Classifying Llcs Under New Irs Ruling Guidelines
| Publication year | 1995 |
| Pages | 741 |
| Citation | Vol. 24 No. 4 Pg. 741 |
1995, April, Pg. 741. Classifying LLCs Under New IRS Ruling Guidelines
The primary purpose for forming a limited liability company ("LLC") is complete limited liability protection for each and every member and manager, plus the single layer tax advantages of a partnership. To achieve these dual goals, it is essential that the LLC be classified as a partnership for federal tax purposes.(fn1)
In determining the tax classification of an unincorporated entity, Treasury Regulations(fn2) direct that an entity's characteristics be measured against the characteristics commonly possessed by corporations. These corporate characteristics are:
Whether the entity is to be classified as a corporation or as a partnership is determined by taking into account the presence or absence of these characteristics.(fn4)(i)associates, (ii) an objective to carry on business and divide the gains therefrom, (iii) continuity of life, (iv) centralization of management, (v) limited liability, and (vi) free transferability of interests.(fn3)
In conducting this analysis, the first two characteristics of associates and an objective to carry on business for joint profit are generally not considered since they are common to both corporations and partnerships. As a result, the determination of whether an entity is to be taxed as a corporation or as a partnership will turn on whether the unincorporated entity possesses continuity of life, centralization of management, limited liability and free transferability of interests.(fn5) For federal tax purposes, an entity will be classified as a partnership if it lacks at least two of these four corporate characteristics.(fn6)
This article first defines how each of the four corporate characteristics operate. It then discusses the application of these characteristics to Colorado LLCs formed under the Colorado Limited Liability Company Act ("LLC Act") both before and after its amendment in 1994. The article concludes with an analysis of new Revenue Procedure ("Rev. Proc.") 95-10(fn7) which sets forth the conditions under which an LLC classification ruling will be issued by the Internal Revenue Service ("Service"). Planning alternatives are suggested wherever appropriate.
Limited liability exists if, under local law, no member is personally liable for the debts of or claims against the entity. On the other hand, this characteristic is lacking if an entity's creditor is able to seek personal satisfaction from at least one member of the entity when the entity's assets are insufficient to satisfy that creditor's claim.(fn8)
Limited liability cannot be negated by a member issuing personal guarantees to selected creditors. First, only those creditors who have been provided guarantees have recourse against the assets of the guaranteeing member. By contrast, local law usually exposes a member's assets to claims by any of the entity's creditors. Second, any payments made under the guarantee merely places the member in the shoes of the creditor via the guarantor's legal subrogation rights. In this instance, liability "arises as a matter of contract rather than under local law.'"(fn9) Hence, any effort at avoiding limited liability will require that at least one member guarantee every entity debt and specifically waive his or her legal subrogation rights.(fn10)
Centralization of management exists if any person (or any group of persons that does not include all members) has continuing exclusive authority to make independent management decisions necessary to conduct the entity's business.(fn11) Those who have such authority may, or may not, be members of the entity and
Centralized management can be accomplished by election, proxy appointment or by any other means which has the effect of concentrating in a management group continuing exclusive authority to make management decisions.(fn13) If the management group lacks such sole authority, the entity will not possess centralized management.(fn14) This would occur where the management group's decisions would have to be ratified by the entity's members. Likewise, centralized management will not exist if the centralized authority merely performs ministerial acts as an agent at the direction of a principal.(fn15)
Centralized management may nevertheless exist if, based on all the facts and circumstances, the members have the unrestricted power to remove members of the management group. However, in determining the presence or absence of centralized management, a limited power of removal for gross negligence, self-dealing or embezzlement will not in itself give the entity the corporate characteristic of centralization of management.(fn16)
The theory behind centralization of management is that the management group manages in a representative capacity for the entity's members. This occurs whenever the management group has the exclusive authority to make independent management decisions for the entity which do not require member ratification. However, there is authority for the position that centralized management does not exist, even for an entity with a controlling management group, if the persons making up that group own a substantial interest in the entity.
The U.S. Tax Court has held, in the context of a limited partnership, that "the 'centralization of management' test will not be met if the general partner has a meaningful proprietary interest" in the partnership.(fn17) The underlying theory is that, if the general partner of a limited partnership owns such an interest, that general partner will be managing not only as a representative of the limited partners, but also for his or her own pecuniary benefit.
How large an interest the general partner must own is not clear. Two examples in the Treasury Regulations indicate that centralization of management will exist where general partners own only 5.7 percent and 2.9 percent of all interests in the limited partnerships.(fn18) By contrast, the Service has indicated that, for advance letter ruling purposes, centralization of management will be found lacking if the general partners own at least 20 percent of all interests in the limited partnership.(fn19) Based on the above, it seems likely that owning a 20 percent interest in the entity will constitute a meaningful proprietary interest, while owning 5.7 percent or less will not.
Even if the management group owns substantial interests in the entity, if the members have the unrestricted power to replace or remove them, centralization of management will exist. The reasoning here is that this power to replace or remove negates any assumption that the management group can act on its own behalf. By being subject to the will of the members it serves, the management group is relegated to managing in a representative capacity.(fn20) Thus, substantially restricting this removal power should prevent an entity from possessing centralized management.
Free transferability of interests exists if each of the members, or those members owning substantially all of the entity's interests, has the power to confer on that member's transferee all the attributes of the member's interest without the consent of the other members.(fn21) For this power of substitution to exist in the corporate sense, the member must be able, without the consent of other members, to confer on his or her substitute all the attributes of that interest in the entity. Thus, the characteristic of free transferability of interests will not exist where each member can assign only his or her rights to share in profits, but cannot assign management rights without the consent of other members. Additionally, there is no power of substitution and no free transferability of interests if, under local law, a transfer of a member's interest causes the entity to dissolve.(fn22)
As indicated, not all interests must be restricted to avoid the free transferability of interests characteristic. However, the percentage of interests that can be freely transferable has been uncertain. Recently, the Service has announced in the context of a limited partnership that free transferability of interests will generally be found lacking if more than 20 percent of all interests in partnership capital, income, gain, loss, deduction and credit is restricted.(fn23) In other words, up to 79 percent of all interests in capital, income, gain, loss, deduction and credit can be freely transferable.
This substitutions power test creates problems for a commonly controlled entity. If an entity is commonly owned, for example, its only members are an individual and his or her wholly owned corporation, the entity may be found to possess free transferability of interests, notwithstanding any transfer restrictions set forth in the entity's organizational or operational documents. Despite the transfer restrictions, the individual, acting for himself and his corporation, has the power of deciding whether an interest in the entity will be transferred.(fn24) Based on this concentration of effective control, the Service could find that this entity has the corporate characteristic of free transferability of interests.
Continuity of life exists if the death, insanity, bankruptcy, retirement, resignation or expulsion of any member will not cause an entity to dissolve. Conversely, this...
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