation; Small Business Corporation.
(1) Governed by 293-A, Business Corporation Act and IRC § § 1361-1378.
(2) Pass through tax treatment at the federal level.
(3) Formed like a C corporation except that corporation must file a S Election, IRS form 2553, and meet the following requirements of Internal Revenue Code:
(a) a domestic corporation
(b) not more than 75 shareholders
(c) The shareholders of the S corporation must be individuals, estates, or certain trusts and cannot be nonresident aliens
(d) not more than one (1) class of stock.
(e) The S corporation cannot be an insurance company, a certain type of financial institution, or a domestic international sales corporation
(4) Making The S Corporation Election
(a) The S Corporation election requires action by both the corporation and the shareholders. The corporation must file a timely election with the IRS on the proper form, and all shareholders must consent in writing to the election. The corporation's election and the shareholders' consents are made by the filing of IRS Form 2553.
(b) There are strict rules relating to the time period within which the S Corporation election must be filed. An S Corporation election for a taxable year may be filed any time during the preceding taxable year, or any time during the first 75 days of the current taxable year. For purposes of determining when an election to be an S Corporation must be made by a new corporation, the new corporation's first taxable year is deemed to begin when it first had shareholders, acquires assets, or begins doing business. IRC § 1362(b). Because there are no extensions of the time to file the election, the corporation's attorney should make certain that all parties agree as to who will file the S Corporation election with the IRS.
(5) Taxable Year
(a) S Corporations generally must adopt a calendar year. The Internal Revenue Code provides that the tax year of an S Corporation must be a "permitted year." A permitted year is either a calendar year or any other accounting year for which the corporation shows a "business purpose" that is satisfactory to the IRS. In practice, it is extremely difficult for a new corporation to establish a "business purpose" for a fiscal year. However, an S Corporation may adopt a fiscal year if it agrees to make periodic estimated payments under IRC § 444.
(6) Managed same as a C corporation.
(a) Like a C corporation, the personal assets of the shareholders are protected.
(b) Financing is sometimes a problem because only one class of stock allowed.
vi. C Corporation.
(1) Governed by RSA 293-A, Business Corporation Act.
(2) Formation requires filing of Articles of Incorporation with the Secretary of State along with fee. Maintenance requires yearly filing of an annual report and filing fee with the Secretary of State.
(3) C corporation is managed by a board of directors who have certain duties set forth in RSA 293-A.
(4) Investor's liability in a C corporation is limited to his capital contribution.
13. Tax Considerations for Choice of Entity.
i. If structured properly, an LLC should be characterized as a partnership for federal income taxation purposes. Some of the tax advantages an LLC has over subchapter C corporations and subchapter S corporations have been widely publicized. An LLC has an advantage over a subchapter C corporation in that it is taxed as a flow through entity. Members must report their pro rata share of income, gain, losses and deductions on their individual income tax returns.
An LLC has advantages over a subchapter S corporation since the entity may have an excess of 75 members; trust, corporations and foreign individuals may be members; and non-pro rata distributions of income and loss may be made from the LLC to the members. Further, if it is contemplated that the entity will be buying mortgaged property or mortgaging property once acquired, and it is anticipated there will be significant operational tax losses, the LLC has an advantage over a subchapter S corporation since the debts of the entity increase the tax basis of the members and their membership interest and therefore increase member’s ability to use losses from the entity to offset income from other sources. This increase in tax basis is realized even though the members lack personal liability.
ii. There are no provisions in the Internal Revenue Code that apply specifically to an LLC. Originally, the IRS laid out strict rules governing whether an LLC could be treated as a partnership for federal tax purposes (the inquiry revolved around whether the company had more corporate or non-corporate characteristics); those rules no longer apply, however, and a company may, in the wake of the "check-the-box" regulations, choose how it wishes to be treated for federal tax purposes: either as a partnership or a corporation. A multi-member LLC will be characterized as a partnership for federal income taxation purposes unless the members elect to be treated as a corporation for tax purposes and file an election with Form 8832 evidencing that election. A single-member LLC owned by an individual will be treated as a sole proprietorship for federal tax purposes. Thus, the owner of a single-member LLC will be required to report earned income on Schedule C.
b. Taxes to be Considered.
i. Federal Income Taxes.
(1) Under § 721 of the Code, no gain or loss should be recognized upon formation of the LLC if the members contribute cash, property or a promise to contribute cash or property in the future. IRC § 721.
(2) The basis of the members’ interest in the LLC generally will reflect the amount of cash and their cost basis in the property they contributed.
(3) If members contribute services for an interest in the LLC, they will immediately recognize ordinary income in an amount equal to the value of their interest in the LLC. Treas. Reg. § 1.721-1(b)(1).
ii. Social Security Taxes.
(1) Social Security taxes include FICA taxes applicable to employees, and the Self-employment tax applicable to “self-employed persons”, including partners of tax partnerships. Economically, FICA taxes and self-employment taxes are identical because employers reduce employees’ salaries by the employers’ share of the FICA taxes.
(2) Social Security taxes are intended to provide substitute income for people who cannot work. Thus, it applies only to earned income. Many business owners have a strong desire to reduce or eliminate their Social Security tax burden. In part, this is due to the high Social Security tax rate. In 2001, the Social Security tax rate is 15.3% of the first $80,400 of earned income and 2.9% of any excess. In addition to concerns regarding the high rates, many people question whether they will actually ever receive any Social Security benefits. Social Security taxes tend to be more of an issue for people earning less than $80,400.
(3) Generally, the only method of reducing Social Security tax liability is to reduce earned income. However, reducing earned income will also result in lower Social Security retirement benefits and lower investment limits for tax favored retirement plans.
(4) Members of non-professional LLCs can avoid Social Security taxes to at least the same extent as owner-employees of S corporations by having a 20% passive co-owner. For purposes of avoiding Social Security taxes, S corporations are always better than LLCs for single-owner businesses. S corporations are also preferable to a professional LLC classified as a partnership for tax purposes.
iii. State Taxes and Fees.
(1) In choosing an entity for formation of a new business, consideration must also be given to applicable state taxes and fees. This should include review of state business and personal income taxes, state taxes on the transfer and/or value of real and personal property, state sales and use taxes, any state withholding taxes and applicable state filing and registration fees. While each state has its own taxation system, the state taxation formation considerations for most states are similar to federal taxation considerations.
i. Reporting Entity – federal taxation. An LLC is not subject to federal income taxation. Rather, members must report their pro rata share of income, gain, loss, deductions and credits. IRC § 701, 702(a). Multi-member LLCs being treated as partnerships for federal tax purposes must obtain a taxpayer identification number and file an annual return on Form 1065, U.S. Partnership Income Tax Return. A partnership that converts to an LLC can use the same taxpayer identification number. A single-member LLC is not required to obtain a federal identification number.
d. Income and Losses.
i. A member’s tax basis in an LLC is increased by the member’s distributive share of income and gains and decreased by the member’s distributive share of losses and deductions. IRC § 702(b).
ii. The New Hampshire LLC statute permits members to divide the LLC’s profits and losses in any way the members determine. If the LLC provides the member’s only source of income, and the member is a material participant in the business, keep in mind that the income is subject to self-employment tax at a rate of 15.3%. IRC § 1401(a). If a member is a passive investor akin to a limited partner, no self-employment tax will be due. See Proposed Treas. Reg. § 1.1402(a)-18. For federal income tax purposes, the LLC agreement of the LLC normally will control how the LLC tax items are allocated among the members.
iii. Because an LLC is a flow-through entity, no risk of double taxation exists for federal tax purposes. Therefore, reasonable compensation, the accumulated earning tax and the personal holding company tax are not federal tax issues for an LLC like they are for a C corporation. However, because the State of New Hampshire taxes LLCs at the entity level, the risk of double taxation by the State is present and the Department of Revenue Administration will be concerned with whether a compensation deduction taken by an LLC is reasonable.
e. Deductibility of Losses.
i. Members may utilize LLC losses against their own income subject to the passive loss, basis and at-risk rules. Under IRC § 722, a member’s basis in the LLC equals the amount of money and adjusted basis of property contributed to the LLC plus the amount of any gain recognized by the member at the time of contribution. The member’s basis is subsequently adjusted to reflect LLC operations; basis is increased by the member’s share of LLC income and reduced, but not below zero, by the member’s share of losses and expenditures. Under IRC § 752, any increase or decrease in the amount of LLC liabilities will also result in a corresponding increase or decrease in the member’s basis in his membership interest.
ii. Under § 704(d), the member may deduct his share of loss only to the extent of the adjusted basis in the membership interest at the end of the year. Further, under IRC § 469, if a member does not “materially participate” in the LLC’s trade or business, losses passed to the member will be characterized as “passive losses” and may only be used to offset “other passive income” and may not be used to offset portfolio income (interest, dividends, etc.) or any other income. Finally, under the “at-risk rules” of § 465, loss from activity is limited to the amount that the taxpayer has “at-risk.” Under § 465(b), a taxpayer is considered to be at risk only to the extent of money and property contributed to the activity and amounts borrowed by the LLC upon which he is personally liable.
iii. One of the major advantages of an LLC over a subchapter S corporation is that the LLC operating agreement may divide the LLCs profits and losses in any way the members desires. The operating agreement will control how the LLC’s profits and losses are allocated among the members. However, these allocations must have “substantial economic effect” or they will not be recognized for federal income tax purposes. If the allocations of profits and losses do not have economic effect, the distributive shares will be reallocated among the members according to their economic interests in the LLC. IRC § 704(b).
iv. The determination of a member’s economic interest in the LLC generally involves a facts and circumstances test to determine the member’s overall economic arrangement independent of tax consequences. The substantial economic effect test applies to all items of LLC income and loss that are not attributed to nonrecourse liabilities or a member’s nonrecourse debt. This test is designed to ensure that the members receive loss allocations that are consistent with their economic interest in the LLC and members receive income allocations where they have economic benefits associated with those allocations. The basic safe harbor test for economic effect requires that:
(1) capital accounts be maintained for the members;
(2) liquidating distributions follow positive capital accounts; and
(3) members with negative capital accounts have a deficit restoration obligation.
Treas. Reg. § 1.704-1(p)(2)(ii)(b)(3).
f. Compensation Issues – Fringe Benefits.
i. Special tax treatment is allowed for a wide variety of employee fringe benefits including health and accident plans and cafeteria plans. Under IRC § 105, a favorable tax treatment of health and accident benefits is not available to “self-employed individuals.” LLC members are treated as if they were self-employed individuals, and they do not qualify for § 105 treatment.
ii. Under IRC § 106, gross income of an employee does not include coverage provided by an employer under an accident and health plan. However, for a member in an LLC, the premiums paid on behalf of these individuals do not qualify for the exclusion under § 106. For an LLC, the cost of the employee coverage is deductible by the LLC, but the member must include this cost in his gross income under § 707(c). Members, however, will be allowed a 60% deduction for the costs of health insurance premiums paid in 2001. IRC § 162(l). The limitation on this deduction will increase to 70% in 2002 and to 100% of health insurance premiums paid beginning in 2003.
g. Other Tax Considerations.
i. Conversion to an LLC.
(1) Existing corporations and partnership might consider converting to an LLC. Because a multi-member LLC is characterized as a partnership for federal income taxation purposes, the partnership tax rules concerning conversion should apply.
ii. Two or more individuals may be able to form a partnership on a tax-free basis. IRC § 721. Therefore, the formation of an LLC by two or more individual will also be a tax-free transaction.
The IRS has ruled that general and limited partnerships may convert to an LLC without causing a termination of the partnership (and thus triggering a potential tax) if after the conversion the old partnership’s business is continued and each partner’s total percentage interest in the profits, losses and capital remain the same. Rev. Rul. 95-37; Rev. Rul. 84-52. The partners are deemed to exchange their interest in the partnership for their interest in the LLC, and their bases will not change if their shares in the new LLC’s liabilities remain the same.
iii. A conversion of a corporation to an LLC is not possible on a tax-free basis. For federal income tax purposes, a state law merger is not a tax-free transaction. Rather, the corporation is treated as if it liquidated and distributed its assets to its shareholders, followed by a contribution by these individuals to the LLC. The corporation recognizes gain or loss on the distribution of assets to its shareholders as if it had sold the property at fair market value. The shareholders would recognize gain to the extent of the fair market value of the assets received over their tax basis in their stock. IRC § 336.
iv. Passive Activity Losses.
(1) Because a multi-member LLC is characterized as a partnership for federal income tax purposes, losses that pass through to members are subject to the passive activity loss rules of IRC § 469. Therefore, if a member is an individual, estate, trust or closely held corporation, the passive activity loss rules will suspend all losses from passive activities to the extent the losses exceed the member’s income from passive activities. IRC § 469(b). The unused loses are suspended until the member has sufficient passive income to offset the losses or the member disposes of his or her entire interest in the passive activity. Id. Losses are considered to be passive unless the member can show that he or she materially participated in the trade or business of the LLC. IRC § 469(c).
(2) Members of an LLC will most likely be treated as limited partners for purposes of the passive activity loss rules. Generally, to materially participate, a limited partner must participate in the partnership’s trade or business for more than 500 hours per year. Treas. Reg. § 1.469-5T. The regulations define the term limited partner to include all holders that are not personally liable for the entity’s debts even if the entity is not a limited partnership as defined by state law. Id. Since members have limited liability, they will likely be characterized as limited partners regardless of their participation in the management of the LLC.
(3) It is possible that members will also be treated as limited partners for purposes of the active participation rules with respect to rental real estate. If an individual member “actively” participates in a rental real estate activity of the LLC, the individual member may be able to deduct up to $25,000 of passive losses from that activity, subject to income limitations. Until the regulations under IRC § 469 are revised, LLC members should take steps to meet the material participation and active participation standards to ensure passive activity loss rules do not apply.
v. At Risk Rules.
(1) Members that are individuals and certain closely held subchapter C corporations are subject to the “at risk” rules of IRC § 465. Under the at risk rules, a member may only deduct losses flowing out of an LLC if the member is considered “at risk.” A member is considered “at risk” for the amount of money and the adjusted basis of property that the member contributed to the LLC, as well as for the member’s share of LLC debt for which the member is personally liable. IRC § 465(b). While the regulations are not clear on this point, LLC members should be able to increase the amount they are at risk by guaranteeing LLC debt if the guaranty renders them personally liable and there are no contributions or subrogation rights to inherit from others. Treas. Reg. § 1.465-24(a)(2).
(2) Members should also be considered to be “at risk” for a share of the LLC’s debt that is considered to be qualified nonrecourse finance even though no member is personally liable on the debt. IRC § 465(b)(6(C). Qualified nonrecourse financing generally exists if the amounts were borrowed from a qualified person who is in the business of lending money and used to hold real property. If the loan is a traditional state law nonrecourse loan secured by a particular piece of property, an LLC should meet the qualified nonrecourse financing rules.
vi. Tax Matters Partner. LLCs with more than 10 members will be subject to the partnership audit rules set forth in the IRC. IRC § 6231(a). If an LLC is subject to these provisions it must have a tax matters partner. IRC § 6231(a)(7). Tax matters partner is the general partner so designated or the general partner with the largest profits interest if no general partner is so designated. Since LLCs have no general partner, the terms of the statute are not easily applied. However, any member of an LLC should qualify as a tax matters partner since all members have the right to participate in the LLC’s management. Regardless, the LLC should designate a tax matters partner where these provisions are applicable.
h. New Hampshire Tax Issues.
i. Taxable Entity. New Hampshire does not recognize pass-through entities for purposes of State taxation. Therefore, an LLC is subject to New Hampshire taxation at the entity level. This is true for the Business Profits Tax, the Business Enterprise Tax and, with certain exceptions, the Interest and Dividends tax.
For federal tax purposes, single-member LLCs are not required to obtain a federal identification number. However, since they are taxable in New Hampshire at the entity level, single-member LLCs are required to obtain a Department Identification Number, or DIN, from the New Hampshire Department of Revenue Administration. This number can be obtained by filing Form DP-200.
i. Application of Check-the-Box Regulations.
(1) For Business Profits Tax (“BPT”) purposes, New Hampshire has adopted the federal Check-the-Box regulations for determining how entities shall determine their entity-level tax base. Thus, subject to certain adjustments, an LLC classified as a partnership for federal tax purposes must determine its BPT taxable income in accordance with federal partnership rules.
(2) Similarly, an LLC classified as a subchapter C corporation for federal tax purposes must determine its BPT taxable income in accordance with federal subchapter C corporation rules.
j. Business Tax Issues.
(1) LLCs are subject to the New Hampshire Business Profits Tax of 8.5% of taxable income and the New Hampshire Business Enterprise Tax, currently 0.75% of business enterprise value. RSA 77-E; RSA 77-A. Taxation of LLCs at the entity level creates some unique Business Profits Tax issues, including reasonable compensation deductions and mixed entity combined groups. In an attempt to place them on par with corporations, LLCs that are taxed as partnerships are allowed to deduct “reasonable compensation” paid to owners. This deduction can only be taken if the owners personally provided services on behalf of the LLC, and the amount deducted must reasonably approximate the value of those services. RSA 77-A:4, III.
(2) Business entities that have unity of ownership, unity of operation and unity of use, or that have an interdependence in their functions are required to file a combined return as a unitary group. For New Hampshire tax purposes, a unitary group can be comprised of multiple different types of entities. Thus, for example, a subchapter C corporation can be part of a unitary group including an LLC taxed as a partnership.
k. Interest and Dividends Tax.
i. An LLC is subject to New Hampshire’s Interest and Dividends Tax, 5% of taxable interest and dividend income, if its shares are “non-transferable.” Conversely, the interest and dividend income of an LLC whose shares are “transferable” will not be subject to the Interest and Dividends Tax. Rather, this income will be considered taxable business profits and subject to the Business Profits Tax. At the same time, an owner receiving a dividend paid by an LLC having transferable shares will be subject to the Interest and Dividends Tax. Thus, for LLCs having “transferable” shares, the Interest and Dividends Tax is applied at the owner level rather than the entity level.
l. Real Estate Transfer Tax.
i. Contributions of New Hampshire real property to LLCs in exchange for LLC interests are subject to the New Hampshire Real Estate Transfer Tax at $15.00/$1000 valuation. RSA 78-B:1. As part of the 2001 budget bill, the New Hampshire legislature modified the Real Estate Transfer Tax to remove the exemption for non-statutory conversions between entity types where ownership interests remained unchanged. Therefore, any real property involved in a non-statutory conversion of a non-LLC entity to an LLC is now subject to the Real Estate Transfer Tax.
MERGERS AND CONVERSIONS
The limited liability company is obviously a very attractive business vehicle. Other business forms include C corporations, S corporations and partnerships. This chapter looks at the conversion and merger strategies and consequences involved in changing from one of these business forms to an LLC.
TERMINOLOGY AND STATE STATUTES
"Conversion" generally means the changing from a partnership to an LLC. For taxation purposes, the goal is to do this with as few negative tax ramifications as possible. Potential tax consequences include the taxation of any gain, the owners' basis in the LLC (usually referred to as outside basis) and the basis of the assets that constitute the LLC (usually referred to as inside basis). The term "merger" usually means the combination of two separate entities into one, for example a partnership and an LLC being merged into one LLC.
In general, most, but not all, LLC statutes use the team merger. 1 Some statues refer to this process as merger and consolidation. 2 In most states other entities are permitted to merge into an LLC. For example, Delaware specifically allows for a merger between a "…corporation,… business trust or association, …real estate investment trust,…common law trust, …unincorporated business,…partnership (including a registered limited liability partnership) or …foreign limited liability company, and…domestic limited liability company." 3 The Maine statute, on the other hand, only refers to the merger of a LLC into another LLC. 4Virtually no statutes use the word conversion.
The importance of these language distinctions may eventually lie in the tax treatment of the merger or conversion. For example, the transaction usually can be structured in one of three ways. Consider an example where the old entity is referred to as Oldco and the new entity as LLC. First, Oldco can be merged into the LLC with the interests in the LLC distributed in liquidation to Oldco's owners. Second, Oldco can be liquidated to its members with the formation of a new LLC with the distributed assets. Finally, Oldco can sell its assets to the LLC. The LLC interests are then distributed to Oldco's owners in liquidation of Oldco. In a state that does not allow a merger, presumably the second and third options will still be available. In a state allowing a merger, all the three options should be available. The problem occurs in considering whether the tax results should be different depending upon which of the three forms the merger utilizes. Unfortunately, there is little IRS guidance on this point. If ultimately all three transactions have the same tax result, then this problem is interesting only from a theoretical possibility. On the other hand, if different tax results arise from different structures, then the state statutes, as well as the planning route chosen, will be critical. Obviously, tax traps for the unwary will exist in such a situation. This subject will be discussed in greater detail below.
In a number of states the LLC must file a certificate of merger. Generally, this certificate asks for the same basic information that is provided in the articles of organization as well as submission of a filing fee. 5 In most states there must be a recitation in the certificate that both entities have voted for and approved the merger.
MERGER OF CORPORATIONS AND LLCs
In general, it makes little tax sense to merge either a C or an S corporation into an LLC. In the case of a C corporation, a double taxation results. First, the corporation will recognize gain on the assets of the corporation. 6 Then the assets will be deemed distributed to the owners of the corporation and the owners will have gain as well. 7 Finally, the transaction will be characterized as a contribution to the new LLC. 8 This result will occur no matter how it is structured. In all events, the sale of assets (creating gain to the corporation) followed by a liquidation to the shareholders (creating gain to the shareholders) will occur. There is really no way to avoid this problem.
In the case of an S corporation there will be a single level of tax occurring at the shareholder level. A private letter ruling recently addressed an S corporation merging with an LLC. 9 The letter ruling states that the basic single level of taxation rule applies to the S shareholders. The difference between their basis in the S corporation and the fair market value of the assets received by the LLC was deemed to be the measure of gain subject to taxation. Presumably, if the holding period of Code section 1223 is met, then the tax would be at capital gains rates. For S corporations there may be a capital gain tax at the corporate level as well. Code section 1374 provides for an S corporate level capital gains tax when the corporation has converted from a C corporation within a 10-year time period and the corporation had built-in gains at the time of the conversion. This point should be considered with care for any S corporation considering conversion into an LLC.
One important exception does apply. Code section 337 allows for the merger of a subsidiary into another entity on a tax-free basis. In another private letter ruling, the IRS had the opportunity to examine a corporate subsidiary merging into an LLC. 10 In essence, the IRS found that the merger would be tax free since the Section 337 provision had been met. This ruling poses an interesting merger approach with the desired tax consequences, albeit in a somewhat limited form, since it will only apply in the case of a subsidiary merging with the LLC.
CONVERSIONS OF PARTNERSHIPS
The most common planning situation that will occur is when a partnership converts to an LLC.
In Revenue Ruling 84-52, the IRS had the opportunity to examine the conversion of a general partnership to a limited partnership. 11 The ruling concluded the following:
· The IRS treated the transaction as a contribution by the partners of their general partnership interests for interests in the limited partnership. The IRS further concluded that Code section 721 would apply to this transaction so that no gain would be recognized by the general partners.
· The business of the partnership was not terminated under Code section 708. As such, there was no need to file a final return, close the tax year or modify any accounting treatment.
· The transaction had to be examined under Code section 752 with regard to the assumption of liabilities. If there is no change in the liabilities, then there is no change in any of the partners' adjusted bases. If there is a change in a partner's share of liabilities causing a deemed contribution by the partner, then the adjusted basis of that partner's interest shall be increased by the amount of such deemed contribution. Likewise, the decrease of any liabilities would be equivalent to a cash distribution from the partnership to the LLC. If this amount exceeded basis, then the partner would recognize gain on the excess.
The IRS has recently foun