LIMITED
LIABILITY
COMPANIES
A COMPREHENSIVE
GUIDE TO
LLC FORMATION
AND OPERATION
T HE T UCKER F IRM |
CORPORATE LEGAL COUNSEL
1723 North Halsted Street
Chicago, Illinois 60614
tel. 1 312 202 0222
[email protected]
www.thetuckerfirm.com
author
Debra J. Tucker, Esq. CPA
The Tucker Firm LLC
1723 North Halsted Street
Chicago, Illinois 60614
[email protected]
www.thetuckerfirm.com
(312) 202-0222
All rights reserved. These materials may not be reproduced or distributed to any other person without written permission from The Tucker Firm,
LLC. This publication is designed to provide general information in regard to subject matter covered. It is sold with the understanding that the
publisher and the author are not engaged in rendering legal, accounting, or other professional service. Although prepared by a professional, this
publication should not be utilized as a substitute for professional service in specific solutions. If legal advice or other expert assistance is required,
the services of a professional should be sought.
about the author
DEBRA J. TUCKER is an attorney and CPA who concentrates
on representing businesses in civil litigation and defending
accountants against claims. She has represented many large
companies in complex litigation, including Office Depot,
Exxon Mobile, Martin Marietta, Illinois Tool Works, Kraft
Foods, Motorola, General Motors Acceptance Corporation,
Skidmore Owings and Merrill, and Ameritech. She also has
defended many large accounting firms, including
PriceWaterhouseCoopers, Arthur Anderson, and Crowe
Chizek. Debra is the founder of The Tucker Firm LLC.
Debra frequently speaks and writes for organizations on legal topics. She has been a
consistent instructor for the Illinois CPA Society, American Institute of Certified Public
Accountants, and American Bar Association. She also has appeared as a legal expert
on WGN-TV Chicago and FOX News.
Debra received her Juris Doctorate with honors from The Law School of the University
of Chicago. She is admitted to practice in the United States Court of Appeals for the 7th
Circuit, the United States District Court for the Northern District of Illinois, Illinois State
Courts, and several other courts around the country. She is an arbitrator for the Illinois
Circuit Court and the NASD and a member of the American Bar Association. She
formerly practiced law with the international law firm of Kirkland and Ellis in Chicago.
Prior to practicing law, Debra received a Bachelor of Science in Accountancy from the
University of Illinois at Urbana-Champaign, where she was a Robert W. Rogers and
James Scholar. She obtained a perfect GPA of 5.0/5.0 and graduated Bronze Tablet,
Summa Cum Laude, and Phi Beta Kappa. On the May 1990 CPA examination, Debra
was awarded the Illinois Bronze Medal for achieving the third-highest score in Illinois,
and she was awarded the National Elijah Watt Sells Award for obtaining one of the 108
highest scores nationally of the 68,050 examination candidates. Debra subsequently
practiced as a CPA with PriceWaterhouse in New York City. Debra is a member of the
Illinois CPA Society and American Institute of Certified Public Accountants, and she
served on the American Institute of Certified Public Accountant’s Special Committee on
Financial Reporting.
contents
I. ENTITY SELECTION
A. History and Types of LLCs
B. The Illinois Limited Liability Company Act
C. Choosing the Right Entity
D. Who Should Use LLCs
II. IMPLEMENTING AN LLC
A. Drafting the Articles of Organization
B. Management Decision-Making
C. Single Member LLCs
D. Foreign LLCs
E. Special Rules for Regulated Professionals
F. Limited Liability of Members and Exceptions
G. Property Transfers to and from Members
H. Securities Law Compliance
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III. ADVANCED TAX ISSUES
A. Check-the-Box Regulation
B. Tax Forms and Numbers
C. Federal Income Tax Differences
D. Contributions of Property
E. Contributions of Services
F. Formation Tax Issues
G. Distributions and Allocations
H. Self-Employment Tax
I. Illinois State Taxes
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IV. OPERATING AS AN LLC
A. Drafting the Operating Agreement and Statutory Limitations
B. Annual Report and Other Required Documents
C. Proper Procedures for Mergers and Conversions
D. Dealing with a Member’s Dissociation
E. Guiding Clients Through Dissolution
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V. SERIES LLCs
A. Formation
B. Conversion
C. Reports
D. Conditions for Limited Liability
E. Operating
F. Taxation
VI. ETHICS IN DEALING WITH LLCs
A. Ethical Standards and Civil Liability
B. The Role of the Attorney as Advisor in LLC Formation
C. Avoiding Conflicts of Interest
D. Confidential Information from a Representation
VII. MASTERING ESTATE PLANNING ISSUES
A. Using an LLC to Hold and Transfer Real Property
B. An LLC as a Valuation “Freeze” Entity
C. Holding Life Insurance Policies in an LLC
D. Using an LLC for Projects
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I. ENTITY SELECTION
A. HISTORY AND TYPES OF LLCs
A limited liability company (“LLC”) is a separate legal entity that may be established pursuant
to state law. The concept of an LLC originated in 1892 in Germany. In 1977, Wyoming was
the first state in the United States to allow an LLC to be formed, and the other states
subsequently followed suit. Today, LLCs are recognized as a valid entity structure in all fifty of
the United States, and LLCs are commonly used.
In August 1996, Delaware authorized the creation of series LLCs, which are a variation of
standard LLCs. The states of Tennessee, Wisconsin, North Dakota, Iowa, Oklahoma, and
Illinois subsequently authorized series LLCs. The Illinois series LLC legislation was enacted on
August 16, 2005. 805 ILCS §180/37-40.
An LLC’s structure consists of one or more members who own interests in the LLC, which are
called “membership interests”. An LLC may choose to be managed either by its member or
members or by a manager or board of managers. Managers may or may not also be members.
An LLC that elects to be managed by its member or members is called a “member-managed
LLC”, and an LLC that elects to be managed by a manager or board of managers is called a
“manager-managed LLC.” An LLC also may elect, but is not required, to have officers.
In a series LLC, the LLC’s assets may be divided into separate groups called series. Each
series may have different members, managers, or membership interests, and they may have
different rights, powers, or duties with respect to the series’ assets.
The important implication of creating series in a series LLC is that the liabilities of a particular
series are enforceable only against the assets of the particular series if certain conditions are
satisfied. The assets contained in other series or the LLC generally are unreachable. This
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TH E T UC K E R F IR M L L C
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(312) 202-0222
provides greater protection for assets than is afforded by other entity types without the
formation of multiple separate entities. It is this feature that makes a series LLC very
advantageous for many types of businesses.
B. THE ILLINOIS LIMITED LIABILITY COMPANY ACT
LLCs in Illinois are formed pursuant to the Illinois Limited Liability Company Act, 805 ILCS §
180/1-1 et. seq. (the “LLC Act”). The Illinois Act is based on the Uniform LLC Act. The Act is
available on the website www.ilga.gov . After entering the site, you can find the Act under the
headings “legislation and laws”, “Illinois compiled statutes”, “business”, “business
organizations”, “limited liability companies”, and “Limited Liability Company Act”. A copy of
the Act can be accessed through the Secretary of State’s website.
The LLC Act codifies many rights and obligations relating to LLCs that are provided by the
common law for other entities. For example, the LLC Act expressly identifies the fiduciary
duties of an LLC’s members whereas these duties arise from the common law for other entity
types. Noticeably absent from the LLC Act are detailed provisions requiring that formalities be
followed in the management of the LLC. For example, the LLC Act does not contain
requirements for holding meetings of the LLC’s members and does not provide for the
appointment of officers or specify their duties.
The LLC Act expressly provides that “[u]nless displaced by particular provisions of this Act, the
principles of law and equity supplement this Act.” 805 ILCS §180/1-43. The LLC Act generally
allows for an LLC’s members to alter the provisions contained in the LLC Act, except with
respect to certain specified issues. (See Section below on Drafting the Operating Agreement
and Statutory Limitations.)
C. CHOOSING THE RIGHT ENTITY
The LLC is one of many types of entities that may be used to hold assets or to operate a
business in Illinois. Other entity types include the sole proprietorship, general partnership,
limited partnership, limited liability partnership, S Corporation, and C Corporation. The factors
to consider in determining the most advantageous entity type include: (1) the number and
character of the owners of the entity, (2) the extent of liability of the owners, (3) business
restrictions, (4) formation and maintenance costs, (5) the flexibility in providing the owners
with a return, (6) the flexibility in segmenting business operations, (7) the ability to raise
ENTITY SELECTION
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capital, (8) the credibility of the entity, and (9) tax differences. Number and Character of
Owners.
An LLC can be formed regardless of the number of owners (called members) of the LLC.
805 ILCS §180/5-1(b). Except for certain professions, an LLC also can be formed regardless
of the character of the owners. (See Section below on Special Rules for Regulated
Professions.) Thus, an LLC can be formed if there is one member or there are multiple
members of the LLC. An LLC also can be formed if its members are legal entities rather than
individuals or if its members are foreign citizens rather than United States citizens.
In contrast, restrictions exist that prohibit other entity types from being used depending on the
number and the character of the entity’s owners. For example, a business cannot operate as a
sole proprietorship if it has more than one owner. A partnership must have two or more
owners. Like an LLC, C corporations can have one or more owners and the character of the
owners are not restricted. S corporations have restrictions on both the number and the
character of their owners. S corporations cannot have more than one-hundred shareholders
and the shareholders cannot be partnerships, corporations, certain types of trusts, certain
tax-exempt organizations, or individuals whose residence is not within the United States and
who are not United States citizens. 26 U.S.C. §1361(b)(1). An LLC can hold shares of an
S corporation without invalidating the corporation’s Subchapter S election, at least if the LLC
does not elect to be taxed as a corporation and the members of the LLC would otherwise
qualify to be owners of the S corporation’s shares directly. IRS Letter Ruling 200107025.
Liability of the Owners.
The members of an LLC generally are not personally liable for the debts and obligations of the
limited liability company, except in certain exceptional circumstances. (See section below on
Limited Liability of Members and Exceptions.) An LLC’s members do not lose their limited
liability by participating in the management of the LLC or by failing to observe formalities in
managing the LLC. 805 ILCS §180/10-10(a) and (c).
In contrast, the owner of a sole proprietorship and the general partner(s) in a general
partnership and in a limited partnership have unlimited personal liability for the debts and
obligations of the company. Like the members of an LLC, limited partners of a limited
partnership and partners in a limited liability partnership have limited liability. However, limited
partners in limited partnerships lose their limited liability if they actively participate in the
management of the limited partnership. The shareholders of an S corporation and C
corporation generally have limited liability.
Business Restrictions.
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Almost all types of assets can be held and almost all types of businesses can be operated as an
LLC. However, the LLC Act contains additional specific requirements if the LLC conducts the
business of insurance, dentistry, or medicine. In addition, the regulatory bodies of certain
other professional services place additional restrictions on LLCs that engage in regulated
professions. (See section below on Special Rules for Regulated Professionals.) These same
types of restrictions exist for providing professional services through other entity types.
Formation and Maintenance Costs.
An LLC is formed by filing an “articles of organization” with the Illinois Secretary of State and
paying a five-hundred-dollar filing fee for a traditional LLC and a seven-hundred and fifty-dollar
filing fee for a series LLC. A series LLC must pay an additional filing fee of fifty dollars for each
series to file a “certificate of designation” for each series. Each year, an LLC must file an
annual report with the Secretary of State and pay a two-hundred and fifty dollar filing fee. A
series LLC must pay an additional fifty dollars for each series to file its annual report. In
addition, Illinois LLCs that transact business in other states generally must register to do
business in those states, and foreign LLCs that transact business in Illinois must register to do
business in Illinois.
An LLC typically incurs professional fees to file the required documents with the Secretary of
State and to draft an operating agreement to govern its internal affairs. Professional fees are
generally not incurred to draft bylaws or shareholders’ agreements for LLCs because
provisions that are usually contained in these documents are integrated into the LLC’s
operating agreement.
In contrast, a sole proprietorship is administratively simple to start. The owner of the sole
proprietorship does not need to file documents with the Secretary of State to form a sole
proprietorship or to file an annual report with the Secretary of State. However, if the sole
proprietorship conducts business other than under the name of the sole proprietor, then the
sole proprietorship must make an assumed name publication.
Similarly, a general partnership is administratively simple to start. Typically, a partnership
agreement is entered into, but this is not legally required. To form a limited partnership, a
Certificate of Limited Partnership must be filed with the Secretary of State and a $150 filing fee
must be paid. A limited partnership must file Biennial Renewal Reports with the Secretary of
State and pay a $150 filing fee. To form a limited liability partnership, a Statement of
Registration must be filed with the Secretary of State and a filing fee must be paid of $200 plus
$100 for each partner above two up to a maximum of $5,000. Each year, the limited liability
partnership must file an Application for Renewal with the Secretary of State and pay a $100
filing fee per partner up to a maximum of $5,000. A partnership typically incurs professional
fees to file any required documents with the Secretary of State and to draft the partnership
agreement to govern its internal affairs.
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A C corporation and S corporation are formed by filing articles of incorporation with the
Secretary of State. The filing fee is $150 plus initial franchise taxes in the amount of 0.15% of
the amount of initial paid in capital (a $1.5 fee for each $1,000 of paid in capital), subject to a
minimum amount of $25. Each year the corporation must file an annual report with the
Secretary of State and pay a $75 filing fee and annual franchise taxes in the amount of 0.1% of
the paid in capital of the corporation (a $1.0 fee for each $1,000 of paid in capital), subject to a
minimum amount of $25. In addition, the corporation also typically incurs professional fees to
file the required documents with the Secretary to State, to draft bylaws, a shareholder’s
agreement, and corporate resolutions. A corporation files a Subchapter S election with the IRS
at no cost to be taxed as a flow-through entity and to be deemed an “S corporation”.
Flexibility in Providing a Return.
LLCs provide a great amount of flexibility in allocating the LLC’s income and loss to the LLC’s
members. Although the LLC Act provides default rules for the distribution of the LLC’s income
and loss to the LLC’s members, the members can alter these default rules by adopting
provisions in the operating agreement. As long as the LLC’s allocations of income and loss to
its members have economic effect, they will be respected by the Internal Revenue Service
(“IRS”) and may provide tax advantages to the LLC’s members.
Series LLCs provide even greater flexibility in allocating the LLC’s income and loss to the LLC’s
members. Income and loss associated with the property of each series can be allocated easily
to the members of each series and different allocation methods can be used for each separate
series.
Similar to an LLC, partnerships allow for flexibility in providing their owners with a return on
their investment. However, C corporations and S corporations do not. In a C corporation,
separate classes of stock must be created in order to treat owners differently with respect to
distributions. S corporations are not permitted to have multiple classes of stock; and
therefore, S corporations are extremely limited in their ability to give a priority return to certain
owners.
Flexibility in Segmenting Operations.
LLCs allow a great deal of flexibility in segmenting a company’s operations and assets. An LLC
provides a company with a very simple and cost effective mechanism to operate a segment of
its business. This is because LLCs are not required to have directors or officers, are not
required to follow other corporate formalities, and can have any number of owners. In
addition, contributions of property to an LLC by its members and distributions of property by
the LLC to its members generally do not constitute taxable events if the LLC has elected flowthrough tax treatment. Thus, an LLC provides a company with a cost effective mechanism to
transfer property in or out of business segments.
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Series LLCs provide a company with even greater flexibility in segmenting its operations and
assets. In a series LLC, a company can segregate its operations solely by forming separate
series with limited liability within the overall LLC legal entity rather than forming multiple legal
entities to limit liability.
In contrast, it is not possible to isolate the assets and obligations of business segments within
any other entity type such that the segments each have limited liability. Although business
segments may be internally managed separately, the segments are treated as one entity for
liability purposes. To obtain limited liability for each business segment, a separate legal entity
would have to be established for each business segment.
Ability to Raise Capital.
An LLC structure provides only a limited ability for the entity to raise capital. Because most
investors prefer to invest in an entity that offers limited liability, an LLC structure helps the
business raise capital. A series LLC enhances a company’s ability to raise capital because it
allows a mechanism whereby investors may invest in some, but not all, of the operations of a
company.
However, LLC membership interests cannot be traded publicly on the major securities
exchanges, and this limits an LLC’s ability to raise capital. An LLC can be changed later to a C
corporation to allow its ownership interests to be traded on an exchange. This process
requires the LLC to be dissolved and the C corporation to be newly formed, and it may be
complicated and costly. In addition, the newly-formed C corporation will not be able to
immediately have its shares traded on a major securities exchange because the exchanges
require a company to operate for a certain number of years before being traded on the
exchange. Therefore, if a company anticipates going public in the near future, the company
typically should not form as an LLC.
A sole proprietorship is more limited than an LLC in its ability to raise capital, and typically it
must rely on its sole proprietor to provide it’s financing. Likewise, a general partnership’s
ability to raise capital is limited because individuals usually do not desire to invest in entities
that do not offer limited liability. Limited partnerships, limited liability partnerships, and S
corporations enhance a company’s ability to raise capital because they offer owners limited
liability. However, the restrictions on the number and character of an S corporation’s owners
limit an S corporation’s ability to raise capital.
C corporations offer the greatest ability to raise capital. The C corporation structure often is
essential for the company’s shares to be traded on the major securities exchanges. Often an
entity that intends on having its ownership interests publicly traded in the future is established
as an S corporation so that it can be taxed as a flow-through entity before it is publicly traded.
When the company is ready to have its shares publicly traded, the company converts from an
S corporation to a C corporation. This process involves changing the company’s tax election
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with the IRS and not the company’s ownership and management structure. It is not
complicated or costly.
Credibility.
In the past, LLCs were not recognized by the laws of all fifty states and few LLCs existed.
Because the business community was not accustomed to dealing with LLCs, LLCs encountered
difficulty in conducting their business and establishing credibility in the marketplace. Today, all
fifty states recognize LLCs as a valid entity type and the entity form is widely utilized. Thus,
LLCs have an easier time transacting business and establishing credibility in the business
community today.
Even though the business world has become more accustomed to LLCs, many legal
uncertainties still exist with respect to LLCs. There are very few court decisions, IRS
determinations, and other authority on issues relating to LLCs. As a result, it is often difficult
to predict how legal issues will be resolved in the context of an LLC.
Greater difficulty exists with respect to series LLCs. Very few states have enacted series LLC
legislation. If the LLC intends on doing business in a state that has not enacted series LLC
legislation, problems may arise. The LLC acts in most states expressly provide that issues
relating to an LLC will be determined according to the laws of the sate in which the LLC was
formed. Thus, a series LLC’s structure and limitations on liability provided by the law of the
state in which the LLC was formed should be respected in these states even if the state has not
enacted series LLC legislation. However, this result depends on the specific provisions of the
LLC act in effect in the particular state in which the LLC is doing business. Thus, if a company
plans to do business in states other than Illinois, the company should first ensure that the
series LLC will be respected in the other states.
Because other entity types have been utilized for an extended period of time, transactions
involving them are often easier and greater certainty exists with respect to legal issues relating
to them.
Tax Differences.
One of the advantages of an LLC is that it offers a great degree of tax flexibility. An LLC can
choose to be taxed like a sole proprietorship or partnership, a C corporation, or an S Corp
subject to certain restrictions. Thus, an LLC generally can choose the tax treatment that
provides the greatest tax advantage to the LLC and its owners given their specific
circumstances. In contrast, sole proprietorships and partnerships must be treated as such for
tax purposes and have no option to be taxed otherwise. Similarly, a C corporation is taxed as
such and cannot elect to be taxed otherwise unless it meets the requirements for making the
Subchapter S election. Most importantly, a C corporation cannot make the Subchapter S
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election if it has multiple classes of stock, and multiple classes of stock are necessary to
distribute income and loss to shareholders in proportions different from their ownership
percentage. Therefore, an S Corporation does not provide any opportunity to minimize taxes
by allocating income and loss to owners in a disproportionate, strategic manner.
Differences exist in the federal income tax, federal self-employment tax, and Illinois states taxes
for entities of different types and their owners.
Federal Income Taxes.
For federal income tax purposes, a single-member LLC can choose to be disregarded as an
entity like a sole proprietorship or a multi-member LLC can choose to be treated like a
partnership. In the alternative, an LLC with any number of members can elect to be taxed as a
separate entity like a corporation.
If a single-member LLC elects to be disregarded for tax purposes, the LLC’s income and loss
flows through and is taxed only to the LLC’s member. If a multi-member LLC elects to be
taxed as a partnership, the rules applicable to partnerships that are set forth in Subchapter K of
the Internal Revenue Code (“Code”) apply to all federal income tax matters. The LLC’s income
and loss flows through and is taxed only to the LLC’s members. Gain generally is not
recognized on contributions of appreciated property to the LLC by the LLC’s members or
distributions of appreciated property by the LLC to the LLC’s members. The member’s basis in
his LLC membership interest includes the member’s share of the LLC’s debt, which enables the
member to claim more tax deductions, absorb more losses, and withdraw more money from
the LLC on a tax-free basis. The LLC’s members are not permitted to exclude from their gross
income employee fringe benefits (such as medical payments and the cost of group term life
insurance) paid for them by the LLC. The LLC is not be able to engage in the tax-free
reorganizations specified for corporations in the Code.
If the LLC elects to be taxed as a corporation, the LLC is taxed pursuant to the rules applicable
to corporations set forth in Subchapter C of the Code. These rules require the LLC to pay
income tax on its income and loss and also require the LLC’s members to pay tax on
distributions they receive from the LLC. This is referred to as the “double tax” because both
the LLC and its members pay income tax arising from the LLC’s income and loss. However,
tax at the entity level can be avoided if the LLC pays all of its profits to its owners as wages
each year. Gain is generally recognized by the LLC’s members on contributions of appreciated
property to the LLC by the LLC’s members unless the contributing member controls at least
80% of the LLC. Gain also is recognized by the LLC and by the LLC’s member on distributions
of appreciated property by the LLC to the LLC’s member. The member’s basis in his LLC
membership interest does not include the member’s share of the LLC’s debt. The LLC’s
members are permitted to exclude from their gross income certain employee fringe benefits
paid for them by the LLC, and the LLC is able to engage in the tax free reorganizations specified
for corporations in the Code.
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An LLC that elects to be taxed as a corporation can further elect to be taxed as an S corporation
if the requirements for making the Subchapter S election are satisfied. These requirements are
that (1) the LLC has no more than 100 members, (2) the LLC’s members are not partnerships,
corporations, certain types of trusts, certain tax-exempt organizations, or individuals whose
residence is not within the United States and who are not citizens, and (3) the LLC has only one
class of membership interests. 26 U.S.C. §1361(b)(1). If an LLC elects to be taxed as an
S corporation, the LLC is taxed pursuant to the rules specifically applicable to S corporations
set forth in Subchapter S of the Code. The rules applicable to C corporations set forth in
Subchapter C of the Code apply to all matters other than those specifically set forth in
Subchapter S.
Basically, this means that the LLC’s income and loss is taxed like partnership income and loss,
i.e. the income and loss flow through and are taxed only to the LLC’s members. In addition,
LLC’s members who own 2% or more of the membership interests of the LLC are required to
include in their gross income employee fringe benefits paid for them by the LLC. The LLC is
treated as a regular C corporation with respect to most other federal income tax rules, such as
corporate distributions, redemptions, liquidations, reorganizations, and the like. Gain generally
is recognized by the LLC’s members on contributions of appreciated property to the LLC by the
LLC’s members unless the contributing member controls at least 80% of the LLC. Gain is
recognized by the LLC on distributions of appreciated property by the LLC to the LLC’s
members. The member’s basis in his LLC membership interest does not include the member’s
share of the LLC’s debt. However, for purposes of deducting losses, the LLC’s member is able
to include the amount of any debt that the LLC owes the member. The LLC is able to engage in
the tax free reorganizations specified for corporations in the Code.
For the most part, the tax treatment that is afforded to LLCs can be obtained by any other entity
type that is taxed pursuant to the same subchapter of the Code pursuant to which the LLC
chooses to be taxed. In other words, if it is advantageous for a single-member LLC to be
disregarded as an entity, then the company can obtain the same tax advantages by operating as
a sole proprietorship. If it is advantageous for a multi-member LLC to be taxed as a
partnership pursuant to the tax rules in Subchapter K, then the company can obtain the same
tax advantages by forming a partnership. Similarly, if it is advantageous for the LLC to elect to
be taxed as a corporation pursuant to the tax rules of Subchapter C, then the company can
obtain the same tax advantages by forming a C corporation. If it is advantageous for the LLC
to be taxed pursuant to the tax rules in Subchapters S and the LLC satisfies the requirements
for making the Subchapter S election, then the company can obtain the same tax advantages
by forming an S corporation.
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Federal Self-employment Tax.
Individuals who are owners of an entity may be required to pay self-employment taxes in the
combined amount of 15.3% on their earnings subject to a cap. A sole proprietor pays selfemployment tax on all of the sole proprietorship’s income and loss.
A general partner in partnerships pays self-employment tax on the guaranteed payments he
receives from the partnership and his distributive share of the partnership’s income and loss.
A limited partner pays self-employment tax only on guaranteed payments he receives from the
partnership as compensation for services he renders for the partnership.
A member of an LLC that chooses to be disregarded as an entity, treated like a partnership, or
an S corporation, pays self-employment tax on the guaranteed payments he receives from the
LLC and his distributive share of the LLC’s income and loss if the member participates in the
management of the LLC. A member who does not participate in the management of the LLC
pays self-employment tax only on guaranteed payments he receives from the LLC as
compensation for services he renders to the LLC.
A shareholder of a C or S corporation does not pay self-employment tax on any amounts
distributed, or allocations of income or loss made, by the corporation to its shareholders by
virtue of their ownership interest in the corporation. The corporation and the shareholders pay
employment tax on any wages paid to the shareholder as an employee of the corporation, and
a shareholder pays self-employment tax on any compensation he receives from the corporation
for services rendered as an independent contractor to the corporation.
Illinois State Income Tax.
Sole proprietorships and single-member LLCs that elect to be treated like them do not pay an
entity-level Illinois state income tax. Rather, the owners pay a personal income tax on the
income and loss of the company at the rate of 3%.
Flow-through entities, including partnerships, S corporations, and LLCs that have chosen to be
taxed like them, also do not pay an entity-level income tax. Id. Their owners pay a personal
income tax on income and loss flowed through to them at the rate of 3%.
35 ILCS §5/201(b)(2)(ii).
C corporations and LLCs that elect to be taxed like them are subject to an entity-level state
income tax of 4.8% of the entity’s net income, and their owners also pay a personal income tax
on distributions made to them by the entity at the rate of 3%. 35 ILCS §5/201(a), (b)(2)(ii),
and (b)(8).
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Illinois State Personal Property Replacement Taxes.
Sole proprietorships and single-member LLCs that elect to be treated like them do not pay
Illinois state personal property replacement taxes. Legal entities that have their income flowedthrough to their owners for income tax purposes are subject to an entity-level 1.5% Illinois
personal property replacement tax based on net income. 35 ILCS §5/201(c) and (d). These
entities include partnerships, S corporations, and LLCs that have chosen to be taxed like them.
Certain investment flow-through entities are exempt from this tax. 35 ILCS §5/205(b).
C corporations and LLCs that elect to be taxed like them are taxed at the rate of 2.5% rather
than 1.5%. 35 ILCS §5/201(d).
Illinois State Franchise Tax.
An LLC is not subject to Illinois franchise taxes on its paid-in-capital even if it elects to be taxed
as a corporation for federal income tax purposes. The Illinois franchise tax only applies to
entities that are legally formed as corporations, including C corporations and S corporations.
The tax is reported on the corporation’s articles of organization and annual reports. It is paid to
the Secretary of State in the amount of $1.5 per $1,000 of initial paid in capital and $1.0 per
$1,000 of the annual paid in capital balance. An LLC pays a fixed annual report fee of $250
without regard to its paid-in-capital and without paying any franchise tax.
805 ILCS §180/50-10(b)(11).
ENTITY SELECTION
11
General Tax Summary.
TAX ITEM
TYPE OF ENTITY AND
LLCs THAT ELECT TO BE SIMILARLY TAXED
Sole
Proprietorship
Partner-ship
C Corp.
S Corp.
1) Income and loss flows through to the owner(s) and
federal and state income tax is paid only by the
owner(s).
Yes
Yes
No
Yes
2) The company pays a federal and state income tax and the
owner(s) pay personal income tax on distributions
received from the entity.
No
No
Yes
No
3) Self-employment tax is paid by the owners on their
distributive shares of the company’s income and loss.
Yes
Yes, except
for limited
partners.
No
No for S
corps.
Yes for LLC
members who
participate in
management.
Yes for LLC
members who
participate in
management
4) Gain is recognized on an owner’s contribution of
appreciated property.
No
No
Yes, except
for ≥80%
owners
Yes, except
for ≥80%
owners
5) The basis of an owner’s ownership interest includes the
owner’s share of the company’s debt.
Yes
Yes
No
No
6) Fringe benefits paid to employee owners are included in
their taxable gross income.
Yes
Yes
No
Yes if ≥2%
owners
7) Tax free corporate reorganizations specified in the Code
can be executed.
No
No
Yes
Yes
8) Illinois Income Tax is paid by the entity
No
No
Yes
No
9) Illinois Personal Property Replacement Tax is paid on the
company’s income.
No
Yes,
at 1.5%
Yes,
at 2.5%
Yes,
at 1.5%
10) Illinois Franchise Tax is paid on paid-in-capital.
No
No
Yes for C
corps.
Yes for S
corps.
No for LLCs
No for LLCs
ENTITY SELECTION
12
Taxation of Series LLCs.
Series LLCs may provide a company with tax advantages that are not obtainable through any
other entity type. Series LLCs may be taxed as one entity or as multiple entities depending on
the extent of the differences in the characteristics of each series. Thus, a tax planner has an
additional dimension upon which to structure the LLC to afford the most favorable tax
treatment for the LLC and its members. Other legal entities are always treated as one tax
entity, and therefore, there is no opportunity to minimize taxes on the basis of the entity being
treated as one or more tax entities.
The treatment of a series LLC as multiple tax entities also could generate some unintended tax
consequences if the LLC is not vigilant. Although a series LLC will operate in many respects
like one entity, the LLC must remember that for tax purposes the series LLC may be treated as
multiple separate entities. Therefore, the tax treatment of a transaction executed by a series
LLC may be different than if the transaction were executed by a single tax entity.
D. WHO SHOULD USE LLCs
Whether a company should operate as an LLC depends on the objectives desired to be
achieved by the business owners and how the LLC compares to other types of entities in its
ability to meet those objectives. (See section above on Factors to Consider in Choosing the
Right Entity.) Because of the flexibility that LLCs offer, LLCs are almost always able to satisfy
all of the objectives of business owners without accompanying disadvantages. In certain
circumstances, the LLC is the cheapest entity structure to achieve desired objectives, and there
is at least one set of objectives that can only be satisfied by an LLC.
Typically, small business owners desire limited personal liability and flow-through tax
treatment for the company’s income and loss. These objectives can be satisfied by an LLC, a
limited liability partnership if there are at least two owners, or an S corporation if the
requirements for making the Subchapter S election are satisfied. Depending on the
circumstances, one of these alternatives may be more cost effective. The initial filing fee and
the annual report fees for a limited liability partnership are higher than for an LLC if the
business has three or more owners and is maintained for five or more years. The initial filing
fee and the annual report fees for an S corporation are higher than for an LLC if the company
has high paid-in-capital. Thus, the LLC is the most cost effective alternative to obtain limited
liability and flow-through tax treatment if these circumstances exist.
The LLC also is the most cost effective alternative to achieve limited liability for multiple
segments of a company’s assets or operations. To obtain limited liability for a business
segment through an entity other than an LLC, separate legal entities must be established and
maintained for each business segment. Initial filing fees and annual report fees would need to
be paid for each separate legal entity. In addition, corporate formalities would need to be
ENTITY SELECTION
13
followed for each separate legal entity. A series LLC is the most cost effective manner in which
to achieve limited liability for multiple segments of a company. It is less expensive to form and
maintain a series within a series LLC than it is to form and maintain a separate legal entity for
each segment of the company.
ENTITY SELECTION
14
II. IMPLEMENTING AN LLC
A. DRAFTING THE ARTICLES OF ORGANIZATION
Articles of Organization Form.
An LLC is formed by filing articles of organization with the Illinois Secretary of State and paying
a filing fee. 805 ILCS §180/5-1(a). A standard LLC files its articles of organization on
Form LLC-5.5 and pays a $500 filing fee. 805 ILCS §180/50-10(b)(1). A series LLC files its
articles of organization on Form LLC-5.5(S) and pays a $750 filing fee. A series LLC must
also file a certificate of designation on Form LLC-37.40 and pay a $50 filing fee to establish
each series in the LLC. 805 ILCS §180/37-40(d). (See section below on Series LLC Formation
– Certificate of Designation.)
The articles of organization must contain the following information:
1) The LLC’s name and address of principal place of business;
2) The LLC’s purposes;
3) The registered agent’s name and registered office’s address;
4) The names and addresses of the manager(s) for manager-managed LLCs or the names
and addresses of the member(s) for member-managed LLCs;
5) Each organizer’s name, address and signature;
6) The effective organization date not more than 60 days after filing, if it is not desired for
the LLC to be formed on the filing date;
1723 North Halsted Street
TH E T UC K E R F IR M L L C
Chicago, Illinois 60614
http://thetuckerfirm.com
(312) 202-0222
7) The latest dissolution date and other agreed-upon events of dissolution, if any;
8) A statement limiting the members’ and/or managers’ authority to affect the LLC’s
interest in real property, if desired;
9) Any other provision for the regulation of internal affairs desired to be stated;
10) For LLCs that accept and execute trusts, a statement from the Office of Banks and Real
Estate of compliance with the Corporate Fiduciary Act; and
11) For series LLCs, notice that the liabilities of the series are limited to being satisfied
from the assets of the series.
805 ILCS 180/5-5(a).
The LLC’s Name.
The LLC’s name stated on its articles of organization must satisfy several requirements.
805 ILCS §180/1-10. The LLC’s name must contain the terms “limited liability company”,
“L.L.C.” or “LLC”; and the LLC’s name cannot contain terms that would indicate that the LLC is
another type of entity, such as “Corp.”, “Ltd.”, “L.P.” or other similar terms. The LLC’s name
must contain the word “trust” if it is organized for the purpose of accepting and executing
trusts; and the LLC’s name cannot contain words implying authorization to be a corporate
fiduciary, such as “trust”, “trustee” or “fiduciary”, unless the LLC complies with the Corporate
Fiduciary Act.
The LLC’s name must be the name under which the LLC transacts business unless the LLC
adopts an assumed name by filing Form LLC-1.20. However, an LLC may use divisional
designations or trade names as long as the LLC’s name is also clearly disclosed. By filing
Form LLC-1.20 and paying a fee of $30 per year, the LLC is permitted to use an assumed name
until the next year ending in either 0 or 5. 805 ILCS §180/50-10(b)(9). The right to use the
assumed name must be renewed thereafter for five year periods by filing Form LLC-1.20 and
paying a $150 filing fee. 805 ILCS §180/50-10(b)(9).
The LLC’s name also must be distinguishable from names of existing Illinois LLCs and
corporations, foreign LLCs and corporations admitted to do business in Illinois, and assumed
and reserved names. The availability of a name can be checked by doing a search at the
following website:http://cdsprod.ilsos.net/corp.html. The availability of a name also can be
checked by calling (217) 524-8008. Names can be reserved for future use by an LLC for up to
90 days by filing an application to reserve a name on Form LLC-1.15 and paying a $300 filing
fee. 805 ILCS §180/50-10(b)(4). Finally, the LLC’s name must comply with all common law
and other statutory laws on unfair competition, trade names, service names and any other right
to the exclusive use of a name.
IMPLEMENTING AN LLC
16
The Illinois Limited Liability Company Act also specifically prohibits an LLC from improperly
using a name. 805 ILCS §180/1-20(h). An LLC cannot use a name other than its organized or
assumed name on a sign or advertisement, and an LLC cannot advertise or list in a telephone
directory an assumed or fictitious name that intentionally misrepresents where the LLC is
located or operated. If the LLC improperly uses a name, it can be fined not less than $501 and
not more than $1,000 for each violation, and each additional day of improper use constitutes
an additional offense.
LLC’s Purposes.
The LLC must state in its articles of organization the purpose for which it is formed. An LLC is
allowed to state that its purpose is “the transaction of any and all lawful businesses for which
LLCs may be organized”. 805 ILCS §180/5-5(a)(2). However, one disadvantage of this stated
purpose is that it does not provide notice to potential entrants into the marketplace that the
LLC’s name is already in use in the particular type of business of the LLC. Thus, it is advisable
to state that the purpose of the LLC is to operate the LLC’s particular type of business and “the
transaction of any and all lawful businesses for which LLCs may be organized.” By this
method, potential entrants are on notice of the LLC’s use of its name for this type of business
and the LLC may expand its operations without exceeding its permitted purpose.
Registered Agent.
The LLC’s registered agent must be an individual who resides in Illinois, an Illinois corporation,
or a foreign corporation having a place of business in Illinois and authorized to do business in
Illinois. If the agent is a corporation, the corporation must be authorized by its articles of
incorporation to act as an agent. 805 ILCS 180/1-35(a).
The LLC’s registered agent may change the address of the LLC’s registered office by filing
Form LLC-1.36/1.37 with the Secretary of State and paying a filing fee of $25
805 ILCS §180/1-35(b) and §180/50-10(b)(15). The registered agent may resign at any time
by first mailing a notice to the LLC at its principal office. At least ten days after sending the
notice of resignation to the LLC, the agent must file a notice of resignation on Form 1.35 with
the Secretary of State and pay a $100 filing fee. 805 ILCS §180/50-10(b)(17). The resignation
is effective on the date specified on the filed form, which cannot be more than thirty days from
the date of its filing. The LLC must place a new registered agent on record within 60 days after
a registered agent’s notice of resignation. 805 ILCS §180/1-35.
A CPA or an attorney establishing an LLC on behalf of a client may find it advantageous to act
as the registered agent for the client. By doing so, the professional can ensure that the LLC
stays in compliance with the ongoing requirements of the LLC Act. The professional may also
find that his duties provide him with the opportunity to stay in close contact with his client
relating to issues that arise over time and to provide additional professional services as needed.
IMPLEMENTING AN LLC
17
However, a professional may not want to assume the responsibilities as agent for the client if
the professional has no assurance that the professional will be able to locate the client and will
be on good terms with the client in the future. It will be extremely difficult for the professional
to satisfy his or her obligations as agent for the client if these conditions are not met.
Management Structure.
Prior to filing the articles of organization, the LLC must choose whether it will be managed by
its members or by managers, who do not need to also be members. If an LLC has managers,
they function similar to a Board of Directors of a corporation. The LLC Act provides that the
LLC’s managers, if any, are appointed, removed, or replaced by vote of a majority of the
members. A manager holds office until a successor has been elected and qualified, unless the
manager sooner resigns or is removed. 805 ILCS §180/15-1(b)(3).
Whether an LLC is member-managed or manager-managed has at least three consequences.
First, if the LLC is manager-managed, the identity of the LLC’s members is not on file with the
Secretary of State’s office on the LLC’s articles of organization for the public to see. Second, if
the LLC is manager-managed, then members of the LLC who are not also managers are not
subject to self-employment taxes on their allocations of profits from the LLC. Third, if the LLC
is manager-managed, then members of the LLC who are not also managers do not have
fiduciary duties to the LLC and they cannot dissociates themselves from the LLC by providing
notice to the LLC. 805 ILCS §180/15-3(g)((1) and §180/25-50(a). LLCs are typically
established as manager-managed LLCs.
Organizers.
The organizers of an LLC are akin to the promoters of a corporation who act prior to the LLC’s
formation to establish the LLC and its business. Each organizer must be over 18 years of age,
but need not be a member of the LLC. 805 ILCS §180/5-1(a).
Limitation of Authority and Internal Regulations.
Provisions governing the LLC’s internal affairs are typically set forth in the LLC’s operating
agreement and not in the LLC’s articles of organization. However, if the provisions are stated
in the articles of organization rather than in the operating agreement, then this provides
effective legal notice of the stated provisions. Thus, an LLC may have an interest in stating
certain provisions in the articles of organization rather than the operating agreement. The
potential disadvantage of stating provisions in the articles of organization rather than in the
operating agreement is that changes to the articles of organization require the LLC to pay a
filing fee to the Secretary of State whereas changes to the operating agreement do not require a
fee.
IMPLEMENTING AN LLC
18
To satisfy these competing concerns, a professional may state in the articles of organization
that an operating agreement exists that governs the internal affairs of the LLC, but not state the
specific provisions that are contained in the operating agreement. By this method, the LLC
gives the public notice that provisions exist, but the LLC does not need to pay a filing fee to the
Secretary of State to change these provisions.
By a particular rule stated in the LLC Act, an LLC is able to protect itself against unauthorized
transfers of its real property by adding a provision to its articles of organization. The LLC Act
provides that any member of a member-managed LLC or manager of a manager-managed LLC
may sign and deliver any instrument transferring or affecting the LLC’s interest in real property.
The instrument is conclusive in favor of a person who gives value without knowledge of the
person’s lack of authority. If the LLC does not want its members and/or managers to have the
authority to transfer its real property and wants to protect itself against unauthorized transfers,
the LLC can state in its articles of organization that its members and/or managers do not have
this authority. This restriction will be effective to prevent the transfer of the LLC’s real property
to a third party, even if the third party gives value for it. 805 ILCS §180/13-5(c).
Filing Fee and Location.
An LLC files its articles of organization with the Illinois Secretary of State unless it is a bank, in
which case it files with the Commissioner of Banks and Real Estate or the federal banking
regulator. 805 ILCS §180/5-5(b) and (d). Unlike corporations, LLCs are not required by state
statute to record their articles of organization in the county in which they transact business.
However, there may be other local requirements that apply to the LLC.
The filing fees due to the Illinois Secretary of State must be paid by certified check, cashier’s
check, Illinois CPA’s check, Illinois attorney’s check, or money order payable to the Secretary
of State. The articles of organization must be typewritten and submitted in duplicate.
Amendments to the Articles of Organization.
An LLC’s articles of organization may be amended by filing an Articles of Amendment Form
LLC-5.25 and paying a $150 filing fee. 805 ILCS §180/50-10(b)(2). Even though an LLC’s
registered agent and office are stated in the LLC’s articles of organization, an LLC can change
the LLC’s registered agent and/or the registered office by filing Form LLC-1.36/1.37 and paying
a $25 filing fee without amending its articles of organization. 805 ILCS §180/50-10(b)(15).
Pursuant to a statement contained on Form LLC-5.25, changes in the LLC’s members and/or
managers are not required to be reported to the Illinois Secretary of State even though the
names of the members or managers are stated on the LLC’s articles of organization.
Amendments to the articles of organization requires the unanimous consent of the members in
member-managed LLCs and manager-managed LLC, except that a majority of the managers
may (1) remove the name of a former manager; (2) remove the registered agent or registered
IMPLEMENTING AN LLC
19
office; (3) change the LLC’s name to alter the “LLC” designation or to add a geographical
attribution; and (4) restate the articles by filing Form LLC-5.30 to integrate into a single
instrument all provisions in effect from prior filings. 805 ILCS §180/15-1(c)(2) and §180/5-15.
B. MANAGEMENT DECISION-MAKING
The LLC Act provides that each member has equal rights in the management and conduct of
the LLC’s business in a member-managed LLC, and each manager has equal rights in the
management and conduct of the LLC’s business in a manager-managed LLC.
805 ILCS §180/15-1(a)(1) and §180/15-1(b)(1). These rights are not in proportion to the
amount of the members’ contributions or the number of his membership interests. Instead,
each member has equal rights.
The LLC Act provides that most decisions of the LLC are made by a majority vote of the
members in a member-managed LLC and by a majority vote of the managers in a
manager-managed LLC. 805 ILCS §180/15-1(a)(2) and §180/15-1(b)(2). However, the
following decisions require the consent of all members:
1) The amendment of the operating agreement.
2) The amendment of the articles of organization, except that a majority of the managers
of an LLC may make some minor changes (See section above on Amendments to the
Articles of Organization.
3) The compromise, as among members, of an obligation of a member to make a
contribution to the LLC or return money or other property paid or distributed in
violation of the LLC Act.
4) The making of interim distributions, including the redemption of an interest.
5) The admission of a new member.
6) The use of the LLC’s property to redeem an interest subject to a charging order.
7) The consent to dissolve the LLC.
8) A waiver of the right to have the LLC’s business wound up and the LLC terminated after
the LLC has dissolved but not wound up its business.
9) The merger of the LLC with another entity.
10) The sale, lease, exchange, or other disposal of all, or substantially all, of the company’s
property with or without goodwill.
IMPLEMENTING AN LLC
20
805 ILCS §180/15-1(c).
Actions requiring the consent of members or managers may be taken without a meeting.
805 ILCS §180/15-1(d). Members and managers also may appoint a proxy to vote or
otherwise act for the member or manager by signing an appointment instrument, either
personally or by the member or manager’s attorney-in-fact. 805 ILCS §180/15-1(e).
The default rules provided by the LLC Act give each manager or member equal voting rights
rather giving them voting rights in proportion to their contributions to the LLC. These default
rules may not produce a desirable result if some members have contributed substantially more
to the LLC than others. Thus, the LLC’s organizers likely will want to provide in the operating
agreement different rules for the management of the LLC than those provided by the LLC Act.
C. SINGLE MEMBER LLCs
LLCs can be formed with only one member. 805 ILCS §180/5-1(a). One-person LLCs are
often used to provide limited liability to individuals who would otherwise operate their business
as a sole proprietorship or would hold real estate in their individual capacity.
The member of a one-person LLC in particular should ensure that he does not act in such a
way that would cause him to lose the limited liability protections that the LLC offers. For
example, the member should not commingle his personal funds with those of the LLC or treat
the LLC’s assets as his own. (See Section below on Limited Liability of Members and
Exceptions.)
In practice, a single member of an LLC often does not execute an operating agreement to
govern his relationship with the LLC. However, even in single-member LLCs, it is advisable for
the member to do so to avoid inadvertently being bound by terms stated in other documents.
This may happen because the LLC Act provides a list of documents that are considered legally
equivalent to an operating agreement in a single member LLC even if the member did not
intend the documents to have the same effect as an operating agreement. These documents
include: (1) any writing as to the LLC’s affairs signed by the sole member; (2) any written
agreement between the member and the LLC as to the LLC’s affairs; and (3) any oral or written
agreement between the member and the LLC as to the LLC’s affairs if the LLC is managermanaged. 805 ILCS §180/15-5(c).
In addition, it is advisable for a single member of an LLC to execute an operating agreement to
allow the LLC to indemnify and to defend the LLC member to the full extent permitted by law if
the LLC member is sued for his conduct relating to the LLC. Absent such a provision, the LLC
would not necessarily be allowed to use its assets for the personal benefit of the member.
IMPLEMENTING AN LLC
21
D. FOREIGN LLCs
A “foreign” LLC is an LLC that is organized under the laws of a jurisdiction other than Illinois.
Foreign LLCs cannot transact business in Illinois unless the LLC files an application for
admission with the Secretary of State, and the LLC is subject to monetary penalties and other
consequences if it fails to do so. 805 ILCS §180/45-5(a) and §180/45-45(d). The Secretary of
State may revoke the LLC’s right to transact business in Illinois upon the occurrence of certain
events, and the LLC may reinstate its admission after its revocation by satisfying certain
requirements. 805 ILCS §180/45-35 and §180/45-65.
Similarly, an Illinois LLC that transacts business in states other than Illinois and in foreign
countries is a “foreign” LLC with respect to these states and countries. Just like a foreign LLC
that transacts business in Illinois must comply with Illinois rules governing foreign LLCs, an
Illinois LLC that transacts business in other states and countries must comply with the rules
governing foreign LLCs effective in those states and countries. If the LLC has not complied
with the legal requirements for doing business in a state, the state may prohibit the LLC from
instituting a lawsuit in the state, require the LLC to pay penalties, and impose other adverse
consequences.
Transaction of Business in Illinois.
Except for certain foreign LLCs transacting an insurance business, a foreign LLC cannot
transact business in Illinois unless it files an application for admission to do so with the Illinois
Secretary of State. 805 ILCS §180/45-5(a). This requirement raises the question of the
meaning of the statutory term “transact business.” If the LLC’s activities in Illinois do not
constitute the “transaction of business” in Illinois, then the LLC does not need to file an
application, but if the LLC’s activities do constitute the “transaction of business” in Illinois then
the LLC does need to file an application.
The LLC Act contains a specific statutory provision that helps an LLC determine whether or not
its Illinois activities constitute the transaction of business. The LLC Act states that the
following activities in Illinois do not constitute the transaction of business:
1) Maintaining, defending, or settling any proceeding;
2) Carrying on activities concerning internal company affairs;
3) Maintaining bank accounts;
4) Maintaining offices, agencies, trustees or depositaries for the LLC’s own securities;
IMPLEMENTING AN LLC
22
5) Selling through independent contractors;
6) Soliciting or obtaining orders if orders require acceptance outside Illinois;
7) Owning real or personal property;
8) Conducting an isolated transaction completed within 120 days; or
9) Having a member or manager who is an Illinois resident.
805 ILCS §180/45-47.
Application for Admission.
In order to obtain the right to transact business in Illinois, a foreign LLC must file an
application for admission to transact business with the Illinois Secretary of State. A regular,
foreign LLC files Form LLC-45.5 and pays a $500 filing fee. 805 ILCS §180/50-10(b)(1). A
series, foreign LLC files Form LLC-45.5(S) and pays a $750 filing fee. A series LLC also must
file a certificate of designation on Form LLC-37.40 and pay a $50 filing fee for each series of
the LLC.
The application for admission to transact business in Illinois contains the following:
1) The LLC’s name and the name under which it proposes to transact business;
2) The jurisdiction and date of the LLC’s formation and the period of its duration;
3) A certificate from the foreign state’s official that the LLC is in existence and a copy of
the LLC’s articles of organization authenticated by the foreign state’s official;
4) The name and address of its Illinois registered agent;
5) The address of the office required to be maintained in the state of organization or if no
requirement, then the LLC’s principal place of business;
6) The purpose for which the LLC was organized and proposes to conduct business in
Illinois and the date upon which the LLC first conducted business in Illinois;
7) A statement of whether the LLC is managed by member(s) or manager(s);
8) A statement that the LLC appoints the Secretary of State as its agent for service of
process if an Illinois agent is not maintained or cannot be found; and
9) For series LLCs, notice that the liabilities of the LLC are limited to being satisfied from
the assets of the series and that a certificate of designation shall be filed.
805 ILCS §180/45-5(a).
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23
The name under which the foreign LLC transacts business in Illinois must be available for use
to a LLC in Illinois. If the name the LLC uses to transact its business in Illinois is different from
the name used for its formation, then the LLC must file an assumed name application Form
LLC-1.20. 805 ILCS §180/45-15.
A foreign LLC must maintain a registered agent and registered office in Illinois. The registered
agent must be an individual who resides in Illinois, an Illinois corporation, or a foreign
corporation having a place of business in and authorized to do business in Illinois.
805 ILCS §180/45-30(1).
To maintain its admission to transact business in Illinois, a foreign LLC must file an annual
report on Form LLC-50.1(F) and pay a $250 filing fee. 805 ILCS §180/45-30(c) and
§180/50-10(b)(11). If the foreign LLC is a series LLC, the LLC must pay an additional fee of
$50 for each series to file its annual report.
Consequences of Failing To Be Admitted.
If a foreign LLC transacts business in Illinois without being admitted to do so, the LLC is liable
for the filing fees and penalties for late filings that otherwise would have been imposed. In
addition, if the LLC fails to be admitted within 60 days after it commences Illinois business, the
LLC is liable for a penalty of $2,000 plus $100 for each month of business. A foreign LLC that
has not been admitted to transact business in Illinois also appoints the Secretary of State as its
agent for process and it cannot maintain a civil action in an Illinois court. The Attorney General
also may bring an action to restrain the LLC from transacting business in Illinois. However, a
foreign LLC’s failure to be admitted to transact business does not impair the validity of any
contract or act or prevent the LLC from defending a civil action in Illinois.
805 ILCS §180/45-45.
Revocation of Admission.
The Illinois Secretary of State may revoke a foreign LLCs admission to transact business in
Illinois if:
1) The LLC fails to:
a. File its annual report or pay any fees or penalties;
b. Appoint and maintain registered agent within 60 days after agent’s notice of
resignation;
c. File a report upon change in the name or address of the registered agent;
d. File any amendment to its application for admission; or
IMPLEMENTING AN LLC
24
e. Renew its assumed name, or apply to change its assumed name, when the LLC
may only transact business within the State under its assumed name.
or
2) The LLC makes a misrepresentation in a document submitted under LLC Act; and
3) The LLC has failed to correct the violation after Secretary of State has given the LLC 60
days’ notice and 120 days have passed from the notice date.
805 ILCS §180/45-35.
Reinstatement and Withdrawal of Admission.
A foreign LLC may reinstate its admission to transact business in Illinois after it has been
revoked by filing an application for reinstatement Form LLC-45.65. The LLC also must file all
reports due and pay all fees and penalties. 805 ILCS §180/45-65. A Foreign LLC may
withdrawal is admission to transact business in Illinois by filing an application for withdrawal
Form LLC-45.40. 805 ILCS §180/45-40.
E. SPECIAL RULES FOR REGULATED PROFESSIONALS
An LLC cannot be formed for the practice of certain professions unless certain requirements
are satisfied as follows:
Accountancy:
A majority of the financial interests and voting rights in the LLC must be held
by persons licensed as a public accountant in some state.
225 ILCS §450/14(b)(2). All members of the LLC, whether licensed or not,
must actively participate in the firm. The LLC must require that all members
comply with the rules promulgated under the Illinois Public Accounting Act,
and the LLC must designate to the Department of Professional Regulations in
writing an individual licensed under the Illinois Public Accounting Act who is
responsible for the proper registration of the firm. 225 ILCS §450/14.3. The
LLC must obtain a license from the Department of Professional Regulation and
pay a $120 fee. 225 ILCS §450/13.
Architecture:
Two-thirds of the LLC’s members must be licensed under the laws of any state
to practice architecture, professional engineering, land surveying, or structural
engineering. The person having the architectural practice in Illinois in his
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charge must be a member of the LLC and must hold a license to practice
architecture under the Illinois Architecture Practice Act. The LLC must register
with the Illinois Department of Professional Regulation and pay a $75 fee.
225 ILCS §305/21(b).
Dentistry:
All members and managers must be licensed dentists under the Illinois Dental
Practice Act. 805 ILCS §180/1-25(3).
Engineering:
The LLC must designate a managing agent in charge of professional
engineering activities in Illinois who maintains a license to practice professional
engineering in Illinois and is a full-time employee of the LLC. The LLC must
register with the Illinois Department of Professional Regulation and pay a $75
fee. 225 ILCS §325/23(a) and (b).
Insurance:
If the LLC carries on a business as a member of a group including incorporated
and individual unincorporated underwriters, the Director of Insurance must find
that the group meets the requirements of subsection (3) of Section 86 of the
Illinois Insurance Code. If insolvent, the is subject to liquidation by the Director
of Insurance under Article XIII of the Illinois Insurance Code.
805 ILCS §180/1-25(2).
Law:
The LLC must satisfy specific requirements and obtain a certificate of
registration from the Supreme Court of Illinois. See a detailed discussion in
the section below.
Professional land surveyors: The LLC must designate a managing agent in charge of land
surveyor activities in Illinois who maintains a license to practice professional
land surveying in Illinois and is a full-time employee of the LLC. The LLC must
register with the Illinois Department of Professional Regulation and pay a $75
fee. 225 ILCS §330/25(a) and (b).
Real estate brokers: Every manager of the LLC must hold a license as a real estate broker and
every member and employee who acts as a salesperson or leasing agent for the
LLC must hold a license as a real estate broker, salesperson, or leasing agent.
No individual salesperson or leasing agent or group of them may directly or
indirectly control more than forty-nine percent of the ownership in the LLC.
The LLC must obtain a license from the Office of Banks and Real Estate and pay
a $125 fee. 225 ILCS §454/5-15(a), (d) and (e).
Medicine:
All members and managers must be licensed to practice medicine under the
Medical Practice Act of 1987 and all organizers must be licensed to practice
medicine or law. 805 ILCS §180/1-25(4) and §180/5-1(a).
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Structural engineering: The LLC must designate a managing agent in charge of structural
engineering activities in Illinois who maintains a license to practice structural
engineering in Illinois and is a full-time employee of the LLC. The LLC must
register with the Illinois Department of Professional Regulation and pay a $75
fee. 225 ILCS §340/19(a) and (b).
Additional restrictions exist for other professions. A professional who establishes an LLC for a
client to practice a regulated profession always should check the statutes and rules governing
the particular profession to ensure that the profession is allowed to be practiced by an LLC and
to ensure that all other applicable requirements have been satisfied. The Illinois Department of
Financial and Professional Regulation maintains a website at http://www.idfpr.com/ that
contains detailed information concerning the licensing requirements for all professions.
LLCs Formed for the Practice of Law.
An LLC formed for the practice of law must first obtain a certificate of registration from the
Supreme Court of Illinois. Il. Supreme. Ct Rule 721(c). An application for registration can be
obtained by calling (217) 782-2035 or from the website http://www.state.il.us/court/ under the
headings “Supreme Court of Illinois” and “Application for Certificate of Registration to Practice
Law as an entity under Supreme Court Rule 721”. The registration fee is $50 and the annual
renewal fee is $40. The LLC must post its certificate of registration at its premises. Il.
Supreme Ct Rule 721.
An LLC cannot obtain a certificate of registration to practice law unless all of the following
conditions are satisfied:
1) Each member and manager is licensed to practice law;
2) Each person who is engaged in the practice of law and who is an employee of the LLC
is licensed to practice law;
3) At least one member is an Illinois bar member and practices law in Illinois;
4) Each member and manager is a member of the bar of each jurisdiction in which the
person practices; and
5) No disciplinary actions are pending against any member or manager.
Il. Supreme. Ct Rule 721(a).
Failure to obtain a certificate is grounds for the Illinois Supreme Court to terminate or suspend
the right of the LLC to practice law or otherwise to discipline it. Il. Supreme Ct Rule 721(b). In
addition, the failure to obtain a certificate causes the LLC’s members to lose the limited liability
protections afforded by Illinois Supreme Court Rule 721, which limits a member’s liability for
the malpractice committed by other members. Ford Motor Credit Co. v. Sperry, 214 Ill.2d 371,
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388, 827 N.E.2d 422, 432, 292 Ill. Dec. 893, 903 (2005). A failure to obtain the certificate does
not prevent the LLC from collecting fees for its services. Storto v. Becker, 341 Ill. App. 3d 337,
345, 792 N.E.2d 384, 391, 275 Ill. Dec. 153, 160 (2nd Dist. 2003).
F. LIMITED LIABILITY OF MEMBERS AND EXCEPTIONS
A member or manager of an LLC is generally not personally liable for the LLC’s debts,
obligations, or liabilities. 805 ILCS §180/10-5(a). However, important exceptions to this
general rule exist under both the common and statutory law.
Under the common law, personal liability may arise if (1) there is a unity of interest and
ownership such that the separate personalities of the LLC and the individual no longer exist;
and (2) the continued adherence to the fiction of a separate corporate existence would sanction
a fraud or promote injustice. In re Kreisler, B.R. 331 B.R. 364, 379 (N.D. Ill. 2005). If an
individual commingles his funds or assets with those of the LLC or treats the LLC’s assets as
his own, this suggests that there is a unity of interest and ownership between the LLC and the
individual. In making the second determination, courts generally consider the following
factors: (1) inadequate capitalization; (2) the failure to issue membership interests; (3) the nonpayment of distributions; (4) the insolvency of the entity; (5) the non-functioning of the
managers or officers; (6) the absence of company records; (7) commingling of funds; (8)
diversion of assets from the LLC by or to a member; (9) failure to maintain arm’s length
relationships amount related entities; and (10) whether the LLC is a façade for the operation of
the dominant shareholder. Jacobson v. Buffalo Rock Shooters Supply, Inc.
278 Ill.App.3d 1084, 1088, 664 N.E.2d 328, 331, 215 Ill. Dec. 931, 934 (3rd Dist. 1996). The
LLC Act expressly alters prior common law by stating that the failure of an LLC to observe
company formalities or requirements for exercise of company powers or management does not
result in personal liability. 805 ILCS §180/10-10(c).
Pursuant to statute, members and/or managers of an LLC also are personally liable as follows:
1) By Agreement: A member is personally liable if the articles of organization so provide
and the member has consented to be bound to it (805 ILCS §180/10-10(d));
2) For Causing Unlawful Distributions: A member or manager is personally liable to the
LLC for the amount by which a distribution by the LLC to its members exceeds the
amount that could have been lawfully distributed if the member or manager votes for or
assents to the unlawful distribution and the member or manager breached his fiduciary
duties or duty of good faith and fair dealing to the LLC (805 ILCS §180/25-35(a));
3) For Receiving Unlawful Distributions: A member is personally liable to the LLC for the
amount by which the distribution received by the member exceeds the amount that
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could have been lawfully distributed to the member if he knew that the distribution was
unlawful. (805 ILCS §180/25-35(b));
4) For Professional Malpractice: A member of an LLC that provides regulated
professional services many be personally liable by virtue of the laws governing the
profession; and
5) For Breach of Fiduciary or Other Duties: A manager or member who breaches his
fiduciary duties or duty of good faith and fair dealing owed to the LLC and/or the
members is personally liable for his breaches (805 ILCS §180/15-3); and
6) For Inappropriate Acts During Dissolution: A member or manager who, with
knowledge of the LLC’s dissolution, subjects the LLC to liability by an act that is not
appropriate for winding up the LLC’s business is personally liable to the LLC for
resulting damages (805 ILCS §180/35-7(b)).
Members’ and Managers’ Liability for Unlawful Distributions.
A member of a member-managed LLC or a member or manager of a manager-managed LLC
who votes for or assents to a distribution is personally liable for the distribution if (1) the
distribution violates the LLC Act, the articles of organization, or the operating agreement; and
(2) the member or manager breached the fiduciary duties or duty of good faith and fair dealing
that he owes to the LLC pursuant to the LLC Act. 805 ILCS §180/25-35(a). The member’s
and manager’s liability is only for the amount of the distribution in excess of the amount that
could have been lawfully distributed. Id.
In addition, a member of a manager-managed LLC is liable for a distribution if (1) the
distribution violates the LLC Act, the articles of organization, or the operating agreement; and
(2) the member knew the distribution was made in violation of one of them.
805 ILCS §180/25-35(b). The member’s liability is limited to the amount of the distribution
received by the member in excess of the amount that could have been lawfully distributed
pursuant to the LLC’s Acts financial standards. Id.
A member or manager who is liable for an unlawful distribution may compel contribution from
all other members or managers who are also personally liable for the unlawful distributions
pursuant to the rules set forth above. 805 ILCS §180/25-35(c).
Liability for Professional Services.
Professional regulations governing certain regulated professions impose personal liability on
professionals who render professional services through an LLC despite the limited personal
liability that the LLC Act affords to an LLC’s members and managers. Specifically, the
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regulations often impose personal liability on a professional for claims arising from the
professional services that the professional and/or others render through the LLC. For example,
the professional regulations governing the practice of public accounting and law impose
personal liability to a certain extent on CPAs and lawyers who practice in an LLC. Professional
regulations do not cause the professionals to be personally liable for the debts and obligations
of the LLC that do not arise directly from the LLC’s rendering of professional services.
The Practice of Public Accounting.
Rule 505 of the AICPA Code of Professional Conduct and similar rules governing public
accountants require that Certified Public Accountants remain responsible, financially and
otherwise, for attest work performed to protect the public interest. Because the LLC Act
provides for limited liability of all members and managers of an LLC, an LLC that performs
public accounting attest work must add provisions to its articles of organization and/or
operating agreement that provide for the personal liability of the Certified Public Accountants to
comply with Rule 505.
The Practice of Law.
The professional rules governing the practice of law provide that practicing law in an LLC or
other entity that normally provides its owners with limited personal liability does not alter a
lawyer’s personal liability for claims arising from the performance of professional services by
the lawyer or by any person under his direct supervision and control. Supreme Ct Rule 722(c).
See also 805 ILCS §180/55-2. Similarly, practicing law in an LLC or other entity does not
change the lawyer’s personal responsibility for his violations of the standards of professional
conduct governing lawyers. Supreme Ct Rule 721(b).
However, practicing law in an LLC or other limited-liability entity does permit a lawyer to take
certain actions that limit his personal liability for claims arising from the performance of
professional services by other lawyers and employees of the entity that the lawyer does not
supervise or control. Supreme Ct Rules 721(d) and 722(b). In particular, a lawyer will not be
personally liable for the acts of other members and other persons arising out of the
performance of professional services by the entity if the entity maintains minimum insurance or
proof of financial responsibility. Supreme Ct Rules 721(d) and 722(b).
Minimum insurance requires the maintenance of an annual insurance policy with coverage of
$100,000 per claim and $250,000 in the aggregate for wrongful conduct in the policy period
and previous six years times the number of lawyers practicing in the entity, but in no event
greater than $5,000,000 per claim and $10,000,000 in the aggregate annually. Supreme Ct
Rule 722(b)(1).
Proof of financial responsibility requires that the entity to maintain funds that are specifically
designated and segregated for the satisfaction of any judgments against the entity, and any of
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its owners or employees, entered by an Illinois court, arising out of wrongful conduct.
Supreme Ct Rule 722(b)(3). The amount of the funds must be no less than the required annual
aggregate for minimum insurance and maintained in the form of (1) a deposit in a trust or in a
bank escrow of cash, bank certificates of deposit, or U.S. Treasury obligations; (2) bank letter
of credit; or (3) a surety bond. Id.
Even if the entity maintains minimum insurance, the entity’s owners are still jointly and
severally liable up to the amount of the deductible amount unless the entity also has provided
proof of financial responsibility in a sum no less than the amount of the deductible. Supreme
Ct Rule 722(2). If minimum insurance or proof of financial responsibility is not maintained, the
articles of organization of an LLC that engages in the practice of law must provide, and in any
event the members shall be deemed to agree, that the members are jointly and severally liable
for the acts of members and other employees arising out of the performance of professional
services by the LLC. Supreme Ct Rule 721(d).
Members’ and Managers’ Liability for Breach of Fiduciary and Other
Duties.
In a member-managed LLC, the LLC’s members owe fiduciary and other duties to the LLC and
to its other members. 805 ILCS §180/15-3(a)-(c). In a manager-managed LLC, the managers
owe fiduciary and other duties to the LLC. 805 ILCS §180/15-3(g). The members of a
manager-managed LLC do not owe any duties, except that members who exercise the authority
of a manager in the management and conduct of the LLC’s business pursuant to the operating
agreement of a manager-managed LLC do owe duties. 805 ILCS §180/15-3(g)(1) and (3). A
manager is relieved of his duties to the extent of the managerial authority delegated to the
members by the operating agreement. 805 ILCS §180/15-3(g)(4). Finally, a person winding
up the LLC’s business as the personal or legal representative of the last surviving member owe
the same duties as the member. 805 ILCS §180/15-3(f).
A member’s or manager’s duties include the fiduciary duties of loyalty and duty of care and the
duty of good faith and fair dealing. 805 ILCS §180/15-3(b)-(d). The duty of loyalty requires
the fiduciary to (1) account for and hold as trustee any property, profit or benefit derived by the
fiduciary in the conduct of the LLC’s business or derived from use of the LLC’s property,
including the appropriation of an opportunity of the LLC; (2) to act fairly when dealing with the
LLC in the conduct of the LLC’s business as or on behalf of an adverse party; and (3) to refrain
from competing with the LLC in the LLC’s business. 805 ILCS §180/15-3(b). In the conduct of
winding up the LLC’s business, the fiduciary’s duty of care is limited to refraining from
engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing
violation of law. 805 ILCS §180/15-3(c). The duty of good faith and fair dealing requires the
member or manager to discharges his duties and exercise his rights relating to the LLC
“consistent with the obligation of good faith and fair dealing.” 805 ILCS §180/15-3(d).
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The LLC Act expressly provides that a member or manager does not violate his duties merely
because his conduct furthers his own interest. 805 ILCS §180/15-3(e). In addition, the LLC
Act expressly allows members and managers to consider in discharging their duties the effect
of any action (including a change in control) upon employees, suppliers, customers, and
communities, and to consider all other pertinent factors. 805 ILCS §180/15-15.
Standing to Sue.
An LLC member may sue the LLC or another member to enforce the member’s operating
agreement rights, the member’s LLC Act rights, and the member’s rights arising independently
of the member’s relationship to the LLC. 805 ILCS §180/15-20(a). In addition, a member may
bring a derivative action on behalf of the LLC to enforce the LLC’s rights where the member
cannot allege an injury distinct from the injury to the LLC. To bring a derivative action, the
member must show that (1) the LLC’s members or managers with authority to sue have
refused to sue or that an effort to cause them to sue is not likely to succeed; and (2) the
member was a member at the time of the subject transaction or became a member through a
person who was a member at the time. 805 ILCS §180/40-1 and §180/40-5. If successful, the
court may award the member reasonable expenses, including attorney’s fees, and shall direct
the member to remit the proceeds to the LLC. 805 ILCS §180/40-15.
LLC’s Liability for a Member’s or Manager’s Acts.
An LLC’s liability for the acts of its members and managers is determined by principles of
agency as codified in the LLC Act. An LLC is liable for wrongful acts and omissions (such as
tortuous conduct) of a member or manager acting in the ordinary course of the LLC’s business
or with the LLC’s authority. 805 ILCS §180/13-10. An LLC is bound by a member’s or
manager’s acts (such as entering into a contract) when the member or manager has either
actual or apparent authority to act on behalf of the LLC pursuant to principles of agency.
805 ILCS §180/13-5.
The LLC Act provides different rules of agency for member-managed and manager-managed
LLCs. In a member-managed LLC, each member has actual authority to bind the LLC if the
member’s act is authorized by the other members. Each member has apparent authority to
bind the LLC if the member’s act is to carry on, in the ordinary course, the LLC’s business or
business of the kind carried on by the LLC. 805 ILCS §180/13-5(a)(1). The LLC is not bound
if the member had no actual authority to act and the person with whom the member was
dealing knew or had notice that the member lacked authority. Id.
In manager-managed LLCs, each manager has actual authority to bind the LLC if the manager’s
act is authorized. Each manager has apparent authority to bind the LLC if the manager’s act is
to carry on, in the ordinary course, the LLC’s business or business of the kind carried on by the
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LLC. 805 ILCS §180/13-5(b). Members in manager-managed LLCs do not have apparent
authority to bind the LLC. Id.
In both member-managed and manager-managed LLCs, different rules of agency apply to the
transfer of real property. Unless the articles of organization limit their authority, any member
of a member-managed LLC or manager of a manager-managed LLC may sign and deliver any
instrument transferring or affecting the LLC’s interest in real property. The instrument is
conclusive in favor of person who gives value without knowledge of the person’s lack of
authority. 805 ILCS §180/13-5(c).
Finally, the rules of agency in both types of LLCs differ after the LLC’s dissolution and after a
member’s dissociation. After dissolution, the LLC is bound by a member’s or manager’s act
that (1) is appropriate for winding up the LLC’s business; or (2) that would have bound the LLC
before dissolution, if the other party to the transaction did not have notice of the dissolution.
805 ILCS §180/35-7(a). For a period of two years after a member’s dissociation without the
LLC’s winding up, the LLC is bound by the dissociated member’s act that would have otherwise
bound the LLC if the other party to the transaction reasonably believed that the dissociated
member was then a member and did not have notice of the member’s dissociation.
805 ILCS §180/35-70.
G. PROPERTY TRANSFERS TO AND FROM MEMBERS
LLC members typically make contributions to the LLC. In exchange, LLC members hold a
“membership interest” in the LLC that entitles them to receive any interim and final
distributions made by the LLC and to be reimbursed by the LLC for certain expenses incurred.
A member may transfer his LLC membership interest to another voluntarily and his interest
may be subject to the rights of his creditors.
Contributions.
To become an LLC member, a person or entity typically makes a contribution to the LLC. The
contribution may be in the form of cash, property, or services rendered. 805 ILCS §180/20-1.
The contribution also may be in the form of a promissory note or other obligation to contribute
cash, property, or services. Id. A member’s obligation to make the agreed-upon contribution
is not excused by death, disability or other inability to perform. 805 ILCS §180/20-1(c). If the
member does not contribute the required property or services, the member is obligated at the
option of the LLC to contribute money equal to its value. Id. A creditor who relies on a
member’s obligation to contribute to the LLC can enforce the member’s contribution
obligation. 805 ILCS §180/20-5(d). The LLC must keep at its principal place of business a list
of each member’s contribution. 805 ILCS §180/1-40(a)(1).
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Reimbursements.
An LLC is obligated to reimburse a member for payments made and liabilities incurred by the
member in the LLC’s ordinary course of business or for the preservation of the LLC’s business
or property. 805 ILCS §180/15-7(a). In addition, an LLC is obligated to repay a member for
advances the member makes to the LLC. 805 ILCS §180/15-7(b). An LLC also must pay the
member interest from the date that the member made the payments or advances.
805 ILCS §180/15-7(c). An LLC is not required to pay a member remuneration for services
performed by the member for the LLC other than for winding up the LLC, unless otherwise
provided by the operating agreement, a contract, or the common law. 805 ILCS §180/15-7(d).
Interim Distributions.
If an LLC makes interim distributions to its members, the distributions must be in equal shares
to the LLC’s members unless the operating agreement otherwise provides.
805 ILCS §180/25-1(a). This default rule can lead to extremely inequitable results if the
members’ contributions are disproportionate. Therefore, a professional drafting an operating
agreement should ensure that the LLC’s method for making interim distributions is expressly
delineated in the operating agreement unless the LLC desires for each member to receive equal
interim distributions.
An LLC cannot make interim distributions to its members if (1) the LLC would not be able to
pay its debts as they become due; or (2) the LLC’s total assets would be less than its total
liabilities and the amount of members’ preferential rights if the LLC were dissolved.
805 ILCS §180/25-30(a). The LLC Act provides detailed rules as to how to perform the
calculation for whether an LLC is permitted to make an interim distribution.
805 ILCS §180/25-20(b)-(e).
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LLC’s Final Distribution of Assets.
When the LLC winds up its operations, its assets are applied and distributed in the following
order:
1) First, the LLC’s assets are applied to discharge obligations to creditors, including
members who are creditors.
2) Second, the LLC’s assets are applied to return all members’ contributions that have not
previously been returned.
3) Third, the LLC’s assets are distributed to its members in equal shares.
805 ILCS §180/35-10.
As with interim distributions, the default rule providing for the members to receive final
distributions in equal shares after the contributions of all members have been returned can lead
to extremely inequitable results. Therefore, a professional drafting an operating agreement
should ensure that the LLC’s method for making final distributions is expressly delineated in
the operating agreement unless the LLC desires for each member to receive equal final
distributions.
Voluntary Transfer of a Member’s Distributional Interest.
The right of a member to receive his appropriate share of the interim and final distributions of
an LLC, if any, is called the member’s “distributional interest”. A member has no absolute
right to receive any distributions, has no interest in the LLC’s property, and has no right to
receive a distribution in kind. 805 ILCS §180/25-1(b) and §180/30-1. A member entitled to
receive a distribution has rights of a general, unsecured creditor. 805 ILCS §180/25-20. A
member’s distributional interest is personal property that may be transferred in whole or in
part. 805 ILCS §180/30-1(b). The operating agreement may provide that the distributional
interest may be evidenced by a certificate and may provide for the transfer of any interest
represented by the certificate. 805 ILCS §180/30-1(c).
A transferee of a member’s distributional interest has no absolute right to become a member
and is not entitled to participate in the LLC’s management or access its records.
805 ILCS §180/30-5 and §180/30-10(d). A transferee may become a member only if the
transferor gives the transferee this right in accordance with the operating agreement or all
other members consent. 805 ILCS §180/30-10. A transferee is entitled to received, in
accordance with the transfer, interim and final distributions that the LLC makes.
805 ILCS §180/30-10(e)(1) and (2). A transferee also may seek a judicial determination that it
is equitable to dissolve the LLC. 805 ILCS §180/30-10(e)(3). A transferor of his distributional
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interest is not released from liability to the LLC under the operating agreement or the LLC Act
even if the transferee becomes an LLC member. 805 ILCS §180/30-10(c).
If the transferee becomes a member of the LLC, the transferee is liable for the transferor’s
contribution obligation and to return any unlawful distributions made by the transferor.
805 ILCS §180/30-10(b). However, the transferee is not obligated for the transferor member’s
liabilities unknown to the transferee at the time the transferee becomes a member. Id.
When forming an LLC, the LLC’s members should consider whether they want to provide in the
operating agreement exit strategies that permit, and/or require, members to withdraw from the
LLC and transfer their membership interests. The LLC Act provides for certain procedures for
a member to disassociate from the LLC and to require the LLC to purchase his membership
interest. (See Section below on Dealing with a Member’s Dissociation.) If the members want
to eliminate this right or set forth additional procedures for the withdrawal, they should do so
in the operating agreement.
LLC members are given a great degree of liberty in crafting these procedures. The provisions
that professionals generally use for corporations can also be used for LLCs. For example, the
operating agreement may restrict the transfer of a membership interest to third parties, contain
a buy-sell agreement, require a member’s interest to be redeemed by the LLC or purchased by
another member, provide a right to sell shares if other shares are sold (co-sale rights), provide
a right of first refusal for membership interests offered for sale, and/or provide the right to
cause a minority member to sell its interest when the majority votes to do so (drag along
rights). Where relevant, the operating agreement also should provide a set price or a method
to determine the price for the transfer of the member’s membership interest.
In addition, the members may wish to ensure in the operating agreement that their
membership interests are not diluted by the LLC’s subsequent sale of additional membership
interests. Often this is accomplished by giving members the right to purchase the additional
interests offered in proportion to their existing interest in the LLC prior to any sale by the LLC
of the interests to others.
Transfer of a Member’s Distributional Interest to Creditors.
A court may charge the distributional interest of a member or a member’s transferee to satisfy
judgments against the member or his transferee. 805 ILCS §180/30-20(a). The court’s
charging order is a lien on the distributional interest and the court may order the interest to be
foreclosed. 805 ILCS §180/30-20(b). The distributional interest may be redeemed by the
judgment debtor, by another member, or by the LLC if the operating agreement permits.
805 ILCS §180/30-20(c).
Importantly, creditors of an LLC member are limited to the remedy of a charging order to
enforce their interest in a member’s distributional interest. This means that the creditor does
not have any control over or voting rights in the LLC. Rather, the creditor only has an
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economic interest in the LLC. Because a creditor attaches an income interest, an argument can
be made that the creditor must pay tax on income allocated to the interest even if no
distributions have been paid to the creditor. Thus, the member’s interest may create a tax
liability for the creditor, and therefore, be undesirable to the creditor.
H. SECURITIES LAW COMPLIANCE
The securities laws apply only to interests that are considered securities. A security exists if a
person contributes money, property, or services to a company in exchange for an interest in
the company by which the person expects to make a return. Securities include both debt and
equity securities.
A membership interest in an LLC generally constitutes a security subject to the federal and
state securities laws. The securities laws impose two types of obligations on an LLC in
connection with the sale of LLC membership interests. First, the “antifraud” provisions of the
securities laws require the LLC to make full and fair disclosure of information relating to the
membership interests to purchasers. Second, the registration provisions require the LLC to
register the membership interests with federal and/or state governmental bodies unless an
exemption from registration applies.
Duty of Fair and Full Disclosure
The duty of full and fair disclosure is independent of the duty to register the LLC membership
interests. Thus, even if an exemption from registration exists, an LLC must ensure that no
false or misleading information is provided to purchasers of the membership interests and no
information is omitted from disclosure that makes the information that is disclosed false or
misleading.
For private offerings, LLCs typically provide investors with a business plan and an “Offering
Memorandum” or “Private Placement Memorandum” prepared by an attorney and an
accountant containing detailed information about the LLC and the LLC’s membership interests.
Among other things, the Memorandum discloses the terms of the offering and the risks
associated with it to investors. The LLC may also attach documents relating to the LLC as
exhibits to the Memorandum.
LLCs that do not want to incur the expense of preparing a formal Memorandum often choose
to provide potential purchasers instead with all of the documents that the LLC has in its
possession that relate to the LLC and the membership interests. For example, the LLC
provides the investors with the terms sheet for the offering, operating agreement, articles of
organization, financial records, and contracts of the LLC. If the LLC relies exclusively on this
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later method, the LLC substantially increases its risk of being subjected to a claim for securities
fraud, and therefore, this method is not recommended in most circumstances.
When an LLC sells its membership interests in a public offering involving public solicitation
and general advertising, the LLC generally must prepare and provide to investors a prospectus.
A prospectus is a very detailed, complex document and its contents are proscribed by law.
Federal Securities Registration.
LLCs that offer their membership interests for sale must file a registration statement with the
securities with the Securities and Exchange Commission to register the offering unless an
exemption from registration applies. There are at least six common registration exemptions,
which are discussed below. A practitioner should remember that the existence of a federal
registration exemption does not exempt the LLC from its duty of providing to purchasers full
and fair disclosure of information relating to the membership interests. Similarly, a federal
registration exemption does not necessarily exempt the LLC from having to register the
securities pursuant to state securities laws or to file a notice of the sale with federal and state
regulatory bodies.
Intrastate Offering Exemption.
Section 3(a)(11) of the Securities Act of 1933, 15 U.S.C. 77c(a)(11), exempts from federal
registration securities offerings by an issuer that are considered to take place entirely within
one state. This exemption was intended to apply only to securities issuances that are genuinely
local in character, which represent local financing by local businesses carried out through local
investment. To qualify for this exemption, a limited liability company issuing membership
interests must meet each one of these three requirements:
1) The LLC must be organized in the state where it is offering the membership interests;
2) The LLC must be doing business in that state; and
3) The LLC must make offers and sales of the membership interests only to residents of
that state.
The interstate exemption does not depend on the dollar value of the offering or the number or
characteristics of the purchasers. If a purchaser resells any of the membership interests to a
person who resides outside the state within a short period of time after the LLC’s offering is
complete (usually a period of nine months), the exemption may be lost with respect to the
entire transaction.
In order to provide issuers with confidence as to whether the three requirements for the
intrastate exemption have been satisfied, the Securities and Exchange Commission
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promulgated Rule 147, 17 CFR 230.147, providing a “safe harbor” rule. Satisfaction of the
tests stated in Rule 147 and compliance with the additional obligations set forth in the Rule will
ensure the issuer that the intrastate offering exemption applies. However, it is possible that
securities offerings that do not meet the tests set forth in Rule 147 may still qualify for the
intrastate offering exemption.
Rule 147 provides that an issuer will be considered to be doing business within a state for the
purpose of determining whether the second requirement for the intrastate offering exemption is
satisfied if:
1) The issuer derived at least 80 percent of its gross revenues and those of its
subsidiaries on a consolidated basis from the operation of a business or of real
property located in, or from the rendering of services within, the state;
2) For its most recent fiscal year, if the first offer of any part of the issue is made during
the first six months of the issuer’s current fiscal year; or
3) For the first six months of its current fiscal year or during the twelve month fiscal
period ending with such six month period, if the first offer of any part of the issue is
made during the last six months of the issuer’s current fiscal year;
4) Provided, however, that this provision does not apply to any issuer which has not had
gross revenues in excess of $5,000 from the sale of products or services or other
conduct of its business for its most recent twelve month fiscal period;
5) The issuer had at the end of its most recent semi-annual fiscal period prior to the first
offer of any part of the issue, at least 80 percent of its assets and those of its
subsidiaries on a consolidated basis located within the state;
6) The issuer intends to use and uses at least 80 percent of the net proceeds to the issuer
from sales made pursuant to Rule 147 in connection with operating a business or of
real property, purchasing real property located in, or rendering services within the
state; and
7) The principal office of the issuer is located within the state.
Similarly, Rule 147 provides that the residency of offerees and purchasers of the security are
determined as follows for the purpose of determining whether the third requirement for the
intrastate offering exemption is satisfied:
1) A corporation, partnership, trust or other form of business organization is a resident of
a state if, at the time of the offer and sale to it, it has its principal office within the state.
2) An individual is a resident of a state if the individual has, at the time of the offer and
sale to him, his principal residence in the state.
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3) A corporation, partnership, trust or other form of business organization which is
organized for the specific purpose of acquiring part of an issue offered pursuant to
Rule 147 is not a resident of the state unless all of the beneficial owners of the
organization are residents of the state.
Rule 147 also places the following additional restrictions on the securities and obligations on
the issuer when securities are offered pursuant to the Rule 147 safe harbor:
1) Limitation on out-of-state resales. During the period in which securities that are part of
an issue are being offered and sold by the issuer, and for a period of nine months from
the date of the last sale by the issuer of the securities, all resales of any part of the
issue, by any person, must be made only to persons resident within the state.
2) Certificate Legend. The issuer must place a legend on the certificate or other document
evidencing the security stating that the securities have not been registered under the
Act and setting forth the limitation on resale stated above.
3) Stop Transfer Orders. The issuer must direct stop transfer instructions to the issuer’s
transfer agent, if any, with respect to the securities, or, if the issuer transfers its own
securities, make a notation in the appropriate records of the issuer.
4) Purchaser Representation. The issuer must obtain a written representation from each
purchaser as to his residence.
5) Disclosure of Limitations. The issuer must disclose in writing, in connection with
any offers for sale or sales, the limitations on resale, the provisions required to be
stated in the certificate legend, and the instructions to be sent to the transfer agent
or noted in the issuer’s records.
Private Offering Exemption Without Regard to the Offering’s Dollar Amount.
Section 4(2) of the Securities Act of 1933, 15 U.S.C. 77d(2), exempts from federal registration
securities offerings by an issuer that do not involve a “public offering”. To qualify for this
exemption, the following requirements must be met:
1) The purchasers of the securities must:
a. Be “sophisticated investors”, which means that they have enough knowledge
and experience in finance and business matters to evaluate the risks and merits
of the investment, or the issuer reasonably believes that the purchasers come
within this description;
b. Have access to the type of information normally provided in a prospectus; and
c. Agree not to resell or distribute the securities to the public.
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2) The issuer cannot use any form of public solicitation or general advertising in
connection with the offering.
The precise limits of this exemption are uncertain. In general, the requirements are more likely
to be satisfied if the number of purchasers is small and their relationship to the company and
its management is close.
To provide greater certainty, the Securities and Exchange Commission promulgated Rule 506,
17 CFR 230.506, as part of Regulation D to provide another “safe harbor” rule. Rule 506
specifies objective standards that an issuer can rely on to determine if the requirements of the
private offering exemption have been satisfied. Rule 506 states that if the following standards
are satisfied, then the private offering exemption applies:
1) The securities are sold only to “accredited investors” and up to thirty-five other
purchasers who, either alone or with a purchaser representative, are “sophisticated
investors”;
2) Non-accredited investors are advised that the securities have not been registered under
the Act and, therefore, cannot be resold unless they are registered under the Act or
unless an exemption from registration is available;
3) The issuer exercises reasonable care to assure that the purchasers are not
underwriters, which may be demonstrated by:
a. Reasonable inquiry to determine if the purchaser is acquiring the securities for
himself or for other persons;
b. Written disclosure to each purchaser prior to sale that the securities have not
been registered under the Act and, therefore, cannot be resold unless they are
registered under the Act or unless an exemption from registration is available;
and
c. Placement of a legend on the certificate or other document that evidences the
securities stating that the securities have not been registered under the Act and
setting forth or referring to the restrictions on transferability and sale of the
securities;
4) The issuer does not use any form of public solicitation or general advertising in
connection with the offering;
5) The non-accredited investors receive disclosure documents that are generally the same
as those used in registered offerings and include disclosures of certain non-financial
statement information and financial statement information, which include at a
minimum an audited balance sheet and other audited statements depending on the size
of the offering;
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6) Any information that is provided to accredited investors is made available to the nonaccredited investors as well;
7) The issuer is available to answer questions by prospective purchasers; and
8) The issuer files with the Securities and Exchange Commission five copies of a notice on
Form D, 17 CFR 239.5, no later than 15 days after the first sale of the securities.
An “accredited investor” under the Securities Acts includes the following:
1) A natural person with income exceeding $200,000 in each of the two most recent years
or joint income with a spouse exceeding $300,000 for those years and a reasonable
expectation of the same income level in the current year;
2) A natural person with a net worth of at least $1 million;
3) A manager or executive officer of the company selling the securities;
4) A business in which all the equity owners are accredited investors;
5) A bank, insurance company, registered investment company, business development
company, or small business investment company;
6) An employee benefit plan, if a bank, insurance company, or registered investment
adviser makes the investment decisions, or if the plan has total assets in excess of $5
million;
7) A charitable organization, business trust, corporation or partnership with total assets in
excess of $5,000,000; and
8) A trust with assets of at least $5 million, not formed to acquire the securities offered,
and whose purchases are directed by a sophisticated person.
Private Offerings Not Exceeding $1,000,000.
Rule 504 of Regulation D, 17 CFR § 230.503, exempts from federal registration certain private
offerings that do not exceed $1,000,000. To qualify for this exemption, the following
requirements must be met:
1) The offering does not exceed the amount of $1,000,000 in a 12-month period;
2) The issuer does not use any form of public solicitation or general advertising in
connection with the offering;
3) The securities are restricted and the purchasers cannot sell the securities without
registration or an applicable exemption;
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4) The issuer exercises reasonable care to assure that the purchasers are not
underwriters, which may be demonstrated by:
a. Reasonable inquiry to determine if the purchaser is acquiring the securities for
himself or for other persons;
b. Written disclosure to each purchaser prior to sale that the securities have not
been registered under the Act and, therefore, cannot be resold unless they are
registered under the Act or unless an exemption from registration is available;
and
c. Placement of a legend on the certificate or other document that evidences the
securities stating that the securities have not been registered under the Act and
setting forth or referring to the restrictions on transferability and sale of the
securities;
5) The issuer files with the Securities and Exchange Commission five copies of a notice on
Form D, 17 CFR 239.5, no later than 15 days after the first sale of the securities; and
6) The issuer is not a “blank check” company with an unspecified business or an
investment company required to be registered under the Investment Company Act of
1940.
This exemption may also be used for an offering involving public solicitation and advertising
and the securities will not be restricted from resale under the following circumstances:
1) The issuer registers the offering exclusively in one or more states that require a
publicly filed registration statement and delivery of a substantive disclosure document
to investors;
2) The issuer registers and sells in a state that requires registration and disclosure
delivery and also sells in a state without those requirements, so long as the issuer
delivers the disclosure documents; or
3) The issuer sells exclusively according to state law exemptions that permit general
solicitation and advertising, so long as the issuer sells only to “accredited investors.”
Private Offerings Not Exceeding $5,000,000.
Rule 505 of Regulation D, 17 CFR 230.505, exempts from federal registration certain private
offerings that do not exceed $5,000,000. To qualify for this exemption, the following
requirements must be met:
1) The offering does not exceed $5,000,000 in a 12-month period;
2) The issuer is not an investment company;
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3) The securities are sold to an unlimited number of “accredited investors” and up to 35
other persons who do not need to satisfy any sophistication or wealth standards;
4) Non-accredited investors are advised that the securities have not been registered under
the Act and, therefore, cannot be resold unless they are registered under the Act or
unless an exemption from registration is available;
5) The issuer exercises reasonable care to assure that the purchasers are not
underwriters, which may be demonstrated by:
a. Reasonable inquiry to determine if the purchaser is acquiring the securities for
himself or for other persons;
b. Written disclosure to each purchaser prior to sale that the securities have not
been registered under the Act and, therefore, cannot be resold unless they are
registered under the Act or unless an exemption from registration is available;
and
c. Placement of a legend on the certificate or other document that evidences the
securities stating that the securities have not been registered under the Act and
setting forth or referring to the restrictions on transferability and sale of the
securities;
6) The issuer does not use any form of public solicitation or general advertising in
connection with the offering;
7) The non-accredited investors receive disclosure documents that are generally the same
as those used in registered offerings and include disclosures of certain non-financial
statement information and financial statement information, which include at a
minimum an audited balance sheet and other audited statements depending on the size
of the offering;
8) Any information that is provided to accredited investors is made available to the nonaccredited investors as well;
9) The issuer is available to answer questions by prospective purchasers; and
10) The issuer files with the Securities and Exchange Commission five copies of a notice on
Form D, 17 CFR 239.5, no later than 15 days after the first sale of the securities.
Offerings to Accredited Investors.
Section 4(6) of the Securities Act of 1933, 15 U.S.C. 77d(6), exempts from registration
securities offerings to accredited investors if the following criteria are satisfied:
1) None of the securities are sold to non-accredited investors;
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2) The total offering price is less than $5 million;
3) The issuer does not use any form of public solicitation or general advertising in
connection with the offering; and
4) The issuer files with the Securities and Exchange Commission five copies of a notice on
Form D, 17 CFR 239.5, no later than 15 days after the first sale of the securities.
Small Offerings.
Section 3(b) of the Securities Act of 1933, 15 U.S.C. 77c(b), authorizes the Securities and
Exchange Commission to issue Regulations that exempt from federal registration securities
offerings by an issuer that involve a small amount of capital. Pursuant to this authority, the
Securities and Exchange Commission promulgated Regulation A exempting from registration
certain small public offerings that satisfied the following criteria:
1) The offering cannot exceed $5 million in any 12-month period;
2) The issuer files an offering statement on Securities and Exchange Commission
Form 1-A with the Commission for review, consisting of a notification, offering circular,
and exhibits;
3) The issuer provides purchasers with an offering circular that is similar in content to a
prospectus; and
4) The issuer is not a “blank check” company with an unspecified business or an
investment company required to be registered under the Investment Company Act of
1940.
Unlike certain other exemptions, securities offered pursuant to Regulation A are not restricted
from resale and may be freely traded in the secondary market after the offering. Offerings
executed pursuant to Regulation A are similar to offerings executed with full registration.
However, Regulation A offerings do have the following advantages over full registration:
1) The financial statements are simpler and do not need to be audited;
2) There are no Exchange Act reporting obligations after the offering unless the company
has more than $10 million in total assets and more than 500 members;
3) The issuer may choose among three formats to prepare the offering circular, one of
which is a simplified question-and-answer document; and
4) The issuer may determine if there is adequate interest in the securities by general
solicitation and advertising (but not solicitation or acceptance of money) before going
through the expense of filing an offering statement with the Securities and Exchange
Commission.
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State Securities Registration
LLCs must not only comply with the federal securities laws, but also the securities law of all
states from which, and to which, the LLC intends to offer its membership interests to investors.
State securities laws are called “blue sky laws” and vary substantially between states.
The Illinois Securities Law of 1953, 815 ILCS 5/1 et. seq., requires an LLC that issues
membership interests to register the membership interests pursuant to Section 5 of the Act
and to file an annual notification pursuant to Section 3 of the Act. Section 4 of the Act sets
forth exemptions to these requirements, and the six most common of these exemptions are
discussed below.
Private Offering Exemption.
Section 4G of the Act exempts from registration any offer, sale or issuance of a security,
whether to Illinois residents or non-residents, where:
1) All sales of the security to Illinois residents within the preceding 12-month period have
been made to not more than 35 investors or have involved an aggregate sales price of
not more than $1,000,000, (excluding the investors and the dollar value of securities
sold to investors in transactions for which another exemption applies);
2) The security is not offered or sold by means of general advertising or general
solicitation in Illinois;
3) No commission, discount, or other remuneration exceeding 20% of the sales price of
the security, if sold to a resident of this State, is paid or given directly or indirectly for
or on account of the sales; and
4) The issuer files an Illinois Form 4G Report of Sale or a U.S. Securities and Exchange
Commission Form D with the Illinois Securities Department and pays a $100 filing fee.
The Form 4G Report of Sale or Form D must be filed on or after the date of the first sale made
to an Illinois resident, but no later than 12 months after the date of the first sale. The filing
covers a 12 month period. If sales occur for more than 12 months, another filing must be
made and filing fee paid. If the securities have been offered pursuant to a federal registration
exemption that requires the issuer to file U.S. Securities and Exchange Commission Form D
with the Commission, then the issuer can file Form D with the Illinois Securities Department in
place of Form 4G.
Accredited Investor Exemption.
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Section 4H of the Act exempts from registration any offer, sale or issuance of a security if the
securities are not sold by means of any general advertising or general solicitation in Illinois and
the securities are sold to the following:
1) A natural person who has, or is reasonably believed by the issuer to have, a net worth
or joint worth with that person’s spouse of $1,000,000 excluding the value of a
principal residence;
2) A natural person who had, or is reasonably believed by the issuer to have, an income or
joint income with that person’s spouse, in excess of $200,000 in each of the two most
recent years and who reasonably expects, or is reasonably expected to have, an income
in excess of $200,000 in the current year; or
3) Any entity in which at least 90% of the equity interest is owned by persons who satisfy
a requirement stated in (1) or (2).
Preorganization Subscription Exemption.
Section 4M of the Act exempts from registration any offer, sale or issuance of a security if the
following conditions are satisfied:
1) The securities are sold pursuant to a preorganization subscription prior to the
organization of the issuer;
2) The number of subscribers does not exceed 25; and
3) No commission or other remuneration is paid or given directly or indirectly for or on
account of the sales of the securities or if any commission or other remuneration is
paid, the securities are not offered or sold by any means of general advertising or
general solicitation in Illinois.
Controlling Person Exemption.
Section 4O of the Act exempts from registration any offer, sale or issuance of securities if the
following conditions are satisfied:
1) The sale is for the direct or indirect benefit of the issuer or of a controlling person;
2) The securities sold, together with securities already owned by the purchaser, constitute
50% or more of the equity interest of the issuer;
3) The number of purchasers is not more than 5; and
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4) No commission, discount or other remuneration exceeding 15% of the aggregate sale
price of the securities is paid or given directly or indirectly for or on account of the
sales.
Large Investment Exemption.
Section 4R of the Act exempts from registration any offer, sale or issuance of securities if the
following conditions are satisfied:
1) The securities are sold to a person who purchases at least $150,000 of the securities
being offered;
2) The purchaser’s total purchase price does not, or it is reasonably believed by the issuer
that the purchase price does not, exceed 20 percent of the purchaser’s net worth, or if
a natural person a joint net worth with that person’s spouse, for one or any
combination of the following:
a. Cash;
b. Securities for which market quotations are readily available;
c. An unconditional obligation to pay cash or securities for which quotations are
readily available, which obligation is to be discharged within five years of the
sale of the securities to the purchaser; or
d. The cancellation of any indebtedness owed by the issuer to the purchaser;
and
3) The Security is not offered or sold by means of any general advertising or general
solicitation in Illinois.
Insider Exemption.
Section 4S of the Act exempts from registration any offer, sale or issuance of securities if the
securities are sold to a person who is a manager or executive officer of the issuer.
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III. ADVANCED
LLC TAX ISSUES
A. CHECK-THE-BOX CLASSIFICATION SYSTEM
An LLC is an “eligible entity” under the “check the box” classification rules under Treasury
Regulation §301.7701-3(a). As a result, an LLC can elect how it will be taxed. The LLC is
required to make its tax elections at certain times.
Tax Elections.
Under the Code, the default rule is that a single-member LLC is disregarded as an entity
separate from its owner and treated like a sole proprietorship. A multi-member LLC is treated
like a partnership. Pursuant to Section 761(a) of the Code, certain partnerships are permitted
to elect to be excluded from the partnership tax provisions in the Code contained in
Subchapter K and to have their partners treated as the direct owners of the partnership’s assets
for tax purposes. This election is not available to LLC because the LLC is a separate and
distinct entity from its owners. Therefore, the LLC must be considered to be the owner of its
property and not the LLC’s members. 26 U.S.C. §761.
By filing IRS Form 8832, a single-member or a multi-member LLC can opt out of the
flow-through tax default rules and be taxed as a separate entity like a corporation instead. The
LLC can further make the Subchapter S election to be taxed like an S corporation by filing IRS
Form 2553 if the specified requirements from making this election are satisfied. These
requirements are that: (1) the LLC has no more than 100 members, (2) the LLC’s members are
not partnerships, corporations, certain types of trusts, certain tax-exempt organizations, or
individuals whose residence is not within the United States and who are not citizens, and (3)
the LLC has only one class of membership interests. 26 U.S.C. §1361(b)(1). If the LLC files
Form 2553 to make the S election, the LLC will be deemed to have made the election to be
1723 North Halsted Street
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Chicago, Illinois 60614
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taxed as a corporation, and the LLC does not need to file Form 8832 to make that election.
Treasury Regulation §301.7701-3(c)(1)(v)(C).
Election Deadlines.
The election to be taxed as a corporation is effective on the date specified by the LLC in its
Form 8832, which cannot be more than 75 days prior to, or more than 12 months after, the
date the form is filed. Once the LLC makes an election to be taxed as a corporation, the LLC
generally cannot change its tax classification again during the sixty months after the effective
date of the election. This sixty-month rule does not apply if the previous election was made by
a newly formed LLC and was effective on the date of the LLC’s formation. Treasury
Regulations §301.7701-3(c)(1)(iv).
To make the Subchapter S election, an LLC files Form 2553 prior to the 15th day of the third
month in the year for which the LLC desires to be taxed as an S corporation.
26 U.S.C. §1362(b)(1). Once made, the election remains in effect until it is terminated by: (1)
the revocation of the election by the LLC, (2) the failure of the LLC to satisfy the requirements
for making the election, or (3) the LLC’s having accumulated earnings and profits and passive
investment income that exceeds twenty-five percent of the LLC’s gross receipts for a period of
three years. 26 U.S.C. §1362(d). Once the LLC’s Subchapter S election has terminated, the
LLC cannot make the election again before its fifth taxable year after the first taxable year for
which the termination was effective.
There are tax consequences when an LLC changes its tax elections, and therefore, the LLC
should ensure that it is aware of these consequences before it makes a change. See Treasury
Regulation §301.7701-3(g). For example, if an LLC changes from being taxed like a
C corporation to being taxed like an S corporation or a partnership, then distributions that are
made of earnings that were accumulated when the LLC was taxed like a C corporation are
subject to tax as if they were dividends.
B. TAX FORMS AND NUMBERS.
An LLC and its members file different federal and state tax returns depending on the tax
election that the LLC has made. An LLC also may need to obtain a federal and state tax
number.
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50
Federal Tax Forms.
A single-member LLC that is disregarded as an entity separate from the member, files no
separate tax return. The member reports the LLC’s income, deductions, gains, losses and
other tax items on the member’s individual income tax return, Form 1040. The LLC’s income
and expenses are reported on Schedule C or Schedule E for rental real estate activities.
An LLC treated as a partnership files Form 1065, U.S. Partnership Return of Income, to report
its activities. The LLC issues K-1s on Schedule K-1, Form 1065 to its members to report the
members’ allocations of the LLC’s income, deductions, gains, losses and other tax items.
Members report their allocations from the LLC on their individual tax returns, Form 1040.
LLCs owned exclusively by a husband and wife teams in Illinois are treated as a partnership
rather than a sole proprietorship, and therefore, they must file IRS Form 1065.
An LLC that has elected to be taxed as a C corporation files its income tax return on
Form 1120, U.S. Corporation Income Tax Return. The LLC issues 1099’s to its members to
report any distributions made to them. Members report distributions they receive from the
LLC on their individual tax returns, typically Form 1040. If the LLC has current or accumulated
earnings, the distributions are reported as dividends on Form 1040, Schedule B. If the LLC has
no current or accumulated earnings and profits, then the distributions first reduce the
members’ basis in their membership interests. Any distributions in excess of the basis are
treated as capital gains and are reported on Form 1040, Schedule D.
An LLC that further elects to be taxed as an S corporation files its income tax return on
Form 1120-S, U.S. Income Tax Return for an S Corporation. The LLC issues K-1s on Schedule
K-1, Form 1120-S to its members to report the members’ allocation of the LLC’s income,
deduction, gains, losses, and other tax items. Members report their allocations from the LLC
on their individual tax returns, Form 1040. Income and expenses are reported on Schedule E.
State Income Tax Returns.
A single-member LLC that is disregarded as an entity separate from the member, files no
separate Illinois state income tax return. An LLC that is treated as a partnership also files no
separate Illinois state income tax return, but it files an Illinois partnership replacement tax
return on Form IL-1065. An LLC that elects to be taxed as a C corporation files its Illinois state
income and replacement tax return on Form IL-1120. An LLC that elects to be treated as an S
corporation files no separate Illinois state income tax return, but it files an Illinois small
business corporation replacement tax return on Form IL-1120-ST.
The members of an LLC file their Illinois state income tax returns on Form IL-1040 irrespective
of the federal tax election that the LLC has made. The members pay Illinois state income taxes
ADVANCED LLC TAX ISSUES
51
based on the member’s federal adjusted gross income, which includes the LLC’s income,
deductions, gains, losses, and other tax items.
Federal Employee Tax Identification Number.
An LLC must obtain a Federal Employee Identification Number (“FEIN”) if the LLC is taxed as a
corporation or a partnership, the LLC’s bank requires the number, the LLC has employees, or
the LLC is subject to excise or alcohol, tobacco and firearm taxes.
An LLC member or his authorized agent can obtain an FEIN for the LLC by filing IRS Form SS-4
with the IRS. If the form is mailed to the IRS, it taxes about four to six weeks to receive the
FEIN. If the form is faxed to the IRS at (859) 669-5760, it taxes about four business days to
receive the FEIN. An LLC member or his authorized agent may also call 1 (800) 829-4933 and
obtain the FEIN by providing orally the information contained on the SS-4 form. For an
authorized agent to obtain the FEIN by phone, the agent also must fax the completed SS-4 form
containing the written authorization for the agent to obtain the FIEN or have a member orally
authorize the agent to obtain the FEIN during the call. Finally, an LLC member or his authorized
agent can obtain an FEIN for the LLC on the internet by going to the website
www.irs.gov/businesses and clicking on “Employer ID Numbers” under “Topics”.
Illinois Business Tax Number.
An LLC must obtain an Illinois Business Tax Number (“IBT no.”) if it has Illinois employees or
is subject to Illinois sales and/or use tax. An LLC can obtain an IBT number by filing REG-1,
Illinois Business Registration Application, with the Illinois Department of Revenue. An LLC
also can obtain an IBT number on the Illinois Department of Revenue’s website at
https://pki.revenue.state.il.us/app/ibr. If the LLC does not apply for an IBT number, the LLC
eventually will receive one automatically from the Illinois Department of Revenue as a result of
filing its articles of organization with the Secretary of State.
C. FEDERAL INCOME TAX DIFFERENCES
The treatment of the LLC for federal income tax purposes will depend on whether the LLC
chooses to be disregarded as an entity or treated as a partnership, elects to be taxed as a C
corporation, or further elects to be taxed as an S corporation. If the LLC elects to be treated as
a partnership, the tax rules that are set forth in Subchapter K of the Code will apply to all
federal income tax matters. If the LLC elects to be taxed as a corporation, the LLC will be taxed
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pursuant to the rules applicable to corporations set forth in Subchapter C of the Code. If an
LLC elects to be taxed as an S corporation, the LLC will be taxed pursuant to the rules
specifically applicable to S corporations set forth in Subchapter S of the Code. Basically, this
means that the LLC’s income and loss will flow through to, and be taxed only to, the LLC’s
members like in a partnership. The rules applicable to C corporations set forth in Subchapter C
of the Code will apply to all matters other than those specifically set forth in Subchapter S.
There are significant differences in how an LLC will be taxed depending on whether the LLC
elects to be subject to the rules in Subchapter K, Subchapter C, or Subchapter S. Some of
these differences are outlined below.
Federal Taxation of Income.
Pursuant to Subchapter K and Subchapter S, an LLC’s income and loss flow through to the
LLC’s members. Only the LLC’s members pay federal income taxes on the LLC’s income and
loss. The LLC itself will not pay federal income taxes.
Pursuant to Subchapter C, an LLC will pay federal tax at a rate up to 34% on its income and
loss, and the LLC’s members will also pay tax personal income tax on any distributions they
receive from the LLC.
Loss Offsets.
Pursuant to Subchapter K and Subchapter S, an LLC’s losses are allocated to the LLC’s
members. Therefore, the members may be able to offset the losses against their other
personal income. However, a member’s ability to deduct or offset a loss is subject to various
limitations such as the passive activity loss rules under Code Section 469 and the “at risk”
limitations under Code Section 465, and the amount of their tax basis in their membership
interests.
Pursuant to Subchapter C, an LLC’s losses are available to offset only the income of the LLC
itself in the form of net operating loss carryovers and carrybacks. 26 U.S.C. §172.
Alternative Minimum Tax.
Pursuant to Subchapters K and Subchapter S, an LLC is not subject to the alternative minimum
tax (“AMT”). However, the LLC’s members will take their share of AMT items allocated from
the LLC into account when computing their personal AMT liability.
Pursuant to Subchapter C, an LLC is subject to the AMT.
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Contributions of Appreciated Property.
Pursuant to Subchapters K, an LLC’s members generally can transfer appreciated property to
the LLC in exchange for a membership interest without having to recognize a gain on the
property provided that the LLC is not an investment company. 26 U.S.C. §721. (See section
below on Members’ Contributions to the LLC.)
Pursuant to Subchapters C and S, an LLC’s member can transfer appreciated property to the
LLC without recognizing a gain only if certain requirements are met. 26 U.S.C. §351.
Generally, the member must own at least 80% of the LLC’s membership interests after the
transfer for gain not to be recognized. Id.
Distributions of Appreciated Property.
Pursuant to Subchapters K, an LLC generally can transfer appreciated property to the LLC’s
members without gain recognition by the LLC or its members.
Pursuant to Subchapter C, an LLC’s transfer of appreciated property to one of its members will
require gain recognition by the corporation and by the member.
Pursuant to Subchapter S, an LLC’s transfer of appreciated property to one of the LLC’s
members will require gain recognition by the LLC but not by the LLC’s member.
Debt.
The members of an LLC generally do not bear the economic risk of loss with respect to the
LLC’s debt. Nevertheless, for an LLC that chooses to be treated as a partnership, an LLC’s
members may include a portion of the the LLC’s debt in computing the tax basis of their
membership interest in the LLC. An increase of a member’s share of the LLC’s debt is treated
as a contribution of money to the LLC by the member. 26 U.S.C. §752(a). A decrease in the
member’s share of the LLC’s debt is treated as a distribution of money to the member.
26 U.S.C. §752(b).
For certain types of debt, a LLC member’s share of the debt is the loss that the LLC member
would bear after all LLC capital is exhausted to satisfy the debt. This allocation method is used
for debt if:
1) The member (or related person) guaranteed repayment of the LLC’s debt.
2) The member (or related person) made a loan directly to the LLC.
3) The member remained liable for recourse debts of a predecessor entity.
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4) The member guaranteed payment of at least 25% of the total interest which will accrue
on a nonrecourse debt.
5) The member provided property as collateral security for the debt.
For all other debt of the LLC, a member’s share of the LLC’s debt will be allocated among the
LLC’s members in the manner that nonrecourse liabilities are allocated to partners in a
partnership. A member’s share of the LLC’s debt equals the sum of the following allocation
tiers for the debt:
1) The member’s share of the LLC’s minimum gain, which is the excess of nonrecourse
debt over the book value of the property securing the debt pursuant to Code
Section 704(b).
2) The member’s share of the Code Section 704(b) minimum gain, which is the gain if the
LLC disposed of all LLC property subject to one or more nonrecourse liabilities of the
LLC in full satisfaction of the liabilities and for no other consideration;
3) The member’s share of the remaining debt of the LLC as determined in accordance
with the member’s share of the LLC’s profits.
26 C.F.R. §1.752-3(a).
The ability of an LLC’s member to include his share of LLC debt in the basis of his membership
interest enables the member to claim more tax deductions, absorb more losses, and withdraw
more money from the LLC on a tax-free basis.
Pursuant to Subchapters C and S, an LLC’s members do not include any portion of the LLC’s
debt in their basis of their membership interests. Pursuant to Subchapter S, an LLC’s
members can use their basis in loans they make to the LLC for loss deduction purposes.
26 U.S.C. §1366(d)(1)(B).
Allocations.
Pursuant to Subchapter K, an LLC may flexibly allocate income, gain, loss, deduction or credit
among the LLC’s members provided that the allocations have substantial economic effect.
26 U.S.C. §704(b).
Pursuant to Subchapter S, an LLC must allocate income, gain, loss, deduction and credit to the
LLC’s members based on their proportionate share of the LLC’s membership interests.
Pursuant to Subchapter C, no allocations are made to the LLC’s members.
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Fringe Benefits.
For an LLC subject to Subchapter K, amounts paid by the LLC to the LLC’s employees for
fringe benefits (such as for health insurance and group term life insurance) are deductible by
the LLC subject to certain restrictions. The amounts paid by the LLC for the fringe benefits
typically are excluded from the gross income of the LLC’s employees. However, employees
who are members of the LLC must include the fringe benefits in their gross income.
For an LLC subject to Subchapter C, employee fringe benefits are deductible by the LLC subject
to certain restrictions. The amounts are excluded from the gross income of the employees
even if the employees are members of the LLC.
For an LLC subject to Subchapter S, employee fringe benefits are deductible by the LLC subject
to certain restrictions. The amounts are excluded from the gross income of employees who
are not members of the LLC or who own less than 2% of the membership interests of the LLC.
26 U.S.C. §1372(a). The amounts are included in the gross income of all employees who own
2% or more of the membership interests of the LLC. . 26 U.S.C. §1372(a)(2).
Accounting Method.
For an LLC subject to Subchapters K and S, the accounting methods of the LLC’s members will
not affect the LLC’s choice of accounting methods. An LLC is allowed to use the cash method
of accounting subject to a few exceptions. An LLC may not be permitted to use the cash
method if the LLC has a C corporation as a member. 26 U.S.C. §448. However, an LLC with a
C corporation member will be permitted to use the cash method if the LLC has average annual
gross receipts of $5 million or less for the prior three years, is in the farming business, or the C
corporation is a personal service corporation. Id. An LLC also may not be permitted to use the
cash method of accounting if the LLC constitutes a tax shelter pursuant to Code
Section 461(i)(3). Id. Finally, the LLC may not be permitted to use the cash method if the LLC
must maintain inventories under Code Section 471. Id.
An LLC subject to Subchapter C may not use the cash method of accounting if it has five
million dollars of receipts or more. 26 U.S.C. §448(b)(3).
Tax Year.
Pursuant to Subchapter K, an LLC’s tax year must conform to the tax year or years of its
members. The LLC must adopt the tax year of a member who owns more than 50% of the
LLC’s profits and capital interests. 26 U.S.C. §706(b)(1)(B). If there is no such member, then
the LLC must adopt the tax year of all members who own at least 5% of the LLC’s profits and
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capital interests. Id. If none exist, then the LLC must adopt either the calendar year or any
other year resulting in the minimum deferral. 26 C.F.R. §1.706-1(b).
An LLC subject to Subchapter C has a great deal of discretion in selecting its taxable year. The
LLC can use its annual accounting period as its taxable year if it is a calendar year or a fiscal
year. 26 U.S.C. §441(b).
Pursuant to Subchapter S, an LLC may choose as its tax year a year ending December 31 or
any other accounting period for which the LLC can establish a legitimate business purpose
other than the deferral of income to the LLC’s members. 26 U.S.C. §1378.
Accumulated Earnings and Personal Holding Company Taxes.
An LLC subject to Subchapter K is not subject to the 15% accumulated earnings tax of Code
Section 531. 26 U.S.C. §532. The LLC also is not subject to the 15% personal holding
company tax of Code Section 541. 26 U.S.C. §542(a).
An LLC subject to Subchapters C or S is subject to the accumulated earnings tax and the
personal holding company tax. 26 U.S.C. §532 and §542(a).
D. CONTRIBUTIONS OF PROPERTY
A member’s contribution of property to an LLC in exchange for a membership interest in the
LLC gives rise to many tax issues. A determinate must be made as to the taxation of the
contribution, the tax basis of the membership interest, the applicability of exceptions to the
general rules, the allocation of any built-in gain, the holding period of the membership interest,
and the taxation of contributed services. These issues are discussed below with respect to
LLCs that are taxed as a partnership pursuant to Subchapter K.
Tax-free Contributions and Carryover Basis.
If an LLC chooses to be treated as a partnership for tax purposes, the LLC and its members
generally do not recognize a gain or loss when property is contributed by the members in
exchange for the LLC’s membership interests. 26 U.S.C. §721(a). This rule applies to property
contributed to members not only when the LLC is initially formed, but also during the LLC’s
life. Id. This rule also applies irrespective of the number of membership interests the
contributing LLC member holds. Id.
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A member’s tax basis in the contributed property is preserved by the LLC. 26 U.S.C. §723.
The member’s tax basis in his LLC membership interest is equal to his basis in the property
contributed. However, any gain that is recognized on the contribution by virtue of the
contribution being made to an LLC that is an “investment company” is added to the LLC’s basis
in the property and the member’s basis in his membership interest. 26 U.S.C. §723. (See
section below on Contributions to Investment Companies.)
Exceptions to Not Recognizing Gain on Contributions.
There are at least four exceptions to the rule that a gain will not be recognized on a member’s
contribution of property to an LLC.
Disguised Sale.
If a member contributes property to an LLC and then the LLC issues a distribution to the
member, the transaction may be deemed to be a disguised sale of the property to the LLC.
26 U.S.C. §707(a)(2)(B). As a result, the contributing member must recognize the gain or loss
on the property upon contribution of the property to the LLC. Id.
If the member’s contribution to the LLC and the distribution by the LLC are simultaneous, then
the transaction is deemed to be a disguised sale if the LLC would not have made the
distribution but for the contribution of the property by the member. Id. If the contribution and
distribution are not simultaneous, then the transfers are rebuttably presumed to be sales under
a multi-factor test. 26 C.F.R. §1.707-3(c). Distributions within two years of a contribution are
presumed to be part of a sale, but a distribution subject to entrepreneurial risk generally will
not be treated as part of a disguised sale. Id.
Disguised Exchange.
If a member contributes property to an LLC and the LLC distributes other property to the
member within seven years of the contribution, the transaction will be deemed to be a
disguised exchange of the property and the contributing member will be required to recognize
the built-in gain on the contributed property. 26 U.S.C. §704(c)(1)(B) and §737. (See section
below on recognition of Built-In Gains.)
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Contribution of a Right to Use Property.
If a member contributes a right to use property to the LLC rather than ownership of the
property in exchange for a membership interest, then the transaction is treated as a lease or a
license. The member reports the consideration that the member receives from the LLC as rent,
and the LLC deducts the amount of the rent only when the recipient reports it as income.
However, if there will be little or no value to the property after the end of the LLC’s period of
use, then a member’s contribution of the right to use the property may be treated as a
contribution of the ownership of the property.
Contributions to Investment Companies.
If a member makes a contribution to an LLC that is deemed to be a contribution to an
“investment company” then the contribution is taxable. 26 U.S.C. §721(b). A contribution to
an LLC constitutes a contribution to an “investment company” if (1) more than 80% of the
value of the LLC’s assets immediately after the receipt of the contribution consists of money,
stocks and corporate securities, options, foreign currencies, derivatives, interests in precious
metals, regulated investment companies, REIT’s, publicly traded partnerships, common trust
funds and any other entity convertible into any of these assets, and (2) the contribution causes
the member’s investment portfolio to be diversified. 26 C.F.R. §1.351-1(c)(1). A member’s
portfolio is not diversified as a result of transfers of identical assets to the LLC by other
members or by a member’s contribution of a portfolio that is already diversified. Id.
If the member’s contribution is a contribution to an investment company, then the member
must recognize gain on appreciated property contributed to the LLC, but the member will not
be allowed to recognize any loss that exists on the contributed property. 26 U.S.C. §721(b).
The basis of the contributed property in the hands of the LLC and the basis of the member’s
LLC membership interest will be increased by any gain recognized upon the contribution.
26 U.S.C. §723.
Recognition of Built-in Gains.
The “built-in gain” on contributed property is the gain represented by the difference between
the fair market value and the basis of the property when the property was contributed to the
LLC. A member who contributes appreciated property to an LLC is responsible for the built-in
gain on the property when the gain is realized by the LLC. 26 U.S.C. §704(c). When the LLC
disposes of the property and recognizes the gain on it, the built-in gain will be allocated only to
the member who contributed the property to the LLC. Id. However, the LLC may disregard
this rule if the disparity between the basis and value of the property is less than 15% of the
basis and $20,000 in the aggregate. 26 C.F.R. §1.704-3(e).
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The LLC also is required to allocate tax depreciation on the property to the noncontributing LLC
members up to the book depreciation and allocate any excess to the contributing member.
26 C.F.R. §1.704-3(b)(1).
Ceiling rules limit the amount of built-in gain and depreciation allocable to the contributing
member to the gain and depreciation actually recognized by the LLC. 26 C.F.R. §1.704-3(b)(1).
For tax purposes, curative allocations of other income or loss are permitted to offset any
book-tax disparity remaining after application of the ceiling. 26 C.F.R. §1.704-3(c). Remedial
allocations also are allowed to eliminate distortions created by the ceiling. 26 C.F.R. §1.7043(d).
The allocation of the built-in gain to the contributing member cannot be avoided by distributing
contributed property to another member. If the contributed property is distributed to another
member within seven years of its contribution, then the contributing member still recognizes
the built-in gain (limited to the actual gain recognized by the LLC). 26 C.F.R. §1.704(c)(1)(B).
In addition, the contributing member must recognize any unrealized built-in gain if the LLC
distributes any other property to the contributing member within seven years of the initial
contribution. 26 U.S.C. §737.
Holding Period.
In general, the LLC’s holding period for property contributed to an LLC includes that period that
the property was held by the contributing member. 26 U.S.C. §1223(2). Similarly, the
contributing member’s holding period for his LLC interest includes the period that he held the
property that he contributed. Id. These rules are called “tacking” rules and may be significant
due to the advantageous tax treatment of capital gains recognized upon the sale of capital
assets held for more than one year.
The tacking rule does not apply to the holding period for the member’s membership interest if
the property contributed was inventory, not a capital asset, or Section 1231 property (ordinary
income generating assets). 26 U.S.C. §1223(1). The tacking rule still does apply to the LLC’s
holding period of the contributed property even if the tacking rule does not apply to the holding
period for the member’s membership interest. 26 U.S.C. §1223(2). If an LLC member
contributes assets to the LLC that have different holding periods, then the member’s LLC
interest will have a split holding period based on the relative values of the assets contributed.
26 C.F.R. §1.1223-3.
Character of Property.
The character of the income, gain, deduction or loss realized upon the disposition of
contributed property is determined based on the purpose for which the property is held at the
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time of its disposition by the LLC. The contributing member’s use of the contributed property
before contributing it to the LLC is not considered. However, ordinary income property is
prevented from being converted to capital gain property and capital loss property is prevented
from being converted to ordinary loss property through contributions to the LLC.
26 U.S.C. §724. This restriction applies to unrealized receivables, inventory items for five years
after their contribution, and property with a built-in capital loss at the time of its contribution.
Id.
E. CONTRIBUTIONS OF SERVICES
If a member contributes services to the LLC in exchange for a membership interest, the
member is taxed on the contribution if the member receives a “capital interest” from the LLC
and is not taxed on the contribution if the member receives a “profits interest” from the LLC.
The theory behind this treatment is that an LLC member who receives a capital interest in the
LLC has received property from the LLC for his services. An LLC member who receives a
profits interest in the LLC may or may not receive anything for his services depending on
whether the LLC is profitable in the future.
Capital Interest.
There are many factors considered in determining whether the member has received a capital
interest or not. However, the focus is on the member’s rights to receive a distribution when
the member’s interest or the LLC itself is liquidated. The IRS has defined a capital interest in a
partnership as “an interest that would give the holder a share of the proceeds if the
partnership’s assets were sold at fair market value and then the proceeds were distributed in
complete liquidation of the interest. This determination is generally made at the time of grant
of the partnership interest.” Rev. Proc. 93-27, 26 C.F.R. §601.201. This same analysis
applies to LLCs. If the interest is contingent on the satisfaction of certain conditions, it is not
considered a capital interest and no compensation will result until the condition is satisfied.
See, e.g., U.S. v. Frazell, 88 T.C. 1405 (1987).
If the member receives a capital interest, then the LLC deducts or capitalizes as appropriate the
amount of the capital interest provided to the member. The member recognizes income for the
value of the capital interest the member receives from the LLC. The value of the capital interest
will depend on whether the services have been rendered already or will be rendered in the
future as well as whether the services are to be deducted or capitalized by the LLC. The
member’s capital account will reflect the value of his capital interest.
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Profits Interest.
If the member receives a profits interest in the LLC in exchange for contributing services to the
LLC, the member generally will not be immediately taxed on the contribution. The IRS has
defined a profits interest as one that is not a capital interest. Rev. Proc. 93-27,
26 C.F.R. §601.201. The member receiving a profits interest has an initial capital account
balance of zero. The member realizes taxable income as the LLC allocates income to the
member, which allocation may even include subsequent appreciation of the LLC’s assets. The
income allocated to the member retains the same character as is realized by the LLC, such as
long-term capital gain or tax-exempt income if realized as such by the LLC.
There are at least three specific exceptions to the rule that a member receiving a profits interest
in exchange for the contribution of services to an LLC is not taxed. A contribution in exchange
for a profits interest is taxed if (1) the member sells his profits interest within two years of its
receipt; (2) the profits interest provides the member with a predictable stream of income from
the LLC; or (3) the profits interest is in an LLC that is publicly traded. Rev. Proc. 93-27,
26 C.F.R. §601.201. All of these profits interests are relatively easy to value and not
particularly speculative, and therefore, they subject the member to tax on the contribution.
The LLC Act provides that each member has an equal interest in the allocations and
distributions of the LLC irrespective of the amount of his capital account. Thus, unless this
default rule is altered by the LLC’s operating agreement, a member who contributes services
likely will be deemed to receive a capital interest and will be subject to tax on its receipt. Thus,
a professional forming an LLC should take care in drafting the operating agreement to ensure
that the member receives the type of interest and is taxed as intended.
Unvested Profits Interest.
If a member contributes services to an LLC in exchange for an unvested profits interest, the
service provider will be taxed as if he is a member who received his profits interest on the date
of its initial grant rather than on the subsequent vesting date if certain conditions are satisfied.
The first condition is that the LLC treats the service provider as a member from the date of
grant. The second condition is that the service provider takes into account his distributive
share of the LLC’s income, gain, loss and deduction for the entire period the interest is held.
The third condition is that no compensation deduction is claimed by the LLC for the interest at
the times of its granting or its vesting. The fourth condition is that all other conditions set forth
in Rev. Proc. 93-27 are otherwise satisfied. See Rev. Proc. 2001-43. It is not necessary for a
Section 83(b) election to be filed in connection with the receipt of a nonvested profits interest.
Id.
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F. FORMATION TAX ISSUES
In addition to the tax issues relating to contributions from an LLC’s members, other tax issues
arise when an LLC is formed. Some of these issues include when depreciation begins and
when organizational expenses and start-up expenditures are deducted.
Depreciation.
An LLC’s first year for depreciation will begin when its business or investment activity begins
and not sooner.
Organizational Expenses.
An LLC may deduct up to $5,000 of the expenses it incurs for the organization of the LLC in the
year that the LLC begins irrespective of whether the LLC chooses to be taxed as a partnership
or a corporation. 26 U.S.C. §709 and 26 U.S.C. §248. Any remaining organizational expenses
are amortized over 180 months, beginning with the month in which the LLC’s business begins.
Id. The $5,000 amount is reduced to the extent that organizational expenses exceed $50,000,
regardless of when they are incurred. Id. Syndication expenses are not considered
organizational expenses and are not eligible to be deducted or amortized. Id.
Start-up Expenses.
An LLC also may deduct up to $5,000 of the expenses it incurs for the start-up and
investigation of the LLC’s business in the year that the LLC begins irrespective of whether the
LLC chooses to be taxed as a partnership or a corporation. 26 U.S.C. §195. Any remaining
start-up expenses are amortized over 180 months, beginning with the month in which the
LLC’s business begins. Id. The $5,000 amount is reduced to the extent that start-up expenses
exceed $50,000, regardless of when they are incurred. Id.
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G. DISTRIBUTIONS AND ALLOCATIONS
An LLC’s members will be taxed on the distributions they receive from the LLC if the LLC elects
to be taxed as a C corporation, and the LLC’s members will be taxed on the allocations of tax
items they receive from the LLC if the LLC chooses to be taxed as a partnership or a
S corporation. An LLC has the flexibility to allocate its tax items to its members
disproportionately. However, the allocations will only be respected for tax purposes if certain
conditions are satisfied.
Taxation of Distributions or Allocations.
If an LLC is taxed as a C corporation, then the LLC pays federal and state income taxes on its
income and loss. The LLC’s members only pay income taxes if they receive distributions from
the LLC. To the extent of the LLC’s accumulated earnings and profits, the distributions are
taxed to the LLC’s members as dividends. Distributions in excess of the LLC’s accumulated
earnings first reduce the LLC members’ basis in their membership interest and then are taxed
as a gain from the sale of their membership interest.
If the LLC is treated as a partnership or S corporation, then the LLC itself pays no federal or
state income tax. The LLC’s members pay income taxes on the LLC’s income, gain, loss,
deductions, and credits that are allocated to them by the LLC. The items allocated to the
members by the LLC will retain the tax characteristics that they had in the hand of the LLC.
26 U.S.C. §702(b). The LLC’s members also pay income taxes on distributions they receive
from the LLC that exceed the LLC member’s adjusted basis in their membership interest.
26 U.S.C. §731(a) and §1368(b).
An LLC is not required to make any cash distributions to its members. As a result, the LLC’s
members may be required to pay taxes as a result of the LLC’s operations, but the LLC
members may not have received payments from the LLC to enable them to pay the tax. Thus,
LLC operating agreements often require the LLC to make distributions to members that at least
cover the member’s tax liability generated from the LLC’s allocation of income to the member.
Flexibility in Allocations.
An LLC can provide in its operating agreement that allocations of tax items to its members will
be made disproportionately. To determine whether a particular allocation method minimizes
the members’ taxes, the LLC should first estimate the amount of its income and loss for each
year for an extended period of time. The LLC’s members should then provide information on
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their personal tax situation. Helpful information includes the members’ anticipated marginal
tax rates and the anticipated amount and character of other income and/or loss that the
members anticipate having in each year in the future. By analyzing this information and
considering applicable tax rules such as the passive activity loss limitations and at-risk rules,
the LLC should be able to determine which members can reap tax benefits from the LLC’s
disproportionate allocations.
Respect of Allocations.
An LLC’s allocations of tax items to its members will be respected for tax purposes only if the
allocations either have “substantial economic effect” or they are in accordance with the
members’ interests in the LLC. 26 U.S.C. §704.
An LLC’s allocations have the required substantial economic effect if the following three
conditions are satisfied:
1) The LLC maintains capital accounts that require the members’ accounts to reflect the
value of contributed and distributed properties as well as income and losses flowing
through to the LLC’s members in accordance with the Section 704(b) Treasury
Regulations;
2) The LLC makes all liquidating distributions in accordance with the positive capital
account balances of members; and
3) The LLC requires each member with a deficit capital account balance to restore the
deficit amount upon liquidation of the LLC, which is known as a deficit restoration
obligations or “DRO”, or the LLC has a qualified income offset provision in its
operating agreement, in which case the allocations will be respected to the extent that
they do not create excess negative capital account balances of the LLC’s members.
26 C.F.R. §1.704-1(b)(2)(ii)(b)(3) and §1.704-1(b)(2)(ii)(d).
H. SELF-EMPLOYMENT TAX
Although there is some uncertainty with respect to the liability of LLC members for
self-employment taxes, authorities generally agree that if an LLC member participates in the
management of the LLC, the member must pay self-employment taxes on both the guaranteed
payments that the member receives from the LLC and the member’s distributive share of the
LLC’s income and loss.
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Rates.
Self-employment tax is comprised of two separate taxes. The first part is a tax for old age,
survivor, and disability insurance (OASDI) in the amount of 12.4% and the second part is a tax
for hospital insurance (HI) in the amount of 2.9%. The amount of the self-employment tax
mirrors the employment taxes on wages paid to an employee. There is a cap on the earnings
subject to the OASDI tax, which is $94,200 in 2006. There is no cap on earnings subject to the
HI tax. To report self-employment income, an individual files Schedule SE of Form 1040.
Self-employment Earnings.
Self-employment tax is paid on “net earnings from self-employment” as defined in the Code.
26 U.S.C. §1402(a). Net earnings from self-employment include (1) the gross income derived
by an individual from a trade or business carried on by an individual; and (2) the individual’s
distributive share of income or loss from any trade or business carried on by a partnership of
which he is a member. 26 U.S.C. §1402(a).
Net earnings from self-employment exclude earnings received for the performance of service
by an individual as an employee. 26 U.S.C. 1402(c)(2). The employer and employee pay
employment taxes on employee wages that are equivalent to the self-employment tax paid by
self-employed individuals.
Net earnings from self-employment also exclude the following types of earnings:
1) Rentals from real and personal property unless the rentals are received in a trade or
business as a real estate dealer;
2) Interest and dividends unless they are received in a trade or business as a dealer of
securities; and
3) Gains and losses from the sale of capital assets.
26 U.S.C. §1402(1)-(3).
Application to Partners.
For general partners in a partnership, self-employment earnings include payments received by
the partner for services rendered to the partnership or for the use of capital by the partnership
provided that the payments are determined without regard to the income of the partnership
(“guaranteed payments”). 26 C.F.R. §1.1402(a)-1(b). A general partner’s self-employment
ADVANCED LLC TAX ISSUES
earnings also include the partner’s distributive share (whether or not distributed) of the
partnership’s income or loss. 26 U.S.C. §1402(a). These rules apply equally to general
partners who activity participate in the partnerships business and who do not. Norwood v.
Commissioner of Internal Revenue, No. 1332-99, 2000 WL 267779 (T.C. March 13, 2000).
A limited partner’s self-employment earnings do not include the partner’s distributive share of
the partnership’s income or loss except for guaranteed payments received by the partner as
remuneration for services he actually rendered for the partnership. 26 U.S.C. §1402(a)(13).
In short, a general partner pays self-employment taxes on his guaranteed payments and his
distributive share of the partnership’s income and loss. A limited partner pays
self-employment taxes only on the guaranteed payments he receives for his services.
Application to LLC Members.
If the LLC has elected to be taxed as a C corporation, then the LLC’s members do not pay
self-employment tax on distributions they receive from the LLC as shareholders even if they
actively participate in the corporation’s business. This is because the LLC’s business is
deemed to be carried on by the LLC and not by its shareholders, and therefore, distributions to
shareholders do not represent gross income derived by the shareholders from a business
carried on by the shareholders. See 26 U.S.C. §1402(a). Of course, the LLC and the LLC’s
members will pay employment taxes on any wages an LLC member receives for services he
performs as an employee of the LLC.
The rules with respect to self-employment taxes that apply to members of an LLC that chooses
to be treated as a partnership will also apply to members of an LLC that has elected to be
treated as an S Corporation. See 26 C.F.R. §1.1402(a)-1(b). However, these rules are
currently uncertain.
In 1994, the IRS issued proposed regulations guidance on self-employment taxes in the form
of proposed regulations. These regulations provided two requirements to be satisfied for a
member of an LLC to be treated as a limited partner for purposes of self-employment tax.
First, the LLC member must lack the authority to make management decisions, and second, the
LLC must have been able to be organized as a limited partnership in the same state, and the
member must have qualified as a limited partner. See Treas. Reg. 209824-96,
62 C.F.R. 1702-01.
In 1996, the IRS withdrew the 1994 proposed regulations and issued new proposed
regulations to better define the issue without the need to look to state law classifications. Id.
The new regulations set forth one standard to be used both for limited partners in limited
partnerships and LLC members in LLCs to determine whether the individual qualified for
treated as a limited partner for purposes of self-employment taxes. Under the 1996 proposed
regulations, a limited partner or an LLC member was treated as a limited partner for
self-employment tax purposes unless he: (1) had personal liability for the debts and claims of
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67
the entity by reason of being a partner or member, (2) had authority to contract on behalf of
the partnership under state law; or (3) participated in the entity’s business for five hundred
hours or more during the tax year.
In addition, under the 1996 proposed regulations, an individual would not be treated as a
limited partner if he provided services as part of an entity in which substantially all of the
activities of the entity involved the performance of services in the fields of law, health,
engineering, architecture, accounting, actuarial science, or consulting.
The IRS’s 1996 proposed regulations were severely criticized and Congress prohibited the IRS
from finalizing them prior to July 1, 1998. To date, the IRS has not finalized these or any other
regulations and Congress has not enacted any legislation on the issue. Therefore, there is
some uncertainty as to whether LLC members must pay self-employment taxes on their
distributive shares of the LLC’s income and loss. However, authorities generally agree that if
an LLC member participates in the management of the LLC, the member should pay
self-employment taxes on their distributive shares.
S Corporation as the Manager.
LLCs may be structured to minimize the self-employment tax liability of its members. One
such structure is a manager-managed LLC with the manager being an S corporation. The
S corporation then employs the LLC’s member(s) to provide services to the LLC and pays them
a fair wage upon which the S corporation and the employees pay employment taxes. In this
structure, Because the members do not technically participate in the management of the LLC
other than as employees of the S corporation, the LLC’s members may not be subject to
self-employment taxes on their distributive shares of the LLC’s income and loss.
I. ILLINOIS STATE TAXES.
Illinois State Income Tax.
LLCs that elect to be taxed like C corporations are subject to an entity-level state income tax of
4.8% of the entity’s net income, and their members also pay a personal income tax on
distributions made to them by the entity at the rate of 3%. 35 ILCS §5/201(a), (b)(2)(ii), and
(b)(8). Flow-through entities, including partnerships, S corporations, and LLCs that have
chosen to be taxed like them, do not pay an entity-level income tax. Id. Their owners pay a
personal income tax on income and loss flowed through to them at the rate of 3%.
35 ILCS §5/201(b)(2)(ii).
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68
Illinois State Personal Property Replacement Taxes.
Single-member LLCs that elect to be treated as a sole proprietorship do not pay Illinois state
personal property replacement taxes. LLCs that have elected to be taxed as a partnership or
S Corporation are subject to an entity-level 1.5% Illinois personal property replacement tax
based on net income. 35 ILCS §5/201(c) and (d). Certain investment flow-through entities are
exempt from this tax. 35 ILCS §5/205(b). LLCs that elect to be taxed as C corporations are
taxed at the rate of 2.5% rather than 1.5%. 35 ILCS §5/201(d).
Illinois State Franchise Tax.
An LLC is not subject to Illinois franchise taxes on its paid-in-capital even if it elects to be taxed
as a corporation for federal income tax purposes. The Illinois franchise tax only applies to
entities that are legally formed as corporations, including C corporations and S corporations.
The tax is reported on the corporation’s annual report and paid to the Secretary of State along
with the corporation’s annual report filing fee. An LLC pays a fixed annual report fee of $250
without regard to its paid-in-capital and without paying any franchise tax.
805 ILCS §180/50-10(11).
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69
IV. OPERATING AS AN LLC
A. DRAFTING THE OPERATING AGREEMENT AND
STATUTORY LIMITATIONS
The LLC Act allows LLC members to enter into an operating agreement to regulate the internal
affairs of the company and to govern the relationship between the members, managers, and
the LLC. 805 ILCS §180/15-5(a).
Absent an operating agreement, the provisions of the LLC Act serve as the default provisions
establishing these rules. The operating agreement typically contains terms that would be found
in the by-laws and shareholder agreements of a corporation. The operating agreement usually
does the following:
1) Specifies the management, governance, and tax plans for the LLC;
2) Describes the contributions of members and the powers and responsibilities they have;
3) Provides for circumstances such as withdrawal, removal, or death of a member; and
4) Provides the methods of distributions and allocations to members.
The LLC Act allows members considerable flexibility in the provisions contained in the
operating agreement. However, the LLC Act prohibits the operating agreement from altering
certain provisions of the LLC Act. 805 ILCS §180/15-5(b). The LLC’s operating agreement
cannot:
1) Restrict rights of a person, other than a manager, member, or transferee of a member’s
distributional interest, under the LLC Act;
2) Reduce a member’s fiduciary duties, except it may:
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3) Identify specific activity types that do not violate these duties, if not manifestly
unreasonable; and
4) Specify the number of members or disinterested managers that may authorize or ratify,
after full disclosure of all material facts, a specific act or transaction that otherwise
would violate these duties.
5) Reduce the obligation of good faith and fair dealing for mangers and members, except
that it may determine the standards by which performance of the obligation is to be
measured, if not manifestly unreasonable;
6) Unreasonably restrict a member’s right to information or records;
7) Vary the right to expel a member if the member engages in conduct that is wrongful, in
breach of the operating agreement or fiduciary duties, or that makes it not reasonably
practicable to carry on the LLC’s business;
8) Vary the requirement that the LLC’s business be wound up if an event occurs that
makes is unlawful to continue the LLC’s business or a member has obtained a judicial
decree requiring wind up; or
9) Restrict the power of a member to dissociate, except that it may determine whether
dissociation is wrongful and may eliminate or vary the obligation of the LLC to
purchase the dissociated member’s distributional interest.
Id.
B. ANNUAL REPORT AND OTHER REQUIRED DOCUMENTS
An LLC is required to file an annual report with the Illinois Secretary of State and to maintain
certain records at its principal place of business. 805 ILCS §180/50-1(a). The filing fee for an
LLC’s annual report is $250. 805 ILCS §180/50-10(b)(11). Series LLCs must pay an
additional filing fee of $50 for each series in a series LLC. A standard LLC files its annual
report on Form LLC-50.1(D) for domestic regular and series LLCs. An LLC’s filing fees for its
annual reports are fixed and apply regardless of the amount of capital of the LLC.
The annual filing fee for an LLC is often lower than for a C corporation with high paid-in-capital.
This is because a C corporation must pay a fixed filing fee of $75 for its annual report plus an
annual franchise tax of .1% of the corporation’s stated and paid-in-capital of the corporation,
subject to a minimum of $25. Therefore, the annual filing fee for an LLC with $1 million in
capital is $250 whereas the annual filing fee for corporation with $1 million in capital is $1,075.
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Finally, an LLC is required to maintain the following records at its principal place of business
named in the articles of organization or other reasonable location specified in the operating
agreement:
1) A list of the name and address of each member, the description and amount
contributed to the LLC by the member, and the date on which each became a member;
2) The articles of organization and any powers of attorney under which documents have
been executed;
3) The LLC’s federal, state, and local income tax returns and reports for the three most
recent years;
4) The current operating agreement and any amendments to it; and
5) Any financial statements of the LLC for the three most recent years.
805 ILCS §180/1-40(a).
These records may be inspected and copied at the request and expense of any member.
805 ILCS §180/1-40(b).
C. PROPER PROCEDURES FOR MERGERS AND
CONVERSIONS
A merger is a transaction in which two or more entities combine and only one of them legally
survives. A conversion is a transaction in which an entity changes from one entity type to
another. The LLC Act contains specific provisions that govern mergers and conversions with
respect to LLCs.
Effect of a Merger.
An LLC may be merged with, or into, one or more LLCs, corporations, partnerships, or other
entities if permitted under the law governing the other entity or entities.
805 ILCS §180/37-20(a). To execute a merger, a plan of merger is prepared and approved and
articles of merger are filed. 805 ILCS §180/37-20(b) and (e).
The effect of a merger is that the separate existence of each entity merged terminates except
for the one entity that survives. 805 ILCS §180/37-30(a)(1). The merger vests in the surviving
entity all property, debts, liabilities, obligations, actions, proceedings, rights, privileges,
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immunities, powers, and purposes. 805 ILCS §180/37-30(a)(2)-(3), (5). A member of an LLC
surviving entity is liable for all obligations of a party to the merger for which the member was
personally liable before the merger. 805 ILCS §180/37-30(e). An LLC that is merged into
another entity is not required to wind up its business in order to merge.
805 ILCS §180/37-30(f).
Plan of Merger.
A plan of merger must state the following information:
1) Each entity’s name;
2) The surviving entity’s name;
3) The surviving entity’s type;
4) The merger’s terms and conditions;
5) The manner and basis for converting the interests of each party into interests of the
surviving entity and/or into money or other property; and
6) The surviving entity’s principal place of business address.
805 ILCS §180/37-20(b).
Approval of the Plan of Merger.
For an Illinois LLC to merge, the plan of merger must be approved by all of the members or by
the number of members specified in the operating agreement. 805 ILCS §180/37-20(c)(1).
For a foreign LLC to merge, the plan of merger must be approved by the vote required by the
law of the state in which the LLC is organized. 805 ILCS §180/37-20(c)(1). If an LLC is
merging with an entity that is not an LLC, the plan of merger must also be approved properly
by that entity. For a partnership or Illinois limited partnership to merge with an LLC, the plan of
merger must be approved by all of the partners or by the number specified in the partnership
agreement. 805 ILCS §180/37-20(c)(3). For any other entity, the plan of merger must be
approved by the vote required for approval of a merger by Illinois law or other state in which
the entity is organized. 805 ILCS §180/37-20(c)(4). If there is no requirement, then the plan of
merger must be approved by all of the owners of interests in the entity. Id.
Articles of Merger.
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A merger is effective only when articles of merger are filed on Form LLC-37.25 with the Illinois
Secretary of State by each entity that is a party to the merger after approval of the plan of
merger. 805 ILCS §180/37-20(e). The articles of merger states:
1) The name and jurisdiction of formation for all entities;
2) For each LLC, the date articles of organization were filed;
3) A statement that a plan of merger has been approved and signed by each entity and a
copy of the plan as approved by any corporation;
4) The name and address of the surviving entity;
5) The merger’s effective date;
6) If an LLC is the surviving entity, any changes in its articles or organization that are
necessary;
7) If the mergers involves a foreign LLC, the jurisdiction and date of filing of the LLC’s
initial articles of organization and the date when its application for authority to do
business was filed; and
8) If the surviving entity is not an LLC, an agreement that the surviving entity may be
served with process and is subject to liability for the obligations of any LLC previously
subject to suit in Illinois and the enforcement under the LLC Act of the right of
members of any LLC to receive payment for their interest against the surviving entity.
805 ILCS §180/37-25(a).
The filing fee for the articles of merger is $100 plus $50 for each entity merged in excess of
two. 805 ILCS §180/50-10(b)(13)
Effect of Conversions.
A partnership or limited partnership may be converted to an LLC if the law governing the
partnership permits it. 805 ILCS §180/37-10(a). To execute a conversion, an agreement of
conversion is prepared and approved and an articles of organization is filed.
805 ILCS §180/37-10(b) and (d).
The effect of a conversion is that the partnership ceases to exist, and the LLC is for all
purposes the same entity that previously existed. 805 ILCS §180/37-10(e) and §180/37-15(a).
All property, debts, liabilities, obligations, pending actions, rights, privileges, immunities,
powers, and purposes vest in the LLC. 805 ILCS §180/37-15(b). All of the partners continue
as LLC members. 805 ILCS §180/37-15(b)(5). A general partner remains liable as a partner
for an obligation incurred by the partnership before the conversion. 805 ILCS §180/37-10(g).
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A limited partner remains liable only to the extent the limited partner was liable for an
obligation incurred by the limited partnership before the conversion. Id.
Agreement of Conversion and its Approval.
The agreement of conversion should include a statement of the terms and conditions of the
conversion of the partnership interests into LLC interests and/or the cash or other
consideration paid. 805 ILCS §180/37-10(c). The agreement must be approved by all of the
partners or by the partners required in the partnership agreement. 805 ILCS §180/37-10(b).
Articles of Organization.
After the agreement of conversion is executed and approved, the LLC must file an articles of
organization. 805 ILCS §180/37-10(d). In addition to the regular items, the articles of
organization must contain a statement of the following:
1) That the partnership was converted to an LLC;
2) The partnership’s former name;
3) The number of votes cast by the partners entitled to vote on the conversion, and the
number or percentage required to approve it; and
4) For a limited partnership, a statement that the certificate of limited partnership shall be
canceled on the conversion date.
Id. The filing fee for this statement is $100. 805 ILCS §180/50-10(b)(14).
D. DEALING WITH A MEMBER’S DISSOCIATION
Practitioners are generally familiar with the concept of dissolution through their dealings with
other types of entities. The dissolution of an LLC relates to process by which the LLC’s
business is wound up and the LLC is terminated. The LLC Act introduces a separate concept
called “dissociation” that is distinct from dissolution and is unique to the LLC. A dissociation
refers to the voluntary or involuntary withdraw of a member from an LLC. Certain events
trigger a member’s dissociation. Once a dissociation occurs, certain rights and obligations
arise.
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Events that Cause a Member’s Dissociation.
The events that cause a member’s dissociation from the LLC are:
1) The receipt of notice by the LLC of the member’s express will to withdraw;
2) Transfer of all of the member’s distributional interest, except for security purposes or a
court charging order not foreclosed;
3) An event or the member’s expulsion as specified in the operating agreement;
4) The member’s expulsion by the other members’ unanimous vote if:
a. It is unlawful to carry on the LLC’s business with the member;
b. Substantially all of the member’s distributional interest has been transferred,
except for security purposes or a court charging order not foreclosed;
c. A corporate member has dissolved, had is charter revoked, or had its right to
conduct business suspended and it is not corrected within 90 days after the
LLC gives notice; or
d. A partnership or LLC member has dissolved and is winding up.
5) The member’s expulsion by judicial determination upon application by the LLC or
another member because the member:
a. Engaged in wrongful conduct that adversely affected the LLC’s business;
b. Willfully or persistently breached the operating agreement or a fiduciary duty;
or
c. Engaged in conduct relating to the LLC’s business that makes it not reasonably
practicable to carry on the LLC’s business with the member.
6) The member has:
a. Become a debtor in bankruptcy or executed an assignment for the benefit of
creditors; or
b. Acquiesced in the appointment of a trustee, receiver, or liquidator of the
member or the member’s property or failed to have the appointment vacated or
stayed within 90 days if the appointment was without the member’s
acquiescence.
7) An individual member has:
a. Died;
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b. Had a guardian or general conservator appointed; or
c. Been judicially determined to be incapable of performing duties.
8) A trust or trustee member or an estate or personal representative of an estate member
has distributed its rights to receive the LLC’s distributions; or
9) A member not an individual, estate or trust (other than a business trust) has had its
existence terminated.
805 ILCS §180/35-45.
A Member’s Power and Legal Right to Dissociate.
A member of a manager-managed LLC cannot dissociate from the LLC unless the operating
agreement provides. 805 ILCS §180/35-50(a). In contrast, a member of a member-managed
LLC can dissociate from the LLC, rightfully or wrongfully, by giving notice. Id. The member’s
dissociation is wrongful only if it breaches an express operating agreement provision.
805 ILCS §180/35-50(b). If the member’s dissociation is wrongful, the member is liable to the
LLC and other members for damages caused by the dissociation. 805 ILCS §180/35-50(c). If
the LLC does not wind up, damages must be offset against distributions due the member.
805 ILCS §180/35-50(d).
Effect of a Member’s Dissociation.
Upon a member’s dissociation, the member ceases to be a member and is treated as a
transferee of a member, except that a member who has not wrongfully dissociated can
participate in the LLC’s winding up. 805 ILCS §180/35-55(b)(1). The member’s fiduciary
duties terminate except that the member’s duty of loyalty (except for the duty not to compete)
and the member’s duty of care continue on matters arising before dissociation.
805 ILCS §180/35-55(b)(3).
Upon a member’s dissociation, the LLC is required to purchase the dissociated member’s
distributional interest if the dissociation does not result in a dissolution and winding up of the
LLC. 805 ILCS §180/35-55(a). The purchase price is the fair value of the distributional interest
on the dissociation date. 805 ILCS §180/35-60(a). The operating agreement may fix the price
and terms, and if the LLC defaults, the member may have the LLC judicially dissolved and
wound up. 805 ILCS §180/35-60(c). Damages for wrongful dissociation and all other
amounts the dissociated member owes the LLC must be offset against the purchase price.
805 ILCS §180/35-60(f).
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The procedure for the LLC’s purchase of the dissociated member’s distributional interest is
established by the LLC Act. 805 ILCS §180/35-60. The LLC is required to deliver a purchase
offer to the dissociated member not later than 30 days after the dissociation.
805 ILCS §180/35-60(b). The offer must include a statement of the LLC’s assets and liabilities
as of the dissociation date, the LLC’s latest balance sheet and income statement, if any, and an
explanation of how the payment amount was calculated. Id.
If the LLC and the dissociated member do not make a purchase agreement for the dissociated
member’s interest within 120 days after dissociation, the member may sue to enforce the
purchase within another 120 days. 805 ILCS §180/35-60(d). The court will determine the fair
value of the member’s distributional interest, considering going concern value, other purchase
agreements, court-appointed appraiser recommendations, legal constraints on the LLC, and
other factors. 805 ILCS §180/35-65(a)(1). The court will then specify the terms of the
purchase, which may include installment payments, subordination to the LLC’s other creditors,
security for a deferred purchase, a covenant not to compete or other restriction on a
dissociated member, and other terms. 805 ILCS §180/35-65(a)(2). Finally, the court will
require the dissociated member to assign his interest to the LLC upon receipt of the purchase
price. 805 ILCS §180/35-65(a)(3).
After the dissociated member delivers the assignment, the dissociated member has no further
claim against the LLC, its member, officers, or managers other than a claim to any unpaid
balance of the purchase price and a claim under any agreement with the LLC or its members
that the court does not terminate. 805 ILCS §180/35-65(b). If the purchase is not completed
as ordered, the LLC must be dissolved upon application and the dissociated member has the
same rights and priorities in the LLC’s assets as if the sale had not been ordered.
805 ILCS §180/35-65(c). If a party to the proceeding acted arbitrarily, vexatiously, or not in
good faith, the court may award reasonable expenses, including attorneys’ fees, and expert
expenses. 805 ILCS §180/35-65(d). The finding may be based on the LLC’s failure to make an
offer to pay or to purchase the interest. Id. Interest must be paid on the amount awarded from
the dissociation date to the date of payment. 805 ILCS §180/35-65(e).
E. GUIDING CLIENTS THROUGH DISSOLUTION
In contract to dissociation, dissolution of an LLC causes the LLC to cease to exist as a legal
entity. Dissolution is triggered by certain specified events. Once one of these events occurs,
the LLC must follow procedures to wind up its business operations, deal with outstanding
claims, distribute its assets, and file articles of dissolution with the Secretary of State.
Events Causing Dissolution.
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An LLC is required to wind up its business and dissolve as a legal entity (1) upon an event
specified in the operating agreement as requiring dissolution, (2) on the consent of the number
of members specified in the operating agreement as required to cause dissolution, or (3) upon
an event that makes it unlawful for the LLC’s business to be continued.
805 ILCS §180/35-1(1)-(3). Dissolution upon a specified event or by consent can be avoided if
the members and any dissociated members unanimously waive the requirement that the LLC
dissolve. 805 ILCS §180/35-3(b). In addition, dissolution upon the dissociation of the last
member can be avoided if within six months (1) the last member’s personal representative
agrees to continue the LLC until the personal representative or designee of the last member is
admitted as a member; or (2) the operating agreement specifically provides for the admission
of a member after there is no longer a remaining member and a member is admitted.
805 ILCS §180/35-3(c).
A court may also order the LLC to dissolve if a transferee of a member’s interest requests the
LLC’s dissolution and the court determines that it is equitable to wind up the LLC’s business.
805 ILCS §180/35-1(5).
A member’s dissociation from the LLC does not require the LLC to dissolve. However, a court
may order the LLC to dissolve on application by a current or dissociated member if the court
determines that:
1) The LLC’s economic purpose is likely to be unreasonably frustrated;
2) A member has engaged in conduct relating to the LLC’s business that makes it not
reasonably practicable to carry on the LLC’s business with that member;
3) It is not otherwise reasonably practicable to carry on the LLC’s business in conformity
with the articles of organization and the operating agreement;
4) The LLC failed to purchase the member’s distributional interest after the member
dissociated himself; or
5) The managers or members in control of the LLC have acted or will act in a manner that
is illegal, oppressive, or fraudulent with respect to the member.
805 ILCS §180/35-1(4).
Finally, the Illinois Secretary of State may administratively dissolve an LLC if (1) the LLC fails to
file its annual report or any other report within 180 days of its due date or the LLC fails to
appoint an Illinois registered agent within 60 days of its former agent’s resignation; and (2) the
Secretary of State has sent a notice of delinquency to the LLC allowing it 120 days to correct
the default. 805 ILCS §180/35-25. After an administrative dissolution, an LLC may be
reinstated by filing an application for reinstatement Form LLC-35.40, filing all reports that are
due, and paying all fees and penalties. 805 ILCS §180/35-40.
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Winding Up the LLC’s Business.
After an event causing the LLC’s dissolution occurs, the LLC must wind up its business. This
process may be done by any member who has not wrongfully dissociated or the last member’s
legal representative. 805 ILCS §180/35-4(a)-(b). The Circuit Court also may order judicial
supervision of the winding up process. Id. The LLC’s business may be preserved as a going
concern for a reasonable time after dissolution but before winding up.
Disposing of the LLC’s Claims.
During the dissolution process, an LLC should undertake steps to dispose of known and
unknown claims against the LLC as provided for in the LLC Act. To dispose of known claims
against the LLC, the LLC may send known claimants a notice of the dissolution in writing
stating:
1) The information required to be included in a claim;
2) The mailing address for claims;
3) The deadline for the claim’s receipt, which may not be less than 120 days after the
notice’s receipt; and
4) The statement that the claim will be barred if not received by the deadline.
805 ILCS §180/25-45(a)-(b).
The claimant’s claim is barred if (1) the claim is not received by the deadline; or (2) the claim is
received by the deadline, rejected by the LLC, and the claimant does not commence a
proceeding to enforce the claim within ninety days after notice of the rejection.
805 ILCS §180/25-45(c).
To dispose of unknown claims against the LLC, the LLC may request the presentation of claim
by publishing notice:
1) At least once in a newspaper of general circulation in the county of the principal office
in Illinois, or if none of the designated office;
2) Describing information required to be contained in a claim and stating the mailing
address where a claim is to be sent; and
3) Stating that a claim is barred unless a proceeding to enforce the claim is commenced
within five years.
805 ILCS §180/25-50(a)-(b).
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Claims are barred if the claimant did not receive written notice for a known claim, the
claimant’s claim was timely sent to the LLC but not acted on, or the claimant’s claim is
contingent or based on an event occurring after the dissolution date. 805 ILCS §180/25-50(c).
Claims that are not known and not barred by the procedures described above may be enforced
against a dissolved LLC to the extent of its undistributed assets or, if the LLC’s assets have
been distributed, against a member to the extent of the member’s proportionate share of the
claim or his distribution, whichever is less. 805 ILCS §180/25-50(c)
Distribution of the LLC’s Assets.
Upon the LLC’s dissolution, the LLC’s assets must be distributed in accordance with certain
priorities. 805 ILCS §180/35-10. (See section above on Property Transfers to and from
Members.)
Articles of Dissolution.
In order to complete the dissolution process, the LLC must file articles of dissolution Form
LLC-35.15 with the Secretary of State and pay a $100 filing fee. 805 ILCS §180/35-15 and
§180/50-10(b)(3). The articles of dissolution must state that:
1) All of the LLC’s debts, obligations, and liabilities have been paid and discharged or that
adequate provision has been made therefore;
2) All of the LLC’s remaining property and assets have been distributed among its
members; and
3) There are no suits pending or that adequate provision has been made to satisfy any
judgment. (805 ILCS §180/35-15(1)-(4).)
OPERATING AS AN LLC
81
V. SERIES LLCs
A. FORMATION
A series LLC is formed by filing with the Secretary of State an articles of organization for the
LLC and a certificate of designation for each series and by providing for the series in the
operating agreement.
Articles of Organization
A series LLC files its articles of organization on Form LLC-5.5(S) and pays a $750 filing fee.
Articles of organization for a series LLC contain the same information as for a standard LLC
except that the series LLC must provide notice that the liabilities of the series are limited to
being satisfied from the assets of the series. 805 ILCS §180/37-40(b). A statement providing
this notice is preprinted on the series LLC articles of organization form. The form states:
The operating agreement provides for the establishment of one
or more series. When the company has filed a Certificate of
Designation for each series, which is to have limited liability
pursuant to Section 37-40 of the Illinois Limited Liability
Company Act, the debts, liabilities and obligations incurred,
contracted for or otherwise existing with respect to a particular
series shall be enforceable against the assets of such series
only, and not against the assets of the Limited Liability
Company generally or any other series thereof, and unless
otherwise provided in the operating agreement, none of the
debts, liabilities, obligations and expenses incurred, contracted
for or otherwise existing with respect to this company generally
or any other series thereof shall be enforceable against the
assets of such series.
1723 North Halsted Street
TH E T UC K E R F IR M L L C
Chicago, Illinois 60614
[email protected]
(312) 202-0222
Certificate of Designation.
In addition to filing an articles of organization, a series LLC also must file on Form LLC-37.40 a
certificate of designation for each series established within the LLC and pay a $50 filing fee for
each certificate. 805 ILCS §180/37-40(d). Certificates of designation for each series may be
filed by the limited liability company or by any manager, person, or entity designated in the
operating agreement for the limited liability company. 805 ILCS §180/37-40(d).
The certificate of designation states (1) the LLC’s name, (2) whether the LLC is established in
Illinois or in another state, (3) the name of the series, and (3) a statement that the LLC’s
registered agent and office shall be the agent and office for the series.
805 ILCS §180/37-40(d). The name of the series must contain the entire name of the LLC and
be distinguishable from the names of the LLC’s other series. Id. If the management of the
series is different from the management of the LLC, the certificate of designation must state the
names and address of the managers or the members who will manage the series. Id. A series
of an LLC will be deemed to be in good standing as long as the LLC is in good standing.
805 ILCS §180/37-40(e). However, the series will not have the additional limited liability
protection that series LLCs afford unless a certificate of designation has been filed by the
series. 805 ILCS §180/37-40(b).
Operating Agreement
The series in a series LLC must be established in the LLC’s operating agreement.
805 ILCS §180/37-40(a). A series can be defined in many different ways. The LLC Act states
that a series may provide for different members, managers, or LLC interests having separate
rights, powers, or duties with respect to specified property or obligations of the LLC or profits
and losses associated with specified property or obligations. Id. A series also may have a
separate business purpose or investment objective. Id. Rather than establishing specific
series from the LLC’s inception, a series LLC’s operating agreement may provide for the
establishment of series or additional series in the future. Id.
With respect to the management of the series LLC, the operating agreement may provide that a
series will be managed by either the member or members associated with the series or by a
manager or managers chosen by the members of the series. 805 ILCS §180/37-40(h). If the
operating agreement does not specify the management of the series, the series’ management is
vested in the members associated with the particular series. Id. The operating agreement may
grant to all or certain of the members or managers of the series the right to vote separately or
with any group of the members or managers associated with the series on any matter.
805 ILCS §180/37-40(i). In the alternative, the operating agreement may provide that a
member or the members of the series have no voting rights. Id.
In order for each series to have limited liability, the operating agreement of the series LLC must
specifically provide for this. 805 ILCS §180/37-40(b). The operating agreement should
SERIES LLCs
83
explicitly state that the debts, liabilities, and obligations incurred, contracted for, or otherwise
existing with respect to a particular series shall be enforceable against the assets of such series
only, and not against the assets of the LLC generally or any other series of the LLC. In
addition, the operating agreement should state that none of the debts, liabilities, obligations,
and expenses incurred, contracted for, or otherwise existing with respect to the LLC generally
or any other series of the LLC shall be enforceable against the assets of such series. Id.
B. CONVERSION
A standard LLC can be converted into a series LLC without first dissolving the standard LLC.
The conversion is accomplished by amending the standard LLC’s articles of organization to
provide for a series LLC. The members of the standard LLC must authorize the conversion by
unanimous vote. 805 ILCS §180/15-1(c)(2). Once authorized, the standard LLC should file an
articles of amendment on Form LLC-5.25 with the Secretary of State to amend its articles of
organization. The articles of amendment should be drafted so as to cause the final articles of
organization to contain the provisions stated on the articles of organization Form LLC-5.5(S),
which is the form used to form a series LLC initially. In particular, the articles of amendment
must contain a provision stating that series exist and that they have limited liability if the series
LLC desires this limited liability.
The filing fee for articles of amendment that convert a standard LLC to a series LLC is $400.
The Secretary of State calculates this fee as the $150 fee regularly charged for filing an articles
of amendment plus $250 representing the difference in the fee for filing an articles of
organization for a series LLC as compared to a standard LLC. Despite the Secretary of State’s
method for calculating the filing fees, only the articles of amendment is filed to accomplish the
conversion and not a new articles of organization.
C. REPORTS
Like a standard LLC, a series LLC must file an annual report with the Secretary of State. A
domestic standard LLC files its annual report on Form LLC-50.1(D). The Secretary of State
has not created the form that will be used for a series LLC to file its annual report. However,
the Secretary of State has indicated that the annual report will be one document rather than a
separate document for each series. The filing fee for an LLC’s annual report is $250 plus $50
for each series if the LLC is a series LLC. 805 ILCS §180/50-10(11). These filing fees are fixed
and apply regardless of the amount of capital of the LLC. Id.
SERIES LLCs
84
D. CONDITIONS FOR LIMITED LIABILITY
The limited liability protection that series LLCs offer for the assets of each series of the LLC is
not automatic. Rather, certain conditions must be satisfied in order for the series LLC to obtain
this limited liability protection. 805 ILCS §180/37-40(b). These conditions are the following:
1) The LLC’s operating agreement must create series and explicitly provide for limited
liability for the series;
2) Separate and distinct records must be maintained for each series;
3) Each series’ assets must be held (directly or indirectly, including through a nominee or
otherwise) separately;
4) Each series’ assets must be accounted for separately;
5) Notice of the limited liability must be contained in the LLC’s articles of organization;
and
6) The series must file a certificate of designation with the Secretary of State.
Id.
The LLC Act also specifies circumstances that will not cause a series LLC to lose its additional
limited liability protection. 805 ILCS §180/37-40(b). A series LLC does not lose its limited
liability if the LLC and any of its series consolidate their operations as a single taxpayer or are
treated as a single business for purposes of qualifying to do business in Illinois or another
state. Id. In addition, the LLC Act states that the LLC and any of its series may work
cooperatively or contract jointly without losing their limited liability protection. Id.
E. OPERATING
A series with limited liability is generally treated like a separate legal entity in conducting its
business. 805 ILCS §180/37-40(b). A series should use its own name to contract, hold title to
assets, grant security interests, sue and be sued, and otherwise conduct its business. Id. The
provisions in the LLC Act will apply to each separate series in the same manner that they apply
to a standard LLC as a whole. 805 ILCS §180/37-40(j). Any event in the LLC’s operating
agreement or the LLC Act that causes a manager or member to cease being a manager or
member of a series will not cause the manager or member to cease being a manager or
member of the LLC in general. 805 ILCS §180/37-40(k).
SERIES LLCs
85
The business of a series can be wound up and the series can be dissolved without causing the
dissolution of the limited liability company as a whole. 805 ILCS §180/37-40(m).
F. TAXATION
Series LLCs may be taxed as one entity or multiple entities. Federal tax law rather than state
business law determines the existence of an entity for tax purposes. Whether a series LLC is
taxed as one or more entities will depend on the characteristics of the series. A series LLC
likely will be taxed as one entity if its series have common economic interests and activities,
ownership, and decision making. However, if the series differ substantially with respect to
these items, then the LLC likely will be taxed as multiple entities.
The IRS has held in a private letter ruling that each series of a Delaware business trust would
constitute a separate entity for tax purposes. IRS Private Letter Ruling, No. 9435015, 1994
WL 474303 (Sept. 2, 1994.) In this situation, each series was to have a distinct investment
objective and invest in a portfolio of securities in which no other series would have an interest.
Each holder of an interest in the trust was to invest in one or more series and his rights and
economic interests were limited to, and determined only with respect to, the particular series in
which he invested. Id.
The IRS has not issued any specific guidance on the taxation of series LLCs, and therefore,
there is a great deal of uncertainty in this area. What is certain is that the tax consequences of
a series LLC being taxed as one entity as compared to multiple entities are substantial. This
aspect of the series LLC provides the tax planner with many opportunities and challenges.
SERIES LLCs
86
VI. ETHICS IN DEALING WITH LLCs
A. ETHICAL STANDARDS AND CIVIL LIABILITY
As with any engagement, a professional must not only comply with the ethical standards set by
his profession, but also ensure that he is not negligent in performing his services.
Professionals who are not lawyers also should be particularly careful not to engage in the
unauthorized practice of law.
Professionals who are not attorneys may attempt to advise individuals on the formation and
maintenance of an LLC. The danger of doing this is that the professional could be deemed to
be engaged in the unauthorized practice of law. Illinois courts have defined the practice of law
broadly to be the giving of advice or the rendition of any sort of service which requires the use
of any degree of legal knowledge or skill. If the advice offered or service provided requires
more than ordinary business intelligence, it constitutes the practice of law.
In general, if a person is merely filling out forms for a company, this is not considered the
practice of law. However, if the person performs a legal analysis of the facts relating to the
company and advises the company on how to proceed, this constitutes the unauthorized
practice of law.
1723 North Halsted Street
TH E T UC K E R F IR M L L C
Chicago, Illinois 60614
http://thetuckerfirm.com
(312) 202-0222
B. THE ROLE OF THE ATTORNEY AS ADVISOR IN LLC
FORMATION
The procedures that an attorney should follow in forming an LLC for a client are extensive. The
attorney should first determine whether the LLC is the most appropriate entity for the client’s
operations, considering the differences among the different entity types. (See the section
above Factors to Consider in Choosing the Right Entity.) The attorney also should ensure that
the LLC Act and any other applicable statutes governing the client’s industry allow for the client
to operate as an LLC. In addition, the attorney should ensure that all of the specific
requirements for the client to be allowed to operate as an LLC are satisfied. (See the section
above on Special Rules for Regulated Professionals.)
Once the attorney has determined that an LLC is desirable and permissible, the attorney should
draft the articles of organization for the LLC. (See section above on Drafting the Articles of
Organization.) Most importantly, the attorney should draft the operating agreement for the
LLC. (See section above on Drafting the Operating Agreement and Statutory Limitations.)
Although an attorney may wish to start the drafting process by using a standard form operating
agreement, an attorney should not allow the form to substitute for the attorney’s good
independent analysis and advice, considering fully the nature of the LLC’s business and its
structure.
During the drafting process, the attorney should meet several times with the key members of
the LLC to determine how the LLC will be structured and operated. For example, the attorney
should discuss what each member will contribute to the LLC, how decisions for the LLC will be
made, what each member will receive from the LLC, and how a member will withdraw from the
LLC. The attorney should ensure that the operating agreement is consistent with the member’s
understanding as to how the LLC will be structured and operated. If an attorney skips this
important step, the members often operate the LLC in a manner that is independent of – and
often inconsistent with – the operating agreement. This creates a situation in which it becomes
nearly impossible to sort out the legal rights and obligations of those involved in the event that
a conflict arises in the future. The attorney may also need to draft employment and/or
independent contractor agreements for the members and/or managers who will be providing
services to the LLC. Finally, the attorney should ensure that the LLC complies with all
applicable securities laws.
An attorney often forms an LLC and then stops providing services to the client relating the
LLC’s setup. By doing so, the attorney not only fails to serve his client well, but also misses
the opportunity for earning additional fees for providing essential services for the ongoing
maintenance of the LLC. At a minimum, an attorney should ensure that either the attorney or
the LLC files its annual report when due every year. The attorney may also wish to consult with
ETHICS IN DEALING WITH LLCS
88
his LLC clients to ensure that the LLC is in compliance with its other ongoing legal obligations
and to determine if anything has changed with the LLC that would require changes to the LLC’s
filings with the Secretary of State or to the LLC’s internal documents. For example, the
attorney should ensure that the LLC has maintained its registered agent in Illinois and has the
records that it is required to keep on file. In addition, the attorney may inquire as to whether
the LLC’s name, members and/or managers, registered agent, principal place of business,
operations or governance has changed. If so, the attorney may inform the LLC that certain of
these changes may require changes to the LLC’s filings and internal documents and offer to
provide services to make any required changes.
Many businesses exist that provide standard forms to the public for forming LLCs or that
provide services to fill out these forms for the LLC without the involvement of an attorney.
These businesses often charge very small amounts to their customers for providing these
documents and services. For example, many companies charge only several hundred dollars
for forming an LLC. An attorney may face an uphill battle to convince a client that it is not in
the client’s best interest to form an LLC solely by using standard forms. Instead, the attorney
may elect to cut his fees and to provide fewer services to his client to tailor the LLC’s
documents to the LLC’s business. However, the attorney should remember that regardless of
the amount of the fee charged, the attorney still has unlimited personal liability for any
malpractice claim that arises from his services. The attorney should think carefully about
whether providing bad service and incurring substantial risk is worth the small fee. An attorney
may determine that a client who is not willing to pay for the attorney doing all of the tasks
necessary to properly form and maintain an LLC should make other arrangements for forming
his LLC.
C. AVOIDING CONFLICTS OF INTEREST
When dealing with an LLC, an attorney may represent the LLC itself and/or one or more of the
LLC’s members individually. If the attorney represents only one person or entity, then no
issues arise as to a potential conflict of interest by the attorney. Thus, if an attorney is retained
to form an LLC, the attorney may wish to represent only the LLC to avoid potential conflicts of
interests. The attorney also should take steps to protect himself against any potential claims of
an improper conflict of interest. For example, the attorney should send an engagement letter to
his client stating precisely the identity of his client and also stating that the attorney is not
representing any other entity or persons involved. The attorney also may send an appropriate
letter to any others involved in the situation to avoid any inference by them that the attorney is
representing them, especially if they are not represented by an attorney. In providing his
services, the attorney should ensure that he at all times is acting for his client and not for any
other entity or person. Finally, the attorney should ensure that he is paid by his client and not
from any other entity or person.
ETHICS IN DEALING WITH LLCS
89
If the attorney chooses to represent two or more persons or entities in dealing with an LLC,
then potential conflicts of interest may arise. The Rules of Professional Conduct state that an
attorney cannot represent a client if the representation of that client will be directly adverse to
another client or be materially limited by the attorney’s responsibilities to another client unless
(1) the attorney reasonably believes that his representation of the client will not be adversely
affected and that there will be no adverse effect on his relationship with the other client; and (2)
each client consents after disclosure. In addition, when the attorney’s representation of
multiple clients in a single matter is undertaken, the disclosure must include an explanation of
the implications of the common representation and the advantages and risks involved. Thus, if
the attorney chooses to represent multiple clients in forming an LLC or otherwise dealing with
an LLC, the attorney should ensure that he complies with these rules.
D. CONFIDENTIAL INFORMATION
FROM A REPRESENTATION
In dealing with an LLC, attorneys and accountants also should be careful not violate the duties
of confidentiality that they owe to their clients. The Illinois Rules of Professional Conduct
prohibit a lawyer, during or after termination of a professional relationship with a client, to use
or reveal a confidence or secret of the client known to the lawyer unless the client consents
after disclosure. Accountants owe their clients a similar duty.
Thus, a lawyer or accountant who deals with LLCs first should ensure that he or she has
clarified who his or her client is. It is possible that the lawyer’s or accountant’s client is the
LLC entity, the LLC’s members or both, provided that the representation is not prohibited by
the rules on conflicts of interest. Only by identifying his client, can the lawyer or accountant
ensure that he or she is not disclosing information improperly to individuals and/or entities
other than his or her client.
ETHICS IN DEALING WITH LLCS
90
VII. MASTERING ESTATE
PLANNING ISSUES
A. USING AN LLC TO HOLD AND TRANSFER REAL
PROPERTY
LLCs are used frequently to hold real property and to carryout like-kind exchanges of real
property.
Reasons to Hold Real Property in an LLC.
The LLC Act expressly authorizes LLCs to own, operate, and lease as a landlord real estate.
LLCs are often used by owners of real estate to insulate the owner from personal liability, to
protect the owner’s identity, and to obtain certain tax advantages.
Owners of real estate who own multiple properties can form separate LLCs to hold each
property so that liability is isolated to the given property. Owners also can form a series LLC
and hold title to each property in a separate series of the LLC so that liability is isolated to the
given property. As long as no grounds exist for piercing the LLC’s veil, this strategy is
effective. (See Section above on Limited Liability of Members and Exceptions.)
Holding title to real estate in an LLC also may assist an individual in keeping the individual’s
name from the public. Unless the member is also an organizer or manager of the LLC, the
member’s name will not appear in the public records of the Secretary of State provided that the
LLC is manager-managed.
1723 North Halsted Street
TH E T UC K E R F IR M L L C
Chicago, Illinois 60614
http://thetuckerfirm.com
(312) 202-0222
Finally, an LLC may provide tax advantages to a real estate owner that are not available through
other entity types. If an LLC chooses to be taxed as a partnership, then the member’s
contribution to the LLC and the LLC’s distribution to the member of appreciated real estate
generally do not cause either the member or the LLC to recognize a taxable gain on the
appreciation. In contrast, if an LLC elects to be taxed as a C corporation or an S corporation, a
taxable gain is recognized on the contribution and distribution of appreciated real estate unless
the member has at least an 80% ownership interest in the LLC as set forth in Section 368(c) of
the Code. 26 U.S.C. §368(c).
In addition, in an LLC that elects to be taxed as a partnership, a member’s share of the LLC’s
debt increases the member’s tax basis in his LLC interest. The increased basis gives the
member a greater ability to deduct losses generated by the LLC. If the LLC elects to be taxed
as a C corporation or S corporation, the member’s tax basis in his LLC interest is not increased
by the member’s share of the LLC’s debt. Because the member’s basis is lower, the member
will not be able to deduct as many losses because deductions in excess of the member’s basis
will be prohibited by the at-risk limitations.
Like-Kind Exchanges.
Use of an LLC to hold real estate does not limit a real estate owner’s ability to carryout a likekind exchange under Section 1031 of the Code. To carry out a like-kind exchange, the same
party who transferred the exchange property must generally receive the replacement property
in the exchange. However, a single-member LLC will be disregarded as a separate entity from
the member for income tax purposes; and therefore, the replacement property may be received
by an LLC whose single member is the transferor of the exchange property. See IRS Ruling,
No. 9807013, 1998 WL 57886, (Feb. 13, 1998.) In addition, under some circumstances, the
IRS has permitted the use of a two-member LLC to be treated as a disregarded entity to
complete the exchange. This has been allowed when the second LLC member does not have
an interest in income or loss of the LLC but is a member of the LLC only for control purposes.
See IRS Ruling, No. 199911033, 1999 WL 148569, (Mar. 19, 1999.)
B. AN LLC AS A VALUATION “FREEZE” ENTITY
If a donor owns an asset that the donor would like to gift to a donee, the donor may use an LLC
to maximize the amount of property that can be transferred subject to the annual gift tax
exclusion and the lifetime transfer exemption, and hence, minimize gift and estate taxes. The
donor would contribute the property to an LLC and then gift the LLC’s membership interests to
the donee rather than gift the asset directly to the donee. For this strategy to succeed in
MASTERING ESTATE PLANNIN G ISSUES
92
minimizing tax, the LLC membership interests must qualify as present interests and be subject
to valuation discounts.
LLC Membership Interests As Present Interests.
For an LLC membership interest to qualify for the annual gift tax exclusion and lifetime transfer
exemption for estate tax purposes, the LLC membership interest must constitute a present
interest. A present interest exists if the donee has the immediate and unconditional right to the
use, possession, or enjoyment of the gifted property or the income from it. 26 U.S.C. 2503(b).
The IRS has held that certain limited partnership interests constitute present interests that
qualify for the annual gift tax exclusion and lifetime transfer exemptions. Internal Revenue
Ruling, No. 9415007, 1994 WL 129157 (Apr. 15, 1994.) It is possible for LLC membership
interests to constitute present interests as well.
However, there is only one published situation in which the IRS has considered the issue. In
Hackl v. Commissioner of the Internal Revenue, the Seventh Circuit Federal Court of Appeals
held that the gifted LLC membership interests at issue did not constitute present interests.
335 F.3d 664 (7th Cir. 2003). The Court’s holding was based on the facts that (1) the LLC’s
operating agreement prohibited the members from selling their membership interests absent
manager approval, (2) any purchaser did have a right to become a member or to participate in
the LLC’s business, (3) the members had no right to compel distributions from the LLC or to
withdraw their capital accounts, and (4) the LLC anticipated generating losses and making no
distributions to its members for a number of years. Id. Accordingly, a donor must ensure that
an LLC’s operating agreement provides for greater current rights than the rights present in
Hackl to cause gifted LLC membership interests to constitute a present interest that qualifies
for the annual gift tax exemption and life time transfer exemption.
Valuation Discounts
Assuming that an LLC is structured such that its membership interests constitute present
interests, a taxpayer may be able to minimize taxes by causing the value of the gifted LLC
membership interests for tax purposes to be less than the member’s proportionate share of the
value of the LLC’s assets. For example, if a donor owns an asset with a fair market value of
$100,000 and gifts twelve percent of the asset directly to the donee, the gift’s value would be
$12,000 if no valuation discounts applied and would be equal to the annual gift tax exemption.
If the donor contributes the asset to an LLC, the donor may be able to gift a higher percentage
of the membership interests than twelve percent and still have the gift’s value be equal to the
annual gift tax exemption. This would occur if there are more valuation discounts that apply to
a gift of the LLC’s membership interests than apply to the asset directly. Thus, the donor could
gift more property without tax.
MASTERING ESTATE PLANNIN G ISSUES
93
The value of LLC membership interests may be discounted for tax purposes for conditions
such as the lack of marketability, lack of control, and minority interest discounts. Valuation
discounts have been permitted on interests in a family limited partnership up to forty percent of
the value of the partnership’s assets. Estate of Jones v. Commissioner, 116 T.C. 121, 139,
2001 WL 233964 (2001). Thus, gifting LLC membership interests subject to valuation
discounts can substantially minimize gift and estate taxes.
Similarly, tax advantages may be obtained by fixing the value of a member’s LLC interest at
below its fair market value by inserting bona fide provisions in the operating agreement to
freeze the value of the membership interest at a certain level. For example, the operating
agreement may provide for the remaining members of the LLC to buy the membership interest
of the member who dies at a price determined by a formula or fixed amount that is below the
fair market value. These provisions may be used to determine the value of the membership
interest for estate tax purposes if the price formula is arm’s length and other conditions are
met.
When LLC interests are given to family members, the taxpayer should take care to ensure that
Section 2701 of the Code does not apply to the transaction. Section 2701 generally provides
that transfers of assets between certain family members will be ignored for gift and estate tax
purposes if the transferor retains an interest in the asset transferred. Section 2701 may apply
to the transfer of an LLC interest if the transfer is made to a family member, while retaining a
liquidation, put, call, conversion, or distribution right and the interest transferred is not of the
same class or proportionally the same as the retained interest. Thus, to avoid triggering
Section 2701, different classes of interests in an LLC should be created and transferred
carefully.
C. HOLDING LIFE INSURANCE POLICIES IN AN LLC
An LLC can hold a life insurance policy on a member that is either payable to the LLC or to a
third-party for a purpose unrelated to the LLC. When an LLC holds a life insurance policy that
is payable to the LLC on the death of an LLC member, the LLC likely possesses the policy’s
incidents of ownership. Thus, when the member dies, the insurance proceeds are likely taken
into account for federal estate tax purposes only to the extent that they increase the value of the
decedent’s membership interest in the LLC. The policy’s face value may not be included in the
decedent’s gross estate. Otherwise, double taxation would result to the decedent because the
proceeds of the policy increase the value of the decedent’s LLC member interest, which is
included in his estate. See Knipp Est. v. CIR, 25 T.C. 153 (1955), aff’d on another issue,
244 F.2d 436 (4th Cir. 1957). Thus, the LLC’s holding of the policy and receipt of the insurance
proceeds may reduce estate tax if valuation discounts exist that can be applied to the
decedent’s membership interest.
MASTERING ESTATE PLANNIN G ISSUES
94
In contrast, when an LLC that is taxed as a partnership holds a life insurance policy on a
member that is payable to a third party, the face amount of the policy likely must be included
with the gross estate of the member upon his death. See Revenue Ruling 83-148.
D. USING AN LLC FOR PROJECTS
LLCs can be used advantageously to carry out subsidiary operations, risky operations, joint
venture projects, or venture capital projects.
Corporate subsidiaries.
A company’s use of an LLC as a subsidiary rather than another type of entity has certain
advantages. Unlike corporations, an LLC is not required to designate directors and officers.
Thus, the company could just name the parent as the manager of the LLC and avoid the added
complication of having a board and officers. The LLC also is not required to follow formalities
in its management to preserve its limited liability. Finally, an LLC that is wholly owned by the
parent company will be disregarded as an entity separate from its parent for federal income tax
purposes if the LLC chooses this tax treatment. Therefore, the LLC will not be required to file a
separate tax return.
Risky Projects.
A company can form an LLC as a wholly owned subsidiary and use it to carry out risky
operations of a company to insulate the liability from the operations from the rest of the
company’s business. For example, a company may lease its fixed assets or license its
intangibles to an LLC at the fair market rent and license fee. The LLC then uses the assets to
carry out the risky business operations and pays the company the rent and license fee. Thus,
the LLC, and not the company, would be liable for claims resulting from the business
operations carried out by the LLC. The rent and license fees paid by the LLC to the company
and the leased assets would be insolated from claims arising from the LLC’s risky operations.
However, before implementing this structure, it is important to review the fraudulent
conveyance and fraudulent transfer statutes for limitations that may apply.
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Joint Venture Projects.
Joint venture projects by two companies are often carried out through a corporate subsidiary.
The companies traditionally join together to form a third corporation for the joint venture.
However, this requires appointing a separate board of directors and officers and following
other required corporate formalities. A separate board of directors and officers for the joint
venture is often unnecessary given that the companies already have a board of directors and
officers in place for each company.
In contrast, the two companies can form an LLC to carry out the joint venture project. With an
LLC, the companies are not required to appoint a board of directors and officers or to follow
other corporate formalities if they are unneeded in the joint venture.
Venture Capital Projects.
LLCs and series LLCs also may be used by venture capitalists. An LLC provides venture
capitalists with the ability to segment business operations and to allocate income and loss
flexibly among investors. The venture capitalists who finance many small businesses can
minimize the number of separate legal entities that need to be maintained by carrying out each
different business within a separate series of the series LLC. In an LLC, the venture capitalists
also can provide for a simple management structure for businesses for which a more complex
structure is unnecessary.
However, if it is anticipated that a venture project will engage in an initial public offering, an an
LLC is generally not preferred. To have ownership interests traded on a major securities
exchange, the entity would need to be a C corporation. LLCs cannot be converted into a
C corporation without being dissolved.
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