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By Thomas Ward, Esq., Kristen Hazel, Esq., Gary Karch, Esq., and Andrea Whiteway, Esq.
McDermott Will & Emery, LLP, Chicago, IL and Washington, DC
On September 14, 2010, the IRS published proposed regulations that address the tax entity classification status of a series of (i) a domestic series limited liability company (LLC), series partnership, series trust, protected cell company (PCC), segregated cell company, segregated portfolio company or segregated account company and (ii) a foreign series or cell company that conducts an insurance business. The proposed regulations generally provide that each series will be treated as a separate entity for income tax purposes. These rules are not yet in effect, but when final will apply to all domestic and certain foreign series organizations, except for certain entities formed prior to September 14, 2010.
In 1996 Delaware become the first state to adopt legislation authorizing the formation of series LLCs to permit the legal separation of rights, powers or duties with respect to specified assets or obligations within each separate series provided certain record-keeping and notice requirements are observed. To date, series LLC statutes have been enacted in Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, Utah and Puerto Rico. Some state statutes permit the creation of separate series within legal entities other than LLCs (such as series limited partnerships and statutory trust series).
A number of states also have statutes that provide for the chartering of a legal entity commonly referred to as a PCC, segregated account company or segregated portfolio company. Like a series in a series LLC, the assets of each cell (or account or portfolio) are segregated from the assets of any other cell. Furthermore, series or cell company statutes in certain domestic jurisdictions and in a number of foreign jurisdictions allow series or cells to engage in an insurance business.
For simplicity, the remaining discussion focuses on a series of a domestic series LLC, but the principles set forth in the proposed regulations are applicable to other domestic series, cell companies, and foreign series and cell companies that conduct an insurance business.
Under current law there is little specific guidance regarding whether for federal tax purposes a series is treated as an entity separate from other series or the series LLC, or whether the company and all of its series should be treated as a single entity for tax purposes. In Notice 2008-19 the IRS requested comments on proposed guidance concerning segregated arrangements, both in the context of arrangements by a cell that constituted insurance for federal income tax and segregated arrangements which do not involve insurance.
Issues Addressed in the Proposed Regulations.
There are three key definitions in the proposed regulations: series organization, series statute and series. In the context of a Delaware series LLC, the state law LLC itself is the "series organization" because it is the juridical entity that establishes and maintains, or under which is established and maintained, a series. Section 18-215 of the Delaware Limited Liability Company Act is the "series statute" because it is the statute that explicitly provides for the organization or establishment of a series and explicitly permits for separate rights, powers or duties with respect to series property or obligations, rights, powers or duties for members or participants of a series, and general segregation of series assets and liabilities from other series or the series organization (other than organizational fees like franchise or administrative costs).
Finally the "series" is each segregated group of assets and liabilities that is established pursuant to a series statute by agreement of a series organization. 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. However, the proposed regulations provide that the term "series" does not include a segregated asset account of a life insurance company.
The proposed regulations take the position that an election, agreement or other arrangement that permits debts and liabilities of other series or the series organization to be enforceable against the assets of a particular series, or a failure to comply with the record-keeping requirements for the limitation on liability available under the relevant series statute, will be disregarded in determining whether a particular series qualifies as a series for tax purposes. For example, the preamble states that a series generally will not cease to qualify as a series under the proposed regulations simply because it guarantees the debt of another series within the series organization.
Domestic Series Treated as an Entity Formed under Local Law.
For federal tax purposes, the proposed regulations provide that each series organized or established under the laws of the United States or of any state, whether or not a juridical person for local law purposes, is treated as an entity formed under local law. The preamble states that "[i]n effect, taxpayers that establish domestic series are placed in the same position as persons that file a certificate of organization for a state law entity."
Given its tax status as an entity formed under local law, the federal tax classification of a series will depend on resolving three classification questions familiar to most tax practitioners:
Is the series an entity separate from its owners within the meaning of Regs. §301.7701-1 and general tax principles?
If the answer is "yes," is the series a business entity within the meaning of Regs. §301.7701-2(a) or can the series be classified as a trust under Regs. §301.7701-4?
Assuming the series is an entity for tax purposes that qualifies as a business entity, is the series an eligible entity that can elect its federal tax classification under the "check-the-box" system or is it a per secorporation under Regs. §301.7701-2?
Foreign Series Engaged in Insurance Business.
The proposed regulations do not apply to series or cells organized or established under the laws of a foreign jurisdiction, with one exception. The proposed regulations treat a series organized or established under the laws of a foreign jurisdiction as an entity subject to entity-classification rules if the arrangements and other activities of the series, if conducted by a domestic company, would result in classification as an insurance company within the meaning of §816(a) of the Code, or §831(c).
Ownership of Series and Series Assets.
For federal tax purposes, the ownership of interests in a series and the ownership of assets associated with a series is determined under general tax principles. The relevant tax inquiry is who bears the economic benefits and burdens of ownership, not simply the identity of the holder of legal title. For example, the preamble provides that if a series organization holds legal title to assets associated with a series because the series statute does not expressly permit an individual series to hold assets in its own name, the series will be treated as the tax owner of the assets if it bears the economic benefits and burdens of the assets under general federal tax principles. Similarly, the determination of who owns an interest in a series and series organization will depend on who bears the economic benefits and burdens of ownership. Common law principles also apply to determine whether a person is a partner in a series classified as a tax partnership.
Entity Status of Series Organization.
The proposed regulations do not address the entity status of a series organization for federal tax purposes.
Application of Tax Law Authority to Series.
Notwithstanding its tax status as an entity formed under local law, the IRS can still apply applicable law, including common law tax principles, to characterize a series or a portion of a series other than as a separate entity for federal tax purposes. For example, if a series has no business purposes or activity other than tax avoidance, it may be disregarded. Furthermore, the preamble provides that the partnership anti-abuse regulations apply to a series or series organization that is classified as a tax partnership.
Effect of Local Law Classification on Tax Collection.
In general, if a series is a taxpayer against whom federal tax may be assessed, any tax assessed against the series may be collected by the IRS from the series in the same manner as the assessment could be collected by the IRS from any other taxpayer. However, differences in local law governing series may have an impact on how creditors of a series, including state taxing authorities, may enforce obligations of a series. Recognizing that fact, the proposed regulations provide that, to the extent federal or local law permits a creditor to collect a liability attributable to a debtor series from the series organization or other series of the series organization, then the series organization or other series of the series organization may be considered the taxpayer from whom the tax assessed against the debtor series may be administratively or judicially collected.
In addition, when a creditor is permitted to collect a liability attributable to a series organization from any series of the series organization, a tax liability assessed against the series organization may be collected directly from a series of the series organization by administrative or judicial means.
Employment Tax and Employee Benefits Issues.
The proposed regulations do not provide how a series should be treated for federal employment tax purposes, nor do they address issues that arise with respect to the ability of a series to maintain an employee benefit plan. However, the preamble provides that to the extent a series can maintain an employee benefit plan, the aggregation rules under §§414(b), (c), (m), (o) and (t), as well as the leased employee rules under §414(n), would apply.
Information Statement about Series.
The proposed regulations provide that each series and series organization is required to file a statement for each taxable year containing the identifying information with respect to the series or series organization as prescribed by the IRS. It is proposed that this statement be filed on or before March 15 of the year following the period for which the return is made. The IRS is also considering revising the Form SS-4 used to secure employer identification numbers to include questions regarding series organizations.
Issues Not Addressed in Proposed Regulations.
The preamble specifically requests comments by December 13, 2010, on the following issues:
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;
The appropriate treatment of a series that does not terminate for local law purposes when it has no members associated with it;
The entity status for federal tax purposes of foreign series or cells that do not conduct insurance businesses and other tax consequences of establishing, operating and terminating all foreign cells or series;
How the series and series organizations will be treated for federal employment tax purposes;
How the series and series organizations will be treated for state employment tax purposes and other state employment-related purposes, and how that treatment should affect the federal employment tax treatment of series and series organizations;
What issues could arise with respect to the provision of employee benefits by a series organization or series; and
The requirements for the series organization and series of the series organization to file a statement and what information should be required on the statement.
The proposed regulations generally would apply on and after the date final regulations are published in the Federal Register. Taxpayers treating series differently for federal tax purposes than series are treated under final regulations will be required to change their treatment. General tax principles (e.g., partnership and corporate division rules) will apply to determine the consequences of the conversion from one entity to multiple entities for federal tax purposes.
The proposed regulations would grandfather series established prior to the publication of the proposed regulations where all series and the series organization have been treated as one entity if certain requirements are satisfied. The requirements are satisfied if:
The series was established prior to September 14, 2010 (that is, on or prior to the date the proposed regulations were published).
The series (independent of the series organization or other series of the series organization) conducted business or investment activity or, in the case of a series established pursuant to a foreign statute, more than half the business of the series was the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies on and prior to September 14, 2010.
If the series was established pursuant to a foreign statute, the series' classification was relevant (generally affects liability of any person for federal tax and information reporting) and more than half the business of the series was the 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 September 14, 2010.
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.
The series and series organization had a reasonable basis (within the meaning of §6662) for their claimed classification.
Neither the series nor any owner of the series nor the series organization was notified in writing on or before the date final regulations are published in the Federal Register that classification of the series was under examination (in which case the series' classification will be determined in the examination).
The grandfather rule will not apply on and after the date there is a change in ownership of the series organization (or series); that is, if any person or persons who were not owners of the series organization (or series) prior to September 14, 2010, come to own, in the aggregate, a 50% or greater interest in the series organization (or series). For this purpose, the term "interest" means: in the case of a partnership, a capital or profits interest, and in the case of a corporation, an equity interest measured by vote or value.
The proposed regulations provide long-awaited guidance with respect to the tax classification of a series in a series organization. While a number of questions remain unanswered, the proposed regulations address the fundamental issue: each series in a domestic series organization and each insurance series in a foreign series organization is treated as a separate entity for tax classification purposes.
For more information, in BNA's Tax Management Portfolios, see Case, 725 T.M., Limited Liability Companies, and in Tax Practice Series, see ¶4100, Limited Liability Companies.
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