Legislature(1997 - 1998)
04/30/1997 04:53 PM L&C
* first hearing in first committee of referral
= bill was previously heard/scheduled
= bill was previously heard/scheduled
HB 266 - LIMITED LIABILITY COMPANIES Number 040 CHAIRMAN ROKEBERG asked Representative Ryan, sponsor of HB 266, "An Act relating to limited liability companies (LLC) and limited partnerships; and providing for an effective date," to present his sponsor statement. REPRESENTATIVE JOE RYAN said, "House Bill 266 hopes to take care of an opportunity that was offered the first of this year. The IRS (Internal Revenue Service), unlimited liability companies and limited partnerships had a rather long complicated set of regulations to try to make sure these people were not using them to escape corporation taxes. And they had a number of tests. If you hit any two of the tests, you're considered, for practical purposes, tax (indisc.) a corporation. And this got very difficult to administer and there were a few of attorneys who could understand it, and so a model law was written as -- well uniform law and this is what's been used. It's been very cumbersome and expensive. And I think two years ago we introduced this limited liability company into Alaska. Well the first of this year the IRS repealed those regulations. Now all you have to do is to make application to check the box as an entry classification and you are -- have done. And we feel that, myself sponsoring this legislation, I feel that we are in an opportunity to remain at the cutting edge of businesses to attract limited liability companies and limited partnerships could be formed in Alaska. With the Internet, today, it makes things a lot easier. And we're cleaning up the statutes and making them easier and more simple -- will allow people to use this vehicle in Alaska in which will eventually bring more business to Alaska." REPRESENTATIVE RYAN said he feels that by passing the bill, we have an opportunity to remain at the cutting edge of businesses to attract limited liability companies and limited partnerships to be formed in Alaska. He said this would clean up statutes and make them more simple. It will allow people to use this vehicle in Alaska which will eventually bring more business to Alaska. He noted there are some witnesses on-line who are much more aware of the technical aspects then he is. Number 209 JERRY WEAVER, Alaska Bankers Association, was on-line in Anchorage. He said because the committee isn't going to vote on the bill, he has no comments at this time. CHAIRMAN ROKEBERG asked Mr. Weaver if the Alaska Bankers Association has an opinion on the bill. MR. WEAVER indicated they didn't at this time. He noted they have only had about an hour to review the bill. CHAIRMAN ROKEBERG said he would try to get an expedited hearing for the bill. He said it would be brought up again on Friday or at the call of the chair. Number 278 MIKE STONE, Certified Public Accountant, testified via teleconference from Anchorage. He noted he is representing himself. Mr. Stone said he will speak to the benefits of passing legislation that would simplify state law given the fact that the IRS did greatly simplify their approach on classification of entities. As Representative Ryan has said many of the tests that were required to be in state law so that we could be assured that these entities would be treated as partnerships for income tax purposes only really are no longer needed because of the IRS' change in position. It literally is a situation where you can check the box and determine whether you want to be active in partnerships or corporations. He said any simplification of the law that would make it easier to work with and fall in line with the "check the box" regulation issued by the IRS would be beneficial. CHAIRMAN ROKEBERG said he remembers what is called a "safe harbor rule." He asked Mr. Stone if that is germane to HB 266. MR. STONE said, "There really were not a safe harbor per se. It was more that we had to be sure that we didn't have continuity of life or we didn't have -- to tell you the truth I can't remember what the four items are off the top of my head, but it was a matter of having to draft, very carefully (indisc.) that you would fail at least two of these tests so you wouldn't be thrown in to be taxed like a corporation even though you are actually organized as a partnership entity. So it was a matter of careful drafting to avoid the tax treatment of being taxed by the corporations." MR. STONE explained there were some rulings that were put out by the IRS that kind of (indisc.) safe harbors saying that, "Well look, if you're gonna have a limited partnership and the general partner is a corporation, then we will respect that corporation as the general partner so long as it has X dollars of equity." Mr. Stone said they were very concerned that a limited partnership would be set up where nobody had liability because the corporation was judgement proof because it had no assets. He said with the IRS backing off from this whole area, those types of concerns really aren't present anymore. Number 585 CHAIRMAN ROKEBERG said he isn't sure why some of the changes are being made in existing statutes when we are trying to speak to IRS regulations. He said one that troubles him is that both in the LLC portion and the limited partnership portion of the bill it requires a unanimous or 100 percent vote of the members to amend or change their operating agreements unless there is another method stipulated in their operating agreement. For example, the LLCs went from two-thirds to all members. He questioned how that would affect the tax situation. MR. STONE said if you have a one member LLC, you could no longer have a two-thirds vote. He noted that particular provision is a default provision, but an operating agreement can state something other than "all" and that will be respected as the law indicates. CHAIRMAN ROKEBERG said it seems to him that there is a prohibition on withdraws and there could be some difficulties that may come about. He said, "For example, if you had a limited partnership which, because of the nature of its asset base, was accruing continual losses and also at the same time with an (indisc.) depreciation schedule, the capital account was going further in the negative and the prospects for a turnaround of that particular partnership were -- if there is an ability to elect to withdraw by a limited partner - at a point in time it may be prudent for the limited partner to be able to withdraw unilaterally and cut his further losses if he made a judgement. And then I'm concerned where in this bill that there is restrictions on the ability to withdraw under this. I mean is there -- are we gonna to be doing something here that would effect that or would in fact that be a circumstance sometimes the fact pattern that I described hypothetically." MR. STONE referred to the situation Representative Rokeberg described and said he has seen that happen in the past. The income tax law has changed somewhat in terms of looking at the at-risk provisions for real estate that kind of lends itself to where you would no longer get to take those losses. He said many limited partners wanted the ability to be rid of these limited partnerships. He said he could not speak to how the provisions in the bill would affect that. He said Chairman Rokeberg's hypothetical example certainly has occurred. Number 897 CHAIRMAN ROKEBERG said, "Right, okay, because it is on page 10 in Section 17, specifically on that point and I brought it up to you because it would be typically some advise a CPA may give to a client if he did an analysis of the investment situation and may have recommended to a client that that would be a prudent course of action. Have you ever been in that situation where you've recommended that?" MR. STONE said it's been more of a situation where he has run the numbers for his client which indicated that if they were tired of dealing with it, the pain would not be too great to get out of it. Number 937 CHAIRMAN ROKEBERG said, "And they usually then -- would their basis be at the time they withdrew and that would be provided for either under the state statutes that applied to that particular - that organization and/or the written agreement?" MR. STONE said, "I'm sorry, I didn't understand your question." CHAIRMAN ROKEBERG responded, "I'm not sure I did either. Let me restate it. So at the point of withdraw be -- depend on the laws of the state of the limited partnership at the time, where that was a domicile say it was a delawarn (ph.) under the partnership or it could be stipulated in the written agreement I take." MR. STONE said what he did was his client, the limited partner, requested of the general partner that he basically relinquish his limited partnership interest. The general partner acknowledged and agreed to that. So that is what happened. Mr. Stone said this would contemplate that the partnership agreement would more than likely allow for the same type of process. Number 1041 RICH HOMPESCH, Attorney, was next to testify via teleconference from Fairbanks. He said he would address Section 3 and Section 17 of the bill. The first thing he would like to bring up is the applicability provision in Section 24. He said these changes in the law wouldn't apply to any existing partnership or LLC unless the entity filed an amendment with the Department of Commerce and Economic Development stating that this law will apply. He said if Chairman Rokeberg is asking about any existing partnerships or LLC, then the answer is that nothing has changed. Those laws would still apply to those existing entities. MR. HOMPESCH referred to page 2, Section 3, and said it states that unless another level of consent is required in the operating agreement of the company, then the written consent of all members is required. He said HB 266 does not prohibit members of a LLC from deciding that 51 percent, two-thirds or any other number of members are required to amend the articles of organization, for example. The bill provides that unless the operating agreement otherwise provides, everyone must agree. He said if you have a 10 percent interest in an entity, it is only fair that terms of your agreement do not vary just because two-thirds of the members are voting in favor of it. Number 1183 CHAIRMAN ROKEBERG asked if that is a policy judgement or does that reflect the new IRS code. MR. HOMPESCH said it does have a very significant impact in the IRS code. He said the question under Chapter 14 of the IRS code is, "What is the value of an interest in a limited liability company or a limited partnership?" What the IRS has done is said for the purposes evaluation, we're going to disregard the terms of the agreement and we're going to look at their state law. Mr. Hompesch said if their state law says that upon two-thirds of a vote of the members, you can change anything in your agreement, then what happens is, for instance on liquidation, the IRS would say if the decedent who owned 80 percent interest in the entity, the IRS would say that decedent could then completely liquidate the company and get the money for the estate. If an estate can be paying 100 percent for its interest in a LLC when a person dies, that person's interest in the LLC will be worth far more than if that entity continued and perhaps (indisc.) liquidated in 20 years. Number 1299 CHAIRMAN ROKEBERG asked Mr. Hompesch to explain the distinctions between what an LLC is and a limited partnership. MR. HOMPESCH said they are very similar. The big difference is in a LLC, although the company is taxed in most instances like a partnership, all of the members have limited liability. He said, "By contrast a limited partnership, though again in most instances is taxed as a partnership, at least one member had unlimited and that member is the general partner." Number 1365 CHAIRMAN ROKEBERG said in a limited partnership you have to have more than one member, but according to the bill before the committee a LLC could be established with one member. MR. HOMPESCH said, "Regulation section 301.77013(A) changed the rules and provides that a sole proprietor could become a limited liability company and still be taxed as the sole proprietor. So that was a direct result of a change in the internal revenue code or the IRS' position." CHAIRMAN ROKEBERG questioned when that happened. MR. HOMPESCH said he believes it part of the "check the box" regulations. He indicated he believes it is a new change. It has a significant impact on Alaskan businesses for this reason. Under existing law, if a person comes to him and says he/she would like to incorporate and have limited liability, but they would be sole shareholder of the entity.... CHAIRMAN ROKEBERG interrupted and said normally he would recommend a "Sub S" if that was appropriate, historically. MR. HOMPESCH said the disadvantage with a Sub S corporation is that if a Sub S corporation distributes assets that have appreciated in value, upon the distribution there is a taxable event. The sole shareholder would have to pay a capital gains tax on any appreciation of the assets. However, if we allow a one member LLC in Alaska, the LLC would taxed as sole proprietorship and most of the time the distribution of an asset from a one member LLC would not be a taxable event. Number 1597 CHAIRMAN ROKEBERG indicated he is very excited as he is a sole proprietor of a business. He asked Mr. Hompesch if he is suggesting that with the passage of HB 266, a sole proprietorship could be turned into an LLC and gain the benefits in terms of liability. He asked, "Under a LLC, is the corporate vale that you get in a "C" type corp., in terms of the case law and what's been built up, how does that compare LLC to a "C" corp. for example?" MR. HOMPESCH explained there are few cases involving LLCs. He said he believes most attorneys would agree that the case law involving corporations is a analogous to limited liability companies so probably the courts would adopt that case law when dealing with the same issuance in a LLC. At this point, he believes it is still an open question. Number 1643 CHAIRMAN ROKEBERG said, "But the primary benefit though is, for example, you go to a lender and arrange for financing and under an LLC, if in fact the lender is willing to grant you that, that they would have only a recourse to the asset rather to an individual unless there was a requirement by a lender of a personal guarantee. Is that correct?" MR. HOMPESCH said that is correct. He noted in his experience, the lender always asks for a personal guarantee. Number 1683 CHAIRMAN ROKEBERG asked what other benefits would accrue under a LLC to a sole proprietor besides the debt and the protection of their own personal portfolio. MR. HOMPESCH said that is all the benefits he can think of. CHAIRMAN ROKEBERG said, "But then if there was a third party cause of action like there is an action in tort, those are the types of things that would protect the assets of the - say it was called a single LLC." MR. HOMPESCH said not necessarily. If the sole member of the LLC was negligent, that person is always going to be liable for their own negligence. This bill does not change that. However, if an employee of the LLC was negligent, but the member was not then the member's personal assets, outside of the LLC, would not be at risk. Number 1751 CHAIRMAN ROKEBERG said, "Mr. Stone, did you cover the two-thirds and the unanimous there sufficiently for the folks here in committee? Because I notice in Section 21 also, you're adding a whole new provision. What's the current law in terms of a change of the partnership agreement for a limited partnership because you've added a new section here that it has to be by unanimous consent on page 12, Section 21?" MR. HOMPESCH responded, "I believe this is the law, but the IRS apparently at times, has argued otherwise. So this will clarify what we think the law is which is all members of partnership agreements have to agree if the agreement is changed." Number 1831 CHAIRMAN ROKEBERG referred to page 3, Section 6 and said a foreign limited company has been added. He asked if that is defined anywhere else in existing statute. MR. HOMPESCH said it is in the definition section of law. This change was suggested by Bob Manley who worked on the original Limited Liability Act and he mentioned that some of the attorneys felt that this should have been clarified in the original act because the definition of a limited liability company does not include a foreign limited liability company. It was understood that this provision was to apply to both. He said Section 6 is not a change that has come about because of a change in the IRS regulations. Number 1900 REPRESENTATIVE RYAN said that we are still talking about using the term "foreign" as a foreign country and/or foreign state. MR. HOMPESCH said that is correct. He noted the reference that Mr. Manley mentioned is in the definition section of 10.50.990. He said, "Sub 9 in existing law says a limited liability company or domestic limited liability company means an organization organized under this chapter that is...." TAPE 97-54, SIDE B Number 001 MR. HOMPESCH continued, "I think it was intended that, as to foreign limited liability companies, there would also be limited liability to third parties. So this is a change that just clarifies that." CHAIRMAN ROKEBERG referred to page 3, Section 7, and asked why language was removed starting on line 23 through 29. He said he isn't sure he fully understands the intention. MR. HOMPESCH explained it is his understanding that when the limited liability company was adopted, there was included a special election under AS 10.15.085(A). He said as he understands, the purpose of this election was to make sure that an Alaska limited liability company would not have one of the four corporate characteristics which is continuity of life. Now that corporate characteristic is really irrelevant, so it was deleted. He said it has been suggested to him by an attorney, David Shaftel, who was involved with the original act, that it would be appropriate to make this deletion. He noted every reference to the old election has been deleted and this is one of them. Number 101 REPRESENTATIVE RYAN explained under the old continuity of the life, people had artificially set up a corporation that somehow would terminate so that there couldn't be continuity of the life and they would quality as a double taxation basis. Now since we no longer need to meet that requirement, this is just striping that excess verbiage out of the document so people don't have to go through these artificial barriers to meet a tax requirement. CHAIRMAN ROKEBERG asked what would occur if there was a failure of the partners within a limited liability company and they wanted to dissolve it and reorganize it. Number 130 MR. HOMPESCH said as long all have agreed to dissolve then it would be dissolved or the court could order it. CHAIRMAN ROKEBERG said what if one person wants to get out. MR. HOMPESCH explained, "If your agreement said that if one member wanted to get out, that that one member could get out, then what you see in Section 7 wouldn't be a problem because Section 7, under 10.50.400 (1) says that you could have a dissolution at any time (indisc.) specified in the operating agreement. So if the operating agreement said if one person wants to dissolve the entity, then the entity dissolves and that's what would happen. Elsewhere, we talk about with withdraw. If the agreement provides that one member may withdraw at any time then of course that provision in the agreement controls over the statute." Number 187 CHAIRMAN ROKEBERG said as a matter of customary practice, would an interest in a LLC be marketable similar to a limited partnership interest. REPRESENTATIVE RYAN said he would imagine it would depend on how they do it. DICK THWAITES, testifying via teleconference from Anchorage, said he believes there might be some securities difference because the limited partnership would have some additional requirements there because you're relying on the general partner and other management. In the LLC, you have more universal management like a partnership and you aren't subject to the same strict rules. CHAIRMAN ROKEBERG asked how long LLCs have been available in American law. MR. THWAITES responded since 1976, and in Alaska since 1995. He said Alaska was actually approached first in 1974, but chose not to adopt it. Wyoming adopted it in 1976, and was the first state. Number 280 CHAIRMAN ROKEBERG said, "Let's move on to Section 8 where the standard for dissolution by court is not reasonably practical to continue operation has been changed to impossible. It seems like we're raising to about the highest standards you can get here. I'm not sure I understand why that was done." MR. HOMPESCH said he isn't sure which states have this language, but the issue is one of valuation by the IRS. If a court can liquidate an (indisc.) LLC and an estate can be paid in cash for its interest, then the more easily the court can do this, the higher the value of the interest in the LLC, and more estate taxes would have to be paid. The members of an LLC in an operating agreement can agree that they will allow the court to dissolve them whenever the court wants to. That would certainly would be enforceable. However, if the members of a LLC do not want the court to dissolve it very easily, in order for that provision to be enforceable, it has to appear in state law. CHAIRMAN ROKEBERG said this would make it more difficult for a dissolution to take effect by court order. MR. HOMPESCH said that is correct. For state tax purposes, it would cause interest in the LLC to be worth less than federal/state tax purposes. CHAIRMAN ROKEBERG asked if that is because the asset base isn't being broken up. MR. HOMPESCH indicated that is correct. It is harder to break it up. CHAIRMAN ROKEBERG said he has several other questions regarding the bill and would contact him directly. ADJOURNMENT CHAIRMAN ROKEBERG adjourned the House Labor and Commerce work session on HB 266 at 5:40 p.m.