Banks Can Take Advantage of LLC Opportunities
By: THOMAS W. GARTON
September 2003
In the last issue of Bank Focus, we discussed the evolving legal and regulatory environment that might be leading toward limited liability companies (LLCs) being qualified to be banks. It hasn't happened yet, but the sands are shifting. Though a bank itself cannot yet be formed as an LLC, LLCs can be useful tools for existing C Corporation and S Corporation banks and their holding companies.
An LLC has at least three important characteristics that make it attractive as a vehicle for ancillary businesses or nonbanking asset holdings of a bank:
First, it provides liability protection for the bank and/or holding company that owns the LLC. Except for contractual obligations guaranteed by the owner or owners of an LLC, the owner has no liability for the obligations of the LLC beyond the owner's capital contribution. This is the same as the protection afforded shareholders under the corporate law.
Second, the LLC provides a tax favored vehicle. An LLC is a pass-through entity for tax purposes, thereby avoiding a double tax on its earnings. If it has more than one member, it is taxed as a partnership, which is a pass-through entity. If it has a single member, the LLC is treated as a disregarded entity for tax purposes, creating the same effect as a pass-through entity. Although a single member LLC has separate state law existence and limited liability, for tax purposes it is treated as though its assets and operations are directly those of the single member. In addition, there is no prohibition against an S Corporation bank or holding company owning member units in an LLC, regardless of whether the LLC is wholly owned or partially owned by the S Corporation.
Third, the LLC can provide a way for a bank or holding company to create performance incentives for executives operating a bank's ancillary businesses. By owning LLC member units, the executive could share in the ownership and profitability of the business she manages, not the entire banking operation. In a variation on this theme, a key employee of a subsidiary LLC could be granted a profits-only interest in the LLC. Receipt of a profits-only interest avoids taxation at the time of the grant of ownership to the employee, eliminates the need for front-end investment by the employee, and results in taxation of only her share of the LLC profits when earned. This is an arrangement that is much more difficult, if not impossible, to structure in a Qualified S Corporation Subsidiary because an S Subsidiary must be wholly owned by the parent (the holding company or the bank) in order to maintain pass-through status as an S Corporation.
Likely candidates for LLCs in the current tax and regulatory environment include such ancillary activities as an insurance agency, holding of real estate for use by the bank, community development activities, and brokerage/financial planning activities. The best time to consider use of the LLC for an ancillary business is at the time it is organized. Although it may not always be the case, tax costs could be incurred in a conversion from a corporate subsidiary to an LLC if the corporate subsidiary has a history of profitable operation.
We can help with the analysis and planning to determine how best to take advantage of the benefits of an LLC for the ownership and operation of ancillary businesses, including consideration of key employee participation in ownership.