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LLC Structuring Challenges: Drafting Tips for Single-MemberLLCs and Series LLCs

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LLC Structuring Challenges: Drafting Tips for Single-MemberLLCs and Series LLCs

Author

Bradford N. DewanMiller, Monson, Peshel, Polacek & Hoshaw

501 West Broadway, Suite 700San Diego, CA

Presenter

BRADFORD N. DEWAN is an attorney with the law firm of Miller, Monson, Peshel,Polacek & Hoshaw. He is a tax and estate planning attorney licensed to practice in thestates of California, Hawaii and Wisconsin. During 30 years of practice, Mr. Dewan hasemphasized tax planning for both individuals and their related business and charitableentities. He earned his B.A. degree, cum laude, from Harvard University, his M.B.A.degree from the University of California at Berkeley and his J.D. degree from theUniversity of Wisconsin, Madison. Mr. Dewan is a member of the Real Property, Probateand Trust Law Section of the American Bar Association, and the Estate Planning and Taxsections of the State Bar of California. His law practice has focused on estate planning,both domestic and foreign. Mr. Dewan has assisted his clients in evaluating andimplementing, where appropriate, various sophisticated and complex strategies, such asqualified personal residence trusts, irrevocable life insurance trusts, grantor retainedannuity trusts, intentionally defective irrevocable trusts and grantor trusts. He advises hisclients on the multi-generational benefits of transferring and inheriting wealth in trustthrough the use of dynasty trusts and beneficiary-controlled trusts. Mr. Dewan is arecognized expert in the tax and estate planning for pension plan benefits and individualretirement accounts (IRAs). He is a frequent lecturer to various professional groups onthe rules affecting distributions from qualified plans and IRAs, and the most effectivestrategies for transferring these unique assets to surviving spouses and the IRA owner'schildren.

LLC Structuring Challenges: Single Member LLCs and Series LLCs

I. Single Member LLC: Does It Provide Asset/Creditor

Protection?

A. In re Albright

In In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003), the debtor

(Ashley Albright) in a converted Chapter 7 bankruptcy case, was also the

sole member and manager of a Colorado limited liability company that

owned certain real estate in Colorado. The Chapter 7 trustee argued that

because the debtor was the sole member and manager of the LLC at the time

when Albright filer her petition, he, as trustee of “her” estate now controlled

the LLC and could cause the LLC to sell the real estate and distribute the net

sales proceeds to the estate.

It is important to note that the trustee did not assert any right to ignore

the LLC under an “alter ego” theory; nor did the trustee attempt to “pierce

the veil” of the LLC.

Relying on 11 U.S.C. sec. 541(a)(1), which provides that “the

commencement of a case . . . creates an estate . . . comprised of . . . all legal

or equitable interests of the debtor in property as of the commencement of

the case,” the court determined that upon the debtor’s filing of a bankruptcy

petition, she effectively transferred her entire membership interest to the

bankruptcy estate, and, as a result, the trustee became a “substituted

member” of the LLC.

The court then reviewed the Colorado LLC Act as to the provisions

dealing with assignment of membership interests and consent as to allowing

an “assignee” to become a “substituted member.” The court noted that the

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statute required the unanimous consent of the “other members” in order to

allow and transferee to participate in the management of the LLC. But the

court then determined that because there were no other members in the LLC,

no such “written unanimous approval of the transfer” was necessary. With

this interpretation, the court held that the bankruptcy filing essentially

resulted in the assignment of the entire membership interest in the LLC to

the bankruptcy estate – not just the economic interests. With this deemed

transfer of the entire membership interest, the trustee thus obtained all of the

debtor’s rights, including the right to control management of the LLC.

Indeed, the court specifically rejected the debtor’s claim, which was relying

on the specific provisions under the LLC statute covering the rights of

creditors, that the trustee would be limited to only obtaining a charging order

remedy against distributions made on account of the LLC membership.

Significantly, the court’s holding was that any such statutory

provision “exists to protect the other members of an LLC from having

involuntarily to share governance responsibilities with someone they did not

choose, or from having to accept a creditor of another member as a co-

manager.” The court was thus taking the position that since the charging

order remedy is to protect the autonomy of the original members, and their

ability to manage their own enterprise, there are, in the case of single-

member LLC, no non-debtor members to protect. As a result, the court

found that any charging order limitation in the statute “serves no purpose in

a single-member limited liability company, because there are no other

members whose interests would be adversely affected.

The court did specifically note that the result would be different “if

there were other non-debtor members in the LLC.” As a further

clarification, the court referred to multi-member LLCs and the LLC statute

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consent provision and suggested that where the non-debtor members do not

consent to a substitute member status for a transferee, the bankruptcy estate

would only be entitled to receive the share of profits or other compensation

by way of income and the return of contributions to which the debtor

member would otherwise be entitled to.

Based on the above analysis, the court ruled that it was appropriate to

allow the Chapter 7 trustee to liquidate the property owned by the LLC, of

which the debtor was the sole member. The court further granted the motion

of the trustee requesting permission to engage a real estate broker to assist in

the process to sell the property.

One result of this decision would be for planners to form only “multi-

member” LLCs rather than “single-member” LLCs. But in a footnote that is

often referred to as the “Peppercorn Members Warning” the court stated

that:

“the harder question would involve an LLC where one member effectively controls and dominates the membership and management of an LLC that also involves a passive member with a minimal interest . . . Notwithstanding this (statutory charging order remedy limitation), 7-80-702 (of the Colorado LLC Act) does not create an asset shelter for clever debtors. To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with ‘peppercorn’ co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors or a bankruptcy trustee with recourse. 11 U.S.C. secs. 544(b)(1) and 548(a).”

B. In re A-Z Electronics, LLC In 2006 a bankruptcy court in Idaho weighed in on the single-

member LLC.

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In In re A-Z Electronics, LLC, 350 B.R. 886 (D. Idaho 2006), the

Office of the U.S. Trustee brought a motion to either convert to a Chapter 11

case, dismiss it, based on the view that there had been an unauthorized filing

of a Debtor’s Chapter 11 petition. In the case, a husband (Ron Ryan), along

with his wife, filed a joint petition for Chapter 7 relief, and in that petition,

listed himself as owning 100% of A-Z Electronics, LLC. Though a “no

asset” report was filed originally, this was withdrawn. Then, the individual

husband debtor sought to file a voluntary Chapter 11 petition for the LLC

itself, signing as its only “managing member.”

The court duly noted that the filing of a bankruptcy petition and

initiation of a bankruptcy case is governed by the Bankruptcy Code. The

court noted that when a debtor is a LLC, questions may arise as to whom

within the debtor possesses the requisite authority to verify and file the

petition in the debtor’s name, citing to a discussion on the issue in the

Collier on Bankruptcy treatise. At the same time, the court noted that it is

state law that is used to determine whether the party signing the entity

petition had the authority to do so. With LLCs, further guidance may come

from the LLC operating agreement, or other required documents. The court

again found that because 11 U.S.C. 541(a)(1) is so broadly drafted,

apparently intentionally, “what becomes property of the estate when a

member of an LLC files bankruptcy depends on the facts.”

The court noted that in Albright, the court spoke of the

difference between a single-member LLC and a multi-member LLC, and

found that the right to control (and not just participate in) management is

significant. Based on this reasoning, because of the husband’s filing for

bankruptcy protection, the trustee became the sole member of the LLC, and

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therefore, now controlled, directly or indirectly, all governance of that entity,

including decisions regarding the liquidity of the LLC’s assets.

Thus, the court found that because of the prior filing by the

husband, it was the trustee who was the only one entitled to manage the LLC

and decide whether the LLC would or would not file for bankruptcy. Since

the trustee was not consulted as to the filing and did not consent to the filing,

the court concluded that the debtor LLC’s petition was not properly

authorized or executed under applicable nonbankruptcy law. Based on this

reasoning, the case was dismissed.

C. In re Modanlo

In In re Modanlo, 412 B.R. 715 (Bankr. Md. 2006), the court was

faced with the question as to whether a Delaware LLC, dissolved because of

a debtor’s filing of bankruptcy, was effectively resuscitated by the actions of

the bankruptcy trustee, as the debtor’s successor, to then give the trustee the

necessary management rights over the LLC.

The debtor argued that when the Chapter 11 petition was filed, he

ceased to be a member of the LLC under Delaware’s LLC Act, and

accordingly, the entity was dissolved pursuant to a provision of the LLC

Act. However, at issue was a provision in Delaware’s LLC Act dealing with

the ability of one to resuscitate a LLC after it has been dissolved. The

debtor believed that these provisions cut-off the right of his trustee to then

come forward. However, the trustee claimed that the debtor ignored other

provisions of the Delaware LLC Act allowing for revocation of dissolution.

Under this provision, notwithstanding any event of withdrawal otherwise

causing dissolution, the LLC organizational papers could still be amended,

whereby the trustee would claim that by and through the debtor’s rights, he

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could designate himself the manager, undo the dissolution, and place the

LLC itself into bankruptcy. In response, the debtor claimed that any such

actions by the trustee would be of no effect since the trustee, by operation of

law, could not have exercised such power.

The court disagreed with the debtor. The court noted that the trustee

emerged, on the eve of the hearing on an emergency motion to take certain

actions, with resolutions looking to provide written consent to the admission

of the personal representative of the last remaining member. Accordingly,

the court determined that the trustee could, in fact, revive the LLC in either

of two ways: (1) the filing of the LLC amendments to further appoint the

trustee as manager; or (2) the written consent document.

The debtor then argued that the trustee could not do so, under the

Delaware LLC Act, because the trustee was not the “personal

representative” of the debtor. In support of this position, the debtor claimed

that the Delaware LLC Act did not expressly state that a “bankruptcy

trustee” came within the definition of a “personal representative,” with the

result that the trustee is prevented from qualifying to serve in such role. But

the court pointed out that the trustee was the “legal representative” of the

estate, and, as such was the only party with standing to prosecute causes of

action belonging to the estate. Based on this analysis, the court determined

that there was no meaningful distinction between a “legal representative”

and a “personal representative.”

In response, the debtor argued that the trustee merely held economic

interests, but lacked any governance or management authority. The court

then methodically went through the Delaware LLC Act provisions that

purposefully prevented the substitution of some stranger into the LLC. The

court expressed its view that this result made sense in the context of multi-

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member LLCs. However, the court noted “that (such) reasoning . . . is

substantially undermined, if not meaningless, in the context of single

member LLCs” since “by definition, there can be no remaining members of

a single member LLC whose personal relationships (among member) could

be compromised by being forced to accept substitute performance from a

stranger such as a bankruptcy trustee.”

Notably, in dicta, the court looked to the sections of the Delaware LLC

Act dealing with assignment of LLC interests and the rights of an assignee.

On these points, the court, using principles of statutory construction and

adopting the reasoning of Albright, found that these particular provisions

inapplicable to cases concerning single-member LLCs. The court relied on

the reasoning of the Albright court (i.e. that because there were no other

members in the LLC, unanimous approval of any transfer was unnecessary).

While noting that statutory construction principles suggest that while “the

plain meaning of legislation should be conclusive,” there are rare cases in

which the literal application of a statute will produce a result demonstrably

at odds with the intentions of the drafters. In such cases, the court reasoned,

it is the intention of the drafters, rather than the strict language, that is to

control .

The bankruptcy court noted that in reaching its decision, Delaware LLC

Act provisions governing assignment and the rights of an assignee, and

mandating written consent, are “meaningless in the context of single-

member LLCs.” As the bankruptcy court in Modanlo noted, “the Debtor . .

.have not articulated, nor can we discern, any significant reason why the

Delaware legislature would have intended, or any policy reason would

compel, the preclusion of governance rights to the Chapter 11 Trustee of the

single-member LLC.”

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D. In re Schwab

In In re Schwab, 378 B.R. 854 (D. Minn. 2007), the trustee

faced a debtor that was attempting to claim exemptions for items that had

been owned by a LLC with respect to which the debtor was the only member

(i.e. “reverse piercing”). The trustee argued that the debtor’s tax return

assigned depreciation of the equipment to the LLC, and therefore, only the

entity can depreciate such equipment. However, the bankruptcy court noted

that depreciation for tax purposes, while creating a strong presumption of

ownership, is not always conclusive. The bankruptcy court found

substantial evidence that the equipment was owned by the debtor

individually, having purchased the equipment in her own name, not the

LLC. She paid for it with her personal line of credit. There existed no

evidence that the debtor transferred the equipment to the LLC or that the

LLC paid any consideration for it.

In a footnote, the court indicated that it would nevertheless find that

principles of equity would allow the debtor to “reverse pierce” the

“corporate veil” of the LLC in order to claim ownership and thus exempt the

subject property. The court cited Cargill, Inc. v. Hedge, 375 N.W. 2d 477

(Minn. 1985), a Minnesota Supreme Court case that allowed reverse

piercing to protect a debtor’s homestead, when the sole corporate

shareholders, the husband and wife, operated their family farm, essentially

as an individual enterprise. This court, relying on what it believed were

compelling circumstances, also allowed reverse piercing of the LLC

corporate veil when it came to the accounts receivables of the entity. For this

holding, the court cited Roepke v. Western Nat. Mut. Ins. Co., 302 N.W.2D

350 (Minn. 1981), a case involving interests in insurance policies, where a

decedent who was the sole shareholder of the identified insured corporation,

8

on vehicles that were used as family vehicles and the family had no other

vehicles.

E. The Olmstead Decision.

(i) Factual Background

In Olmstead, the Federal Trade Commission (FTC) sought to

shut down an advance-fee credit card scheme operated by Shaun Olmstead,

with the assistance of a Julie Connell, and operated out of two LLC entities,

Peoples Credit First, LLC (“PCF”) and Consumer Preferred, LLC (“CP”).

528 F.3d 1310 (11th Cir. 2008). Apparently Olmstead and Connell mailed

out over 10 million solicitation, which created the impression that, in

exchange for a payment of $45 or $49, a consumer would receive a platinum

credit card like a VISA or Mastercard with a $5,000 credit line. More than

200,000 customers purchased these cards, only to find that they weren’t

VISAs or Mastercards, were merely colored platinum, and had limited

purchasing power. Base on consumer complaints, the FTC then filed its

action, alleging that Olmstead, Connell and their LLCs violated the Federal

Trade Commission Act, prohibiting unfair or deceptive trade practices.

Eventually the FTC was able to obtain a stipulated preliminary injunction

extending an asset freeze and receivership of a TRO to include several non-

party LLCs in which either Olmstead or Connell were the sole member. The

court then placed these single-member LLCs into receivership, viewing the

defendants’ management of them as violating the terms of the previously

implemented freeze. The FTC moved for summary judgment, which the

Federal district court granted, entering a judgment for injunctive relief and

for more than $10 million in restitution against the defendants, and the

defendants appealed this grant of summary judgment.

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The United States Court of Appeals for the Eleventh Circuit

certified the following question to the Florida Supreme Court:

Whether, pursuant to F.S. 608.433(4), a court may order a judgment-debtor to surrender all right, title and interest in a debtor’s single-member limited liability company to satisfy an outstanding judgment? Interestingly, the Florida Supreme Court felt it appropriate to

rephrase the certified question to the following:

Whether Florida law permits a court to order a judgment-debtor to surrender all right, title and interest in the debtor’s single-member limited liability company to satisfy an outstanding judgment? (ii) Majority Decision In approaching the issue, the Florida Supreme Court looked to

the Florida LLC Act and compared the same to the generally available

creditor’s remedy of levy and execution under sale found in F.S. 56.061.

Quite significantly, the majority found that “(a)n LLC is a type of corporate

entity, and an ownership interest in an LLC is personal property that is

reasonably understood to fall within the scope of “corporate stock.”

The majority decision first notes that the LLC is a “business

entity originally created to provide tax benefits akin to a partnership and

limited liability akin to the corporate form.” Transfer of ownership interests

is generally restricted under the statute. As such, the majority viewed this

characteristic of LLCs as underlying the establishment of the LLC charging

order remedy, a remedy it noted was created for the personal creditors of

partners. As stated, “the charging order affords a judgment creditor access to

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a judgment debtor’s rights to profits and distributions from the business

entity in which the debtor has an ownership interest.”

Turning to the statutory framework for Florida LLCs, and in

particular, the Florida LLC Act, the majority noted how F.S. 608.405

provides for single-member LLCs, and how the interest of a member in a

LLC is personal property, as set forth in F.S. 608.431.

The Court then went on and reviewed the assignment

provisions set forth in F.S. 608.432, noting that any assignment will not

necessarily transfer an associated right to participate in the LLC’s

management, and that if such rights are not transferred, then any such

assignment merely entitles the assignee to economic interests to which the

assignor was entitled, “to the extent assigned.”

The Court then turned to the Florida LLC Act provisions

governing the rights of an assignee to become a member, F.S. 608.433. In

particular, as per the certified question from the Eleventh Circuit, the Court

looked at F.S. 608.433(4), authorizing the charging order remedy for a

judgment creditor of a member:

“on application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the limited liability company membership interest of the member with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of the assignee of such interest. This chapter does not deprive any member of the benefit of any exemption laws applicable to the member’s interest.” Before looking specifically at Florida’s LLC Act Charging

Order Limitations (see statute quoted above) found in its current Florida

LLC Act, the majority believed it appropriate to first turn to what it believed

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was “Generally Available Creditor’s Remedy of Levy and Sale Under

Execution,” F.S. 56.061. The Court noted that this law, giving judgment

creditors a remedy against judgment debtor’s ownership interests in

corporations, has been a part of Florida law since 1889.

The Court then concluded that an LLC is a type of corporate

entity, and how an ownership interest in an LLC is personal property, akin to

“corporate stock.” Noting that the defendants had not contended that F.S.

56.061 does not by its own terms extend to an ownership interest in an LLC

or that the lower court’s order did not comply with its requirements, the

majority concluded that this statute applied, unless expressly displaced by

Florida’s LLC Act. Finding that it was not expressly displaced, the majority

concludes that the generally available remedy of levy and sale under

execution per F.S. 56.061 must authorize a transfer to a judgment creditor of

all of a LLC member’s right, title and interest, by and through a “simple

assignment of the interest to the transferee.”

At that point, the court turned back to the Florida LLC Act and

found that any limitation on assignee rights found in F.S. 608.433(1) has no

application to the transfer of rights in a single-member LLC. Furthermore,

F.S. 608.433(4)’s provision that a judgment creditor has only the rights of an

assignee of (an LLC) interest simply acknowledges that a judgment creditor

cannot defeat the rights of nondebtor members of an LLC to withhold

consent to the transfer of management rights. According to the majority

decision, this provision does not support an interpretation which gives a

judgment creditor of the sole owner of an LLC less extensive rights than the

rights that are freely assignable by the judgment debtor citing Albright and

Modanlo.

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While concluding that F.S. 608.433(4) limits the rights of a

judgment creditor to the rights of an assignee, the Court also resolved that

this provision does not expressly establish the charging order remedy as an

“exclusive remedy.” In reaching this view and phrasing the issue as to

whether it is justified to infer that the Florida LLC Act’s Charging Order

Limitations is exclusive, the Florida Supreme Court concluded that these

limitations were non-exclusive. Not only did the Court want to see

“exclusive remedy” language in the statute, perhaps, though still a question,

the Court may also have wanted language expressly displacing the general

applicability of Florida’s remedies of levy and sale under execution of F.S.

56.061 which, in the Court’s view, treats LLC interests as “corporate

interests.”

(iii) Judge Lewis’ Dissenting Opinion

In an opinion nearly triple in size as the majority opinion, Judge

Lewis (with Judge Polston concurring) took strong exception to the

majority’s decision.

It is clear from the start, that Judge Lewis felt that the majority

stepped across the line of statutory interpretation and judicially re-wrote the

Florida LLC Act. Judge Lewis looked to the views of commentators and

experts in the field, like Bishop and Kleinberger, Ribstein, Rutledge & Gue,

and Stein, who questioned the propriety of any such decision. As Judge

Lewis put it, an adequate remedy existed for the FTC in the case, without the

majority having to take the extreme step of rewriting the plain and

unambiguous language of the Florida LLC Act:

This is extremely important and has far reaching impact because the principles used to ignore the LLC statutory language under the current factual circumstances apply with equal force to multimember LLC entities and, in essence,

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today’s decision crushes a very important element for all LLCs in Florida. If the remedies available under the LLC Act do not apply here because the phrase “exclusive remedy” is not present, the same theories apply to multimember LLCs and render the assets of all LLCs vulnerable. (emphasis added) As Judge Lewis saw it, the majority had engaged in an

impermissible rewriting of the Florida LLC Act, and failed to directly

address what he saw to be the “critical issue of whether the charging order

provision applies uniformly to all LLCs regardless of membership

composition.” To Judge Lewis, the LLC Act itself displaced the use of the

execution statute, and the majority did not possess the authority to judicially

rewrite the statute through a speculative inference not reflected in the

legislation. In his view, as expressed in the opinion, Judge Lewis believes

that the majority disregarded the principle that in general an LLC exists

separate from its owners, distinguishing it from partnerships. As he states,

“the majority obliterates the clearly defined lines between the LLC as an

entity and the owners as members.”

Judge Lewis notes that the Legislature is presumed to have

known of the charging order status and other remedies when it introduced

the single-member LLC statute, and by not making any further changes to

the statute, the Legislature expressed its intent for the charging order

provision and other statutory remedies to apply uniformly to all LLCs. Judge

Lewis believed that the majority failed to correctly observe that the Florida

LLC Act, as amended in 1999, mandated that one be admitted and also

maintain economic interest in the LLC. These amendments were made after

the modification made to allow for single-member LLCs. Again, Judge

Lewis takes this to mean that the majority has obliterated the distinction

between economic and governance rights by allowing a judgment creditor to

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seize both the economic rights and governance rights from the member and

to liquidate the separate assets of the entity.

Furthermore, Judge Lewis believes that the majority ignored

the separation between the particular separate assets of an LLC and a

member’s specific membership interests in the LLC. As he put it, the ability

of a member to voluntarily assign his, her or its interest does not subject the

property of an LLC to execution on a judgment. Under the facts of the case,

Judge Lewis noted that it was the trial court that “force the judgment debtors

to involuntarily surrender their membership interests in the LLCs, and then

authorized a receiver to liquidate the specific LLC assets to satisfy the

judgment.

In Judge Lewis’ view, the transfer of a membership interest in

a LLC is restricted by law and the internal operating documents of the LLC.

In the context of a single-member LLC, the restraint on transferability

expressly provided for in the Florida LLC Act cannot be made to disappear.

In addition, the charging order remedy does not divest the member of a

membership interest in the LLC as the member retains governance rights,

and merely provides the judgment creditor with an economic interest, until

the judgment is satisfied.

Judge Lewis acknowledges the policy concerns expressed by

the FTC but he suggests that the Florida LLC Act “simply does not create a

different mechanism for obtaining the assets of a single-member LLC as

opposed to a multimember LLC, and therefore, there is no room in the

statutory language for different rules. For Judge Lewis, the conclusion

reached by the majority lacks statutory support, and destroys the isolated

premise that the charging order provision can only apply to multimember

15

LLCs. Simply put, Judge Lewis finds that the remedy afforded to the FTC is

one that is not available under the plain language of the Florida LLC Act.

Noting that the “preferred creditor’s remedy” is to effectuate a

transfer and surrender of the membership interest that is the subject of a

charging order, thereby increasing the creditor’s chances of having the debt

satisfied, Judge Lewis goes through the case law that had previously

established that a charging order was the exclusive remedy for judgment

creditors in the partnership context i.e. Givens & Myrick v. Second Nat’l

Bank of Clearwater, 335 So.2d 343 (Fla. 2nd DCA 1976). For Judge Lewis,

the “non-exclusivity” language appearing in the Florida LLC Act is

irrelevant to the analysis, as the plain language of the statute is to apply

universally to judgment creditors of all LLCs regardless of the composition

of the membership. As a result, Judge Lewis sees this decision as a disaster

for multimember LLCs.

If, as Judge Lewis views it, the plain language of the Florida

LLC Act implements statutory restrictions on the transfer and assignment of

membership interests in LLCs, then these mechanisms limit what a judgment

creditor of a member of any type of LLC can do to obtain satisfaction of a

judgment against the membership interest. In Judge Lewis’ view the plain

language of the Florida LLC Act states that the charging order is one that the

court may impose. It is the only mechanism in the entire statute specifically

allocating a remedy for a judgment creditor to attach the membership

interest of a judgment debtor. Accordingly, the plain language of the Florida

LLC Act does not limit its remedy to the multimember circumstances. As

Judge Lewis views statutory construction principles, the majority’s

interpretation that the charging order remedy (limitation) only applies to

multimember LLCs can only be given effect if the plain language renders an

16

absurd result. In Judge Lewis’ opinion, when the Legislature amended the

assignment of interest and charging order provisions to create different

procedures for single-member and multimember LLCs, the Legislature “had

not yet contemplated the situation before us.” In Judge Lewis’ analysis,

when the actual language in the LLC Act does not distinguish between the

number of members in an LLC, then the charging order must apply with

equal force to both types of LLCs.

Finally, from Judge Lewis’s perspective, the Florida LLC Act

mandates that one must determine what rights a charging order provision

grants any judgment creditor. Thus one must look to F.S. 608.432 of the

Florida LLC Act, and there, it is clear, at least to Judge Lewis, that the

judgment creditor does not even become an assignee, but rather, “that the

rights of the judgment creditor do not exceed those of an assignee.”

(Emphasis in original). Reading both F.S. 608.433(4) and 608.432 together,

Judge Lewis concludes that a judgment creditor may be assigned a portion

of the economic interest, depending on the amount of the judgment. In other

words, Judge Lewis walks through the scenario where a judgment were for

less than the value of either the membership interest or the asses in the LLC,

and how members might then transfer a portion of their economic interests

and thereby, still retain an economic and governance interest in the LLC.

Thus, in this situation, the judgment creditor would only have the right to

receive distributions and allocation of income in an amount corresponding to

the satisfaction of a partial economic interest. And, therefore, the judgment

creditor does not receive any governance rights. Another concern for Judge

Lewis is that based on the majority’s decision, a judgment creditor could

force a single-member LLC to surrender all of its interest and liquidate the

17

assets specifically owned by the LLC, even if the judgment were for less

than the assets are worth.

Judge Lewis notes that judgment creditors have alternatives,

other than the charging order remedy. First, the creditor can seek to dissolve

the LLC, obtain an order of insolvency against the judgment debtor, or

obtain an order conflating the LLC and the member to allow a court to reach

the property assets of the LLC. Judge Lewis believes that the majority

refuses to even acknowledge any of these other approaches. The fact that

multiple steps are involved, is, according to Judge Lewis, the method

prescribed by statute. In his view, the majority created a “shortcut” and

rewrote the law to allow for a simple, surrender-and-transfer order of a

member’s entire right, title and interest in a LLC. Judge Lewis concludes

with a walk-through of the steps a judgment creditor would have to pursue

after obtaining a charging order against the member in a single-member

LLC.

F. Do Single-Member LLCs have a role in Asset Protection?

After Olmstead, the issue becomes whether a single-member

LLC can provide any meaningful asset protection.

(1) Piercing of the Veil Standard Remains Strong

With any LLC in Florida, there is a statutory codification of the

“piercing of the veil” standards. F.S. 608.701. By this provision, “in any

case in which a party seeks to hold the members of the LLC personally

responsible for the liabilities or alleged improper actions of the LLC,” the

other party will stand to benefit from a piercing-of-the-veil standard and case

law standard. By this, the Florida Legislature had established its intent to

have courts apply the Florida case law governing the piercing of the veil

standard.

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(2) But “Underneath” Protection Seems to be Lacking

Nevertheless, and mindful of the decision in Olmstead, LLCs

may not have the kind of underneath protection once assumed. At a

minimum, practitioners will need to see if appropriate “exclusive remedy”

language is contained in their home LLC statute, coupled with cross-

referencing that will further properly displace any of the general remedy

statutes (e.g. F.S. 56.061), as noted by the Olmstead decision, if the state in

question views LLC interests as akin to corporate interests under such

statute.

(3) The Importance of Statutory Interpretation

What is clear from the decision in Olmstead is how the entire

body of case law on single-member LLCs from all jurisdiction is going to be

of assistance when dealing with single-member LLCs and asset protection

issues in a particular state (or at a minimum, those states lacking the

necessary language in its statute found by the highest court in the state to be

binding). By focusing on existing language, practitioners and Legislators

must evaluate whether the rationale of Olmstead may be utilized by

judgment creditors to attack existing LLC charging order limitation statutes

that are shown to have failed to have effectively displaced (presumably,

expressly) any generally available creditor remedies of levy and sale under

execution. This assumes, of course, that the state law in question views LLC

interests to be corporate-like, when looking at the remedies afforded

judgment creditors. If so, then Legislators may not be inclined to sit on their

existing statutes, even those with expressly stated “exclusive remedy”

provisions.

For these reasons, and as the decision in Olmstead clarifies,

practitioners are reminded that when applying statutory interpretation

19

principles, great care must be taken. If one perceives that the court cases and

law have focused on an entity statute that sought to borrow on other entity

statutes (or the case law as to such statutes), one might want to make sure

that the highest court in the state has specifically ruled on the interpretation

upon which lawmakers or practitioners have previously relied. As one can

see from the Olmstead decision, problems can emerge when one particular

entity’s governing statute is amended, but another entity statute is left alone,

unchanged.

LLCs, touted for years as the entity of choice, and of course, a

flexible entity, and great for financial and tax planning, has to be re-

examined. As a hybrid of the corporation, limited partnership and general

partnership, LLCs also have corporate characteristics. As legislators

continue to borrow heavily from partnership or corporate statutes, or rely on

uniform acts, when implementing legislative fixes, one must recognize that

differing views may still be taken by any court, when applying statutory

interpretation principles. As can be seen from the Olmstead decision, courts

may differ even as to the plain language of the statute.

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II MASTERING THE USE OF LLCs IN ESTATE PLANNING

I. Limited Liability Company: The Basics

A. A legal entity created by state statute.

B. The LLC may own assets, engage in business operations, investment

activities on a for profit basis.

C. The LLC may be “Member-Managed” or “Manager-Managed.” Articles

of Organization or other organizational document filed with a state agency will often require the designation of whether the LLC will be “Member-Managed” or “Member-Managed.”

D. If Manager-Managed, the Manager need not be a Member of the LLC and

the LLC is often referred to as having “centralized management.”

E. A Member-Managed LLC is referred to as having “decentralized

management.”

F. The Manager is typically charged with managing and controlling all of the

business operations of the LLC.

G. Unlike a general partner of a limited partnership, a Manager of an LLC is

typically not responsible or personally liable for the debts, liabilities and

obligations of the LLC.

H. A Manager in a “Manager-Managed” LLC will usually receive some

compensation for the management services provided.

I. The Members of a “Manager-Managed” LLC will traditionally have no

control or involvement in the daily operations of the LLC.

J. Members will usually have limited voting rights e.g. regarding admission

of new Members, distributions of funds in addition to that needed to pay

income taxes, and dissolution or liquidation of the LLC in order to

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enhance valuation discounts. A state statute may mandate the rights of

Members as to various actions or transactions like those listed above.

K. Significantly, as compared to general partners, neither Members nor

Managers have any responsibility for the debts, liabilities or obligations of

the LLC beyond their capital contributions or agreements to make

additional capital contributions, thus they have only “limited liability.”

L. An LLC established by a family is often referred to as a “family limited

liability company” or “FLLC” and will have family members as the

Members and Manager(s) of the FLLC. Note also that IRC section 704(e)

is titled “Family Partnerships” and will apply to FLLCs when taxed as

partnerships. [Primary purpose of section 704(e) is to avoid income

shifting between donor and donee.]

M. A FLLC may have a non-family member as the Manager who will control

the daily operations of the FLLC.

N. FLLCs are usually structured as Manager-Managed so that the control of

the FLLC will be exercised by only certain family members or family-

controlled entities.

II. Selection of an FLLC vs. a Family Limited Partnership

A. FLLCs are certainly simpler than a FLP since there is only one entity

where with a FLP the general partner may be another entity because of the

unlimited liability of the general partner for the debts and obligations of

the FLP.

B. But there is no “uniform” LLC statute as with limited partnerships.

C. There is not extensive case law involving LLCs as compared to FLPs (see

below for a discussion of some of the more recent cases).

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D. States that attempt to enhance estate tax minimization with there entities

typically apply those changes to both the limited partnership and the

limited liability company. For example, effective October 1, 2009,

Nevada now has a law that allows the creation of a restricted LLC and a

restricted LP. Under this new statute these “restricted entities” have a

default provision which restrict distributions to the members or the

partners for ten-year period. This will likely result in creating a

significantly higher ceiling on valuation discounts that is not available in

any other state. These provisions are designed to mitigate the reduction of

discounts when “applicable restrictions” are disregarded under IRC

2704(b). See Treas. Reg. 25.2704-2(b).

E. Consideration also needs to be given as to whether the specific state

statute provides the a “charging order” is the sole remedy or whether the

statute also includes a foreclosure option.

III. Selection of Manager of an FLLC.

A. An individual can serve as the Manager. B. If an individual is named as the Manager, it might be appropriate to have

the Operating Agreement list several successors or lines of successors.

C. A corporation serving as the Manager may solve this potential problem.

D. Potential problem if Manager also has a greater than 50% Membership

interest in the FLLC: IRC section 708(b)(1)(B) states that if within any

12-month period there is a sale or exchange of fifty percent or more of the

total interest in the capital and profits of a partnership (here assuming

FLLC is taxed as a partnership), the partnership could be considered

terminated for income tax purposes. The consequences of this inadvertent

termination is that the tax year of the FLLC would be closed and any

existing tax elections, e.g. IRC section 754 election, would be terminated.

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IV. Use of Corporation as Manager.

A. Corporation as a statutorily created entity with perpetual existence may

solve the issues related to the death, disability, incompetence of humans.

B. Management fees to corporation can provide tax planning opportunities

inside the corporation.

C. Family members can serve as directors, officers and employees of the

corporation and, as a result, can receive compensation, whether as wages

or commissions or bonuses as long as such compensation remains

reasonable.

D. The compensation will be a deductible expense of the corporation and the

family member will take such compensation into his or her taxable

income.

E. Potential benefit: by splitting income among the various family members,

tax savings are likely if the family members are in different tax brackets.

F. The family members who are employees can participate in various

employee benefit plans. This would include medical, health, dental, and

accident insurance; medical reimbursements to cover health insurance

deductibles or exclusions (HSA plans), disability insurance, cafeteria

benefit plans and very importantly, retirement plans such as defined

contribution pensions, profit-sharing plans, 401(k) plans and post

retirement medical reimbursement plans under IRC section 419.

G. The above benefits would be limited if the family members holding

Membership Interests in the FLLC also became employees of the FLLC.

The “2%” partnership rule would apply to those owning more than 2% of

the FLLC (attribution rules would also apply).

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H. Use of corporation as Manager presents control issues. If a single family

member owns more than fifty percent of the shares, then risk that a

creditor of the shareholder could levy upon the shares of such family

member to satisfy any judgment resulting in the “controlling shares” being

in the hands of a non-family member with adverse interests.

I. A solution maybe the use of a Voting Agreement among the shareholders

of the corporation. Under the Voting Agreement, the shareholders commit

to electing certain named individuals to the board of directors. The shares

obtained by the creditor may still be subject to the Voting Agreement.

This provides a high level of certainty as to who will serve on the board of

directors and, in turn, who will be the officers of the corporation

overseeing the day-to-day operations.

J. Use of S Corporation as Corporate Manager. A benefit might be that there

is no taxation at the entity level. But the disadvantage in the use of an S

Corporation is that some special tax rules apply (i.e. partnership tax rules)

that limit the deductibility of the fringe benefit expenses/payments for

those holding more than 2% of the S Corporation’s shares (see IRC

section 1372).

K. Disadvantages of use of corporation as Manager: The LLC entity might

have been selected because of its simplicity as compared to other entities,

but the use of corporation as Manager may well eliminate the desired

simplicity. The added complexity is related to:

(1) Need to file Articles of Incorporation or other corporate charter, (2) Need to obtain separate EIN for the corporation,

(3) Prepare and file separate tax return apart from the FLLC,

(4) Must observe corporate formalities, i.e. adoption of bylaws and

compliance with its rules, comply with annual meeting

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requirements for shareholders and board of directors, specific

board of director approval of various actions of the officers not

in the ordinary course of the business operations.

V. Options For Holding FLLC Membership Interests.

A. Individuals: Individuals may hold Membership Interests but this presents

potential problems regarding probate and asset protection.

B. Trusts: Consideration should be given to having the interests of the

organizers of the FLLC held in a revocable trust so the Membership

Interests will not be subject to probate at death or a guardianship or

conservatorship proceeding in the event the individual should die or

become mentally disabled.

C. Joint Revocable Trust: In some states it may be appropriate to implement a

joint revocable trust for the two spouses. However, if one of the spouses

has significant creditor exposure, then the property might be partitioned

or, if community property, converted into separate property; then separate

revocable trusts would be created to own the respective Membership

Interests.

D. Irrevocable Trusts: Once the family member who formed the FLLC has

decided to make gifts of the Membership Interests then those interests will

likely be transferred to irrevocable trusts whose beneficiaries are other

family members e.g. children of the FLLC organizer. The parents, as the

grantors, will have the power to control the trust and protect the interests

of the children through carefully drafted provisions in the trust agreement

that provide directions and guidance to the trustees. In addition, through

the spendthrift provisions included in the trust agreement, the beneficial

interests of the children can be protected from bankruptcy, creditor law

suits and divorce lawsuits.

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E. GSTT Provisions: With irrevocable trusts appropriate provisions can be

included so that the trust will terminate at a specific age of the beneficiary

but will continue until the death of the beneficiary. However, it is

important to consider the appropriate allocation of the GSTT exemption in

order that no GST tax is incurred upon the liquidation of the trust and

distribution of the assets to the children of the beneficiaries (who also are

the grandchildren of the grantors). In addition, the trust provides the

mechanism for the assets to pass to the grandchildren and not the spouse

of the child. In this way the interests in the FLLC can remain in the

family. [Note: IRC section 2664 states that there will be no generation-

skipping transfers after December 31, 2009.]

VI. Estate Planning Strategies Involving FLLCs.

A. Grantor Retained Annuity Trust (GRAT) or Grantor Retained Unitrust

(GRUT): A GRAT or GRUT is often used in concert with FLLCs in estate

plans for individuals with significant net-worth. If the senior generation

wants to make gifts of the Membership Interests in a FLLC because of the

expectation that such interest will appreciate in the future, then a GRAT or

GRUT are good alternatives to consider. In such a situation, the

Membership Interest is transferred to the GRAT and the grantor retains the

right to distributions in the form of annuity payments from the GRAT for

a period of years. At the end of the term of the GRAT, the Membership

Interests will then be transferred to the remainder beneficiary, either

outright or in trust. Because the grantor has retained this annuity interest, a

significant discount can be realized for gift tax purposes.

PLANNING IN 2010: With no GST Tax, a strategy to take advantage of

this situation the trust might include language that names a dynasty trust of

which the grandchildren are the beneficiaries if there is no GST tax but

names the children if there is a GST tax.

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B. Charitable Remainder Trust (CRT): A CRT can also serve as a recipient

of the Membership Interest much like the GRAT discussed above.

However, at the end of the term of the CRT (usually at the death of the

grantor rather than a specific term of years) the Membership Interests will

pass to one or more tax exempt organizations under IRC 501(c)(3).

CAVEAT: If a CRT holds a Membership Interest, then the assets of the

FLLC should be restricted to passive investment assets (assets that

produce passive income e.g. interest, dividends, rents and royalties) rather

than interests in any unincorporated businesses. Holding these latter

assets could result in the CRT becoming subject to tax under the unrelated

business taxable income rules (UBTI) under IRC sections 511 and 512.

C. CRT-2: A specific but very aggressive strategy would involve the

formation of an LLC with a small percentage of the Membership Interest

held by a taxable entity which could also serve as the Manager. The

Manager would have the power to control all distributions from the LLC

to its Members. The balance of the Membership Interests would be held

by a NIMCRUT, i.e. a net income with makeup CRT. Since the LLC is a

“pass-through entity” and the NIMCRUT is tax exempt, neither the LLC

nor the NIMCRUT will pay tax on the income allocated to the NIMCRUT

based on its percentage Membership Interest. This allows that portion of

the income to grow tax free within the LLC. When the creator of this

structure wants income from the NIMCRUT, the Manager authorizes the

distribution of cash (nominally income) to the Members which includes

the NIMCRUT. Under the rules governing CRTs, a CRT does not have

“distributable income” unless it actually receives cash.

D. Charitable Lead Trust. With a Charitable Lead Trust, the distributions are

made to a charity for a period of years. The CLT could provide that at the

end of the term, the corpus will be distributed to a dynasty trust with the

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grandchildren as the beneficiaries if there is no GST tax. But if there is a

GST tax, then the distribution is made to the children.

E. Intentionally Defective Grantor Trust (IDGT): An IDGT is an irrevocable

trust that allows all assets transferred to it to be excluded from the

grantor’s estate. But for income tax reasons, in contrast to estate tax

objectives, the trust is intentionally designed so that the grantor will be

taxed on any income realized by the IDGT even though no cash will

actually be distributed to the grantor but will be held for ultimate

distribution to the beneficiaries of the IDGT. “Grantor Trust” status is

usually obtained by reserving to the grantor one or more of the powers

described in IRC section 675. As a result, the grantor will be taxed on the

income of the trust but all assets in the trust, however transferred, will not

be included in the grantor’s gross estate for estate tax purposes.

Consequently, when FLLC Membership Interests are transferred into the

IDGT, the grantor will pay tax on any income allocated to the IDGT by

the FLLC. By paying the tax, the grantor is reducing the size of the estate

and preserving assets in the IDGT for future growth so such assets are not

reduced by tax payments.

F. IDGT-2: In lieu of gifting assets to the IDGT and using up the grantor’s

federal estate tax exemption, the assets can be sold to the IDGT without

the grantor incurring any taxable income. Such “sales” are ignored for

income tax purposes because the grantor and the IDGT are viewed as the

same taxpayer. See Rev. Rul. 85-13, 1985-1 CB 184, Treas. Reg. 1.671-

4(b)(2), and Reg. 301.6109-1(a)(2). In this scenario, the grantor sells the

FLLC Membership Interest to the IDGT but no capital gain or loss is

triggered. The IDGT will usually give the grantor a promissory note which

may be secured by the FLLC interest. Since the transaction is treated as a

“sale” between the grantor and the IDGT, the grantor is not treated as

making a gift so long as the “sale” is for full and adequate consideration.

On the death of the grantor, the value of the note is included in the gross

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estate but not the value of the FLLC Membership then held by the IDGT.

In addition the value of the note may actually decrease over time as the

principal is paid down.

G. Independent Special Distribution Manager. If the client is the manager of

the FLLC, then consideration should be given to having the Operating

Agreement provide for a “Independent Special Distribution Manager.”

This Independent Special Distribution Manager would possess the

exclusive power to authorize distributions from the FLLC and to vote on

the liquidation and dissolution of the FLLC. See Estate of Strangi, 417 F.

3d 468 (5th Cir. 2005).

H. IRC section 2511(c). This Section, effective as of January 1, 2010, states

that attempts at transferring property to non-grantor trusts as “incomplete

gifts” will not work. Such transfers will be treated as “completed gifts.” In

contrast, apparently, such “incomplete gifts” can still be recognized as

such with respect to transfers to a grantor trust.

I. IRC section 1022. This Section, effective as of January 1, 2010, describes

the “carryover “ basis rules with respect to property of a decedent who

dies in 2010. The basis for the beneficiary will be the lesser of the cost

basis of the decedent or the FMV on date of death. But there may be a

problem with a membership interest in an LLC that holds, for example,

commercial property. Under Section 705, the adjusted basis of the

membership interest is increased by the annual distributive share of the

LLC’s taxable income allocated to that Member in order to avoid “double

taxation” when the Member later sells the membership interest. ISSUE: If

the value of the commercial property has decreased significantly as a

result of the economic downturn, then the basis of the membership interest

will be “lowered” down to the FMV which may be significantly less than

the basis. But this may result in higher taxes if property is held onto and

30

sold only after appreciating back to higher values. This would, indeed,

result in “double taxation.” Direction from the IRS will be needed on this

issue. Cf. basis if membership interest is transferred by gift.

VII. Estate of Murphy vs. United States

FACTS: Murphy owned substantial interests in a publicly traded oil company

(he served as CEO and Chairman of the Board), a timberland and

farmland company and a bank. He formed an FLP to centralize

management and protect against dissipation of those family assets, and

transferred his interests in the three companies (having a value of about

$90M) to the FLP in two ways: (1) directly into the FLP or (2) through the

FLLC that was created to serve as the general partner of the FLP. The

concern about dissipation arose because two of decedent’s four children

had pledged and sold many of the family assets that had previously been

given to them. The other two children shared Murphy’s asset

management philosophy and participated in the planning for the FLP and

subsequently in the operations. Decedent retained assets worth about

$130M. Murphy individually and as trustee of several revocable trusts

acquired a 96.75% limited partnership interest. The FLLC, through its

capital contributions, obtained a 2.25% general partnership interest. The

FLLC itself was owned 49% by Murphy and 51% by the two participating

children.

At decedent’s death, he owned a 95.25365% limited partnership interest in

the FLP and the FLLC owned a 2.28113% general partner interest.

The FLP made only two distributions during decedent’s life: (1) a pro rata

distribution to partners in one year to cover the partner’s federal taxes for

income allocated to them by the FLP; and (2) a non pro rata distribution to

decedent of stock in another company (so the company could convert to an

S corporation) and this non pro rata distribution was properly reflected in a

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reduction in decedent’s percentage interest in the FLP and reduction in his

capital account in the FLP.

Decedent made annual gifts of FLP interests to his children, their spouses

and eight grandchildren.

At death the FLP was worth about $131.5M.

The estate tax return showed decedent’s 95.25365% limited partner

interest in the FLP at $74,082,000 after applying a 41% discount.

The estate’s interest in the FLLC was determined after applying two levels

of discounts: (1) a 20% lack of control/marketability discount for the

general partner interest owned by the FLLC, and then (2) a 11.1% lack of

control and 32.5% lack of marketability discount (a combined discount of

40%) for valuing the estate’s interest in the FLLC. The overall combined

discount was 52%. Thus the value of the 49% interest in the FLLC was

determined using a tiered entity approach. While not cited, this tiered

entity approach is consistent with the result in the 2008 Astleford case

(T.C. Memo 2008-128) which allowed multiple levels of discounts for a

tiered entity.

SUMMARY: FLLC’s 2.28113% general partnership interest in the FLP: a

20% lack of control/lack of marketability discount. Estate’s 49% interest

in the FLLC: (1) 11.1% lack of control discount and (2) a 32.5% lack of

marketability discount.

Combined two-tier overall discount: 52.02%.

Note: A Graegin note was used to borrow funds to pay the estate tax.

Cite: W.D. of Arkansas, El Dorado Div., Case No. 07-CV-1013.

VIII Suzanne J. Pierre v. Comm’r

FACTS :

1. Mother wanted to provide for her son and granddaughter, but was

concerned about keeping her family’s wealth intact. A plan was

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developed for her to fund an LLC and make transfers of interests in the

LLC to trusts for her son and granddaughter.

2. On July 13, 2000, Mother organized a single-member LLC. She did

not elect to treat the LLC as a corporation for federal tax purposes by

filing Form 8832, Entity Classification Election, so by default the LLC

was treated as a disregarded entity.

3. On September 15, 2000, Mother transferred $4.25M in cash and

marketable securities into the LLC.

4. Twelve days later, on September 27, 2000, Mother transferred her

entire interest in the LLC to two separate trusts, one for her son and

one for her granddaughter. This happened in two steps. First, she gave

9.5% interest to each trust. Then she sold a 40.5% interest to each

trust for a secured note, with the face amount determined by an

appraisal that applied a 30% discount (although a mistake in valuing

the underlying assets resulted in a 36.55% discount).

5. Mother filed a gift tax return for 2000 reporting the gifts. The IRS took

the position that the transfers made by a gift and sale should be valued

as a proportionate share of the underlying assets (without any

discount).

6. IRS first determined that Mother’s gift transfers of the 9.5% Pierre

LLC interests to the trusts should be treated as gifts of proportionate

shares of the Pierre LLC assets and not as transfers of interests in

Pierre LLC. Secondly, the IRS determined that Mother made gifts to

the trusts of the 40.5% interests in Pierre LLC to the extent that the

value of 40.5% of the underlying assets of Pierre LLC exceeded the

value of the promissory notes Mother received from the trusts.

ISSUE: “The parties disagree … about whether the check-the-box regulations

require that Pierre LLC be disregarded for Federal gift tax valuation

purposes.” (Emphasis added), The court also stated: “The issue to be

decided is whether certain transfers of interests in a single-member limited

liability company (LLC) that is treated as a disregarded entity pursuant to

33

sections 301.7701-1 through 301.7701-3, Proceed. & Admin. Regs.,

known colloquially and hereinafter referred to as the check-the-box

regulations, are valued as transfers of proportionate shares of the

underlying assets owned by the LLC or are instead valued as transfers of

interests in the LLC, and, therefore, subject to valuation discounts for lack

of marketability and control.”

[A separate opinion will be issued to address: “(1) Whether the step

transaction doctrine applies to collapse the separate transfers to the trusts

and (2) the appropriate valuation discount, if any.”]

IRS POSITION: Mother elected to treat the LLC as a disregarded entity

separate from its owner “for federal tax purposes” under the check-the-box

regulations. Regulation 301.7701-3(a) provides that “[w]hether an

organization is an entity separate from its owners for federal tax purposes

is a matter of federal tax law and does not depend on whether the

organization is recognized as an entity under local law.” Because the LLC

is treated as a disregarded entity, the transfers of interests in the LLC

should be treated as transfers of cash and marketable securities, i.e.

proportionate shares of the LLC’s assets, rather than as transfers of

interests in the LLC for purposes of valuing the transfers to determine

federal gift tax liability.

TAXPAYER POSITION: Mother argues that, for Federal gift tax valuation

purposes (emphasis added), State law, not federal tax law, determines the

nature of a taxpayer’s interests in property transferred and the legal rights

inherent in that property interest. Mother contends that the court must look

to State law to determine what property interest was transferred and then

value the property interest actually transferred to apply the Federal gift tax

provisions to that value to ascertain gift tax liability. Under New York

law, it was argued, a member of an LLC has no interest in specific

property of the LLC. Accordingly, the transfers of interests in the LLC

were properly valued as interests in the LLC for purposes of valuing her

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transfers to the trusts with appropriate lack of control and lack of

marketability discounts applied.

OPINION: The court started by giving a brief summary of the statutes,

regulations, and case law that constitutes the Federal gift tax valuation

regime. It continued by noting that the US Supreme Court has clarified

that the Federal gift tax is constitutional as an excise tax rather than a

direct tax (which must e apportioned proportionately by population)

because it is a tax on the power to give property to another. “A

fundamental premise of transfer taxation is that State law defines the tax

treatment of those property rights. See Morgan v. Commissioner, 309 U.S.

78 (1940). It is well established that the Internal Revenue Code creates

“’no property rights but merely attaches consequences, federally defined,

to rights created under state law.’” United States v. Nat. Bank of

Commerce, 472 U.S. 713 (1985) (quoting United States v. Bess, 357 U.S.

51, 55 (1958).” (Emphasis added). [See also Knight v. Comm’r, 115 T.C.

506 (2000): “State law determines the nature of property’s rights, and

Federal law determines the appropriate tax treatment of those rights.”]

Under New York law petitioner did not have a property interest in the

underlying assets of Pierre LLC, an entity recognized under New York

law as an entity separate and apart from its members. “Accordingly, there

was no State law “legal interest or right” in those assets for Federal law to

designate as taxable, and Federal law could not create a property right in

those assets. Consequently, petitioner’s gift tax liability is determined by

the value of the transferred interests in Pierre LLC, not by a hypothetical

transfer of the underlying assets of Pierre LLC.

Check-The-Box Regulations and Single-Member LLCs. The court then

analyzed whether the check-the-box regulations alter the historical Federal

gift tax valuation regime described above. After noting that an LLC has

some features the same as corporations but also some features of a

35

partnership (management flexibility, pass-through taxation), the court

states that Section 7701 (which underpins the check-the-box regulations)

does not make it clear whether an LLC falls within the definition of a

partnership, a corporation, or a disregarded entity taxed as a sole

proprietorship. The “Kinter Regulations” that applied before became

“unnecessarily cumbersome to administer”.

“The Internal Revenue Code prescribes the classification of various

organizations for federal tax purposes. Whether an organization is an

entity separate from its owners for federal tax purposes is a matter of

federal tax law and does not depend on whether the organization is

recognized as an entity under local law.” Reg. 301.7701-1(a)(1).

[Emphasis added].

But then, Reg. 301.7701-3(a) provides that: “A business entity **** can

elect its classification for federal tax purposes as provided in this section.

An eligible entity *** with a single owner can elect to be classified as an

association or to be disregarded as an entity separate from its owner.”

The court continues: “There is no question that the phrase “for federal tax

purposes” was intended to cover the classification of an entity for Federal

tax purposes, as the check-the-box regulations were designed to avoid

many difficult problems largely associated with the classification of an

entity as either a partnership or a corporation; i.e. whether it should be

taxed as a pass-through entity or as a separately taxed entity.”

Statement of Issue: “The question before us now is whether the check-the-

box regulations require us to disregard a single-member LLC, validly

formed under State law, in deciding how to value and tax a donor’s

transfer of an ownership interest in the LLC under the Federal gift and tax

regime.”

36

Conclusion: Check-the-Box Regulations Do NOT Alter the Historical

Federal Gift Tax Valuation Regime. While the IRS cited several cases

involving LLCs, the court did not find any of them relevant. McNamee v.

Dept. of the Treasury, 488 F.3d 100 (2d Cir. 2007); Littriello v. United

States, 484 F.3d 372 (6th Cir. 2007); Shepherd v. Commissioner, 115 T.C.

376 (2000); Senda v. Commissioner, 433 F. 3d 1044 (8th Cir. 2006);

Mirowski v. Commissioner, T.C. Memo. 2008-74. Regarding Mirowski,

the Court, in a footnote, stated: “We do note that in Estate of Mirowski we

refused to adopt an interpretation that “reads out of Section 2036(a) in the

case of any single member LLC the exception for a bona fide sale that

Congress expressly prescribed when it enacted that statute.”

“If the check-the-box regulations are interpreted and applied as respondent

contends, they go far beyond classifying the LLC for tax purposes. The

regulations would require that Federal law, not State law, apply to define

the property rights and interests transferred by a donor for valuation

purposes under the Federal gift tax regime. We do not accept that the

check-the-box regulations apply to define the property interest that is

transferred for such purposes.” [Emphasis added]

“To conclude that because an entity elected the classification rules set

forth in the check-the-box regulations, the long-established Federal gift tax

valuation regime is overturned as to single-member LLCs would be

“’manifestly incompatible’” with the Federal estate and gift tax statutes as

interpreted by the Supreme Court.”

The court noted that Congress has enacted various provisions of the IRC

that explicitly disregard valid State law restrictions in valuing transfers.

Where Congress has determined that the “willing buyer, willing seller”

and other valuation rules are inadequate, it has provided exceptions to

address valuation abuses, e.g. IRC 2701-2704. But Congress has not acted

37

to eliminate entity-related discounts in the case of LLCs or other entities

generally or in the case of a single-member LLC specifically.

“In the absence of such explicit congressional action and in light of the

prohibitions in section 7701, the Commissioner cannot by regulation

overrule the historical Federal gift tax valuation regime contained in the

Internal Revenue Code and substantioal and well-established precedent in

the Supreme Court, the Court of Appeals, and this Court, and we reject

respondent’s position in the instant case advocating an interpretation that

would do so. Accordingly, we hold that petitioner’s transfers to the trusts

should be valued for Federal gift tax purposes as transfers of interests in

Pierre LLC and not as transfers of a proportionate share of the underlying

assets in Pierre LLC. [Emphasis added]

Cite: 133 T.C. No. 2 (8/24/09)

IX. Hegarty v. Commissioner, T.C. Summary Opinion 2009-153

FACTS:

1. Sean Hegarty was employed – full time – by Carteret Mortgage Corp.

Kerry Hegarty, his wife, was employed as real estate salesperson.

2. On August 1, 2003, Sean and Kerry formed Blue Marlin, L.L.C., a

Maryland limited liability company, each owning a 50% interest.

3. Blue Marlin was organized to conduct a charter fishing activity using a

“46-foot Post luxury cruiser” purchased and retrofitted by Sean and

Kerry.

4. The amount of time Sean and Kerry participated in the business was

recorded in a written log they kept. But that log was lost during their

move from the Washington D.C. area to Florida.

5. However, Sean and Kerry reconstructed the amount of time they

participated in the business using numerous receipts.

38

6. The evidence presented demonstrates that they were actively involved

more than 100 hours during the year at issue, 2003, and satisfied the

Court that (with minor exceptions) they were the only individuals who

participated in the business.

7. For Federal tax purposes Blue Marlin LLC did not elect to be treated

as an entity separate from Sean and Kerry and they reported the

income and expenses attributable to the business on a Form 1065, U.S.

Return of Partnership Income.

8. That return, which was not examined by the IRS, showed income of

$9,583, expenses totaling $74,161 (which included depreciation of

$26,173) and a net loss of $64,578.

9. The net loss was deducted on a Schedule E, Supplemental Income and

Loss, included with petitioners’ timely filed joint 2003 Federal income

tax return and was taken into account in the $267,187 adjusted gross

income reported on that return.

10. In the IRS notice of deficiency, the Service disallowed the deduction

attributable to the loss from Blue Marlin on the grounds that, during

2003 the business was a passive activity because Sean and Kerry did

not “materially participate” in the business.

DISCUSSION:

1. IRS relied on IRC 469 to support the disallowance of the loss from

Blue Marlin.

2. Section 469 generally disallows for the taxable year any passive

activity loss.

3. “Passive activity loss” is defined as the excess of the aggregate losses

from all passive activities for the taxable year over the aggregate

income from all passive activities for that year.

4. A “passive activity” is any activity which involves the conduct of any

trade or business in which the taxpayer does not materially participate.

39

5. A “trade or business” is defined as any activity in connection with a

trade or business or any activity for the production of income under

IRC 212. See IRC 469(c)(6).

6. A taxpayer is treated as “materially participating” in an activity only if

the taxpayer is involved in the operations of the activity on a basis

which is regular, continuous, and substantial. IRC 469 (h)(1).

7. The participation of the taxpayer’s spouse is taken into account in the

determination of the extent to which a taxpayer materially participates

in an activity. IRC 469(h)(5).

8. The applicable regulations provide that if:

(i) the individual participates in the activity for more than 500

hours during such year; or

(ii) the individual’s participation in the activity for the taxable

year constitutes substantially all of the participation in such

activity of all individuals (including individuals who are

not owners of interests in the activity) for such year; or

(iii) the individual participates in the activity for more than 100

hours during the taxable year, and such individual’s

participation in the activity for the taxable year is not less

than the participation of any other individual (including

non-owners) for such year; or

(iv) the activity is a significant participation activity for the

taxable year, and the individual’s aggregate participation in

all significant participation activities during such year

exceeds 500 hours; or

(v) the individual materially participated in the activity for any

5 taxable years ( whether or not consecutive) during the 10

preceding the taxable year in question; or

(vi) the activity is a personal service activity, and the individual

materially participated in the activity for any 3 taxable

40

years (whether or not consecutive) preceding the taxable

year; or

(vii) based on all of the facts and circumstances, the individual

participates in the activity on a regular, continuous and

substantial basis during such year,

then the invidual will be treated as materially participating in an

activity for purposes of IRC 469. Temp. Regs. 1.469-5T(a)(1)

through (7).

IRS POSITION: The IRS argued that because the business was conducted

through a limited liability company, the taxpayers are treated as limited

partners in considering whether they materially participated in the

business. Section 469(h) states: “Except as provided in regulations, no

interest in a limited partnership as a limited partner shall be treated as an

interest with respect to which a taxpayer materially participates.” Under

the Regulations, a limited partner will be treated as materially

participating if the taxpayer satisfies either (i), (v) or (vi) above.

Referencing this subsection, the IRS argued that they did not materially

participate in the business because they have not established that their

participation in the business during 2003 exceeded 500 hours.

TAX COURT: The Tax Court, referring to Garnett v. Commissioner, 132 T.C.

____ (2009) (slip op. at 22), concluded that the IRS’s reliance upon IRC

469(h)(2) was misplaced and held that the material participation of a

taxpayer who participated in a business conducted through a limited

liability company is determined with reference to any of the seven tests

listed above. The Tax Court then referred to the test that holds a taxpayer

is treated as having materially participated in the activity if he or she

participates in the activity for more than 100 hours during the taxable year

and the taxpayer’s participation in the activity for the taxable year is not

less than the participation of any other individual. The Tax Court was

satisfied that Sean and Kerry satisfied this test. Thus, based on those

41

factors, the Tax Court concluded that they materially participated in the

business during 2003, and the deduction attributable to that business was

not subject to the limitation under IRC 469.

SEE ALSO: Gregg v. U.S., 186 F. Supp. 2d 1123 (D. Ore. 2000); Thompson

v. U.S., 104 AFTR 2d 2009-XXXX (Ct. Cl. Case No. 06-cv-00211,

7/20/2009).

X. Linton v. United States, No. 2:08-cv-00227 (W.D. Wash. July 1, 2009)

FACTS:

1. Sometime in November 2002 – William forms WLFB Investments,

LLC.

2. January 22, 2003 – William gives 50% of WLFB Investments, LLC to

his wife, Stacy.

3. January 22, 2003 – William quitclaims separate undeveloped real

property to WLFB Investments, LLC

4. January 22, 2003 – William executes letters authorizing transfer of

securities to WLFB Investments, LLC.

5. January 22, 2003 – William assigns assets to WLFB Investments,

LLC.

6. January 22, 2003 – William and Stacy execute separate trust

agreements for the benefit of their four children, but do not date them

(date of January 22, 2003 was filled in on a subsequent date by their

lawyer)

7. January 22, 2003 – William and Stacy execute separate documents

entitled “Gift of Percentage Interest in WFLB Investments, LLC,” but

do not date them (date of January 22, 2003 was filled in on a

subsequent date by their lawyer)

8. January 24, 2003 – The brokerage house confirms transfer of the

assigned securities.

42

9. January 31, 2003 – The date that their lawyer testified that he “made a

mistake” and meant to put on the trusts and gift assignments.

IRS AUDIT: The IRS audited the gift tax returns and proposed an assessment

on the grounds of both “indirect gift” and “step transaction doctrine.”

LINTON: Rather than face the Tax Court, the Lintons paid the assessment and

filed a refund action in the local federal district court.

COURT: The district court carefully analyzed the testimony of William and

his tax advisors, and quotes from their testimony in the opinion. The

district court then analyzed the facts through the prism of the prior indirect

gift jurisprudence: Shepherd v. Comr., 115 T.C. 376 (2000); Estate of

Jones v. Commr., 116 T.C. No. 11 (2001); Gross v. Commr., T.C. Memo

2008-221; Senda v. Commr., T.C. Memo 2004-160, aff’d 433 F. 3d 1044

(8th Cir. 2006).

RULING: The court determined that each trust agreement indicated that the

trust was effective upon transfer of property to the trust, and that at the

time of execution of each trust agreement, each trust had interests in

WLFB Investments, LLC. Furthermore, the court specifically pointed out

that the Gift Documents expressly stated that each trust was dated on the

same date as the respective gifts.

Thus, the court found that this case was similar to both Shepherd (indirect

gift due to transfer of assets simultaneously or prior to the gift of LLC

interests) and Senda (indirect gift under Shepherd because it was unclear

as to the chronology of events).

The court also went through an analysis of all three tests under the step

transaction doctrine (namely, the “binding commitment” test, the “end

result” test and the “pre-arrangement” test) and found that the series of

events in the case constituted a step transaction under all three tests.

As a result, the district court denied the Linton’s motion for summary

judgment and granted the motion for summary judgment filed by the

United States.

43

Cf. Holman v. Commr., 130 T.C. 12 (2008) (six days apart) and Gross v.

Commr., T.C. Memo 2008-221 (eleven days apart).

44

ATTACHMENT #1

45

ESTATE PLANNING TOOLBOX:

OPERATIONAL AND DISSOLUTION ISSUES OF

FLLCs TAXED AS PARTNERSHIPS

I. Aggregate and Entity Concepts of Partnerships

A. Business Law

Despite various arguments and discussions, the Uniform Partnership Act

continues to manifest the aspects of both the aggregate theory and entity concepts.

B. Tax Law

Tax law also reflects the amalgamation of the two concepts: entity and aggregate.

Certainly Subchapter K is a mixture of both.

(i) Aggregate Concepts. Several provisions of Subchapter K evidence an

aggregate approach. For example, section 701 states: “A partnership as such

shall not be subject to the income tax imposed by this chapter. Persons

carrying on business as partners shall be liable for income tax only in their

separate or individual capacities.” The aggregate concept is also seen in

section 702 which deals with income, deductions, and credits of partners.

Section 702(a) states that each partner shall take into account separately the

appropriate distributive share of the specified classes of partnership income,

gain, loss deduction or credit. The aggregate concept is evident in other

sections. For example, section 705 provides that each partner must determine

the adjusted basis for his partnership interest. The adjusted basis of a

partner’s interest is fundamental in determining:

1. Gain or loss, if any, resulting from the distribution of

partnership property, including money.1

2. The adjusted basis of property, other than money,

distributed to the partner from the partnership.2

3. The amount of gain or loss realized on the sale or exchange

of the partner’s partnership interest.3 1 IRC section 731(a). 2 IRC section 732.

46

4. The limitation on the partner’s deduction of a distributive

share of partnership loss.4

(ii). Entity Concepts. But partnerships are predominantly viewed as an entity

for federal income tax purposes:

1. A partnership has its own taxable year.5

2. A partnership is not terminated unless one of the events

listed in section 708(b) occurs.6

3. A partner may engage in a transaction with a partnership in

a capacity other than as a partner of the partnership, and generally

the transaction will be treated as occurring between the partnership

and one who is not a partner.7

4. Most elections are made by the partnership.8

(iii)Tax classification. A domestic eligible entity (a domestic business entity

that is not a trust or a per se corporation, except as an association by virtue of

an election) that does not make an election is automatically classified as a

partnership if it has two or more members.9

II. The Family Partnership.

A. Section 704(e).

This section was adopted in order to restrict and prohibit any attempts at

“assigning” taxable income to another taxpayer, e.g. a family member, by

transferring a partnership interest, whether by gift or sale, in order that some

proportion of the income of the partnership will be allocated to a family

member in a lower income tax bracket. However, efforts to attempt this

“assignment” or “transfer” of tax able income have diminished as a result of

recent reductions in tax rates.

3 IRC section741. 4 IRC section 704(d). 5 IRC section706. 6 IRC section 708(b) 7 IRC section 707(a). 8 IRC section 703(b). 9 Reg. section 301.7701-3(b)(2) and (3).

47

B. Requirements of Section 704(e).

1. Recognition of Partner Status. Under Section 704(e) a transferee of a

partnership interest will be recognized as a partner irrespective of whether

the interest was acquired by purchase or by gift if (i) the partnership is one

in which capital is a material income-producing factor and (ii) the

transferee actually owns a capital interest in the partnerhip.10

2. Capital as a Material Income-Producing Factor. This section and related

regulations require that capital be a material income-producing factor in

order for the recognition of a person as a partner based on such person’s

owning a partnership interest. Under the regulations if a “substantial

portion of the gross income of the business is attributable to the

employment of capital in the business conducted by the partnership” then

capital will be viewed as material income-producing factor.11 The

regulations provide some further clarification by noting that capital will

ordinarily be considered a material income-producing factor if the

business operations of the partnership require substantial inventories or a

substantial investment in plant, machinery or equipment. In contrast,

“capital is not a material income-producing factor where the income of the

business consists principally of fees, commissions, or other compensation

for personal services performed by members or employees of the

partnership.”12

3. Limitations on the Allocation of Partnership Income. Despite satisfying

the statutory requirements for actual ownership by a person who acquired

the partnership interest by gift, specific limitations apply in determining

such partner’s distributive share of the partnership income.

(a) Reallocation of Income to Donor for Compensation. In order to be

respected for income tax purposes, the distributive share of

partnership income to the donee of a partnership interest must have

accounted for a reasonable compensation of services provided by

10 IRC section 704(e)(1); Reg. 1.704-1(e)(1)(ii). 11 Reg. 1.704-1(e)(1)(iv) 12 Reg. 1.704-1(e)(1)(iv)

48

the donor.13 These restrictions actually take precedence over the

section 704(b) “substantial economic effect” provisions. As stated

in the regulations,

In determining a reasonable allowance for services rendered by the partners, consideration shall be given to all the facts and circumstances of the business, including the fact that some of the partners may have greater managerial responsibility than others. There shall also be considered the amount that would ordinarily be paid in order to obtain comparable services from a person not having an interest in the partnership.14

(b) Reallocation of Income Attributable to Capital of Donor and

Donees. A donee partner’s distributive share of partnership income

will be denied for tax purposes “to the extent that the portion of

such share attributable to donated capital is proportionately greater

than the share of the donor attributable to the donor’s capital.”15

The goal of this provision is to prevent a reallocation of income to

the donee partner in the form of a return on the donee’s capital

interest in the partnership rather than the donor’s actual capital

contribution.

III. Conduit Concept of Partnership Taxation.

A. Section 701.

Under this section a partnership as such is not subject to federal income tax.

The persons carrying on the business as partners will be liable for income tax

only in their separate or individual capacities.

B. Section 702.

Under this section, in determining a person’s income tax, each partner will

take into account separately such partner’s distributive share of the

partnership’s income, gain, loss, deduction or credit. Each of these items is

separately reported on Schedule K of the partnership tax return, and each

13 IRC section 704(e)(2). 14 Reg. 1.704-1(e)(3)(i)(c). 15 IRC section 704(e)(2).

49

partner’s share of each item is shown on the Schedule K-1 furnished by the

partnership to the partner. With the information on his Schedule K-1 at hand,

each partner is then required to report separately in such partner’s individual

tax return the partner’s distributive share of each item.16

IV. The Anti-Abuse Regulation.

A. Reg. 1.701-2.

The above referenced Treasury Regulation is titled the “Ant-Abuse Rule.”

This regulation is intended to restrict, if not eliminate, the use of Subchapter K

for tax avoidance purposes. Under this Treasury Regulation if a partnership is

formed and a principal purpose of such partnership is to reduce substantially

the present value of the partners’ “aggregate federal tax liability,” the

Commissioner has the ability to recast the transaction. It is important to note

that this Treasury Regulation only applies to income taxes and not to estate

and gift taxes.

The Treasury Regulation starts by reiterating the familiar refrain that

Subchapter K is intended to maximize flexibility for those persons wishing to

jointly conduct a business but desiring to avoid incurring a tax at the entity

level. But the Treasury Regulation then quickly notes that there are three

requirements implicit in Subchapter K:

(i) The partnership must be bona fide and each partnership transaction or

series of related transaction (individually or collectively, the transaction) must

be entered into for a substantial business purpose;

(ii) The form of each partnership transaction must be respected under

substance over form principles; and

(iii) subject to certain exceptions, the tax consequences under Subchapter K to

each partner of partnership operations and of transactions between the partner

and the partnership must accurately reflect the partners’ economic agreement

16 IRC section 702(a); Reg. 1.702-1(a).

50

and clearly reflect the partner’s income (i.e. collectively there must be a

proper reflection of income).17

The Treasury Regulation goes on to note that Subchapter K and its regulations

must be applied in a manner that is consistent with the intent of Subchapter K.

Accordingly, if a partnership is formed in connection with a transaction a

principal purpose of which is to reduce substantially the present value of the

partners’ aggregate federal tax liability in a manner that is inconsistent with

the intent of Subchapter K, the Commissioner can recast the transaction for

federal tax purposes, as appropriate to achieve tax results that are consistent

with the intent of Subchapter K, in light of the applicable statutory and

regulatory provisions and the pertinent facts and circumstances. As a

consequence, even though the transaction may fall within the literal words of

a particular statutory or regulatory provision, the Commissioner has the

authority to determine that:

(1) The purported partnership should be disregarded in whole or in

part, and the partnership assets and activities should be considered,

in whole or in part, to be owned and conducted, respectively, by

one or more of its purported partners;

(2) One or more of the purported partners of the partnership should not

be treated as a partner;

(3) The methods of accounting used by the partnership or a partner

should be adjusted to reflect clearly the partnership’s or the

partner’s income;

(4) The partnership’s items of income, gain, loss, deduction or credit

should be reallocated; and

(5) The claimed tax treatment should otherwise be adjusted or

modified.18

The Treasury Regulation further states that determination of a principal

purpose to reduce the partners’ overall aggregate tax liability is based on “all

17 Reg. 1.701-2(a) 18 Reg. 1.701-2(b).

51

the facts and circumstances.” There is then listed seven factors that may be

indicative that a partnership was used to substantially reduce the aggregate

federal tax liability:

(1) The present value of the partners’ aggregate federal tax liability is

substantially less than had the partners owned the partnership’s assets

and conducted the partnership’s activities directly;

(2) The present value of the partners’ aggregate federal tax liability is

substantially less than would be the case if purportedly separate

transactions that are designed to achieve a particular end result are

integrated and treated as steps in a single transaction;

(3) One or more partners who are necessary to achieve the claimed tax

results either have a nominal interest in the partnership are

substantially protected from any risk of loss from the partnership’s

activities (through distribution preferences, indemnity or loss guaranty

agreements, or other arrangements), or have little or no participation in

the profits from the partnership’s activities other than a preferred

return that is in the nature of a payment for the use of capital;

(4) Substantially all of the partners (measured by number or interests in

the partnership) are related (directly or indirectly) to one another;

(5) Partnership items are allocated in compliance with the literal language

of sections 1.704-1 and 1.704-2 but with results that are inconsistent

with the purpose of section 704(b) and those regulations, with specific

scrutiny given to partnerships in which income or gain is specially

allocated to one or more partners that may be legally or effectively

exempt from federal taxation (e.g. an exempt organization or a

taxpayer with unused federal tax attributes such as net operating

losses, capital losses or foreign tax credits);

(6) The benefits and burdens of ownership of property nominally

contributed to the partnership are in substantial part retained (directly

or indirectly) by the contributing partner (or a related party); or

52

(7) The benefits and burdens of ownership of partnership property are in

substantial part shifted (directly or indirectly) to the distributee partner

before or after the property is actually distributed to the distributee

partner (or a related party).19

The Treasury Regulations provide further that, in addition to the above

described “anti-abuse rule,” the Service can continue to assert and rely upon

various familiar judicial principles including “substance over form,” “step

transactions,” and “sham transactions” to attack perceived abusive

transactions, and that the rule set forth in these regulations does not limit the

applicability of the above principles and related authorities.20

V. DISTRIBUTIVE SHARES OF PARTNERSHIP INCOME, GAIN, LOSS,

DEDUCTION AND CREDIT

A. Basic Statutory Scheme.

A partnership is not a taxpaying entity but is only a vehicle for determining the

taxable income, gain, loss, deduction or credit of joint enterprise with two or more

owner/taxpayers. Section 704 serves as the guidepost for determining each

partner’s “distributive” share of the above listed items. The use of the term

“distributive” is significant. A partner is taxed on such partner’s “distributive”

share, not on what is actually distributed to him. Section 704(a) defines this

concept: “A partner’s distributive share of income, gain, loss, deduction, or credit

shall, except as otherwise provided in this chapter, be determined by the

partnership agreement.” This rule for determining a partner’s distributive share

only applies to the allocation of the income tax effects of each of the listed items.

But section 704 leaves this allocation of the income tax effects up to the partners

as specified in the partnership agreement. Thus a partner’s interest in the

partnership is the basic test for determining whether the allocation to each partner

of the distributive share of income, gain, loss, deduction or credit will be

respected for tax purposes.

19 Reg. 1.701-2(c). 20 Reg. 1.701-2(i).

53

B. Substantial Economic Effect.

In order for an allocation of the above tax items to be respected, such allocation

must satisfy the “substantial economic effect” test set forth in section 704(b).21

This substantial economic effect test has two prongs each of which must be

satisfied at the end of each taxable year in which the allocation was made:

1. The tax allocation must have economic effect; and

2. The economic effect must be substantial.

This test has several components, namely the partners’ (i) capital accounts, (ii)

liquidation rights, (iii) deficit payback provisions, and (iv) any related offsetting

allocations. The test seeks to reveal whether or not the economic effects of an

allocation are commensurate with the tax consequences.

C. Economic Effect Requirements.

As noted above, for an allocation to be respected each partner who receives the

tax allocation must also receive the economic benefit or burden related to such

allocation. Under the basic economic effect test, the partnership agreement must

require for the full term of the partnership:

1. Capital accounts must be created and maintained in the manner

described in the Treasury Regulations.22

2. All liquidating distributions must be made in accordance with the

partners’ positive capital account balances.23

3. Any partner with a deficit capital account following the liquidation of

his interest must be unconditionally obligated by the end of the taxable

year (or, if later, within 90 days of the date of liquidation) to restore the

amount of such deficit (i.e. a “deficit restoration obligation”) to the

21 Reg. 1.704-1(b)(1)(i) and 1.704-1(b)(3) 22 Reg. 1.704-1(b)(2)(ii)(b)(1) and Reg. 1.704-1(b)(2)(iv) (maintenance of capital accounts). Under this basic rule, a partner’s capital account must be increased by: (1) the amount of money contributed by the partner to the partnership, (2) the FMV of property contributed by the partner (net of liabilities secured by the property that the partnership is considered to assume or take subject to under sec. 752). The capital account must be decreased by: (1) the amount of money distributed to the partner by the partnership, (2) the FMV of property distributed to the partner by the partnership (net of liabilities secured by the property that the partner is considered to assume or take subject to under sec. 752), (3) partnership expenditures not deductible or properly chargeable to the partnership’s capital account under sec. 705(a)(2)(B), and (4) the partner’s share of the partnership’s book loss or deductions (or items thereof) excluding items accounted for in (3) directly above. 23 Reg. 1.704-1(b)(2)(ii)(b)(2)

54

partnership with such funds to be paid to creditors or distributed to other

partners in accordance with their positive capital account balances.24

However, the Treasury Regulations state that, if specified conditions are

satisfied, an alternate test for the economic effect of a tax allocation to a

partner is available with respect to a partner who does not have an

unconditional deficit restoration obligation under the partnership

agreement. If there is no deficit restoration obligation, then the

partnership agreement must contain a “qualified income offset” as to that

partner or partners.25

D. Related Issues

The following is a list of issues and concepts related to appropriately determining

a partner’s distributive share:

1. Nonrecourse deductions,

2. Partner’s share of minimum gain,

3. Minimum gain chargeback,

4. Partnership minimum gain,

5. Partner nonrecourse deductions,

6. Property contributed at value different from basis: allocation of income,

gain, loss and deduction. Sec. 704(c)

VI TRANSACTIONS BETWEEN PARTNERS AND PARTNERSHIPS

A. Categories of Payments to Partners.

There are essentially three categories into which payments made to a partner will

fall. Which category applies will depend upon the characterization of the

relationship between the partner and the partnership within the context of the

transaction:

1. If the partner is acting in a capacity other than that of a partner, the

payment will be treated as if made to one who is not a partner (i.e.

payment to a third party) under sec. 707(a)(1).

24 Reg. 1.704-1(b)(2)(ii) & (b)(3) 25 Reg. sec. 1.704-1(b)(2)(ii)(d).

55

2. If the partner is acting in the capacity of a partner, and either (i) the

payment is for services rendered to the partnership or (ii) the use of

capital, and finally the amount of the payment is determined without

regard to the income of the partnership, the payment will be treated as a

“guaranteed payment” under sec. 707(c) and will be treated as a payment

to a third party for purposes secs. 61, 162 and 263.

3. If the partner is acting in the capacity of a partner and the amount of the

payment is determined with regard to the income of the partnership, the

payment will be treated as a distributive share of partnership income and

as a distribution of partnership property under secs. 704(a), 702 and 731.

VII OPTIONAL BASIS ADJUSTMENT OF PARTNERSHIP PROPERTY AFTER

TRANSFER OF A PARTNERSHIP INTEREST.

A. The Problem.

A purchaser, or transferee upon death, of a partnership interest typically has a

basis (outside basis) for that interest which differs from such purchaser’s or

transferee’s partner’s share of the bases of the assets to the partnership (inside

basis). But this likely disparity can lead to income tax consequences for the

acquiring or transferee partner with respect to pre-acquisition or pre-transfer

appreciation or depreciation of the partnership’s assets. But if an election under

section 754 is in effect, section 743(b) allows for certain adjustments that

eliminate many of these adverse consequences to the purchaser. Section 743(b)

attempts to avoid unfairness to purchasers or transferees by permitting an

adjustment to the basis of the partnership property so as to reflect either (1) the

purchase price of the interest if acquired by sale or (2) the basis of the interest

under section 1014(a) if acquired by inheritance. The adjustment permitted under

Section 743(b) with respect to the property of the partnership only affects the

purchaser or transferee-upon-death. Importantly the adjustment is available only

if the partnership has made an election under Section 754.

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B. Making the Election Under Section 754.

The Treasury Regulations provide that the election is “filed with the partnership

return for the taxable year during which the . . .transfer occurs.”26 For example, if

a partner sells his interest or dies on December 30th and the partnership is on the

calendar year, the partnership must make the election in a written statement filed

with the partnership’s timely filed return, including any extensions for that tax

year.

C. Maintenance by Partnership of Records of Basis Adjustment and Its Affects.

While the transferee partner is the one who will benefit from any adjustment, it is

the partnership who is required under section 754 to make the election to adjust

basis under section 743(b). Moreover, the election made by the partnership can

be revoked only by the partnership, subject to the approval of the Service.

It is clear from the Regulations that it is the partnership that has the responsibility

for reporting the basis adjustments.27 Consequently, when a partnership becomes

aware of a subject transfer, it has the responsibility to attach statements regarding

the required information and integrating the basis adjustment into the partner’s

distributive share as reported on the K-1. In addition, a statement of the

adjustment and the related facts must be attached to the partnership return.28

But the transferee partner does have an affirmative obligation to promptly notify

the partnership of the acquisition of the partnership interest and the basis for such

acquired interest.29 This notification requirement is imposed on the transferee

partner where the partnership has a section 754 election in effect and an interest is

acquired either by sale or exchange or death. Importantly, the partnership may

rely upon the partner’s notice, unless it receives or possesses information to the

contrary and is not actually required to make the section 743(b) adjustment until it

receives such notice from the transferee.30

26 Reg. 1.754-1(b)(1) 27 Reg. 1.743-1(k) 28 Reg. 1.743-1(k)(1) 29 Reg. 1.743-1(k)(2) 30 Reg. 1.743-1(k)(3), 1.743-1(k)(4) and 1.743 -1(k)(5)

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D. Community Property Problems.

Section 743(b) permits and adjustment to the basis of partnership property “in the

case of a transfer of an interest in a partnership . . upon the death of a partner.”

But an interesting issue occurs when a spouse is partner and the partnership

interest is community property, i.e. the other spouse has an immediate, vested,

one-half interest in that partnership interest. Various issues arise where the one-

half community property interest of the decedent partner spouse is transferred to

the surviving spouse. Because the nonpartner spouse previously held a one-half

community property interest, the death of the partner spouse did not transfer that

one-half interest to the surviving spouse. This technical interpretation of

applicable state law would result in depriving the nonpartner spouse of the benefit

of a section 743(b) adjustment for that spouse’s original one-half interest.

The Service addressed these issues in Revenue Ruling 79-12431 where it

considered a community property partnership interest where a section 754

election was in effect at the time of the partner spouse’s death. The Ruling

concluded that the entire community property interest, that of both the partner

spouse and the nonpartner spouse, will be considered to have been transferred for

purposes of section 743(b). Consequently, the section 743(b) adjustment is made

with respect to the entire partnership interest. The Ruling also held that the same

result would apply if the deaths were reversed, i.e. the nonpartner spouse

predeceased the partner spouse.

VIII TERMINATION OF A PARTNERSHIP

A. Basics of Partnership Termination

Section 708(a) provides that the general rule is that an existing partnership “shall

be considered as continuing if it is not terminated.” Thus the presumption is that

a partnership continues unless one of the events which precipitates a termination

has occurred during the taxable year.

31 1979-1 CB 224

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The only events which will cause a partnership to terminate for federal tax

purposes are set forth in section 708(b), which provides that a partnership will be

considered terminated only if:

(1) “no part of any business, financial operation, or venture of the partnership

continues to be carried on by any of its partners in a partnership;” or

(2) “within a 12-month period there is a sale or exchange of 50 percent or more of

the total interest in partnership capital and profits.”

Under the California Revised Limited Partnership Act (which is repealed January

1, 2010), a limited partnership is dissolved and its affairs shall be wound up upon

the happening of the first to occur of the following:

(1) At the time or upon the happening of events specified in the partnership

agreement;

(2) Unless otherwise provided in the partnership agreement, upon the written

consent of all general partners and a majority in interest of the limited partners;

(3) Unless otherwise provided in the partnership agreement, when a general

partner ceases to be a general partner under CRLP section 15642, unless either (i)

there is one or more general partners who continue the business of the limited

partnership, or (ii) if there is no remaining general partner, a majority in interest

of the limited partners (or such greater interest provided in the partnership

agreement) agree in writing to continue the business of the limited partnership and

within six months admit one or more general partners.32

The new limited partnership statute that becomes effective in 2010,33 the Uniform

Limited Partnership Act of 2008 (“ULPA”), does vary with respect to its

dissolution provisions.

Under section 15908.01 of the ULPA, a limited partnership is dissolved, and its

activities wound up only upon the occurrence of one of the following:

(a) the happening of an event specified in the partnership agreement;

(b) the consent of all general partners and of limited partners owning a

majority of the rights to receive distributions as limited partners;

32 CRLP section 15681 33 Limited partnerships formed prior to 2008 may elect to be governed by the new statute. Corp. Code sec. 15912.06. But the new Act does govern all limited partnerships formed on or after January 1, 2008

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(c) after the dissociation of a person as a general partner;

(1) if the limited partnership has at least one remaining general

partner and a consent to dissolve the limited partnership is given

within 90 days after the dissociation by partners owning a majority

of the rights to receive distributions as partners at the time of

consent; or

(2) if the limited partnership does not have a remaining general

partner, the passage of 90 days after the dissociation, unless before

the end of the period:

(A) consent to continue the activities of the limited partnership and

admit at least one general partner is given by limited partners

owning a majority of the rights to receive distributions as limited

partners at the time the consent is to be effective; and

(B) at least one person is admitted as a general partner in

accordance with the consent; or

(d) the passage of 90 days after the dissociation of the limited

partnership’s last limited partner, unless before the end of the period

the limited partnership admits at least one limited partner.

But a limited partnership may not be terminated for tax purposes even though it

may be dissolved under state law. “Dissolution” and “winding-up” are strictly

state law concepts. For example, notwithstanding the “dissolution” of a limited

partnership under the above provisions, that limited partnership remains in

existence until it has completed its “winding up,” essentially the complete

distribution of its assets to its creditors and then partners.34

Briefly, section 708(b)(2) states special termination rules in the case of a merger

or consolidation of two or more partnerships into one partnership or, in the case of

a division of a partnership into two or more partnerships.

In comparison to state law, the primary effect of a termination of a partnership for

federal tax purposes is that it closes the partnership taxable year. Under the

general rule, the taxable year of a partnership does not close other than at its

34 CRLP section 15684

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normal year end except: (1) on termination of the partnership, in which event the

partnership taxable year closes with respect to, and thus affects, all partners;35 or

(2) on the termination of the entire interest of a partner in the partnership by

reason of death, liquidation, or otherwise (e.g. sale or exchange)36 in which event

the partnership tax year closes only with respect to that partner unless the

disposition of the partner’s interest terminates the partnership whereby all of the

partners will be affected. If the limited partnership does terminate, then the “old”

partnership ceases to exist for income tax purposes. Any successor partnership is

deemed to be a new partnership as though it were newly formed.

B. Termination by Sale or Exchange of 50 Percent or More Interest

As noted above, Section 708(b)(1)(B) states that a termination of a partnership

will occur if “within a 12-month period there is a sale or exchange of 50 percent

or more of the total interest in partnership capital and profits.” It is important to

note that the Regulations clarify that, in order to have a termination of the

partnership, there must be a sale or exchange of 50 percent or more of the total

interests in both partnership capital and profits. Consequently, a sale of a 30

percent interest in partnership capital and a 60 percent interest in partnership

profits does not constitute a termination of the partnership.

While Section 708(b)(1)(B) refers to a “sale or exchange,” the Regulations are

clear that there may be a series of sales of partnership interests that results in the

sale or exchange of the requisite 50% partnership interests. Consequently, it is

the cumulative total of these sales within any period of 12 consecutive months

that is considered.37 Moreover, the statutory language makes it clear that tax-free

exchanges such as those under Section 351 or Section 721 are included in the

term “exchanges.”

C. Exceptions to “Sale or Exchange” Treatment

The statutory requisite to termination under Section 708(b)(1)(B) is either that a

sale or exchange has occurred. These two terms, “sale” and “exchange” have been

broadly defined. But the Regulations make it clear that certain transactions do not

35 Reg. 1.708-1(b)(3); IRC sec. 706(c)(1); Reg. 1.706-1(c)(1) 36 IRC sec. 706(c)(2)(A) 37 Reg. 1.708-1(b)(2)

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come within the definitions of these two terms. For example, transfers of

partnership interests by gift, bequest, inheritance or the liquidation of that interest

by the partnership will not be considered to be either “sales” or “exchanges.”38

Under the Regulations “a disposition of a partnership interest by gift (including

assignment to a successor in interest) . . . is not a sale or exchange for purposes of

this subparagraph.”39 But despite this apparent exclusion created by the

Regulations, in the case of a gift the transfer of a share of partnership liabilities to

the donee partner may convert the transaction into a sale or exchange. In

addition, Madorin v. Commr.40 suggests that the transfer of a partnership interest

to a revocable trust may constitute a Section 708 sale or exchange when events

occur that cause the trust to become irrevocable which, then, has the effect of

relieving the grantor of partnership liabilities, thus resulting in a deemed

disposition of the partnership interest.

Technically, a sale or exchange occurs whenever there is a transfer to the donee

partner of any amount of the donor’s share of partnership liabilities. But if the

share of liabilities transferred to the donee does not exceed the adjusted basis of

the partnership interest, then there is no taxable gain to the donor partner. In such

a situation, the Regulations should control and the gift of a partnership interest

should not be treated as a sale or exchange under Section 708(b)(1)(B).

Similarly, a transfer of a partnership interest by bequest or inheritance also is

specifically excluded from sale or exchange treatment.41

But, in contrast, the treatment of a distribution of a partnership interest from a

trust or estate is less clear. The Regulations do not explicitly exclude such

distributions from being treated as a “sale or exchange.” Thus, while transferring

a partnership interest to a trust or estate (if in the form of a gift or bequest) does

not constitute an exchange under Section 708, a distribution of such an interest

from the trust or estate may end up being viewed as such an exchange. This

distinction may arise because Section 761(e) states that, for purposes of Section

38 Reg. 1.708-1(b)(2) 39 Id. 40 84 TC 667 (1985) 41 Id.

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708, any distribution of an interest in a partnership (not otherwise treated as an

exchange) shall be treated as an exchange. But indications of public policy and

provisions of other sections of Subchapter K suggest, if not dictate, that

distributions from estates or trusts should be exempt from the coverage of Section

761(e).42 However, there is not clarity since Reg. 1.761-1(e), effective May 9,

1997, does not contain such an exemption.

D. Tax Consequences of Termination by Sale or Exchange under Section

708(b)(1)(B).

For federal tax purposes, a sale or exchange within a 12-month period of a 50% or

more of the interests in partnership capital and profits results in a constructive

termination of the partnership under Section 708(b)(1)(B) even though the

partnership continues operations for business and state law purposes. While the

treatment of any such constructive termination differs as to whether it occurred

before or after May 9, 1997, the following discussion will discuss the treatment of

such terminations occurring after May 9, 1997.

Regarding terminations under Section 708(b)(1)(B) occurring after May 9, 1997

resulting from a “sale or exchange” within a 12-month period of a 50% or more

capital and profits interest in a partnership, Regulation 1.708-1(b)(4) creates a

fictionalized transaction described below:

If a partnership is terminated by a sale or exchange of any interest, the following is deemed to occur: The partnership contributes all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership, and, immediately thereafter, the terminated partnership distributes interests in the new partnership to the purchasing partner and the other remaining partners in proportion to their respective interests in the terminated partnership in liquidation of the terminated partnership, either for the continuation of the business by the new partnership or for its dissolution and winding up.

The termination of the old partnership by reason of such sale or exchange occurs

on the date of the sale or exchange which by itself, or in connection with other

42 Reg. 1.706-1(c)(3)(vi), ex. (3) (distribution of a partnership interest by an estate is not a sale or exchange of the interest; the partnership taxable year does not close with respect to the estate as partner)

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sales or exchanges within the 12-month period, totals 50% or more of the total

capital and profits interests of the partnership.43

(1) Closing of Taxable Year of Terminated Partnership.

A major tax consequence of this constructive termination, regardless of whether

the “new” partnership continues in business or dissolves, is the closing of the

taxable year of the terminated partnership. This could result in the a very

negative result of potentially bunching of as much as 23 months of taxable

income to the remaining partners of that partnership if the partners and that

partnership were on different taxable years.44

(2) Continuing Tax Attributes.

While Section 708(b)(1)(B) terminates the partnership which realized a 50% or

more transfer of “capital and profits” interest, the Regulations create some tax

attributes for the constructive “new” partnership resulting in the “new”

partnership being treated as if it were simply a continuation of the constructively

terminated partnership. It is interesting to note that these tax attributes would not

be “created” with a truly new partnership created by the terminated partnership by

its actually transferring its assets and liabilities to such new partnership in

exchange for interests in the new partnership followed by the liquidation of the

“terminated” partnership.

(i) Taxpayer identification number. Under the Regulations, the

constructively created new partnership retains the employer identification number

of the terminated partnership.45

(ii) Capital accounts of partners. The Regulations provide that the capital

accounts in the new partnership of the transferee partner and the remaining

partners remain the same as they were in the terminated partnership.46 This is

quite significant since capital accounts serve as the basis for the determination of

the partners’ distributive shares of income, gain, loss and deduction, of the new

partnership.

43 Reg. 1.708-1(b)(3)(ii) 44 But Section 706(b) may prevent this from happening. 45 Reg. 301.6109-1(d)(2)(iii) 46 Reg. 1.708-1(b)(4), ex. (ii); Reg. 1.704-1(b)(2)(iv)(l)

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(iii) Book value of transferred assets. The book value of the assets

constructively transferred to the new partnership is the same as it was to the

terminated partnership.47 The book value of property that had been contributed to

the terminated partnership is the fair market value at the time of contribution

subsequently adjusted for any cost recovery occurring after its contribution.

(iv) Section 704(c) property. In the event of a deemed transfer of property

to a new partnership by reason of a constructive termination of a partnership

under section 708(b)(1)(B), the Regulations provide that property deemed

transferred to the new partnership is section 704(c) property to the new

partnership only to the extent that it was section 704(c) property to the terminated

partnership. As a result, none of the other non-section 704(c) assets transferred to

the new partnership will be considered section 704(c) property even though their

tax basis and fair market value may differ.48 This has the beneficial effect of

eliminating the possible creation of another layer of section 704(c) property by

reason of the constructive contribution of assets.

(3) Gain or Loss.

The issue of whether the constructive transfer of the new assets and liabilities of

the terminated partnership to the new partnership under the regulations to section

708(b)(1)(B)49 results in a gain or loss to the terminated partnership is not

specifically addressed. But the regulations under section 752(a)50 make it clear

that any increase or decrease in the liabilities resulting from the constructive

contribution of assets to the new partnership will be netted so that the liabilities

would have no effect on the determination of gain or loss to the terminating

partnership resulting from such constructive property contribution. Thus, there

will be no gain or loss recognized to the terminated partnership on the

constructive transfer.51

47 Id. 48 Reg. 1.704-3(a)(3)(i) and Reg. 1.708-1(b)(4), ex. (iii) 49 Reg. 1.708-1(b)(1)(iv) 50 Reg. 1.752-1(f) 51 Secs. 721 and 731

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(4) Basis of Transferred Assets

The Regulations make it clear that the tax basis of the assets constructively

contributed to the new partnership is the same as their basis to the terminated

partnership.52 This is the same treatment accorded the contribution of property to

a partnership in most other situations.

(5) Holding Period of Transferred Assets

Under the regulations, if the basis of contributed property in a partnership is the

same as the basis of such property to the contributing partner, then the holding

period to the partnership for such property includes the holding period of the

contributing partner.53 Since the basis of the property constructively contributed

to the new partnership is the same as its basis to the terminated partnership, the

holding period to the new partnership for that property will include the holding

period of the terminated partnership.54

(6) Basis of New Partnership Interest/ Effect of Liabilities

The reduction in the partners’ shares of liabilities of the terminated partnership by

reason of the distribution of the interests in the new partnership is offset by the

liabilities of the new partnership. Consequently, despite some potential views to

the contrary, there is no change in the basis of the partners’ interests in the

terminated partnership or in the basis of the interests in the new partnership.55

(7) Elections

While there are many reasons to conclude that the new partnership created under

this constructive transfer of assets is simply a continuation of the terminated

partnership, this conclusion may not be correct. If the business of the terminated

partnership is continued by the new partnership, it is advisable not to conclude the

these partnerships are the same but that there is actually a new partnership and

new elections must be made.56 Thus the new partnership is well advised to “re-

make” all relevant elections including: (i) taxable year, (ii) method of accounting,

52 Reg. 1.708-1(b)(4), ex. (ii) 53 Reg. 1.723-1 54 Id.; IRC sec. 1223(2) 55 Sec. 732; Rev. Rul. 87-120, 1987-2 CB 161 56 Reg. 1.704-3(a)(2)

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(iii) cost recovery method, (iv) the section 754 election, (v) method of accounting

for inventory, and likely others.

(8) Dissolution of New Partnership

If the new partnership instead of continuing the business of the terminated

partnership elects to dissolve and wind up the such business, the tax consequences

of this termination should follow the rules and consequences of a termination

under section 708(b)(1)(A) as a result of the cessation of the business by a

partnership.

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ATTACHMENT #2

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ATTACHMENT # 3

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Internal Revenue Bulletin: 2010-45

November 8, 2010

REG-119921-09

Notice of Proposed Rulemaking Series LLCs and Cell Companies

Table of Contents

• AGENCY: • ACTION: • SUMMARY: • DATES: • ADDRESSES: • FOR FURTHER INFORMATION CONTACT: • SUPPLEMENTARY INFORMATION:

o Background o 1. Introduction o 2. Entity Classification for Federal Tax Purposes o A. Regulatory framework o B. Separate entity classification o C. Insurance company classification o 3. Overview of Series LLC Statutes and Cell Company Statutes o A. Domestic statutes o B. Statutes with respect to insurance o Explanation of Provisions o 1. In General o 2. Classification of a Series that is Treated as a Separate Entity for Federal Tax Purposes o 3. Entity Status of Series Organizations o 4. Continuing Applicability of Tax Law Authority to Series o 5. Applicability to Organizations that Qualify as Insurance Companies o 6. Effect of Local Law Classification on Tax Collection o 7. Employment Tax and Employee Benefits Issues o A. In general o B. Employment tax o C. Employee benefits o 8. Statement Containing Identifying Information about Series o Proposed Effective Date o Special Analyses o Comments and Requests for a Public Hearing

• Proposed Amendments to the Regulations o PART 301—PROCEDURE AND ADMINISTRATION

• Drafting Information

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Notice of proposed rulemaking.

SUMMARY:

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This document contains proposed regulations regarding the classification for Federal tax purposes of a series of a domestic series limited liability company (LLC), a cell of a domestic cell company, or a foreign series or cell that conducts an insurance business. The proposed regulations provide that, whether or not a series of a domestic series LLC, a cell of a domestic cell company, or a foreign series or cell that conducts an insurance business is a juridical person for local law purposes, for Federal tax purposes it is treated as an entity formed under local law. Classification of a series or cell that is treated as a separate entity for Federal tax purposes generally is determined under the same rules that govern the classification of other types of separate entities. The proposed regulations provide examples illustrating the application of the rule. The proposed regulations will affect domestic series LLCs; domestic cell companies; foreign series, or cells that conduct insurance businesses; and their owners.

DATES:

Written or electronic comments and requests for a public hearing must be received by December 13, 2010.

ADDRESSES:

Send submissions to: CC:PA:LPD:PR (REG-119921-09), Room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-119921-09), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically, via the Federal eRulemaking portal at www.regulations.gov (IRS REG-119921-09)

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed regulations, Joy Spies, (202) 622-3050; concerning submissions of comments, Oluwafunmilayo (Funmi) Taylor, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

1. Introduction

A number of states have enacted statutes providing for the creation of entities that may establish series, including limited liability companies (series LLCs). In general, series LLC statutes provide that a limited liability company may establish separate series. Although series of a series LLC generally are not treated as separate entities for state law purposes and, thus, cannot have members, each series has “associated” with it specified members, assets, rights, obligations, and investment objectives or business purposes. Members’ association with one or more particular series is comparable to direct ownership by the members in such series, in that their rights, duties, and powers with respect to the series are direct and specifically identified. If the conditions enumerated in the relevant statute are satisfied, the debts, liabilities, and obligations of one series generally are enforceable only against the assets of that series and not against assets of other series or of the series LLC.

Certain jurisdictions have enacted statutes providing for entities similar to the series LLC. For example, certain statutes provide for the chartering of a legal entity (or the establishment of cells) under a structure commonly known as a protected cell company, segregated account company or segregated portfolio company (cell company). A cell company may establish multiple accounts, or cells, each of which has its own name and is identified with a specific participant, but generally is not treated under local law as a legal entity distinct from the cell company. The assets of each cell are statutorily protected from the creditors of any other cell and from the creditors of the cell company.

Under current law, there is little specific guidance regarding whether for Federal tax purposes a series (or cell) is treated as an entity separate from other series or the series LLC (or other cells or the cell company, as the case may be), or whether the company and all of its series (or cells) should be treated as a single entity.

Notice 2008-19, 2008-1 C.B. 366 requested comments on proposed guidance concerning issues that arise if arrangements entered into by a cell constitute insurance for Federal income tax purposes. The notice also requested comments on the need for guidance concerning similar segregated arrangements that do not involve

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insurance. The IRS received a number of comments requesting guidance for similar arrangements not involving insurance, including series LLCs and cell companies. These comments generally recommended that series and cells should be treated as separate entities for Federal tax purposes if they are established under a statute with provisions similar to the series LLC statutes currently in effect in several states. The IRS and Treasury Department generally agree with these comments. See §601.601(d)(2)(ii)(b).

2. Entity Classification for Federal Tax Purposes

A. Regulatory framework

Sections 301.7701-1 through 301.7701-4 of the Procedure and Administration Regulations provide the framework for determining an organization’s entity classification for Federal tax purposes. Classification of an organization depends on whether the organization is treated as: (i) a separate entity under §301.7701-1, (ii) a “business entity” within the meaning of §301.7701-2(a) or a trust under §301.7701-4, and (iii) an “eligible entity” under §301.7701-3.

Section 301.7701-1(a)(1) provides that the determination of whether an entity is separate from its owners for Federal tax purposes is a matter of Federal tax law and does not depend on whether the organization is recognized as an entity under local law. Section 301.7701-1(a)(2) provides that a joint venture or other contractual arrangement may create a separate entity for Federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom. However, a joint undertaking merely to share expenses does not create a separate entity for Federal tax purposes, nor does mere co-ownership of property where activities are limited to keeping property maintained, in repair, and rented or leased. Id.

Section 301.7701-1(b) provides that the tax classification of an organization recognized as a separate entity for tax purposes generally is determined under §§301.7701-2, 301.7701-3, and 301.7701-4. Thus, for example, an organization recognized as an entity that does not have associates or an objective to carry on a business may be classified as a trust under §301.7701-4.

Section 301.7701-2(a) provides that a business entity is any entity recognized for Federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under §301.7701-3) that is not properly classified as a trust or otherwise subject to special treatment under the Internal Revenue Code (Code). A business entity with two or more members is classified for Federal tax purposes as a corporation or a partnership. See §301.7701-2(a). A business entity with one owner is classified as a corporation or is disregarded. See §301.7701-2(a). If the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner. However, §301.7701-2(c)(2)(iv) and (v) provides for an otherwise disregarded entity to be treated as a corporation for certain Federal employment tax and excise tax purposes.

Section 301.7701-3(a) generally provides that an eligible entity, which is a business entity that is not a corporation under §301.7701-2(b), may elect its classification for Federal tax purposes.

B. Separate entity classification

The threshold question for determining the tax classification of a series of a series LLC or a cell of a cell company is whether an individual series or cell should be considered an entity for Federal tax purposes. The determination of whether an organization is an entity separate from its owners for Federal tax purposes is a matter of Federal tax law and does not depend on whether the organization is recognized as an entity under local law. Section 301.7701-1(a)(1). In Moline Properties, Inc. v. Commissioner, 319 U.S. 436 (1943), the Supreme Court noted that, so long as a corporation was formed for a purpose that is the equivalent of business activity or the corporation actually carries on a business, the corporation remains a taxable entity separate from its shareholders. Although entities that are recognized under local law generally are also recognized for Federal tax purposes, a state law entity may be disregarded if it lacks business purpose or any business activity other than tax avoidance. See Bertoli v. Commissioner, 103 T.C. 501 (1994); Aldon Homes, Inc. v. Commissioner, 33 T.C. 582 (1959).

The Supreme Court in Commissioner v. Culbertson, 337 U.S. 733 (1949), and Commissioner v. Tower, 327 U.S. 280 (1946), set forth the basic standard for determining whether a partnership will be respected for Federal tax purposes. In general, a partnership will be respected if, considering all the facts, the parties in good faith and acting with a business purpose intended to join together to conduct an enterprise and share in its profits and losses. This

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determination is made considering not only the stated intent of the parties, but also the terms of their agreement and their conduct. Madison Gas & Elec. Co. v. Commissioner, 633 F.2d 512, 514 (7th Cir. 1980); Luna v. Commissioner, 42 T.C. 1067, 1077-78 (1964).

Conversely, under certain circumstances, arrangements that are not recognized as entities under state law may be treated as separate entities for Federal tax purposes. Section 301.7701-1(a)(2). For example, courts have found entities for tax purposes in some co-ownership situations where the co-owners agree to restrict their ability to sell, lease or encumber their interests, waive their rights to partition property, or allow certain management decisions to be made other than by unanimous agreement among co-owners. Bergford v. Commissioner, 12 F.3d 166 (9th Cir. 1993); Bussing v. Commissioner, 89 T.C. 1050 (1987); Alhouse v. Commissioner, T.C. Memo. 1991-652. However, the Internal Revenue Service (IRS) has ruled that a co-ownership does not rise to the level of an entity for Federal tax purposes if the owner employs an agent whose activities are limited to collecting rents, paying property taxes, insurance premiums, repair and maintenance expenses, and providing tenants with customary services. Rev. Rul. 75-374, 1975-2 C.B. 261. See also Rev. Rul. 79-77, 1979-1 C.B. 448, (see §601.601(d)(2)(ii)(b).

Rev. Proc. 2002-22, 2002-1 C.B. 733, (see §601.601(d)(2)(ii)(b)), specifies the conditions under which the IRS will consider a request for a private letter ruling that an undivided fractional interest in rental real property is not an interest in a business entity under §301.7701-2(a). A number of factors must be present to obtain a ruling under the revenue procedure, including a limit on the number of co-owners, a requirement that the co-owners not treat the co-ownership as an entity (that is, that the co-ownership may not file a partnership or corporate tax return, conduct business under a common name, execute an agreement identifying any or all of the co-owners as partners, shareholders, or members of a business entity, or otherwise hold itself out as a partnership or other form of business entity), and a requirement that certain rights with respect to the property (including the power to make certain management decisions) must be retained by co-owners. The revenue procedure provides that an organization that is an entity for state law purposes may not be characterized as a co-ownership under the guidance in the revenue procedure.

The courts and the IRS have addressed the Federal tax classification of investment trusts with assets divided among a number of series. In National Securities Series-Industrial Stocks Series v. Commissioner, 13 T.C. 884 (1949), acq., 1950-1 C.B. 4, several series that differed only in the nature of their assets were created within a statutory open-end investment trust. Each series regularly issued certificates representing shares in the property held in trust and regularly redeemed the certificates solely from the assets and earnings of the individual series. The Tax Court stated that each series of the trust was taxable as a separate regulated investment company. See also Rev. Rul. 55-416, 1955-1 C.B. 416, (see §601.601(d)(2)(ii)(b)). But see Union Trusteed Funds v. Commissioner, 8 T.C. 1133 (1947), (series funds organized by a state law corporation could not be treated as if each fund were a separate corporation).

In 1986, Congress added section 851(g) to the Code. Section 851(g) contains a special rule for series funds and provides that, in the case of a regulated investment company (within the meaning of section 851(a)) with more than one fund, each fund generally is treated as a separate corporation. For these purposes, a fund is a segregated portfolio of assets the beneficial interests in which are owned by holders of interests in the regulated investment company that are preferred over other classes or series with respect to these assets.

C. Insurance company classification

Section 7701(a)(3) and §301.7701-2(b)(4) provide that an arrangement that qualifies as an insurance company is a corporation for Federal income tax purposes. Sections 816(a) and 831(c) define an insurance company as any company more than half the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. See also §1.801-3(a)(1), (“[T]hough its name, charter powers, and subjection to State insurance laws are significant in determining the business which a company is authorized and intends to carry on, it is the character of the business actually done in the taxable year which determines whether a company is taxable as an insurance company under the Internal Revenue Code.”). Thus, an insurance company includes an arrangement that conducts insurance business, whether or not the arrangement is a state law entity.

3. Overview of Series LLC Statutes and Cell Company Statutes

A. Domestic statutes

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Although §301.7701-1(a)(1) provides that state classification of an entity is not controlling for Federal tax purposes, the characteristics of series LLCs and cell companies under their governing statutes are an important factor in analyzing whether series and cells generally should be treated as separate entities for Federal tax purposes.

Series LLC statutes have been enacted in Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, Utah and Puerto Rico. Delaware enacted the first series LLC statute in 1996. Del. Code Ann. Tit. 6, section 18-215 (the Delaware statute). Statutes enacted subsequently by other states are similar, but not identical, to the Delaware statute. All of the statutes provide a significant degree of separateness for individual series within a series LLC, but none provides series with all of the attributes of a typical state law entity, such as an ordinary limited liability company. Individual series generally are not treated as separate entities for state law purposes. However, in certain states (currently Illinois and Iowa), a series is treated as a separate entity to the extent provided in the series LLC’s articles of organization.

The Delaware statute provides that a limited liability company may establish, or provide for the establishment of, one or more designated series of members, managers, LLC interests or assets. Under the Delaware statute, any such series may have separate rights, powers, or duties with respect to specified property or obligations of the LLC or profits and losses associated with specified property or obligations, and any such series may have a separate business purpose or investment objective. Additionally, the Delaware statute provides that the debts, liabilities, obligations, and expenses of a particular series are enforceable against the assets of that series only, and not against the assets of the series LLC generally or any other series of the LLC, and, unless the LLC agreement provides otherwise, none of the debts, liabilities, obligations, and expenses of the series LLC generally or of any other series of the series LLC are enforceable against the assets of the series, provided that the following requirements are met: (1) the LLC agreement establishes or provides for the establishment of one or more series; (2) records maintained for any such series account for the assets of the series separately from the other assets of the series LLC, or of any other series of the series LLC; (3) the LLC agreement so provides; and (4) notice of the limitation on liabilities of a series is set forth in the series LLC’s certificate of formation.

Unless otherwise provided in the LLC agreement, a series established under Delaware law has the power and capacity to, in its own name, contract, hold title to assets, grant liens and security interests, and sue and be sued. A series may be managed by the members of the series or by a manager. Any event that causes a manager to cease to be a manager with respect to a series will not, in itself, cause the manager to cease to be a manager of the LLC or of any other series of the LLC.

Under the Delaware statute, unless the LLC agreement provides otherwise, any event that causes a member to cease to be associated with a series will not, in itself, cause the member to cease to be associated with any other series or with the LLC, or cause termination of the series, even if there are no remaining members of the series. Additionally, the Delaware statute allows a series to be terminated and its affairs wound up without causing the dissolution of the LLC. However, all series of the LLC terminate when the LLC dissolves. Finally, under the Delaware statute, a series generally may not make a distribution to the extent that the distribution will cause the liabilities of the series to exceed the fair market value of the series’ assets.

The series LLC statutes of Illinois, 805 ILCS 180/37-40 (the Illinois statute), and Iowa, I.C.A. §489.1201 (the Iowa statute) provide that a series with limited liability will be treated as a separate entity to the extent set forth in the articles of organization. The Illinois statute provides that the LLC and any of its series may elect to consolidate their operations as a single taxpayer to the extent permitted under applicable law, elect to work cooperatively, elect to contract jointly, or elect to be treated as a single business for purposes of qualification to do business in Illinois or any other state.

In addition, under the Illinois statute, a series’ existence begins upon filing of a certificate of designation with the Illinois secretary of state. A certificate of designation must be filed for each series that is to have limited liability. The name of a series with limited liability must contain the entire name of the LLC and be distinguishable from the names of the other series of the LLC. If different from the LLC, the certificate of designation for each series must list the names of the members if the series is member-managed or the names of the managers if the series is manager-managed. The Iowa and Illinois statutes both provide that, unless modified by the series LLC provisions, the provisions generally applicable to LLCs and their managers, members, and transferees are applicable to each series.

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Some states have enacted series provisions outside of LLC statutes. For example, Delaware has enacted series limited partnership provisions (6 Del. C. §17-218). In addition, Delaware’s statutory trust statute permits a statutory trust to establish series (12 Del. C. §3804). Both of these statutes contain provisions that are nearly identical to the corresponding provisions of the Delaware series LLC statute with respect to the ability of the limited partnership or trust to create or establish separate series with the same liability protection enjoyed by series of a Delaware series LLC.

All of the series LLC statutes contain provisions that grant series certain attributes of separate entities. For example, individual series may have separate business purposes, investment objectives, members, and managers. Assets of a particular series are not subject to the claims of creditors of other series of the series LLC or of the series LLC itself, provided that certain record-keeping and notice requirements are observed. Finally, most series LLC statutes provide that an event that causes a member to cease to be associated with a series does not cause the member to cease to be associated with the series LLC or any other series of the series LLC.

However, all of the state statutes limit the powers of series of series LLCs. For example, a series of a series LLC may not convert into another type of entity, merge with another entity, or domesticate in another state independent from the series LLC. Several of the series LLC statutes do not expressly address a series’ ability to sue or be sued, hold title to property, or contract in its own name. Ordinary LLCs and series LLCs generally may exercise these rights. Additionally, most of the series LLC statutes provide that the dissolution of a series LLC will cause the termination of each of its series.

B. Statutes with respect to insurance

The insurance codes of a number of states include statutes that provide for the chartering of a legal entity commonly known as a protected cell company, segregated account company, or segregated portfolio company. See, for example, Vt. Stat. Ann. tit. 8, chap.141, §§6031-6038 (sponsored captive insurance companies and protected cells of such companies); S.C. Code Ann. tit. 38, chap. 10, §§38-10-10 through 39-10-80 (protected cell insurance companies). Under those statutes, as under the series LLC statutes described above, the assets of each cell are segregated from the assets of any other cell. The cell may issue insurance or annuity contracts, reinsure such contracts, or facilitate the securitization of obligations of a sponsoring insurance company. Rev. Rul. 2008-8, 2008-1 C.B. 340, (see §601.601(d)(2)(ii)(b)), analyzes whether an arrangement entered into between a protected cell and its owner possesses the requisite risk shifting and risk distribution to qualify as insurance for Federal income tax purposes. Under certain domestic insurance codes, the sponsor may be organized under a corporate or unincorporated entity statute.

Series or cell company statutes in a number of foreign jurisdictions allow series or cells to engage in insurance businesses. See, for example, The Companies (Guernsey) Law, 2008 Part XXVII (Protected Cell Companies), Part XXVIII (Incorporated Cell Companies); The Companies (Jersey) law, 1991, Part 18D; Companies Law, Part XIV (2009 Revision) (Cayman Isl.) (Segregated Portfolio Companies); and Segregated Accounts Companies Act (2000) (Bermuda).

Explanation of Provisions

1. In General

The proposed regulations provide that, for Federal tax purposes, a domestic series, whether or not a juridical person for local law purposes, is treated as an entity formed under local law.

With one exception, the proposed regulations do not apply to series or cells organized or established under the laws of a foreign jurisdiction. The one exception is that the proposed regulations apply to a foreign series that engages in an insurance business.

Whether a series that is treated as a local law entity under the proposed regulations is recognized as a separate entity for Federal tax purposes is determined under §301.7701-1 and general tax principles. The proposed regulations further provide that the classification of a series that is recognized as a separate entity for Federal tax purposes is determined under §301.7701-1(b), which provides the rules for classifying organizations that are recognized as entities for Federal tax purposes.

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The proposed regulations define a series organization as a juridical entity that establishes and maintains, or under which is established and maintained, a series. A series organization includes a series limited liability company, series partnership, series trust, protected cell company, segregated cell company, segregated portfolio company, or segregated account company.

The proposed regulations define a series statute 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 (1) members or participants of a series organization to have rights, powers, or duties with respect to the series; (2) a series to have separate rights, powers, or duties with respect to specified property or obligations; and (3) 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. For purposes of this definition, a “participant” of a series organization includes an officer or director of the series organization who has no ownership interest in the series or series organization, but has rights, powers, or duties with respect to the series.

The proposed regulations define a series as a segregated group of assets and liabilities that is established pursuant to a series statute by agreement of a series organization. A series includes a 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 term “series” does not include a segregated asset account of a life insurance company, which consists of all assets the investment return and market value of which must be allocated in an identical manner to any variable life insurance or annuity contract invested in any of the assets. See §1.817-5(e). Such an account is accorded special treatment under subchapter L. See generally section 817(a) through (c).

Certain series statutes provide that the series liability limitation provisions do not apply if the series organization or series does not maintain records adequately accounting for the assets associated with each series separately from the assets of the series organization or any other series of the series organization. The IRS and the Treasury Department considered whether a failure to elect or qualify for the liability limitations under the series statute should affect whether a series is a separate entity for Federal tax purposes. However, limitations on liability of owners of an entity for debts and obligations of the entity and the rights of creditors to hold owners liable for debts and obligations of the entity generally do not alter the characterization of the entity for Federal tax purposes. Therefore, the proposed regulations provide 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 not prevent a series from meeting the definition of “series” in the proposed regulations. For example, a series generally will not cease to be an entity under the proposed regulations simply because it guarantees the debt of another series within the series organization.

The proposed regulations treat a series as created or organized under the laws of the same jurisdiction in which the series is established. Because a series may not be a separate juridical entity for local law purposes, this rule provides the means for establishing the jurisdiction of the series for Federal tax purposes.

Under §301.7701-1(b), §301.7701-2(b) applies to a series that is recognized as a separate entity for Federal tax purposes. Therefore, a series that is itself described in §301.7701-2(b)(1) through (8) would be classified as a corporation regardless of the classification of the series organization.

The proposed regulations also provide that, for Federal tax purposes, ownership of interests in a series and of the assets associated with a series is determined under general tax principles. A series organization is not treated as the owner of a series or of the assets associated with a series merely because the series organization holds legal title to the assets associated with the series. For example, if a series organization holds legal title to assets associated with a series because the statute under which the series organization was organized does not expressly permit a series to hold assets in its own name, the series will be treated as the owner of the assets for Federal tax purposes if it bears the economic benefits and burdens of the assets under general Federal tax principles. Similarly, for Federal tax purposes, the obligor for the liability of a series is determined under general tax principles.

In general, the same legal principles that apply to determine who owns interests in other types of entities apply to determine the ownership of interests in series and series organizations. These principles generally look to who

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bears the economic benefits and burdens of ownership. See, for example, Rev. Rul. 55-39, 1955-1 C.B. 403, (see §601.601(d)(2)(ii)(b)). Furthermore, common law principles apply to the determination of whether a person is a partner in a series that is classified as a partnership for Federal tax purposes under §301.7701-3. See, for example, Commissioner v. Culbertson, 337 U.S. 733 (1949); Commissioner v. Tower, 327 U.S. 280 (1946).

The IRS and the Treasury Department considered other approaches to the classification of series for Federal tax purposes. In particular, the IRS and the Treasury Department considered whether series should be disregarded as entities separate from the series organization for Federal tax purposes. This approach would be supported by the fact that series are not generally considered entities for local law purposes (except, for example, potentially under the statutes of Illinois and Iowa, where a series may be treated as a separate entity to the extent set forth in the articles of organization). Additionally, while the statutes enabling series organizations grant series significant autonomy, under no current statute do series possess all of the attributes of independence that entities recognized under local law generally possess. For example, series generally cannot convert into another type of entity, merge with another entity, or domesticate in another jurisdiction independent of the series organization. In addition, the dissolution of a series organization generally will terminate all of its series.

The IRS and the Treasury Department believe that, notwithstanding that series differ in some respects from more traditional local law entities, domestic series generally should be treated for Federal tax purposes as entities formed under local law. Because Federal tax law, and not local law, governs the question of whether an organization is an entity for Federal tax purposes, it is not dispositive that domestic series generally are not considered entities for local law purposes. Additionally, the IRS and the Treasury Department believe that, overall, the factors supporting separate entity status for series outweigh the factors in favor of disregarding series as entities separate from the series organization and other series of the series organization. Specifically, managers and equity holders are “associated with” a series, and their rights, duties, and powers with respect to the series are direct and specifically identified. Also, individual series may (but generally are not required to) have separate business purposes and investment objectives. The IRS and the Treasury Department believe these factors are sufficient to treat domestic series as entities formed under local law.

Although some statutes creating series organizations permit an individual series to enter into contracts, sue, be sued, and/or hold property in its own name, the IRS and the Treasury Department do not believe that the failure of a statute to explicitly provide these rights should alter the treatment of a domestic series as an entity formed under local law. These attributes primarily involve procedural formalities and do not appear to affect the substantive economic rights of series or their creditors with respect to their property and liabilities. Even in jurisdictions where series may not possess these attributes, the statutory liability shields would still apply to the assets of a particular series, provided the statutory requirements are satisfied.

Furthermore, the rule provided in the proposed regulations would provide greater certainty to both taxpayers and the IRS regarding the tax status of domestic series and foreign series that conduct insurance businesses. In 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. The IRS and the Treasury Department believe that the approach of the proposed regulations is straightforward and administrable, and is preferable to engaging in a case by case determination of the status of each series that would require a detailed examination of the terms of the relevant statute. Finally, the IRS and the Treasury Department believe that a rule generally treating domestic series as local law entities would be consistent with taxpayers’ current ability to create similar structures using multiple local law entities that can elect their Federal tax classification pursuant to §301.7701-3.

The IRS and the Treasury Department believe that domestic series should be classified as separate local law entities based on the characteristics granted to them under the various series statutes. However, except as specifically stated in the proposed regulations, a particular series need not actually possess all of the attributes that its enabling statute permits it to possess. The IRS and the Treasury Department believe that a domestic series should be treated as a separate local law entity even if its business purpose, investment objective, or ownership overlaps with that of other series or the series organization itself. Separate state law entities may have common or overlapping business purposes, investment objectives and ownership, but generally are still treated as separate local law entities for Federal tax purposes.

The proposed regulations do not address the entity status for Federal tax purposes of a series organization. Specifically, the proposed regulations do not address whether a series organization is recognized as a separate entity for Federal tax purposes if it has no assets and engages in no activities independent of its series.

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Until further guidance is issued, the entity status of a foreign series that does not conduct an insurance business will be determined under applicable law. Foreign series raise novel Federal income tax issues that continue to be considered and addressed by the IRS and the Treasury Department.

2. Classification of a Series that is Treated as a Separate Entity for Federal Tax Purposes

If a domestic series or a foreign series engaged in an insurance business is treated as a separate entity for Federal tax purposes, then §301.7701-1(b) applies to determine the proper tax classification of the series. However, the proposed regulations do not provide how a series should be treated for Federal employment tax purposes. If a domestic series is treated as a separate entity for Federal tax purposes, then the series generally is subject to the same treatment as any other entity for Federal tax purposes. For example, a series that is treated as a separate entity for Federal tax purposes may make any Federal tax elections it is otherwise eligible to make independently of other series or the series organization itself, and regardless of whether other series (or the series organization) do not make certain elections or make different elections.

3. Entity Status of Series Organizations

The proposed regulations do not address the entity status or filing requirements of series organizations for Federal tax purposes. A series organization generally is an entity for local law purposes. An organization that is an entity for local law purposes generally is treated as an entity for Federal tax purposes. However, an organization characterized as an entity for Federal income tax purposes may not have an income or information tax filing obligation. For example, §301.6031(a)-(1)(a)(3)(i) provides that a partnership with no income, deductions, or credits for Federal income tax purposes for a taxable year is not required to file a partnership return for that year. Generally, filing fees of a series organization paid by series of the series organization would be treated as expenses of the series and not as expenses of the series organization. Thus, a series organization characterized as a partnership for Federal tax purposes that does not have income, deductions, or credits for a taxable year need not file a partnership return for the year.

4. Continuing Applicability of Tax Law Authority to Series

Notwithstanding that a domestic series or a foreign series engaged in an insurance business is treated as an entity formed under local law under the proposed regulations, the Commissioner may under applicable law, including common law tax principles, characterize a series or a portion of a series other than as a separate entity for Federal tax purposes. Series covered by the proposed regulations are subject to applicable law to the same extent as other entities. Thus, a series may be disregarded under applicable law even if it satisfies the requirements of the proposed regulations to be treated as an entity formed under local law. For example, if a series has no business purpose or business activity other than tax avoidance, it may be disregarded under appropriate circumstances. See Bertoli v. Commissioner, 103 T.C. 501 (1994); Aldon Homes, Inc. v. Commissioner, 33 T.C. 582 (1959). Furthermore, the anti-abuse rule of §1.701-2 is applicable to a series or series organization that is classified as a partnership for Federal tax purposes.

5. Applicability to Organizations that Qualify as Insurance Companies

Notice 2008-19 requested comments on proposed guidance setting forth conditions under which a cell of a protected cell company would be treated as an insurance company separate from any other entity for Federal income tax purposes. Those who commented on the notice generally supported the proposed guidance, and further commented that it should extend to non-insurance arrangements as well, including series LLCs. Rather than provide independent guidance for insurance company status setting forth what is essentially the same standard, the proposed regulations define the term series to include a cell, segregated account, or segregated portfolio that is formed under the insurance code of a jurisdiction or is engaged in an insurance business (other than a segregated asset account of a life insurance company).

Although the proposed regulations do not apply to a series organized or established under the laws of a foreign jurisdiction, an exception is provided for certain series conducting an insurance business. Under this exception, a series that is organized or established under the laws of a foreign jurisdiction is treated as an entity if the arrangements and other activities of the series, if conducted by a domestic company, would result in its being classified as an insurance company. Thus, a foreign series would be treated as an entity if more than half of the series’ business is the issuing or reinsuring of insurance or annuity contracts. The IRS and the Treasury Department

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believe it is appropriate to provide this rule even though the proposed regulations otherwise do not apply to a foreign series because an insurance company is classified as a per se corporation under section 7701(a)(3) regardless of how it otherwise would be treated under §§301.7701-1, 301.7701-2, or 301.7701-3.

The IRS and the Treasury Department are aware that insurance-specific guidance may still be needed to address the issues identified in §3.02 of Notice 2008-19 and insurance-specific transition issues that may arise for protected cell companies that previously reported in a manner inconsistent with the regulations. See §601.601(d)(2)(ii)(b).

6. Effect of Local Law Classification on Tax Collection

The IRS and Treasury Department understand that there are differences in local law governing series (for example, rights to hold title to property and to sue and be sued are expressly addressed in some statutes but not in others) that may affect how creditors of series, including state taxing authorities, may enforce obligations of a series. Thus, the proposed regulations provide that, to the extent Federal or local law permits a creditor to collect a liability attributable to a series from the series organization or other series of the series organization, the series organization and other series of the series organization may also be considered the taxpayer from whom the tax assessed against the series may be collected pursuant to administrative or judicial means. Further, 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.

7. Employment Tax and Employee Benefits Issues

A. In general

The domestic statutes authorizing the creation of series contemplate that a series may operate a business. If the operating business has workers, it will be necessary to determine how the business satisfies any employment tax obligations, whether it has the ability to maintain any employee benefit plans and, if so, whether it complies with the rules applicable to those plans. Application of the employment tax requirements will depend principally on whether the workers are employees, and, if so, who is considered the employer for Federal income and employment tax purposes. In general, an employment relationship exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished. See §§31.3121(d)-1(c)(2), 31.3306(i)-1(b), and 31.3401(c)-1(b).

B. Employment tax

An entity must be a person in order to be an employer for Federal employment tax purposes. See sections 3121(b), 3306(a)(1), 3306(c), and 3401(d) and §31.3121(d)-2(a). However, status as a person, by itself, is not enough to make an entity an employer for Federal employment tax purposes. The entity must also satisfy the criteria to be an employer under Federal employment tax statutes and regulations for purposes of the determination of the proper amount of employment taxes and the party liable for reporting and paying the taxes. Treatment of a series as a separate person for Federal employment tax purposes would create the possibility that the series could be an “employer” for Federal employment tax purposes, which would raise both substantive and administrative issues.

The series structure would make it difficult to determine whether the series or the series organization is the employer under the relevant criteria with respect to the services provided. For example, if workers perform all of their services under the direction and control of individuals who own the interests in a series, but the series has no legal authority to enter into contracts or to sue or be sued, could the series nonetheless be the employer of the workers? If workers perform services under the direction and control of the series, but they are paid by the series organization, would the series organization, as the nominal owner of all the series assets, have control over the payment of wages such that it would be liable as the employer under section 3401(d)?

The structure of a series organization could also affect the type of employment tax liability. For example, if a series were recognized as a distinct person for Federal employment tax purposes, a worker providing services as an employee of one series and as a member of another series or the series organization would be subject to FICA tax on the wages paid for services as an employee and self-employment tax on the member income. Note further that, if

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a domestic series were classified as a separate entity that is a business entity, then, under §301.7701-3, the series would be classified as either a partnership or a corporation. While a business entity with one owner is generally classified as a corporation or is disregarded for Federal tax purposes, such an entity cannot be disregarded for Federal employment tax purposes. See §301.7701-2(c)(2)(iv).

Once the employer is identified, additional issues arise, including but not limited to the following: How would the wage base be determined for employees, particularly if they work for more than one series in a common line of business? How would the common paymaster rules apply? Who would be authorized to designate an agent under section 3504 for reporting and payment of employment taxes, and how would the authorization be accomplished? How would the statutory exceptions from the definitions of employment and wages apply given that they may be based on the identity of the employer? Which entity would be eligible for tax credits that go to the employer such as the Work Opportunity Tax Credit under section 51 or the tip credit under section 45B? If a series organization handles payroll for a series and is also the nominal owner of the series assets, would the owners or the managers of the series organization be responsible persons for the Trust Fund Recovery Penalty under section 6672?

Special administrative issues might arise if the series were to be treated as the employer for Federal employment tax purposes but not for state law purposes. For example, if the series were the employer for Federal employment tax purposes and filed a Form W-2, “Wage and Tax Statement,” reporting wages and employment taxes withheld, but the series were not recognized as a juridical person for state law purposes, then administrative problems might ensue unless separate Forms W-2 were prepared for state and local tax purposes. Similarly, the IRS and the states might encounter challenges in awarding the FUTA credit under section 3302 to the appropriate entity and certifying the amount of state unemployment tax paid.

In light of these issues, the proposed regulations do not currently provide how a series should be treated for Federal employment tax purposes.

C. Employee benefits

Various issues arise with respect to the ability of a series to maintain an employee benefit plan, including issues related to those described above with respect to whether a series may be an employer. The proposed regulations do not address these issues. However, to the extent that a series can maintain an employee benefit plan, the aggregation rules under section 414(b), (c), (m), (o) and (t), as well as the leased employee rules under section 414(n), would apply. In this connection, the IRS and Treasury Department expect to issue regulations under section 414(o) that would prevent the avoidance of any employee benefit plan requirement through the use of the separate entity status of a series.

8. Statement Containing Identifying Information about Series

As the series organization or a series of the series organization may be treated as a separate entity for Federal tax and related reporting purposes but may not be a separate entity under local law, the IRS and Treasury Department believe that a new statement may need to be created and required to be filed annually by the series organization and each series of the series organization to provide the IRS with certain identifying information to ensure the proper assessment and collection of tax. Accordingly, these regulations propose to amend the Procedure and Administration Regulations under section 6011 to include this requirement and a cross-reference to those regulations is included under §301.7701-1. The IRS and Treasury Department are considering what information should be required by these statements. Information tentatively being considered includes (1) 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; (2) the jurisdiction in which the series organization was formed; and (3) 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 IRS and Treasury Department are also considering the best time to require taxpayers to file the statement. For example, the IRS and Treasury Department are considering whether the statement should be filed when returns, such as income tax returns and excise tax returns, are required to be filed or whether it should be a stand-alone statement filed separately by a set date each year, as with information returns such as Forms 1099. A cross-reference to these regulations was added to the Procedure and Administration regulations under section 6071 for the time to file returns and statements. The proposed regulations under section 6071 provide that the statement will be a stand-

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alone statement due March 15th of each year. In addition, the IRS and Treasury Department are considering revising Form SS-4, “Application for Employer Identification Number,” to include questions regarding series organizations.

Proposed Effective Date

These regulations generally apply on the date final regulations are published in the Federal Register. Generally, when final regulations become effective, taxpayers that are treating series differently for Federal tax purposes than series are treated under the final regulations will be required to change their treatment of series. In this situation, a series organization that previously was treated as one entity with all of its series may be required to begin treating each series as a separate entity for Federal tax purposes. General tax principles will apply to determine the consequences of the conversion from one entity to multiple entities for Federal tax purposes. See, for example, section 708 for rules relating to partnership divisions in the case of a series organization previously treated as a partnership for Federal tax purposes converting into multiple partnerships upon recognition of the series organization’s series as separate entities. While a division of a partnership may be tax-free, gain may be recognized in certain situations under section 704(c)(1)(B) or section 737. Sections 355 and 368(a)(1)(D) provide rules that govern certain divisions of a corporation. The division of a series organization into multiple corporations may be tax-free to the corporation and to its shareholders; however, if the corporate division does not satisfy one or more of the requirements in section 355, the division may result in taxable events to the corporation, its shareholders, or both.

The regulations include an exception for series established prior to publication of the proposed regulations that treat all series and the series organization as one entity. If the requirements for this exception are satisfied, after issuance of the final regulations the series may continue to be treated together with the series organization as one entity for Federal tax purposes. Specifically, these requirements are satisfied if (1) The series was established prior to September 14, 2010; (2) 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 foreign series, 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; (3) If the series was established pursuant to a foreign statute, the series’ classification was relevant (as defined in §301.7701-3(d)), 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; (4) 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 for any taxable year; (5) The series and series organization had a reasonable basis (within the meaning of section 6662) for their claimed classification; and (6) 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).

This exception will cease to apply on the date any person or persons who were not owners of the series organization (or series) prior to September 14, 2010, own, in the aggregate, a 50 percent or greater interest in the series organization (or series). For this purpose, the term interest means (i) in the case of a partnership, a capital or profits interest and (ii) in the case of a corporation, an equity interest measured by vote or value. This transition rule does not apply to any determination other than the entity status of a series, for example, tax ownership of a series or series organization or qualification of a series or series organization conducting an insurance business as a controlled foreign corporation.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations.

Pursuant to the Regulatory Flexibility Act (5.U.S.C. chapter 6), it is hereby certified that the regulations will not have a significant economic impact on a substantial number of small entities. The regulations require that series and series organizations file a statement to provide the IRS with certain identifying information to ensure the proper assessment and collection of tax. The regulations affect domestic series LLCs, domestic cell companies, and foreign series and cells that conduct insurance businesses, and their owners. Based on information available at this time, the IRS and the Treasury Department believe that many series and series organizations are large insurance

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companies or investment firms and, thus, are not small entities. Although a number of small entities may be subject to the information reporting requirement of the new statement, any economic impact will be minimal. The information that the IRS and the Treasury Department are considering requiring on the proposed statement should be known by or readily available to the series or the series organization. Therefore, it should take minimal time and expense to collect and report this information. For example, the IRS and the Treasury Department are considering requiring the following information: (1) 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; (2) The jurisdiction in which the series organization was formed; and (3) 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 IRS and the Treasury Department request comments on the accuracy of the statement that the regulations in this document will not have a significant economic impact on a substantial number of small entities. Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small businesses.

Comments and Requests for a Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) that are submitted timely to the IRS. Alternatively, taxpayers may submit comments electronically directly to the Federal eRulemaking portal at www.regulations.gov.

The IRS and the Treasury Department request comments on the proposed regulations. In addition, the IRS and the Treasury Department request comments on the following issues:

(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 for 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 the Federal employment tax issues discussed and similar technical issues should be resolved;

(5) How 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 (comments from the states would be particularly helpful);

(6) What issues could arise with respect to the provision of employee benefits by a series organization or series; and

(7) The requirement for the series organization and each series of the series organization to file a statement and what information should be included on the statement.

All comments will be available for public inspection and copying. A public hearing may be scheduled if requested in writing by a person who timely submits comments. If a public hearing is scheduled, notice of the date, time and place for the hearing will be published in the Federal Register.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 301 is proposed to be amended as follows:

PART 301—PROCEDURE AND ADMINISTRATION

Paragraph 1. The authority citation for part 301 is amended by adding entries in numerical order to read in part as follows:

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Authority: 26 U.S.C. 7805 * * *

Section 301.6011-6 also issued under 26 U.S.C. 6011(a). * * *

Section 301.6071-2 also issued under 26 U.S.C. 6071(a). * * *

Par. 2. Section 301.6011-6 is added to read as follows:

§301.6011-6 Statements of series and series organizations.

(a) Statement required. Each series and series organization (as defined in paragraph (b) of this section) shall file a statement for each taxable year containing the identifying information with respect to the series or series organization as prescribed by the Internal Revenue Service for this purpose and shall include the information required by the statement and its instructions.

(b) Definitions—(1) Series. The term series has the same meaning as in §301.7701-1(a)(5)(viii)(C).

(2) Series organization. The term series organization has the same meaning as in §301.7701-1(a)(5)(viii)(A).

(c) Effective/applicability date. This section applies to taxable years beginning after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

Par. 3. Section 301.6071-2 is added to read as follows:

§301.6071-2 Time for filing statements of series and series organizations.

(a) In general. Statements required by §301.6011-6 must be filed on or before March 15 of the year following the period for which the return is made.

(b) Effective/applicability date. This section applies to taxable years beginning after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

Par. 4. Section 301.7701-1 is amended by:

1. Adding paragraph (a)(5).

2. Revising paragraphs (e) and (f).

The additions and revisions read as follows:

§301.7701-1 Classification of organizations for Federal tax purposes.

(a) * * *

(5) Series and series organizations—(i) Entity status of a domestic series. For Federal tax purposes, except as provided in paragraph (a)(5)(ix) of this section, a series (as defined in paragraph (a)(5)(viii)(C) of this section) 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.

(ii) Certain foreign series conducting an insurance business. For Federal tax purposes, except as provided in paragraph (a)(5)(ix) of this section, a series organized or established under the laws of a foreign jurisdiction is treated as an entity formed under local law 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 section 816(a) or section 831(c).

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(iii) Recognition of entity status. Whether a series that is treated as a local law entity under paragraph (a)(5)(i) or (ii) of this section is recognized as a separate entity for Federal tax purposes is determined under this section and general tax principles.

(iv) Classification of series. The classification of a series that is recognized as a separate entity for Federal tax purposes is determined under paragraph (b) of this section.

(v) Jurisdiction in which series is organized or established. A series is treated as created or organized under the laws of a State or foreign jurisdiction if the series is established under the laws of such jurisdiction. See §301.7701-5 for rules that determine whether a business entity is domestic or foreign.

(vi) Ownership of series and the assets of series. For Federal tax purposes, the ownership of interests in a series and of the assets associated with a series is determined under general tax principles. A series organization is not treated as the owner for Federal tax purposes of a series or of the assets associated with a series merely because the series organization holds legal title to the assets associated with the series.

(vii) Effect of Federal and local law treatment. To the extent that, pursuant to the provisions of this paragraph (a)(5), a series is a taxpayer against whom tax may be assessed under Chapter 63 of Title 26, then any tax assessed against the series may be collected by the Internal Revenue Service from the series in the same manner the assessment could be collected by the Internal Revenue Service from any other taxpayer. In addition, to the extent Federal or local law permits a debt attributable to the series to be collected from the series organization or other series of the series organization, then, notwithstanding any other provision of this paragraph (a)(5), and consistent with the provisions of Federal or local law, the series organization and other series of the series organization may also be considered the taxpayer from whom the tax assessed against the series may be administratively or judicially collected. Further, 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.

(viii) Definitions—(A) Series organization. A series organization is a juridical entity that establishes and maintains, or under which is established and maintained, a series (as defined in paragraph (a)(5)(viii)(C) of this section). A series organization includes a series limited liability company, series partnership, series trust, protected cell company, segregated cell company, segregated portfolio company, or segregated account company.

(B) Series statute. A series statute is 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—

(1) Members or participants of a series organization to have rights, powers, or duties with respect to the series;

(2) A series to have separate rights, powers, or duties with respect to specified property or obligations; and

(3) 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.

(C) Series. A series is a segregated group of assets and liabilities that is established pursuant to a series statute (as defined in paragraph (a)(5)(viii)(B) of this section) by agreement of a series organization (as defined in paragraph (a)(5)(viii)(A) of this section). 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 term series does not include a segregated asset account of a life insurance company. See section 817(d)(1); §1.817-5(e). 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 for purposes of this paragraph (a)(5)(viii)(C).

(ix) Treatment of series and series organizations under Subtitle C — Employment Taxes and Collection of Income Tax (Chapters 21, 22, 23, 23A, 24 and 25 of the Internal Revenue Code). [Reserved.]

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(x) Examples. The following examples illustrate the principles of this paragraph (a)(5):

Example 1. Domestic Series LLC. (i) Facts. Series LLC is a series organization (within the meaning of paragraph (a)(5)(viii)(A) of this section). Series LLC has three members (1, 2, and 3). Series LLC establishes two series (A and B) pursuant to the LLC statute of state Y, a series statute within the meaning of paragraph (a)(5)(viii)(B) of this section. Under general tax principles, Members 1 and 2 are the owners of Series A, and Member 3 is the owner of Series B. Series A and B are not described in §301.7701-2(b) or paragraph (a)(3) of this section and are not trusts within the meaning of §301.7701-4.

(ii) Analysis. Under paragraph (a)(5)(i) of this section, Series A and Series B are each treated as an entity formed under local law. The classification of Series A and Series B is determined under paragraph (b) of this section. The default classification under §301.7701-3 of Series A is a partnership and of Series B is a disregarded entity.

Example 2. Foreign Insurance Cell. (i) Facts. Insurance CellCo is a series organization (within the meaning of paragraph (a)(5)(viii)(A) of this section) organized under the laws of foreign Country X. Insurance CellCo has established one cell, Cell A, pursuant to a Country X law that is a series statute (within the meaning of paragraph (a)(5)(viii)(B) of this section). More than half the business of Cell A during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. If the activities of Cell A were conducted by a domestic company, that company would qualify as an insurance company within the meaning of sections 816(a) and 831(c).

(ii) Analysis. Under paragraph (a)(5)(ii) of this section, Cell A is treated as an entity formed under local law. Because Cell A is an insurance company, it is classified as a corporation under §301.7701-2(b)(4).

* * * * *

(e) State. For purposes of this section and §§301.7701-2 and 301.7701-4, the term State includes the District of Columbia.

(f) Effective/applicability dates—(1) In general. Except as provided in paragraphs (f)(2) and (f)(3) of this section, the rules of this section are applicable as of January 1, 1997.

(2) Cost sharing arrangements. The rules of paragraph (c) of this section are applicable on January 5, 2009.

(3) Series and series organizations—(i) In general. Except as otherwise provided in this paragraph (f)(3), paragraph (a)(5) of this section applies on and after the date final regulations are published in the Federal Register.

(ii) Transition rule—(A) In general. Except as provided in paragraph (f)(3)(ii)(B) of this section, a taxpayer’s treatment of a series in a manner inconsistent with the final regulations will be respected on and after the date final regulations are published in the Federal Register, provided that—

(1) The series was established prior to September 14, 2010;

(2) 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;

(3) If the series was established pursuant to a foreign statute, the series’ classification was relevant (as defined in §301.7701-3(d)), 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;

(4) 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;

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(5) The series and series organization had a reasonable basis (within the meaning of section 6662) for their claimed classification; and

(6) 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).

(B) Exception to transition rule. Paragraph (f)(3)(ii)(A) of this section will not apply on and after the date any person or persons who were not owners of the series organization (or series) prior to September 14, 2010, own, in the aggregate, a fifty percent or greater interest in the series organization (or series). For purposes of the preceding sentence, the term interest means—

(1) In the case of a partnership, a capital or profits interest; and

(2) In the case of a corporation, an equity interest measured by vote or value.

Steven T. Miller, Deputy Commissioner for Services and Enforcement.

Note

(Filed by the Office of the Federal Register on September 13, 2010, 8:45 a.m., and published in the issue of the Federal Register for September 14, 2010, 75 F.R. 55699)

Drafting Information

The principal author of these proposed regulations is Joy Spies, IRS Office of the Associate Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and the Treasury Department participated in their development.

* * * * *

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