RLLPs and LLCs: Practical Considerations About Limited Liability Partnerships and Companies
By Byron F Egan *
A. General. The Texas Limited Liability Company Act, as amended in 1993 and 1997, is found at Article 1528n of Vernon's Texas Civil Statutes (the "LLC Act"). The operational provisions of the LLC Act are modeled after the TBCA, the Texas Miscellaneous Corporation Laws Act ("TMCLA"), and TRLPA. Texas was the fourth state to adopt an LLC statute and now every state has adopted an LLC Act.
All equity holders of an LLC have the limited liability of corporate shareholders even if they participate in the business of the LLC. Thus the LLC Act contemplates that LLC's will be organized with features that resemble corresponding features of corporations.
Under the Check-the-Box Regulations, a domestic LLC with two or more members typically would be treated for federal income tax purposes as a partnership. An LLC is subject to Texas corporate franchise tax.
An underlying premise of the LLC Act is that the LLC is based in large part upon a contract between its members, similar to a partnership agreement. As a result, fundamental principles of freedom of contract imply that the owners of an LLC have maximum freedom to determine the internal structure and operation of the LLC. Thus the LLC Act would be classified as a "flexible" LLC statute. This freedom of contract, however, could have resulted in the inadvertent loss of partnership classification for federal income tax purposes under the Former Classification Regulations.
The LLC Act in many cases provides "default" provisions that reflect the common expectations of persons engaged in business under the Prior Classification Regulations, and to permit these expectations to be met in the event that the organizational documents for an LLC do not include a provision specifically dealing with an issue. Those default provisions, however, may result in restrictions on the LLC that are not necessary under the Check-the-Box Regulations and may unnecessarily change the intended business deal. Examples of provisions which were often included in an LLC structure because of the Former Classification Regulations and which are required by neither the LLC Act nor the Check-the-Box Regulations:
(i) limited duration (the LLC Act now permits an LLC to have a perpetual duration like a corporation);
(ii) management by Members rather than Managers;
(iii) restrictions on assignments of interests beyond what is required by applicable securities laws and the desires of the parties; and
(iv) dissolution of the LLC upon the death, expulsion, withdrawal, bankruptcy or dissolution of a Member.
B. Taxation.
1. Check the Box Regulations. Domestic LLCs that have two or more members ordinarily will be classified as partnerships for federal income tax purposes, unless the LLC makes an election to be classified as an association taxable as a corporation. A single member LLC will be disregarded as an entity separate from its owner under the Check-the-Box Regulations, unless an election is made for it to be taxed as a corporation.
2. Other Tax Issues Relating to LLCs.
(a) Franchise Taxes. An LLC with gross receipts of $150,000 or more is subject to the Texas franchise tax. As a result, an LLC is subject to a franchise tax equal to the greater of (1) 0.25% of its "net taxable capital," which equals its Members' contributions and surplus, and (2) 4.5% of its "net taxable earned surplus." The "net taxable earned surplus" of an LLC is based on the entity's reportable federal taxable income with the compensation of officers and Managers being added back (unless the LLC has more than one Member but does not have more than 35 Members) and certain other adjustments and with that amount being apportionable to Texas based on the percentage of the LLC’s gross receipts from Texas sources. An LLC with fewer than 35 Members can eliminate its Texas franchise tax based on "net taxable earned surplus" with Member compensation, subject to limits on unreasonable compensation. Texas administrative regulations provide that a single Member LLC may not deduct officer and director compensation paid to the Member in computing "net taxable earned surplus." Such an LLC may, however, deduct compensation paid to officers or managers other than a Member-Manager.
In each other state in which an LLC does business it will be necessary to ascertain the franchise and income tax treatment of foreign LLC's doing business therein. Since most state income tax regimes are based on the federal adjusted gross income, an LLC treated as a partnership for federal income tax purposes should be treated as such for state income tax purposes in the absence of a specific state statute.
(b) Flexible Statute. In Rev. Rul. 88-76, I. R. B. 1988-38, 22, a Wyoming LLC was held to lack continuity of life and free transferability of interest, because the Wyoming LLC statute requires the unanimous vote of all remaining Members to continue the LLC upon a Dissolution Event, and the consent of all LLC Members for any transferee of an interest to participate in the management of the LLC or to become a Member. The Wyoming LLC statute is considered a "bullet proof statute" because an LLC formed thereunder will always lack these two corporate characteristics important under the Prior Classification Regulations. By contrast, the Utah LLC statute and the Texas LLC Act are considered "flexible statutes" because they allow the Members to vary their Regulations to allow greater organizational flexibility (thus, creating the possibility that an LLC organized thereunder would be taxable as an "association" rather than a partnership under the Former Classification Regulations). In the Utah Ruling, the IRS noted that "[b]ecause of the flexibility accorded by the Utah Limited Liability Company Act, a Utah LLC may be classified as a partnership or as an association taxable as a corporation depending upon the provisions adopted in the LLC's articles of organization or operating agreement" under the Former Classification Regulations. Similarly, an LLC formed under the Texas LLC Act could be structured so as to be taxable as a partnership or as an association for federal income taxation purposes.
(c) One Member LLC. The LLC Act permits a one-Member LLC, the status of which is now certain under the Check-the-Box Regulations. As previously stated, for federal income tax purposes, a single Member domestic LLC will be disregarded as an entity separate from its owner unless it elects to be taxed as a corporation. Many state LLC statutes do not authorize single member LLCs.
(d) Contributions of Appreciated Property. As a general rule, a transfer of appreciated property in exchange for an interest in an LLC classified as a partnership will not result in any gain or loss being recognized by the transferor, the LLC or any of the other Members of the LLC. The tax basis of the transferor in the LLC interest thereof and of the LLC in the transferred property is the basis the transferor had in the transferred property at the time of the transfer. Under certain circumstances, a Member's contribution of property may result in a net reduction in liability to that Member in excess of the Member's tax basis in the contributed property. In such a situation, the Member will recognize a gain to the extent of such excess.
(e) Self-Employment Tax. Individuals are subject to a self-employment tax on self-employment income. The tax rate aggregates up to 15.3% and consists of (i) a 12.40% social security equivalent tax on self-employment income up to a 1998 contribution base of $68,400 (adjusted annually for inflation), plus (ii) a 2.9% medicare tax on all self-employment income (there is no ceiling). An individual's wage income is applied against the contribution base. Self-employment income generally means an individual's net earnings from the individual's trade or business. An individual's self-employment income includes his distributive share of the trade or business income from a partnership of which he is a partner (including an LLC classified as a partnership for federal income tax purposes), subject to the exception that a limited partner's distributive share of income or loss from a limited partnership generally will not be included in his net income from self employment.
In 1994 the IRS issued proposed regulations providing that an individual Member's share of income from a trade or business of the LLC is subject to self-employment tax (assuming the LLC is treated as a partnership for federal income tax purposes) unless (i) the Member is not a managing Member and (ii) the entity could have been formed as a limited partnership rather than an LLC in the same jurisdiction and the Member could have qualified as a limited partner. See Treas. Reg. § 1.1402(a)-18 (Proposed). If the LLC does not have designated Managers with continuing and exclusive authority to manage the LLC, then all Members will be treated as Managers for this purpose.
On January 10, 1997 the IRS withdrew its 1994 proposed regulation dealing with employment taxes in the LLC context and proposed new regulations that would apply to all entities (including LLCs) that are classified as partnerships under the Check-the-Box Regulations. The IRS said that it was proposing a "functional" approach that would define "limited partner" for federal tax purposes, irrespective of the state law classification, because of the proliferation of new business entities such as the LLC as well as the evolution of state limited partnership statutes. Under the proposed regulations:
"Generally, an individual will be treated as a limited partner under the proposed regulations unless the individual (1) has personal liability (as defined in section 301.7701-3(b)(2)(ii) of the Procedure and Administration Regulations) for the debts of or claims against the partnership by reason of being a partner; (2) has authority to contract on behalf of the partnership under the statute or law pursuant to which the partnership is organized; or, (3) participates in the partnership's trade or business for more than 500 hours during the taxable year. If, however, substantially all of the activities of a partnership involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting, any individual who provides services as part of that trade or business will not be considered a limited partner."
Until the proposed regulations are effective for an LLC Member, there is a risk that the IRS will treat any individual Member's share of the trade or business income of the LLC as being subject to self-employment tax, even if the Member is not a Manager and would be treated as a limited partner under the 1997 proposed regulations, based on the IRS position set forth in Private Letter Ruling 9432018, which was issued prior to the proposed regulation. Under both current law and the 1997 proposed regulations, an LLC Member will be subject to self-employment tax on guaranteed payments for services, and Members will not be subject to self-employment tax on distributions if the LLC is treated as an association taxable as a corporation for Federal tax purposes.
The Taxpayer Relief Act of 1997 prohibited the IRS from issuing any temporary or final regulations relating to the definition of a limited partner for employment tax purposes that would be effective before July 1, 1998. The legislative history indicates that Congress wants the IRS to withdraw the controversial proposed regulation discussed above, which would impose a tax on limited partners. A "sense of the Senate" resolution in the Senate amendment expressed dissatisfaction with the proposed regulation, noting that Congress, not the Treasury or the IRS, should determine the law governing self-employment income for limited partners.
C. Members; Managers. The owners of an LLC are called "Members," and are equivalent to shareholders in a corporation or limited partners of a limited partnership. The "Managers" of an LLC are generally equivalent to directors of a corporation and are elected by the Members in the same manner as corporate directors are elected by shareholders. Under the LLC Act, however, an LLC may be structured so that management shall be by the Members as in the case of a close corporation or a general partnership, and in that case the Members would be analogous to general partners in a general or limited partnership but without personal liability. For an LLC to be taxed as a partnership it must have at least two Members, although the LLC Act would permit an LLC to have only one Member; a single Member LLC is not treated as a separate entity under the Check-the-Box Regulations unless it elects to be taxed as a corporation (i.e., a single Member LLC may be taxed as a sole proprietorship or corporation, but not as a partnership).
Under the LLC Act, any "person" may become a Member or Manager. Because of the broad definition of "person" in the LLC Act, any individual, corporation, partnership, LLC or other person may become a Member or Manager. Thus, it is possible to have an LLC with a corporation as the sole Manager just as it is possible to have a limited partnership with a sole corporate general partner.
D. Purposes and Powers. Under the LLC Act, an LLC may generally be formed to conduct any lawful business, subject to limitations of other statutes which regulate particular businesses. It has all of the powers of a Texas corporation or limited partnership, subject to any restrictions imposed by statute or its Articles of Organization ("Articles") or regulations ("Regulations").
E. Formation; Articles of Organization. An LLC is formed when one or more persons file Articles, similar to a certificate of limited partnership under TRLPA and articles of incorporation under the TBCA, with the Texas Secretary of State ($200 filing fee). The initial Articles must contain (1) the name of the LLC, (2) the period of its duration, which may be perpetual, (3) its purpose, which may be the transaction of all lawful business for which LLC's may be organized, (4) the address of its initial registered office and the name of its initial registered agent at that address, (5) if the LLC is to have a Manager or Managers, a statement to that effect and the names and addresses of the initial Manager or Managers, or if the LLC will not have Managers, a statement to that effect and the names and addresses of the initial Members, (6) the name and address of each organizer, (7) specified information if the LLC is to be a professional LLC, and (8) any other provisions not inconsistent with law. An LLC's existence as such begins upon issuance of a certificate of organization by the Secretary of State. An LLC may also be formed pursuant to a plan of conversion or merger, in which case the articles may be part of the plan, do not need to be filed separately with the Secretary of State and become effective upon the effectiveness of the plan.
The name of an LLC must contain words or an abbreviation to designate the nature of the entity. The designation may be any of the following: the words "Limited Liability Company," or "Limited Company" (Limited may be abbreviated "Ltd." and Company may be abbreviated "Co."), or the acronyms LLC or LC (with or without the periods). The name must not be the same as or deceptively similar to that of any domestic or foreign LLC, limited partnership or corporation authorized to transact business in Texas. Prior to accepting Articles for filing, the Secretary of State reviews its LLC, limited partnership and corporation records to determine whether the LLC's proposed name is impermissibly close to that of an existing LLC, limited partnership or corporation.
F. Regulations. Most of the provisions relating to the organization and management of an LLC and the terms governing its securities are to be contained in the LLC's Regulations, which would contain provisions similar to those in limited partnership agreements and corporate bylaws. The Members of an LLC have the power to adopt, alter or amend the regulations, although the articles of organization or regulations may provide that the Managers also have the power to adopt, alter or repeal the Regulations. SB 555 deleted the prior LLC Act requirement that initial Regulations be adopted by the Managers. Unless otherwise provided in the Articles or Regulations, the adoption, amendment or repeal of regulations requires the unanimous vote of the Members or, if the power to amend, alter or repeal is vested in Managers, the unanimous vote of the Managers.
Although the Regulations will ordinarily contain the capital account and other financial and tax provisions found in a typical limited partnership agreement, the LLC Act does not require that the Regulations ever be approved by the Members or be filed with the Secretary of State or otherwise made a public record. Nevertheless it may be desirable for the Members to approve the Regulations and agree to be contractually bound thereby. The Members' express agreement to be contractually bound by the Regulations should facilitate enforcement thereof and their being treated as a "partnership agreement" for federal income tax purposes.
In some other states, the agreement which is referred to in Texas as Regulations is referred to as "operating agreement" or the "LLC agreement."
G. Management. The business and affairs of an LLC with Managers are managed under the direction of its Managers, who can function as a board of directors and may designate officers and other agents to act on behalf of the LLC. A Manager may be a corporation or other entity, and it is possible to have an LLC which has a single Manager that is a corporation or other entity. The Articles or the Regulations, however, may provide that the management of the business and affairs of the LLC may be reserved, in whole or in part, to its Members. Thus an LLC could be organized to be run without Managers, as in the case of a close corporation under the TBCA, or it could be structured so that the day to day operations are run by Managers but Member approval is required for significant actions as in the case of many joint ventures and closely held corporations.
The Regulations should specify who has the authority to obligate the LLC contractually or to empower others to do so. LLC Act § 2.21B provides that all officers, agents, Managers and Members of an LLC, as among themselves and the LLC, have such authority in the management of the LLC as may be provided in its Regulations or as may be determined by resolution of the Managers or, to the extent to which management is reserved to them, the Members. LLC Act § 2.21C provides that the following are agents of an LLC: (1) any officer or other agent who is vested with actual or apparent authority; (2) each Manager (to the extent that management of the LLC is vested in that Manager); and (3) each Member (to the extent that management of the LLC has been reserved to that Member). LLC Act § 2.21D provides than an act (including the execution of an instrument in the name of the LLC) for the purpose of apparently carrying on in the usual way the business of the LLC by any of the persons named in LLC Act § 2.21C binds the LLC unless (1) the person so acting lacks authority to act for the LLC and (2) the third party with whom the LLC is dealing is aware of the actor's lack of authority. Lenders and others dealing with an LLC can determine with certainty who has authority to bind the LLC by reference to its Articles, Regulations and resolutions, just as in the case of a corporation. In routine business transactions where verification of authority is not the norm in transactions involving corporations, the same principles of apparent authority should apply in the LLC context.
Members and Managers acting on behalf of an LLC should disclose that they are acting on behalf of the entity and that it is an LLC. Under common law agency principles, an agent can be personally liable on a contract made for an undisclosed or unnamed principal.
The LLC Act contains no requirements as to the terms of Managers, but allows Regulations to provide for specified terms of Managers and annual or other regularly scheduled meetings of Members; if the Regulations are silent as to the term, the default is to retention of the Managers. LLC Act § 2.14 allows any number of classes of Managers, and contains no requirement that such classes either be equal or nearly equal in number or be elected in strict rotation at successive annual meetings of Members.
The duty of Managers to an LLC and its Members is fiduciary in nature and should be measured by reference to that of corporate directors, although the LLC Act does not state specifically that Manager fiduciary duties exist or attempt to define them. By analogy to corporate directors, Managers would have the duties of care and loyalty and should have the benefit of the business judgment rule. Further, by analogy to a corporate director who in theory represents all of the shareholders of the corporation rather than those who are responsible for his being a director, a Manager should be deemed to have a fiduciary duty to all of the Members. In a joint venture, the duty to all Members could be an issue since the Managers would often have been selected to represent the interests of particular Members; the issue could be addressed by structuring the LLC to be managed by Members who would then appoint representatives to act for them on an operating committee which would run the business in the name of the Members. In such a situation, the Members would likely have fiduciary duties analogous to partners in a general partnership.
SB 555 amended LLC Act § 2.20 to provide that the Regulations (i) may expand or restrict the duties (including fiduciary duties) and liabilities of Members, Managers, officers and others to the LLC and (ii) provide for their indemnification without restriction by reference to the TBCA or otherwise. Whether courts will enforce amended LLC Act § 2.20 as broadly as it is written remains to be seen. Previously the limitation of liability and indemnification provisions in TMCLA § 7.06 and TBCA § 2.02-1, respectively, were made applicable to LLCs by LLC Act § 8.12.
The LLC Act § 2.17, which is based on TBCA § 2.35-1, provides that, unless the Articles or Regulations otherwise provide, a transaction between an LLC and one or more of its Managers or officers, or between an LLC and any other LLC or other entity in which one or more of its Managers or officers are Managers, directors or officers or have a financial interest, shall be valid notwithstanding the Manager or officer is present or participates in the meeting of Managers which authorizes the transaction or the Manager's votes are counted for such purpose, if any of the following is satisfied:
(i) The material facts as to the transaction and interest are disclosed or known to the Managers, and the Managers in good faith authorize the transaction by the affirmative vote of a majority of the disinterested Managers even though the disinterested Managers are less than a quorum; or
(ii) The material facts as to the transaction and interest are disclosed or known to the Members entitled to vote thereon, and the transaction is approved in good faith by a vote of the Members; or
(iii) The transaction is fair to the LLC as of the time it is authorized, approved or ratified by the Managers or Members.
H. Capital Contributions. The contribution of a Member may consist of any tangible or intangible benefit to the LLC or other property of any kind or nature, including a promissory note, services performed, a contract for services to be performed or other interests in or securities or other obligations of any other LLC or other entity. The Regulations ordinarily would contain provisions relative to capital accounts and the allocation of profits and losses comparable to those in a limited partnership agreement.
I. Allocation of Profits and Losses; Distributions. Allocations of profits and losses, and distributions of cash or other assets, of an LLC are made to the Members in the manner provided by the Regulations. If the Regulations do not otherwise provide, distributions are made on the basis of the agreed value of the contributions made by each Member. A Member is entitled to receive distributions from an LLC prior to its winding up to the extent and at the times specified in the Regulations. An LLC may not make a distribution to its Members to the extent that, immediately after giving effect to the distribution, all liabilities of the LLC, other than liabilities to Members with respect to their interests and nonrecourse liabilities, exceed the fair value of the LLC assets. A Member who receives a distribution that is not permitted under the preceding sentence has no liability to return the distribution under the LLC Act unless the Member knew that the distribution was prohibited.
J. Limited Liability. The LLC Act provides that, except as provided in the Regulations, a Member or Manager is not liable to third parties for the debts, obligations or liabilities of an LLC, although Members are liable for the amount of any contributions they agreed to make. Members may participate in the management of the LLC without forfeiting this liability shield. Since the LLC Act deals expressly with the liability of Members and Managers for LLC obligations, the principles of "piercing the corporate veil" should not apply to LLC's in Texas, although this issue will no doubt be litigated. Some state LLC statutes expressly deal with the veil piercing issue by providing that the LLC veil will be pierced to the same extent as the corporate veil or that the Members will have the same liabilities as corporate shareholders.
K. Nature and Classes of Membership Interests. A membership interest in an LLC is personal property. It does not confer upon the Member any interest in specific LLC property. A membership interest may be evidenced by a certificate if the Regulations so provide.
The Regulations may establish classes of Members having expressed relative rights, powers and duties, including voting rights, and may establish requirements regarding the voting procedures and requirements for any actions including the election of Managers and amendment of the Articles and Regulations. The Regulations could provide for different classes of Members each authorized to elect a specified number or percentage of the Managers. The LLC Act generally allows even more flexibility in structuring classes of Members than is available in structuring classes of corporate stock under the TBCA or classes of limited partnership interests under TRLPA.
An LLC membership interest would ordinarily be considered a "security" for the purposes of the Securities Act of 1933, as amended, and state securities or blue sky laws. The offering and sale of an interest must either be registered under applicable federal and state securities laws or effected in a private or other transaction structured to be exempt from those requirements.
Prior to September 1, 1995, an LLC membership interest represented by a certificate would ordinarily have been considered a "security" for the purposes of Chapter 8 of the Texas Business and Commerce Code as in effect prior to that date ("Pre 9/1/95 B&CC"). Such an interest would ordinarily have been considered a "certificated security" under Pre 9/1/95 B&CC § 8.102 because it would have been (a) represented by an instrument issued in bearer or registered form; (b) of a type dealt in as a medium for investment; and (c) a class or series of shares, participations, interests or obligations. Under Pre 9/1/95 B&CC, security interests in certificated LLC interests would have been perfected by possession, as in the case of corporate shares. Security interests in membership interests which were not evidenced by an instrument would have been perfected by a financing statement filing under Pre 9/1/95 B&CC § 9.
Under H.B. 3200 which became effective September 1, 1995, LLC membership interests are not "securities" governed by Chapter 8 of the Texas Business & Commerce Code, as amended by H.B. 3200 ("Post 9/1/95 B&CC"), unless the interests are dealt in or traded on securities exchanges or markets or unless the parties expressly agree to treat them as such. Under Post 9/1/95 B&CC Chapter 9, LLC membership interests should be classified as "general intangibles," whether or not represented by a certificate, and security interests would be perfected by a financing statement filing. There is a transition/grace period until January 1, 1996 for security interests in LLC membership interests previously perfected by possession under Pre 9/1/95 B&CC Chapter 8.
Under the LLC Act, like under TRLPA, a judgment creditor of a Member may on application to a court of competent jurisdiction secure a "charging order" against the Member's membership interest. In a "charging order" a court "charges" the membership interest such that any distributions thereon are made as directed by the court, but does not order foreclosure of the interest or compel any distributions. A charging order should not permit a judgment creditor of a Member to receive distributions on an interest subject to a prior perfected security interest.
L. Assignment of Membership Interests. Unless otherwise provided in an LLC's Regulations, (1) a Member's interest in an LLC is assignable in whole or in part, (2) an assignment of a membership interest does not of itself dissolve the LLC or entitle the assignee to participate in the management and affairs of the LLC or to become, or to exercise any of the rights of, a Member, (3) an assignment entitles the assignee to be allocated income, gain, loss, deduction, credit or similar items, and receive distributions, to which the assignor was entitled to the extent those items are assigned and, for any proper purpose, to require reasonable information or account of transactions of the LLC and to make reasonable inspection of the books and records of the LLC, and (4) until the assignee becomes a Member, the assignor continues to be a Member and to have the power to exercise any rights or powers of a Member, except to the extent those rights or powers are assigned. An assignee of a membership interest may become a Member if and to the extent that the Regulations so provide or all Members consent. Until an assignee is admitted as a Member, the assignee does not have liability as a Member solely as a result of the assignment.
Regulations would typically contain restrictions on the assignment of interests to facilitate compliance with applicable securities and tax laws. Membership interest transfer restrictions contained in Regulations are enforceable.
M. Dissolution. LLC Act § 6.01A provides that an LLC is dissolved upon the occurrence of any of the following events:
(1) when the period (if any) fixed for its duration, which may be perpetual (prior to its amendment in 1993, the LLC Act provided a maximum duration of 30 years);
(2) on the occurrence of events specified in the Articles or Regulations to cause dissolution;
(3) the action of the Members to dissolve the LLC (in the absence of a specific provision in the Articles or Regulations, the vote will be by a majority of the Members);
(4) if no capital has been paid in, the act of a majority of the Managers or Members named in the Articles to dissolve the LLC;
(5) except as otherwise provided in the Regulations, upon the death, expulsion, withdrawal pursuant to or as provided in the Articles or Regulations, bankruptcy or dissolution of a Member or the occurrence of any other event which terminates the continued membership of a Member in the LLC; or
(6) entry of decree of judicial dissolution under the LLC Act because it is not reasonably practicable to carry on the business of the LLC in conformity with its Articles and Regulations.
LLC Act § 6.01B provides, however, that an LLC is not dissolved if (a) one of the events specified in (1) (expiration of fixed duration), (2) (events specified in Articles or Regulations to cause dissolution) or (5) (death, withdrawal, bankruptcy, etc.) above occurs, (b) there is at least one remaining Member and (c) the business of the LLC is continued as provided in the Articles or Regulations or, if not so provided, by all remaining Members. Unless otherwise provided in the Articles or Regulations, an election to continue the business of the LLC must be made within 90 days after the date of the occurrence of the event of dissolution. If an election to continue the business of the LLC is made following the termination of the period fixed for the duration of the LLC or the occurrence of events specified in the Articles to cause dissolution, the election is not effective unless an appropriate amendment is made by the LLC to its Articles during the three-year period following the date of the event of dissolution, extending the period fixed for the duration of the LLC or deleting the event specified in the Articles that caused the dissolution, as applicable.
Since (i) under the Check-the-Box Regulations continuity of life is not an issue in determining whether an LLC will be treated as a partnership for federal income tax purposes and (ii) there is considerable flexibility under the LLC Act in defining the circumstances in which an LLC is dissolved, the Articles and Regulations should henceforth focus on dissolution from a business rather than a tax standpoint. The result in many cases will be that the LLC will not dissolve until the parties take affirmative action to cause dissolution.
On the dissolution of an LLC, its affairs must be wound up as soon as practicable by its Managers, or Members or other persons as provided in its Articles or Regulations or by resolution of the Managers or Members. Before filing articles of dissolution with the Secretary of State, the LLC shall (i) cease to carry on its business, except as may be necessary for the winding up thereof, (ii) mail written notice of its intention to dissolve to each of its known creditors and claimants, and (iii) collect its assets, discharge its obligations or make provision therefor, and distribute the remaining assets to its Members. In the event a dissolving LLC's assets are not sufficient to discharge its obligations, the LLC is required to apply the assets as far as they will go to the just and equitable payment of its obligations. At any time prior to the issuance of a certificate of dissolution by the Secretary of State, an LLC may revoke voluntary dissolution proceedings by the written consent of all of its Members. Upon the issuance of the certificate of dissolution by the Secretary of State, the existence of the LLC terminates except for the purpose of suits and other proceedings by Members, Managers and other LLC representatives.
N. Merger; Conversion. Part Ten of LLC Act contains merger provisions for LLC's allowing an LLC to merge with one or more LLC's or "other entities" (i.e. any corporation, limited partnership, general partnership, joint venture, joint stock company, cooperative, association, bank, insurance company or other legal entity, whether organized for profit or not, to the extent that the laws or constituent documents of the other entity permit the merger). The merger must be pursuant to a written plan of merger containing the provisions required by LLC Act § 10.02 and the entities involved must approve the merger by the vote required by their respective governing laws and organizational documents. Under LLC Act § 10.03 a merger is effective when the entities file appropriate articles of merger with the Secretary of State.
The merger provisions in Part Ten of the LLC Act were modeled on the provisions of Section 2.11 of TRLPA and (with respect to LLC Act § 10.05) TBCA § 5.16. Important changes from TRLPA include (i) a requirement of unanimous approval by the Members of the LLC of mergers and share exchanges unless the Regulations provide otherwise and (ii) a broad description in LLC Act § 10.03.A of the persons who may execute the articles of merger. The provisions of LLC Act § 10.05 are drafted broadly to allow application of the provision to all types of entities that own, are owned by, or are under common ownership with a domestic limited liability company in the required percentage.
LLC Act § 10.08, like Texas’ other business entity statutes, now authorizes an LLC to convert to another form of entity, or convert from another into an LLC, without going through a merger or transfer of assets, and has provisions providing the mechanics of the adoption of a plan of conversion, for owner approval, for filings with the Secretary of State, and for the protection of creditors.
O. Relationship to TBCA and TMCLA. The 1991 LLC Act § 8.12 provided that, to the extent that the LLC Act contains no provision with respect to one of the matters provided for in the TBCA and the TMCLA, such acts (as amended from time to time) will supplement the LLC Act to the extent not inconsistent with the LLC Act. In particular, TBCA § 2.02-1 and Part 5 with respect to indemnification and mergers, respectively, and TMCLA § 7.06 with respect to the limitation of director liability (made applicable to Managers) were incorporated.
The 1991 LLC Act was left relatively short to give maximum flexibility of parties to tailor organizational structures to transactional needs, and the references to the TBCA and TMCLA were inserted to allow established bodies of law under those statutes to be used to fill the gaps not filled by the LLC Act, the Articles or the Regulations. Concepts of "piercing the corporate veil" which have developed under the TBCA are inconsistent with the concepts of limited liability of Members in the LLC Act and were not intended to be carried over. Concepts of cumulative voting and preemptive rights from TBCA §§ 2.22-1 and 2.29D may have been incorporated into the 1991 LLC Act by LLC Act § 8.12, although this conclusion was not free from doubt.
The Bar Committee preparing the 1993 amendments to the LLC Act concluded that 1991 LLC Act § 8.12 was overbroad and presented interpretational difficulties and revised LLC Act § 8.12 to designate the sections of the TBCA and the TMCLA incorporated by reference. As amended in 1993 and 1997, LLC Act § 8.12A provides that only the following TBCA provisions apply to an LLC and its Members, Managers and officers:
2.07 (registered name)
4.14 (amendments of Articles, merger and dissolution pursuant to Federal bankruptcy laws)
5.14 (derivative suits)
Part Seven (involuntary dissolution and receivership).
LLC Act § 8.12B provides that any of the following TMCLA provisions apply to an LLC, its Members, Managers and officers:
2.03 (obligations to ostensible LLC)
2.04 (exclusive right of trustee to sue under indentures and security documents)
2.05 (facsimile signatures on debt instruments)
2.06 (consideration for indebtedness and guarantees)
2.09 (interest rate on borrowings)
2.09A (alternative interest rate on borrowings)
3.01 (veteran entities)
7.01-7.05 (correction of defective filings with Secretary of State)
SB 555 deleted from the list of incorporated by reference provisions TMCLA § 7.06 (limitation of Manager liability) in light of more specific provisions now contained in the LLC Act regarding such matter. LLC Act § 2.20 was amended by SB 555 to expand the power of Articles and Regulations to modify the duties (including fiduciary duties) and liabilities of its Members, Managers and provide for their indemnification. The Articles and Regulations now govern such matters without statutory restriction, although it is possible that courts will impose public policy limits.
LLC Act § 8.12C was added clarifies the translation of corporate terms such as "directors," "shareholders" and "shares" into the LLC context.
TBCA concepts of cumulative voting and preemptive rights are clearly not incorporated by reference into the LLC Act. Organizers desiring to provide those rights must expressly provide them in the Articles or Regulations, although an express denial thereof in the Articles or Regulations still seems useful so that all parties will be aware of the result.
P. Foreign LLC's. The LLC Act provides a mechanism by which a limited liability company formed under the laws of other jurisdictions can qualify to do business in Texas as a foreign limited liability company (a "Foreign LLC") and thereby achieve in Texas the limited liability afforded by the LLC Act to a domestic LLC. The LLC Act defines Foreign LLC so broadly that business trusts and other entities afforded limited liability under the laws under which they were organized can qualify to do business and achieve limited liability in Texas. When a foreign entity with "trust" in its name (such as a real estate investment trust) seeks to qualify to do business in Texas as a Foreign LLC, the Secretary of State will not qualify the Foreign LLC to do business until it obtains a letter of no objection from the Banking Department because the trust business in Texas is subject to regulation by the Banking Department.
The Foreign LLC qualification mechanism is derived from, and mirrors, TBCA Part Eight. Any Foreign LLC "doing business" in Texas, like a foreign corporation, is required to qualify to do business in Texas by filing an application to do so with the Secretary of State. The analysis of whether a Foreign LLC is "doing business" in Texas so as to have to qualify is the same as for a foreign corporation. The internal affairs of a Foreign LLC, including the personal liability of its Members for its obligations, are governed by the laws of its jurisdiction of organization.
Q. Professional LLC's. Part Eleven of the LLC Act expressly provides for the formation of professional LLC's and to specify the statutory requirements for such entities. The provisions of Part Eleven, including the definition of "professional service," are based upon the Texas Professional Corporation Act ("TPCA"). Unlike the TPCA, however, physicians, surgeons and other doctors of medicine are not excluded from forming professional LLC's.
A professional limited liability company (a "PLLC") is required by LLC Act § 11.02 to contain in its name "the words ‘Professional Limited Liability Company’ or the abbreviation ‘P.L.L.C.’ or ‘PLLC’." LLC Act § 11.03 provides that a person who is not either a "professional individual" (defined as an individual who is licensed or otherwise authorized to render the professional service of the PLLC, either within Texas or in any other jurisdiction) or a "professional entity" (defined as a person other than an individual that renders the same professional service as the PLLC only through partners, members, shareholders, Managers, directors, associates, officers, employees or agents who are professional individuals or professional entities) may not be a Member, Manager or officer of the PLLC. The PLLC, but not the individual Members, Managers or officers, is jointly and severally liable with a Member, Manager, officer, employee or agent rendering professional service for an error, omission, negligence, incompetence, or malfeasance on the part of the Member, Manager, officer, employee or agent when the Member, Manager, officer, employee or agent is rendering professional service in the course of employment for the PLLC under LLC Act § 11.05.
R. Limited Banking Associations. A new Subchapter C of Chapter 3 to the Texas Banking Code (Tex. Rev. Civ. Stat. Ann. art. 342-301) was added in 1993, introducing yet another tax-flow-through entity: the "limited banking association" (an "L.B.A."). The L.B.A. is in essence a state bank with the characteristics of an LLC but tailored to the requirements of the bank regulators. The IRS has taken the position that an L.B.A. will be classified as a corporation rather than a partnership in a private letter ruling dated September 27, 1995 (PLR 9551032), and the Check-the-Box Regulations confirm the IRS' previous conclusion.
S. Diversity Jurisdiction. The cases are divided as to whether the citizenship of an LLC for federal diversity jurisdiction purposes should be determined by analogy to a partnership or a corporation. Where citizenship is determined in accordance with partnership precedent, an LLC is deemed a citizen of each state in which it has a Member. Where corporate precedent is applied, an LLC is a citizen of its state of incorporation and the state where its principal place of business is located.
* Copyright © 1999 by Byron F. Egan. All rights reserved.
Byron F. Egan is a partner of Jackson Walker L.L.P. in Dallas, Texas. Mr. Egan is a former Chairman of the Texas Business Law Foundation and is also former Chairman of the Business Law Section of the State Bar of Texas and of that Section's Corporation Law Committee.
The author wishes to acknowledge the contributions of the following in preparing this paper: Daniel G. Easley, Steven D. Moore, Janie L. Treanor, Bradley L. Whitlock and John R. Williford of Jackson Walker L.L.P.; Elizabeth S. Miller of Baylor University School of Law; and Carmen Flores and Lorna Wassdorf, Office of Secretary of State of Texas.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.