The Uncertain Tax Status of Series LLCs

Many of the statutes authorizing series LLCs parrot the Delaware statute, or at least include provisions that are substantially the same. Illinois has gone one step further in spelling out the 'separateness' of each series. For example, the Illinois law states that each series may, in its own name, contract, hold title to assets, grant security interests, sue and be sued, and otherwise conduct business and exercise the powers of an LLC under the Illinois LLC Act. Moreover, the Illinois statute is the only one to provide clearly that each series will be treated as a 'separate entity' to the extent set forth in the articles of organization of the LLC.

Entity Classification Problem

So far, the Internal Revenue Service has not weighed in on the proper tax classification of series LLCs. Accordingly, lawyers recommending this new form of entity to clients or considering a series LLC for an ancillary business of the law firm or other purpose should proceed with caution.

Depending on how one looks at it, a series LLC might be taxed in one of three ways:

• The LLC could be taxed as a single entity, much like a limited partnership having different classes of partners;
• Each series could be treated as a disregarded entity owned by the LLC (i.e., the entity could own property but not have to file a tax return), even if the series is respected as a separate legal entity for other state law purposes; or
• Each series could be taxed as a separate entity that is owned directly by the members of the series.

Although the federal entity classification rules contained in Treasury regulations are the starting point for determining the tax classification of an entity, they do not deal specifically with series LLCs. According to the regulations, an enterprise may constitute a separate entity for federal income tax purposes only if it constitutes a business entity within the meaning of the regulations and it is not a per se corporation. (A per se corporation is an entity that the IRS deems a statutory corporation and which therefore cannot choose another tax classification.) Unfortunately, this is about as far as the regulations go, providing little guidance as to what attributes or characteristics of an enterprise are relevant for purposes of making this determination.

Rulings and Court Decisions

The IRS and the courts have been more helpful. In several cases, they have treated an enterprise, whether established under state law or simply by contract among its owners, as a separate entity. The determining factor is whether the enterprise changes the legal and economic relationship between the owners and their assets. For example, in Bergford v. Commissioner, 12 F.3d 166 (9th Cir. 1993), the court held that an arrangement between owners of computer equipment and the manager of a sale-leaseback program to finance, purchase, lease, and remarket equipment should be taxed as a partnership. Similarly, the court in Bussing v. Commissioner, 89 T.C. 1050 (1987), concluded that a purported sale of computer equipment and an indirect leaseback of that equipment should be taxed as a partnership.

The IRS reached the same result in Technical Advice Memorandum 7951006, which involved a complex arrangement among co-owners of undivided interests in a pipeline, and in Private Letter Ruling 7919065, where an agreement among a corporation, municipalities, and cooperatives to share ownership and generating output of a nuclear generating plant was classified as a partnership.

Perhaps the strongest precedent for taxing each series of an LLC as a separate entity is the series LLC's similarity to a Delaware statutory trust. As early as 1949, the Tax Court in National Securities Series-Industrial Stocks Series v. Commissioner, 13 T.C. 884 (1949), acq. 1950-1 C.B. 4, held that each series of such a trust may be regarded as a separate taxpayer. This decision was followed shortly by the IRS' own Revenue Ruling 55-416, 1955-1 C.B. 416, reaching a similar result.

National Securities and Revenue Ruling 55-416 have formed the basis for a number of private letter rulings issued since their promulgation. Those private letter rulings focus on two principal features of the trusts: 1) the fact that a holder is limited to the assets of the series in which he or she participates and may share in the income only of that series, and 2) the fact that payment of expenses, charges, liabilities, and other obligations of each series is limited to the assets of that series. These are features currently found in series LLCs as well.

Other support for separate tax classification can be found in General Counsel Memorandum 39211, dealing with the series of a trust registered with the SEC under the Investment Company Act of 1940 as a no-load diversified, open-end investment company, and in Revenue Ruling 55-39, 1955-1 C.B. 403, where the IRS ruled that securities acquired by a general partnership that were segregated from the other assets of the partnership for the benefit of one partner could be taxed separately to that partner and not the other partners, notwithstanding the fact that the securities were held in a single partnership.

Interplay with Other Code Provisions

The tax classification of a series LLC can have important ramifications throughout the Internal Revenue Code, so the question regarding classification is not an academic one. The proper filing of many tax elections, for example, will depend upon whether a series LLC is a single taxpayer, or whether each series is a separate entity. Questions that may arise include:

• Whether each series can make a separate election of how to be classified for federal income tax purposes, that is, whether it can check the box;
• Whether each series can elect a different tax year;
• Whether each series can determine its own method of accounting; and
• Whether each series can make a separate election regarding methods of depreciation, amortization of pollution control facilities, deduction of research and experimental expenditures, expensing of certain depreciable business assets, deferral of gain on an exchange of like-kind property or involuntarily converted property and the use of certain inventory methods.

Further Cautions

Until the IRS provides definitive guidance on how series LLCs should be taxed, practitioners also should chart a careful course when using series LLCs in transactions where, for example, the rules on ownership attribution and related party restrictions may apply. At this time, it is unclear whether those rules will apply separately to each series or to the LLC as a whole. Other areas of uncertainty include how the partnership termination rules under '708 of the Code would apply if a majority of the interests in a series were transferred, but not a majority of the interests in the LLC as a whole, and how the rules of '704(b) on the allocation of nonrecourse liabilities would apply to debt incurred by a series and secured by its assets, but not the assets of any other series.

Similar caution should be exercised when using a series LLC to combine in one entity two or more businesses formerly owned by different parties, and when converting an existing LLC to a series LLC. Either of these transactions could result in unexpected tax consequences to the members, depending on how the series LLC is classified for tax purposes.

The sidebar illustrates several of the preceding scenarios.

What should practitioners using series LLCs do in the meanwhile? Pending the issuance of guidance, those who desire to treat each series as a separate taxable entity for federal income tax purposes should follow strictly the requirements spelled out in the statute under which the LLC is formed for segregating the assets of one series from another, such as maintaining separate and distinct records, holding separate accountings of assets of each series, and, where required, providing a separate designation for each. Also, a separate employer identification number should be obtained for each series, and a separate tax return should be filed for each.

Finally, as is the case in any situation where multiple corporations are operated by common owners, all contracts, correspondence, business cards, and other communications by a series should clearly indicate its separate status from other series of the LLC.

Michael E. Mooney is the managing partner of Boston law firm Nutter, McClennen & Fish, LLP, and has also served as manager of the Tax Department. He maintains an active tax and business practice, representing organizations and individual clients on a broad range of domestic and international tax issues. He is a fellow of the American College of Tax Counsel, executive director of the Federal Tax Institute of New England Inc., and a member of the Boston Tax Forum.

Over the last decade, seven states, led by Delaware in 1996, have adopted statutes authorizing the formation of series LLCs. These statutory entities are a special form of LLC that provides for the establishment of one or more designated series of members, managers, or LLC interests within the LLC applicable to separate assets or operations, each with a separate business purpose or investment objective. In a series LLC, the debts, liabilities, and obligations relating to one series are enforceable only against the assets of that series and not against the assets of the LLC generally or the assets of any other series.

Authorizing Statutes

The seven states that have adopted series LLC statutes include Delaware, Iowa, Oklahoma, Illinois, Nevada, Utah, and Tennessee. Several of those states also recognize a separate series of an LLC formed in another state so long as the series registers as a separate series when it qualifies to do business in the state.

Many of the statutes authorizing series LLCs parrot the Delaware statute, or at least include provisions that are substantially the same. Illinois has gone one step further in spelling out the 'separateness' of each series. For example, the Illinois law states that each series may, in its own name, contract, hold title to assets, grant security interests, sue and be sued, and otherwise conduct business and exercise the powers of an LLC under the Illinois LLC Act. Moreover, the Illinois statute is the only one to provide clearly that each series will be treated as a 'separate entity' to the extent set forth in the articles of organization of the LLC.

Entity Classification Problem

So far, the Internal Revenue Service has not weighed in on the proper tax classification of series LLCs. Accordingly, lawyers recommending this new form of entity to clients or considering a series LLC for an ancillary business of the law firm or other purpose should proceed with caution.

Depending on how one looks at it, a series LLC might be taxed in one of three ways:

• The LLC could be taxed as a single entity, much like a limited partnership having different classes of partners;
• Each series could be treated as a disregarded entity owned by the LLC (i.e., the entity could own property but not have to file a tax return), even if the series is respected as a separate legal entity for other state law purposes; or
• Each series could be taxed as a separate entity that is owned directly by the members of the series.

Although the federal entity classification rules contained in Treasury regulations are the starting point for determining the tax classification of an entity, they do not deal specifically with series LLCs. According to the regulations, an enterprise may constitute a separate entity for federal income tax purposes only if it constitutes a business entity within the meaning of the regulations and it is not a per se corporation. (A per se corporation is an entity that the IRS deems a statutory corporation and which therefore cannot choose another tax classification.) Unfortunately, this is about as far as the regulations go, providing little guidance as to what attributes or characteristics of an enterprise are relevant for purposes of making this determination.

Rulings and Court Decisions

The IRS and the courts have been more helpful. In several cases, they have treated an enterprise, whether established under state law or simply by contract among its owners, as a separate entity. The determining factor is whether the enterprise changes the legal and economic relationship between the owners and their assets. For example, in Bergford v. Commissioner , 12 F.3d 166 (9th Cir. 1993), the court held that an arrangement between owners of computer equipment and the manager of a sale-leaseback program to finance, purchase, lease, and remarket equipment should be taxed as a partnership. Similarly, the court in Bussing v. Commissioner , 89 T.C. 1050 (1987), concluded that a purported sale of computer equipment and an indirect leaseback of that equipment should be taxed as a partnership.

The IRS reached the same result in Technical Advice Memorandum 7951006, which involved a complex arrangement among co-owners of undivided interests in a pipeline, and in Private Letter Ruling 7919065, where an agreement among a corporation, municipalities, and cooperatives to share ownership and generating output of a nuclear generating plant was classified as a partnership.

Perhaps the strongest precedent for taxing each series of an LLC as a separate entity is the series LLC's similarity to a Delaware statutory trust. As early as 1949, the Tax Court in National Securities Series-Industrial Stocks Series v. Commissioner , 13 T.C. 884 (1949), acq . 1950-1 C.B. 4, held that each series of such a trust may be regarded as a separate taxpayer. This decision was followed shortly by the IRS' own Revenue Ruling 55-416, 1955-1 C.B. 416, reaching a similar result.

National Securities and Revenue Ruling 55-416 have formed the basis for a number of private letter rulings issued since their promulgation. Those private letter rulings focus on two principal features of the trusts: 1) the fact that a holder is limited to the assets of the series in which he or she participates and may share in the income only of that series, and 2) the fact that payment of expenses, charges, liabilities, and other obligations of each series is limited to the assets of that series. These are features currently found in series LLCs as well.

Other support for separate tax classification can be found in General Counsel Memorandum 39211, dealing with the series of a trust registered with the SEC under the Investment Company Act of 1940 as a no-load diversified, open-end investment company, and in Revenue Ruling 55-39, 1955-1 C.B. 403, where the IRS ruled that securities acquired by a general partnership that were segregated from the other assets of the partnership for the benefit of one partner could be taxed separately to that partner and not the other partners, notwithstanding the fact that the securities were held in a single partnership.

Interplay with Other Code Provisions

The tax classification of a series LLC can have important ramifications throughout the Internal Revenue Code, so the question regarding classification is not an academic one. The proper filing of many tax elections, for example, will depend upon whether a series LLC is a single taxpayer, or whether each series is a separate entity. Questions that may arise include:

• Whether each series can make a separate election of how to be classified for federal income tax purposes, that is, whether it can check the box;
• Whether each series can elect a different tax year;
• Whether each series can determine its own method of accounting; and
• Whether each series can make a separate election regarding methods of depreciation, amortization of pollution control facilities, deduction of research and experimental expenditures, expensing of certain depreciable business assets, deferral of gain on an exchange of like-kind property or involuntarily converted property and the use of certain inventory methods.

Further Cautions

Until the IRS provides definitive guidance on how series LLCs should be taxed, practitioners also should chart a careful course when using series LLCs in transactions where, for example, the rules on ownership attribution and related party restrictions may apply. At this time, it is unclear whether those rules will apply separately to each series or to the LLC as a whole. Other areas of uncertainty include how the partnership termination rules under '708 of the Code would apply if a majority of the interests in a series were transferred, but not a majority of the interests in the LLC as a whole, and how the rules of '704(b) on the allocation of nonrecourse liabilities would apply to debt incurred by a series and secured by its assets, but not the assets of any other series.

Similar caution should be exercised when using a series LLC to combine in one entity two or more businesses formerly owned by different parties, and when converting an existing LLC to a series LLC. Either of these transactions could result in unexpected tax consequences to the members, depending on how the series LLC is classified for tax purposes.

The sidebar illustrates several of the preceding scenarios.

What should practitioners using series LLCs do in the meanwhile? Pending the issuance of guidance, those who desire to treat each series as a separate taxable entity for federal income tax purposes should follow strictly the requirements spelled out in the statute under which the LLC is formed for segregating the assets of one series from another, such as maintaining separate and distinct records, holding separate accountings of assets of each series, and, where required, providing a separate designation for each. Also, a separate employer identification number should be obtained for each series, and a separate tax return should be filed for each.

Finally, as is the case in any situation where multiple corporations are operated by common owners, all contracts, correspondence, business cards, and other communications by a series should clearly indicate its separate status from other series of the LLC.

Michael E. Mooney is the managing partner of Boston law firm Nutter, McClennen & Fish, LLP, and has also served as manager of the Tax Department. He maintains an active tax and business practice, representing organizations and individual clients on a broad range of domestic and international tax issues. He is a fellow of the American College of Tax Counsel, executive director of the Federal Tax Institute of New England Inc., and a member of the Boston Tax Forum.