Forming a limited liability company is complicated. It’s complicated because the states have not adopted a uniform method of forming a limited liability company. There is no uniform method for forming an LLC because there is no consensus among the states about what a limited liability company is. And the differing views mean that one state may require one method for forming an LLC and another state may require something very different.

Generally speaking, the differences can be broken down into two opposing views. Some states view LLCs as modified corporations, and other states view LLCs as branches of the partnership family tree. Another way of representing the difference in views is that some states view LLCs as statutory creatures, while other states view LLC as contractual creatures. Those states that view LLCs as contractual creatures will require that an LLC have at least one member and an agreement between/among/of the member(s) in order to form an LLC.

When forming an LLC, it pays to understand the view of the state in which you are forming the LLC.  Maine has adopted the partnership view. Under Maine law, you need three things to form an LLC:

1. At least one Member (31 MRS Section 1531(1)(C));
2. A duly completed and executed certificate of formation filed with the Secretary of State (31 MRS Section 1531(1)(A)); and
3. A limited liability company agreement (31 MRS Section 1531(1)(B)).

Paragraph 1 only lists the ingredients to form an LLC. It is not the entire recipe. Paragraphs 2 and 3 provide the directions. They tell you how and when to mix these ingredients.

Paragraph 2 provides that the limited liability company agreement may be entered into either before, after or at the time of the filing of a certificate of formation. That might make you believe that it does not matter whether an agreement exists when the certificate is filed, but, that would be misleading. It is misleading because paragraph 2 does not tell you when the LLC is formed. It only references the time when the certificate is filed. Since the certificate can provide that the LLC is formed after the date the certificate is filed, this provision does not tell you much about whether the limited liability company agreement must exist at or before the time the LLC is formed according to the certificate. That job is left to paragraph 3.

Paragraph 3 provides that the limited liability company is formed when the certificate is filed or at a later date provided in the certificate provided that there is substantial compliance with the requirements to form a limited liability company. In other words, at the time designated by the certificate for forming the LLC, all conditions to forming the LLC must exist. In other words, a limited liability company agreement must then be entered into or otherwise existing.

Most certificates of formation filed with the Maine Secretary of State provide that the LLC is formed when the certificate is filed. Thus, most LLCs formed in Maine are only duly formed under the statute if a limited liability company agreement for that LLC is entered into or otherwise exists when the certificate is filed.

The takeaway:  if you are forming a Maine LLC, date your initial limited liability company agreement on or before the date that the certificate of formation for that LLC is filed with the Secretary of State.

An LLC electing to be treated as an S corporation first needs to amend its LLC Agreement. Failing to amend the LLC Agreement may cause an otherwise good S election to be invalid.

A partner in a tax partnership can be subject to self-employment tax on that partner’s distributive share of partnership income. Limited partners, however, are not subject to self-employment tax on their distributive shares. Further, some, but not necessarily all, of a partner’s distributive share of income is subject to self-employment tax. At some point, I’ll post some thoughts on the scope of the issue raised by self-employment taxes on distributive shares of partnership income, and some ways to deal with them. This post is about a common response to self-employment taxes on partnership income:  making an election to treat the partnership as an S corporation.

An LLC may elect to be treated as an S corporation, if it is a small business corporation. An LLC is treated as a small business corporation if it meets the requirements of Code Section 1361(b):

• Has 100 of fewer “shareholders”
• Generally, only individual “shareholders” (though an estate and some trusts can be shareholders)
• No nonresident alien shareholders
• Only one class of stock.

The last criterion (single class of stock) is something the LLC interest holders and their advisors must address, ideally before the election is made. The LLC will meet the single class of stock requirement only if it’s governing documents provide that all shares confer identical interests in distributions and liquidation proceeds.

The LLC Agreement is generally the governing document for this purpose. In most cases, the LLC Agreement as drafted for the LLC as a partnership will fail to provide that all “shares” will confer identical rights to distributions and liquidation proceeds. That’s because the typical LLC Agreement for an entity making this election says that the LLC interest holders will share in liquidation proceeds according to their capital account balances. In many cases, the capital account balances will not be according to “shareholdings”.

In addition, distribution provisions in the LLC Agreement may provide that interim distributions are not shared exactly according to “shareholdings”.

Except in the rare instance that all distributions are shared in proportion to capital contributions, and all interest holders contributed cash, and each acquired his/her interest at the same time as all other interest holders acquired theirs, the LLC Agreement will be at odds with Section 1361(b)’s single-class of stock condition.

This post is intended to highlight that it’s important to amend the LLC Agreement before making an S election. It’s also important to consider capital account balances in issuing shares of “stock” and the tax consequences of the deemed section 351 transaction that happens on the election. Finally, it’s important to remove all of the partnership tax provisions of the agreement and insert in their place language that agrees with the single class of stock condition and reflects the fact that the unitholders will receive a pro rata share of S corporation income, as opposed to a distributive share of partnership income.

If you fail to clean up the LLC Agreement before making the election, all may not be lost. Code Section 1362(f) allows the LLC to correct S elections that are invalid because the makers inadvertently failed to correct an LLC agreement comply with Code Section 1361(b) conditions. However, the relief available under Code Section 1362(f) is limited. Nobody will want to rely on this.

Business and tax attorneys draft partnership agreements, including LLC agreements. These agreements often contain cash waterfall provisions that are designed to cause cash to be distributed a certain way until certain investors achieve a designated internal rate of return. For example, partnership waterfall provisions may provide that available cash is distributed as follows:

 

• First, to A until A has achieved an 8% internal rate of return (IRR);
• Second, 10% to B and 90% to A until A has achieved a 15% IRR;
• The balance, 20% to B and 80% to A.

 

How do you know whether A has achieved a prescribed internal rate of return? Typically, an agreement fails to address this question. Instead, it addresses how to compute the internal rate of return. But, the partnership knows the internal rate of return. The partnership needs to know how much cash to distribute.

In 2014, Bradley Borden, a law professor at Brooklyn Law School, wrote an article entitled “Math Behind Financial Aspects of Waterfalls”. It was published in the October 20, 2014 edition of Tax Notes Today. Brad does a great job of describing financial concepts and formulae that matter in drafting partnership waterfall provisions. Moreover, he makes great drafting points for us. Principally, we should draft agreements that guide partnerships in distributing amounts. Most waterfall provisions don’t do that. They focus on IRR. They tell the partnership how to compute IRR. But, as Brad points out, we know the IRR. We don’t know the amount to distribute to meet that IRR.

To determine the amount to distribute to A in the example above, we need to determine the future value of A’s contributions as of a given time using the given IRR. To determine the future value, we need to know exactly what the IRR is. That’s our job as drafters: define exactly what IRR is – the rate, compounding period, and also how to divide the rate for mid-accrual payments. We then apply that rate to one or more present value numbers (contributions when made) and previously distributed cash amounts to determine the correct future value. That future value, applying the given IRR (i.e., the discount rate), makes the net present value of all distributions equal zero. And that’s the result that we intend to achieve when we draft waterfall provisions with reference to an IRR.

I am still thinking about drafting the partnership agreement provision that will accomplish this. For now, I am using something similar to what Brad provides in his article. I also am employing examples. That may be the best approach in any case. Of course, the example should be consistent with the drafted provisions. Easier said than done.

Brad’s article is worth a careful read. It’s pretty dense, but, it’s also really instructive.