Illinois Limited Liability Companies (“LLC”) are governed by 805 ILCS 180/1-1. The Limited Liability Company Act (“LLCA”).
An LLC is a separate legal entity and requires certain procedural steps be followed. First, the LLC organizer(s) must file articles of organization (the LLC counterpart to a corporation’s Articles of Incorporation) with the appropriate state agency (generally, the Secretary of State). The articles of organization must contain: the name and address of the principal place of business of the LLC; its period of duration; the business purpose (ordinarily, language to the effect of for the transaction of any or all lawful business for which limited liability companies may be organized under the Limited Liability Company Act); the registered agent’s name, the registered agent’s address; the name(s) and address(es) of the initial LLC’s manager(s) or members; and a statement indicating that the LLC is managed by managers; the names and addresses of each organizer; and any other provision the members/managers elect to include.
Before the articles of organization can be filed, however, a name must be chosen and approved by the Secretary of State (the purpose of this approval is to prohibit the use of the same or similar names by two different business entities). An LLC must contain the words “Limited Liability Company” or the abbreviations “L.L.C.” or “LLC” after its name to indicate that it is an LLC. The name must not contain any of the following words or abbreviations: “Corporation,” “Corp.,” “Incorporated,” “Inc.,” “Ltd.,” “Co.,” “Limited Partnership,” or “L.P.”.
Next, an operating agreement should be prepared listing the rights and duties of all of the members. Here, as well as in the company minutes if so adopted after the LLC’s formation, is the appropriate place for language to be included governing business succession and ownership interest transfer restrictions. Even though more expensive than a corporation, the costs associated with forming an LLC are relatively minimal in relationship to the asset protection features inherent in a properly drafted operating agreement in addition to statutory protection.
Because professionals typically have conducted business in unincorporated forms, they have faced unlimited liability for obligations arising from their professional practices. Those who have incorporated their practices may have encountered income tax problems (including double taxation of income when operating as a C corporation if one does not zero out their earnings and the lack of flexibility in ownership and operation as an S corporation) and nontax problems (including administrative costs and the view that operation in incorporated form is either “unprofessional” or impractical). LLC’s appear to avoid these problems.ii
As a result, LLC structures had become the focal point of professionals, including accountants and lawyers, seeking protection from unlimited liability while avoiding double taxation and the need to incorporate. A number of states have provisions specifically allowing professionals to practice as LLC’s.iii Though the new rage appears to be the usage of LLP’s!
Nonetheless, there are important unresolved questions concerning multistate practice by professional LLC’s, including the issue of cross-border protection from liability and the difficulty for multistate firms to meet state regulatory or statutory restrictions.iv In order to be a member of a professional service LLC, the member typically must be authorized by law to provide the professional services for which the LLC was formed. Under the LLC statutes of some states, it is required that all members of a professional LLC be authorized to practice in the particular state in which the LLC is organized. Under the legislation of some states, members need be authorized only by the law of the state in which they actually render services.
As described below, the potential impact of LLC acts in general and the LLC in particular:
other professionals practicing in Illinois merits consideration.
Attorneys and Law Firms:
On April 1, 2003, the Illinois Supreme Court issued an amendment to Supreme Court Rule 721 and created Rule 722, authorizing limited liability legal practice.vi The Rules were in response to a joint petition filed by the Chicago Bar Association and Illinois State Bar Association in March 2002 requesting that the Court amend the Rules to allow lawyers practicing in limited liability entities to be protected from unlimited vicarious liability under certain circumstances. The Rules took effect July 1, 2003.
The Rules eliminate mandatory vicarious liability of law firm partners for malpractice committed by other firm lawyers not in their control. The centerpiece of the Rules is a quid pro quo permitting lawyers with an equity interest in professional corporations, professional associations, limited liability companies, and registered limited liability partnerships to avoid vicarious liability as long as the firm maintains adequate insurance or other proof of financial responsibility.
A minimum level of insurance under the rules is $ 100,000 per claim and $ 250,000 annual aggregate, times the number of lawyers in the firm, and insurance need not exceed $ 5,000,000 per claim and $ 10,000,000 annual aggregate. As a result, the Rules improve clients’ ability to recover for malpractice. While every other state allows limited liability practice in some form, only 11 require insurance as a condition of limited liability. Illinois is now one of twelve states that clearly express an interest in putting clients’ interests first and the interests of their attorneys in making a living in a competitive environment at a disadvantage versus other licensed professionals.
Additional provisions of the Rules protecting clients are that partners remain fully liable for their own malpractice and that of lawyers under their direct supervision and control, partners remain jointly and severally liable for amount of insurance deductible unless proof of financial responsibility is provided in the amount of the deductible, and law firm assets remain liable for malpractice committed by any firm lawyers.
The American Institute of Certified Public Accountants (AICPA) was among the first professional organizations to recognize the potential viability of the LLC as a practice vehicle on a profession-wide basis. Before 1992, the AICPA prohibited the practice of accountancy in any form other than as a proprietorship, a partnership, or a professional corporation whose characteristics corresponded to AICPA Code of Professional Conduct Rule 505. The rule was amended in January 1992 by an overall majority of members of the AICPA voting on the issue, and Rule 505 as revised allows members to select any organizational form, including the LLC, to better serve accountants’ needs in connection with limiting their exposure to liability and facilitating their ability to establish multi-state practices in order to better serve clients who operate in more than one state.
Most of the LLC acts enacted to date have not explicitly authorized or approved of use of LLC’s by accountants; however, as a statutory matter this does not appear to be necessary as long as they are not explicitly precluded from using LLC’s. Indeed, the majority of LLC acts remain silent on this point. A Kansas Attorney General’s opinionvii has authorized the use of LLC’s by accountants, but other states, including Illinois, have not explicitly issued rulings or attorneys general’s opinions regarding such usage.
In Illinois, the practice of public accounting is governed by statute.viii A person, either individually or as a member of a partnership or an officer of a corporation, may be deemed to be in practice under the Illinois Public Accounting Act. 225 ILCS 450/8. The practice of public accounting without licensure with the Illinois Department of Professional Regulation is a Class B misdemeanor. 225 ILCS 450/7, 450/28(a). The Illinois Public Accounting Act was amended by P.A. 88-36, effective January 1,1994, to permit the practice of public accounting in limited liability company form. 25 ILCS 450/8. The LLC must make application to the Department of Professional Regulation for licensure and pay the requisite fee. 225 ILCS 450/13.
In Illinois, the Illinois Society of Certified Public Accountants has actively sought to remove regulatory restrictions that might preclude the practice of accountancy via the LLC form. It is anticipated that in light of the amendments to the Illinois Public Accounting Act many accountants will utilize the LLC as a form of business, and it is unlikely that the Illinois Supreme Court will invalidate this form of organization or prevent limitation of accountants’ liability. Although use of the LLC is unlikely to protect a member from personal liability for his or her own malpractice, there is a good likelihood that the LLC form will protect a member of an accounting firm from vicarious personal liability for malpractice committed by a co-owner unlike the case for lawyers, discussed above. Since accountants can utilize LLC’s in Illinois, it is anticipated that most accounting firms will explore the structure, using a cost-benefit analysis in their deliberations. Accountants likely to give serious thought to using the LLC format are those who are engaged in practices prone to malpractice and/or bankruptcy (i.e., those who prepare certified audits for publicly traded companies, those who provide tax advice and/or tax return preparation, and those involved in audits of industries such as savings and loans and banks that have been relatively prone to potential professional liability litigation in the event of the bankruptcy or collapse of their audited clients).
The typical disadvantages of using LLC’s also apply to professionals, including the filing fees and related costs of formation and operation, which are substantially higher than those of the general partnership form; the lack of law in interpreting many of the provisions that must be utilized in the firm’s operating agreement; and the uncertain protection that LLC’s provide with respect to shielding a member from practice liability (such as malpractice) that arises due to actions of other members or employees of the firm. In addition, there are certain tax issues relating to operating as an LLC when one is in a professional practice, including a question of the ability to retain the cash method of accounting rather than being forced into the accrual method, with potentially disastrous tax consequences.
On the basis that every member actively practiced the profession and had voting rights on numerous matters affecting the firm’s governance and operation, the IRS has indicated in two Private Letter Rulings a willingness to permit professional service LLC’s to use the cash method of accounting. See PLRs. 9321047, and 9328005. It is by no means clear that medium- or large-sized firms will be willing to permit all their members to participate in firm management to the extent permitted in the aforementioned letter rulings. Therefore, professionals would be prudent to seek letter rulings for their own protection absent a Revenue ruling or regulation promulgated on point.ix
The so-called [“Final 4”] national accounting firms have chosen to operate as limited liability partnerships (LLPs) rather than as LLC’s. It is understood that this choice was based on numerous factors, including the inability of professionals to operate as LLC’s in a few states, the relative ease of registering as an LLP and remaining uncertainties as to the deductibility under §736 of payments to redeem the interests of members of an accounting firm LLC. Accounting firms doing business in Illinois or adjoining states are free to practice in LLC or LLP form, and small and medium-sized Illinois accounting firms use both types of formats.
However, a cost-benefit analysis may cause many service providers to determine that operation in partnership or corporate form is preferable, particularly if the perceived magnitude and risk of personal liability are minor.
LLC Basic Advantages
Because of their flexibility and relative simplicity, the LLC is well suited for both start-up businesses and more mature businesses. LLC’s have several advantages:
LLC’s provide greater management flexibility than corporations. For instance, corporations are required to have a formal structure with directors and corporate officers. LLC’s are simply run by the members or managers.
LLC’s provide greater flexibility with regard to income distribution than do corporations. When corporations pay dividends, those profits must be distributed evenly on a dollar per share basis. LLC’s may distribute income as desired.
If a small business is interested in “pass-through” taxation, then LLC’s have an advantage over S Corporations with regard to ownership flexibility. All shareholders of S Corporations must be citizens or permanent residents of the United States and there may be no more than 75 shareholders in total. LLC’s do not have these restrictions, again allowing greater operating flexibility.
Caveat: LLC distributions, unless structured properly pursuant to its operating agreement are generally subject to self-employment tax, whereas, dividends on S corporations are not.
Erosion of charging order protection via judicial foreclosure against a member’s interest
i Incorporated substantially from IILCE on LLCs (2000).
ii See Sheldon I. Banoff, From the Thoughtful Tax Advisor: Top Ten Reasons for Professionals to Consider Using LLCs, 73 Taxes 515 (1995).
iii See Sheldon I. Banoff, Alphabet Soup: A Navigator’s Guide -What Business Form Is Best for Professionals? , 4 A.B.A.BQs.L. Today, No.4, 10 (Mar.-Apr. 1995).
iv See Sheldon I. Banoff, Setting Up a Multistate, Professional Practice as an LLC, 2 J. Limited Liability Cos. 66 (Fall 1995).
v Jennifer T. Nijman, PRESIDENT’S PAGE: NEW LIMITED LIABILITY RULES GOOD FOR LAWYERS AND THEIR CLIENTS, 17 CBA Record 12 2003.
vi A copy of the Rules can be found on the CBA website at www.chicagobar.org.
vii See Op. Att’y Gen. (Kan.) 92-23 (Feb. 14, 1992).
viii See the Illinois Public Accounting Act, 225 ILCS 450/0.01, et seq.
ix See generally Sheldon I. Banoff, New IRS Ruling Encourages Professionals To Form Limited Liability Companies, 79 J. Tax’n 68 (1993); Sheldon I. Banoff, New Ruling Adds Further Encouragement for Large Firms To Form LLCs, 81 J. Tax’n 12 (1994).
x § 805 ILCS 180/10-10. Liability of members and managers. . . . (c) The failure of a limited liability company to observe the usual company formalities or requirements relating to the exercise of its company powers or management of its business is not a ground for imposing personal liability on the members or managers for liabilities of the company.
Richard M. Colombik, JD, CPA, is an award-winning attorney and CPA with a doctorate in jurisprudence with distinction and was formerly on the tax staff of one of the world’s wealthiest families.
Mr. Colombik has also been a tax manager at a Big Four accounting firm, the State Bar’s liaison to the Internal Revenue Service (IRS), vice president of the American Association of Attorney-CPAs, and vice chairman of the American Bar Association’s Tax Section of the General Practice Council, as well as the past chair of the Illinois State Bar Association’s Federal Tax Committee. Mr. Colombik has also served on the liaison committee to the Washington, DC, National Office of the IRS. Mr. Colombik is also a member of the Asset Protection Committee, American Bar Association, and a member of its captive insurance subcommittee.
Mr. Colombik has appeared on numerous television shows, hosted a weekly radio show on tax and business planning, and authored more than 100 articles on income taxation, asset protection planning, IRS defense, and estate planning. He has also instructed more than 100 seminars to professional groups, business groups, bar associations, CPA societies, and insurance groups. This is in addition to authoring a published work on business entity structures offered by the Illinois Institute of Continuing Legal Education, as well as writing a chapter for The Estate Planning Short Course and Asset Protection Planning.