Jorge Otoya, Bird Education Specialists in Taxation
Summary:
I have noticed an uptick in questions this past tax
season on series Limited Liability Companies (Series LLCs). A Series LLC is a relatively new kid in
school and much still remains to be answered about their behavior. It has been a little over 3 years since the
Treasury proposed regulations with respect to the income tax classification of
a series of domestic Series LLCs, a cell of a domestic cell company, or a
foreign series or cell that conducts an insurance business. (REG-119921-09, 26 CFR Part 301 (September 14, 2010). In this blog I revisit the state of the
law with respect to Series LLCs and outline the proposed regulations, which
essentially provide that a series that meets its requirements, irrespective of
whether it is a juridical person, will be treated as an entity formed under
local law for federal tax purposes, and thus able to determine its
classification under Treas. Reg. § 1.301.7701-1 and general federal tax
principles.
Background:
Series LLCs
Delaware enacted the first series LLC statutes in 1996 and
we witnessed the birth of a new baby.
Subsequently, several states had their own baby by enacting their own
“series statutes” which allow the formation of a “series organization” able to
establish separate series underneath it.
These types of entities are known by different names, depending on the relevant
state…series LLCs, segregated account companies, segregated portfolio
companies, and protected cell companies, to name a few (for purposes of this
blog I will refer to all of these as Series or Series LLCs). However, despite their different labels, series share
three common characteristics. First,
a series can have different classes of ownership interests. Second, each class of ownership
interest may be tied to a specific group of assets or business operations, each
potentially housed in a separate series.
Third, a creditor is limited only to the assets of the debtor series to
satisfy its claim (as long as the requirements of the series statute are
satisfied).
Lets take an example.
Assume that a real estate sponsor wishes to offer investors the
opportunity to participate in three different real estate asset types: (1) rental;
(2) development; and (3) investment.
The sponsor could set up three separate real estate funds to house each
specific type of asset.
Alternatively, the sponsor could simply establish a separate series to
house each asset type. Under the latter,
the series organization could issue three different types of ownership
interests or series, each representing a different asset type. For example, series A could represent
an interest in rental real estate; series B could represent an interest in the construction
business; and series C in real estate investment.
As mentioned above, one of the benefits from using a series
is that it shields the assets housed in a series from claims a creditor may
have against another series. Using
the example above, if a creditor had a construction related claim against
series B, he or she would be limited to the assets of that series only. The creditor would not be able satisfy
his or her claim with the assets of series A or C. But liability protection can also be achieved by using other types of legal entities. For example,
one could form a single member limited liability company (SMLLC). So, why form a series over a SMLLC? Perhaps there is a tax advantage? Well maybe… But creating and operating a series is generally not
driven by tax reduction. Instead, series LLCs typically have lower state
filing fees and take less time to organize and set up than their distant
cousin, the SMLLC. However, the
use of series also creates some uncertainty with respect to the classification of
the series organization and the separate series underneath it for federal income tax
purposes.
The Check the Box Regulations
In 1997, Treasury simplified the law with respect to the
classifications of an entity for federal income tax purposes by issuing the
Check the Box regulations (the CTB Regulations). Prior to the CTB Regulations, taxpayers had to consider a multitude
of factors in determining the classification of an entity and the answer
depended on the specific facts and circumstances in each case. In many cases, it was uncertain whether
the chosen classification would ultimately be respected. As we all know, the CTB Regulations are
a much-celebrated piece of guidance in this area because they provide taxpayers with certainty by allowing eligible entities to elect their own
classification by simply checking a box on Form 8832. However, despite their celebrated status, the CTB
Regulations do not provide certainty with respect to series LLCs.
A bit more background may be in order. The CTB Regulations allow an “eligible” entity to elect its
own classification. A prerequisite
for achieving eligible entity status is that an entity must be a "separate" entity. Can a series be a "separate" entity under the CTB Regulations???
In this regard, the CTB Regulations provide that whether an organization
is a separate entity is a matter of federal tax law and does not depend on whether
the organization is recognized as an entity under local law. (Treas. Reg. §
301.7701-3(a)(1)). In the same
breath, however, the CTB Regulations also warn taxpayers that an entity formed
under local law is not always recognized as a separate entity for federal tax
purposes. (Treas. Reg. § 301.7701-3(a)(3)). For example, an organization formed by a state is not
recognized as a "separate" entity for federal tax purposes if it is an integral
part of the state. (Ibid). It is
unclear under these provisions whether a series can qualify as a "separate" entity, given that it is typically not a juridical entity under state law. In other words, even though a given
series may have its own name and potentially distinct business purpose, it is
not recognized as a local law entity, and therefore might not be a "separate" entity for federal tax purposes.
Proposed Regulations:
The proposed regulations attempt to resolve this uncertainty
with respect to the tax classification of domestic series and certain (not all) foreign
series. They do so by treating a series as an entity formed under local law, irrespective of whether
the series is a juridical entity. This treatment would enable a series to
determine its treatment under the CTB Regulations and under general tax principles.
Requirements
In order for a series to be treated as an entity formed
under local law under the proposed regulations, it must be organized or established under U.S. law or under
the law of any state. (Prop. Treas. Reg. § 301.7701-1(a)(5)(i)). An entity
established under the laws of a foreign jurisdiction can only be treated as an
entity formed under local law under the proposed regulations if its
arrangements or other activities would result in its classification as an insurance
company within the meaning of § 816(a) or § 831(c) if it were a domestic
company. (Prop. Treas. Reg. § 301.7701-1(a)(5)(ii)). Whether a series, that is treated as an entity formed under
local law, is recognized as a "separate" entity for federal income tax purposes
will be determined under the CTB Regulations and under general tax principles.
(Prop. Reg. § 301.7701-1(a)(5)(iii)).
A "series" is defined by the proposed regulations as a
segregated group of assets and liabilities established pursuant to a “series
statute” by agreement of a “series organization.” (Prop. Treas. Reg. §
301.7701-1(a)(5)(viii)(C)).
A "series" includes a series, cell, segregated account, or segregated
portfolio, including a cell, segregated account, or segregated portfolio that
is formed under the insurance code of a jurisdiction or is engaged in an
insurance business. (Ibid). However, a "series" does not include a
segregated asset account of a life insurance company. (Ibid).
A "series organization" is defined as a juridical entity that
establishes and maintains a series (or under which a series is established and
maintained). (Prop. Reg. Treas. § 301.7701-1(a)(5)(viii)(A)). A "series organization" includes a series
LLC, series partnership, series trust, protected cell company, segregated cell
company, segregated portfolio company, or segregated account company. (Ibid).
A "series statute" is defined as a statute of a state or
foreign jurisdiction that explicitly provides for the organization or establishment
of a series of a juridical person and explicitly permits that:
- Members or participants of the series organization have rights, powers or duties with respect to the series;
- A series to have separate rights, powers, or duties with respect to specified property or obligations; and
- The segregation of assets and liabilities such that none of the debts and liabilities of the series organization (other than liabilities to the state or foreign jurisdiction related to the organization or operation of the series organization, such as franchise fees or administrative costs) or of any other series of the series organization are enforceable against the assets of a particular series of the series organization. (Prop. Reg. Treas. § 301.7701-1(a)(5)(viii)(B)).
Information Statement
If a series is treated as an entity formed under local law
under the proposed regulations, the series organizer and the series are
required to file a statement for each taxable year containing the identifying
information with respect to the series organization as prescribed by the IRS,
including information required by the statement and its instructions. (Prop.
Reg. Treas. § 301.7701-6(a)). The proposed regulations do not
specifically provide what information is required to be included in the
statement.
However, in the preamble to the proposed regulations,
Treasury and IRS indicate that they are tentatively considering requiring both the
series organization and the series to provide (i) the name,
address, and taxpayer identification number of the series organization and each
of its series and status of each as a series of a series organization or as the
series organization; (ii) the jurisdiction in which the series organization was
formed; and (iii) an indication of whether the series holds title to its assets
or whether title is held by another series or the series organization and, if
held by another series or the series organization, the name, address, and
taxpayer identification number of the series organization and each series
holding title to any of its assets.
The statement must be filed on or before March 15 of the year following
the period for which the return was made. (Prop. Reg. Treas. § 301.6071-2(a)). The due date of the
statement will therefore be the same for taxpayers that file a return for the
entire year or for a portion of the year.
Effective Date and Transition Rule
The proposed regulations generally apply on the date they
are published as final regulations in the Federal Register. (Prop. Reg. Treas.
§ 301.7701-1(f)(3)). The preamble indicates that if on the
effective date, taxpayers are treating their classification inconsistent with
their classification as determined under the final regulations a taxpayer will
be required to change its classification. Moreover, the preamble warns that general tax principles will apply to determine
the tax consequences of the conversion, potentially resulting in income
recognition. For example, this
would be the case if a series organization and its underlying series were previously
treated as one partnership for federal tax purposes, and under the final
regulations are required to convert to multiple partnerships. In such case, despite the general
non-recognition treatment of partnership divisions, gain may be recognized in
certain situations under the “mixing bowl” rules of §§ 704(c)(1)(B) and 737.
There is, however, a transition rule that applies if a
series established its classification prior to, September 14, the date the
proposed regulations were published in the Federal Register. (Prop. Reg. Treas.
§ 301.7701-1(f)(3)(ii)(A)). The transition
rule will apply provided that:
1
The series (independent of the series
organization or other series in the series organization) conducted business or
investment activity, or, in the case of a foreign series, more than half of the
business of the series was issuing insurance or annuity contracts or reinsuring
the risks underwritten by insurance companies on and prior to the date on which
the regulations become final;
2
In the case of a foreign series, the series’
classification was relevant (as defined in Treas. Reg. § 301.7701-3(d)) and
more than half of the business of the series was issuing of insurance or
annuity contracts or the reinsuring of risks underwritten by insurance
companies for all taxable years beginning with the taxable year that includes
the date on which the regulations become final;
3
No owner of the series treats the series as an
entity separate from any other series of the series organization or from the
series organization for purposes of filing any federal income tax returns,
information returns, or withholding documents in any taxable year;
4
The series and series organization had a
reasonable basis (within the meaning of § 6662) for their claimed classification;
and
5
Neither the series nor any owner of the series
nor the series organization was notified in writing on or before the date on
which the regulations become final, that the classification of the series was
under examination. (Ibid).
Taxpayers that meet these requirements are able to continue
to treat the series organization and its underlying series as originally
classified. (Ibid). The transition
rule will cease to apply, however, on and after the date on which there is a
change of ownership. (Ibid). (Prop.
Reg. Treas. §
301.7701-1(f)(3)(ii)(B)). For this purpose, a change of ownership will
occur if any person or persons who were not owners of the series prior to
September 14, 2010, own in the aggregate an interest of 50% or more in the
series organization (or series). (Ibid).
The term interest is defined in the regulations a capital or profits
interest in the case of a partnership and an equity interest measured by vote
or value in the case of a corporation. (Ibid).
What this Means For You and Your Clients
The final regulations could result in a change to the
existing classification of a series organization and its underlying series. Whether a series will be treated as a
separate partnership under the proposed regulations may largely depend on the
manner in which the deal is structured and on the particular state statute in
which the series is established.
For example, under Delaware state law, a member of a series organization
may be treated as having property rights with respect to the assets of the
series (as opposed to property rights only to the series ownership interest). This factor tends to show that a
certain series and the members of a series organization, that have tracking
rights with respect to specific assets of a particular series, constitute a
separate partnership for federal income tax purposes.
Additionally, the final regulations will play an important
role in structuring a taxpayer’s business going forward. For instance, the real estate fund sponsor
of our example above could consider using a SMLLC to conduct each of its
activities (rental, construction, and investment). Assume that the fund is determined to be the sole owner of
each SMLLC (and that it does not elect to be treated as an association taxable as
a corporation under the CTB Regulations) so that each LLC is disregarded as
separate from the fund. Under
state law, each LLC ought to be afforded liability protection from the
creditors of the other LLCs and the fund.
Although certain economies available through the use of a series may be
lost, others may be gained. The
fund and each disregarded entity ought to be treated as one partnership for
federal income tax purposes. The
same may not be true with the use of the series, which could result in the
treatment of the series organization and each series type as a separate
partnership for federal income tax purposes (The investors in series A, series
B, and series C are treated as separate partnerships). The resulting cost of
this treatment could exceed the cost savings of using a series in the first
place.
Request for Comments
Lastly, in the Preamble, the Treasury and the IRS have
requested comments with respect to the proposed regulations in general and
specifically with respect to the following issues, each of which should be considered
as part of our client discussions:
1
Whether a series organization should be
recognized as a separate entity for Federal tax purposes if it has no assets
and engages in no activities independent of its series;
2
The appropriate treatment of a series that does
not terminate under local law purposes when it has no members associated with
it;
3
The entity status for federal tax purposes of
foreign cells that do not conduct insurance businesses and other tax
consequences of establishing, operating and terminating all foreign cells;
4
How federal employment tax issues and similar
technical issues should be resolved.
5
How series and series organizations will be
treated for state employment tax and related purposes and how that treatment
should affect the federal employment tax treatment of series and series
organizations.
6
What issues could arise with respect to the
provision of employee benefits by a series organization or series;
7
The requirement for series organization and each
series of the series organization to file a statement and what information
should be included on the statement.
Conclusion
The items for comments requested by Treasury indicate that
there are still a myriad of unsolved mysteries applicable to Series LLCs. It is hoped that as Series LLCs begin to gain more steam in
real estate and other ventures, that there will be a more pressing need to address these
questions and to finalize the Regulations. But for now, this issue is in the freezer, behind the
ice-cream, meat, and peas and carrots…guidance is not expected any time
soon.
Include your comments
regarding Series LLCs below. Also,
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