choice of entity in real estate transactions (with

CHOICE OF ENTITY IN REAL ESTATE TRANSACTIONS

(With Emphasis On PartnershipsAnd Limited Liability Companies)

SANFORD J. LIEBSCHUTZ

Roc heste r, N.Y .

STEVEN A. WATERS

San Antonio, Texas

Am erican Co llege of Rea l Estate Law yers

1994 Spring Meeting

Tucson, Arizona

i

Choice of Entity in Real Estate Transactions

(With Emphasis On Partnerships

And L imited Liability Compa nies)

Tab le of C onten ts

Page

I. SCOPE OF DISCUSSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

II. OVERVIEW OF CHOICE OF ENTITY PROCESS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

A . IDENTIFYING OBJECTIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

B. IMPORTANT FACTORS IN SELECTING THE BUSINESS ENTITY . . . . . . . . . . . . . 2

1. Form ation a nd M ainten ance Req uirem ents . . . . . . . . . . . . . . . . . . . . . . . . . 2

2. Exte nt of L iability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

3. Management and Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

4. Tran sferab ility of Inte rests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

5. Leg al Flex ibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

6. Continuity of Existence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

7. Methods For Getting Money Out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

8. Tax Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

C. SUMMARY OF ENTITIES COMMONLY USED BY REAL ESTATE OWNERS . . . . 2

1. Sole Proprietorships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2. General Partnerships and Joint Ventures . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

3. Limited Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

4. Registered Limited Liability Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

5. Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

6. S Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

7. Limited Liability Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

D . SOURCE MATERIALS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

E. UNIFORM LIMITED LIABILITY COMPANY LEGISLATION . . . . . . . . . . . . . . . . . . 5

1. Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

2. IRS Rulings Since 1988 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

3. NCCU SL Project . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

4. Sup plem ental M aterials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

III. FEDERAL INCOME TAX CLASSIFICATION -- INTRODUCTORY DISCUSSION . . . . . . . . . . . 7

A . SUMMARY OVERVIEW OF CORPORATE CHARACTERISTICS . . . . . . . . . . . . . . 8

1. Formation Alone Is Not Enough . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

2. Four Critical Characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

3. "Other Factors" . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

4. History of the Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

B. DETAILED DISCUSSION OF CORPORATE CHARACTERISTICS . . . . . . . . . . . . . . 9

1. Continu ity of Life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

2. Centralization of Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

3. Lim ited Lia bility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

4. Free Tran sferab ility of Inte rests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

ii

5. Obtaining a Ruling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

IV. DETAILED, COMPARATIVE DISCUSSION OF LIMITED PARTNERSHIPS, LIMITED

LIABILITY COMPANIES AND S CORPORATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

A. FORMATION AND MAINTENANCE REQU IREMENTS . . . . . . . . . . . . . . . . . . . . . . 14



3. S Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

B. EXTENT OF LIABILITY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19



3. S Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

C. MANAGEMENT AND CONTROL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23



3. S Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

D. TRANSFERABILITY OF INTERESTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29



3. S Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

E. LEGAL FLEXIBILITY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32



3. S Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

F. CONTINUITY OF EXISTENCE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35



3. S Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

G. TAX CONSIDERATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38



3. S Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

H. METHODS FOR GETTING VALUE OUT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

1. General Rule - Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

2. Com parison Su mm ary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

3. Gains v. Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

4. Shifting Taxable Items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

V. SUMMARY OF THE VARIOUS CONSIDERATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

A. GENERAL OVERVIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

B. ENTITY BY ENTITY COMPARISON . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

1. On e Ow ner - P roprie torship , S Co rp, LL C or L imited Partn ership . . . . . . . 45

2. Multiple Owners -- Numerous Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

C. COMPARISON OF STRUCTURES CHART . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

VI. CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

iii

Attac hm ents

Appendix A LLC & LLP State Legislation

Appendix B IRS Re ven ue R ulin gs / P riva te Le tter R ulin gs (C lass ifica tion Issu es) F or L LC 's

Appendix C Com parison O f Structures C hart

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CHOICE OF ENTITY IN REAL ESTATE TRANSACTIONS(With Emphasis On PartnershipsAnd Limited Liability Companies)

By

San ford J. L iebsc hutz

Steven A . Waters

II. SCOPE OF DISCUSSION.

This article analyzes and compares various business entities available to parties who desire to acquire, own,

operate, or develop real estate, and discusses factors relevant to the decision of the best entity for the particular

situation. Although tax considerations are usually very important in the selectio n pro cess a nd w ill be highlighted

in this paper, there is not an exhaustive treatment of tax issues. However, because federal income tax pass-through

treatment is required by most real estate owners, this paper places much greater emphasis on partnerships and

limited liabili ty companies than on other entit ies. Mainly, for comparative purposes (although they can be the

entity o f cho ice), su bcha pter S corp oration s are co vered in som e deta il, as we ll.

The authors note, with modest apology, the disproportionate number of references to Texas law. The

general princ iples, howe ver, are the sam e for mo st jurisdictions, although details differ.

IV . OVERVIEW OF CHOICE OF ENTITY PROCESS .

B. IDENTIFYING OBJECTIVES.

It is elementary that a lawyer cannot provide effectiv e counsel on entity selection without first understanding

the client's current business situation and objectives. Among the frequently relevant issues are:

! Nature of the real estate involved;

! Proposed business objectives in acquiring the real estate (e.g. for development, lease, operation

(e.g. hotel) or later resale);

! Likelihood that the business objective will change;

! Number, nature, and experience of the parties to the transaction;

! Type of business form in which the parties to the transaction are currently operating and the

ability to convert to another form withou t suffering adverse tax consequ ences;

! Fina ncial re sourc es of th e partie s, and the ne ed fo r and timing of ob taining outsid e cap ital;

! The parties' tax situation and objectives, and whether the objectives are different for different

owners; and

! The importance of l imited liability.

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Without a clear understanding of the client 's situation and objectives, a practit ioner cannot effectively

recommend the best entity choice for the proposed transaction.

D . IMPORTANT FACTORS IN SELECTING THE BUSINESS ENTITY.

The basic factors that typically influence the selection of the ownership entity in a real estate transaction

include:

2. Formation and M ainten ance Req uirem ents : The ease and expense of forming and maintaining

the entity;

4. Extent of Lia bility : The extent to which the owners are liable for the obligations of the

business;

6. Management and Control: The extent of control desired by the ow ners;

8. Tran sferab ility of Inte rests : The extent and ease by which an ownership interest in the entity

may be transferred;

10. Legal Flex ibility : The extent to which the actions of the owners of the business are governed

and limited by law (and their ability to contractually vary that result) and the ease with which the form of business

can be changed;

12. Con tinuity of Existence: The e xtent to whic h the o wn ers de sire that th e entity have contin uity

of existence;

14. Methods For Getting Money Out : The key issue for many owners -- when and how do I get

paid; and

16. Tax Considerations: The tax treatment of the entity, its owners and em ployees.

This paper w ill test the more imp ortant entity forms against these factors.

F. SUMMARY OF ENTITIES COMMONLY USED BY REAL ESTATE OWNERS .

This Section C. provides a b rief, rudimentary summ ary of the forms of own ership used with varying

frequency in real estate transactions. Although some of the entities generally are not preferred under the current

state of the la w, fo r reaso ns tha t will be expla ined (u sually , tax and liability reasons), each is mentioned because

a uniq ue co mb ination of facto rs imp ortan t to a pa rticular c lient m ay lea d to us e of a fo rm th at, in mo re typic al

circumstances, would be considered inadvisable. However, the extended discussion later in the pape r prim arily

invo lves a c om pariso n of p artners hips (e spec ially lim ited pa rtnersh ips), lim ited liab ility com panie s and , main ly

for illustration, subchapter S corp orations.

2. Sole Proprietorships.

In a sole proprietorship, the business is conducted by an individual who owns all of the property.

There are no formal requirements for a sole proprietorship to exist other than, perhaps, dedication by the proprietor

SAW - 3

of a portion of his or her individual assets to a specific business purpose and, if appropriate, the filing of an

assumed business name certificate.

4. General Partnerships and Joint Ventures.

A general partn ership is, by statutory definition, an association of two or more persons to carry on

a busin ess for profit as co-o wn ers. A joint venture is, essentially, a general partnership with a limited purpose

(which has led to its widespread use for real estate project ow nership). Therefore , to the limited extent the y are

discussed in this p aper, th ese tw o entitie s are co nside red the sam e. A g enera l partne rship is n ot taxe d as a s epara te

entity from its partners.

6. Limited Partnerships.

A limited partnership (sometimes " L P'ship ") is a partnership that has one or more general pa rtners

(who are liable for the obligations of the partnership) and one or more limited partners (liable only to the extent

of their actual or committed investment in the partnership). Like general partnerships, a l imited partnership is not

taxed as a separate entity from its partners. Because the creation of a limited partnership involves the filing of a

certifica te with the state, that form tends to be somewhat more formal than general partnerships, although a limited

partn ership can b e crea ted by oral ag reem ent.

8. Registered Limited Liability Partnerships.

A regis tered limited liabili ty partnership ("LLP") is a special type of general partnership in which,

in certain circumstances, some LLP partners are not liable for debts and obligations of the partnership that arise

from errors, omissions, negligence, incompetence, or malfeasance committed without the knowledge of the

protected partner by another partner or employee not supervised by the protected partner. This has been described

as "a d ram atic bre ak fro m trad ition, . . ." in A . Brom berg and L . Ribste in, Bromberg & Ribste in on Partn ership ,

(1988) [hereinaf ter "BROMBERG AND RIBSTEIN"], page 5:83, descr ibing the creat ion of an LLP under the

Tex as U niform Partn ership Act , TEX. REV. CIV. STAT. ANN. art . 6132b, § 45 (Vernon 1991). Note that, for

Texas partnerships created after December 31, 1993, LLP's are created under the new Texas Rev ised P artners hip

Act, TEX . REV . CIV . STA T. A NN ., art. 613 2b-1 , § 3.08 (Ver non 199 4). A p ar tnership in Texas obtains

registered limited liability partnership status by filing required identify ing inf orm ation w ith the S ecreta ry of S tate

and a fee of $ 200 (up in 199 3 from the orig inal $1 00 fe e). [VIP NOTE: Registra tion mu st be renew ed ann ually

in the same way the status is originally created. For profession al service organization s, this annual expense may lead

to the use of professional LLC's, now allowed in several states, at least whe re local tax issues don 't get in the w ay.]

Also, an LLP must maintain $100,000 of liability insurance covering the types of torts for which liability under

the statute is shielded. Partners in an LLP remain liable for their own torts and the partnership itself is liable for

the torts of partners and employ ees.

No te that at least in some states (e .g . Texas) , a l imited par tnership can also be an LLP, w h ic h ca n gi ve so m e

measure o f additional protection to a general partner when there are several active general partners.

Do not consider LLP's and limited partnerships as substitutes for each other, or as alternatives to achieve

the same objectives. An LLP is stil l a general p artners hip whos e partners hav e joint and sev eral liability (tort

and/or contract, depending on the state), with the limited shield of personal assets in certain circumstances that is

described abov e. For example, if the partnership properly incurs an obligation for borrowed money, LLP status

does not do for the general partner what limited partne r status w ould do fo r a limite d par tner. On the other hand,

in a circumstance where LLP status provides a shield from particular tort liability , then a shield ed L LP p artner is

in much the position of a l imited partner -- the entity and its assets are fully liable, but the partner 's personal, non-

partnership assets generally are protected.

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As shown in Appendix A, a number of states have followed Texas' lead by adopting LLP enabling

legislation, and several others have pending legislation.

10. Corporations.

A corp oration is a lega l entity formed under state law that provides its ow ners -- the shareh olders --

with limited liability. The law treats corporations as having a personality and existence distinct from that of its

owners an d, accordingly, taxes them a s entities separate from their shareholders.

12. S Corporations.

An S Corpo ration (sometimes " S Corp") is a so-called "small business corporation" that has made

the required election under the Internal Revenue Code of 1986, as amended (the "IRC"), to be treated as having

the federa l incom e tax a ttributes of a pa rtnersh ip. On non -tax issu es, the S Corp is treated the same as other

corporations.

14. Limited Liability Companies.

A limited liability comp any (som etimes "LLC") is a no n-co rpora te entity orga nized und er a state

enabling statute that affords its owners -- called "mem bers" -- the lim ited liab ility of a c orpo rate sh areho lder w hile

also providing the opp ortun ity for the flow-through tax treatment of a partn ership . This d ual be nefit is expected

to make L LC's very pop ular in many bu siness contexts, includ ing rea l estate. B ut, as discussed below, in some

states there are local tax issues that are a serious deterrent to using this otherwise desirable form of ownership.

H . SOURCE MATERIALS .

Although some of the following statutes are de scribe d in detail elsewhere in the paper, they are collected

here for convenience:

"UPA" Uniform Partnership Act (1914), promulgated by the National Conference of Commissioners on

Uniform State Law s ("NCC USL ").

"ULPA " Uniform Limited Partnership Act (1916), promulgated by NCCUSL.

"RULPA " Uniform Lim ited Pa rtnersh ip Ac t (197 6), pro mu lgated by N CC US L to replace ULPA, as amended

by replace men t Uniform Limited P artnership A ct (1985).

"RUPA " Uniform Partn ership Act (1993), approved and recommended by NC CUS L for enactmen t, August

6, 1993.

"ULLCA" Draft Uniform Limited Liability Company Act, currently being drafted by a Drafting Committee

appointed by NCCUSL in summer 1992. (See a full description of ULLCA in Sect ion E., below.).

"TUPA " Texas U niform Partnership A ct, art. 6132b, Texas Revised C ivil Statutes.

"TRLPA" Texas Rev ised L imited Partn ership Act, a rt. 613 2a-1 , Tex as Re vised Civil S tatutes (g enera lly , but

not identically, con forming to 1985 R ULP A).

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"TRPA" Texas Revised Partnership Act, art . 6132a-1.01-10.04, Texas Revised Civil Statutes (generally, but

not identically, con forming to RUP A).

"TLLCA" Texas Lim ited Lia bility C om pany Act, a rt. 1528n, §§ 1.01-9.02, Texas Revised Civil Statutes (Supp.

1993), in its second generation after 199 3 amen dmen ts.

J. UNIFORM LIMITED LIABILITY COMPANY LEGISLATION.

2. Background.

The LLC movement focused on obtaining in a single business entity a combination of limited liability

for all of the owners of the business with federal partnership taxation of the entity. No othe r business en tity form

offered this un ique c om binatio n. Th e origin al dom estic lim ited liab ility company statute was adopted in Wyoming

in 1977. The Wyoming LLC Act was tailored in a bulletproof manner to, i t was hoped, achieve a pa rtnersh ip

taxation ruling; that is, i t required that all LLC's conform to a certain format that was anticipated to be looked upon

favo rably by the Internal Revenue Service. However, the Wyoming Statute did not receive approval by the

Internal Rev enue Serv ice un til a 1988 public ruling (Rev. Rul. 88-76). Florida enacted LLC Legislation in 1982,

but received no ruling as to tax ability as a partnership until 1993 (R ev. Rul. 93-5 3).

4. IRS Rulings Since 1988.

The Internal Revenue Service conducted a study before its 1988 decisio n on the W yom ing L LC A ct;

since its 1988 ruling, the Service has enco urag ed the prolifer ation o f state L imited Liability Com pany enac tmen ts

through release of a multitude of private letter rulings and thirteen more public revenue rulings, through early

1994. As a result, states enthusiastically responded, many at the urging of various bar associations. As of

Februa ry 1994, 37 states h ave adopted LLC Statutes, the vast major ity of them (30) in 1992 and 1993. LLC

legislation is pending in all remaining states and the District of Columbia and it is anticipated that a substantial

number of additional state statutes will be adopted in 1994, including New York and California, both of whom

have had pending legislation for at least two years. (See Appendix A for a list of states and reven ue rulings).

6. NCCU SL Project.

b. Initiation.

The National C onferenc e of Com missioners on Uniform State Laws ("NCCUSL ") appointed

a study com mittee whic h in ea rly 19 92 re com me nded that a L imi ted Liability Company project be undertaken.

A Draf ting Comm ittee was appointed in the summer of 1992. Since then, the Drafting Committee has been

working and has prepared a draft Uniform Limited Liability Company Act ("ULLCA"). The draft act received

a first reading at the annual meting of the Conference in August of 199 3 and it is anticip ated th at a second (and,

it is hoped) final reading and approval will take place at the NCCU SL annual meeting scheduled for August of

1994.

d. Seco nd G enera tion S tatute .

The ULLCA draft has attempted to be a second gene ration L LC A ct. The variou s state ac ts

were patterned after a variety of formats and differ widely. As noted above, the Wyoming Statute was adopted

in a bulletproof format and has been followed by a number of states. On the other hand, recent state statutes have

been mu ch m ore flex ible. Th e NC CU SL s tudy noted that w hile pro mo ting flex ibility for each state en actm ent,

state law d iversity mig ht ultim ately im pede the pre dictab ility and therefo re the u tility of inte rstate L imited Liability

Com pany busin ess ac tivity; thu s they saw the ne ed fo r a Un iform Act.

SAW - 6

f. RUPA /RULPA M odel, But Significant Differences.

Initially, the ba sic structure of the draft U LLC A follow ed the Re vised Un iform Partnership Act

(RUPA) and where applicable the Revised U niform Lim ited Partnership Act (RU LPA) as m odels. It also included

conc epts from the M odel B usine ss Co rpora tion A ct. However, in the course of the drafting and revision, some

of RUPA/RULPA ideas have been discarded to more clear ly a l ign an LLC as its own creature with significant

differences from the trad itional p artners hip en tities, altho ugh retainin g the p artners hip p ass-thr oug h taxa tion go al.

h. Flex ibility.

The major determination of the D rafting Com mittee was that U LLC A sh ould be a fle xible

statute offering the ability to tailor an LLC to various needs. For instance it has provided for the organization of

LL C's by a s ingle in dividu al ( th e is su e of w hether this will be acceptable to the Service is sti ll open. See the

discussion in Section V.B.1., below). It also provides that an LLC may be organized for any lawful purpose, rather

than requiring it to be organized for profit. This is mo re in the corporate mode rather than in the partnership mode.

ULLCA in its current draft form also provides for conversions of partnerships, l imited partnerships and

corporations to LLC 's, and for mergers am ong the various en tities.

j. Open Issues.

There are so me issues still to be resolved, such as: should any portion of an operating

agreement be required to be in wri ting; what is the extent of fiduciary duties among mem bers and m anagers;

defau lt rules for distributions; disassociation rules; and what constitutes notices of limitations on authority, among

others.

l. IRS Blessing.

If approved by the Conference at i ts 1994 summer meeting, it is hoped by the D raftin g

Comm ittee that ULLCA w ill receive an affirmative blessin g by the R even ue S ervice . This w ould enco urag e its

adoption as a second generation statu te replacing early statutes or providin g for the basis to m odify existing state

LLC statutes.

8. Sup plem ental M aterials .

Ribstein and Keating on Limited Liability Companies Shepard's/M cGraw-H ill, Inc. (2 volume s)

(updated annually) This set contains a through analysis of all factors relating to Limited Liability Companies, and

a detailed discussion of business organization choice, business and ta x issue s. It com pares the diffe rent state

statutes with respect to various issues relating to formation and operation of LLCs. It includes the text of all state

statutes, and the Prototype Act prepared by the section of Business Law of the American Bar A ssocia tion an d all

statutory cites and forms.

Gue, Thomas Earl - Understanding the Lim ited Lia bility C om pany : A B asic Com parative Primer (Parts 1

and 2) 37 Sou th Dako ta Law R eview, V olume 37, Issues 1 a nd 3 (19 92) T his arti cle is a scholarly view of the

entire subje ct of L imited Liability Com panie s and related legislatio n plus an in depth discussion of the federal

taxation issues.

VI. FEDERAL INCOME TAX CLASSIFICATION -- INTRODUCTORY DISCUSSION.

The controlling desire for partnership treatment for federal income tax purposes often quickly narrows the

choice of entity process to a comparison of partnerships (limited or general, but more often limited), LLC's and,

SAW - 7

less frequently, S Corps. The price exacted by the IRS for partnership tax treatment -- for partnerships and limited

liability com panie s -- is that th e entity "look" m ore like a p artners hip tha n a co rpora tion, m easu red ag ainst ce rtain

characteristics. S Co rps are like other corporations, except that certain very strict statutory limitations must be

observed. The refore , this disc ussion of par tnersh ip tax tre atme nt and corpora te cha racteristic s app lies on ly to

partnerships and LL C's.

[Because of the impo rtance of the topic to th e choice o f entity discus sion, and because reference s to the

issue appea r frequen tly in this paper, i t was fel t that a discussion here would be useful. But, in some

later sections, the substantive issue is treated relatively fully, to avoid constant cross-references (and

page-flipping). Much of the following discussion is taken from C lifton, Fijolek and Sim on, An

Expanded Analysis of Texas Limited Liability Companies, and w ith citations thro ugh Ju ly 1, 1993 . This

Article III. is referred to e lsewhere as "TA X CL ASSIF ICAT ION." ]

B. SUMMARY OVERVIEW OF CORPORATE CHARACTERISTICS.

2. Formation Alone Is Not Enough.

Formation of an entity as a limited partnership or an LLC is not sufficient to assure partnership tax

treatment for fed eral inc om e tax p urpo ses. Ins tead, th e entity mu st be stru ctured to hav e (or n ot have) certain

characteristics. The specific entity created for the specific transaction, having (or not) one or more characteristics

that i t is allowed but not required to have, must be tested against certain characteristics to determine federal income

tax classification.

4. Four Critical Characteristics.

The definitions of partnership and corporation are found in Section 7 701(a)(2) an d (3), respectively,

of the Internal Re venue Code of 1986 , as amen ded (" Code"). Treasury Regulations §§ 301.7701-1 through -3 (the

"Regulations") expand the basic definitions and address the classification of organizations as partnerships, or as

associations taxab le as co rpora tions. T reasu ry Re gulati ons § 301 .7701 -2(a)(1 ) lists the fo llowin g as th e six

characteristics that distinguish a corporation from other forms or organ izations, such as partnerships:

(i) associates;

(ii) business objective toward a division of profits;

(iii) continuity of life;

(iv) centra lized m anag em ent;

(v) limited liability; and

(vi) freely transferable interests.

Treasury Regulation § 301.7701-2(a)(2) notes that the first two characteristics -- associates and a profit-sharing

motivation -- are com mo n to all bu sine ss o rga niza tion s an d do n't contribute anything to the determination whether

an unincorporated organization shou ld be cons idered a partnership (good) or an association taxable as a corporation

(bad). Treasury Regulations § 301.7701-2(a)(3) accordingly makes the remaining four corporate characteristics

the keys to the classification issue.

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Thus, to avoid being taxed a s a corporation for federal income tax purposes, an entity must have two or less

of the four critical corporate characteristics.

6. "Other Factors" .

Whether an organization possesses or lacks a particular corporate characteristic requires a facts and

circumstances evaluation. Treasury Regulations § 30 1.77 01-2 (a)(1). " Othe r factor s" no t listed in the regulations

also may be co nside red w hen c lassifyin g an o rgan ization . See Larson v. Commissioner, 66. T.C. 159 (1976); Rev.

Rul. 79-106, 1979-1 C.B. 448 (identifying seven factors that are not significant "other factors"); and GCM 38281

(the Service appa rently con clude d that th e W yom ing L LC s tatute's tre atme nt of W yom ing L LC's as "en tities" co uld

cons titute a significant "other factor" in determining par tnership or association classification). To date, how ever,

the Service has not cons idered any "other fac tors" in any c lassi ficat ion rul ing involving an LLC.

8. History of the Regulations.

For those interested in more detail, Section 3.06 of McKee, Nelson and Whitmire, Federal Taxation

of Partnerships a nd Partne rs, second ed ition (1990), contains an instructive discu ssion of the history of Treasury

Regulations § 301.7701-1 through -3, which is a fascinating example of the relationship among the administrative,

legislativ e and judicia l branc hes o f the fed eral go vern me nt.

D . DETAILED DISCUSSION OF CORPORATE CHARACTERISTICS.

2. Continu ity of Life.

b. The Regulations.

Con tinuity of life exists when an organization is not dissolv ed on the death, insanity,

bankruptcy, retiremen t, resignation or exp ulsion of any mem ber. Treasury Regu lations § 301 .7701-2(b )(1).

Conversely, an organization that dissolves on the happening of one of these events to any member does not have

continuity of life.

Final regulations effective June 14, 1993 (T.D. 8475, 1993-23 IRB 11) relaxed the former position. The

Regulations now prov ide tha t a limited partne rship will not have continuity of life if, upon the occurrence of any

specified withdraw al event for a ge neral partner, the partnership may be continued by consent of (i) the remaining

general partners or (ii) at least a majority in interest of all remaining partners. The movem ent to a ma jority in

interest standard (versus the form er un anim ous c onse nt) by the final Regulations is a positive development in the

classification area, allowing greater freedom to provide for co ntinuation of the business on the separation o f a

mem ber. Unfortunately, the Regu lations refer only limited partnerships and do not add ress LLC's.

d. The Service's Position.

Rev. Proc. 89-12, 1989-1 C.B. 798, as applied to limited partnerships organized under a statute

corresponding to the RULPA, requires only the vote of a majority in interest of the lim ited pa rtners to continue

the partnership on the removal of a general partner. Rev. Proc. 92-35, 1992-18 I.R.B. 21, modified Rev. Proc. 89-

12 by providing that continuity of life will not exist in a l imited partnership formed under a statute conforming to

RULPA if the partnership may be continued upon the bankruptcy or removal of a general pa rtner only on the vote

of (i) the remaining general partners or (ii) at least a ma jority in interest of all remaining partners. As n oted in

Section B.l.a., above, now final Treasury Regulations § 301.7701-2(b)(1) also applies this more favorable standard.

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Un til recently, the Service's ruling position for LLC's to avoid continuity required unanimous consent for

continuation. For example, in PLR 9010027, the Service ruled that a Florida LLC had continuity of life because

its articles (as permitted by the Florida Act) allowed continuation after the occurrence of a dissolution event by

a ma jority (rather than unanimo us) vote. Consistently, the Service ruled in PLRs 8937010, 9029019 and 9030013,

that a Flor ida LLC lacked continuity of life when its articles required a unanimous vote to con tinue th e LL C's

business u pon a m emb er's ceasing to be an LLC mem ber.

The situation for LLC's is improving. Another private letter ruling, PLR 9308027, expressly stated that an

LLC did not have continuity of life where dissolution occurred upon specified events and the election to continue

the LLC was mad e by a majo rity of m anag ing d irectors and a majo rity in inte rest an d nu mb er of all r em aining

mem bers.

f. Conclusion.

Som e states' statutes, e.g. W yom ing's, p reclud e con tinuity o f life; othe rs (e.g., T exas ) perm it

flexibility in the o rgan ization al structu re of th e LL C, the reby allow ing the LLC mem bers to dete rm ine whether

their LLC will or will not hav e the corpo rate characteristic of con tinuity of life. Unless th e me mb ers tak e full

advantage of the available flexibility in the operating agreement, however, even LLC's formed in states where the

flexibility is allow ed w ill not ha ve co ntinuity of life. Th anks to Rev. Pro c. 92-35 an d the new ly revised Tre asury

Regulations § 301.7701-2(b)(1), it now is apparent that a majority in interest stand ard (n ot un anim ity) exis ts

regarding the effect of having the abili ty to continue a limited partnership on the oc curre nce o f a disso lution e vent.

Further, because PL R 9308 027 has ado pted the same m ajority in interest standard for an LLC, it now appears that

LL C's and limited partnerships will be treated the same on the cont inui ty of l ife issue. One day, perhaps, the

Service will treat LLC's and limited partnerships con sistently on all classification issues.

4. Centralization of Management.

b. The Regulations.

An organization will have centralized m anagem ent if any person or group of persons consisting

of less than all the owne rs has the continuing exclusive autho rity to make ma nagem ent decisions for the business.

Treasury Reg ulation s § 30 1.77 01-2 (c)(1). T he ke y is the man ager's a bility, as a man ager a nd n ot as an own er, to

contr actua lly bind the organization. But, the Service recognizes a safe harbor of 20% -- Rev. Proc. 89-12 provides

that a limited partnership w ill not have cen tralization of man agem ent whe re general pa rtners own 20% or more

of the partnership interests. The theory is that a g enera l partne r with s uch a subs tantial sta ke as an ow ner is acting

for itself, not just in a representative capacity for the limited partners.


(1) The Serv ice's po sition is re ason ably c lear tha t centra lization of m anag em ent is

avoid able for lim ited pa rtnersh ips. W ith two favo rable LLC private letter rulings relating to limite d par tnersh ip

safe harbors in the area of continuity of l ife and free transferability of interests, and the frequent reference by the

Serv ice to R ev. P roc. 89 -12 in private letter rulin gs inv olving LLC 's, it was reasonable to conclude that an LLC

managed by m anag ers w ho o wn 20% or m ore o f the inte rest in th e LL C w ould not have centralized management

(in other words, that non-manager members and limited partners, and member-managers and general partners,

wo uld be considered functionally the same). Quite surprisingly, the Service in Rev. Rul. 93-6, held that a Colorado

LLC with five members, all of whom were also m anagers, had centralization of ma nagem ent because management

of the LLC was vested in managers, not members. Rev. Rul. 93-6, 1993-3 I.R.B. 9, 10.

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1 A post-script -- Revenue Procedure 95-10 was issued in late December 1994.

(2) Rev. Rul. 93-6 appears to directly contradict the ap plicab le Treasury Reg ulations,

which prov ide tha t "an o rgan ization has ce ntralize d m anag em ent i f any pers on (or any grou p of persons which

does not inc lude a ll the mem bers) has continuing exclusive authority to make the management decisions necessary

to the conduct of the business for w hich the org anization w as forme d." Treasury Regulations Section 301.7701-

2(c)(1) (emph asis supplied). Th e apparen t rationale for the Serv ice's holding that the C olorado LLC had

centralized management is that the decision-making authority rested with the members as elected managers, not

as members. Nevertheless, the express language of the Treasury Regulations, stating that centralized management

exists only where the d ecision-making g roup does not include all m emb ers of the organ ization , is clearly

contradictory.

(3) The Service's em phas is on th e electiv e pos ition of m anag ers sug gests th at only

LL C's that reserve management exclusively to their members, as members, can avoid having centralization of

ma nage me nt. This holding in Rev. Rul. 93-6 is unfortunate and may create a significant problem for many existing

LL C's that ve st ma nage me nt in m anag ers an d po ssess e ither (bu t not b oth) o f the characteristics of free

transfe rability of interests or continuity of life. Those LL C's will now hav e to disclose th is issue in their tax

returns, beca use th eir partn ership classification will be in direct conflict with published authority on the issue. And

in Colorado, that statute requires that LLC's be m anaged by manag ers.

(4) The re is som e hop e that th e Ser vice w ill soon rem edy th is ano ma ly. As part of

its business plan for 1993, the Service indicated that it will issue a revenue procedure providing guidance on the

classific ation o f LLC s. High lights & Doc um ents, January 19, 1993, 1415, 1419.1

f. Conclusion.

While many LLC statutes allow management either by managers or members, as prov ided in

the LLC's articles of organizat ion, the cu rrent p osition of the S ervice appe ars to b e that u nless m anag em ent is

reserved to the members, the LLC will have centralized management. If managers/members are considered

comparable to general par tners in l imited par tnerships, then Rev. Proc. 89-12 supports the posit ion that an LLC

shou ld not have centralized management if the managers own at least 20% of the LLC interests. Aside from Rev.

Proc. 89-12, an inte resting ques tion aris es if an LLC reserv es m anag em ent to th e me mb ers w ho in turn d esign ate

one member to act on all but certain specified decisions pursuant to statutory proxy and other voting rights. The

effectiveness of such an a rrangem ent to avoid c entralization of m anagem ent characteriza tion may turn on whether

the desig nated "ma nagin g m em ber" w ould have the sam e app arent a utho rity as a g enera l partne r in a partnership,

as desc ribed in Tre asury Reg ulation s § 30 1.77 01-2 (c)(4). C om pare th e cen tralized man agem ent an alysis in

Exa mp les (2) a nd (3 ) to Ex am ples (4 ), (5) an d (6) o f Trea sury R egula tions § 301 .770 1-2(g ).]

6. Lim ited Lia bility .

b. The Regulations.

An orga nizatio n will have the corporate characteristic of limited liability if no member of the

organization has personal l iability for the debts of the organization. Treasury Regula tions § 301 .7701-2(d )(1).

For limited partne rships , limited liability m ay be prese nt wh ere the gene ral partner is w ithout s ubsta ntial ass ets

availab le to the partnership 's creditors and is a "d umm y" acting as the agent for the lim ited partners. Treasu ry

Regu lations § 301 .7701-2(d )(2).

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Because of th e sta tuto ry lim itatio n of a m em ber 's l iabili ty (which some states allow to be varied

in the operating agreement), no published LLC classification ruling has found that an LLC lacked limited liability.

Such a ruling shou ld be o btaina ble for a n L LC org aniz ed in a sta te (e. g. T exa s) tha t auth oriz es th e LL C's articles

or operating agreement to impose member liabi lity fo r the LL C's debts , if the pa rticular L LC in clude s the liab ility

provision. In the context of l imited partnerships, the Service has provided specific guidelines in Rev. Proc. 89-12

and GCM 39798, 1989-7 I.R.B. 22 (10/24/89), that describe minimum net worth safe harbo r requirements for

general partners for advance ruling purposes.

f. Conclusion.

As a gen eral rule , the LL C or p artners hip fo rm is chosen because of the abili ty to (i) l imit the

liability of the members and (ii) achieve classification as a partnership for federal incom e tax purposes.

Accordingly, LLC 's usua lly concede the corporate characteristic of l imited liability, which requires careful

organization to avo id the re ma ining th ree co rpora te cha racteristic s, to pro tect partnership classification status.

Limited partnerships have a bit more structural flexibility on the liability issue.

8. Free Tran sferab ility of Inte rests .

b. The Regulations.

Me mb ership interes ts are not freely transferab le under Treasury Regulations § 301.77 01-2(e)(1 )

unless each member (or those members own ing substan tially all of the interests in the entity) has the po wer,

without the consent of the other members, to substitute for himself in the same organization a person who is not

a member of the orga nizatio n. Fo r the req uisite po wer o f subs titution to exist, the mem ber m ust be able, a gain

witho ut con sent o f the oth er m em bers, to confer upon the member's transferee all the a ttribu tes o f the me mb er's

interest in the organization. Im porta ntly, free transfe rability o f interes ts will not exist w here th e votin g righ ts

associated with a member's interest are not transferable, even if the econom ic rights associated with the interest

are fully transferable.


Un til PLR 921 001 9, eve ry pu blishe d priv ate letter ru ling co ncern ing th e classification of L LC 's

created under a domestic LLC statute found the absence of free transferability of interests because unanimous

member consent was required to approve a subs titute member, even though no such unanim ity requirement applied

to transfers of the economic interests. Fortunately, PLR 9210019 confirms that a more flexible arrangem ent works,

too. There, it was determined that approval of a membe r's transfe r requ ires on ly the c onse nt of the sole

man ager/me mbe r, and the transfer of the manager/member's interest requires only the appr oval o f a m ajority in

interest of the m em bers. S ubse quen tly, PL R 92 190 22 h eld tha t appro val of o nly a majority in interest of the non-

transferring mem bers w as req uired to sub stitute a m em ber fo r ano ther. F inally, in Rev. Proc. 92-33, 1992-17

I .R.B. 28, the Service supplemented Rev. Proc. 89-12 by stating that with respect to the "substantially all" phrase

found in the Trea sury R egula tions, a p artners hip w ill lack fre e trans ferab ility of interests if throughout the life of

the partnership the partnership agreement expr essly restricts the transferability of partnership interests representing

mo re than 20% of all inte rests in p artners hip ca pital, inc om e, gain , loss, de ductio n and credit.

f. Conclusion.

The Treasury Reg ulation s divid e me mb ership interests into two components in testing for free

transfe rability of interests: (i) econ om ic rights -- i.e. the right to profits and distributio ns, and (ii) voting and

SAW - 12

management rights . As long as further member consent is required to approve the transfer of voting and

management rights, the entity w ill not ha ve free transfe rability o f interes ts wh ere the econ om ic rights are free ly

transferable. Thus, the critical question on the issue of free transferability of interests is: What level of other

member cons ent is requ ired? N o free tra nsfera bility of in terests e xists in the contex t of a limited partnersh ip where

the general partner has the absolute discretion to approve transfe rs of lim ited pa rtner inte rests. See Treasury

Regulations § 30 1.77 01-3 (b), Ex am ple (1) and P LR 9 014 030 . See also PLR 9210019, discussed above, regarding

manager approval of member transfers. Similarly, in Rev. Rul. 88-79, 1987-2 C.B. 361, the Service determined

that a Missouri business trust did not hav e free transferability of interests where a person could not become a

substituted participant without the approval of a ma jority of the managers. Then, in PLR 9219 022, discussed

above, the Service ruled that consent of a majority in interest of no n-tran sferring mem bers w as suff icient to

approve a substitution. Until PLR 9210019, i t was uncertain whether the Service had adopted a more restrictive

view toward LLC's by allowing only unanimous consent to transfers to avoid the characteristic of free

transferability of interests. That question appears to have been resolved in favor of a majority in interest and/or

manager approval standard for LLC 's.

10. Obtaining a Ruling.

b. Revenue Procedures.

In Rev. Proc. 88-44, 1988-2 C.B. 634, the Service removed from its "no ruling" area the

classification of LLCs und er Co de S ection 770 1, and then im me diately issued Rev. Rul. 88-76 classifying a

Wyoming LLC as a p artnership for federal income tax pu rposes. Shortly therea fter, the Service issued Rev. Proc.

89-12, 1989-1 C.B . 798 , as sub sequ ently amplified by Rev. Proc. 91-13, 91-1 C.B. 477, Rev. Proc. 92-33, 1992-17

I .R.B. 28 and R ev. P roc. 92 -35, 1 992 -18 I.R .B. 21 , dealin g with the conditions and requirements under which the

Service would consider the classification of an organization as a partn ership for federal income tax purposes. Rev.

Proc. 93-1, 1993 -1 I.R.B. 10, provides further information co ncerning the current ruling proced ure process.

d. Appl icabil ity of Rev. Proc. 89-12 to LLCs.

Although it does not dire ctly m ention LLC 's, Rev . Proc . 89-1 2 is refe rred to in almost ev ery

dom estic LLC private letter ruling. But, even though Rev. Proc. 89-12 is procedural ly capable of addressing LLC

classification issues, fundamental differences in the nature of LLC's and limited partnerships suggest that rulings

in this area would be improved by the issuan ce of a separate revenue procedure for LLC's, or a modification of

Rev. Proc. 89-12 to directly address LLC concerns. For example, consider the minimum capital account

requ irem ents of Section 4 .03 of Re v. Proc. 89 -12 -- the pro vision applie s only to gen eral pa rtners a nd p resum ably

is related in some way (although not expressly) to the test for limited liability, which most LLC's will concede.

Un til the Service issu es additional ruling s with safe ha rbors comparable to those found relating to limited

partnerships, the tax classification of LLC's is unnecessarily uncertain.

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VIII. DETAILED, COMPARATIVE DISCUSSION OF LIMITED PARTNERSHIPS, LIMITED LIABILITY

COMPANIES AND S CORPORATIONS.

This Article IV is a comp arative discussion of limited partnersh ips ("L P'ships"), limited liability companies

("LLC 's") and sub chapter S c orporations (" S Corps"), against the factors listed in Section II .B., abov e. For each

factor, there is a brief summary at the beginning, followed by a detailed discussion.

B. FORMATION AND MAINTENANCE REQUIREMENTS.

The ease and expense of forming and maintaining the entity:

SUMMARY

L P'ship Formation can range from a "standard" agreement to a highly-negotiated,

complex d ocumen t custom-crafted to fit the pa rties' business needs.

Usually, there are no ongoing maintenance requirements, except to reflect

changes in the identity or address of GP's, unless the governing

jurisdiction h as an an nual filing o r fee require ment.

LLC From a documentation standpoint, a hybrid between S Corp and L P'ship,

but comparable to L P'ship.

As with partnerships, can range from very simple to complex, expensive

and time-consuming.

S Corp Except for the requirement to make an election, requires normal

corporation formation.

General corpora te maintenance requirements (annu al meetin gs, corpo rate

formalities), but VIP need to ensure that no non-qualifying persons

become sh areholders.

Winner: For pure simplicity, S Corp , if there is a " plain va nilla" busin ess deal,

with fixed ow nership and m anage ment (i.e . if the busin ess deal do esn't

require a complicated buy-sell or other shareho lders' agreement).

However, the range for any of the three forms is from quite lengthy

and co mplicat ed docu menta tion to a st andar d, off-the -shelf mo del.

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b. Certific ate of L imited Partn ership .

(2) Basic Req uirem ents .

To become qualified as a limited partnership, a partnership must fi le a certificate of

limited partnership with the Secretary of State or equivalent office of the state of formation. Under RULPA and

similar modern statutes, the certificate must include only very limited information:

(a) N a m e. The name of the lim ited pa rtnersh ip (wh ich typ ically m ust co ntain

the wor ds "L imited Partn ership ," "Limited," or the abbreviations "L.P." or "L td.," as the last words o r letters

of the nam e, and m ay not co ntain the nam e of a limited pa rtner who is not also a gen eral partner);

(b) Address - Registered Office. The address of the registered office and the

name an d address of the registered agent in the state of formation for service of pro cess;

(c) Address - Principal U.S. Office. The address of the principal office in the

United States wh ere records are to be kept for inspection pu rposes;

(d) General Partner Information. The name, and the mailing and street address

of each general partner; and

(e) Other. Any other matters the general partners desire to include.

(4) Effect of Non-Compliance.

If there is a defective filing, unless there is "substantial compliance" (whatever that

means) with th e requ irem ents for the filing of the certificate of l imited partnership, the partnership may be treated

as a general partnership, thereby exposing limited partners to personal liability for the partnership's obligations.

No te that the Texas statute contains a unique provision allowing a would-be limited partner caught by a defective

filing to file a statement that it believed that it was a limited pa rtner. Tha t filing pro tects the perso n from liability

for up to 180 days (TRLPA §3.04); thereafter, further action, such as fil ing a suit , is required to continue th e

protection. TR LPA §3.04(b).

d. Execution.

The original certificate of limited partnership must be signed by all general partners. Unlike

under the ULPA requirements, RULPA and other modern lim ited partnership statutes do not require limited

partners to be named in or to execute the cert if icate. The limited partnership commences either when the

certifica te is filed w ith the d esign ated sta te filing office, and the filing fee is paid, or at a later date specified in the

certificate.

f. Maintenance -- Amendment .

On ly a few events -- including (i) the admission of a new general partner, (ii) the withdrawal

of a general partner, (iii) a change in the n a m e of the lim ited pa rtnersh ip or (iv) a change in the registered office

or name or address of the registered agent -- require the amendment of the certificate of l imited partnership. The

amendment is required to be filed within 30 days o f the ev ent. A lso, the general partner must promptly file an

SAW - 15

amendment if the general partner become s aware that a certificate is false in any material respect, but has no

liability if it files the a me ndm ent w ithin 30 days after it first has or should have had knowledge of the material

falsity.

h. Limited Partnership Agreement.

Unlike statutes governing general partnerships and joint ven tures, RUL PA an d other m odern

limited partnership statutes require that the partners enter into a partnership agreement, but the agreement may be

oral. See, e .g ., TRLPA §2.0 1. H owever, certain essential terms of the partnership agreement, such as the

allocation of profits and losses and the sharing of distributions, must be in writing or they will be governed by the

statute, as a fallback.

Although the limited partnership agreement can be combined with the certificate of limited partne rship, it

usua lly isn't, because the partners don't want the terms of their internal agreement to be m ade public via the

certificate. Also , inclusio n of u nnec essary items in the certificate increases the chances that a change will occur

with respect to one, which increases the general partner's "no false certificate" burden (see paragra ph c., abov e).

Filing a combined document was common under ULPA, where many more things were required to be in the

certifica te to validly be part of a particular partnership, but can be exp ected to be very rare und er modern statutes.

j. Statement of Pu rpose.

In a limited partnership, there can be competing considerations between the general and limited

partners regarding the statement of purpose:

LP 's - On the one hand, there may be tension between the limited partners ' wanting some control over

the sco pe o f the gen eral par tner 's free dom to ac t (ofte n, w ith th e lim ited par tner s' m one y!) a nd t he g ene ral p artn er's

desire, or need, for a free hand to cond uct the partnership's business.

GP's - On th e othe r han d, the g enera l partne r ma y wa nt the purpose to be narrowly defined so the

general par tner may more safely engage in independent business activities in the same industry without fear of

improperly competing with the partnership in violation of i ts duty of loyalty.


b. Articles of Organization.

The orga nizatio n req uirem ents u nder a state's L LC s tatute to form an L LC a re typic ally

com parab le to the requirements under the state 's Business Corporation Act to form a corporation. In Texas, for

example, the required filing is of an LLC 's Articles of Orga nization ("Articles"), which are sim ilar and func tionally

equivalent to, a corporation's articles of incorporation.

Article 3.02 o f the TLL C Ac t requires the A rticles to contain the follow ing items (a fairly typ ical list):

(2) N a m e. Name of the LLC.

(4) Term . The period of the LLC's duration (original statute impo sed m aximu m term

of 30 yea rs; recent ame ndm ent allows p erpetual term , but the term m ust be stated).

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(6) Registered Agent. The n am e and addr ess of its register ed ag ent.

(8) M anagement Authority . Names an d addresses of the initial manager or m anagers,

if management authority is to be placed with one or more managers, and a statement of that fact. If, on the other

hand, management is reserved to the members, the names and add resses of the m emb ers must b e included . (As

discussed above, "TAX CLAS SIFICATIO N," Article III., and in Section G ., below , vesting man agem ent in

man agers (even when they are members) currently results in the LLC's having the corporate characteristic of

centralized m anagem ent).

The Articles ma y contain o ther provisions that the organize rs desire to include relating to the LLC's internal

affairs, so long as not inconsistent with other law.

Article 2 .03 of the Texas TLLC Act, as recently amended, requires that a Texas LLC's name contain one

of the follo wing : (i) "Lim ited Liab ility Company," (ii) "Limited Company," (ii i) "L.L.C." (this natural abbreviation

was just add ed), (iv ) "LL C," (v ) "LC ," or (vi) "L.C ."

d. Operating Agreement or Regulations.

An LLC is allowed by the enabling statute, but is not required, to adopt an operating agreement

(in Texas, the term "regulations" is used for the same functional document) governing operation and management

of the LL C. The operating agreement may contain any provisions for the regulation a nd m anagem ent of the affairs

of the LLC that are no t inconsistent with law or the Articles.

In one sense, the operating agreement serves the same purpose as the by laws of a corporation; however, they

really are more analogous to a l imited partnership agreement. In fact, the "fallback" or "default" provisions of

many LLC statutes are mo deled after, and therefore are very similar to, the fallback provisions of the state's limited

partn ership statute. Likewise, many of the sam e sub jects that c an be mo dified w ithin a lim ited pa rtnersh ip

agreement under the state's limited partne rship s tatute may be m odified in the L LC's oper ating a greem ent. (Note

that not a ll states allow the same degree o f flexibility in the op erating a greeme nt.)

For example, among the things that many LLC acts allow to be controlled by the operating agreement are:

(i) indemnification of managers an d offic ers; (ii) requirements for admitting a member after the LLC has been

formed; (iii) limitations on assignment of a membership interest; (iv) the manner in which distributions are to be

shared; and (v) specifications of events that will cause a dissolution.

The initial operating agreement of an LLC usually is adopted by the manager or managers named in the

Articles, or by the members (if management has been reserved to the members, as allow ed in most states). The

mem bers (who need not be managers) may thereafter repeal or modify the operating agreement or adopt a new

one. The operating agreement may provide that m anag ers can not alte r, am end o r repea l the op erating agree me nt,

either in who le or in part (as describe d in the ope rating agreem ent).

Most real estate owners who otherwise would have used a limited partne rship, a nd th eir cou nsel, typica lly

will spend considerable time drafting and adopting customized regulations to fi t the particular business

relationship. Care must be taken, however, to count corporate characteristics, because taking advantage of the

flexibility offered in a particular area may caus e an L LC to have a corp orate c harac teristic that it oth erwis e wo uld

not have . Therefore, the flexibility offered by many LLC statutes should not be blindly enjoyed. See the detailed

discussion in Article III., above, " TAX CLA SSIFIC ATIO N."

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6. S Corporations.

b. Req uirem ents .

In additio n to the form ation re quire me nts for regular, or "C" corporations (e.g. filing Articles

of Incorporation, paying initial franchise taxes and filing fees, adopting bylaws, etc.), several requiremen ts must

be met and maintained to ensure S Corp status, including the following:

Special S Corp Limitations

! The corporation must not be a member of an affil iated group;

! The corporation may not have more than 35 shareholders at any one time;

! The corp oration may not ha ve sh areho lders w ho ar e not in dividu als or who are

non-resident aliens; and

! The corporation may not have more than one class of stock (although differences

in voting rights are p ermitted).

These restrictions must be kept in mind (and relevant facts obtained from the c lient) when th e various en tities are

being evaluated. In so me ca ses (e.g. whe n a paren t/subsidiary relationship or foreign ow ners are involved), an S

Corp cann ot be u sed. B ecau se tran sfers to n on-q ualifyin g sha reho lders w ill cause the ele ction to lapse, it is crucial

to disallow (generally through a sha reholders' agreemen t) those transfers.

d. Election Pro cedure .

A corporation may elect S Corp status for a current year at any tim e dur ing the prior tax able

year or at any time on or befo re the 15th d ay of the third m onth of the c orporation's cu rrent tax year. The election

is ma de by the co nsen t of all share hold ers an d the filin g of IR S Fo rm 2 553 . Failing to timely make the election

may result in an unanticipated "conversion," with attendant, undesirable tax consequences. (See paragraph c,

imm ediate ly follow ing.)

f. Conversion.

A corporation converting from C Corporation to S Corp sta tus is not subject to tax on the

conversion but may be subject to a corporate level tax on the sale or disposition of an asset that was held on the

effective date of its election and had a fair market value in excess of its tax basis at that time ("a built-in gain").

This tax may be imposed on any built-in g ain for a period of ten years after the conversion.

Similar issues exist regarding contribution to or distributions by an S Corp (or C Corporation) of properties

with built-in gain. By comparison, prop erty is m uch m ore ea sily co ntribu ted to a nd d istribute d from a partn ership

or an LLC on a tax-free ba sis. See the brie f, com parativ e discu ssion b elow at Section H. "Getting The Value

Out."

D. EXTENT OF LIABILITY.

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The extent to which the owne rs are liable for the obligations of the business is usually a controlling issue

in choosing the entity:

SUMMARY

L P'ship LP's have no liability unless they participate in the control of the

partnersh ip in certain circumstances; but, L P'ships are required to have

a GP with unlimited liability.

With some potential tax implications, the liability problem can be

structured around by having an entity, such as a corporation or an LLC,

as the GP.

LLC Generally, sam e liability insulation as corpo rate shareholde r.

Better than L P'ship because there is no requirement to have a GP.

S Corp Absent a "piercin g the corp orate veil" situation, shareholders genera lly

have complete insulation from liability.

Winner: Slight edge to S Corporations and LLC's, but quite manageable for

L P'ships.


b. Limited P artners.

Absent a contractual im position of liability, (e.g., a guaran ty), limited partners g enerally are

not personally liable fo r the obligations o f a l imited partnership. Indeed, one of the key attractions of the limited

partn ership form is the limitation of the liability of a limited partner to its capital contribution to the limited

partnership, plus any cash or property the limited partner agrees in writing to contribute. Limited liabili ty may be

lost, how eve r, if (i) th e lim ited par tner 's surname appears in the partnership name or, (i i) in the abse nce o f certain

protections, if the limited partner active ly take s part in man aging the bu siness of the lim ited pa rtnersh ip. See, e .g.,

TRL PA § §3.03(a), (d).

(2) First Layer of Protection -- Safe Harbor. Most modern limited partnership statutes

(see, e.g. , RULPA § 3.03(b)) contain "safe harbor" provisions defining rights and actions that will not subje ct a

limited partner to liabili ty as a general partner, including:

(a) consulting w ith and adv ising a gene ral partner,

(b) acting as a contractor for, or an agent or employee of, the limited partnership

or of a gen eral partner,

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(c) proposing, approving, or disapproving certain matters relatin g to partnership

business (in some states, e.g. TRLPA § 3.03(b)(8)(K), this includes a very broad "any other matter stated in the

partnership agreement"), or

(d) acting as a surety for, or guaranteeing specific obligations of, the limited

partn ership .

Note : These safe harbor provisions, especially in states like Texas and Delaware,

allow the partners to give a very broad management role -- which, in fact, can approach

comp lete control -- to one o r more limited partne rs, with out en dang ering th e partn er's

limited liability.

(4) Second Layer of Protection -- Creditor Reliance. Even if the pa rticipatio n in

management by a limited partner whose name is n ot part of the partne rship nam e exceed s the defined " safe

harb ors," the limited partner will maintain limited liability except to third parties dealing with the limited

partn ership who (i) hav e actu al kno wled ge of the lim ited pa rtner's p articipa tion, and (ii) at the time of the

transaction and b ased on the limited partne r's con duct, re ason ably b elieve that the limite d par tner is a general

partner. See, e.g., TR LPA §3.03(a).

d. Gene ral Partners .

A general partner of a l imited partnership has the same personal liabil i ty for the limited

par tner ship 's obliga tions a s a gen eral pa rtner in a general partnership. Nevertheless , using a corporation or an LLC

to be th e gen eral pa rtner ef fective ly limits the personal l iabili ty of any individual to the individual 's investment

in the partnership or general partner. If the general partne r doe s not h ave a sepa rate ide ntity or is insu fficiently

capitalized, how ever, th e limite d par tnersh ip m ay ha ve the corp orate c harac teristic of lim ited liab ility. This

increases the pressure to avoid two of the other corporate characteristics, to maintain partnership tax trea tmen t.

See th e "TA X C LA SSIF ICA TIO N" d iscuss ion at Article III., above.


b. Gen erally .

The liabi l ity of a m em ber o r ma nage r of an LLC is com parab le to tha t of a co rpora te

sharehold er. The refore , the ge neral ru le is that LLC members and managers are not liable for the debts, obligations

or liabilities of an LLC, inclu ding un der a judgm ent decree, o r order of a cour t. See, e.g. , TLLC Act Art. 4.03.

In som e states, th e ope rating a greem ent of th e LL C m ay sp ecifica lly pro vide fo r a differ ent res ult.

The exceptions, as with the promised contributions of limited partners to a limited partnership, impose on

a member of an LLC perso nal liab ility to the LLC to perf orm any e nforc eable com mitm ent to contribute cash or

prop erty to or to perform services for the LLC. In some states, enforceability requires a written commitment. That

obligation can be waived by the consent of all members, or the operating agreement of the LLC may provide for

relaxation of the obligation, but those compromises are not binding on a credi tor who extends credit to the LLC

in relianc e on th e me mb er's com mitm ent to m ake th e con tribution . See, e .g., TL LC A ct A rt. 5.02 . Al so, in an

insolvency context, a member may be obligated to repay any distribution received if the member knew of the

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insolvency, which is the s ame res ult under TRLPA §6.07 for distrib utions to a lim ited pa rtner. T LLC Act A rt.

5.09.

d. Interstate Activities of An LLC; Extraterritorial Application.

A key open issue involving use of the LLC form is the extent to which the limited liability of

mem bers will be respected when the LLC cond ucts business in states that have not adopted an LLC statute. The

fear is that the fallb ack position in those states will be to treat the members as general partners in a general

partnership, with each having joint, or joint and several (depending on the particu lar state's g enera l partne rship

rules), liability fo r the de bts and obligations of the LLC. Fortunately, the problem sho uld be diminishing -- alm ost

eighty perce nt (80 %) o f the U .S. states have now adop ted LL C leg islation a nd th e othe rs are c onsid ering it.

f. Doing Business In Other States -- Planning Ideas.

Comm entators have offered a number of structural planning ideas intended to overcome the

unce rtainty of l imited liability treatment in a state without an LLC statute, but each has one or more potential

drawback s. For example , one has sugges ted that an LLC register as a foreign corporation in states that do not

legislativ ely recog nize L LC's . The th oug ht is that th e regis tration w ould serve as notice and some authority to treat

the LLC as a corporation (with limited liability for i ts owners) in that state. However, i t simply may not be

poss ible to meet the qualification requirements of any given state, and there certainly is no guaranty that the

registration would bind creditors to LLC limited liability treatment of the me mbers.

h. Pierc ing T he V eil.

As described in the following Section 3.b., courts have developed a body of law allowing them

to "pierce the co rporate veil" to disreg ard the limited liability of share hold ers of a corp oration . It is conc eivab le

that, for an inadequately capitalized LLC, a similar approach will be taken. That prospect should be monitored.

6. S Corporations.

b. Shareh olders .

The key re ason for ch oosin g to op erate in corp orate fo rm is th e ava ilability o f limited liability

to the shareholders. Usually, the liability of shareholders is limited to their investment in the S Corp.

d. Pierc ing T he C orpo rate V eil.

Cou rts have deve loped a bod y of la w that allows them to "pierce the co rporate veil" to disreg ard

the limited liability o f share hold ers. Co urts loo k prim arily at the fo llowin g three factors to dete rmin e wh ether to

pierce the co rpora te veil:

(1) the failure to observe corporate forma lities;

(2) the domination of the corporation by a controlling shareholder; and

(3) undercapitalization of the corporation.

In most cases where the corporate veil has been pierced, the corporation has been used for an improper purpose,

and fraud or bad faith is involved.

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F. MANAGEMENT AND CONTROL.

The extent of participation in man agemen t and control desired by the ow ners:

SUMMARY

L P'ship Management is by the GP's or, frequently, a single Managing GP.

Howev er, there is grea t flexibility to alloca te mana gemen t authorit y

among all partners, including LP's (although, to avoid liability concerns,

some care must be taken in the case of LP's).

LLC Flexible alternatives to man age throug h mana gers (who need not be

members), or to reserve man agemen t to members, or a combination. But,

there are tax classification issues to co nsider if done throu gh man agers.

There are no liab ility concerns resulting from the mere fact of member

participa tion in ma nagem ent.

S Corp Normal corporate management structure: board of directors, officers, etc.

Shareholders can be in volved a s board memb ers and/o r officers, gen erally

without fear of liability.

In more com plicated situations, a voting agreem ent or other shareh olders'

agreem ent may be neces sary to reg ulate the co rporation 's mana gemen t.

Winner: No clear winner -- offsetting pluses and minuses with each.


b. Gen erally .

(2) Control V ested in Ge neral Partners .

Because the control of a l imited partnership is vested in th e general partners,

management tends, in a sense, to be centralized. For federal income tax pu rpose s, how ever, a limited partne rship

organized und er RUL PA or a sim ilar statute generally does not have the corporate characteristic of "centralized

ma nage me nt." The theory is that the gene ral partn er is acting in its own behalf, as well as for the limited partners.

But, as discussed in detail in Article III., abov e, the IR S w ill not giv e an adv anced ru ling that centralized

management does not exist (i) if the general partner owns less than a 20% interest in the limited partnership or

(ii) the limited partners have an unre stricted r ight to re mo ve the gene ral partn er. See , "TA X C LA SSIF ICA TIO N,"

abov e, Article III..

Exc ept as lim ited by statute o r by th e partn ership agree me nt, the g enera l partne rs in a lim ited pa rtnersh ip

have the powers of a partner in a general partnership. See, e.g., TRLPA §4.03(a). Limited partne rs ma y lose their

limited liability if the y activ ely pa rticipate in ma nage me nt (except as allowed under the safe harbo r provisions o f,

e.g., TRLPA § 3.03(b), including the potentially very broad Section 3.03(b)(8)(K) discussed above, and subject

SAW - 23

in all cases to the reasonable reliance limitation imposed on creditors). Under mod ern limited partnership statutes,

all partners and their assignees, acting d irectly o r throu gh re prese ntative s, hav e a bro ad righ t of acc ess to

partnership books and records and other information regarding the affairs of the partnership. See, e .g . , TRLPA

§1.07.

(4) Class es of V oting R ights .

The partnership agreement may establish various classes or groups of limited partners

having various rights, powers or duties, including voting rights. See, e.g. , TRLPA §3.02.

d. Fiduciary Obligations.

(2) Limited P artners.

Gen erally, limited partners do not have fiduciary obligations to each other or to th e

general partners. It is conc eivab le, how ever, th at a lim ited pa rtner g iven b road man agem ent righ ts und er a statu te

like TRLPA §3.03(b)(8)(K) has fiduciary du ties.

Note : A safe harbor like TRLPA §3.03(b)(8)(K) that allows limited partners to, in a

sense, "act like general partners," raises the issue of the standard of conduct to be applied

to a limited partner who permissibly exercises such control. Does the limited partner have

the same fidu ciary duty to the othe r partners a s a gener al partne r? One could resp ectably

argue that it should. A well-drafted partnership agreement should speak to the issue,

whether to state that the limite d partne rs have n o fiduciary duty to the other partners or that

they have the same fiduciary duty as a genera l partner. Q uery wh ether pub lic policy co uld

be invoked to strike down a provision absolving a "controlling" limited partner from any

fiduciary duty to the o ther partners.

One could seek to limit the fiduciary duty of a l imited partner -- and, perhaps, to preempt a court 's taking

a contrary position -- b y stipulating in the partnership agreement itself that the limited partner is not l iable for

actions "not opposed to" the interests of the partnership. On the other hand, if the limited partners are passive, the

agreement mig ht state generally that the limited partners have no fiduciary duties to one another or to the general

partners.

(4) Gene ral Partners .

Like partne rs in a g enera l partne rship, th e gen eral pa rtners in a limited pa rtne r sh ip owe

to each other and to the limited partners fiduciary duties of good faith, loyalty and due care.

(a) Betwe en Partners .

General partners at least, are fiducia ries to ea ch oth er with respe ct to pa rtnersh ip

business and, a ccord ingly, m ust act w ith loya lty, goo d faith, fa irness a nd h ones ty in de aling w ith each oth er.

These fiducia ry ob ligation s proh ibit partn ers from using partne rship a ssets fo r their ow n ben efit, com peting with

the partnership, usurping business opportunities of the partnership, or using confidential information for personal

advantage. Latter v. Kilbou rn, 150 U.S . 524 (189 3). State c om mo n law typica lly requ ires pa rtners to disclo se all

material facts known to them that relate to partnership affairs. For example, the court in Johnson v. Buck, 540

S.W.2d 393 (Court App. - Corpus Christi 1976), citing to the 1938 Texas Sup reme C ourt case of Johnson v.

Peckham , 120 S.W .2d 786, sum marized the duty a s follows:

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It is a rule of long standing that each partner in a partnership business is a confidential agent of the

other partner, and each is required to make full disc losure of all pa rtnersh ip facts k now n to him with

respect to partnership affairs.

Johnson v. Buck, at 399.

A partner must account to the partnership and hold as trustee for the partnership any be nefits or profits a

partner derive s, with out the cons ent of o ther pa rtners, fro m th e form ation, c ond uct, or liq uidatio n of th e partn ership

or from the partner's use of assets of the partnership. UPA § 21(1)

[Note : The only use in UPA of the term "fiduciary" is in the title of this Section: "Partne r Accou ntable

as a Fiduciary".]

(b) Pre-Formation.

Although the law in many states is not very well-developed on the issue, in some

states prospective partners appa ren tly do not owe each other fiduciary duties during pre-formation negotiations

leading to the creation of a partnership. See, e .g., Reyes-Retana v. PTX Food Corp., 709 S.W.2d 695, 697 (Tex.

App. -- San Antonio 1986, writ ref 'd n.r.e.) (holding that no fiduciary duty existed among parties agreeing to form

a partnership because no partnership existed when the challenged transactions took place). Th ere is a split of

autho rity in othe r jurisdic tions. S ee B RO MB ERG AN D R IBS TEIN , §§ 6.0 6, 6.07 , at 6:62-63, 6:72-73. The

general law of fraud and dec eit may, ho weve r, apply . See, e.g. Chien v. Chen , 759 S.W .2d 484 , 495 (Tex . App. --

Austin 1988, no writ) and BROM BERG AN D RIBSTEIN, § 6.06, at 6:63.

(c) Ratio nale .

F iduciary duties are owed by partners to each other largely because the parties

have joint and several liability for partnership debts and because their m utual agency relationship enab les any

partner to bind the partnership (and the jointly and severally liable other partners) to obligations created by the

partner within the scope of the partnership's business.


b. Choo sing M anagers .

An LLC's affairs are handled by its managers, unless the LLC's operating agreement reserves

all or part of the management authority to the members. See, e.g., TLLC Act Art. 2.1 2. R eservation to the

mem bers is much more likely and manageable in an LLC with few me mb ers, w ho all desire to be active in the

business (and , as no ted be low, h elps to avoid havin g the c orpo rate ch aracte ristic of centralized management. The

man agers are functiona lly equivalent to (i) the direc tors of a corpo ration and (ii) the m anaging partners of a

partnership, except that the mana gers do not have to be owne rs.

The number of initial managers is fixed by the Articles; thereafter, the number is fixed by and as provided

in the regulations. The man agers are elected annu ally by a vote of the mem bers . See, e.g., TLLC Act Articles

2.12-2.13. The managers may be divided into classes with staggered terms, if provided in the regulations. Un less

the regula tions requi re i t, the managers need not be e i ther sta te of formation res idents or members of the LLC.

SAW - 25

Note : Current IRS rulings provide that management through managers gives the L LC the c orpora te

characteristic of centralized management. This is discussed in more detail in the "TAX

CLAS SIFIC ATIO N" pro visions of Article III., above.

d. Action B y M anagers .

Many LLC statutes allow the managers considerable flexibility in conducting the LLC 's

business. In those states, such as Texas, the regulations (or operating agreement) are the blueprint, with the

enabling statute providing "fallback" rules where the operating agreement is silent. A typical statutory fallback

is action by a ma jority vote at a meeting attended by a majority of the managers. See, e.g. , TLLC Act Art. 2.16.

Other states, e.g . Colo rado , require that man agem ent be cond ucted by m anag ers (w hich p roba bly co ntribu ted to

the unfortunate conclusion of Rev. Rul. 93-6, discussed above in Article III.).

Also, the statutes vary in the level of statutory detail . For example, the TLL CA conta ins co nside rable d etail,

authorizing the establishment of committees, establishing quorum requirements and dealing with appointment of

officers. On the other hand, the approach of the ULLCA is to leave the details for coverage in the opera ting

agree me nt.

f. Individual Authority To Bind LLC.

LLC statutes are fairly sp ecific in desc ribing the ca tegor ies of p erson s wh o can create

obligations and d ebts binding on the LLC. Essentially, it 's a matter of authority, which can reside in the following

place s, subje ct to va riation b y the a rticles or oper ating a greem ent:

(1) One or m ore m anag ers, if management has generally been vested in a manager

or manag ers;

(2) A m em ber o r me mb ers, if management is retained by the members; or

(3) Any officer or other agent who has actual or apparent authority.

E.g., TLL C A ct Art. 2 .10. U nless th e auth ority to a ct wa s give n co- exten sively to more than on e of these groups,

the exclusive authority to act on behalf of the LLC would reside within the category to which management has

been given or reserved.

h. Rights of Members - Voting.

The rights o f me mb ers to vote on LLC matters have characteristics of shareholder and limited

partner rights. The m emb ers may vote on an y LLC matter prov ided in the articles or op erating agre ement,

including the election of managers at the annu al me eting of members. Among other things, the operating

agreement may p rovide for class v oting by m emb ers, entitling them to elec t one or m ore man agers . See, e .g.,

TLLC Act Art. 2.13.

As with the TBCA and the TRLPA, the TLLC Act allows the creation of one or m ore classes or groups of

mem bers having v arious rights, pow ers and duties , includ ing v oting r ights. T he reg ulation s (ope rating a greem ent)

may provide fo r the future creation of additional classes or groups of m embers ha ving rights, powers, or duties,

even if senio r to thos e of ex isting cla sses o r grou ps of m em bers. T LLC Act A rt. 4.02. Als o, the operating

agreement may conta in pro vision s gov ernin g the e xercis e of vo ting righ ts, including waiver of requirem ents,

actions by consen t without a meeting and proxy and q uorum req uirements.

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j. Fiduciary Obligations.

LL C's are too new to mak e definitive statem ents abou t the application to m emb ers or mana gers

of fiduciary duties. However, one can certainly make an educated prediction, and that's what is attempted here.

(2) Mem bers.

It is likely that members who are not man agers will have no fid uciary duties , as gen erally

is the case with passive limited pa rtners. (See the discu ssion at subp aragraph b.(1), above .) Mem bers wh o are

manag ers, on the other hand, may have fiduciary duties to the other members. In this status, a member/manager

is a hybrid b etween a general pa rtner, and a limited partne r autho rized to particip ate in management, with perhaps

a slight lean towa rd the gene ral partner end of that continuum. Therefore, the argument made in subparagraph

b.(1), abov e, that lim ited pa rtners in volv ed in m anag em ent co uld b e exp ected to hav e fiduc iary du ties, wo uld

apply.

(4) Man agers .

Man agers who are not members should have the same fiduciary duties as managers who

are members, and are fun ctiona lly much like corporate directors and officers. The precise nature and extent of the

duties will, perhaps, be defined by future case law.

(6) Legislation.

Second-generation LLC statutes will likely addr ess the fiducia ry responsibility issue.

For example, the draft ULLCA generally follows the mode l o f RUPA, imposin g on m anagers (w hether m emb ers

or not) the duties of loyalty, care and good faith, and providing that those duties can't be waived (although

standards by which performance of the duties is measured can be establis hed, if not ma nifestly unreaso nable). In

states that adopt a statute comparab le to RUPA , but which do n ot address LLC fiduc iary issu es dire ctly, it is

reaso nable to con clude that the cour ts of tha t state w ill look to the R UP A-eq uivale nt as a m odel.

Under U LLCA , memb ers who are no t managers w ill have no fiduciary duties.

6. S Corporations.

Like the shareho lders of a C C orporation, sh areholders o f an S Co rp may participate in the

management and control of the business, without endangering their limited liability. The shareholders of an

S Corp are not restricted in their participation as officers or directors of the S Corp.

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H. TRANSFERABILITY OF INTERESTS.

The extent and ease by which an ownership interest in the entity may be transfe rred, an d any und esirab le

consequen ces:

SUMMARY

L P'ship Transfers of a GP 's interest can cause dissolution and, therefore, typically

are restricted by contract. Such a restriction also helps on the "free

transferability of interests" tax classification issue.

Transfers of an LP's interest does not cause a dissolution concern.

Distinction betwee n transfer o f economic rights and tran sfer of partner

status, including (particula rly for GP's) man agemen t rights.

Because of fiduciary duties and other personal relationships, and

partnersh ip tax classificati on concerns, transfe rability and the right to

become a substituted partner are usually restricted.

LLC Same general concerns as with L P'ship.

S Corp Subject to securities laws issues and contractual limitations among the

shareholders, shares are freely transferable.

Free transferability creates a con cern regarding p otential tran sfers to

non-qualifying shareholders, which typically results in contractual

limitations amon g the shareho lders.

Winner: Limited partnerships -- currently treated less restrictively than L LC's;

S Corp shares are legally freely transferable, but contractual

limitations usually are imposed.


b. Assignment by Limited Partner.

Unless the partnersh ip agre em ent pro vides otherw ise, the e cono mic rig hts of a limited partner --

the limited partner 's share of profits and its share of the assets on dissolution -- may be assigned without the prior

consent of other partners and without triggering dissolution. The assignee has no liability as a partner unless the

assignee has become a substituted limited partner, which requires the approval of all other partners or an enabling

provision in the partnership ag reemen t. See, e.g., TRL PA § 7.02(a)(4).

d. Assignment by General Partner.

The assignment provisions of RULPA (§702) also apply to general partners. The Texas

counterp art has a unique provision that gives the limited partners, by the vo te of a m ajority in interest of the limited

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partners and in the absence of a co ntrary prov ision in the pa rtnersh ip agre em ent, the right to te rmin ate the general

partner status of a g eneral partner w ho assigns all rights as a general p artner. TRL PA § 7.02(a)(4).

f. Certificates of Partnership Interest.

To facilitate transfe rability, so me mo dern limited partne rship s tatutes (e .g., TRL PA § 7.02(c))

provide that a partnership interest may be evidenced by a certificate of partnership interest. Th ese certificates are

espe cially usefu l in large p ublicly -held partne rships to pro vide liq uidity to a limite d par tnersh ip interest, making

it more attractive to investors.

h. Tax - Corp orate C harac teristic .

An RULPA limited partnership lacks free transferability of interests (one of fou r key corp orate

characteristics, two of wh ich must be avoided to ensure partnership federal income tax treatm ent), unless partners

owning substantially all of the interests in the partnership have the po wer, without the c onsent of o ther partners ,

to substitute for themselves in the partnership a person who is not a partner. Treas. Reg. Section 30 1.7701 -2(e)(1).

The IRS has recently announced that i t generally will rule that a partnership lacks free transferability of interests

if, throughout the life of the partnership, the partnership agreement expressly restricts (within the meaning of

Treas. Reg. §301 .7701-2(e)(1)) the transferability of partnership interests representing more than 20% of all

interes ts in partnership capital, income, gain, loss, deduction, and credit . Rev. Proc. 92-32, 1992-18 I.R.B. 28

(April 27, 19 92).

VIP Note : Thus, even tho ugh mo dern limited partnership statutes allow a limited

partnersh ip agreem ent to give a n assigno r the unilate ral right to admit its assignee into the

partnersh ip as a new limited partner, such a provision should not be included without first

assuring either that more than 20% of the other interests are restricted or that at least two

of the other three corporate characteristics have been avoided.


Following the lead of sister l imited part nership statutes, LLC statutes generally allow the free

assignment of on ly econom ic rights, but not managem ent rights, and do not automatically confer member status

on the assignee. Rather, the assignor continues to be able to exercise all rights, including voting rights, that have

not been assign ed, un til the assig nee is admitted as a member in the manner provided in the operating agreement

or on the consent of all other m embers. As w ith many limited partnership statutes, s om e LLC statutes are flex ible

enough to enable the LLC's const ituent documents to permit free transferability of economic and management

rights.

Therefore, the free transferability advantage of oper ating in corp orate fo rm c an be obtain ed w ith an LLC

by writing the operating agreem ent to accomp lish the desired freedom. However, as noted above, there are critical

federal tax classification issues that m ust be taken into acco unt. Don 't blindly or blithe ly take adva ntage of this

freedom -- cou nt the characteristics.

6. S Corporations.

No direct restrictions are imposed on the transfe rability o f stock in an S C orp. As a p ractical matter,

how ever, freedom to transfer is lim ited by the rules gove rning eligible S C orp shareh olders -- certain transfers

SAW - 29

might violate the 35-shareholder l imit or result in an ineligible person (such as a corporation or a non-resident

alien) becom ing a shareh older.

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J. LEGAL FLEXIBILITY .

The extent to whic h the a ctions of the o wn ers of th e bus iness a re go vern ed an d limite d by law (a nd th eir

ability to contractually vary that result) and the ease with which the form of business can be changed:

SUMMARY

L P'ship. In most ways, en ormously flexible -- large ly a matter of contra ct among

the partners, with the statute serving only as a fallback.

Howev er, care must be taken to count corporate characteristics (such as

free transferab ility, which th e partner s are allow ed to crea te by contract,

but which can endange r partnership tax treatment) when deciding how

much of the freedom to use.

[Tax basis and related items are discussed in Section G., below.]

LLC Genera lly, same a nalysis as fo r partnersh ips; but, so far the IRS has not

treated L P'ships and LLC's exactly the same in the partnership tax

classification area (allowing somewhat less flexibility on certain issues for

LLC's).

[Tax basis and related items are discussed in Section G., below.]

S Corp Much less flexibility than with the other forms of ownership.

The limitations include inability to have corporate or nonresident alien

owners; tax basis available only for contributions and loans to the

corporation, but not for the shareh olders' perc entage sh are of corp orate

loans; and, inherently less flexible corporate structure.

Winner: Slight edge to L P'ships over LLC's (because of IRS anomalies), but

both are enormously flexible.

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Most provisions of modern limited partnership statutes can be altered by contra ct, giving particip ants

significant flexib ility in structuring the entity. Among other things, under the more flexible statutes, the

partnership agreement may:

! Establish multiple classes or groups of limited or general partners having va rious rights,

pow ers or duties, includin g voting righ ts (see, e.g., TRLP A §§3 .02, 4.05).

! Alloc ate profits a nd lo sses, an d dete rmin e distrib utions , with th e statute servin g on ly as

a fallback.

! Stipu late conditions for admission of a new limited partner after formation (otherwise,

all must con sent).

! Mo dify events o f withdraw al of general p artner.

! Impose liabili ty on a partner for contribution obligation and specify consequences of

non -pay me nt.

! Specify circum stanc es un der w hich a partne r is entitle d to a distribution be fore

withdrawal and before partnership liquidation.

! Provide for continuation of the business after dissolution.

! Allow a partner to adm it an assignee as a substituted partne r.

These are on ly a few of the m any a reas w hich th e sta tute allo ws to be co ntrolled by the limited partne rship

agreement. There is great flexibili ty.


As with lim ited pa rtnersh ips, a k ey ad vanta ge to th e LL C form of ow nersh ip is flex ibility. Generally,

the sam e flexibil i ty available to limited partnerships is available to LLC's, through customized articles and

operating agree me nts. A s with limited partne rships , how ever, th e flexib ility can carry a potential tax classification

risk that must be carefully evaluated -- one cannot blindly take advantage of the statutory flexibility in certain areas

without risking the pa ss-thro ugh partne rship ta x class ification that pro bably led to th e cho ice of th is entity in the

first place.

b. Statuto ry Fle xibility .

The s tates vary considerably in the f lexibil ity they allow the organizers and owners of an LLC

in structu ring th eir intern al relatio nship . The W yom ing sta tute (the first LLC statute), and those which followed

it, are relative inflexible. These are sometimes called "bulletproof" statutes beca use th eir lack of flex ibility, in p art,

ensures that partnership tax status will not be lost because of fa ilure to avoid the req uisite nu mb er of co rpora te

characteristics. Other statutes, such as Texas , Delawa re and the ULLCA, are more flexible, and are sometimes

referred to as "flexible bulletproof" statu tes. For example, Rev. Rul. 93-38, 1993-21 I.R.B. 4, the Service

evaluated the federal tax classification of Delaware LLC's formed under the Delaware Limited Liability Company

Act, using the following example of two LLCs: (1) one LLC did not vary from the default provisions of the

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statute, and was fou nd to have only the co rpora te cha racteristic of lim ited liab ility (wh ich, as n oted a bov e, is

usua lly conced ed); and (2) the second LLC took advantage of statutory flexibility to (A) vest management in three

man agers elected by the m em bers, (B ) allow an ass ignee to partic ipate in management of the LLC and (C) provide

that the LLC continued after the termination of membership of a mem ber, and w as found to have all four key

corporate characteristics.

The point here is that where a flexible statute exists, the drafter has the freedom to choose to have one o r more

corpora te characteristics. Where th e flexibility is used, there must be careful counting of characteristics to avoid losing

partnersh ip tax treatm ent.

d. Tax Classification Concerns.

As noted imm ediate ly abo ve, it m ay no t be ad visab le, at least fo r now , to take adva ntage of all

of the f lexibility offere d by man y LL C statu tes. Se e "TA X C LA SSIF ICA TIO N," a bov e, at Article III..

6. S Corporations.

In additio n to be ing su bject to the sam e una lterable state corporate laws as C Corporations, the tax

rules governing S Corps are m andatory and c annot be chan ged by ag reement. As a result, S Corp s are n ot nea rly

as flexible as partnerships or LLC's.

Furthermore, S Corps can only have one class of stock (contractual "sp ecial allocations" are n ot allowed ),

although differences in voting rights are allowed. As a result, preferences in interest in an S Corp can only be

achieved throu gh co mp ensa tion or debt a rrang em ents, o r other mo re com plicate d struc tures, a limitation that

seve rely reduces the entity's flexibility.

Finally, as noted above, tax basis is more difficult to obtain for an S Corp sharehold er than for a partner or

LLC mem ber.

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L. CONTINUITY OF EXISTENCE.

The exten t to wh ich the own ers de sire that th e entity have contin uity of existen ce ca n be im porta nt:

SUMMARY

L P'ship. Partnership statutes, w hich control in the a bsence of a co ntrary agreement

among the partners, prevent perpetual existence. However, subject to tax

classification issues, virtually perpetual existence may be provided by

contrac t.

But, the absen ce of a perpetua l continuity of life is a positive factor in the

partnership tax classification area.

Therefore, if continuity of life is provided for, then the other three

classification characteristics must be examined more closely.

LLC Governing statutes in different jurisdictions vary (e.g. some impose a

maximum term while others allow perpetual existence), but the

approp riate analysis is the same a s for an L P'ship -- if existence can

continue perpetua lly, then on e corpo rate char acteristic is present and the

other three mu st be exam ined close ly (and, w ith liability generally being

conceded, this leaves only two, both of which must be avoided to ensure

partnership tax treatment).

S Corp Typically, it has the perpetual existence of all corpo rations, bu t is subject

to loss of S Corp status if a non-qualifying party becom es a sharehold er.

Howev er, unlike L P'ships and LLC's, perpetual existence has no adverse

effect on federal incom e tax status.

Winner: If continuity of existence alone, with no hint of an adverse effect on tax

status, is desired, then S Corp wins. Generally, however, this is not

the most critical issue in th e choice of entity a nalysis.


b. Events of Dissolution.

Generally, a limite d par tnersh ip is diss olved whe n the firs t of the fol low ing occu rs: (i) a

dissolution event specified in the partnersh ip agreement; (ii) written consent of all partners; (iii) withdrawal

(including death and bankruptcy) of a general partner; or (iv) entry of a decree of judicial dissolution. The death,

bank ruptc y or o ther w ithdraw al of a lim ited pa rtner o r the as signm ent

of a l imited partner 's interest to a third party, however, does not affect the continuity of existence of the limited

partnership, unless the partners provide to the contrary.

d. Reconstitution.

After dissolution, a l imited partnership may be reconstituted and its business continued without

winding up or termination if (i) there is at least one general partner remaining and the partnership agreement

SAW - 34

perm its the bu siness to be c arried o n, or (ii) all of the partners agree in writ ing to con tinue th e bus iness w ithin

90 days after dissolution and ap point one or m ore new ge neral partners.

Importantly, som e limite d par tnersh ip statute s allow a limite d par tnersh ip to have a non-partner l iquidator

after dissolution, with expressed insulation from liability as a gen eral pa rtner. S ee, e.g ., TRLPA § 2.02(f), which

now also p erm its the ce rtificate o f limited partne rship to be am ende d to identify the non-partner liquidator (which

gives the liquida tor a great deal of c omfo rt).

f. Tax - Corp orate C harac teristic .

One of the fo ur ke y cor pora te cha racteristic s in the ta x class ification area is " contin uity of life."

Basically, continuity of life wil l not be found to exist if the partnership dissolves on the death, insanity,

bankruptcy, retirement, resignation or expulsion of any of its general pa rtners. Treas. Reg . §301.77 01-2(b)(1).

Continuation in the manner allowed under Article 8 of RULPA will not cause there to be continuity of life.

No te that the IRS recently announced that i t will not find that a limited partne rship h as the c orpo rate

chara cteristic of continuity of life if, under local law and the partnership agreem ent, the bankruptcy or removal

of a general pa rtner of a l imited partnership causes a dissolution of the partnership unless the remaining general

partners or at least a majority in interest of all remainin g partners agree to continue the partnership. Rev. Proc.

92-35, 1992-18 I.R.B. 21 (May 4, 1992). See Article III., above, "TAX CLASSIFICA TIO N," fo r a com plete

discussion.


If the operating agreement adopted for an LLC is silent regarding continuation after a dissolution, then

und er a typ ical LL C statu te (e.g., T LLC Act A rticle 6.0 1), and follow ing the limited partne rship m odel, th ere is

a dissolution on the first to occur of the following:

a. The period fixed for du ration of the LLC ex pires;

b. The occu rrence of events specified in the Articles or regulations;

c. Written consent of all mem bers;

d. The death, retirement, resignation, expulsion, bankruptcy, or dissolution of a member

or the occurrence of any other event that terminates the mem bersh ip of a m em ber in the LL C, unless there is at

least one remaining member and the business of the LLC is continued by the con sent of the nu mbe r of mem bers

stated in the articles or regulations or, if not so stated, by all remaining members; or

e. Entry of decree of judicial dissolution under Article 6.02.

Therefore, if the operating agreement is s ilent on continuation, the LLC would be wound up on dissolution.

Under current IRS posit ions, taken mainly in private le tter rulings (see "TAX CLASS IFIC AT ION ," abo ve, in

Article III.) , continuity of l ife will be found not to exist only if an LLC's operating agreement (or the statute, if not

in the operating agreem ent) requires unanimous consent of all members to continue. If the operating agreement

specifies continuation by a majority vote (as the RULPA also allows), then under current IRS interpretations the

LLC will have continuity of l ife. As a result, the rules are more restrictive for LLC's than for l imited partnerships

(for l imited partnerships, continuity of l ife will not be found i f the continuation under certain circumstances

requires a vo te of all remaining general pa rtners or at least a ma jority in interest of all remaining partners).

SAW - 35

6. S Corporations.

Corporations can h ave a perp etual e xisten ce. Unlike sole proprietorships -- and partnerships that do

not contractually provide for continuation after dissolution -- the removal, death or incapacity of a director, officer

or shareholder will not disrupt the continuity of the corporation.

Typically, the board of directors, together with a two-thirds vote of shareholders, or the shareholders alone

on unanim ous consent, m ay cause the dissolution of a corporation upon the filing with the Secretary of State of

articles of disso lution. See, e.g. , TBCA, Part Six. Additionally, the charter of a corporation may be dissolved by

the state for failure to pay franchise taxes.

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N. TAX CONSIDERATIONS.

The tax treatment of the entity, its owners and employees is often the single most impo rtant factor in the

entity-choice decis ion. A number of the relevant tax issues have been discussed above, in Article III., "TAX

CLA SSIF ICA TIO N," and sprinkled through the other sections. There is a discussion of important tax issues, also,

in Sec tion H ., following.

SUMMARY

The desire of most real estate owners for partnership federal income tax treatment (usua lly coupled with a desire

for limited liability) leads to narro wing the cho ices of entity to the three discussed in detail in this paper.

L P'ship. Ensuring partnership tax treatment by avoiding more than two of the four corpora te

characteristics (continu ity of life, limited liability, free transferability of interests and

centralizatio n of ma nagem ent) is para moun t.

Care, and giving up some of the available contractual freedom (e.g. not taking full advantage of

the ability to admit the transferee of a partner as a substituted partner), can ensu re partne rship

tax treatm ent.

Also, although the allocations must have "substantial economic effect" (i.e. affect your

pocketbook, not just your tax bill), partners are free to specially allocate tax items among

themselves in ratios different from their basic owne rship percentag es.

Subject to certain limitations and prerequisites, partners may obtain tax basis (against which

deductions m ay be taken) for the ir percentage sha re of partnership ind ebtedness.

LLC Essentially, LLC's are treated the same as partnerships -- subject to a couple of stricter

limitations and requirements, they allow for very flexible, and favorable, federal income tax

treatmen t.

S Corp Partners hip tax treatm ent results from (i) makin g the requ ired election and (ii) satisfying the

ownership requirements (e.g., no corporate or nonresident alien ow ners).

S Corps ca nnot mak e special allocations.

But, there are no c oncerns rega rding coun ting corporate ch aracteristics.

Winner: Flexibility favors L P'ships and L LC's.

L P'ships have a slightly ea sier time o f it in the cha racteristic s/classificatio n area; but, LL C's

have a potential tax basis advanta ge in qualifying fo r non-recou rse basis treatment for an

entity-recourse debt.

SAW - 37


Most partnership agreements drafted by counsel specifically cover the important issue of allocating

the federal income tax incidents of owing the real property. (Of course, not every effort to deal with allocations

is succ essfu l or cor rect, bu t it wou ld be u nusu al for the subje ct not to be co vered at all.)

b. Allocations v. Distributions.

One important point lost even on relatively experienced practit ioners is the distinction between

alloca tions and distributions. These areas are clearly related, and an allocation often affects the amo unt of a

distribution ( and the tax laws now essentially require that), but they aren't the same thing. The allocation of tax

items typically would cover profits and losses and, in some cases, specific deductions. On the other hand, the

distribution provisions directly deal with how and when the cash or other assets of the partnership are distributed

to the pa rtners. If th e partn ers are sharin g eve rythin g on a "he ads u p" ba sis -- that is, s trictly in accordance with

their profit-sharing percentages -- then neither the allocation nor the distribution provisions are complicated and,

in fact, can be very short. If , on the other hand, there are disproportionate "special allocations," then the allocation

prov isions often are quite lengthy and complicated (and require a tax expert 's help). They also tend to include

numerous references to Internal Revenue Code or Treasury Regulations sections. (Limited partnership agreem ents ,

where one seems more often to find investor partners who receive disproportionate tax alloca tions, o ften co ntain

"boilerplate" tax allocation provisions designed to apply if there ever are special alloca tions, ev en if no ne is

initially p resen t or then conte mp lated.)

d. Operations v. Liquidation.

As a general proposition, partners have much flexibility regarding allocations and distributions

during the operational period of a partnership, provided that at l iquidation they "pay for" prior allocations, because

the tax laws require that allocations have "substantial economic effect" -- partners are not allowed to enjoy bene fits

(i.e., "paper" losses) vis-a-vis the tax collector without feeling the pinch in their wallets (i.e., "hard do llar" losses).

f. Statutory Provisions.

Because it is a much more mod ern statute than UPA (1985 vs. 1914), the RULPA, contain s

"fallback" or "defa ult" allo cation prov isions in tende d to fairly reflect the partner's expe ctations, which today are

often heavily influenced by federal income tax considerations (e.g., when there's an investor to whom

dispro portio nate allocations are made to "pay back" the investment). Because most written agreements have

allocation provisions, Section 503 of RULPA states that allocations are made in the manner provided by a written

partn ership agreement. The statutory fallback provision, filling what should be a rare gap (i.e., one the written

agreement fails to cover), allocates profits and losses among the partners in accordance with the relative value of

the partners' unreturned capital contributions.

As a gene ral ma tter, if on a udit the Internal Revenue Service determines that allocations have been made

improperly, an adjustment may be required. This "correction" may have a m aterial effect on the partners' business

expectations, and underscores the importance of the drafter's knowing the tax consequences of includ ing (o r not)

certain provisions in the agreement. At a minimum, the drafter should be informed enough to advise the p artners

if a requested allocation, from a business deal standpoint, would likely not be supported by the Service on an au dit.

SAW - 38


Many of the relevant tax considerations are discussed in various places, above, including a detailed

discussion in Article III., "TAX CLASSIFICATION ." The key points are summarized below.

b. Federal Income Tax Classification.

In additio n to allo wing any o r all own ers to p articipa te in management without any individual

liability to third parties, LLC 's are used to achieve partnership pass-through federal income tax treatment. As noted

imm ediate ly above in Sect ion F., and in detail in Article III., this requires avoidin g two o f the four c orporate

characteristics of (i) limited liability, (ii) centralized management, (i ii) free transferability of interests and

(iv) continuity of life.

(2) Lim ited Lia bility .

As noted , the lim ited liab ility cha racteristic gene rally w ill be co nced ed. But , some LLC

statutes do allow the constituent documents to create liabili ty.

(4) Continu ity of Life.

As described in Sect ion F., above, care must be taken to draft the regulations or operating

agreement to avoid the continuity of life characteristic (that is, to assure that an LLC do es not have continuity of

life), if that is one of the two characteristics that the LLC must avoid to preserve its federal pass-through tax

treatm ent.

(6) Free Tran sferab ility of Inte rests .

The Treasury Regulatio ns look at two components of an ownership interest in testing

for free transferability: (i) econ om ic rights , which typically are the right to receive profits and distributions, and

(ii) voting and othe r management rights. If only the economic rights are freely transferable (which is the case

under modern partnership statutes and under LLC statutes, absent a contractual agreement to the contrary), then

free transfe rability w ill be av oided . On th e othe r han d, if, for ex am ple, the regu lations of an L LC a llowed a

member to trans fer the m em ber's in terest to a third pa rty and , witho ut con sent, to make the transferee a substituted

mem ber, then the element of free transferability would be p resent. Again, this does not, by itself, elim inate

pass-through tax treatment; but, it does lock-in one of the four corporate cha racte ristics -- the refore , great care

wo uld have to be taken to avoid centralized management and continuity of life if, as anticipated, limited liability

is conceded.

The rules appl icable to limited partnerships and LLCs are the same and should be applied in the same

man ner. How ever, public pronoun cements hav e distor ted the manner in which these rules apply to limited

partnerships and only private ruling s hav e defin ed the man ner in which these rules apply to LLC's . See, e .g . , PLR

9210019 (Texas law -- no free tran sferab ility wh ere full substitution of non-manager members requires only the

consent of the sole manager, and transfer of the manager's interest requires consent of a majority in interest of the

members.). A detailed discussion is set forth in Article III., abov e, "TA X C LA SSIF ICA TIO N."

(8) Centralized Management.

As noted above, some LLC statutes allow an LLC to be managed either by managers or

mem bers, as pro vided in the A rticles. However, the current IRS position appears to be that unless management

is reserved to the mem bers, the LL C w ill have centra lized m anag em ent. For example, in Revenue Ruling 93-6,

SAW - 39

the IRS held that a Colorado LLC with five members, all of whom were also managers, had centralization of

management beca use m anag em ent of th e LL C w as ve sted in man agers rather th an m em bers. Rev. Rul. 93-6, 1993

- 3 I .R.B. 9, 10. The IRS's rationale was based on the fact that the decision-making authority rested in the

mem bers' capacity as elected ma nage rs, rathe r than in their ca pacity as m em bers. T his do es no t com port w ith

Treasury Regu lations § 301 .7701-2(c )(1), which states that "an organization has centralized management if any

person (or any group of persons which does not include all the mem bers) had contin uing exclu sive au thority to

make the manag ement dec isions necessary to the condu ct of the business for w hich th e org aniza tion w as form ed."

Because the treatment of LLC's conflicts with the treatment of limited partnersh ips and the T reasury Regulations

themselves, this ano ma ly sho uld b e elim inated in the fu ture. F or no w, the only com ple tely safe w ay to a void

centralization of managem ent in the LLC co ntext is to reserve managem ent to all of the membe rs, as memb ers.

S o m e of the practical problems of reserving management to all of the members may be avoidable by having

the members to whom that management has been reserved name one or more, but fewer than all, of their number

to cond uct ac tual da y-to-d ay m anag em ent. This w ould be comparable to multiple general partners naming a

managing general partner, or to the sharehold ers of a close co rporation de legating m anagem ent to one sh areholder.

At this time it can only be suggested (but not guaranteed) that such a solution would be respected by the IRS and

result in a findin g of n o cen tralizatio n of m anag em ent.

(10) Franchise Taxes.

State legislatures everyw here are furiously looking for way s to increase state revenues.

In som e states ( e.g., Flo rida, N ew Y ork's p ropo sed sta tute an d Te xas), th is has re sulte d in the imp osition of a

franchise or corporate income tax applic able to corp oration s and to LLC's (but not to partnerships). For example,

in Tex as, 19 91 am endm ents to the Texas franchise tax laws impose on corporations doing business in Texas a tax

equal to the greater of (i) 0.25% of "net taxab le cap ital" (which is similar to the old computation, but reduced from

0.525% to 0.25%) and (ii) 4.5% of federal taxable income, with certain adjustments. Texas Tax Code

§ 1.71.001(a)(2). By any name, this is a corporate incom e tax, wh ich is a s eriou s draw back to ope rating in

corp orate form. The Texas legislature made this tax applicable to LLC's, presumably because they a re

"corp oration -like."

In limited circumstances, the federal income tax be nefit of effectively converting recourse indeb tedne ss to

nonrecourse by using an LLC -- because no owner has perso nal liab ility, all debts are effectively nonrecourse and

the additional tax ba sis that is created is shared b y the m emb ers as they ag ree -- may outweig h the adv erse

consequences of the state franchise tax.

6. S Corporations.

b. Federal Income Taxes.

The only reaso n to elect S C orp status is the tax advantage of the pass-through partnership tax

treatm ent; otherwise, the o peration for state law purpose s is the same a s with a C C orporation. T he cost of S Corp

status is the requirement to suffer shareholder and other r estriction s that do not ap ply to a C C orpo ration o r to

partnerships or LLC 's. If S Corp status is properly elected, and if the rules that must be satisfied for that statu s to

be maintained are observed, flow-through aspect of the basic fede ral incom e tax treatmen t is the same as fo r a

partnership. There are, however, very important distinctions. For e xam ple, a shareholder in an S Corp may not

increase its tax basis by any p ortion of the c orpo ration's debt o r by p erson ally gu arante eing c orpo rate de bt. Th is

difference makes ownership throu gh a lim ited liability company or partnership more desirable than through an

S Corp.

SAW - 40

d. Franchise Taxes.

S Corporations are subject to the same franchise tax liability as C Corporations and LLC's, as

discussed at subparagraph (5), above.

SAW - 41

P. METHODS FOR GETTING VALUE OUT.

The key is sue fo r ma ny o wn ers -- w hen a nd h ow do I g et valu e out:

SUMMARY

L P'ship Distribution of prope rty not a tax able even t. Recipien t partner has

carryover holding period and takes a basis equal to lesser of partn ership 's

tax basis in the p roperty o r partner's ta x basis in its pa rtnership in terest.

Cash distributions don't result in entity taxation; distributee partner taxed

only to ex tent tax exc eeds distribu tee's tax bas is in partner ship interest.

LLC Generally, treated the same as L P'ship.

S Corp Distribution of prope rty is a taxable event. Ca n result in co rporate level

tax if property "tainted" because of a C Corporation history.

Shareholder has new holdin g perio d and ta kes tax ba sis equal to

property's fair market value.

Cash distribution generally treated the sa me as for L P'ship, unless S Co rp

has retained earnings from prior period as a C Corporation.

Winner: If gains are planned for, advanta ge to L P'sh ip or LLC because no

taxable event on property distribution. But, if property has declined

in value, S Corp has advantage of being able to generate tax loss by a

distribution (without a disposition outside the ownership group).

2. General Rule - Partnerships.

The partne rship fo rm o f ow nersh ip allow s con sidera ble flex ibility, an d gen erally favo rable tax

treatm ent, in getting assets into and out of the partnership, and in allocating and distributing income and ca sh

among the partners. G enerally, there is more flexibili ty during the operational phase of the partnership than on

liquidation -- at the end of the day, the scorecard (in the form of the partners ' capital accounts) must be totaled,

and final distributions mad e accordingly. Tax b asis, capital account balances and allocations made during the

partnership term all have direct bearings on h ow the assets com e out to the partners.

4. Com parison Su mm ary.

A com parativ e sum ma ry of th is issue m ay be mo re use ful than separa ting the discu ssion b y entity

type. The major difference between L P'ships and L LC's , on the one h and, a nd S Corp s, on th e othe r, relates to

the distribution of property other than cash. Any entity taxed as a partnership (i.e. general partnerships and mo st

limited partnerships and LLC's) does not treat a distribution of pro perty as a taxa ble event; ho weve r, an S C orp

does. Although the S Corp generally is not required to pay any tax itself when it distributes property (unless the

property is "tainted" because the property has a C corp oration history ), the S Corp is requ ired to re cogn ize ga in

or loss on the distr ibution of pro perty as if it we re sold for its fair m arket v alue. A s a resu lt, each of its

sharehold ers mu st reco gnize an allo cable share of the c orpo ration's gain o r loss. B ecau se of th is differe nce in

SAW - 42

taxation, the tax basis and holding period of distributed property in a distributee's hands also is different. A partner

has a carry over hold ing p eriod and ta kes a basis in the property equal to the lesser of the pa rtnersh ip's tax b asis

in that pro perty and th e partn er's tax b asis in its p artners hip inte rest. An S Corp shareholder has a new holding

period and takes a tax basis in the property equal to the property's fair market value.

Otherwise, the entities generally are treated similarly. Cash distributions do not result in any entity taxation,

and the dis tr ibutee has a tax o nly to th e exte nt the c ash d istributio n exc eeds the distr ibutee 's tax ba sis in his

ow nersh ip interest. T he ex ceptio n to this rule is if an S Corp has some retained earnings from a period that i t or

a predecessor was a C corporation.

6. Gains v. Losses

Assuming you plan for gains rather than losses, the adv antage goes to partnerships or L LCs becau se

they do n ot hav e a tax able e vent o n a pro perty distribu tion. H ow ever, if p rope rty has decli ned in value, then

S Corp has an advantage, as it can generate a tax loss for i ts owners by simply distributing that property, without

a further disposition or liquidation.

8. Shifting Taxable Items.

An other consideration in this area relates to shifting taxable items. There are extensive rules that

prevent the use of a partnership to shift taxable gain or loss on appreciated or depreciated property, respectively,

from a con tributing partne r to othe rs. No simila r rules a pply to S Corp s, wh ich ca n pre sent a p lannin g op portu nity

in the right circumstances.

X . SUMMARY OF THE VARIOUS CONSIDERATIONS.

B. GENERAL OVERVIEW .

C and S Corporations p rov ide owne r s w ith protection from liabilities arising out of the operation of a

business. Unless there is an overriding reason to use a C Corp oration , how ever, a real esta te inve stme nt sho uld

genera l ly be made by means of a tax pass- through enti ty l ike an S Corp , a partnership , or an LLC.

Although there are many circumstances in which using a gene ral partn ership or a joint venture is

appropriate, if the owners want to limit their liability (as is usual), the general partne rship is n ot pref erred . LL C's

provide protection against liabili ty, but the local tax treatment of them may be un favo rable. Limited partnerships

provide limited liability to lim ited pa rtners, b ut no t to the g enera l partne rs (altho ugh this lim itat ion may be

effectively avo ided by c reating a corp oration to be the general pa rtner of the limited pa rtnership).

Consequently, in mo st situatio ns, rea l estate a ctivities g enera lly sho uld b e org anize d in limited partnership,

S Co rp or L LC f orm to get th e ben efit of bo th pas s-throu gh tax treatm ent an d som e limite d liability .

D . ENTITY BY ENTITY COMPARISON.

2. On e Ow ner - P roprie torship , S Co rp, LL C or L imited Partn ership .

Wh ere there is only one owner, the person's desire to limit l iability as an owner must first be

determined. If l iabili ty avoidance is desired, then the S Corp is perhaps the easiest option. But, an S Corp may

be subject to a local tax (e.g., franchise tax). For that reason, the best solution may be partnership form, used by

forming a corporation or subsidiary to be the general partner in a lim ited pa rtnersh ip. Tw o neg ative a spec ts of this

SAW - 43

tiered structure are (i) the added expense of form ing an d m aintain ing (e.g ., tax retu rns, co rpora te formalities) the

additional entity, and (ii) a risk that the IRS ma y attempt to treat the partnership as a corporation for tax purposes

by finding three or more of the four corporate characteristics. Also, it is more difficult, although not impossible,

to ensure p artnership tax treatm ent if there is a sole corpo rate general pa rtner.

Note that the TLLCA and the current draft of the ULLCA allow a one-member LLC. There has been no

determination by the Service that a one-me mb er LL C w ill be treated as a partnership for federal income tax

purposes. In fac t, it is this fea ture of the TLLCA which, to da te, has prec luded the issuance of a ru ling by the IRS

that a Texas LLC will be so treated for federal income tax purposes. Consequently, Texas practit ioners are not

taking advantage of the one-owner feature of the TLLCA.

4. Multiple Owners -- Numerous Options.

As no ted abov e, the basic cho ices of entity wh en there are m ultiple owne rs are gene ral partn ership

(join t venture), l imited partnership, C Corporation, S Corp, and LLC. Although the general partnership/joint

venture option remains viable, especially where all of the investors will be required by lenders or other third parties

to have liability for the debts of the enterprise, because the desire fo r limited liability is o ne of the ke y go als in

choosing the form of business entity today, general partnerships and joint ventures will not be discu ssed in this

comparison.

Likewise, although a C Corporation may be the be st cho ice in so me circum stanc es, bec ause that w ill rarely

be the case in a real estate transaction, C Corporations are not discussed in this comparison. Both C Corporations

and general partnerships/joint ventures are, howe ver, included in the "Com parison of S tructures" chart attached

to this paper.

b. S Co rp v. L P'ship .

The decisio n betw een th ese tw o entitie s often turns p rima rily on balancing th e com plete

absence of personal liability for S Corp own ers w ith the fre edom and fle xibility o ffered by the partne rship; b ut,

the follo wing factors can a lso be releva nt:

(2) Formation Cos ts - Generally, it is less expens ive to pre pare c onstitu ent do cum ents

for an S Corp than for an L P'ship; filing expenses vary by state.

(4) Participation in Management - There are no restrictions on par t ic ipation by

sharehold ers of a S Corp in the management of the corporation, as officers, directors or employees; while broad

rights can b e gran ted to limited partners, there are still restrictions and risks (of loss of limited liability) associated

with full participation in managem ent by limited partners.

(6) Tran sferab ility - Subject to co ntrary agree me nts am ong the ow ners, th e eco nom ic

rights associated with either type of ownership interest are freely transferable. However, subject to the use of buy-

sell or other shareholders ' agreements to preclude transfers to non-qualifying sharehold ers (which is very

importan t), the en tire ow nersh ip intere st of an S Co rp sha reho lder is u sually mo re read ily transfe rable than the right

to become a substituted limited partner in an L P'ship.

(8) Type of Owner - The re are n o restric tions o n wh o can own an L P'ship interest,

but there are severe restrictions on who can be a shareholder in an S Corp (ow nersh ip is lim ited to U .S. resid ents

and citizens and cert ain U.S. trusts). If there are foreign owners or non-individual owners, an S Corp is not

available.

SAW - 44

(10) Number of Ow ners - There is no limit on the number of L P'ship owners (subject

to potential securities laws issues), whereas there can be no more than 35 shareholders of an S Corp.

(12) Federal Tax Issues - The pen dulum begins to sw ing towa rd the L P'sh ip form w hen

federal income tax considerations are introduced. Although both entities are pass-through entities that avoid tax

at the entity level, the tax ba sis of an S Corp shareholder includes only the amount of money the shareholder has

contributed or le nt to the c orp ora tion , and doe s no t incl ude the s har eho lder 's pro rata sha re o f the cor por atio n's

nonrecourse debt. On the other hand, a limited partner has a tax b asis eq ual to th e valu e of its inv estm ent in its

L P'ship interest, plus its perc entag e sha re of p artners hip n onre cour se de bt, plus (this would be som ewhat less

usual) any partnership d ebt for wh ich it is personally liable (for exa mple, as a g uarantor).

- The allocation of tax items of an S Corp are made to the shareholders prorata

based on their stock ownership (or through complex compensation or debt structures); on the other hand, there is

freedom to m ake special allocations in the L P'ship context that differ from ow nership percentages.

(14) State Taxes - The scale tips even further in favor of the L P'ship in states wh ere

a franchise tax applies to a corporation but not a partnership.

Conclusion: Although the S Corp ha s attractive features and so me adva ntages, the L P'sh ip genera lly

would be the entity of choice, and esp ecially wh ere a state fra nchise or sim ilar tax ap plies to corp orate

entities but not to partnerships.

d. S Corp v. LLC.

When the merits of an S Corp are being considered against those o f an LLC , the following a re

the key factors:

(2) Tran sferab ility - Under app licable statutory law, an ownership interest in either

an S Corp or an LLC may be freely and fully transferred to a third party. However, in the LLC context, under

current IRS private rulings, if more than economic r ights are transferred w ithout conse nt of the m anager o r a

majority-in-interest of the other members, the corp orate chara cteristic of free tran sferab ility would be present. For

an S Corp, transfers to an unqualified shareholder, which would jeopardize S Corp (and partnership taxation)

status, a re trou bleso me , but like ly wo uld b e prev ented by ag reem ent.

(4) Type of Owner - The same advantages described with respect to an L P'ship,

above, wou ld app ly in the case o f an L LC h ere: an LLC offers m uch m ore fre edom to hav e foreig ners a nd en tity

mem bers.

(6) Number of Ow ners - No upper limit with LLC's, but there can be only 35 S Corp

shareholders.

(8) Federal Tax Issues - The same adva ntage s of op erating in L P 'ship fo rm w ould

apply to LLC's here, with the potential additional advantage that LLC recourse debt is shared by the members as

nonreco urse debt (be cause no mem ber has pe rsonal liability).

(10) State Taxes - Both forms of entity are tagged here, but there are some open issues

wi th regard to the income of an LLC.

SAW - 45

Conclusion: Except where extraterritorial activity is contemplated (especially in a state with no LLC

statute), the LLC form, with its greater flexibility for federal income tax purposes and types of owners,

will generally be preferred to an S Corp.

f. LLC v. L P 'ship .

The primary factors that should be considered in the d ecision betw een th ese tw o typ es of e ntity

are as follows:

(2) Participation in Management - The mem bers o f an L LC a re m ore fre e to fully

particip ate in management, either as mem bers or as mana gers, than are the limited partners of an L P'ship, without

fear of losing limited liability.

(4) Tran sferab ility - Although most states' LLC and L P'ship statute treat the issue of

transfe rability of interests similarly, there is currently more risk from a tax classification standpoint regarding

LLC's than for L P'ships, as is more fully discussed above.

(6) L im ited Liab ility - Al l mem bers of an LLC have limited liability, where there must

be at least one general partner of an L P'ship who has full l iabili ty. While an adequately capitalized corporation

or other e ntity (su ch as an L LC! ) can b e use d as th e gen eral pa rtner to g ive lim ited liab ility to all ow ners, that

option is generally more expensive than using an LLC and may not necessarily result in the partnership's lacking

limited liability for tax purposes.

(8) Federal Tax Issues - As noted above , third party indebtedness which is recou rse

debt to an LLC is shared in the tax basis of all memb ers in the way that nonreco urse debt is shared by the partners

of an L P'sh ip; on th e othe r han d, abs ent lim ited pa rtner g uaran tees, on ly the general partner of an L P'ship may

take a dvan tage o f partn ership recou rse de bt.

(10) State Taxes - As discussed in the comparison between an S Corp and a n L P 'ship

in Subparagraph a., above, those s ta tes tha t impose a f ranchise or corpora te income tax on corpora tions and LLCs

provide an add itional major advantage to partnerships.

Conclusion: Where franchise or other loc al tax issues are presen t, L P'ships generally will be preferred

to LLC 's for real estate investm ents.* Ad ditionally, the uncertain extraterritoria l treatmen t of LLC 's

is another current (but, perhaps, diminishing) disadvantage to their use for enterprises that expect much

activity outside the state of formation.

F. COMPARISON OF STRUCTURES CHART.

Attached to this p aper is a chart comparing the various structures' treatment of the key factors that bear on

the choice of entity.

SAW - 46

XII. CONCLUSION.

Cho osing the "rig ht" entity for a real estate transaction is not always a simple matter. Many issues, some

complex, often must be carefully analyzed. Revenue rulings and other Internal Revenue Service pron oun cem ents

must be monitored. Nevertheless, in the current environment, the choices most often are reduced to limited

partnerships and LL C's , which, if carefully structured, offer the attractive combination of (i) limited owner liabili ty,

(ii) partnership federal income tax treatment and (iii) considerable flexibility. Unfortunately, some jurisdictions

impose a franchise or similar tax on LLC's, rendering them unusable.*

* Subsequent to the preparation of this paper, it was learned that the proposed New

York LLC legislation has been modified to delete the provision for a franchise tax for

LLC's, and to add a provision enabling the form ation of professional LLP's.

Attac hm ents

Appendix A LLC & LLP State Legislation

Appendix B IRS Re ven ue R ulin gs / P riva te Le tter R ulin gs (C lass ifica tion Issu es) F or L LC 's

Appendix C Com parison O f Structures C hart

s-0006145.04

choice of entity in real estate transactions (with

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