Limited Liability Companies: What You Need To Know

LIMITED LIABILITY COMPANIES: WHAT YOU NEED TO KNOW

by Gary Jacobson and Larry Morrison

Limited liability companies (LLCs) have been called the greatest innovation in business ownership in the Past 100 years. They combine the liability protection and the general look and feel of a corporation (although they're not corporations), with the flexibility and tax advantages of a partnership. However, along with those benefits and flexibility comes its inevitable corollary: complexity. The very fact that you have so much flexibility means that you're dealing with a complex entity.

Every agent in the Commercial Property/Casualty insurance marketplace is seeing a steadily increasing number of clients organized as LLCs. To serve them properly and avoid E&O exposure, agents needs to know the basics of LLCs. It's also nice to be aware of their additional sales opportunities!

Agency owners can also use LLCs to improve clusters greatly, enhancing their ability to acquire another agency (or to hire an established producer with a book of business). Owners can even use LLCs to help with their own estate planning.

LLCs are hybrids, combining corporate and partnership characteristics. Every state now allows them in one form or another. They provide Personal Liability protection for members against outside third parties (analogous to the protections of a corporation), 'fire walls' between the LLC members themselves, and the flexibility and pass-through taxation of a partnership. An LLC's 'members' are similar to a corporation's stockholders, and can even manage the LLC directly from the bottom up by voting on all matters. Alternatively, they can set up managers at the top to run it, which are comparable to the officers and directors of a corporation. The LLC agreement itself combines many provisions found in a corporation's articles and bylaws and in shareholder buy/sell agreements.

It's important to note that LLCs aren't the same as limited liability partnerships (LLPs). LLPs are mostly for classic 'professional' firms, such as those comprised of CPAs or attorneys. They don't protect members from commercial-type debts, such as a premises lease, or from their own professional malpractice; but they do provide protection from cross-liability for E&O and torts of the LLP's other participants.

Your clients-and you-can benefit from LLCs in a number of ways:

Consider using one instead of a partnership or sole proprietorship to hold real estate (such as your agency office building). Benefits include tax, cash and profit allocation opportunities, and Liability protection. Consider them as one asset-protection strategy. For example, clients often place individual apartment buildings into a series of separate LLCs to compartmentalize their investment portfolio in case of catastrophic lawsuits or under-insured losses involving any of their buildings. They're a good way to shield owners of raw land from runaway jury awards to trespassers or the like. In joint-venture situations, they can make dissolution ('divorce') of the LLC's members easier and more tax efficient.

LLCs can be very effective in estate planning. Members can achieve a step-up in basis at death. LLCs can also substitute for a trust or family limited partnership in many cases. You can use 'discounting' concepts you may have heard about for impressive estate tax savings. LLCs can also be used as an effective alternative to Subchapter S corporation structure, with their similar 'pass-through' taxation characteristics; earnings are taxed only once (directly to the members) rather than having to pay a top level of taxes first at the entity level and then again upon distribution of the remainder to the principals. Entering or leaving an LLC is generally not a taxable event if handled in the right manner.

Consider using LLCs in agency-specific situations such as clusters, in creating producer incentives, and for mergers and acquisitions. However, existing corporations should not be converted directly into LLCs!

It's true that conventional C corporations have the potential for lower taxes on profits left in the corporation annually; the federal corporate tax rate on the first $50,000 of profits is 15%. However, they may also result in very high taxes when the agency is sold, since intangible value such as 'goodwill' and 'expirations' or 'accounts' are effectively double-taxed in a sale of assets out of the corporation. Your combined tax can then easily exceed 50% (in some states, it can be over 70%) -- but careful tax planning can often reduce some of this very high exposure. The double-tax problem is relatively new, having started in 1989 as a result of the 1986 tax act. Unfortunately, the majority of agencies today are C corporations.

With Subchapter S corporations, on the other hand, all income flows through onto the owners' personal tax returns; that is, no tax is paid at the corporate level first. In addition, they may result in much lower taxes in a typical 'asset sale' than they would with C corporations. They have no double-tax problem if they've always been an S corporation. They also face no double-tax problem if they switched from C to S status more than 10 years before the sale. If they switched to S status from C status less than 10 years ago, then they become subject to double taxation. However, sophisticated tax planning can often reduce that burden substantially as well.

General partnerships are easy to create-sometimes even by accident. Their main problems are unlimited liability of the partners to third parties, and cross-liability between the general partners. Several major accounting firms have been destroyed by this. If you're in a cluster, it's probably a general partnership (with unlimited cross-liability) unless you have formalized the relationship into something else along the way. General partnerships do benefit from flow-through taxation, which offers such advantages as a great flexibility as to how profits are allocated. Your client in a general partnership has very different insurance needs than one with the Personal Liability shield of a corporation or LLC.

With limited partnerships, the 'limited' partners do have some Liability protection. However, they can accidentally lose the status of 'limited' partner if they become too involved in management, inadvertently becoming a 'general partner' with all associated risks. If the partnership is being sued, guess what the opposing lawyers will probably try to do? They must find at least one general partner-which can be a corporation under certain circumstances-with unlimited potential liability. Limited partnerships also benefit from flow-through taxation, with great flexibility as to how profits should be allocated. Tax effects for a limited partner are different than for a general partner if a partnership interest is being sold and the partnership is not capital intensive. Insurance agencies aren't considered capital intensive in this context.

LLCs, as already explained, have the Liability shield of a corporation combined with the flexibility and tax effects of a partnership-possibly the best of all worlds. They also have flow-through taxation. Depending on details of the specific LLC, they may be similar to either a general or a limited partnership when a membership interest is sold.

Conversion of a general partnership into an LLC is usually pretty simple. It can probably be done with no tax effects, while preserving the same relationships among the partners as before the conversion. On the other hand, conversion of a limited partnership into an LLC can be difficult, depending on the provisions of the limited partnership agreement. In principal, it can be done tax free; however, if the relative rights of the partners change, and the change itself has economic value, then taxes will be owed.

Conversion of a corporation into an LLC, however, is difficult and is quite likely to generate tax at the time of the conversion. Unless there's a strong nontax business motive, this is generally not recommended-and never without experienced tax counsel! Simply starting a new LLC and renewing business there instead of in the existing agency corporation is a bad idea because it would be considered (and taxed) as an 'asset sale' by the corporation. Instead, the corporation's assets can be contributed to the LLC in exchange for an LLC membership interest. The 'units' of the LLC acquired in exchange for the book would then continue to be held inside the contributing corporation as an asset in place of those accounts, retaining the same tax basis as the accounts did-just don't dissolve the corporation. This is not, in and of itself, a taxable event if performed properly-but be sure you haven't accidentally transferred goodwill for less than its fair market value. In this manner, an insurance agency can effectively transfer a book of business to the LLC (helpful in a variety of situations, as explained later).

An in-depth discussion of your local LLC laws is beyond the scope of this article, particularly since each state statute is slightly different. One should never attempt to change your status without the help of an experienced business attorney. However, a brief overview may be helpful.

Many states have what is known as a flexible LLC law, containing few absolute requirements. However, you should always have an LLC agreement. It will usually include numerous provisions like a corporation's articles, bylaws, and shareholder buy/sell agreement. This is also where the valuation methodology, voting control, and numerous 'exit strategies' would be found. These can make for a complex and intimidating document. The LLC will have units or the like indicating percentage of ownership, as with corporate stock, but perhaps they won't be certified.

If the statute lacks an LLC agreement or specific provisions for one, various 'default provisions' will probably apply to fill in the gaps. Since the participants will most likely have no idea what these default provisions are, we recommend that you develop an explicit and detailed agreement-or not do an LLC at all.

A simple certificate of formation (the statute specifies its contents) is first filed with the state to establish the LLC. LLCs may usually be used for any lawful business except banking or acting as an insurer. Generally there are no restrictions about whom the members of the LLC can be (except with professional LLCs); charities, nonresident aliens, trusts, and other entities may all be acceptable. In some states, you must have at least two members.

Management can be carried out directly by the members or by 'managers' (similar to a corporation's officers or board of directors). If the LLC certificate doesn't expressly forbid it, then the members will probably manage it directly by majority vote. There may be some risk in that format, since individual members may be able to bind the LLC contractually on third-party transactions despite agreement provisions between them prohibiting this. Also, your LLC agreement is usually not a public document, so no one has notice of any limitations on powers of the members. If your initial certificate filed with the state specifies 'managers,' then third parties have received notice on public record of your manager-controlled format.

Generally there will be no liability solely for being a member or manager of the LLC; but the parties still retain certain exposures similar to 'piercing the corporate veil' if they do not observe and document the proper formalities in establishing and operating their LLC.

Unless the agreement provides otherwise, members will probably be free to transfer their ownership interest in the LLC. However, without unanimous consent of the remaining members, a transferee might not be allowed to exercise any of the transferor's management rights.

A 'charging order' might be the exclusive remedy for creditors of a particular member, making it difficult to get their rights against an LLC membership interest belonging to a debtor. The creditor may even get a nasty surprise by being taxed on the LLC's income attributable to a debtor member whose interest has been taken over-but receive no cash distributions from the LLC with which to pay those taxes.

A member generally ceases to be a member in the event of certain named events. The effect on the LLC and the other members then depends on what the LLC agreement or your state statute says.

A producer must be able to spot some basic insurance issues:

For example, is the LLC governed directly by the members or by managers? That is, does the person you're dealing with have the authority to bind the LLC on purchasing insurance?

Does the LLC need insurance to receive the Liability protection of an LLC? In some states, a professional LLC (PLLC) may be required by statute to take out Errors & Omissions (E&O) insurance; otherwise, the members themselves may be held liable up to that limit. What, if any, personal assets of the LLC owners are exposed to possible loss through a lawsuit? Is additional coverage needed to protect the assets inside the LLC itself? The 'causing individuals' are not protected from their own torts. Be sure to refer the client to an attorney.

Is your agency part of a cluster? It may well be an accidental general partnership, with unlimited potential cross-liability for all partners. Is your E&O coverage adequate to cover all possible mistakes your cluster partners may make? The cluster could probably be converted to an LLC easily, generally affording protection for every member against the liabilities of other members. Each agency in the cluster-and perhaps some individual stockholders of the agency corporations and/or individual producers as well-becomes a member of the LLC instead. This agreement is also a good place to include nonpiracy restrictions-and to have each member-agency corporation principal sign separately at the end, agreeing to be bound by the same restrictive covenants as his or her fellow corporations).

Is your agency acquiring another agency? Odds are good that the target agency will be a C corporation, with all the tax problems that status creates when an agency's sold. An LLC can be used to help solve that problem for the sellers-otherwise (1) you probably won't have a deal once a CPA tells the seller about the extraordinary tax consequences of an asset sale format, or (2) you get zero write-off if you do a stock purchase. The potential for tax savings in this area are immense; so is the potential for catastrophic errors. Be sure to consult appropriate professional advisors.

Is your agency merging with another agency? The merged agency can be a newly-created LLC, with each of the merging agencies (corporations, sole proprietorships, other LLCs, and so on) as the members. If the merger doesn't work out, the LLC is much easier than a conventional merger of corporations would be to unwind without tax consequences.

Are you interested in hiring an established producer with his or her own book of business? The producer can contribute that book of business directly to the LLC in exchange for a membership interest without creating a taxable event-or get it back out as an easy divorce, if that's permitted under the LLC agreement, without creating a taxable event. The producer's ownership in the LLC can even vary from year to year (a substantial advantage), and be tied to the size of his or her book of business. When the time comes for the producer or member to retire, the ownership interest can often be liquidated on very tax-advantaged terms under Section 736 of the Internal Revenue Code, allowing an immediate write-off (essentially in full) of payments to the withdrawing party at the time they're paid, instead of a zero write-off if instead you were to have repurchased corporate stock owned by a producer, or 15-year write-off if you had bought the producer's accounts.

How are the LLC-related assets technically held? Your authors commonly use the following two different nontechnical terms:

• Confederation format. A conventional clustering arrangement might continue its overall look and feel by leaving the individual agency books of business as an asset of each agency. They could simply contribute a nominal amount of cash to start the LLC. The LLC's identity might not show on the declaration sheets or be know to the public at all; or it may be publicized for marketing purposes. The LLC has a master producer code, and the member agencies each have subproducer codes. Contingent bonuses might be shared equally, or based on relative production with the various carriers. The LLC itself might have no employees; each agency, perhaps in different cities, would retain its own staff.
• Entity format. Each agency might actually contribute its accounts directly to the LLC in exchange for an ownership interest in the LLC itself. A member agency corporation would thereby end up owning units (analogous to stock) of the LLC, having the same tax basis as the book of business contributing to the LLC. The LLC may itself have a number of employees doing the central support functions (a bank may be interested in providing the central service hub for the group, even acting as manager of the LLC, with an option to acquire the member agencies in the future). The LLC itself may buy other agencies and/or be the stand-by purchaser, on predetermined price formula and terms, in an agency principal's death or disability.

If your agency is organized as a C corporation and you don't have 10 years to wait before selling, you'll need to explore creative ways to control the very high tax you could end up paying. Some of the techniques you should consider involve the use of LLCs.

If you're currently a C corporation, consider asking your tax advisors about switching to S corporate status. A big reason to switch is that most agency sales are asset sales, and the owners of agencies organized as C corporations are literally double-taxed in the event of an asset sale. The combined federal tax on the seller from this double tax is higher than 50%. Consider making this switch as soon as possible, since the double-tax problem doesn't go away entirely until 10 years after you switch. Switching from C to S status is easy, but should be done in consultation with your CPA.

An LLC can have stunningly better after-tax results for the owners (especially as compared with a C corporation) when the time comes to sell the agency; however, if you're already incorporated, this is probably not an option directly. You may wish to have your C corporation become a member and then freeze its book of business and let normal attrition occur over time, while at the same time you personally or a new S corporation owned by you becomes a member of the LLC and begin writing all new accounts-not renewals of those left in the C corporation-in your name. This avoids double taxation on those new accounts when you eventually sell them.

At least this helps you keep from compounding the C corporation double-tax issue. Be sure not to distribute your C corporation's accounts out to you personally, and then contribute them yourself to the LLC! That could cause a tax catastrophe, whereby the entire fair-market value of those accounts would be taxed to you personally as ordinary income (as a 'dividend' from the corporation) at the time you received them.

LLCs are a tremendous innovation, and every agency will see more clients using and needing to insure them. They may be of tremendous value in your own agency as regards clustering, mergers and acquisitions, producer development, exit strategies, and overall tax- and estate-planning tools. Their incredible flexibility, however, does bring with it substantial complexity, so don't use them without competent legal advice and taking the time to understand what you're getting into. Our clients now ask us, 'Is there any reason to use an LLC?' Within a couple years, the question instead will be, 'Is there any reason we would not use an LLC?'