Overview of LLCs in CA
The following is taken from chapter 1 of the book “Forming and Operating California Limited Liability Companies” published by Continuing Education of the Bar. Copyright held by The Regents of the University of California. This page is not updated regularly and may not be current.
Chapter 1 was written by Richard G. Burt
Overview of California Limited
A. Scope and Purposes of Book §1.1
B. Limited Liability Company Basic
1. What Is a Limited Liability Company? §1.2
2. Advantages of LLC Form Over Limited Partnership and S Corporation Forms §1.3
a. Advantages Over Limited Partnership §1.4
b. Advantages Over S Corporation §1.5
II. OVERVIEW OF CALIFORNIA’S LLC ACT
A. Definition of LLC §1.6
B. Business Purpose §1.7
C. Powers §1.8
D. Default Rules §1.9
E. Articles of Organization §1.10
F. Operating Agreement §1.11
G. Owners Not Personally Liable §1.12
H. Capital Contributions §1.13
I. Profits and Losses §1.14
J. Distributions §1.15
K. State Taxes and Fees §1.16
L. Management and Fiduciary Duties §1.17
M. Voting Rights §1.18
N. Membership Interests §1.19
O. Right of Access to Information §1.20
P. Securities Laws §1.21
Q. Withdrawal §1.22
R. Dissolution §1.23
S. Mergers and Reorganizations §1.24
T. Statutory Conversions §1.25
U. Foreign LLCs §1.26
III. ADVANTAGES AND DISADVANTAGE
A. Advantageous Uses of LLCs §1.27
B. Problem Areas §1.28
§1.1 A. Scope and Purposes of Book
This book is a basic practice guide to organizing, operating, merging, converting, and dissolving California limited liability companies (LLCs). The book also covers the operation of foreign LLCs in California (chap 14) and series LLCs (chap 15).
This book extensively discusses the tax issues involved in forming and operating an LLC (chaps 4-5), as well as in converting an existing entity to an. LLC or vice versa (chap 11). Business and other nontax factors to consider in selecting the LLC form of business (chaps 3, 6), as well as filing requirements (chap 7), concerns relating to securities laws and issuance of membership interests (chap 12), and LLC operation (chap 13) and dissolution (chap 16) are also discussed
This book also provides long-and short-form annotated operating agreements, with a discussion of when to use these forms (chaps 8-10). Prescribed Secretary of State forms are reproduced, as discussed, throughout the book
This introductory chapter discusses LLCs generally, summarizes California’s LLC law, and outlines the advantages and disadvantages of LLCs.
B. Limited Liability Company Basics
§1.2 1. What Is a Limited Liability Company?
A limited liability company is a form of business organization that is treated as a partnership for income tax purposes and as a corporation for liability purposes. Generally, an LLC is a legal entity formed under a statutory scheme that allows one or more owners to carry on a business with none of the owners having personal liability for the obligations of the business.
Under the Beverly-Killea Limited Liability Company Act of 1994 (Corp C §§17000-17655) (the Act), an LLC is formed when articles of organization are filed with the California Secretary of State on the Secretary of State’s Form LLC-l and, generally, one or more LLC “members” enter into an operating agreement. The operating agreement may be entered into either before or after the articles of organization are filed. Corp C §17050. It may be oral or written and may consist simply of an agreement to form an LLC (Corp C §17001(ab))
The salient nontax characteristics of an LLC are limited liability for its owners (as in a corporation) and freedom to structure management rights and financial interests in the entity in virtually any configuration the parties wish (as in a partnership).
Most often, an LLC will elect to .be treated as a partnership for income tax purposes, in which case the income, gains, losses, deductions, and credits of the LLC generally will flow through to its members for reporting on their personal tax returns.
§1.3 2. Advantages of LLC Form over Limited Partnership and S Corporation Forms
Until the advent of the LLC, the limited partnership and the S corporation were the primary forms of business entity used to achieve the tax status and limited liability features now offered by the LLC. Each of those forms of business organization, however, has drawbacks. An LLC can provide the advantages of a limited partnership or an S corporation without the disadvantages.
§1.4 a. Advantages Over Limited Partnership
Although a limited partnership allows pass-through tax treatment, flexibility in financial structuring, and limited liability for limited partners, at least one person, i.e., a general partner, must be fully liable for the obligations of the business, and limited partners may not take part in the control of the business without jeopardizing their limited liability.
Unlike a limited partnership, no LLC owner (“member”) need be personally liable for the company’s obligations, and each member is permitted to manage the company and to take part in the ·control of its business without losing the member’s limited liability (Corp C §§17101, 17150).
§1.5 b. Advantages Over S Corporation
Although an S corporation allows pass-through tax treatment and limited liability for all owners, S-corporation status limits the parties’ flexibility in structuring their financial arrangements because of the requirements that the corporation have no more than one class of stock (IRC §1361(b)(1)(D)) and that items of income, gain, loss, deduction, or credit be taken into account in accordance with the shareholders’ prorata share of the corporation’s stock (IRC §1366). Furthermore, only individuals, estates, certain types of trusts, and certain tax-exempt organizations are permitted to be S-corporation shareholders (IRC §1361(b)(1)(B)), and an S corporation will lose its pass-through tax treatment if an ineligible entity becomes a shareholder. Finally, the pass-through income tax treatment offered by an S corporation differs somewhat from that of a partnership, and this different treatment can sometimes have adverse tax consequences. See §§3.32-3.37.
An LLC can have different classes of ownership; income, gain, loss, and other items may be allocated disproportionately to ownership without affecting the LLC’s pass-through tax treatment. Unlike an S corporation, any “person”–i.e., any individual, partnership, limited partnership, trust, estate, association, corporation, other limited liability company, or other entity, whether domestic or foreign–can be a member of an LLC. See Corp C §17001(ae).
II. OVERVIEW OF CALIFORNIA’S LLC ACT
§1.6 A. Definition of LLC
An LLC is defined in Corp C §17001(t) as an entity having one or more members that is organized under the Act. The definition in Corp C §17001(t) makes it clear that an LLC is an entity rather than an aggregation of the members.
§1.7 B. Business Purpose
Corporations Code §17051(a)(2) requires that the articles of organization of a California LLC contain the following prescribed statement:
The purpose of the limited liability company is to engage in any lawful act or activity for which a limited liability company may be organized under the Beverly-Killea Limited Liability Company Act.
Under Corp C §17002(a), an LLC may engage in any lawful business activity, whether or not for profit, except:
·The banking business;
·The business of issuing insurance policies and assuming insurance risks; or
·The trust company business.
Further, although it is clear that a profession may not be practiced in LLC form, there is some uncertainty over the degree to which a domestic or foreign LLC may render “professional services” that require a license, certification, or registration authorized by the Business and Professions Code. Corp C §§13401-13401.5, 17375; see §§1.28, 3.92, 7.13.
An LLC also may operate as a health care service plan if it is a subsidiary of a health care service plan licensed under Health and Safety Code Ch 2.2 and the LLC is established to serve an existing line of business of the parent health care service plan. Corp C §17002(b).
In California, the limited liability partnership (LLP) form is available to partnerships engaged in the practice of architecture, public accountancy, or law. Corp C §16101(6). For discussion of LLPs, see Advising California Partnerships, chap 6 (3d ed Cal CEB 1999).
Some other states permit the formation of professional limited liability companies (PLCCs) for the practice of law or other professions. California does not; nor will the Secretary of State allow PLCCs formed in other jurisdictions to register to do business in California.
§1.8 C. Powers
In carrying out its business activities, an LLC has all the powers of a natural person. Corp C §17003. This includes the right to be a promoter, stockholder, partner, member, manager, associate, or agent of any person. Corp C §17003(k). It also includes the right to sue and be sued, to make contracts, to lend money, and to issue notes and bonds. Corp C §17003(b), (d), (g)-(h).
An LLC can enforce any pre-organization contract made on its behalf, if the LLC adopts or ratifies the contract after formation. 02 Dev., LLC v 607 S. Park, LLC (2008) 159 CA4th 609, 71 CR3d 608 (assignment of rights in hotel purchase agreement).
§1.9 D. Default Rules
The Act sets forth in great detail rules governing the relationship of the members to each other and to the LLC, but expressly permits the members to vary most of the rules by provisions in the articles of organization or operating agreement. See Corp C §17005(a). The rules set forth in the Act apply in default of an agreement of the members to the contrary. With some limited exceptions, freedom of contract for internal affairs is the controlling principle of the Act. The rules that may not be changed or that may be varied only in a specified fashion are enumerated in Corp C §17005(b)-(c). On permitted modifications of the default rules, see §§8.4-8.5.
§1.10 E. Articles of Organization
The articles of organization, amendments of the articles, and other filings with the Secretary of State are generally made on preprinted forms prescribed by the Secretary of State. See §7.15 for Form LLC-1 (Articles of Organization). The parties may add to the articles any provision not inconsistent with law (Corp C §17051(c)), e.g., a restriction on the authority of the managers (Corp C §17051(c)(4)). The contents of the articles do not constitute constructive notice, however, and such a restriction or other limitation would not be binding on anyone without actual knowledge. Corp C §17051(d)(3). If provisions of the articles of organization conflict with the operating agreement, the articles control. Corp C §17005(f).
§1.11 F. Operating Agreement
The operating agreement ordinarily sets forth the agreement of the LLC’s members, much as a partnership agreement sets forth the agreement of the partners. An operating agreement typically covers, among other things, the members’
·Obligation to contribute capital;
·Allocations of profit and loss;
·Shares of distributions; and
·Management and voting rights.
On forms of operating agreements, see chaps 8-10.
§1.12 G. Owners Not Personally Liable
The owners of an LLC are called members. See Corp C §17001(x). The Act states that a member is not personally liable for any contract, tort, or other obligation of the LLC by virtue of being a member. Corp C §17101. Further, the Act specifically permits members to manage the business and affairs of an LLC (Corp C §17150) and states that persons acting as managers of an LLC will not be liable for any contract, tort, or other obligation of the LLC by virtue of being a manager. Corp C §17158. Members of an LLC may waive their limited liability and agree to be obligated personally for any or all of the debts, obligations, and liabilities of the LLC, as long as the waiver is set forth in the articles of organization or in a written operating agreement that specifically refers to Corp C §17101(e).
§1.13 H. Capital Contributions
A member may contribute to .the capital of an LLC money or other property, services, or a promise to provide property or services. Corp C §17200(a). A member is not excused from performing a promise to contribute property or services by reason of death, disability, or otherwise, unless the articles of organization or operating agreement excuse it. Corp C §17201(a)(1).
A member who fails to contribute property or services may be required, at the LLC’s option, to contribute cash in an amount equal to the fair market value of the property or services that have not been contributed; in addition, other rights (such as the right of specific performance) may be asserted against the noncontributing member. Corp C §17201(a)(2).
A provision in the operating agreement that specifies the consequences of a member’s failure to make a promised contribution is enforceable unless the noncontributing member establishes that the provision was unreasonable under the circumstances when the agreement was made. Corp C §17201(a)(3).
Unless provided otherwise by the articles of organization or operating agreement, a member is not obligated to make any additional contribution to the LLC. Corp C §17200(b).
§1.14 I. Profits and Losses
Unless the operating agreement provides otherwise, profits and losses will be allocated among the members in proportion to their capital contributions. Corp C §17202. One of the advantages of an LLC is the flexibility accorded members in the allocation of profits and losses. The tax effect of such allocations, often an important consideration, may depend on compliance with the IRS’s “special allocation” regulations. See §§5.36-5.50 and Comments to the forms in §§9.23-9.31.
§1.15 J. Distributions
Unless the operating agreement provides otherwise, distributions that are a return of capital will be made in proportion to the capital contributions made by each member and distributions that are not a return of capital will be made in proportion to the members’ allocated shares of profit. Corp C §17250.
The Act sets forth certain restrictions on distributions, principally prohibitions on making distributions that render the LLC unable to pay its bills as they come due in the usual course of business and on making distributions that make the LLC’s total assets less than the sum of its total liabilities. Corp C §17254. The recipient of a distribution made in violation of these statutory restrictions or in violation of the operating agreement may be required to return it to the LLC (Corp C §17254(e)) and the managers or members who voted in favor of such a distribution may be held personally liable for the amount of the distribution that exceeded permitted levels (Corp C §17255(a)). The statute of limitations for claims relating to distributions is generally four years. Corp C §17254(f).
§1.16 K. State Taxes and Fees
An LLC must pay a tax of $800 per year for the privilege of being an LLC regardless of gross receipts or net income. Rev & T C §17941. This amount is equal to the minimum tax imposed on corporations, including S corporations (Rev & T C §23153(a)), on limited partnerships (Rev & T C §17935(a», and on limited liability partnerships (Rev & T C §17948(a)). New corporations are not required to pay the minimum franchise tax for their first taxable year, but this exception to paying the $800 annual minimum tax does not apply to new LLCs. Rev & T C §23153(f)(1)-(2).
An LLC pays no net income tax, but unless it has total income of less than $250,000, the LLC must pay an annual fee based on the total income derived from or attributable to California for the taxable year. This annual fee is in addition to the $800 tax mentioned above. Rev & T C §17942(a). For taxable years beginning on or after January 1, 2009, the annual fee must be estimated and paid no later than the 15th day of the 6th month of the taxable year. See §§5.4-5.5.
§1.17 L. Management and Fiduciary Duties
An LLC allows as much or more flexibility in structuring management and control than any other form of business organization under California law. An LLC can be managed either by all the members (a “member-managed LLC”) or by one or more managers (a “manager-managed LLC”). The managers in a manager-managed LLC may be either members or nonmembers. The default rule is that an LLC is considered to be member managed (Corp C §17150), but the default rule is effectively superseded by the articles of organization because Item 6 of Secretary of State Form LLC-1 (Articles of Organization) requires a statement indicating whether the LLC is member managed or manager managed, and the articles prevail over any conflicting provision in the operating agreement (Corp C §17005(f)). See also Corp C §17151(b); §7.20.
In a member-managed LLC, each member is an agent of the LLC, and any act of a member for the apparent purpose of carrying on in the usual way the affairs of the LLC binds the LLC. Corp C §17157(a). Although the members may agree that a member has no authority to act, either generally or with respect to a particular matter, third parties are not bound by that agreement absent their actual knowledge that the member lacks authority to act. Corp C §17157(a). The rules in this regard are similar to the rules that apply to general partnerships.
In a manager-managed LLC, no member is an agent of the LLC by virtue of being a member. Corp C §17157(b)(1). Instead, every manager is an agent of the LLC, and any act of a manager for the apparent purpose of carrying on in the usual way the affairs of the LLC binds the LLC. Corp C §17157(b)(2). A manager’s lack of authority to act is not binding on third parties without actual knowledge of the lack of authority. Corp C §17157(b)(2). The rules in this regard are similar to the rules that apply to limited partnerships (a manager corresponds to a general partner, and a member corresponds to a limited partner) except that the active participation by a member in the management and control of an LLC will not create liability for the member (see Corp C §§17101, 17150; compare Corp C §15632(a) (Corp C §15903.03(a) under the Limited Partnership Act of 2008) with Corp C §§17101, 17150).
Whether the LLC is member managed or manager managed, the LLC may have officers, including a president, chief financial officer, and secretary. Corp C §17154. Officers, like managers, may, but need not, be members. Corp C §§17151(a), 17154(a).
Each member of a member-managed LLC has the fiduciary duties of a manager. Corp C §17150. The fiduciary duties that a manager owes to the LLC and its members are the same as those of a partner to a partnership and its partners. Corp C §17153. The fiduciary duties that a manager owes to the LLC and its members may be modified only in a written operating agreement “with the informed consent of the members.” Corp C §17005(d).
No person who is a manager or an officer of an LLC has any personal liability for any contract, tort, or other obligation of the LLC by virtue of being a manager or officer. Corp C §17158.
§1.18 M. Voting Rights
LLC members have voting rights as specified in the articles of organization or operating agreement. The right to vote may be based on number, capital interest, share of profits, or any other basis. The right to vote may be by class or group of members, and some members may have voting rights to the exclusion of other members. Corp C §17103(a). If the articles of organization and operating agreement are silent with respect to voting rights, the default rules are as follows:
(1) Each member may vote in proportion to the member’s interest in current profits. Corp C §17103(a)(1).
(2) Unanimity is required for a vote to amend the articles of organization or operating agreement (Corp C §17103(a)(2)).
(3) The vote of a “majority in interest of the members” is sufficient on all other matters requiring a vote of the members. Corp C §17103(a)(3). This includes a vote to continue the business of the LLC after dissolution and a vote to approve an assignment of a membership interest and the admission of the assignee as a member.
The articles of organization or operating agreement can change the above default rules. For example, they may provide that the articles of organization or operating agreement may be amended by a majority in interest, rather than the unanimous vote of the members. However, in no case may the articles or operating agreement permit such amendment by less than a majority in interest. Corp C §17005(b)(3).
Corporations Code §17104 contains an extensive set of default rules for holding meetings, including rules on giving notice, determining quorums, proxies, and action by written consent in lieu of a meeting. See generally chap 13.
§1.19 N. Membership Interests
The rights of a member in an LLC are collectively referred to as the member’s membership interest. A membership interest includes not only a member’s economic interest in the LLC but also all other rights of a member, such as the rights to manage, vote, and receive specified information. Corp C §17001(z). An economic interest in an LLS is a person’s right to share in profits and losses of the LLS and the right to receive distribution from the LLS, but an economic interest does not include any other rights of a member, such as the right to manage or to vote, or, except as specified in Corp C §17106, the right to information. Corp C §17001(n). See §§6.17, 9.73, 13.17, and 16.20 about inspection rights.
Both a membership interest and an economic interest are personal property and neither comprises an interest in the property of the LLC. Corp C §17300. See Gilliam v Speier (In re KRSM Props., LLC) (BAP 9th Cir 2004) 318 BR 712 (member owners sold LLC’s real property and used proceeds to pay their personal income tax obligations; when LLC filed for bankruptcy, trustee obtained order for IRS and Franchise Tax Board to return money used to pay taxes; court held that under Corp C §17300, LLC’s member owners have no direct ownership interest in property of LLC, so use of sale proceeds to pay personal tax obligations was improper); Paclink Communications, Int’l, Inc. v Superior Court (2001) 90 CA4th 958, 109 CR2d 436 (court held that individual members of LLC had no standing to sue for fraudulent transfer of company assets and could bring derivative action in name of company only).
The distinction between a membership interest and an economic interest is most important when dealing with the transfer of an interest in the LLC. See §12.3. The default rule is that the transfer of a membership interest requires the consent of a majority in interest of the members not transferring their interests, but the transfer of an economic interest requires no consent. Corp C §17301(a)(1).
The transfer of an economic interest simply entitles the transferee to receive from the LLC any allocations of income and loss and any distributions that the transferor had the right to receive; the transfer of an economic interest does not dissolve the LLC or entitle the transferee to vote, participate in management, or exercise any other rights of a member. Corp C §17301(a)(2)-(3). The Act provides procedures for creditors of a member to obtain a charging order on the member’s membership interest. Corp C §17302. See §12.8. There may be good reasons under the tax and securities laws, however, to restrict the transfer of an economic interest in the LLC even though the transferee has no voting, management, or other rights. See §4.18 on tax considerations; see chap 12 for securities law considerations,
The default rule is that the transferee of an economic interest may be admitted to the LLC as a member, in substitution for the transferor, only on a vote in favor of such admission by a majority in interest of the other members (Corp C §17303(a)), but whether or not such substitution occurs, the transferring member remains liable to contribute capital as agreed and to return any distributions made in violation of law or the operating agreement (Corp C §§17301(b), 17303(c)).
The operating agreement may provide for the termination of a member’s membership or economic interest. On termination of a member’s economic interest, the member is entitled to return of the member’s capital contribution. Any provision of the operating agreement concerning the termination of membership and the return of a member’s contribution will be enforceable unless the member establishes that the provision was unreasonable under the circumstances when the agreement was made. Corp C §17100(c). The right of a member to assert that such a provision is unreasonable may not be eliminated by the articles of organization or the operating agreement. Corp C §17005(b)(2).
§1.20 O. Right of Access to Information
Members and holders of economic interests have the right to obtain certain information from the LLC, including the right to inspect and copy the LLC’s books and records on reasonable request. Corp C §17106. California resident members of a foreign LLC who have at least 25 percent of the voting interests of the membership have the same information and inspection rights that would apply if the LLC were a California LLC. Corp C §17453. The right to information under Corp C §§17106 and 17453 may not be modified by the articles of organization or operating agreement. Corp C §17005(b)(4). On inspection rights, see §§6.17, 9.73, 13.16, and 16.20.
§1.21 P. Securities Laws
An interest in an LLC is presumed to be a security under California law unless all the members are actively engaged in its management. Corp C §25019.
NOTE: Evidence that members vote or have the right to vote, or the right to information concerning the LLC’s business and affairs, or the right to participate in management, does not establish, without more, that all members are actively engaged in the management of the LLC. Corp C §25019.
An LLC interest would probably be held to be a security under federal law as an “investment contract” for members who expect to receive a profit solely from the efforts of others. See §12.14.
§1.22 Q. Withdrawal
The LLC’s articles of organization or operating agreement may provide that a member may withdraw, resign, or retire from the LLC on the happening of specified events, or that a member does not have the right to withdraw. Corp C §17252(a). Notwithstanding any restriction in the articles or operating agreement, a member may withdraw at any time by giving written notice to the other members. The withdrawn member is not entitled to payment for the membership interest and has only the rights of the holder of an economic interest. If the withdrawal is in violation of the operating agreement, the LLC has the right to offset any damages for the breach of the operating agreement from any amounts otherwise distributable to the withdrawn member. Corp C §17252(a). The foregoing withdrawal provisions are default rules and may be modified by the articles of organization or operating agreement.
§1.23 R. Dissolution
An LLC will dissolve at the time specified in the articles of organization, if any, or on the happening of the events, if any, specified in the articles of organization or operating agreement. Corp C §17350(a). In addition, a majority in interest of the members or greater percentage of the voting interests specified in the articles of organization or operating agreement may vote to dissolve. Corp C §17350(b). Neither the articles of organization nor the operating agreement may eliminate the right of a member to vote on the dissolution of an LLC. Corp C §§17005(b)(3), 17103(c). A dissolved LLC must wind up its affairs. Corp C §17352. See §16.35.
An LLC may also be dissolved on the entry of a decree of judicial dissolution under Corp C §17351. See §16.12
§1.24 S. Mergers and Reorganizations
The Act expressly authorizes the merger of one or more LLCs into another LLC (Corp C §17550(a)(1», the merger of other business entities into an LLC (Corp C §17550(a)(3)), and the merger of an LLC into other types of business entities (Corp C §17550(a)(2)), including corporations, limited partnerships, general partnerships, business trusts, real estate investment trusts, or unincorporated associations (other than nonprofit associations). Corp C §17001(ac). The laws under which the other business entities are organized must authorize the other business entities to effect such a merger. Corp C §17550(b). On LLC mergers and reorganizations, see chap 11.
A limited partnership formed under the California Revised Limited Partnership Act (CRLPA) is authorized to effect a merger with a domestic or foreign LLC. Corp C §§15611(v), 15678.1. (This will continue to be true under the Limited Partnership Act of 2008 (Corp C §§15900-15912.07) also known as Re-RULPA, which becomes effective between January 1, 2007, and January 1, 2010. See Corp C §§15901.02(u), 15911.11.)
Similarly, a California corporation is authorized to merge with a domestic or foreign LLC. Corp C §§1113, 174.5. A general partnership is authorized to merge into an LLC, but the merger must be specifically permitted by the general partnership agreement. Corp C §16902.
A merger agreement must be approved by at least a majority in interest of the members. Corp C §17551(a). Neither the articles of organization nor the operating agreement may eliminate the right of a member to vote on a merger. Corp C §§17005(b)(3), 17103(c).
When an LLC is a party to a merger or certain other reorganizations and a member does not wish to participate in the merger or reorganization, the member may require that his or her interest be purchased for cash at its fair market value. Corp C §17601.
§1.25 T. Statutory Conversions
California LLCs may convert into another form of business entity, including a foreign entity, provided that the law under which the other business entity is organized expressly permits the formation of such an entity by conversion and provided certain other conditions are met. Corp C §17540.2. If the conversion is into a domestic or foreign partnership (including a limited partnership) or into a foreign LLC, each member of the converting LLC must receive the same percentage interest in the profits and capital of the entity into which the LLC is converted as the member had in the converting LLC at the time of the conversion. If the conversion is into any other business entity, each member of the converting LLC must be treated the same as each other member of the same class with respect to any distribution of cash, rights, or other property (including securities) of the converted entity (unless all members of the class consent), and any nonredeemable membership interests of the converting LLC may be converted only into nonredeemable interests in the converted entity (unless all holders of the nonredeemable membership interests consent). Corp C §17540.2
A California general partnership (other than a registered limited liability partnership) may be formed by conversion from an LLC. Corp C §16908. A limited partnership governed by the California Revised Limited Partnership Act (CRLPA) (Corp C §§15611-15723) or the Limited Partnership Act of 2008 (Re-RULPA) (Corp C §§15900-15912.07) may be formed by conversion from an LLC. Corp C §§15677.8, 15911.08. A California corporation may be formed by conversion from an LLC. Corp C §1157.
Other forms of business entities (including a foreign entity) may convert into a California LLC only if the converting entity is authorized to effect the conversion by the law under which the other business entity is organized and certain other conditions are met. Corp C §17540.8.
A California general partnership (other than a registered limited liability partnership) may convert into an LLC. Corp C §16902. A limited partnership governed by the California Revised Limited Partnership Act may convert into an LLC. Corp C §15677.2. (This will continue to be true under Re-RULPA; see Corp C §15911.02.) Each partner of the converting partnership must receive the same percentage interest in the profits and capital of the LLC as that partner had in the converting partnership at the time of the conversion.
A California corporation is permitted to convert into a domestic LLC under Corp C §1151, but such a conversion would probably be treated as a liquidation of the corporation for income tax purposes. Each share of the converting corporation must be treated the same as every other share of the same class or series of the converted entity with ,respect to any distribution of cash, rights, or other property (including securities) to be received by the shareholder (unless all shareholders of the class or series consent), but that does not preclude the shareholders from appointing one or more managers of the LLC under the plan of conversion. Corp C §1151(a). If any obligation is to be imposed on the holder of any share of the converting corporation, each share of the same class or series of the converted entity must be treated equally with respect to the obligation (unless all shareholders of the class or series consent). Corp C §1151(a). Any nonredeemable common shares in the converting corporation may be converted only into nonredeemable equity interests in the LLC (unless all such holders consent). Corp C §1151(a).
On conversion of an LLC into another entity or of another entity into an LLC, the rights and property of the converting entity are vested in the entity formed by conversion, and the debts and obligations of the converting entity are the debts and obligations of the entity formed by conversion. Corp C §17540.9(b). The Act expressly states that an entity that converts into another entity under the Act is “for all purposes the same entity that existed before the conversion.” Corp C §17540.9(a). Notwithstanding the broadness of that statement, the conversion of an entity may have significant tax consequences. Statutory conversions generally are exempt from the permit requirements of the Corporate Securities Law of 1968 (Corp C §§25005.1, 25103(h)). See §§11.12-11.13. On statutory conversions, see §§11.24-11.40.
§1.26 U. Foreign LLCs
The Act permits a foreign LLC to do business in California, provided the LLC registers with the California Secretary of State. Corp C §17451. The penalties for not registering are similar to those imposed on foreign corporations that do business in California without qualifying. See Corp C §§2203, 17456. Failure to register does not make a foreign LLC’s members liable for the obligations of the LLC. Corp C §17456(c).
The laws of the state or country under which the foreign LLC is organized govern its internal affairs and the liability and authority of its managers and members. Corp C §17450(a). A foreign LLC may not be denied registration by reason of any difference between the foreign law and California law. Corp C §17450(b).
III. ADVANTAGES AND DISADVANTAGES
§1.27 A. Advantageous Uses of LLCs
The favored tax treatment of the LLC, its limited liability features, and its flexibility for structuring financial and managerial operations make the LLC an especially desirable form of business organization for a new business to consider. An LLC can be particularly advantageous in the following situations:
Start-up businesses. Subject to the considerations discussed in §1.28, every start-up business should consider the LLC form of organization, whether it is a comer grocery store, real estate venture, or corporate high-tech joint venture.
Existing unincorporated businesses. Any existing business that is a partnership and any sole proprietor bringing in a partner should consider converting to LLC form. Generally, the conversion can be done without triggering income tax. On converting to an LLC, see chap 11.
Real estate investments. Because LLCs combine limited liability and flexible management with the ability to pass through losses and deductions, make special allocations, and avoid double taxation on the sale of appreciated assets, LLCs should be particularly attractive for real estate investments.
Joint ventures. An LLC can be an useful alternative to a general partnership or corporation as a means of organizing a joint venture or “strategic alliance.” LLCs are preferable to general partnerships because of the limited liability they provide to members (thus eliminating the need for a venturer to form a special-purpose corporation) and are preferable to corporations because of pass-through tax treatment and the avoidance of double taxation
Estate planning. The LLC, by virtue of its partnership tax treatment, limited liability, and flexibility of management and financial structures, may prove to be a valuable estate-planning tool for transferring ownership interests in businesses and real estate. See §§3.91, 4.36-4.39.
§1.28 B. Problem Areas
Although the LLC form of organization has many desirable features, it is not suitable for every business. An LLC may not be appropriate in the following situations
Existing incorporated businesses. Converting a corporation into an LLC will generally result in a taxable liquidation of the corporation, even if the corporation has elected to be an S corporation. See chap 11. A statutory merger or conversion of a corporation into an LLC, for example, will ordinarily be treated as a liquidation of the corporation and a contribution of the distributed assets by the shareholders to the LLC. The tax cost of liquidating the corporation should be calculated and considered before deciding to convert a business entity from a corporation to an LLC.
Businesses planning to go public. With some exceptions, a partnership whose ownership interests are publicly traded is taxed as a corporation. An LLC that becomes publicly traded would therefore lose one of the primary benefits of being an LLC, i.e., partnership tax treatment, and, compounding that loss, the capital markets might discount the value of an ownership interest because of unfamiliarity with LLC interests as compared to stock. An LLC could incorporate before going public and avoid this result, and for certain businesses, an initial period of operation as an LLC may be suitable. Until it incorporates, however, an LLC could not offer tax-favored incentive stock options and employee stock purchase plans, which are common ways of compensating and motivating employees working for a business intending to go public, and, as mentioned above, an LLC might not attract certain investors. See §4.8.
Professional practices. A California LLC is not authorized to practice a profession that, if practiced in corporate form, would have to be organized as a professional corporation. See §3.92.
Certain regulated businesses. Businesses in certain regulated industries may need to be in corporate form to achieve limited liability because the governing statute may not recognize the LLC as a form of entity that can receive a license, certification, or registration. In addition, the limitation on practicing a profession, mentioned in the preceding paragraph (see Corp C §17375), may apply more broadly to any business that requires such licensure, certification, or registration.
On July 23, 2004, the California Attorney General rendered an opinion that a business that provides services that require a license, certification, or registration under the Business and Professions Code may conduct its activities as an LLC if the services rendered require only a nonprofessional, occupational license. The opinion stated that determining whether a particular service would be “professional” or “nonprofessional” would.require an examination of the educational, training, and testing prerequisites, but it did not specify which services would be “professional” for the purpose of allowing an LLC to render them. 87 Ops Cal Atty Gen 109 (2004).
In light of the uncertainty, most practitioners are being cautious and advising clients they cannot use the LLC form of organization for any business that requires a license, certification, or registration under the Business and Professions Code. See §§3.92, 7.13. In addition, businesses in certain regulated industries may need to be in corporate form to comply with regulatory requirements.