In the legal profession, especially estate and tax planning, we are guilty of using acronyms or abbreviations to describe certain types of entities, and many times the tax characteristics thereof.
Some of the more common uses in the firm’s practice involve using initials to describe either the legal entity, or fairly technical tax aspects or elections. This first article will deal with entities, and in our next newsletter, we will deal with some of the more commonly used tax descriptive acronyms, such as QSST, QDRO, ESBT and QTIP.
In the entity world, we are normally looking at three characteristics in trying to assist the client in choosing the best format for their future business activities. The characteristics are:
- Protection against liability;
- Tax aspects – is it a pass through, or does the entity pay the taxes? and
- Management structure.
Forty years ago, your choices were fairly limited, and basically you could choose a corporation, which provided protection against liability, and then you had to choose if you wanted a regular subchapter “C” corporation (describing the subpart of the Internal Revenue Code in which corporate taxation is found, starting at §301) or a subchapter “S” (describing the sub part of the Internal Revenue Code in which corporate taxation is found, starting at §1361). Both “C” corporations and “S” corporations protect the shareholders from liability. “C” corporations pay a tax at their level, and “S” corporations pass their income or losses, under fairly complicated rules, to their shareholders (who then pay the tax or receive the tax benefit). Other types of corporations permitted (sometimes with different tax characteristics) include “not-for-profits,” which are generally governed by totally different provisions of the Internal Revenue Code, and Professional Corporations (“P.C.’s”), which were intended to allow the corporate practice of professions, subject to fairly strict rules regarding operations and ownership. P.C.’s have modified “C” corporation tax rules which, to a certain degree, limit their tax benefit, though they can provide protection against personal liability, especially in situations involving multiple member professional groups.
Other choices include entities under subchapter “K”, which basically are partnerships. Once again, forty years ago, you had two descriptive types of partnerships. General partnerships had full pass through of tax attributes, but had the burden of joint and several liability among the partners. This would mean that if one partner did an act on behalf of the partnership, resulting in potential liability, all of the other partners were jointly and severally liable and responsible for that act, and possibly resulting damages. Your alternative for a pass through entity (once again, under more complicated rules) were limited partnerships (“L.P.s”). These had a general partner (“G.P.”) and limited partners. The general partner had full management responsibilities, and the limited partners had very limited voting power, but in exchange for that, they had limited liability, whereas the general partner had full liability.
In partnerships, you usually had majority rule, and in limited partnerships you had general partner rule. In the corporate arena, you had officer rule, as approved by boards, as approved by shareholders.
Against this background, creative tax practitioners and state legislatures took it upon themselves to create other types of entities, which offered more flexibility for the owners and tried to achieve pass-through status without personal liability. The more common entities formed, and the acronyms used, are:
Limited Liability Companies (LLCs)
Like general partnerships, these are basically full pass through entities, but the members (as they are called) are not subject to personal liability for acts of the entity, but only for their personal acts. These were started in the 1980s, and Missouri adopted its Act in 1993, and these are probably the dominant form of new business entities formed in the United States today. They have benefits such as while having an Operating Agreement, they are not usually required to keep annual minutes or file franchise taxes or annual registration reports.
Limited Liability Limited Partnerships (LLLPs)
These are special limited partnerships which are known as registered limited liability limited partnerships (“LLLPs”), and are required to file annual renewal applications electing to be taxed as an LLLP. The benefit of the LLLP is that the general partner, while still having full management authority, has the same protection as the limited partners from liability.