Report of the
Joint Fiscal Office
to the

House Ways & Means Committee
and the
Senate Finance Committee

Limited Liability Companies

December 15, 1996

Legislative Joint Fiscal Office

Stephen A. Klein, Chief Fiscal Officer
Douglas J. Williams, Deputy Fiscal Officer
Maria Belliveau, Associate Fiscal Officer
Catherine Benham, Associate Fiscal Officer
Rebecca J. Buck, Staff Associate
Sandra J. Noyes, Systems Manager

Prepared under the direction of the

Legislative Joint Fiscal Committee

Sen. Stephen W. Webster, Chair
Rep. Oreste V. Valsangiacomo, Vice Chair
Rep. Kathy Beyer
Rep. Sean P. Campbell
Rep. John S. Freidin
Sen. Robert D. Ide
Sen. Matt Krauss
Rep. Thomas A. Little
Sen. Thomas G. Macaulay
Sen. Elizabeth M. Ready

Report Prepared by

Douglas J. Williams, Deputy Fiscal Officer
&
Thomas P. Ciaraldi, Consulting Research Associate

Vermont Legislative Fiscal Office
1 Baldwin Street, Montpelier Vermont 05633
Tel: 802-828-2295
Fax: 802-828-2483
E-Mail: Doug@leg.state.vt.us

This study is not intended to be a tax primer with regard to Limited Liability Companies. Anyone considering conversion to this form of business organization should seek competent legal and tax advice.

Members of the House Ways & Means Committee
1995 - 1996

Representative Oreste Valsangiacomo, Chair
Representative John Freidin, Vice Chair
Representative Karen Kitzmiller, Clerk
Representative Andrew Christiansen
Representative Danny Deuel
Representative Robert Harris
Representative Steven Howard
Representative Constance Houston
Representative John LaBarge
Representative Gene Sweetser

Members of the Senate Finance Committee
1995 - 1996

Senator Stephen Webster, Chair
Senator Sara Gear, Vice Chair
Senator Peter Shumlin, Clerk
Senator Tom Bahre
Senator Fred Ehrich
Senator Matt Krauss
Senator Cheryl Rivers

Table of Contents

Acknowledgments

The Joint Fiscal Office would like to thank all those who contributed to this report:

William Russell, Chief Legislative Counsel
Emily Tartter, Legislative Counsel
Herb Olson, Legislative Counsel
Richard Gebhart, Assistant Director of Research,
Washington Department of Revenue

and we would like to acknowledge the following resources which were used in the preparation of the report:

The Bureau of National Affairs, Tax Management Portfolios
State Tax Notes
The Commerce Clearing House U.S. Master Tax Guide

EXECUTIVE SUMMARY:

Vermont’s Limited Liability Company (LLC) statute constitutes a main stream approach to the creation of these hybrid business entities and it is consistent with the statues enacted by the majority of states. Further, we find that:

• Passage of LLC legislation helps to ensure that Vermont remains competitive with respect to the formation of new businesses, the retention of existing businesses, and the operation of foreign LLC’s within Vermont.

• Because Vermont has both a corporate and personal income tax, the tax structure created by Act #179 establishes a balance that is likely to minimize the impact on the general fund.

• Based upon our survey of states and the rigorous study conducted by New York, it is our opinion that Vermont’s LLC law will have a negligible impact on general fund revenue.

PURPOSE:

Act # 179 of the 1996 session of the General Assembly requires, "The Joint Fiscal Office, with assistance from the staff of the Legislative Council, under the direction of the Joint Fiscal Committee, shall conduct a study of state taxation of limited liability companies. The study shall compile and review the tax and fee costs associated with limited liability companies among the states and territories of the United States and an analysis of the policy implications to take into consideration in set ting tax rates and fee levels to apply to limited liability companies. The study shall also analyze the revenue impacts of implementing taxation of limited liability companies in ways similar to the taxation of such entities in other states. The Vermont Department of Taxes shall cooperate with and provide assistance as needed to the Joint Fiscal Office to facilitate the study. The study shall be submitted to the House Ways and Means Committee, the Senate Finance Committee, the Clerk of the House and Secr etary of Senate on or before December 15, 1996."

ORGANIZATION OF STUDY:

The examination of Limited Liability Companies (LLC’s) is extremely complex because of the emerging nature of this form of business organization. Further, any attempt to predict the behavior of existing businesses or the form of organization of businesses that may come into existence in the future is, by definition, speculative. These limitations necessitate a qualitative approach to this study.

As a consequence, we explore the essence of the LLC and the advantages and disadvantages of converting to, or initially organizing as, an LLC. The study also reviews the current literature on the subject of LLC’s and contains a survey of state tax treatment.

Finally, the study outlines the qualitative impact on Vermont general fund revenue. Efforts to quantify the impact on the general fund will require additional, future research when actual data on LLC formation is available.

The Introduction provides background information on Limited Liability Companies and the differences and similarities with other forms of business organization.

The Discussion section explores the experience of New York State with its LLC law and reviews the different tax structures that the 50 states have applied to domestic and foreign LLC’s.

In the Probability Matrix section we examine the likelihood of conversion from existing forms of business organization to the LLC form.

The section on Findings describes, in qualitative terms, the most probable impact on Vermont general fund revenues.

The section on Recommendations makes suggestions for the future study of Vermont LLC’s.

This study also includes a Glossary of terms and an Appendix containing additional background information.

INTRODUCTION:

"Before the Internal Revenue Code can be applied to any entity, the entity must demonstrate that it actually functions as the type of entity it claims to be. This can be done by passing tests developed under federal income tax law. It is not enough to have satisfied a state’s standards of entity formation. ...recognition by a state is not tantamount to recognition by the IRS. [ U.S. Master Tax Guide, Commerce Clearing House, Inc., 1996] " For example, if an unincorporated business poss esses three or more corporate characteristics, the IRS taxes the business as a corporation regardless of the form of organization recognized by the state. The corporate characteristics are:

• limited liability

• centralized management

• continuity of life

• free transferability of interests

In an effort to avoid having partnerships, trusts, associations and other organizations treated as corporations, state governments have created hybrid entities under state law which are neither partnerships nor corporations. States had three main goals in creating this new entity, known as the Limited Liability Company (LLC). They wanted to provide:

• limited liability and pass through treatment for income (like an S corporation)

• more organizational flexibility than an S corporation

• fewer restrictions on member’s activities than a limited partnership.

In general, states treat LLC’s as separate legal entities. The organizers of the business must file articles of organization similar to a partnership agreement or corporate by-laws. An LLC will be classified as a partnership if it has two or fewer characteristics of a corporation. If classified as a partnership, the owners of an LLC enjoy all of the flexibility of the partnership form of organization combined with limited liability.

The owners of an LLC are referred to as "members," rather than stockholders or partners, and the organization may be managed by non-members or members who reserve management rights.

Some existing business entities, and every new business being started, should evaluate the LLC structure to see if it fits their needs. The section that follows lists some of the advantages that the LLC structure has over other organization types.

ADVANTAGES OVER SUBCHAPTER S CORPORATIONS

An LLC can have (and a subchapter S corporation cannot have):

• more than 35 members.

• members that are corporations or trusts.

• members that are foreign corporations, trusts, or individuals.

• more than one stock class.

• subsidiaries.

• flexibility in planning distributions and allocations of income.

Note: Beginning with tax year 1997, federal law increases the membership limitation on subchapter S corporations from 35 to 75. Beginning with tax year 1998, federal law will permit subchapter S corporations to have members that are corporations or trusts [ U.S. Master Tax Guide, Commerce Clearing House, Inc., 1996] .

ADVANTAGES OVER PARTNERSHIPS

An LLC has:

• limited liability of members which is important to investors.

• greater financing options.

• members may participate more than partners in a limited partnership.

• similar to a limited partnership but without a general partner.

ADVANTAGES OVER C CORPORATIONS

An LLC:

• avoids the "double taxation" of income. A C corporation’s income is taxable to the corporation as income, and, if paid to shareholders as dividends, taxable to shareholders as personal income.

• makes multi-state operations possible without consolidated return restrictions.

• allows income pass through from subsidiary to parent without dividend restrictions.

• member’s liability is limited to extent of capital contributed, or obligated.

ADVANTAGES OVER PROFESSIONAL SERVICE COMPANIES

A Professional Limited Liability Company (PLLC) or a Limited Liability Partnership (LLP):

• is taxed at the member’s individual tax rate as opposed to professional service companies (PSC’s), which are taxed at the highest corporate tax rate, without the benefit of the usual graduated rates.

• has the advantage of tax-free transfer of appreciated property to the LLP without recognition of gain (in contrast to a transfer of corporate stock where the shareholder recognizes the gain.)

• can transfer appreciated property to a member without recognizing a gain. (In a corporation, both the corporation and the stockholder recognize the gain.)

• offer the members liability protection from misdeeds of other members or staff not under their direct control. The member’s exposure is only to the level of his or her contribution obligation. A corporate shareholder, however, can lose the money invested in capital stock, any paid-in surplus, and the accumulated retained earnings of the company. Note: Members of a PLLC cannot limit their liability with respect to their own malpractice or that of employees under their direct control.

DISCUSSION:

Alternative State Tax Structures

Income tax

Of the 50 states and the District of Columbia, 41 states (including Vermont) and the District of Columbia tax LLC’s in the same manner that the federal government taxes the LLC. That is, if the Internal Revenue Service (IRS) has ruled the LLC is a C corporation, then the LLC will be subject to both federal and state corporate income tax. On the other hand, if the IRS has ruled the LLC is a partnership (for tax purposes), then the LLC members will be subject to personal income tax on distributions from the LLC.

Three states (Nevada, South Dakota, and Wyoming) have no corporate or personal income tax. The remaining six states have unique income tax arrangements. These are summarized as follows:

Arkansas: Regardless of the federal tax classification of an Arkansas LLC, the state taxes the LLC as a partnership.

Washington: Similar to Arkansas, the state treats all LLC’s as partnerships, regardless of the federal tax classification of an LLC.

Florida: Regardless of the federal tax classification of an LLC, the state taxes all LLC’s as C corporations because Florida does not have a personal income tax.

Texas: All LLC’s are subject to the corporate franchise tax. Texas has no personal income tax.

Pennsylvania: Regardless of the federal tax classification of an LLC, the state taxes LLC’s as C corporations unless the LLC is a "restricted professional company." Pennsylvania has both state and local personal income taxes.

Michigan: Regardless of the federal tax classification of an LLC, the state imposes its single business tax (in lieu of the corporate income tax); in addition, members of an LLC are subject to income tax on distributions from the LLC.

Vermont Comment:

• With both a corporate and personal income tax, Vermont is one of the 41 states that taxes an LLC in accordance with its federal tax status.

• Currently, out-of-state shareholders do not pay any Vermont income tax on their share of income (dividends or subchapter S distributions). LLC members will have to file returns.

• C-corporation conversions to LLC’s will have to pay state and federal tax on any asset gain realized in the corporate liquidation. (No corporation with significant gain would convert).

Entity level tax

Of the 50 states and the District of Columbia, 17 states (including Vermont) and the District of Columbia have established some form of entity level tax [ See Appendix 1] . The majority of states, 33, impose no entity level tax on the LLC. The entity level tax varies. It may be a:

• flat "franchise" tax (Alaska, Arkansas, Delaware, Vermont. Wisconsin)

• tax on the number of LLC members (New York, Tennessee)

• tax on gross receipts (California)

• percentage of a defined base (Connecticut, District of Columbia, Florida, Kansas, Illinois, Michigan, New Hampshire, Texas, Washington, West Virginia).

Vermont Comment:

• Vermont is one of the 17 states that has created a flat entity level tax. A tax of $150 is imposed each year on the LLC. This tax is identical to the C corporation minimum tax and the S corporation tax. On passage of Act # 179, Vermont also extended the $150 "franchise" tax to partnerships.

New York State Study of LLC’S; PLLC’S; and LLP’S

In preparation for this study, we contacted those states which have had an LLC law in place for the longest period of time. Our purpose was to ascertain the experience of those states with respect to businesses converting to the LLC form of organization and the subsequent general fund impact. We spoke to Tax Department representatives from Colorado, Oregon, Utah, Massachusetts, Rhode Island, Maine, and New York. In addition, we contacted the Federation of Tax Administrators. The general opinion of th ese state representatives was that the passage of an LLC law had an insignificant impact on general fund revenue. We discovered that only one state, New York, had undertaken a serious attempt to track the impact of their LLC law. Indeed, New York began building a predictive model two years before passage of their law. New York formed a task force of Tax Department researchers and representatives from the business community in an effort to predict the behavior of businesses. What follows is a summary of New York’s findings.

New York developed a computer model [ State Tax Notes, January 1, 1996] to predict the impact of the LLC legislation over the first five years. They studied the possible costs of conversions from C corporation and S corporation to LLC’s. The model compared the three-year tax savings to the administrative and tax costs of conversion. The model assumed that any corporation that had a savings over the three-year period would convert.

The model also studied the possible partnership conversions. Generally, there is no cost to convert a partnership. The question is whether or not the advantage of liability is worth the cost of the minimum LLC/LLP fee.

The study ignored the C corporation/S corporation filers who pay the minimum tax. Generally, they would still pay the minimum tax as an LLC (the minimum for both is $325 in New York).

Model Predictions

The model predicted that:

• Fewer than 1,000 C corporations would convert over the five year period. Those that did convert would do so because of the corporate tax savings resulting from the pass through of income to the members.

• 35,000 partnerships (about 40%) would convert over the same five year period (the majority would be real estate partnerships, followed by service partnerships).

• No subchapter S corporations would convert (subchapter S corporations already have the pass through feature, they would have to deal with the liquidation costs, and because of the unfavorable taxation for nonresident members).

• LLC’s would be, primarily, the choice of existing partnerships and new businesses.

The Actual Results: Prediction Actual results

Conversions: first year 8 months

C Corporation 175 138

S Corporations 0 197

Partnerships 8,300 ?

Other LLC’s formed 5,409

Total 8,475 5,744

Projected 12 months 8,475 8,616 [ Projection based upon straight line calculation method]

There is no information as to how many of the 5,409 "Other LLC’s formed" (from the chart above) were previously partnerships.

Far more subchapter S corporations converted than New York had estimated. The majority (53%) of them were real estate businesses. New York suspects that they were the corporate partners of limited partnerships who now can achieve limited liability without the need for the subchapter S corporation as a general partner. Another 31% were service corporations. Many of them were professional corporations which opted for the simpler structure of an LLP or PLLC.

Of the 138 C corporations to convert, 95 were non-minimum taxpayers. Why did so many non-minimum C corporations convert in spite of the liquidation costs? The conversion/liquidation [ See Appendix 2 for a discussion of liquidation and conversion] costs may have been over estimated if a corporation can make a "tax free" transfer to an LLC subsidiary. If that is the case, then the main obstacle to conversion is gone.

It is important to note that in the first 8 months 5,744 LLC’s were created. Of that number, only 335 were C corporations or S corporations. The remainder were either new businesses or partnership conversions. Unfortunately, at the time the LLC law went into effect, New York was unable to gather any information about the prior existence of these organizations. Later, New York was able to trace some of the corporation conversions through name matches.

The New York study concluded, "Overall, the initial projections for LLC/LLP conversions appear consistent with the first year outcome. However, as with any new entity form,

businesses need time to examine the implications for conversion to this new form. The true test of the predictions will come in future years. The third and fourth years after enactment will provide the true test of the robustness of the projections. This will give businesses with more complicated structures the chance to analyze all the advantages and disadvantages of the LLC/LLP entity holds. [ State Tax Notes, January 1, 1996] "

With respect to the impact on the general fund, New York estimates that "of the more than 5,700 LLC’s/LLP’s, only 335 of the first year conversions are either C or S corporations. These accounted for more than $400,000 worth of corporate tax revenue loss (measured by their prior year liability)." Further, the New York study notes that they "do not know how much of this [loss] will be offset by increased personal income tax liability, the LLC/LLP per-member fee, or any tax on li quidation paid with the following year’s tax return." Clearly, the net general fund loss was less than $400,000. This loss must be viewed in the context of New York’s annual corporate income tax base revenue of $1.5 billion.

The model suggests that by the end of the 5th year, approximately 1,000 C corporations will have converted to the LLC form of organization resulting in a gross loss of corporate income tax revenue of $21 million. This loss represents 1.4% of the total corporate income tax base. As noted above, the New York study makes no attempt to estimate the increase in personal income tax revenue paid by members of the newly formed LLC’s.

New York was hampered in evaluating general fund impact because "[they] were initially unable to obtain any history of these entities, such as determining which were new entities, which were prior partnerships, and which were prior corporations. [They] could also not obtain their federal or state employer identification numbers. The only way [they] could derive any information about these businesses and any prior incarnations was through name matches."

PROBABILITY MATRIX:









Business "Form" Conversion Chart








Probability of conversion to LLC/LLP type structure










Chart #1













Current Structure

Possible Change to:





LLC

LLP

PLLC




C Corporations







Small

P

P

X




Medium

NP

NP

X




Large

X

X

X




S Corporations






Small

VP

VP

X




Medium

P

P

X




Large

NP

NP

X




Partnerships







Small

VP

VP

X




Medium

VP

VP

X




Large

P

P

X




Professional Corps.







Small

X

X

VP




Medium

X

X

P




Large

X

X

P




New Business Units







Small

VP

VP

VP




Medium

P

P

P




Large

NP

NP

NP











Very Probable

VP






Probable

P






Not Probable

NP






Not Possible

X






(or VERY unlikely)





Rating Methodology

The rating system in Chart #1 is used to illustrate the probability that any type of organization will convert to the "hybrid" Limited Liability structure. As usual, there are positive and negative aspects to these conversions which must be analyzed for each organization. For the purpose of this study, we assumed that an organization would convert to an LLC/LLP/PLLC if the benefits from conversion would recover the costs of conversion within three years. Any attempt to generalize like this must be accompanied with the caveat that each individual case will have a different "net score" when the positives and negatives are totaled.

Organization Size

Just as each type of organization will have different reasons for deciding whether or not to convert, different size organizations within a "type" will have similar choices to make. To help evaluate these choices we divided the organizations into categories of small, medium and large.

A small corporation (either C corporation or S corporation) might be one of the 8,800 Vermont corporations that file annually and pay the $150 minimum tax. These corporations have a taxable income, apportioned to Vermont, of less than $2,727 and they tend to be closely held corporations (very few stockholders).

A large corporation could be a publicly traded C corporation. It could also be a C corporation or an S corporation with large investment in fixed assets and inventory.

A small partnership could be two people owning and operating a retail store or a service company.

A large partnership could be a cooperative with 30 partners. It could also be a real estate development company organized as a limited partnership with an S corporation as the general partner and any number of limited partners.

Each type and size organization will have to evaluate, among others, the following positive and negative aspects of conversion before making their decision.

Positive Aspects of Conversion

• Limited liability.

• Amount "At-risk" is limited to a member’s contribution obligation.

• Pass-through treatment for income avoids double taxation.

• Flexibility to have different types of owners (foreign & domestic).

• Few restrictions on members activities.

• Allowed to own subsidiaries.

• Easier than consolidated corporate returns for multi-state companies.

• Unlimited number of members.

• Flexibility in allocation of distributions and income.

• Flexibility in providing compensation and fringe benefits.

• Conversion of existing partnerships does not require an organization change

(simply register as an LLP).

• Popular with multi-state companies that do not need free transferability of assets because such returns are easier than consolidated corporate returns.

Negative Aspects of Conversion

• "At risk limitations" may limit deduction of losses by members.

• "Passive activity" rules may limit deduction of losses by members.

• Members have no control over managers and no right to demand an accounting.

• Serious disagreements between members can cause the dissolution of the entire business.

• Creditors can look to members if a distribution caused company’s insolvency

(not true with dividends to shareholders in corporations).

• To obtain the limited liability benefit the organization must give up two desirable characteristics of the following three: centralized management, transferability of interest or continuity of life.

• If the managers are non-members, or members owning less than 20% ownership, the IRS could void the LLC status and treat the managers as general partners.

• Corporate conversion requires the creation of an entirely new entity. In most

cases this will include the liquidation of the first corporation and the recognition of gain, by the corporation and the shareholders, on the distribution of the corporate property to shareholders.

• "Limited life" because the death, retirement, resignation, expulsion, bankruptcy or dissolution (of corporate or partnership member) of a member causes an LLC/LLP/PLLC to dissolve. Note: Members can, on a unanimous vote, decide to continue.

• Fringe benefits paid to members are taxable as ordinary income

• Fiscal year is limited to the same year as the members holding the majority of interests in the profits.

Probability Analysis

The list that follows includes some of the justifications for the ratings included in Chart #1. This list is not all inclusive and it does not purport to say that every organization in each "size and type" category will reach the same decision regarding conversion to a LLC/LLP/PLLC organization. Each existing organization, and each new venture, will decide on its type of organization by evaluating its own circumstances.

C Corporations

Small - Rated "Probable" because small asset size reduces tax consequences of conversion. Minimum tax is the same. The shareholders are usually the Board Members and the managers of the company. After conversion they all become member/managers. Profits and losses are passed through for the members to take on their personal returns.

Medium - Rated "Not Probable" because growth to this level suggests some longevity and asset accumulation. The tax on conversion of these assets is likely to be high due to appreciated value of assets or the depreciated basis in the assets. Also, this size corporation usually has a greater number of shareholders to whom transferability and centralized management is important.

Large - Rated "Not Possible". If the corporation stock is publicly traded it can not give up two of the corporate attributes. If the corporation is just a larger version of the description in "Medium" above the same reasoning applies, only more so. Also, the transfer of liabilities to the new organization may prove difficult as creditors are sensitive to the security underlying any indebtedness.

S Corporations

Small - Rated "Very Probable" because small asset size reduces the cost of conversion. These corporations have only a few shareholders and an LLC has flexibility in planning distributions and allocations that an S corporation does not possess. This is very desirable for a company with different degrees of participation by stockholders.

Medium - Rated "Probable" because larger asset size increases the cost of conversion. However, the increased number of stockholders (not limited to 35), the lack of restriction on the "types" of stockholders (foreign and corporate) and the flexibility on distributions and allocations should outweigh the cost.

Large - Rates as "Not Probable" because the larger asset size will increase the cost of conversion beyond acceptable levels. Also, liquidation of the S corporation is done under the C corporation rules. Therefore, gain is recognized at the corporate level on any appreciated property and this gain flows through to the shareholders. However, some may convert because of the reasons listed under "Medium" above and because the LLC organization allows subsidiary ownership not allo wed by the S corporation structure.

Partnerships

Small - Rated as "Very Probable" because there is virtually no cost of conversion. The only requirement is to file with the Secretary of State as an LLC. No dissolution of the original partnership is required. Benefits include limited liability, member participation allowed (unlike Limited Partnerships) and elimination of the General Partner aspect of Limited Partnerships.

Medium - Rated as "Very Probable" for the reasons listed under "Small" above.

Large - Rated as "Probable" for the reasons listed under "Small" above. However, a large Limited Partnership, for example, may not want to give up the centralized management function available with a General Partner. Also, the General Partner is accountable to the Limited Partners whereas members of an LLP have no such control over managers.

Professional Corporations (Personal Service Corporations)

Small - Rated as "Very Probable" because limited asset size reduces the cost of conversion. A PLLC offers the same limited liability from another member’s wrongful acts, or those of an employee beyond the member’s direct control, without the double taxation burden of a regular PSC. PSC’s are taxed at the highest marginal rate (no benefit of graduated rate schedules) and distributions are then taxable to the stockholders as dividends. A PLLC eliminates this double burde n and the income is taxed at the member’s individual rate.

Medium - Rated as "Probable" because of the benefits listed under "Small" above. However, at this size, the cost of conversion becomes more of a factor. Most PSC’s use the Cash Method of accounting and the largest asset is usually the Accounts Receivable. Liquidation would involve the recognition of fair market value of the receivable which were held in the PSC at zero basis.

Large - Rated as "Probable" for the same reasons as listed in Medium above.

New Business Units

Small - Rated as "Very Probable". There is no liquidation, therefore no conversion cost. LLC type entity offers the flexibility of a partnership with the limited liability protection of a corporation. Pass-through income (loss) treatment, with special allocation rules, make LLC entities attractive to small entities with a limited number of members or managers.

Medium - Rated as "Probable" for the same reasons as in Small above. However, Passive Activity, At Risk and fiscal year limitations make it less than "Very Probable".

Large - Rated as "Not Probable" because, to get the benefit of limited liability, the entity must eliminate two of the three remaining corporation characteristics: centralized management, transferability of interest or continuity of life. For an organization with many investors, extensive capital investment, large long-term borrowing and with large fixed asset holdings it may be impossible to select two of the characteristics to eliminate.

FINDINGS:

From the point of view of state government tax revenue, the essential question to be answered is: "How will enactment of an LLC law impact the general fund?" As indicated at the beginning of this study, it is not possible to answer this question in quantitative terms at the present time. However, based on the foregoing probability analysis and the experience of New York, we offer the following qualitative observations:

Existing Businesses:

• Subchapter S corporation conversion to a LLC will have a neutral impact on the general fund.

• Partnership conversion to a LLC will have a neutral impact on the general fund because Act #179 imposes a minimum $150 tax on partnerships.

• Small C corporation conversion to a LLC will have a neutral impact on the general fund.

• Medium C corporation conversion to a LLC will have a negative impact on the general fund because of the elimination of the double tax structure. However, some of this loss will initially be offset by conversion costs.

New Businesses:

• An LLC that might have organized as a subchapter S corporation will have a neutral impact on the general fund.

• An LLC that might have organized as a partnership will have a neutral impact on the general fund because Act #179 imposes a minimum $150 tax on partnerships.

• An LLC that might have organized as a C corporation could result in a loss of general fund revenue if the corporation eventually grew to medium proportions.

• As a general rule, most new businesses do not show a profit for the first one or two years.

An LLC will pass through the loss resulting in a decrease in personal income tax liability for the members. Because the same is true for subchapter S corporations and partnerships, there is no difference to the general fund.

However, an LLC that might have organized as a C corporation will pass through the loss to the members, while the C corporation will carry forward the loss and apply this net operating loss to future profits. In either case, the result is a decrease in general fund revenue. The difference is a question of timing. A net general fund loss would occur only if the C corporation began paying dividends to shareholders in the future.

Summary Finding:

• Based upon our survey of states and the rigorous study conducted by New York, it is our opinion that Vermont’s LLC law will have a negligible impact on general fund revenue.

RECOMMENDATIONS:

• The General Assembly should require the Secretary of State to create a mechanism for tracking the conversion of existing businesses to LLC’s. This information should be structured in a manner usable by the Tax Department and communicated to the Tax Department in order that the Department may be able to quantify changes in corporate and personal income tax revenue resulting from such conversion.

• The General Assembly should require the Tax Department to evaluate the impact of Act #179 three years after implementation of the LLC law, i.e., after tax year 1999 data has been collected and analyzed.

GLOSSARY:

Bulletproof statute: An LLC statute so narrowly drafted that it ensures that an entity will be treated as a Partnership for federal income tax purposes. Offers limited flexibility.

C Corporation: What most of us think of as a "regular" corporation. The letter "C" in the title indicates that the corporation is taxed pursuant to "Subchapter C" of the IRS Code. A corporation is a separate legal entity formed by business associates to conduct a business venture and distribute the profits among investors through dividends. Corporate ownership is evidenced by one, or more, classes of capital stock. The business affairs are overseen by a board of directors.

Corporate Characteristics: The four main characteristics of a corporation are explained as follows:

Limited liability: The reduction or elimination of the economic risk associated with the investment. Stockholders are not held personally liable for corporate debts, liabilities, or losses.

Centralized management: Management through corporate officers and a board of directors. Investors do not get involved in day-to-day operations and they rely on the fiduciary responsibilities of management .

Continuity of life: The life of the entity is perpetual and not affected by the life, death, solvency, insolvency, or any other aspect of a shareholder’s life.

Free transferability of interests: Stockholders can buy, sell, trade, mortgage, or otherwise encumber their interests in the corporation, i.e. their capital stock. In most closely held corporations (and most partnerships) real restrictions are imposed on this transferability in the form of "buy-sell" agreements.

Corporate Income tax: The tax, usually calculated on Net Profit (income less expenses), paid by the corporation before any distributions to the shareholders.

Entity tax: A tax, paid by the entity (sole proprietorship, partnership, corporation, professional service corporation, association etc.), levied without regard to income or expenses. This tax is usually either a "flat rate" (as in Vermont), or a "per member" fee with a minimum/maximum (as in New York).

Flexible statute: An LLC statute that allows the entity to structure its operating agreement so as to lack any two corporate characteristics and obtain partnership income tax treatment.

Limited Liability Company (LLC): A hybrid entity that under state law is neither a partnership nor a corporation. It offers its owners (members) protection from personal liability for the debts of the business. It may have no more than 2 of the corporate characteristics and, by default, limited liability is usually one of them. An LLC pays no income tax because it passes its income through to the members. The business affairs are overseen by managers.

Limited Partnership: A partnership with one or more General Partners and one or more Limited Partners. The General Partner is the "manager" of the business and assumes all of the liability risk for the operation. The Limited Partners are actually "investors" who are allowed to have little, or no, active participation in the operations and have "liability" for partnership debts and losses only to the extent of their contributions. The General Partner receives compe nsation for services while the Limited Partners receive a share of the net income/loss (as their return on investment).

Partnership: An association of two or more persons to carry on as co-owners a business for profit.

Personal Service Corporations (PSC’s): Also known as Professional Service Corporations. Used in many states for professionals to operate with protection from vicarious liability and general claims against the corporation.

Professional Limited Liability Company (PLLC): The PLLC offers its members the same advantages as those described in the LLC definition above. However, the liability protection does not extend to the member’s own negligent conduct or that of employees under the member’s direct control. This form is required of professionals in many states.

S Corporation (or Subchapter S Corporation): A "regular" corporation whose shareholders unanimously elect to be taxed as a partnership. The letter "S" in the title indicates that the corporation made the election available under "subchapter S" of the IRS Code. The corporation, through this election, also assumes a number of restrictions such as; no more than 35 shareholders; one class of stock, no corporate shareholders, and others. The S corporation pays no inco me tax because it passes its income through to the shareholders. The business affairs are overseen by a board of directors.

APPENDIX

Appendix 1: 50 STATE SURVEY

State

LLC Law Enacted

Income Tax Treatment

Treatment of Foreign LLC's

LLC Subject to Tax on Capital Values

LLC Subject to other taxes besides income, property sales & franchise

Composite Returns for non-resident members

Is Withholding required on non-resident member distributable shares?

How is member's basis in the LLC calculated?

AL

Yes

Federal

Federal

No

No

Allowed

No


AK

Yes

Federal

Federal

N/A

Yes

N/A

N/A

Same as Federal except for oil & gas companies

AZ

Yes

Federal

Federal

N/A

No

Allowed

No

Same as Federal

AR

Yes


Partnership

Yes

Yes

Allowed

No

Same as Federal

CA

Yes

Federal

Federal

N/A


N/R

N/R

N/R

CO

Yes


Federal

N/A


Allowed

LLC must pay 5% if member does not agree in writing to file

Same as Federal

CT

Yes

Federal

Federal

No

Corporate

No

No

Same as Federal

DC

Yes

Federal

Federal

Yes

No




DE

Yes

Federal

Federal

Yes

Business License & Gross Receipts

Allowed

Yes

Same as Federal

FL

Yes

Corporation

Corporation

N/A

Intangible, Documentary Stamp & Motor Fuel

N/A

N/A

Same as Federal

GA

Yes

Federal

Federal

No

N/R

Allowed

Yes

Same as Federal

HI

SB-2723 passed 4/29/96; effective, if signed, 4/30/97

Federal

Partnership

No





ID

Yes

Federal

Federal

N/A

N/R




IL

Yes

Federal

Federal

Yes

N/R

Allowed

No

Same as Federal

IN

Yes

Federal

Federal

N/A

N/R

Allowed

Yes

Same as Federal

IA

Yes

Federal

Federal

N/A





KS

Yes

Federal

Federal

Yes

No

Allowed

No

Same as Federal

KY

Yes

Federal

Federal






LA

Yes

Federal

Federal

Yes

Yes

No

No

Same as Federal

ME

Yes

Federal

Federal

No

No

Yes

No

Same as Federal

MD

Yes

Federal

Federal

No

No

Yes

Yes

Same as Federal

MA

Yes

Federal

Federal

No





MI

Yes

Federal

Federal

No





MN

Yes

Federal

Federal

No

Fee based upon property, payroll & sales

Yes

Yes

Same as Federal

MS

Yes

Federal

Federal

No





MO

Yes

Federal

Federal

No

No

Yes

Yes

Same as Federal

MT

Yes

Federal

Federal

No





NE

Yes

Federal

Federal

No



LLC must pay at highest rate if member does not agree in writing to file


NV

Yes



N/A





NH

Yes

Federal

Federal

N/A





NJ

Yes

Federal

Federal

N/A

No

Yes

No

Same as Federal

NM

Yes

Federal

Federal

N/A





NY

Yes

Federal

Federal

No

$50/member; min. $325,max. $10,000

Yes

No

Same as Federal

NC

Yes

Federal

Federal

No

Intangible Tax

No

LLC manager must pay tax for members

Same as Federal

ND

Yes

Federal

Federal

N/A

No


No

Same as Federal

OH

Yes

Federal

Federal






OK

Yes

Federal

Federal

No

No


Yes

Same as Federal

OR

Yes

Federal

Federal

No

No

Yes

No

Same as Federal

PA

Yes

Corporation

Corporation






RI

Yes

Federal

Federal




LLC must withhold at corporate rate if member does not agree in writing to file


SC

Yes

Federal

Federal






SD

Yes



N/A





TN

Yes

Federal

Federal

Yes

$50/member; min. $300,max. $3,000




TX

Yes

Corporation

Corporation

Yes

No



N/R

UT

Yes

Partnership

Corporation

N/A

No

N/A

N/A

Same as Federal

VT

Yes


Federal


No

Yes

No

Same as Federal

VA

Yes

Federal

Federal


No

No

No


WA

Yes



N/A





WV

Yes

Federal

Federal

Yes

No

Yes

Yes

Same as Federal

WI

Yes

Federal

Federal

No

Yes, if corp.

Temporary Recycling Surcharge


Same as Federal

WY

Yes








Appendix 2: LIQUIDATION AND CONVERSION PROCEDURES

Existing C Corporation Conversion:

Probably not likely for medium or large corporations because of the double tax on the recognized gain (by stockholders and the corporation) will be too high a price. There may be limited cases where the assets have not appreciated or where the corporation has a net operating loss (NOL) carry forward.

There are three ways to liquidate a corporation to an LLC:

1. Liquidate the corporation to the shareholders first and then the shareholders

contribute the assets to an LLC.

2. The shareholders form a new LLC, contribute their corporation stock to the capital of the LLC, and then liquidate the corporation into the LLC

3. Formation of an LLC jointly, by the corporation and the stockholders, followed by a liquidation of corporation’s LLC interest to the shareholders.

From a practical & tax perspective, option #2 makes the most sense. The corporation assets are transferred only once (avoids paying any local transfer taxes twice). Assets have a stepped-up basis in the LLC to market value. Shareholders donated appreciated value stock to the LLC so the gain is allocated back to the shareholders. Members would have a carryover value of the stock into the LLC.

Option #1 involves transferring the assets twice with the possibility of exposure to liabilities at the owner level on the corporation liquidation.

If C corporation conversion to an LLC is still attractive, here are some considerations:

1. If there was only 1 shareholder in the corporation, there will have to be at least 2 in the LLC. Note: Vermont’s LLC law permits 1 member LLC’s.

2. Liabilities in place at the corporate level may prove hard to put in place at the LLC level.

3. Creditors may have different requirements for an LLC

4. Liquidating distributions usually trigger capital gain to shareholders whereas an operating distribution is an ordinary dividend.

5. Accumulated earnings and profits can be wiped out without tax consequences.

Existing S Corporation Conversions

When an S corporation liquidates, generally the C corporation liquidation rules apply. Therefore, gain is recognized at the corporate level for any appreciated property and this gain flows through to the shareholders where it increases their basis in their stock and is subject to tax. The shareholder may also have to recognize gain if the appreciated value of the assets received exceeds the basis of their stock. The shareholder may have a capital loss if the basis of the stock is approximately equal t o the assets transferred and the assets are Sec 1231 business assets that cause a corporate level capital gain distribution.

There are three ways to liquidate a corporation to an LLC:

1. Liquidate the corporation to the shareholders first and then the shareholders contribute the assets to an LLC.

2. The shareholders form a new LLC, contribute their corporation stock to the capital of the LLC, and then liquidate the corporation into the LLC

3. Formation of an LLC jointly, by the corporation and the stockholders, followed by a liquidation of corporation’s LLC interest to the shareholders.

Option #1 is cumbersome, as with C corporations.

Option #2 makes it necessary to give up S corporation election and have taxable liquidations at the corporate and shareholder levels.

Option #3 is the best because it "wraps" the S corporation with the LLC. In this way, the S corporation restrictions can be overcome because whatever the S corporation could not do, the LLC is allowed to do. Actually, the S corporation would not have to be liquidated, thereby deferring the liquidation tax indefinitely.

Appendix 3: EXAMPLES OF USES FOR LLC/LLP/PLLC ENTITIES

Real Estate Development -

The early year losses common to these activities pass through to members. Later years profits are passed through to members and are subject to one level of tax, as opposed to two levels with a corporate entity. Also, members enjoy limited liability regardless of their level of participation, unlike Limited Partnerships.

Interstate Operations

A much simpler organizational structure than corporate entities filing consolidated returns.

Venture Capital/Startup Companies

Especially good for risky high-tech industries where startup research and development costs are high and the outcome is uncertain. A subsidiary LLC could be formed whose members would be the parent company and venture capital investors. The parent high-tech company and the investors would both be protected against liabilities and the R&D credits could be allocated to the investors.

Professional Service Organization

Many of these organizations (i.e. attorneys, accountants and architects) are currently general partnerships. The PLLC/LLP form offers the members liability protection from the malpractice of other members or staff beyond their supervision.

Corporate Joint Ventures

When several high-tech companies join together for a joint research project, each corporation could form a single purpose subsidiary to hold their interest in the joint venture LLC. Each company is insulated form joint venture liabilities.