On September 14, 2010, the Treasury Department and the Internal Revenue Service published Proposed Regulations (REG-119921-09) addressing certain federal tax consequences of domestic series LLCs or foreign series that conduct an insurance business. Prior to the promulgation of these Proposed Regulations, it was unclear whether each series would be treated as a separate entity for federal tax purposes or whether all series would be treated as parts of a single business entity. While many questions remain unanswered, the Proposed Regulations provide guidance with respect to certain fundamental questions, including when a series will be respected as a separate entity. The effective date provisions, including the risks of taking a position contrary to the Proposed Regulations and a transitional rule for existing series LLCs, are of particular note.
Background on Series LLCs
Several states permit a limited liability company to create separate subdivisions of assets and liabilities (each commonly referred to as a series), each with its own business and investment objectives, members and managers, rights, duties and powers, and profit and loss sharing. If certain requirements are satisfied, enforcement and collection of liabilities and obligations of a series may be limited to the assets of such series. The LLC (referred to as the series LLC or the series organization) and its individual series are all generally treated as a single juridical entity for state law purposes, although some states provide for separate entity treatment. A primary advantage to the series LLC structure is cost savings, such as paying only one filing fee for the series organization as opposed to separate fees for each series. Further, by combining in one LLC company agreement the rights, duties, powers and economic rights and obligations of multiple series, there may also be a savings of time and legal cost.
Proposed Regulations
The Proposed Regulations provide that for federal tax purposes a series will be treated as an entity formed under local law, despite the fact that most state statutes provide otherwise. Although local law status is not determinative, this fictional construct generally will result in each series constituting a separate entity for federal tax purposes, allowing one to apply the check-the-box regulations to determine the tax classification of each series. Thus, if a series is not subject to special tax status rules applicable to REITS, REMICS or trusts, or otherwise classified as a per se corporation, it will be treated as a “business entity” eligible for classification as a corporation (upon election) or as a partnership (if it has at least two members) or a disregarded entity (if it has only one member). To illustrate, assume that a series organization has two series, Series A with two associated members and Series B with one associated member. Under the Proposed Regulations, Series A and Series B are each considered entities formed under local law. As a result, under the check-the-box regulations, assuming the local law entities were respected as separate entities and not otherwise classified as corporations or subject to special tax treatment, the default classification for Series A is a partnership and Series B is a disregarded entity.
Importantly, the Proposed Regulations may yield the same result even in those instances in which the liabilities and obligations of one series may be paid from the assets of another series or the series organization. Prior to the Proposed Regulations, some had taken a contrary view and incorrectly assumed that limiting the recourse of creditors of a series to the assets of that series would be required for separate entity classification.
The Proposed Regulations call for an annual information return to be filed by the series organization and each series.
The Proposed Regulations do not address the classification of the series organization itself, including whether it is treated as a separate entity if it has no assets or activities apart from the series. Also, the Proposed Regulations provide no guidance for series organized under foreign law except for certain foreign series conducting insurance business. Moreover, the Proposed Regulations do not address how a series is treated for federal employment tax purposes or explain whether a series may maintain an employee benefit plan.
Effective Date and Transitional Rule
The Proposed Regulations become effective on the date they are published as final regulations. Generally, taxpayers that treat a series organization and its series as a single entity prior to the publication of final regulations will be required to change their treatment to conform to the final regulations at such time. Such disaggregation may be subject to the rules of section 708 of the Internal Revenue Code for partnerships or sections 355 and 368(a)(1)(D) of the Internal Revenue Code for corporations. Thus, taxpayers taking a position contrary to the Proposed Regulations should carefully consider the tax ramifications of a reorganization if the Proposed Regulations are adopted as final regulations.
An exception applies for a series organization and its series that were organized and conducting business or investment activity prior to the date of publication of the Proposed Regulations and that were treated as a single entity prior to such date. Such a series organization and its series may continue to report as one entity provided that the members and series report consistently, the series and series organization had a reasonable basis for such treatment, and the issue of classification was not under examination prior to publication of final regulations. Series lose this exception, however, if persons who were not owners before the date the Proposed Regulations were published acquire a 50% or greater interest in capital or profits in the case of a partnership or a 50% or greater equity interest measured by vote or value in the case of a corporation.
This article was prepared by William P. Bowers (bbowers@fulbright.com or 214 855 3903), Patrick L. O'Daniel (podaniel@fulbright.com or 512 536 5264), Peter D. Smith (pdsmith@fulbright.com or 512 536 3090), Robert W. Phillpott (rphillpott@fulbright.com or 713 651 5284) and Michael P. Flamenbaum (mflamenbaum@fulbright.com or 212 318 3079) from Fulbright’s Tax Practice Group. If you have any questions or need any assistance related to these or any other tax matters, please contact the authors listed above or any of the attorneys in Fulbright’s Tax Practice Group.
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