Need a partner or investor? Consider an LLC

NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because of changes in the law from the date shown at the end of the article. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided.

Automobile dealers are increasingly transferring minority interest in their dealerships to third parties. They are doing so for a variety of reasons–to bring in new management, to turn the dealership around, or in preparation for retirement, or simply to raise cash.

Often, however, the dealership is owned by a corporation and there may be numerous reasons why the third party should not own stock in the corporation. For example, if the corporation has significant assets in addition to the dealership itself, the current shareholders would be justifiably concerned about the new minority shareholder having an interest in the non-dealership assets. The value of the non-dealership assets might also make the price per share prohibitively expensive for the minority owner. Creditors also complicate the situation: the non-dealership assets of the corporation will continue to be available to dealership creditors, even if the majority owner is no longer actively involved in the business. Subsidiary corporations or preferred and common stock offer some assistance here, but current tax law limits their usefulness.

California’s recently enacted Limited Liability Company Act offers new business and tax planning strategies that may help resolve many of these issues.

Rather than selling stock of the corporation to the proposed minority owner, the existing corporation and the proposed minority owner would form a Limited Liability Company through which dealership activities would be conducted.

A Limited Liability Company (“LLC”) is a business entity that is generally treated as a corporation for purposes of determining liability under state law but may be structured as either a corporation or a partnership for federal and state income tax purposes. Usually, classification as a partnership provides the more desirable tax benefits.

An LLC may be funded with money, property, services or an obligation to contribute money, property or services. For example, the corporation could contribute its dealership business to the LLC in return for a majority interest in the LLC (and retain its other assets in the corporation) and the minority owner could contribute money and/or a note for its minority interest in the LLC. The LLC would then own the dealership and all activities would be conducted through it. If the LLC is organized as a partnership for tax purposes, the contribution of the going business (the dealership activities) will generally be tax-free. However, certain LIFO adjustments may be required.

With only the dealership assets belonging to the LLC, the corporation could retain all other assets, generally beyond the reach of creditors of the LLC. And, under partnership tax treatment, other than a graduated minimum tax which caps out at $4,500 for gross revenues over $5,000,000, no income taxes are payable by the LLC as the income of the business is taxed only at the owner’s level.

An LLC has distinct advantages over other business forms. In contrast to a corporation, an LLC organized as a partnership has only a single level of taxation while corporate earnings are subject to double taxation. LLC members are not exposed to unreasonable compensation issues and, unlike a corporation, the accumulated earnings tax and the personal holding company tax are not imposed on an LLC. Furthermore, items of income and loss can be specially allocated to members.

While there are no significant tax differences between an LLC organized as a partnership and a general or limited partnership, there are significant differences in the liability of the members. In a general partnership, all partners have unlimited liability. In a limited partnership, at least one partner is required to have unlimited liability and if a limited partner participates significantly in the management of the limited partnership, that partner may be liable for the debts of the partnership. In contrast, all members of an LLC have limited liability. Furthermore, members of the LLC may participate in management and not become liable for debts of the LLC.

S corporations, like partnerships and LLCs, have only a single level of taxation at the owner’s level. However, restrictions are imposed on S corporations as to both the number and kind of shareholders the S corporation may have. In contrast, there are no restrictions on the number or kind of entities that may be members of an LLC.

LLCs are not the perfect business entity for all situations and there are certain disadvantages associated with LLCs. For instance, partnership tax treatment means members are taxed on the LLC’s income even if the income is not actually distributed to the members, and individual members may be subject to higher marginal income tax rates than corresponding corporate tax rates. Complicated tests also pertain to whether partnership tax treatment is available to an LLC, some of which place limits on the free transferability of interests in the LLC and on the ability of the LLC to continue after the death, bankruptcy or withdrawal of a member. Having all members involved in management may also result in certain inefficiencies. Careful planning and drafting of the legal documents, however, can usually avoid these problems.

A Limited Liability Company could also be useful in situations where a dealer might want to separate out some dealership operations with a separate business entity. A dealer might want to have a separate entity for the dealership’s leasing operation, body shop department, or any other department or business in which the dealership is engaged. Either the dealer or the dealership corporation could be a partner in the LLC with an individual who might run that aspect of the business and who would have an equity interest in the LLC without having an interest in the entire corporation. The owners of the LLC would not have personal liability for the LLC’s acts and would have all of the benefits described above. An LLC thus can be a very flexible business entity which can be used to provide employees an interest in a particular aspect of the dealership’s business. It is likely that many imaginative concepts will arise out of this new business entity now authorized under California law.

In a buy-in or a buy-out, as in all business transactions, there is no substitute for careful business and tax planning. The lure of a single level of income tax combined with limited liability offered by an LLC is appealing, but the ultimate choice of a business entity should be made only after thorough consultation with your legal and business advisors.

Action in Washington over the last few weeks may offer more help soon. A bill by Senators Hatch and Pryor would allow S corporations to own, and be owned by, other closely held corporations, and to issue different classes of stock. And the IRS itself has proposed even more sweeping reforms under which all forms of closely held business entities would simply elect between partnership or corporate tax treatment, with no complicated tests. From our experience, dealers would benefit greatly if either of these proposals became law.

This article was written in 1995.