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Is a limited liability company treated the same as a partnership? Let’s assume that each one is composed of the same parties with the same percentage interests. The answer is, it depends. It depends on why you are asking the question and whose law applies. This article will compare treatment for federal taxes, state taxes, principals’ third-party liability; and for title insurance coverage. The Internal Revenue Code generally treats these entities the same. That is, they are not separately taxed, and gains and losses are passed through to the partners or members. On the other hand, some states may treat them differently. This doesn’t happen in many states, but Pennsylvania still treats an LLC like a corporation when it comes to capital stock taxes. Some lawyers and other consultants have advised using LLCs instead of limited partnerships in Pennsylvania real estate deals. Unfortunately they have been occasionally embarrassed to find that their client’s LLCs have been unexpectedly saddled with capital stock taxes that wouldn’t have been levied against limited partnerships. While these capital stock taxes are being reduced each year, these taxes could still impair net returns. Let’s look at the way courts are treating the liability of partners and members of an LLC. The main reason that we use LLCs instead of partnerships is that we expect to have limited liability for the interested parties. If you use a general partnership, the partners of that partnership may have to pay contract and tort claims instituted by third parties. On the other hand, the LLC generally will protect its members against that kind of liability. However, you can also provide protection for partners by proper use of a limited partnership. Unfortunately, recent cases indicate that the protection doesn’t always work, even with an LLC. Some cases “pierce the veil” of the LLC, particularly where the member has complete control of the LLC’s policy and business practices; the control is used to avoid personal liability previously assumed by the member and the LLC has not observed separating the corporate formalities between the members and the LLC. Suppose partners want liability protection and a general partnership transfers real estate to an LLC whose members are the same as the partners. Will the partnership’s title insurance carry over to the common-controlled LLC? The insured party will argue that the LLC should have the same benefits as the partnership because it is the alter ego of the partnership and there has been no substantive change of ownership. For the most part, cases have rejected that theory and have held that the standard title policy does not extend coverage to the LLC. To a large extent courts have strictly construed the definition of “the insured” in these policies, which extend coverage to “those who succeed to the interest of such insured by operation of law as distinguished from purchase, including, but not limited to, heirs, distributees, devisees, survivors, personal representatives, next of kin or corporate or fiduciary successors.” Cases in California, Idaho, Illinois and Maryland have all rejected “alter ego” arguments made by owners in attempts to extend insurance coverage to these grantees. The analysis in these cases is based on interpretation of the policy, and they have rejected the argument that a deed to the related LLC is a transfer “by operation of law.” There are some exceptions to this, and a recent case in New Jersey extended coverage to the grantee in an analogous situation. In that case the court applied an alter ego theory and supported the idea that there was no reason for the parties “to expect that the title insurance company would not recognize their continued ownership of the property.” That view does not seem to be one that will be widely adopted. Transfer Taxes What about realty transfer taxes when a partnership transfers real estate to an LLC comprised of the same members with the same percentage interests as the partners of the transferring partnership? Partners sometimes do this to limit their personal liability. Will the transaction be exempt as a transfer to an alter ego? Again, the answer is that it depends. Remember, in Pennsylvania that tax could turn out to be substantial. It is based on the defined value of the property as set forth in the Transfer Tax Act and in regulations. The Pennsylvania tax is 1 percent. The local tax is an additional 1 percent, except in certain municipalities. For example, in Philadelphia the tax is an additional 3 percent. A recent published ruling has confirmed the way the Pennsylvania Department of Revenue will treat these transactions for the state’s 1 percent. This is also confirmed by recently proposed RTT regulations. Beware. This type of transaction could prove to be a trap for the unwary. If you form the LLC and transfer the owned real estate by deed, the Department of Revenue takes the position that the transaction is fully taxable. The alter ego theory doesn’t help the taxpayer here. The transfer is taxed just as though it were a transfer to a completely unrelated party. However, by handling the transfer in a slightly different way, the taxpayer can accomplish its objective without a state transfer tax. The cited ruling spells out that if the transaction is carried out as a conversion from a partnership to an LLC, there will be no tax. Anyone contemplating that type of transaction should carefully review the ruling, which spells out how the taxpayer can avoid the tax. Once the limited partnership is formed with identical membership interests to the partners’ interests in the partnership, the partnership must then merge into the LLC. “In that transaction, the general partnership is absorbed into the limited liability company, which takes its place without the dissolution of the general partnership.” The real estate then “flows” to the LLC as a result of the merger. Presto! The taxpayer winds up accomplishing the intended transfer to the LLC, but without a tax. In a sense, the form of the transaction governs the substance. Apparently, the Philadelphia tax authorities will not recognize a partnership-to- LLC conversion exemption, and will assess the 3 percent transfer tax on similar mergers involving Philadelphia real estate. This brings us back full circle to the original question, does the law treat partnerships the same as LLCs? The answer: It depends. HARRIS OMINSKY is with the law firm of Blank Rome and is a former president of the board of the Pennsylvania Bar Institute.

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